After a careful examination of the Arch Communications Inc. case and the valuation done by the Analyst, we believe that there are following issues with valuation which should be examined very closely –
1) Technicality Error in the preparation of the Free Cash Flow: In the FCF prepared by John Adams: Tax and Change in Net Working Capital items cannot be observed. We may assume that, this was done on purpose since both of these values were accepted as “0” throughout the forecast period.
* In the absence of knowledge about the details for tax implications in US and the effect of the expected Westlink Holdings acquisition on existing tax base, we accepted the tax assumption made by John Adams as correct. In normal conditions we need to investigate thoroughly the tax issue and the permitted number of years that loss can be carried forward in US. * We think that accepting the “Change in Net Working Capital” as “0” throughout the forecast period is a strong assumption. The negative Net Working Capital (for 2005 Current Assets-Current Liabilities = 33,671-49,172 = 15,501 ) structure may change within forecasted period against to company due to increasing competition. But we still continue with the “0” ∆ Net Working Capital assumption of John Adams.
2) WACC Estimate:
John Adams used the following parameters/assumptions in his WACC calculations: Rf: 7%
Market Risk Premium (“MRM”): 7%
Beta Arch: 1.6
Borrowing Rate: 11%
Eqity/Debt Ratio: 40% / 60%
And based on these:
Re= Rf+ βArch x MRP = 7% + 1.6 x 7% = 18.2 %
WACC = 0.4 x Re + 0.6 x Rd and accepted tax shield from cost of debt as “0” due to the “0” tax cost of the company during the forecasted period. WACC = 0.4 x 18.2% + 0.6 x 11.0% = 13.88% =>13.9%
* In the absence of details about the βArch calculation of John Adams we accepted this assumption as accurate. [ Dear All: Please feel free to comment on Beta and cost of debt assumptions, also on 0 tax assumption in WACC...
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