Valuation of Mercury Athletic Footwear- Finance Case Solution Sample

QUESTION

 

Valuing Mercury Athletic

To perform a preliminary valuation, Liedtke developed a base case set of financial projections based on forecasts of revenue and operating income for each of Mercury’s four main segments as shown in Exhibit 6. Liedtke’s base case assumed that women’s casual footwear would be wound down within one year following an acquisition, as he doubted that WCF would be willing to sell Mercury without it. He further assumed that Mercury’s historical corporate overhead-to-revenue ratio would conform to historical averages. To accompany the operating projections, Liedtke prepared projections for certain balance sheet accounts for Mercury, shown in Exhibit 7; these corresponded to operating assets and liabilities that Liedtke expected would be required to support his operating projections. He did not prepare projections for debt or equity accounts since Mercury

likely would not have its own balance sheet and capital structure following an acquisition by AGI. To estimate a discount rate, Liedtke planned to assume the same degree of leverage for Mercury that AGI currently used, which he estimated to be 20%, measured as debt divided by the market value of AGI’s invested capital. Given current credit market conditions, he expected this degree of leverage to imply a cost of debt of 6.0%.4 Finally, his analysis would assume a 40% tax rate, equal to AGI’s anticipated marginal tax rate.

After examining Mercury’s value using the base case assumptions, Liedtke also wanted to consider the value of possible synergies. Specifically, he believed that AGI’s inventory management system could be adopted by Mercury at little incremental cost and would reduce Mercury’s DSI to the same level as AGI’s. In addition, he thought it was possible that Mercury’s women’s casual footwear line could be folded into Active Gear’s, rather than discontinued. In that case, he thought the combined businesses could achieve an EB

 

 

ANSWER

 

Case Analysis

Industry Analysis

Both the companies belong to the footwear industry which is a highly competitive industry in itself. The margins in this particular industry are very thin and for higher profitability the company depends on scaling up the sales of the product. Also, customer’s brand loyalty plays a very important role in this industry. This is because the fashion is continuously changing at high pace and it puts pressure on the company to be able to deliver what customer wants. If the company is not able to deliver on time than the customer will move on to its competitor.

Also, in this particular industry every brand, style of the footwear and their use have their own customer base. So, a company specializing in one particular design or use would have characteristic of that particular market. A united company which has presence in multiple brands will have more stable performance results than a company dealing in one particular brand.

Also, margins in this particular industry are highly dependent on the inventory management by a particular company. If the company is able to keep its days to sale inventory ratio low, than it has chances of earning higher returns.

AGI

AGI was founded in the year 1965 which produced high quality tennis and golf shoes. At the beginning of the year 1970 AGI moved into casual footwear thus diversifying their business. As in the year 2006, more than 42% of the AGI’s revenue came from athletic shoes which were sold via 5700 of stores. AGI did not sell through big box discount stores. Recently, AGI has started facing the problem. Being a relatively small company AGI was losing its competitive advantage specially because of consolidation of manufactures in china. Also, company’s policy not to sell through big box discount stores has been a major factor of reduced revenue growth rate in the recent years.

Mercury

Mercury Athletic footwear is a subsidiary of the West Coast Fashion. The company mainly deals in four major categories of product, Men’ Athletic Wear, Men’s Casual Wear, Women’s Athletic Wear and Women’s Casual Wear. They basically aim at urban and youth market which is one of the most lucrative market in this particular industry. The target customers of this particular company are from the age 15 to 25. Also, mercury does not discriminate its sales channel. It is sold through departmental stores, speciality retailers, wholesalers and independent distributors.

Possible Synergies

There is whole lot of scope of synergies between the two companies such as

  • There would be increase in sales which would be because of use of the same sales channel and diversification based on new markets
  • The overall production efficiency will increase because of consolidation in manufacturing facilities. The new firm will have higher production volume, thus giving them the power to be able to negotiate for lower cost from different manufacturers and suppliers
  • Logistics efficiency will also improve. The combined company would be able to combine the logistics operation for both companies, thus ultimately decreasing overhead cost and possibly offer more efficient distribution network
  • AGI has a higher profitability margin which is mainly because of better management of the inventory of the company, the same can be implemented in Mercury to increase the profitability of the combined company
  • Lastly, the two company’s brands target different customers markets. This would help the combined company to venture into different markets

Valuation

Working Capital

For the purpose of valuation first thing is we are required to calculate the working capital requirement of mercury over the coming years. Working capital is the most important thing in this particular industry. This is because the margins in this industry are very less and poor management of working capital would result in reduced profitability.

Working Capital Calculation

2006

2007

2008

2009

2010

2011

Current Assets

 

 

 

 

 

 

Cash

10676

4161

4195

4566

4894

5130

Accounts receivable

45910

47888

48857

53164

56978

59715

Inventory

73149

83770

85465

92999

99672

104460

Prepaids

10172

14474

14767

16069

17222

18049

Total Current Assets

141913

152300

155292

168807

180776

189365

 

 

 

 

 

 

 

Current Liabilities

 

 

 

 

 

 

Accounts payable

16981

18830

18985

20664

22149

23214

Accrued expenses

18810

22778

22966

24996

26792

28081

Total Current Liabilities

35791

41608

41951

45660

48941

51295

 

 

 

 

 

 

 

Working Capital

106122

110692

113341

123147

131835

138070

 

 

 

 

 

 

 

Additional Working Capital Requirement

 

4570

2649

9806

8688

6235

Cash Flow Calculation

Once the working capital requirement was calculated, rest things were already given in the case from which could calculate the cash flows of the company

 

2007

2008

2009

2010

2011

Revenue

 

 

 

 

 

Men’s Athletic

251957

282192

310411

335244

352006

Man’s Casual

52179

53223

54287

55916

57594

Women’s Athletic

138390

153613

167438

179159

188117

Women’s Casual

36802

 

 

 

 

Consolidated Revenue

479328

489028

532136

570319

597717

 

 

 

 

 

 

Operating Expenses

 

 

 

 

 

Men’s Athletic

218435

244647

269112

290641

305173

Man’s Casual

43834

44711

45605

46973

48382

Women’s Athletic

124302

137976

150393

160921

168967

Women’s Casual

37265

 

 

 

 

Consolidated Operating Expenses

423836

427334

465110

498535

522522

 

 

 

 

 

 

Corporate Overhead

8487

8659

9422

10098

10583

 

 

 

 

 

 

Total Expenses

432323

435993

474532

508633

533105

 

 

 

 

 

 

EBIT

47005

53035

57604

61686

64612

 

 

 

 

 

 

Less Tax @ 40%

18802

21214

23042

24674

25845

 

 

 

 

 

 

EAT

28203

31821

34562

37012

38767

 

 

 

 

 

 

Add: Depreciation

9587

9781

10643

11406

11954

 

 

 

 

 

 

Less: Capital Expenditure

11983

12226

13303

14258

14943

 

 

 

 

 

 

Less: Change in Working Capital

4570

2649

9806

8688

6235

 

 

 

 

 

 

Free Cash Flow to Firm

21237

26727

22096

25472

29543

Valuation

For the purpose of valuation, we require two things, first is the terminal growth rate and the second is WACC. The case tells us that the WACC is in the range of 6% to 10%. As far as terminal growth rate is considered we take a range from 1% to 5%.

The Value of Mercury at Different Rates

Terminal Growth Rate

1%

2%

3%

4%

5%

Cost of Capital

6%

550567

667571

862578

1252591

2422633

7%

456298

531426

644117

831935

1207572

8%

389055

440758

513141

621716

802674

9%

338699

376072

425903

495666

600311

10%

299597

327622

363655

411698

478959

Given the synergies and positive NPV’s at all the possible scenarios, AGI should go ahead with the acquisition of the company.

 

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