Akua Acheampong

Jody Grewal
Kieng Iv
Rhea 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
 Itis 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 Value
 Terminal
Value

Liquidation Going Concern

Assumption Assumption

Liquidation Market Constant

value Multiples growth
Approach Advantages Disadvantages When to use approach

Book value Simple Ignores some assets and liabilities Appropriate when the
Historical cost: backward looking minimum value of a
Subject to accounting manipulation company needs to be
determined.
Replacement Current Subjective estimates Appropriate when a
Value Value may be difficult to come by company is deciding
whether to buy another
company or build a new
one from scratch.
Liquidation Conservative Ignores going concern value Appropriate when assets
Value Uncertainty about value of assets in the are marketable
market
Multiples Simple Earnings subject to accounting The approach is used as a
Widely used manipulation business valuation
Snapshot estimate: may ignore cyclical, benchmark
secular changes
Provides relative value, not absolute value

Constant Reflects the Errors in growth rate and/or discount rate Appropriate when cash
Growth time value of can provide improper value flows are strong and
Method money Easy to abuse or misuse relatively consistent
Requires estimate on when firm will grow at
stable rate
Going Concern Timeline

Forecast Horizon Cash Flows beyond the

Forecast Horizon

Terminal Value

As far into the PV of future cash Importance: All future cash flows,
future as CFs can flows beyond the not only the ones that you can
be forecasted forecast horizon forecast, determine value

KEY: When Stable Growth Begins

Set the forecast horizon
Stop Forecasting Cash Flows
Estimate a Terminal Value
 Projected Cash Flows by Investment
$350
$300
$250
Movie
$200 Studio
$Millions

$150 Bottling
Plant
$100
Toll Road
$50
$0
($50) 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29
Year Stable growth of 2%
($100)
begins in year 27:
($150) -Production capacity
Stable growth of 2% Stable growth of 2% reached
begins in year 3: begins in year 12: -Estimate TV at yr 27
-Operational capacity -Plant reaches capacity
reached -Estimate TV at yr 12
-Estimate TV at yr 3
 Arcadian Growth Rate vs. Cash Flows
Very unstable
500
growth 200
Growth Rate
400 150
Resembles

Cash Flows ($M USD)

Cash Flow Bottling Plant
300 Forecast 100
Growth Rate

200 50

100 0

0 -50
1 2 3 4 5 6 7 8 9 10 11 12

-100 -100
Year
 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 Ratio
2. Price/Book Value Ratio
3. Constant Growth Rate

Assumptions:
1. WACC 20%
2. At end of forecast horizon Arcadian is a
mature company
 Arcadian Sierra
P/E 15 20 P/E 15 20
2014 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 Explanation

PE 15 20 PE 15 20
Arcadian 144% 130% Sierra 157% 137%
Arcadian Sierra
Price to Book Ratio 8.5 Price to Book Ratio 8.5
BV of Equity $672 BV of Equity $199
Terminal Value $5,708 Terminal Value $1,691
PV Terminal Value $922 PV Terminal Value $228
PV 05-14 CF ($151) PV 05-15 CF ($118)
PV $771 PV $109
60% Ownership $462 60% Ownership $66

Terminal Value Explanation

Arcadian 120% Sierra 208%
Options:
1. Real growth rate in the economy = 3%
2. Real growth rate in the Pharmaceutical Industry = 5%
3. USA Population growth = 1%
Fisher Equation
Inflation=2%

g No min al (1 g Re al ) x (1 g Inflation) 1

Nominal Rates
1. 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%

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 185 189 194 203 212 219
PV free cash flows 2005-2014 ($151) ($151) ($151) ($151) ($151) ($151)
Total Present Value $33 $38 $43 $52 $61 $68
60% Ownership $20 High
$23 Range
$26 $31 $37 $41
Terminal 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 141 144 147 154 160 164
PV free cash flows 2005-2015 ($118) ($118) ($118) ($118) ($118) ($118)
Total Present Value $23 $26 $29 $35 $42 $46
60% Ownership $14 Low
$16 Range
$17 $21 $25 $27
Terminal Value Explanation 619% 555% 513% 436% 384% 359%
 Arcadian Sierra Difference Applicable

Price/Earnings Ratio
Low End: 15 204 125 79 No

High End: 20 303 191 112 No

Price/Book Ratio 462 66 396 No

Constant Growth
31 21 10 Yes
Rate
 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: $21M
Abandonment Point: $31M

Management Bonus
If management hits forecast in years
2013-2014, 5% incentive $2M present
value 2013 2014
Arcadian's Forecast $134 $231
Sierra'sForecast $28 $98
Difference $106 $132
5% $5 $7
PV $2