Akua AcheampongJody Grewal

Kieng IvRhea Rasquinha

Background and Current Issues Terminal Value Estimators of Terminal Value Forecast Horizon Quantitative Analysis Recommendations

Arcadian: • Gene diagnostics industry

Investment Opportunity:• Original Offer: 60% equity interest in

Arcadian for $40M

Value of the Investment: • Determined through estimating terminal

value

It is the lump sum of cash flows at the end of a stream of cash flows, which represent:• The proceeds from exiting an investment;• The present value of all cash flows beyond the

forecast horizon

Terminal values are important because:• They are present in the valuation of almost

every asset• They measure the “continuing value” derived

from the going concern of the business.

Importance of Terminal ValueImportance of Terminal Value

Approach Advantages

Disadvantages When to use approach

Book value Simple •Ignores some assets and liabilities •Historical cost: backward looking •Subject to accounting manipulation

Appropriate when the minimum value of a company needs to be determined.

Replacement Value

Current •Subjective estimates •Value may be difficult to come by

Appropriate when a company is deciding whether to buy another company or build a new one from scratch.

Liquidation Value

Conservative

•Ignores going concern value •Uncertainty about value of assets in the market

Appropriate when assets are marketable

Multiples •Simple•Widely used

•“Earnings” subject to accounting manipulation•“Snapshot” estimate: may ignore cyclical, secular changes •Provides relative value, not absolute value

The approach is used as a business valuation benchmark

Constant Growth Method

•Reflects the time value of money

•Errors in growth rate and/or discount rate can provide improper value •Easy to abuse or misuse•Requires estimate on when firm will grow at stable rate

Appropriate when cash flows are strong and relatively consistent

Terminal Value

Forecast Horizon Cash Flows beyond the Forecast Horizon

Going Concern Timeline

Importance: All future cash flows, not only the ones that you can forecast, determine value

PV of future cash flows beyond the forecast horizon

As far into the future as CFs can be forecasted

• KEY: When Stable Growth Begins…• Set the forecast horizon • Stop Forecasting Cash Flows• Estimate a Terminal Value

1

Projected Cash Flows by Investment

($150)

($100)

($50)

$0

$50

$100

$150

$200

$250

$300

$350

3 5 7 9 11 13 15 17 19 21 23 25 27 29Year

$Mill

ion

s

MovieStudioBottlingPlantToll Road

Stable growth of 2% begins in year 27:-Production capacity reached-Estimate TV at yr 27

Stable growth of 2% begins in year 12:-Plant reaches capacity-Estimate TV at yr 12

Stable growth of 2% begins in year 3: -Operational capacity reached-Estimate TV at yr 3

Arcadian Growth Rate vs. Cash Flows

-100

0

100

200

300

400

500

1 2 3 4 5 6 7 8 9 10 11 12

Year

Gro

wth

Rat

e

-100

-50

0

50

100

150

200

Cash Flow

s ($M U

SD

)

Growth Rate

Cash FlowForecast

Very unstable growth

Resembles Bottling Plant

Limitations:• Forecasts for 10 and 11 years, but neither attains stable

growth• Ideally, we should continue forecasting until stable growth

begins Difficult due to the company being in its early stages

When should TV be estimated?

At end of 2013? Cash flow growth is volatile after 2013

At end of the Forecasted Cash Flow period? Cash Flow growth has declined and will further decline until 5% is

reached

It is reasonable to assume that growth will fall to 5% by 2016 given the pattern of decline since 2013

Use the End of the Forecasting Period to Estimate TV

Best Options:1. Price/Earnings Ratio2. Price/Book Value Ratio3. Constant Growth Rate

Assumptions:1. WACC – 20%2. At end of forecast horizon Arcadian is a

mature company

Arcadian SierraP/E 15 20 P/E 15 202014 Net Income 203$ 203$ 2015 Net Income 162$ 162$ Terminal Value 3,045$ 4,060$ Terminal Value 2,430$ 3,240$ PV Terminal Value 492$ 656$ PV Terminal Value 327$ 436$ PV 05-14 CF (151)$ (151)$ PV 05-15 CF (118)$ (118)$ PV 341$ 505$ PV 209$ 318$ 60% Ownership 204$ 303$ 60% Ownership 125$ 191$

Terminal Value ExplanationPE 15 20 PE 15 20Arcadian 144% 130% Sierra 157% 137%

Arcadian SierraPrice to Book Ratio 8.5 Price to Book Ratio 8.5BV of Equity $672 BV of Equity $199Terminal Value $5,708 Terminal Value $1,691PV Terminal Value $922 PV Terminal Value $228PV 05-14 CF ($151) PV 05-15 CF ($118)PV $771 PV $10960% Ownership $462 60% Ownership $66

Terminal Value ExplanationArcadian 120% Sierra 208%

1)1()1( Remin InflationalalNo gxgg

EquationFisher

Options:1.Real growth rate in the economy = 3%2.Real growth rate in the Pharmaceutical Industry = 5%3.USA Population growth = 1%

Nominal Rates1.Nominal growth rate in the economy ~ 5%2.Nominal growth rate in the Pharmaceutical Industry ~ 7%3.USA Population growth = 1%

Best Rate: Nominal growth rate in the economy ~ 5%

Inflation=2%

Arcadian's View

Annual growth rate to infinity 2% 3% 4% 5% 6% 7%

Weighted average cost of capital 20% 20% 20% 20% 20% 20%Adjusted free cash flow 2015 202 194 185 180 174 165 Terminal value 2014 1,142 1,173 1,200 1,257 1,314 1,355 PV of terminal value 2014 185 189 194 203 212 219PV free cash flows 2005-2014 ($151) ($151) ($151) ($151) ($151) ($151)

Total Present Value $33 $38 $43 $52 $61 $6860% Ownership $20 $23 $26 $31 $37 $41Terminal Value Explanation 554% 495% 455% 392% 347% 324%

Sierra Capital's View

Annual growth rate to infinity 2% 3% 4% 5% 6% 7%

Weighted average cost of capital 20% 20% 20% 20% 20% 20%Adjusted free cash flow 2016 185 177 168 163 157 148 Terminal value 2015 1,049 1,073 1,093 1,142 1,189 1,219 PV of terminal value 2015 141 144 147 154 160 164PV free cash flows 2005-2015 ($118) ($118) ($118) ($118) ($118) ($118)Total Present Value $23 $26 $29 $35 $42 $4660% Ownership $14 $16 $17 $21 $25 $27Terminal Value Explanation 619% 555% 513% 436% 384% 359%

Low Range

High Range

Arcadian

Sierra Difference Applicable

Price/Earnings RatioLow End: 15

High End: 20

204

303

125

191

79

112

No

No

Price/Book Ratio 462 66 396 No

Constant Growth Rate

31 21 10 Yes

Arcadian

Sierra Difference

Constant Growth Rate 122 92 30

Option on Future Opportunities

Further financing needed• 40M barely covers 2005 projected cash deficit• Debt financing

High debt financing costs: low current earnings -> low interest coverage, low operating income margin -> high cost of debt

Impact on WAcc

IPO/Early Exit• Distribute shares to clients tax-free• Compare with

Affymetrix (P/E 50.09, P/B 8.56,P/FCF 97.5, P/SALES 7.49) Illumina (PB 8.46, P/SALES 8.82)

Current Average Investment weighting: $31.25M

Counteroffer: $21MAbandonment Point: $31M

Management Bonus If management hits forecast in years

2013-2014, 5% incentive $2M present value 2013 2014

Arcadian's Forecast $134 $231Sierra'sForecast $28 $98

Difference $106 $1325% $5 $7PV $2