MGMT 2700 Corporate Finance-Structuring Venture Capital

The other major disadvantage of private investment is that it does not offer the scope to the company MGMT to promote the company in public which can easily be done by IPO investment

Operating cash flow forecast for MGMT for years 2018 to 2022 (five years) using the Projections of the investment bank, Appendix-1

Here the EBITDA has been calculated for the projected years of the 2018-2022 for a 5 years period on the basis of the following assumptions:

Growth in sales is 20% per annum until 2022, after OCF will grow at 4% indefinitely

Gross margin 80% of sales

R&D expenses 10% of sales

SG&A expenses 33% of sales

Depreciation expense 20% growth per annum

Capital expenditures and intangibles annual investment 6% of sales

The sum or cumulative value of the EBITDA for the duration of 5 years projection is

The cumulative EBITDA is close to the estimated enterprise value of the company MGMT.

Valuation based on 7 times forward (2018) EBITDA = $44.34 × 7 + $26.2 (cash) = $336.60 million.

The enterprise value can be defined as  the total value of a firm’s equity and debt. And can also be described as the total market value of a company’s expected cash flow stream. A company’s EBITDA is assumed to be measure of that stream. Furthermore, EBITDA is a company’s net income with tax, interest, depreciation, and amortization expenses that are being added back. Thus EBITDA is not an exact measure of a company’s cash flow but it is considered as an important proxy measure of the cash flow which if earned will be able to pay the tax interest and depreciation in future in smooth manner.

Thus Enterprise Value = Multiple * EBITDA

However the assumption of working capital has not being used for the calculation of cash flow as the working capital is the difference between current asset and current liabilities and gives a brief picture of the present financial situation of the company where as the cash flow is a demonstration of the company's ability to generate cash over a specific period of time. Thus a sound cash flow demonstrates that the business is having a strong source of generating working capital (Acharya et al.,2012).

Thus the company is capable to generate estimated positive cash flow for each of the year of the projected duration and net cash flow is net off “Capital expenditure and investment in intangible asset”. Thus the projection defines that   investment in MGMT is a profitable venture(Jennergren,  2011.).

Justification of underlying assumptions of the Investment bank

Looking at the assumptions it can be said that the assumption of “Capital expenditures and intangibles annual investment 6% of sales” and “Working capital reduction is 30% of sales in 2018 only but it is increased back on year 2022” are not justified. As a business has to make substantial investment for capital expenditure for attaining substantial growth and cash flow which should not be as low as 6%  of the estimated values of sales and if this level of investment increases then the cash that will be generated from investment will decrease.

Again the assumption of working capital is not relevant to the cash flow projection and therefore is not justified at all and the sudden reduction in working capital by 30% in 2018 is not justified at all.

Estimated weighted average cost of capital for MGMT assuming that the business is an all-equity business entity, Appendix-2

Here it has been assumed that MGMT is an all equity capital firm and therefore there is no debt in the capital structure of the company

WACC  = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)

And the calculated WACC of the company is 12% assuming that the market value of equity is $215 million USD and it is the total value of the firm as the firm is not raising any debt capital (thus there is no debt or cost of debt present in the calculation)

For the calculation of the cost of equity the following formula is being used

Cost of equity= risk free return+ Estimated firm-size risk premium for this company + β*(Estimated market risk premium)

Where β = Estimated systematic risk (beta) for the video game sector

The “Estimated firm-size risk premium for this company” has been added to the risk free return as the company Raju Technology, Inc. Is investing in to a small company MGMT and investment in a small company is very risky as it may fail to generate the estimated return because of its small scale operation. So the company is paying a premium return for its small scale that is being added to the risk free return(Brooks & Mukherjee,  2013).

Estimated market risk premium = Market return – risk free return

 Calculation of DCF model using the concept of OCF, Appendix-3

Operating cash flow (OCF) is a measure regarding the amount of cash generated by a company's regular business activities. The importance of generating the operating cash flow is to assess the capability of the business in generating positive cash that will be required for maintaining the growth of the business

Here the DCF has been calculated on the basis of the yearly OCF for the projection period under consideration and the calculated DCF on the basis of OCF is 240.7460463, USD

Again the estimated proposed investment per the proposal of the investment bank is $500,000

Therefore DCF recommends that the company MGMT is undervalued as according to DCF each share will be sold at around $560000 but the estimated investment per share being proposed is $500000(Kaplan & Atkinson, 2015).

 Suggestions regarding buying the GY apps by MGMT, Appendix-4

Here the calculation has been done on the basis of the assumption that the company GY is an all equity entity and there4fore there is no debt in the capital structure of the company.

In order to calculate the cumulative present value of the given neutral cash flows the DCF method has been used where the cost of equity of 12% has been used as the rate of discounting he estimated periodic or annual neutral cash flow.

Assumptions of the model are as follows:

Probability of neutral scenario = 50%(P1)

Probability of best case scenario = 35%(P2)

Probability of worst case scenario = 15%(P3)

Best case cash flow is 150% more than neutral scenario cash flow

Worst case cash flow is (-15%) less than neutral scenario cash flow

The maximum estimated suitable price to be paid for buying GY app is 88 million USD

Estimated price to be paid (88 million USD) = P1*DCF1 + P2*DCF2 + P3*DCF3; which is the probability weighted fair values of investments with respect to different scenarios

So if the app is being offered at 25 million USD then it should be considered as economic investment as it is much lower than the maximum level of investment and therefore the investment proposal should be accepted(Easley et al.,2010).

Advantages and disadvantages of investment in equity or a convertible subordinated debenture 

If RTI is making one time investment in MGMT then choosing the option of investment in equity will be easy and comprehensive for the company RTI as equity investment gives a specific figure regarding by investing how much capital how much share value the RTI is owning in the company and being an equity investor RTI is supposed to get the share of profit of the company either in the form of dividend or capital growth.

On the other hand if RTI invest in MGMT in terms of convertible debenture instrument then RTI will receive the return on inversed debenture as per debenture contract and after the specified time the debenture investment will automatically used in purchasing the equity of the same company probably at a discounted price as per the terms of the convertible debenture.

Here the analysis reveal that the company MGMT is going to attain huge growth in future and therefore it is expected that the price of share as well as performance of the company will grow in future (Levin & Light, 2015). 

Thus it is suggested that the option of investing in convertible debenture is suggested to RTI for investing in MGMT as this option will offer the opportunity to RTI to get a secured return under debenture contract and to observe the performance of MGMT and will  accordingly take the decision of converting the debenture in to equity.

So it is recommended that the RTI should make private equity investment in MGMT by using the instrument of convertible debenture for the said projection period of 2018-2022.

Reference:

Acharya, V.V., Gottschalg, O.F., Hahn, M. & Kehoe, C., (2012). Corporate governance &value creation: Evidence from private equity. The Review of Financial Studies, 26(2), pp.368-402.

Brooks, R. &Mukherjee, A.K., (2013). Financial management: core concepts. Pearson.

Bruton, G.D., Filatotchev, I., Chahine, S. &Wright, M., (2010). Governance, ownership structure, &performance of IPO firms: The impact of different types of private equity investors &institutional environments. Strategic management journal, 31(5), pp.491-509.

Easley, D., Hvidkjaer, S. &O’hara, M., (2010). Factoring information into returns. Journal of Financial &Quantitative Analysis, 45(2), pp.293-309.

Jennergren, L.P., (2011). A tutorial on the discounted cash flow model for valuation of companies. SSE/EFI Working paper series in business administration, (1998), p.1.

Kaplan, R.S. &Atkinson, A.A., (2015). Advanced management accounting. PHI Learning.

Levin, J.S. & Light, R.S. eds., (2015). Structuring venture capital, private equity &entrepreneurial transactions. Wolters Kluwer Law & Business.

Levis, M., (2011). The performance of private equity?backed IPOs. Financial Management, 40(1), pp.253-277.