Discounted cash flows

The discounted cash flow method is widely used method for valuation, especially in deals of merger and acquisitions. The entity’s future free cash flows are estimated and discounted back to value the firm. Thus, this provides reliable estimate of the valuation for the company. To discount back the free cash flows, the company has to make certain assumptions in order to determine the cost of capital.

This valuation model can be applied to Cerent. The projection data is available, which can be used to estimate the future free cash flows for the firm. The income statement projections by Merrill Lynch can be used for this purpose. EBITDA is taken for the projected years 2000,2001, and 2002. After which the tax expense was deducted to reach to PAT.

Capital expenditure or simply CAPEX was forecasted using the historical data from the balance sheet. The moving average growth rates are calculated for each year, which then are taken at average to forecast the CAPEX for future years. Moreover, to make the growth rate more real, it is reduced by 50%. Working capital was also forecasted using the same technique used for CAPEX. The changes in working capital are also included to forecast the FCFF.

After all calculations and incorporation of Capex and WC, the FCFF for the firm is calculated for the projected years. The formula used is as follows:

Total Free Cash Flow = EBITDA – (Tax Exposure) – (Changes in Working Capital) – (Required Capital Expenditures)

Terminal value was also calculated using the WACC (discount rate) and growth rate. Growth rate is assumed to be 4%, while WACC is calculated using the information provided in the case and assumed information. Weight of equity and weight of debt were given in the case, which was extracted from the balance sheet. Cost of debt was also figured out using the financial statements (see excel). Cost of equity was assumed, where the risk free rate is taken from online source, while beta and market risk premium are assumed. The WACC is calculated to be 5.22%.

The terminal value is added to the net FCFF, after which it is discounted back by the rate of WACC. Discounted cash flow valuation model gives the value of $808,494,000 for Cerent.

Evaluation of acquisition offer

Therefore, after the valuation, the value of Cerent is calculated to be $13.4 million and as per the DCF, it is $808 million. The valuation from the balance sheet method is totally irrelevant because it only depicts the value of assets owned by the company. In the technological business, assets are not worth more as compared to the business it owns. The future business prospect of Cerent is highly feasible. The DCF analysis is an appropriate indicator of the company’s value.

Cisco has offered to buyout the company with price range between $3.7 and $5.9 billion dollars, which is quiet high from the company’s valuation. Therefore,it is recommended that Cerent should accept the offer.

EPS and growth implications

It is to be considered what earning growth would make this acquisition accretive for CISCO. Accretive can be defined as the increase in EPS as a result of increased revenues and earnings after the acquisition has been made. The pre-acquisition net profit is taken from the projection,which is provided in the case. For year 2000, the net profit is $3300.09. The net profit margin is calculated by dividing the net profit on sales. Number of shares was given that gives an EPS of $0.92.

For Cerent, the company was generating loss. Thus, the net margin is in negative. As per the question requirement, it is assumed that the net profit margin is equal to that of Cisco. Thus assuming the same net margin of 20.85%, the net profit for the company is calculated to be $30.40 million………………….

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