Lester Electronics Final Paper
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Lester Electronics Incorporated (LEI), after arduous study, has resolved to acquire Shang-Wa Electronics. Through this acquisition, LEI will develop a new strategy to maximize shareholder wealth. The company will discuss the valuation of the company and how to finance the purchase.
Capital Budgeting:
The decision to purchase Shang-Wa Electronics started with the benchmarking of decisions that other corporations in a similar situation have made. Once the projects have been trimmed down to a reasonable list, we will use financial concepts of internal rate of return (IRR) and net present value (NPV) to make the dollar values comparable. Based on this analysis the purchase of Shang-Wa provided an IRR of 11.92% and NPV of $31,882.48 million. (Exhibit 1) The positive values indicated the favorability of the purchase.
Valuation:
The first step in the acquisition process is a sound valuation of the firm of interest. There are many methods for valuation, but we will limit our analysis to the most commonly used and easily understood. The three methods used will derive a valuation and form a cross-check for the value of Shang-Wa Electronics. Solid valuation will require an in-depth research to support any assumptions.
Method 1
The Discounted Cash Flow Method (DFC) approach describes a method to value a project or an entire company using the concepts of the time value of money. The DCF method determines the present value of future cash flows by discounting them using the appropriate required rate of return (RRR). (Ross−Westerfield−Jaffe, 2004) This is necessary because cash flows in different time periods cannot be directly compared since most people prefer money sooner rather than later. Conceptually, the cash flows from operations are discounted from future terms.
The first step in the process is to determine the length of time to forecast the future cash flow. Typically a company forecast cash flows for 4 or 5 years into the future. One can determine the amount of years based on their payback period. This is to say that the company wishes to have the business turn profitable. The average company will use five years. LEI will use 4 because the life of technology components can become obsolete within a relatively short period time. Therefore it is in LEIs best interest to use a 4 year payback period.
Next, we must determine the growth of the company as a whole. LEI has a global sales force with the most weight of sales coming from the United States. Each geographic location will have different sales growth; therefore we must find the average growth rate for the industry globally. During the industry research we interviewed sales representatives, reviewed our past performance, and reviewed trade industry references. Based on interviews and references from “Supply Watch”, an industry newsletter, we have determined that the global growth will be 6% for the foreseeable future. (Ariba, 2006) We then apply this growth rate to the future cash flows for years 1 through 4.
Lastly, we will determine the required rate of return (RRR). There are several methods to determine this value. For example, there is the cost of capital and “general rule of thumb” approach. For the purposes of this valuation we will use the “rule of thumb” approach. Specifically, we will use 19% to discount the dollars to present terms. We derived this number from the average RRR American companies have used to discount their projects, as of 2006. This is in line with corporate giants, such as General Electric, which use a RRR of 20%.
We will disregard the cash flow from investing and finance because they display outlays which can be discontinued or are non-recurring. For example, the cash flow from investing shows outlays for the purchase of property. This outlay can be ceased, and will not require further investment unless directed by future strategy. The only exception will be the interest payment on current debt, which will be displayed as cash outlays. Based on the DFC method the value of Shang-Wa is $110 million. (Exhibit 2)
Method 2
Capitalization of earnings is another commonly used method. It involves first determining a figure that represents the historical annual earnings of the company. Generally, this is EBIT (earnings before interest and taxes). EBIT is divided by a “capitalization rate” that represents the return the buyer requires on the investment in light of the market rate for other investments of comparable risk. LEI has an EBIT of $22,921,000, for the last year financials are available, which is divided by the RRR of 19%. Therefore based on the calculations:
$22,921,000 (EBIT) / .19 (RRR)
= $120,641,000 Value of Shang-Wa Electronics
Method 3
This method usually involves a multiplier to determine the worth of a business,