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  • Subject area(s): Marketing
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  • Published on: 14th September 2019
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Question 1

Step 1: Model Analysis

“Cost of capital” refers to the opportunity cost of making a specific investment. It is the rate of return that could have been earned by putting the same money into a different investment with equal risk. Thus, the cost of capital is the rate of return required by the investor when they are making investment decisions. (Investing Answers, 2017)

Cost of capital varies depending on the structure of financing– it is cost of debt if the company is financed solely of debt while it is the cost of equity of the company is consisted of equity financing. Most of the companies are usually structured by a combination of debt and equity to finance their businesses, and for those companies a weighted average of all capital sources is utilised to reflect the overall cost of their capital which is widely known as the weighted average cost of capital (WACC). (Investopedia, 2017)

The cost of debt is usually the interest rate required by the lender. However, since interest expense is tax-deductible, the after-tax cost of debt is calculated as:

Yield to maturity of debt x (1 - T) where T is the company's marginal tax rate.

Because the rate of return demanded by equity investors is not as clearly defined as that of debt lenders, it is more complicated to calculate the cost of equity. Theoretically, the cost of equity is estimated by the Capital Asset Pricing Model (CAPM) = Risk-free rate + (Beta*Risk Premium).

The principle behind CAPM refers to two ways of compensation requited by investors: time value of money and risk. The time value of money is represented by the risk-free (Rf) rate in the formula and compensates investors for placing money in any investment over a period of time. The other half of the CAPM formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) (how the price of a specific stock is reacted to the change in the overall stock market) to the market premium (Rm-Rf): the return of the market in excess of the risk-free rate. Beta reflects the level of risk of certain asset is compared to overall market risk and is therefore a function of the volatility of the asset and the market as well as the correlation between the two. (Investopedia, 2017)

In this case, as an unlevered cost of capital is required for further analysis, we will therefore be using the CAPM model to remove the effect of debt cost as well as to avoid duplicated tax deduction in following analysis.

Step 2: Beta Analysis

In Exhibit E, Distell's 5 Year Equity Beta is provided however we will carry out further analysis instead of simply applying it into the CAPM model based on two main reasons:

1. In this case we are evaluating the acquisition of Distell's wine assets in South Africa only, not the whole company. However, the beta given is for the whole company which may consist of other assets which have different risk profiles to the wine business. To form a reasonable estimate of the beta of the wine assets in South Africa we will use the average of the Beta of the four selected wine and spirit producers as comparables to project the beta .

2. The beta provided (and those of the four comparable companies) are all equity beta – ie. levered beta. Levered beta reflects a company's entire capital structure so it takes into consideration any debt. As we are evaluating the risk profile of the wine assets, regardless of the debt/equity split of the company itself, we require an unlevered beta.

For the reasons outlined above we must first de-lever the beta of those four comparable and then take the average of the four unlevered beta to yield an estimation of Distell's wine asset beta.

Step 3: Beta Calculation

According to the formula:

Unlevered Beta = Equity Beta * Equity Ratio + Debt Beta * Debt Ratio


Equity ratio = equity value/asset value

Debt ratio = debt value/asset value


Equity value = Shares outstanding * Share price (in Exhibit F)

Asset value = Net Debt + Equity value

Firstly, we multiply the close stock price by the number of shares outstanding given in the Exhibit F to calculate the equity value, which we then add to net debt given to get the total asset value (see tab Beta). We can then calculate the equity and debt ratio simply dividing them by the asset value.

Secondly, we use the debt beta of these four companies to complete the deleveraging calculation. In this case, we assume the debt beta for all four firms is 0. The reason behind is mainly because we assume the debt is risk free and is not related to the market volatility. (In real world, the debt beta is not always 0 but still very negligible compare to the equity beta as we usually assume that the company will not default on any interest or coupon payment.)

Finally, after we have all these components we can then calculate the unlevered beta for these four comparable (see tab Beta), we then take the average of these four unlevered beta and get the final estimation for the beta of Distell's wine asset which is 0.64.

Step 5: Apply CAPM

Using the formula of Capital Asset Pricing Model (CAPM) we calculate the cost of equity by applying the risk-free rate (in this case we are using the long-term UK Gilt 30 Year Yield 3.94%), market risk premium 7% and the earlier-derived beta of 0.64.

CAPM = Risk-Free Rate + Beta*Market Risk Premium

= 3.94% + 0.64*7%

= 8.41%

Question 2

Step 1: Methodology Analysis

The Adjusted Present Value method (APV) is built upon the Modigliani and Miller theory which demonstrates the company's value is independent of how it is financed, under the assumptions of no tax or transaction cost. The APV method further expands the theory by taking into account the tax deductible from interest expenses raised by debt of the company, it separates the investment decision and the financing decision in valuation. It is used for complex structuring where debt plans are critical. (Acuitasinc, 2017)

In comparison with the Discounted Cash Flow method, which uses Weighted Average Cost of Capital (WACC) as the discount rate, the APV method provides an alternative way to take consideration of changing debt and equity structure. It accomplishes changing debt levels by separating financing effect on value from the value of the operation itself. Therefore, the APV is a more flexible way to estimate project value when a company is expected to have changing financing structure over time. (Corporate Finance Institute, 2017)

There are two parts for APV model: the net present value of the project (investment decision) and the present value of the tax shield (the financing decision).

Step 2: Present Value of Project

In this step, we will try to have an estimation on the investment decision.

1.   Present value of free cash flow

We will first make an assumption for depreciation and amortization. We assume a 2% increase in the depreciation and amortization cost versus Distell's historical financials.

As outlined in the case, EBIT is assumed to be constant after FY2019. Therefore, we project the EBIT after 2019 to be £4.5m, equal to the 2018 estimate given by Waitrose Business Development Department. Change in net working capital is flat and capital expenditure is £8.3m per year after FY2019. Using the formula

Free Cash Flow = EBIT (1-tax rate) + (depreciation and amortization) - (change in net working capital) - (capital expenditure)

we have projected below cash flow associated with the acquisition as below:

Projected Year Ending

2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

EBIT 3.7 3.7 3.9 4.2 4.5 4.5 4.5 4.5 4.5 4.5

D&A 4.5 4.9 5.1 5.2 5.4 5.5 5.6 5.7 5.8 6.0

WC change 4.6 4.0 4.3 4.5 4.8 0.0 0.0 0.0 0.0 0.0

CapEx 7.3 7.5 7.8 8.0 8.3 8.3 8.3 8.3 8.3 8.3

FCF (4.69) (3.92) (4.09) (4.29) (4.47) 0.48 0.59 0.71 0.82 0.94

Having projected the cash flow, we now apply a discount rate to get the present value. As calculated in Question 1 for CAPM, we derive the discount rate using the formula

Discount Factor = 1/(1 + Discount Rate)n

and multiply the discount factor with the Free Cash Flow. Finally, we sum up the present value of the free cash flow for every year, yielding a Net Present Value of future incremental cash flows of  -£15.14m

2.   Present value of perpetuity

We will then calculate the present value of the vineyard based on the assumption that it has a perpetuity growth rate of 1%. Given the formula for present value of growing perpetuity

PV = D/(r-g)


D = cash flow (in this case we will use the discounted free cash flow for year 2013)

r = discount rate

g = growth rate

PV of Vineyards' Perpetuity = 0.42/ (8.41%-1%)

    = 5.65

By summing up the present value of the free cash flow projected for the next ten years and the present value of the vineyards' perpetuity, we can then get the total net present value of the acquisition of -£9.48m.

Step 3: Present Value of Tax Shield

Next we estimate the impact of the tax shield on the financial decision. Put simply, interest is paid from pre-tax earnings, so by lowering taxable earnings, interest reduces taxable profit and hence tax paid. (Financial Times, 2017)

Given that Distell is based in South Africa, we make the assumption that the usual South African corporate tax rate of 28% applies for projections after FY2013.

First we calculate the interest payment in each of the ten projected years

Interest payment per year = Total amount of Debt * Cost of Debt

     = 46m * 6.5%

     = 2.99m

We then multiply the interest payment by the tax rate of 28% to yield the tax shield, and apply the discount factor to the tax shield to give its Present Value.

The discount factor used will not be the same one applied to our free cash flow. Since the tax shield comes as a result of debt financing, we will discount it by the cost of debt (6.5%), rather than the asset cost used previously.

Using the formula Discount Factor = 1/(1 + Discount Rate)^n we determine the present value for the tax shield created for the next 10 years. Summing these together gives a total present value of the tax shield of £6.02m.

Projected Year Ending

2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Interest 2.99 2.99 2.99 2.99 2.99 2.99 2.99 2.99 2.99 2.99

Tax Shield 0.84 0.84 0.84 0.84 0.84 0.84 0.84 0.84 0.84 0.84

Discount Factor 0.94 0.88 0.83 0.78 0.73 0.69 0.64 0.60 0.57 0.53

PV of Tax Shield 0.79 0.74 0.69 0.65 0.61 0.57 0.54 0.51 0.47 0.45

Step 4: Project Value Including Tax and Terminal Value

Using the formula of Adjusted Present Value = Net Present Value of the project + Present Value of Tax Shield, we now have the final result for the value of this acquisition:

APV = -£9.48 + £6.02 = -£3.47m

Question 3

Step 1: Project cash flow without implementing the technology

According to the case, the packaging costs without electricity savings will increase by 8% per year after 2018, and bottling costs without the electricity savings will rise at 10% per annum after 2018. We can therefore project the packaging and bottling cost for year 2019 to year 2023:

Projected Year Ending

2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Packaging 8.96 9.68 10.45 11.28 12.17 13.15 14.20 15.33 16.56 17.88

Bottling 3.07 3.39 3.73 4.11 4.52 4.97 5.46 6.01 6.61 7.27

Step 2: Project cash flow with the technology implemented

According to the estimation made by the engineers, the reduction in electricity usage from the biofuel product would generate savings of 3% per year on future packaging costs and 6% on bottling costs. Given the savings will begin in 2015, we project the packaging and bottling cost for year 2015 to year 2023:

Projected Year Ending

2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Pkg w/ tech 8.96 8.69 8.43 8.18 7.93 7.69 7.46 7.24 7.02 6.81

Btl w/ tech 3.07 2.89 2.71 2.55 2.40 2.25 2.12 1.99 1.87 1.76

Step 3: Discount the savings into present value

After projecting both the cash flow with and without implementing the new technology, we can calculate the difference between both and determine the incremental cash associated with this investment. We then discount the incremental cash flow into present value.

Projected Year Ending

2014 2015 2016 2017 2018 2019 2020 2021 2022 2023

Savings on Pkg 0.00 0.98 2.01 3.10 4.24 5.45 6.73 8.09 9.54 11.07

Savings on Btl 0.00 0.50 1.02 1.56 2.12 2.71 3.35 4.02 4.74 5.51

Total Saving 0.00 1.48 3.03 4.65 6.36 8.16 10.08 12.11 14.28 16.58

Initial invest (15.00) 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Cash flow (15.00) 1.48 3.03 4.65 6.36 8.16 10.08 12.11 14.28 16.58

DF 0.92 0.85 0.78 0.72 0.67 0.62 0.57 0.52 0.48 0.45

PV (13.84) 1.26 2.38 3.37 4.25 5.03 5.73 6.35 6.90 7.40

Question 4

The net present value of this acquisition with the technology is calculated as per below:

NPV = NPV of the investment of technology + APV of the acquisition

   = £28.83m + (-£3.47m)

   = £25.37m

Taking consideration of the initial £46m purchase price, we can foresee a negative net present value for whole acquisition of - £20.63m.

Therefore from our point of the view the initial purchase is over-priced.

We argue that from a financial perspective the deal is structured in the most efficient possible way; being entirely debt-funded, the tax shield is maximised, as is the IRR of the equity.

We identify 4 other strategic factors that should be considered before deciding to reject the current proposed deal.

Moving upmarket:  Considerable sales synergies could be created as a result of the acquisition. The global reach of Waitrose (its brand is present in over 30 countries) could mean that Distell's produce can be more efficiently distributed in markets willing to pay more for the same bottles. This effect could be magnified by local marketing campaigns focused on South African wine as a whole. This strategy has been demonstrated successfully by Beckman's Jose Cuervo Company. (El Financiero, 2017)

Cutting costs:   There are numerous business functions within Distell that could potentially be more efficiently organized. These include marketing, distribution and R&D, insofar as they can be operated remotely. It may also be possible to negotiate large scale electricity supply contracts with Eskom, the state-owned power company. In particular, our new technology may help stagger Distell's electricity requirements outside of peak hours.

Reducing the operating costs of Distell in this way would increase cash flows and thus the NPV of the deal.

Value captured in the balance sheet:   It may be worth considering other forms of valuation:  Currently the working capital is increasing each year, which significantly distorts the value of free cash flows. If we consider looking to eventually liquidate Distell's assets, rather than holding it to perpetuity, then the £46m bid looks more reasonable. Distell's balance sheet shows that the company's assets outweigh its liabilities by £91.8m.

Distell Balance Sheet, simplified 2013

Assets 97.6

Accounts receivable 12.7

Inventories 46.9

Property, plant and equipment 38.0

Liabilities 5.8

Accounts payable 5.8

Equity 91.8

Paying less:  Waitrose could lower their bid for the company. As per our analysis, the NPV of Distell's cash flows, without technology or tax shield, is -£9.48m. Assuming the current owners value their business more highly than this, the next step would be to value the assets of Distell as part of Waitrose and share the synergies with the seller.

Coinvest with Distell's current shareholders: An alternative deal structure could be the following:

1. Waitrose invests £15m in the development and implementation of the energy-saving technology.

2. The value created by this investment is shared between Waitrose and Distell's current shareholders in a proportion such that Waitrose recovers at least its investment + expected return (NPV>0).

3. Distell's wine operations become profitable. Thus both parties gain: existing shareholders are better off and Waitrose gains a controlling stake in the company.

4. Ideally Waitrose would look to retain the local management team to ensure the acquisition transition runs as smoothly as possible.

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