Corporate Finance Professor Gonzalo Chavez

Corporate Finance Group Task Distribuciones Canarias, S.A. Group A N1 J. Ernest Doering Nikita Matunov Enrico Nahoum Hana Sawaqed Laura Vlez Jun Wang

Corporate Finance Professor Gonzalo Chavez

Background

DISCASA is a supermarket based in the Canary Islands. It has experienced steady growth since its creation in the beginning of the 80s, and in the 90s it became the leading supermarket chain on the island. However, from 2005 onwards the companys growth started to diminish. This was due to the entry of big players in the islands supermarket industry, which took market share from DISCASA. Also, the market in the island reached maturity, and opening new branches would risk cannibalization of existing ones. DISCASA evaluated its situation and identified three options to counteract this slow-down of growth. Of these three options, the most attractive and economically viable one was to expand to the Iberian Peninsula by acquiring a small, well-established supermarket chain. They identified SUARSA as a potential target. Of the many challenges presented by this acquisition, the hardest is how to present the deal to the shareholders, since this acquisition will entail a modification (downward) of the dividend policy. This objection is not unwarranted since most of the shareholders are company employees who earn little and rely heavily on the dividends to make ends meet. We will now evaluate both DISCASA and SUARSA before and after the potential acquisition in order to convince the shareholders that by reinvesting their dividends in the company through this acquisition they stand to receive a higher ROI in the long run. 1.Value of DISCASA with its current capital structure The valuation of any company includes the calculation of free cash flows and the estimation of WACC. For the DISCASA case, we will mainly use Exhibit 7 (from the case), since the forecasts are already given. We have to evaluate DISCASA under two different scenarios (a) with the current capital structure and (b) with the target capital structure. The only difference in these two scenarios is the WACC, since Free Cash Flows will stay the same no matter how the structure changes as no interest expense is included into FCF calculation. Calculation of the Free Cash Flows As EBIT, CAPEX and changes in WK forecasts (2008-2013) were given, we therefore used the following formula for FCF calculation: 1 The main difficulties were the calculation of CAPEX changes and depreciation. In Exhibit 7 the amount of Net Fixed Assets doesnt change from 2008 to 2013. However, depreciation was stable over the years with value of 3,125 for every year. This means that CAPEX amounts were equal to depreciation and thus the net effect of fixed assets was zero. We assumed that forecasts given in Exhibit 7 were the best estimations; therefore they have been used in our calculation. Following the calculation of FCF for the future years, we can then estimate the growth rate of FCF (please see Appendix 1). The calculated growth rate in the past years did not change much and the growth rate for year 2012 and 2013 did not change at all - therefore, we assumed that the proper growth of free cash flows rate for future years (in perpetuity) equals to the growth rate of 2013 (0.8%). A small growth rate such as this might be considered negligible, but taking into the account that the market is mature and the company faces huge competition, a growth rate of 0.8% could be considered as a reasonable one.

Corporate Finance Professor Gonzalo Chavez

WACC estimation Most of the information for calculating the WACC of the company was given and we can use the formula:

Where - Cost of debt; - Cost of equity, However, current capital structure was not given. In order to calculate current capital structure, we used historical and forecasted information in Exhibit 7 and calculated the leverage ratio D/(D+E) and gearing ratio E/(D+E) for every year, with all other information given. We then calculated WACC for every year. The difference between WACCs of different years is not significant - please see the Table 1 below: Table 1 - Capital structure and WACC

Although we have WACC for every year, it is logical to use only one WACC (the average one) for calculating the present values of cash flows as well as terminal value calculation. The main assumption in this scenario was that the equity beta does not change much (due to non-significant changes in leverage levels) and the cost of debt does not change much as well. The estimated average WACC for current leverage equals 10.82% (Please see Appendix 2). As a result, the NPV of DISCASA with current capital structure is 22.935 M.

2.Value of DISCASA with target capital structure FCF does not change in this scenario and the only change is WACC. It was assumed that the cost of debt did not change for the calculation of the WACC at the target leverage level. However, the cost of equity will change. We unleveraged the equity beta by using the current equity structure (year 2007) and then leveraged it back by using the target leverage ratio (30%). The formula we used to leverage/unleverage beta is: , where we assumed 0 As the result the new =1.72 and the new WACC equals to 10.59% (Please see Appendix 2). After estimated free cash flows and WACC, we calculated terminal value of the company in 2013 year by using the growth rate. The formula is: Values of the company: with current debt structure 22.935 mln with target debt structure 23.464 mln In addition, we performed a sensitivity analysis of valuation based on changes in growth rate and WACC (please see Appendix 3). With growth rate changes from 0.4% to 1.2% and with WACC changed from 10% to 11%, NPV changed from 22 mln to 25.6 mln.

Corporate Finance Professor Gonzalo Chavez

3. Stand-alone value of SUARSA Before any acquisition it is standard procedure for the acquiring company to valuate the target firm at its standalone value. In the case of SUARSA we are forecasting for 6 years (2008-2013) using certain assumptions. In order to calculate the WACC we had to first calculate the cost of equity or using the data from Exhibit 4 from the case: Then we used that value for the WACC calculation based on the capital structure at the end of 2007 year:

Thus, the stand-alone SUARSAs WACC equals 9.52%. The main issue in calculation the value of stand-alone SUARSA was the estimation of free cash flows; following assumptions were used:

The decline in sales is not permanent because the company will have to change the current situation. Thats why we assumed there will be a sales increase of 2% - (average market growth) in the future years. The same applies to FCF growth rate. The margin ratio ((SALES-COGS)/SALES) remains constant. EBITDA also remains constant at 1.31% of sales (which is average for the company from the previous 3 years see Appendix 4). Account Receivables days, Inventory days, Accounts Payables days remain constant in future years. Net Fixed Assets will go down by 5% annually, which means that CAPEX will be lower than depreciation. Thats because in current terms the company has to change its capital budget and decrease it (please see Appendix 4). When calculating the WACC, we used the capital structure for the year 2007, (Exhibit 4 from the case) because we assumed no significant change in the capital structure of the company in the future. We are using Long Term Debt as a balancing line. As the result the amount of long term debt stays pretty the same in the future years (please see Appendix 4).

Our calculation resulted in an estimation of an NPV of 7.4 million with no synergies included. The major part of the NPV calculation is the terminal value of 4.8 million (present value), which was calculated with the WACC and growth assumptions mentioned above. The sensitivity report is attached as well (Please see Appendix 4) It is worth noting that if DISARSA decides to pay 7.4 million for SUARSA, Goodwill will be generated by an amount of the difference between NPV and net assets (or equity) of SUARSA (7.4-5.3 = 2.1 million). 4. Value SUARSA assuming it is now managed by DISCASA We are already given all the forecasts of future P&L and BS line items, so the main difficulty is to calculate the WACC. We cannot use the current DISCASAs WACC because the capital structure will change after the acquisition.

Corporate Finance Professor Gonzalo Chavez

. And the , where: LT debt of SUARSA LT debt of DISCASA debt necessary for acquisition equity of DISCASA equity of SUARSA the acquisition price the goodwill generated by the acquisition We are assuming that DISCASA has enough negotiation power to purchase SUARSA at its stand-alone price of 7.4 million. DISCASAs current cash balance would allow it to purchase SUARSA without the need for additional financing, assuming no dividends will be paid and we have enough cash to operate the company. As a result, the new capital structure of the new company will be:

.. ....

38.4%

1 61.6%

Additionally, we adopted a new equity beta based on the new capital structure of 1.95. As the base equity beta (for unleveraging and leveraging back) we used the beta of DISCASA because all processes and procedures of the new company will be in line with DISCASAs ones. This resulted in a WACC of 10.52% and an NPV of 16.3 million. Benchmark evaluation. Additionally we used another approach to estimate the price of the company by using the recent trend of the acquisitions in the market. The regression model was implemented in order to estimate the benchmark price of SUARSA based on exhibit 10 from the case. Please see Appendix 5 for the model. We used two variables total surface (sales area) * % of acquisition and yearly turnover * total surface (sales area). The reason for using exactly these variables is that combination of those gave us the best interrelation between the price and variables. From this model we can see that the trend of the price fluctuations is non-linear and adjusted R2 is 97%, which means the correlation between the variables is very strong. Please see following graph for reference.
80,000 70,000 60,000 50,000 40,000 30,000 20,000 10,000 -10,000 0 2 4 6 Real prices Estimated prices

Corporate Finance Professor Gonzalo Chavez

The formula for regression model is 26884 4.2 1 3.66 2/100000 Where X1 is total surface (sales area) * % of acquisition, X2 is yearly turnover * total surface (sales area). (Please see Appendix 5) The result of regression model evaluation is 16.469 what is surprisingly close to FCF evaluation including synergies. The results of different approaches to evaluation are below:

Conclusion In conclusion, for DISCASA shareholders the lower the price we can pay for SUARSA the better, which is the stand-alone value of 7.4 million according to our calculations. Nevertheless, we made assumptions that may be hard to accept by SUARSAs management even though we believe them to be conservative. Business owners tend to over value their own companies. SUARSA, additionally, has assets that are valuable for retailers such as DISCASA, and its national positioning meets DISCASAs national expansion strategy.

Corporate Finance Professor Gonzalo Chavez

Appendix 1. Valuation of DISCASA

Corporate Finance Professor Gonzalo Chavez

Appendix 2. WACC and betas calculation

Corporate Finance Professor Gonzalo Chavez

Appendix 3. Sensitivity analysis

Corporate Finance Professor Gonzalo Chavez

Appendix 4. SUARSA forecast and evaluation.

Corporate Finance Professor Gonzalo Chavez

Appendix 5. Benchmark regression model evaluation.