Valuation of Calaveras Vineyards

Marshawn Pettes
Calaveras Vineyards fair market value of assets was estimated to be $5 million to $7 million. Is the purchase price of $4.122 million a discount for a company that could be worth $7 million or could this amount be an overstatement

MBA 634 Measurement II DeVos Graduate School Summer 2013 7/16/2013

Valuation of Calaveras Vineyards The proposal from Tom Howell, a managing director with NationsBank, noted that Calaveras Vineyards fair market value of assets was estimated to be $5 million to $7 million. There are assumptions that a purchase price for the assets of the firm of $4.122 million would represent a significant discount. I prepared a valuation of Calaveras using multiple financial methodologies to test those assumptions. The purpose of this valuation is to determine Calaveras fair market value (equity value) and compare it to the purchase price. If I am going to purchase this company, I would like to know if $4.122 million is really a discount for a company that could be worth $7 million or if the numbers on the proposal is an overstatement. Discounted Cash Flow Utilizing Ernst and Andersons forecast and Higgins formula, I calculated Calaveras estimated free cash flow. The terminal value and the net present value were derived from the free cash flow. As a buyer, I would like to know what the company is worth today. The net present value or enterprise value includes the companys debt. According to Higgins, if you are buying a company you will be responsible for that companys debt. Therefore I would focus more so on the companys equity value in my decision of purchasing this company or not. The equal value not only removes the total debt from the enterprise value but it also adds back cash from the beginning of the forecast (see Figure 1). Weighted Average Cost of Capital (WACC) Cost of Debt Anne Clemens, a senior vice president at Goldengate Capital, assumed an interest rate of 9.5% on both the revolver and term loan. For my analyst I felt that the average of the two would make a better number for during my calculation of the cost of debt. According to Higgins, the figure for debt includes only interest-bearing debt because other liabilities are either the result of tax accruals that are subsumed in the estimation of after-tax cash flow or spontaneous sources of cash that are part of working capital in the investments cash flows. Therefore the proport ion of Debt calculation would include the noncurrent debt, the current portion of that debt, and the revolving line of credit because they are all interest bearing debt that was not included in the working capital (see Figure 4). Calaveras cost of debt at 5.83% is not bad. However their proportion of debt of approximately 76% of their total capital concerns me. I assume that the company may have borrowed a lot of money on a small base of investments. If this true than the company is highly leveraged. Cost of Equity

Valuation of Calaveras Vineyards A 30-year T-bond rate was used as the risk free rate in calculating the cost of equity. Calaveras is a small company therefore the arithmetic mean premium of the returns on small-company stocks less returns on long-term government bonds was selected as the risk premium (see Figure 2). The beta was created based on the three comparable companies that Clemens assistant identified (see Figure 3). Comparatives I compared Calaveras to 81 manufacturers of wine and brandy (see Figure 3). I noticed that majority of Calaveras solvency, efficiency, and profitability ratios ranged in between the upper and median quartiles. However, I also noticed that the quick ratio and the current ratio are in two different quartiles. The difference between the two ratios is the inventory. This shows that Calaveras maintains more inventories compared to the other 81 manufactures. In addition, Calaveras sales to inventory, assets to sales, and return on net worth are all ranged in between the lower and median quartile. Key Drivers and Sensitivity Terminal Growth Rate I have identified the key drivers of this valuation as the Terminal Growth Rate and the Discount Rate. I noticed that the two rates can make a big difference in the companys value if either rate was to increase or decrease by as little as one percent (see Figure 5). The growth rate would have a much larger effect on the companys value than the discount rate. Choosing a growth rate that is too high or too low could alter your decision making process and result in a bad decision. Discount Rate However, the companies discount rate could also alter the decision making process. There are many different factors that ties into the discount rate in which there are no real way of knowing which factor is better than the other. This could be one of the reasons why finance methodology contains significant ambiguity. For example, the discount rate includes a risk premium. The risk premium can be viewed as a geometric mean or an arithmetic mean. Either one could cause a significant change in the companies discount rate (see Figure 6). From an arithmetic standpoint, if you compare the returns on all common stock to the returns on small company stock, the discount rate would change by at least 4%. This change will take place regardless if you use long-term government bonds or U.S. treasury bills. The change in discount rate would impact the equity value by approximately $1.9 million, assuming a 2% growth rate (see Figure 5). This large difference could make or break a decision.

Valuation of Calaveras Vineyards On the other hand, Anne Clemens believes that Calaveras would gravitate toward the industry-average capital structure. If this is so, Calaveras will have a new risk. Therefore, I recalculated Calaveras beta by determining the new risk of being in business utilizing, Canandaigua, Finn & Sawyer, and Froggs Jump, market value debt to equity ratio as the market leverage (see Figure 3). As a result, the new risk could bring the discount rate down by one percent in which will increase the equity value by approximately $380,000 in the assumed growth rate remained the same at 2%. Final Decision In conclusion, base off the information from my valuation of Calaveras, I would not buy this company for $4.122 million. Calaveras has too much debt in which drives their equity value down to about $2.798 million. My assumed growth rate of 2% would have to triple to reach an equity value of about $4.140 million (see Figure 6). Even if the company follows Clemens belief and gravitates toward the industry-average capital structure the equity value will still be less than the purchase price. Also, the discount rate would have to be as low as 14% in order for this deal to make sense. This is a 3% difference from the discount rate I calculated in Figure 2. My valuation led me to believe that the purchase price in Tom Howell proposal is an overstatement. Therefore I will not purchase Calaveras Vineyards assets.

Valuation of Calaveras Vineyards Figure 1: Discounted Cash Flow

Forecast Income Statement (All values in thousands) 1995 1996 1997 4,193.00 4,681.00 4,967.00

Income Statement Sales Revenue Cost of Goods Sold Estates Selected Chardonnay California Generic Special Accts. Winery Total Gross Profit Selling, General and Admin. Amortization of Org. Costs EBIT Tax Expense @37% Net Income Add Back Depreciation Add Back Amortization Less Change in NWC Less Capital Expenders FCF Terminal Value FCF w/ Terminal Value NPV/ Enterprise Value Less: Beginning Net Debt Plus: Beginning Cash Plus: Excess Mkt Sec Equity Value Assumptions Perpetuity Growth Rate Beta Risk-Free rate (30-year treasuries) Assumed Market Risk Premium Assumed Tax Rate Assumed WACC

1994 3,704.00

1998 5,348.00

422.00 560.00 638.00 664.00 781.00 259.00 310.00 365.00 380.00 395.00 412.00 509.00 613.00 696.00 724.00 177.00 120.00 124.00 129.00 135.00 215.00 224.00 233.00 242.00 252.00 625.00 650.00 677.00 704.00 732.00 85.00 88.00 92.00 96.00 100.00 (2,196.00) (2,461.00) (2,742.00) (2,911.00) (3,119.00) 1,508.00 1,732.00 1,939.00 2,056.00 2,229.00 (519.00) (587.00) (655.00) (695.00) (749.00) (60.00) (60.00) (60.00) (60.00) (60.00) 929.00 1,085.00 1,224.00 1,301.00 1,420.00 343.73 401.45 452.88 481.37 525.40 585.27 683.55 771.12 819.63 894.60 116.00 166.00 216.00 266.00 316.00 60.00 60.00 60.00 60.00 60.00 519.00 302.00 201.00 216.00 152.00 250.00 250.00 250.00 250.00 250.00 (7.73) 357.55 596.12 679.63 868.60 5,878.46 6,747.06

(7.73) 4,747.97 2,000.00 50.00 2,797.97

357.55

596.12

679.63

2% 3.74 5.85% 12.4% 37% 17%

Valuation of Calaveras Vineyards Figure 2: Weighted Average Cost of Capital (WACC)

Revolver Loan Term Loan Average Clemens Assumption Prime Rate 8.75% 9.75% 9.25% 9.50% 6.75%

WACC Cost of Debt Avg. Revolver and Term Loan Tax Rate Cost of Debt Proportion of Debt Cost of Equity 30-Year T-Bonds Beta Risk Premium (Arithmetic) Cost of Equity Proportion of Equity WACC WACC @ Industry-average Capital Structure Cost of Debt Avg. Revolver and Term Loan Tax Rate Cost of Debt Proportion of Debt Cost of Equity U.S. Government Interest Rates Beta Risk Premium (Bond Returns) Cost of Equity Proportion of Equity WACC 9.25% 37% 5.83% 75.74% 9.25% 37% 5.83% 75.74%

5.85% 3.74 12.40% 52% 24.26% 17%

5.85% 3.45 12.40% 49% 24.26% 16%

Valuation of Calaveras Vineyards Figure 3: Comparative Analyzes Comparable Companies

(Calculate BETA)

Canandaigua Beta (unlevered) Finn & Sawyer Beta (unlevered) Frogg's Jump Beta (unlevered) Risk of Being in Business Leverage Unleveraged Proportion of Equity Equity Beta of Calaveras Vineyards Comparable Companies
(Calculate BETA) Move toward Industry-average Capital Structure

0.54

1.31

0.867 0.91

0.91 24% 3.74

Canandaigua Equity Beta Market Value of Equity Beta Asset Finn & Sawyer Equity Beta Market Value of Equity Beta Asset Frogg's Jump Equity Beta Market Value of Equity Beta Asset Risk of Being in Business Leverage Unleveraged Proportion of Equity Equity Beta of Calaveras Vineyards

0.59

0.723 0.42657

1.35

0.952 1.2852

0.95

0.844 0.8018 0.84

0.84 24% 3.45

Valuation of Calaveras Vineyards

Comparative on Manufacturers of Wine and Brandy (81 establishments for 1993) Upper Lower Ratios Solvency Calaveras Quartile Median Quartile Quick Ratio 0.07 1.2 0.04 0.02 Current Ratio 1.4 5.5 2.5 1.5 Curr liab to net worth (%) 39% 8 44 102.7 Total liab. To net worth (%) 76% 28.8 103.4 186.4 Efficiency Collection Period (days) 45.6 29.2 51.3 69.2 Sales to Inventory (x) 1.1 2.6 1.4 0.8 Assets to Sales (%) 243% 95.8 136.7 287.9 Acct. Payable to Sales (%) 5% 4.9 11.3 17.7 Profitability Return on Sales (%) 10% 7.3 2.8 -0.2 Return on Assets (%) 4% 8.1 2.3 -0.1 Return on Net Worth (%) 4% 16.6 7.7 1.1

Figure 4: Net Working Capital

NWC Working Capital Change in Net Working Capital (At Closing) 1994 1995 1996 1997 1998 2,116.00 2,635.00 2,937.00 3,138.00 3,354.00 3,506.00 519.00 302.00 201.00 216.00 152.00

Valuation of Calaveras Vineyards Figure 5: Sensitivity Sensitivity of NPV and Equity Value to Discount Rate and Growth Rate
Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Discount Rate 17% 17% 17% 17% 17% 17% 17% 17% 17% 17% 17% Discount Rate 18% 18% 18% 18% 18% 18% 18% 18% 18% 18% 18% Discount Rate 19% 19% 19% 19% 19% 19% 19% 19% 19% 19% 19% NPV Equity Value $3,831.33 $1,881.33 $3,982.12 $2,032.12 $4,150.64 $2,200.64 $4,340.23 $2,390.23 $4,555.09 $2,605.09 $4,800.65 $2,850.65 $5,083.99 $3,133.99 $5,414.56 $3,464.56 $5,805.22 $3,855.22 $6,274.02 $4,324.02 $6,847.00 $4,897.00 NPV Equity Value $4,075.63 $2,125.63 $4,248.47 $2,298.47 $4,442.92 $2,492.92 $4,663.30 $2,713.30 $4,915.16 $2,965.16 $5,205.76 $3,255.76 $5,544.80 $3,594.80 $5,945.48 $3,995.48 $6,426.30 $4,476.30 $7,013.97 $5,063.97 $7,748.55 $5,798.55 NPV Equity Value $4,349.58 $2,399.58 $4,549.05 $2,599.05 $4,775.13 $2,825.13 $5,033.50 $3,083.50 $5,331.62 $3,381.62 $5,679.42 $3,729.42 $6,090.47 $4,140.47 $6,583.72 $4,633.72 $7,186.59 $5,236.59 $7,940.17 $5,990.17 $8,909.06 $6,959.06

Valuation of Calaveras Vineyards

Continued Discount Rate NPV Equity Value 16% $4,658.76 $2,708.76 16% $4,890.74 $2,940.74 16% $5,155.85 $3,205.85 16% $5,461.74 $3,511.74 16% $5,818.62 $3,868.62 16% $6,240.39 $4,290.39 16% $6,746.51 $4,796.51 16% $7,365.10 $5,415.10 16% $8,138.34 $6,188.34 16% $9,132.50 $7,182.50 16% $10,458.05 $8,508.05 Discount Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Discount Rate 14% 14% 14% 14% 14% 14% 14% 14% 14% 14% 14% 15% 15% 15% 15% 15% 15% 15% 15% 15% 15% 15% NPV $5,010.29 $5,282.37 $5,596.32 $5,962.59 $6,395.46 $6,914.89 $7,549.76 $8,343.35 $9,363.67 $10,724.10 $12,628.71 NPV $5,413.26 $5,735.54 $6,111.54 $6,555.89 $7,089.12 $7,740.84 $8,555.50 $9,602.91 $10,999.46 $12,954.62 $15,887.37 Equity Value $3,060.29 $3,332.37 $3,646.32 $4,012.59 $4,445.46 $4,964.89 $5,599.76 $6,393.35 $7,413.67 $8,774.10 $10,678.71 Equity Value $3,463.26 $3,785.54 $4,161.54 $4,605.89 $5,139.12 $5,790.84 $6,605.50 $7,652.91 $9,049.46 $11,004.62 $13,937.37

Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Growth Rate

Valuation of Calaveras Vineyards

Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% Growth Rate 0% 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

Continued Discount Rate NPV Equity Value 13% $5,879.62 $3,929.62 13% $6,265.68 $4,315.68 13% $6,721.94 $4,771.94 13% $7,269.45 $5,319.45 13% $7,938.63 $5,988.63 13% $8,775.10 $6,825.10 13% $9,850.57 $7,900.57 13% $11,284.52 $9,334.52 13% $13,292.06 $11,342.06 13% $16,303.36 $14,353.36 13% $21,322.20 $19,372.20 Discount Rate 12% 12% 12% 12% 12% 12% 12% 12% 12% 12% 12% Discount Rate 11% 11% 11% 11% 11% 11% 11% 11% 11% 11% 11% NPV $6,425.26 $6,893.84 $7,456.15 $8,143.41 $9,002.49 $10,107.02 $11,579.73 $13,641.52 $16,734.21 $21,888.68 $32,197.63 NPV $7,071.87 $7,649.51 $8,355.52 $9,238.03 $10,372.68 $11,885.55 $14,003.57 $17,180.59 $22,475.64 $33,065.73 $64,835.99 Equity Value $4,475.26 $4,943.84 $5,506.15 $6,193.41 $7,052.49 $8,157.02 $9,629.73 $11,691.52 $14,784.21 $19,938.68 $30,247.63 Equity Value $5,121.87 $5,699.51 $6,405.52 $7,288.03 $8,422.68 $9,935.55 $12,053.57 $15,230.59 $20,525.64 $31,115.73 $62,885.99

Valuation of Calaveras Vineyards Figure 6: Sensitivity Continued Sensitivity of Risk Premium to WACC
Geometric Mean Premium Returns on ALL common stock less returns on: Long-Term Government Bonds U.S. Treasury Bills Returns on SMALL company stock less returns on: Long-Term Government Bonds U.S. Treasury Bills Risk Premium 5.5% 6.6% 7.4% 8.5% Risk Premium 7.2% 8.6% 12.4% 13.8% WACC 11% 12% 13% 14%

Arithmetic Mean Premium Returns on ALL common stock less returns on: Long-Term Government Bonds U.S. Treasury Bills Returns on SMALL company stock less returns on: Long-Term Government Bonds U.S. Treasury Bills

WACC 13% 14% 17% 19%