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

 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 Value

Terminal Value

Liquidation Assumption

Going Concern Assumption

Liquidation value

Market Multiples

Constant growth

Approach Book value

Advantages Simple

Disadvantages Ignores some assets and liabilities Historical cost: backward looking Subject to accounting manipulation Subjective estimates Value may be difficult to come by

When to use approach Appropriate when the minimum value of a company needs to be determined. Appropriate when a company is deciding whether to buy another company or build a new one from scratch. Appropriate when assets are marketable The approach is used as a business valuation benchmark

Replacement Value

Current

Liquidation Value Multiples

Conservative

Ignores going concern value Uncertainty about value of assets in the market Earnings subject to accounting manipulation Snapshot estimate: may ignore cyclical, secular changes Provides relative value, not absolute value

Simple Widely used

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

Going Concern Timeline

Forecast Horizon

Cash Flows beyond the Forecast Horizon

Terminal Value

As far into the future as CFs can be forecasted

PV of future cash flows beyond the forecast horizon

Importance: All future cash flows, not only the ones that you can 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 $200 Movie Studio Bottling Plant Toll Road

$Millions

$150 $100 $50 $0 ($50) ($100) ($150)

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

9 11 13 15 17 19 21 23 25 27 29

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

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

Arcadian Growth Rate vs. Cash Flows

500

Very unstable growth

200

Growth Rate
400

Growth Rate

300

Cash Flow Forecast

Resembles Bottling Plant

150
Cash Flows ($M USD)

100

200

50

100

0 1 -100 Year 2 3 4 5 6 7 8 9 10 11 12

-50

-100

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 P/E 2014 Net Income Terminal Value PV Terminal Value PV 05-14 CF PV 60% Ownership $ $ $ $ $ $ 15 203 3,045 492 (151) 341 204 20 $ 203 $ 4,060 $ 656 $ (151) $ 505 $ 303

Sierra P/E 2015 Net Income Terminal Value PV Terminal Value PV 05-15 CF PV 60% Ownership $ $ $ $ $ $ 15 162 2,430 327 (118) 209 125 $ $ $ $ $ $ 20 162 3,240 436 (118) 318 191

Terminal Value Explanation PE 15 Arcadian 144%

20 130%

PE Sierra

15 157%

20 137%

Arcadian Price to Book Ratio BV of Equity Terminal Value PV Terminal Value PV 05-14 CF PV 60% Ownership

8.5 $672 $5,708 $922 ($151) $771 $462

Sierra Price to Book Ratio BV of Equity Terminal Value PV Terminal Value PV 05-15 CF PV 60% Ownership

8.5 $199 $1,691 $228 ($118) $109 $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%

FisherEquation

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

Inflation=2%

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 Weighted average cost of capital Adjusted free cash flow 2015 Terminal value 2014 PV of terminal value 2014 PV free cash flows 2005-2014 Total Present Value 60% Ownership Terminal Value Explanation Sierra Capital's View Annual growth rate to infinity Weighted average cost of capital Adjusted free cash flow 2016 Terminal value 2015 PV of terminal value 2015 PV free cash flows 2005-2015 Total Present Value 60% Ownership Terminal Value Explanation

2% 20% 202 1,142 185 ($151) $33 $20 554%

3% 4% 20% 20% 194 185 1,173 1,200 189 194 ($151) ($151) $38 $43 $23 Range $26 High 495% 455%

5% 20% 180 1,257 203 ($151) $52 $31 392%

6% 20% 174 1,314 212 ($151) $61 $37 347%

7% 20% 165 1,355 219 ($151) $68 $41 324%

2% 20% 185 1,049 141 ($118) $23 $14 619%

3% 4% 20% 20% 177 168 1,073 1,093 144 147 ($118) ($118) $26 $29 Low $16 Range $17 555% 513%

5% 20% 163 1,142 154 ($118) $35 $21 436%

6% 20% 157 1,189 160 ($118) $42 $25 384%

7% 20% 148 1,219 164 ($118) $46 $27 359%

Arcadian Sierra Price/Earnings Ratio Low End: 15 High End: 20

Difference

Applicable

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: $21M Abandonment Point: $31M Management Bonus If management hits forecast in years 20132014, 5% incentive $2M present value
Arcadian's Forecast Sierra'sForecast Difference 5% PV 2013 $134 $28 $106 $5 $2 2014 $231 $98 $132 $7