The guideline public company method employs the invested capital model where returns to debt and equity include EBIT, EBITDA, and revenues.. The follow- ing ratios were computed for each
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were adequately similar to Cardinal to determine value based on the price paid for alternative investments in the public markets.
The guideline public company method employs the invested capital model where returns to debt and equity include EBIT, EBITDA, and revenues These returns are compared to the mar- ket value of invested capital (MVIC), rather than the equity price per share, because the returns are to debt and equity Based on re- search and analysis of the guideline companies, considering their performance and strategic strengths and weaknesses, along with industry conditions and trends, they were compared to Cardinal based on various operational performance measures The follow- ing ratios were computed for each of the guideline companies, in- cluding the mean and median for each ratio:
MVIC to EBIT MVIC to EBITDA MVIC to Revenues
To begin the search for guideline companies we selected the following criteria:
Public Guideline Companies
Industry SIC 2841: Printing and Publishing
Size Annual sales between $7.5 million and $750
million (within a factor of 10 times the size of Cardinal)
Time Transactions as of the valuation date
Type Minority interest transactions
Exhibit 16-11 Stand-Alone Fair Market Value: Implied Multiple
of Adjusted EBIT/EBITDA (in thousands)
Implied Implied Year 5 EBIT Multiple EBITDA Multiple
Normalized EBIT for Year 5 $7,650 4.67
Normalized EBITDA for
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Status Profitable companies, financially solvent and
reasonably leveraged, that are freely and actively traded
Growth Companies whose recent historical growth rates
and forecasted growth rates are reasonably similar Domicile U.S corporations
The guideline companies that were selected are:
Guideline Companies
The following is a brief description of each company.
• CRP Publications: a diversified media company that
produces nine journals that cover emerging technology
industries It also provides market research services.
• Night Rider, Inc.: operates through three subsidiaries,
which publish special-interest magazines relating to the
motorcycle, trucking, and tattoo industries.
• Industry Trends: publishes 21 industry-specific journals and newsletters, which it markets through affiliations with
industry trade associations.
• Hanover Media: publishes, produces, and distributes
Christian-oriented magazines, online services, and books, and markets a line of religious gift and stationery products.
• Leisure Living: markets resorts and time-sharing resort
properties as well as three consumer magazines that cover the travel and leisure industry.
From available public sources, extensive information about the five public guideline companies was gathered, including their annual reports, U.S Security and Exchange Commission’s Forms
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10-K, and information from various stock reporting services and industry analysts’ reports The operating performance, financial position, and cash flow of each company was analyzed Their com- petitive advantages and disadvantages were considered in light of industry and economic conditions From this data, the informa- tion in Exhibit 16-12, about the companies’ operating perform- ance, is summarized.
From the data in Exhibit 16-12, operating multiples that pare the market value of invested capital to EBIT, EBITDA, and revenue per share are computed and presented in Exhibit 16-13, along with the resulting mean and median multiples of each op- erating measure These multiples reflect investor consensus of the value of these five companies in this industry and present a basis for selection of appropriate multiples for Cardinal based on these alternative investment choices.
com-Exhibit 16-12 Guideline Company Operating Performance
Per Share
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Exhibit 16-14 Comparison of Cardinal With Guideline
Companies
Comparison to the Guideline Discussion Companies
Cardinal’s current ratio and quick ratio are
both just above the industry average shown
in Exhibit 16-6 Cardinal’s cash position has
declined while its current liabilities have
increased in the last year
Cardinal’s total assets, accounts receivable,
inventory, and fixed assets are all carried at
substantially higher levels relative to the
company’s sales than any of the guideline
public companies This reflects substantial
inefficiency in the utilization of all of these
assets and sharply reduces the cash flow to
capital providers
Cardinal’s debt, though decreasing steadily
over the last five years as a percentage of
total assets, is higher than four of the five
guideline companies
Cardinal’s stronger profit margins
compensate somewhat for the company’s
weaker asset utilization to generate profits
similar to the guideline companies
Cardinal’s 15% annual compound growth
rate over the last five years is less than three
of the five guideline companies, but its
projected long-term growth is similar to that
of the guideline companies and the industry
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Based on this comparison of Cardinal with the guideline public companies, the following value multiples shown in Exhibit 16-15 were selected as appropriate for Cardinal when compared to the guide- line companies considering Cardinal’s performance and risk profile.
Estimate of Equity Value of Guideline Company Method
The market value of the company’s long-term debt is subtracted in Exhibit 16-16 from the previously determined value of invested capital, to obtain an equity value, which for the market approach
identi-Exhibit 16-15 Calculation of Invested Capital Value of Cardinal
Based on the Guideline Company Approach
Normalized Operating Value Estimated Invested Procedure Results for Year 5 Multiple Capital Value
Exhibit 16-16 Calculation of Equity Value of Cardinal Based on
the Guideline Company Approach
Estimated Invested Market Value of Estimated Procedure Capital Value Long-Term Debt Equity Value
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newspapers and electronic reporting services located in the western United States Western was traded on the NASDAQ stock exchange, and, in that transaction, Granite paid a 72% premium over Western’s preacquisition stock price This transaction, which was paid for in Granite’s stock, reflected a multiple of nine times Western’s forecasted EBITDA Over the last 10 years, Granite has made numerous such acquisitions of local and regional newspaper chains, which is part of a long-term trend of consolidation in the newspaper industry Further analysis of this transaction and others made by Granite led to the conclusion that the price paid and the resulting multiples from this transaction reflect synergies unique
south-to Granite and do not provide a reliable basis for determination of Cardinal’s value In general, it is inappropriate to attempt to es- tablish “the market” based on the results of a single transaction.
Rejection of the Adjusted Book Value Method
To consider the fair market value on a stand-alone basis of nal from the perspective of the value of the assets owned by the company, an adjusted book value computation could be per- formed This method, which assumes value is derived from a hy- pothetical sale of the specific tangible and intangible assets of the company, does not specifically recognize general intangible value that may exist as a result of the company’s technology, customer base, reputation, and other general goodwill factors While gen- eral goodwill value can be computed through a computation
Cardi-known as the excess earnings method, this is generally not done in
val-uations for merger and acquisition This is a method that is plied usually only in the valuation of very small businesses, such as professional practices, so it will not be used to appraise Cardinal.
ap-Summary and Conclusion of Stand-Alone Fair Market Value
The results of the valuation procedures employed to compute the fair market value of Cardinal’s equity are summarized in Ex- hibit 16-17 After employing the various reconciliation method- ologies explained in Chapter 13, the fair market value of equity
is determined to be $20.1 million, including Cardinal’s erating assets.
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COMPUTATION OF INVESTMENT VALUE
This computation of investment value will use the multiple-period discounting method and will recognize the synergies that can be achieved through this acquisition.
Risk and Value Drivers
To develop the discount rate for equity and the weighted average cost of capital (WACC) to be used by Omni in its evaluation of Cardinal, adjustments, shown in Exhibit 16-18, have to be made
to the rates developed previously in Exhibits 16-8 and 16-9 for Cardinal Omni is a midcap-size publicly traded company, so the size adjustment for Omni is substantially less than for Cardinal.
In addition, most of the specific company risk factors for nal can be eliminated when it operates as a division of Omni In developing the specific company risk premium for Omni, the ad- ditional risk created by the presence of competitors much larger than Cardinal is eliminated by Omni’s size and market strength However, because Omni does not possess substantial expertise or experience in the rural market served by Cardinal, it imposed a 1% risk premium to reflect its movement into a less certain mar- ket Omni’s financial strength eliminates the financial and man- agement risk factors that exist with Cardinal as a stand-alone business.
Cardi-While some doubt exists as to whether Cardinal’s strong tomer loyalty can be maintained when the company operates as a division of a conglomerate, Omni management is attracted to the very high untapped sales potential of this customer base While Cardinal lacks the expertise and resources to take advantage of this sales potential, Omni sees this as a substantial synergistic ad- vantage that reduces the riskiness of this acquisition.
cus-The discount rate to equity of 14.5% from Exhibit 16-18 is combined with Omni’s cost of debt at the prime rate of 9%, based
on the market value of Omni’s debt and equity shown in Exhibit 16-19 to yield the WACC discount rate of 12.23% and the WACC cap rate of 8.23%.
It should be obvious from a comparison of Omni’s WACC count of 12.23% in Exhibit 16-19 versus Cardinal’s of 17.97% from
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Exhibit 16-18 Rates of Return (Discount Rate) Applicable to
Net Cash Flow to Equity (As of the Appraisal Date)
Equity Risk Premium (Rm Rf)b 7.50%
Average Market Return for Large-Cap Stock 13.50%
Average Market Return Adjusted for Size to
Specific Company Risk Premium Adjustmentsd:
Customer Base (sales potential) (1.00) 0.00
Rate of Return for Net Cash Flow to Equity e 14.50%
aThis is the 20-year U.S Treasury Bond
b The Equity Risk Premium is applied to recognize the additional risk associated with vesting in publicly traded common stock (equities) instead of the risk-free 20-year U.S.Bond
in-cEmpirical evidence indicates Omni’s size will still justify a size premium of approximately1%
dOmni’s lack of experience or expertise in this market raises its overall risk profile Part ofthe synergy of Omni acquiring Cardinal is that the following risk drivers will be either elim-inated or reduced: thin management and Cardinal’s premerger heavy debt Omni con-cludes that the sales potential of the underserved customer base reduces risk
eThis is a rate of return or discount rate directly applicable to net cash flow as it is based
on the return to investors, net of income tax to their corporations
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Exhibit 16-19 Weighted Average Cost of Capital (WACC) and
Capitalization Rate Applicable to Net Cash Flow
Computation of WACC and Conversion to Cap Rate
to WACC
Debt @ Borrowing Rate (1 t)d
WACC Discount Rate for Net Cash Flow to Invested Capital 12.23%
Less: Long-Term Sustainable Growthe 4.00%
Capitalization Rate for Net Cash Flow to Invested Capitalf 8.23%
aThe discount rate applicable to forecasted net cash flow is from Exhibit 16-18
bOmni’s debt-equity mix is derived from Omni’s market values of debt and equity
c The ratio is the equity-debt split (see note b).
dOmni borrows at prime
eThe long-term sustainable growth rate was provided in the case narrative
fThe WACC capitalization rate is applicable to net cash flow to invested capital, that is, thenet cash flow inclusive of the returns to debt and equity
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Exhibit 16-9 that Cardinal’s operations are substantially safer when located within the size and depth of Omni than when operating as
a stand-alone company Thus, the first factor contributing to the increase in Cardinal’s investment value to Omni over its stand- alone fair market value is the reduction in risk.
Normalization, Synergy, and Net Cash Flow Adjustment Issues
Exhibit 16-20 shows the normalization adjustments and tion of net cash flow to invested capital forecasted for Omni’s ac- quisition of Cardinal.
computa-Lou Bertin’s Compensation
Bertin’s estimated above-market compensation of $750,000 ally will be adjusted the same as it was in the valuation of the com- pany on a stand-alone basis Omni concluded that Cardinal’s man- agement was thin enough that market-level compensation for a chief executive officer was required Omni further concluded that
annu-if possible, Bertin should be retained to make use of his specialized knowledge and to assist in the transition process In structuring this transaction, an option would be to continue to pay Bertin the above-market compensation, with this payment being a tax-de- ductible expense to the buyer and compensation taxed only once
at the individual level to the seller The purchase price could be duced by this excess compensation, although the parties should consult tax and legal counsel regarding the legality of this payment arrangement.
re-Jeffrey Meier’s Compensation
No adjustment is required for Meier’s compensation It is pated that he would not continue with the company after an ac- quisition but a suitable replacement would be paid his salary.
antici-Market Research
Market research information is of continuing critical importance
to Omni, particularly since the acquirer believes that they can make better use of the untapped sales potential in this market No adjustment is required.
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Operating Assets
There remains no adjustment required to the company’s return for these items, which Omni indicates it does not wish to purchase Therefore, they are not considered part of the company’s operat- ing value but would be added to it in computing total enterprise value of invested capital and equity.
Director’s Fees
Cardinal incurred annual administrative costs of $40,000, related
to its board of directors, which will be eliminated immediately upon sale of the company.
Severance Costs
Omni management estimates that $800,000 in severance costs will
be incurred in each of the first two years after the acquisition lated to terminated employees.
re-Transaction Costs
Omni management estimates that legal, tax, and intermediary costs related to the acquisition of Cardinal will total $1.8 million and will be incurred at the time of the acquisition.
Revenue Enhancements
Taking advantage of Omni’s much more advanced customer tionship management software, diversified distribution system, and superior capability to generate advertising income, Cardinal’s rev- enue growth in Year 6 above the preacquisition forecasted annual 4% increase in pretax income to invested capital, shown on the first line
rela-of Exhibit 16-20, will raise this income $1 million per year for Years 7 through 9 and $400,000 per year thereafter After this, Cardinal’s growth should approximate the industry average annual rate of 4%.
Economies in Cost of Sales
Once capital expenditure improvements have been implemented
in Year 6, cost of sales is expected to decline, as forecasted in Exhibit 16-20 Once again, in a real valuation situation, these forecasted changes would be supported by substantial detail and analysis.