How to Value a Company

Introduction 

The report presents an analysis on discounted cash flow for a pre-merger between Rockwell Systems Electronics and Fast Vent Constructions. The RSE was planning for possible acquisition of FVS. However, the feasibility of the move is ongoing, as many considerations needs to be factored in before initiating the merger. Based on the series of meetings that have been conducted so far, it is apparent that FVC was to become a subsidiary of RSE. It was also agreed that FVC would preserve its identity. In addition, FVC is expected to preserve top management team and all other employees as no layoff were contemplated. RSE found out that FVS has a good management and hence do not plan to change the management. Gordon Smith, who is currently the FVC CEO is expected to have a salary increase of between $50,000 and $200,000 per year if the merger goes through. Despite all these, the price of the deal is still a problem. One of the challenge facing the pricing strategy is that the two companies have different stock exchange affiliation. FVC, for example, traded on the NASDAQ, while RSE traded on American Stock Exchange. Consequently, it is important to collect and analyze financial data in order to establish the value of each company. This will make it easier to determine the pricing and establish the feasibility and viability of the merger. A discounted cash flow is best approach that can be employed in determining and estimating the attractiveness of the merger. The approach relies on the future free cash flow projections. It then subjects them to discount rate in order to get a present value estimate. The weighted average cost of capital (WACC) would be used to represent the discount rate. The first step that would be taken is to determine or project the company’s future cash flow growth. 

Estimation of WACC 

WACC plays an important role in determination of DCF (Petitt & Ferris, 2013). Consequently, it is important to first establish the WACC because it will be used in future calculation. Using excel functions and formulas, WACC was determined as summarized in exhibit TN6. The table below summarizes the calculations made. 

ROCKWELL SYSTEMS AND ELECTRONICS
Estimation of WACC for Fast Vent and RSE
	FVC	RSE
Pretax cost of debt	0.0%	7.0%
Tax rate	40%	40%
After-tax cost of debt	0.0%	4.2%
Beta	1.00	1.25
Risk-free rate	4.5%	4.5%
Market risk premium	5.5%	5.5%
Cost of equity	10.0%	11.4%
Debt/capital	0%	10%
Equity/capital	100%	90%
WACC	10.0%	10.7%
Assumptions:	Source:
Pretax cost of debt	Case Exhibit 9: Baa debt yield.
Tax rate	Case text.
Beta	For RSE and Flinder, case footnote 2, page 5. For comparison with Flinder, see case Exhibit 7, where the average unlevered beta of peer firms is 0.94.
Risk-free rate	Case Exhibit 10: 30-year bonds.
Market risk premium	Case Exhibit 10

 From the table above, it is apparent that the WACC for Fast Vent Constructions is 10.0 percent, while that of RSE is 10.7 percent. 

Enterprise value and, DCF, Net Present Value (NPV) 

Using the assumptions that the growth rate is 4.5 percent, WACC rate is 10 percent and tax rate is 40 percent, enterprise value can be established by using the NPV, total free cash flow and WACC ratio as shown in the excel. The current price per share is $39.75 as indicated in Exhibit 6. The Pre-runup share price is $31.50 as indicated in Exhibit 6. The value per share or discounted cash flow is established by dividing enterprise value by the number of shares. The DCF obtained is $44.95. It is also important to note that since there was no debt, the equity value is equal to enterprise value, which is $109,671. The table below summarizes the different calculations done in excel. 

ROCKWELL SYSTEMS AND ELECTRONICS
RSE Pre-merger Valuation of Fast Vent
(dollar figures in thousands, expect per-share amounts)
Assumptions
Growth rate	4.5%
WACC	10.0%
Tax rate	40%
							Steady state
Free Cash Flow	2007	2008e	2009e	2010e	2011e	2012e	2013e
		20.74%	10.74%	10.91%	10.93%	10.84%	4.52%
Sales	$49,364	$59,600	$66,000	$73,200	$81,200	$90,000	$94,068
Cost of goods sold	37,044	43,816	48,750	54,104	59,958	66,200	69,192
Gross profit	12,320	15,784	17,250	19,096	21,242	23,800	24,876
Selling, general, & admin. (SG&A) expenses	2,936	3,612	4,124	4,564	5,052	5,692	5,949
Other income	228	240	264	288	320	352	368
Earnings before interest and taxes (EBIT)	9,612	12,412	13,390	14,820	16,510	18,460	19,294
Taxes		(4,965)	(5,356)	(5,928)	(6,604)	(7,384)	(7,718)
Net operating profit after taxes (NOPAT)		7,447	8,034	8,892	9,906	11,076	11,577
Net working capital	16,840	20,331	22,515	24,971	27,700	30,702	32,090
Net PPE	18,268	22,056	24,424	27,088	30,049	33,306	34,811
NOPAT		7,447	8,034	8,892	9,906	11,076	11,577
+ Depreciation		1,660	1,828	2,012	2,212	2,432
− Capital expenditures (CAPEX)		5,448	4,196	4,676	5,173	5,689	1,505
− Increase in net WC		3,491	2,184	2,456	2,729	3,002	1,388
Free Cash Flow		168	3,482	3,772	4,216	4,817	8,683
Terminal value						157,881
Total Free Cash Flow		$168	$3,482	$3,772	$4,216	$162,698
Enterprise value	$109,671
Less debt	$0
Equity value	$109,671
Number of shares	2,440
Value per share (DCF)	$44.95
Current price per share	$39.75
Pre-runup share price	$31.50

It is also important to establish the DCF, equity value and current price per share for RSE International. The exhibit TN5 in the excel summarizes the different calculations and formulas used. The calculations were based on assumptions that the growth rate is 4.5 percent, the WACC is 10.7 percent and the tax rate is 40 percent. Using the information from exhibit 5, free cash flow was determined. The table below summarizes the analyses carried out. 

ROCKWELL SYSTEMS AND ELECTRONICS
Pre-merger Valuation of RSE International
Assumptions:
Growth rate	4.5%
WACC	10.7%
Tax rate	40%
	2007	2008e	2009e	2010e	2011e	2012e	2013e
Sales	$2,187,208	$2,329,373	$2,480,785	$2,642,037	$2,813,769	$2,996,658	$3,132,107
Cost of goods sold	1,793,510	1,920,085	2,064,243	2,216,470	2,367,290	2,537,259	2,651,943
Gross profit	393,698	409,288	416,542	425,567	446,479	459,399	480,164
Selling, general, & admin. (SG&A) expenses	120,296	129,786	139,481	151,027	161,315	169,826	177,502
Earnings before interest and taxes (EBIT)	273,402	279,502	277,061	274,540	285,164	289,573	302,662
Taxes	109,361	111,801	110,824	109,816	114,066	115,829	121,065
Net Operating Profit after Taxes	164,041	167,701	166,237	164,724	171,098	173,744	181,597
Net working capital	422,597	447,956	486,428	528,407	574,238	624,303	652,521
Net PPE	389,321	426,522	459,404	498,497	541,109	587,580	614,139
NOPAT		167,701	166,237	164,724	171,098	173,744	181,597
+ Depreciation		26,800	27,950	29,770	31,700	33,170
− Capital expenditures (CAPEX)		64,001	60,832	68,863	74,312	79,641	26,559
− Increase in net WC		25,359	38,472	41,979	45,831	50,065	28,218
Free Cash Flow		105,141	94,883	83,652	82,655	77,208	126,820
Terminal value						2,058,565
Total Free Cash Flow		$105,141	$94,883	$83,652	$82,655	$2,135,773
Enterprise value	$1,575,096
Less debt	$155,795
Equity value	$1,419,302
Number of shares	64,417
Value per share (DCF)	$22.03
Current price per share	$21.98

  Net Present Value (NPV) 

Net Present value is crucial in determining whether a given investment is going to yield positive returns over a given period of time. It is one of measures used to evaluate present value of the company. Using the discount rate of 7.5 percent, NPV can be estimated by discounting the cash flows for the five years. 

NPV for RSE before synergy 

The table below summarizes the NPV for RSE before synergy. 

Year 1	105141
Year 2	94883
Year 3	83652
Year 4	82655
Year 5	2135773
Discount rate	40.00%
NPV	$572,625.35

NPV for RSE before merger is $ 572,625.35 

NPV for FCV pre-merger 

Year 1	168
Year 2	3482
Year 3	3772
Year 4	4216
Year 5	162698
Discount rate	40%
NPV	$34,619.79

The fact that NPV for RSE pre-merger is $572,625.35 clearly reveals that the merger is worthwhile. It shows that RSE is likely to yield a lot of cash flows and profits following the merger 

Cost synergies 

Cost synergies helps in determining the amount of the cost that can be saved following synergy. The most the cost, the more feasible the merger is. 

RSE cost synergy 

The table below summarizes the NPV for RSE following the cost synergy 

Year 1	900
Year 2	1800
Year 3	1800
Year 4	1800
Year 5	35188
Discount rate	7.50%
NPV	$29,702.08

FCV Cost synergy 

Year 1	1200
Year 2	2400
Year 3	2400
Year 4	2400
Year 5	46918
Discount rate	7.50%
NPV	$39,603.24

The NPV for cost synergies above shows that both companies would save a lot of money. FCV would save approximately $39,603.24, while RSE would save$29, 702.08. These values are impressive and suggest that the merger is feasible. 

Internal Rate of Return (RRR) 

IRR is one of the indices used to measure the effectiveness of a given investment plan. IRR can be calculated using the excel formula. The IRR for the pre-merger is shown below. The IRR is based on an assumption that the initial investment for merger is $1575096 

Year 0	-1575096
Year1	105141
Year 2	94883
Year 3	83652
Year 4	82655
Year 5	2135773
IRR	11%

The IRR is strong positive (11 percent). This is an indication that the by investing what it has presently ($1575096) in forming the merger, RSE is likely to get additional of 11 percent after five years. This is a good indication that the merger is feasible. 

The Payback period for RSE 

Based on the calculation from the excel, it is apparent the payback period for RSE is 2.5. This value is low and hence it implies that the merger is bound to give good results. 

DCF before and after synergy 

Discounted cash flow can give a hint on whether the merger is feasible or not. From the calculation it is apparent that the current premerger value for share is $44.95. The value with cost synergies for FVC is $61.16 and the value with cost synergies for RSE is $57.11. Consequently, the DCF valuations shows that the merger is profitable and feasible. 

DCF valuations		Total equity value		Price per share
	Current premerger value		$110	$44.95
	Value with cost synergies (FVC)		$149	$61.16
	Value with cost synergies (RSE)		$139	$57.11

Summary of values for FVC Deal 

Values such as price of stock, book value of equity, DCF valuation during pre-merger and after synergy are summarized below 

ROCKWELL SYSTEMS AND ELECTRONICS
Summary of Values for Fast Vent Deal
			Total equity value (M)	Price per share
Current stock price			$97.0	$39.75
Book value of equity			$36.8	$15.07
Liquidation value			$50.0	$20.48
PE ratio of comps
	All comps (case Exhibit 8)	18.6	$103.4	$42.38
	Watts Industries	15.0	$83.6	$34.27
DCF valuations
	Current premerger value		$110	$44.95
	Value with cost synergies (FVC)		$149	$61.16
	Value with cost synergies (RSE)		$139	$57.11
Recent transactions (All)
	Equity value to net income	35.6	$198.2	$81.24
	Ent. value to sales	1.58	$78.2	$32.03
	Ent. value to op. income	29.8	$293.0	$120.08
	Ent. value to cash flow	16.0	$181.6	$74.45
	Average premium	31%	$126.9	$52.01
	Average of recent transactions values		$175.6	$72.0

Recommendation 

Based on the foregoing analysis, it is evidenced that the synergy is likely to result in positive and better results. Using the NPV, it is apparent that the merger is likely to yield more value to the RSE. The fact that NPV for RSE pre-merger is $572,625.35 clearly reveals that the merger is worthwhile. It shows that RSE is likely to yield a lot of cash flows and profits following the merger. The cost of synergies also reveals that the merger will enable the two companies save a lot of money. RSE, for example, would save $29,702.08, while FVC would save $39,603.24. This is a positive indication that the merger favors both companies. As far as IRR is concerned, it is clear that the merger will earn RSE additional of 11 percent of its current investment. This shows that the RSE should pursue the merger plan. Similarly, the playback period supports the merger because the playback period is low. 

References 

Brigham, E. F., & Houston, J. F. (2013).  Fundamentals of financial management . Mason, Ohio: South-Western. 

Petitt, B. S. P., & Ferris, K. R. (2013).  Valuation for mergers and acquisitions . Upper Saddle River, N.J: FT Press.