LAB International Inc. Case Solution
Alternative 3: Sell LAB Pharma
Pros
LAB Pharmaâ€™s division isnot generating any profit and consuming most of the cash flows of the company. Therefore,selling the division would also resolve the fund raising issue for the expansions of LAB research.
Cons:
The investors have interest to fund the company in the future because the LAB Pharma admitted the mistake of purchasing focusinhalation. The market perception of the less value of the division will result in alow selling price for the division. It is also challenging and difficult to find a company that hasmatching product portfolio as Lab Pharma.
4)a.Â Â Â Â Â (10 points) Establish FCFF estimated for 2006-2010 years using information provided in Exhibit 10 of the case. Note that you do not have stuffiest information to forecast financial statements, but you have all the necessary information to build free cash flows.
Â For the year ended Dec 31, | |||||
Â 2006EÂ | Â 2007EÂ | Â 2008EÂ | Â 2009EÂ | Â 2010EÂ | |
Â Revenue (Cdn$000) | 50,000 | 56,000 | 65,000 | 75,000 | 84,000 |
Â EBITDA margin (%) | 18 | 18 | 18 | 19 | 20 |
EBITDA | 9000 | 10080 | 11700 | 14250 | 16800 |
Â Depreciation and amortization (Cdn$000) | 3,500 | 4,000 | 4,500 | 4,600 | 4,700 |
EBIT | 5,500 | 6,080 | 7,200 | 9,650 | 12,100 |
Â Tax rate (%) | 32 | 32 | 32 | 32 | 32 |
Â Capital expenditures (Cdn$000) | 10,000 | 12,000 | 12,000 | 4,000 | 4,000 |
Â Change in working capital (Cdn$000) | 400 | 576 | 864 | 960 | 864 |
FCFF | -3160 | -4441 | -3468 | 6202 | 8064 |
(5 points) Estimate Terminal Cash Flow using growing perpetuity approach. Assume 4% growth rate.
Terminal value of cash flows using the growing perpetuity approach can be calculated by the following formulawhich is;CA$642,629.5
- Calculate Cost of Equity.
Cost of Equity | 2005 | 2004 | ||
Dividend (ex. 4) | 802 | 1,069 | ||
Total Shareholdersâ€™ Equity (ex.5) | 54,380 | 35,534 | ||
Cost of Capital | 0.014 | 0.03 | ||
0.022 |
(5 points) Find in the case estimates of proper RFR and market premium.
RFR refers to risk free rate, which is the starting point of all the models expecting a return. An asset can be risk free by no risk associated to the cash flows and there should be no reinvestment risk. The risk free rate for the company should be default Government zero coupon.
The Government bonds can be associated with the duration of the cash flows used by the company. The data used in this is of 5 years, thereforefive yearsâ€™ time should be taken, which is 4.15%.
The risk premium is a critical component in the portfolio of any company. The risk premium is widely used in corporate finance and valuation of the company. The company is of small size, which evaluates its risk premium increase by 1.50%. By adding the market risk premium of 5%, the new market premium is 6.50%.
- (10 points) Estimate beta of the LAB Research using comparable.
The comparable beta is 1.3 which is used to calculate the geared beta of the Lab research division by using Debt/ Equity ratio of the Lab research division is 1.01(Levered Beta of Lab Research Division)
Â iii.Â Â Â Â Â Â Â (5 points) Estimate cost of equity of LAB Research. Note that final estimate of cost of equity should incorporate small stock premium. That is, the final Ke=Rf+beta*(market premium) + small stock premium.
The Cost of equity with an additional small stock premium is 6.75500%. The incorporate small stock premium was 1.5%, which was added in the cost of equity.
- (5 points) Estimate WACC of LAB Research.
The WACC is calculated by the formula, which is
The assumption for the values used in calculation of WACC is as follows:
Cost of debt = 7.754%
Cost of Equity = 5.26%
E/V = .41
D/V = .59
Tax = 32%
After the values incorporated in the formula, we get a WACC of 5.27%……………….
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