Active Gear, Inc. (AGI) is a privately held footwear company and is contemplating the possibility of acquiring Mercury Athletic Footwear. West Coast Fashions Inc., a large designer and marketer of men’s and women’s branded apparel recently announced that it plans to shed its Mercury Athletic Footwear subsidiary. AGI’s head of business development, John Liedtke, believes acquiring Mercury Athletic Footwear is a good option for the company. Although AGI is currently among the most profitable firms in the footwear industry, it is also much smaller than most of its competitors, which the company’s management views as a competitive disadvantage. During the past three years AGI’s revenue has grown at an average annual rate of only 2.2% while the industry average is about 9.7%. Liedtke believes that acquiring Mercury Athletic Footwear would double AGI’s revenue, increase its leverage with contract manufactures, and expand AGI’s presence in relators and distributers. Before acquiring Mercury Athletic Footwear, Liedtke wants a complete evaluation of the opportunity. Quantitative Analysis
An effective method of quantitatively evaluating a possible acquisition of a company is to complete an excess free cash flow analysis. This method is designed to estimate the present value of a business. To run this analysis, an analyst needs to determine the correct discount rate to use, which is also a company’s estimated weighted average cost of capital. An estimation of a company’s long-term growth rate also needs to be made. Then using this estimated growth rate an analyst needs to determine the excess free cash flow per period, which is the amount of cash that a business can payout to investors after paying for all investments necessary for growth. To find this, an analyst usually determines, for each period, the net income after taxes. Then add back the depreciation expense and take into consideration the effects that capital expenditures and changes in working capital have on free cash flow. After the excess free cash flow for each future period has been determined, each period’s cash flow is discounted to its present value. The sum of the present value of all the excess future cash flows then represents the present value of the business.
In the first excess free cash flow analysis ran for Mercury Athletic Footwear, as can be seen in Exhibit 1, we used the assumptions given by Liedtke. Liedtke assumed that Mercury’s women’s casual footwear would be wound down within one year following an acquisition. Liedtke assumed this segment of Mercury would be wound down because it reported an operating loss in each of the last two years, and he doubts West Coast Fashions would be willing to sell Mercury without it. He additionally made operating predictions, as well as projections, for certain balance sheet accounts for Mercury for the next five years. He also assumed that Mercury’s historical corporate overhead-to-revenue ratio would conform to historical averages. Another assumption Liedtke made was Mercury would use the same degree of leverage that AGI currently uses, which is 20%, and current credit market conditions would stay the same, which resulted in an estimated WACC of 6%. He also assumed Mercury’s long term growth would be 2% per year, and the tax rate would stay at the present rate of 40%. As can be seen in Exhibit 1, every year for the next ten years following the acquisition has a positive excess free cash flow. The total present value for the next ten years’ excess cash flow is $204,315.25. So according to these assumptions, if Mercury was to operate for ten years after the acquisition, its present value would be $204,215.25.
We decided that excess future free cash flow analyses should be ran on Mercury by changing Mercury’s WACC. There are two main factors that affect the estimate for a company’s WACC . These factors are company’s leverage and the credit...