WALTHAM, INC.: Acquisition of Artforever.com Waltham, Inc., a publicly traded firm, is considering the acquisition of a private company, Artforever.com, which specializes in restoring damaged artwork and vintage photographs for high net worth individuals. Waltham’s CEO and chairman of the board, Willie Ray, described the motivation for the acquisition as follows: “We are running out of profitable investment opportunities in our core vintage shoe restoration business, and our shareholders expect us to continue to grow. Therefore, we must look to acquisitions to expand into growing markets.” Waltham, Inc.’s common stock is currently trading at $50 per share, and the firm has 100,000 shares outstanding. The book value of the common stock is $20 per share. However, as mentioned by Mr. Ray, sales had been slowing recently and the board was concerned that soon the share price would also begin to flag as investors figured out that the firm was running out of positive NPV investments. The firm has $2,000,000 market value of bonds with a coupon rate of 5%, which are currently trading at a yield to maturity of 6.2%. You have been hired by Waltham to evaluate the proposed acquisition of Artforever.com. Your job is to perform a thorough analysis of the merits of the proposed acquisition and make a recommendation to senior management. After several meetings with Waltham management and a review of Artforever’s financial performance and industry structure, you gathered the data shown in Table 1 below. Table 1 Forecast Data for Artforever.com (in $’000) 2013 2014 2015 2016 2017 Sales Revenue 1,000.0 1,250.0 1,875.0 2,100.0 3,750.0 Investment in CapEx and NWC 25.0 55.0 170.0 80.0 80.0 Depreciation 15.0 30.0 50.0 72.0 80.0 Interest payments 94.4 101.4 108.6 115.9 122.4 Artforever.com currently has $1,475,000 (market value) in long-term debt, with a coupon rate of 7%. Its cost of goods sold (COGS) is expected to be 42% of sales revenues, and selling, general and administrative (SG&A) expenses are expected to be 15 percent of revenues. The depreciation numbers listed above are already included in COGS percentage estimates. The firm’s current cost of borrowing is 6.2%. Your research indicates that Artforever has a target debt to value ratio of 15%, based on its management’s assessment of the probability and costs of financial distress. You note that this is different from the capital structure of Waltham and wonder how this would factor into your analysis. Although Artforever.com is a rapidly growing company, your analysis of industry structure suggests that competition in the art restoration market is likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free cash flows beyond 2017 will be a more modest 2.0% per year. You have also gathered the market data in Table 2 below. Table 2 Market Data Current yield to maturity on 30 year treasury bonds 2.50% Current yield to maturity on 3 month treasury bills 2.0% Most recent 1-year return on the S&P 500 5.3% Estimate of expected average return on the S&P 500 over the next 30 years 8.0% Your analysis of Artforever.com’s industry reveals that most of the firms in the industry, like Artforever, are private firms. However, you find a close competitor, ArtToday.net, that is in the same line of business and is publicly traded. ArtToday has a long-term target debt to equity ratio of 0.75, and has been historically quite close to that target. A regression analysis of ArtToday’s historical returns against the market returns yields an equity beta of 1.5. ArtToday currently has 50,000
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