CFA Institute CFA-Level-II Exam - Topic 3 Question 81 Discussion

Marsha McDonnell and Frank Lutge are analysts for the private equity firm Thorngate Ventures. Their primary responsibility is to value the equity of private firms in developed global economies. Thorngate's clients consist of wealthy individuals and institutional investors. The firm invests in and subsequently actively manages its portfolio of private firms.

During a discussion with junior analysts at the firm, McDonnell compares the characteristics of private firms with that of public firms and makes the following statements:

Statement 1: Private firms typically have higher risk premiums and required returns than public firms because private firms are usually smaller and thus thought to be riskier. Furthermore, the lack of access to liquid public equity markets can limit a private firm's growth.

Statement 2: Because of their higher risk, private firms may not be able to attract as many qualified applicants for top positions as public firms. Due to the higher risk, the managers they do attract tend to have a shorter-term view of the firm and their tenure at the firm, compared to public Firm managers. As a result, the private firm may neglect profitable long-term projects.

Due to its considerable success, Thorngate has recently attracted a substantial inflow of capital from investors. To deploy that capital, McDonnell and Lutge are considering the purchase of Albion Biotechnology. Albion is using advances in biotechnology for application in the pharmaceutical field. The analysts are primarily interested in Albion because the firm's research team is developing a drug that Thomgate's current pharmaceutical firm is also working on. McDonnell estimates that combining research teams would result in advances that no pharmaceutical competitor could match for at least two years. The firm is currently owned by its founders, who are familiar to Lutge through previous social contacts. Lutge hopes to avoid a competitive bidding process for the firm, because its founders have not advertised the firm's sale publicly.

McDonnell is also examining the prospects of Balanced Metals, a metal fabrication firm. Thorngate currently does not have any manufacturing firms in its portfolio, and Balanced would provide needed exposure. The growth in sales at Balanced has been impressive recently, but it is expected to slow considerably in the years ahead due to increased competition from overseas firms. The firm's most valuable assets are its equipment and factory, located in a prime industrial area.

Balanced was previously considered for possible purchase by a competitor in the metal fabrication industry. Although (he sale was not consummated, McDonnell has learned that the firm estimated that costs could be reduced at Balanced by eliminating redundant overhead expenses. McDonnell has obtained the following financial figures from (he Balanced Metals CFO as well as the previously estimated synergistic savings from cost reductions. Capital expenditures will equal depreciation plus approximately 4% of the firm's incremental revenues.

Current revenues $22,000,000

Revenue growth 7%

Gross profit margin 25%

Depreciation expense as a percent of sales 1%

Working capital as a percent of sales 15%

SG&A expenses $5,400,000

Synergistic cost savings $1,200,000

Tax rate 30%

Lutge is valuing a noncontrolling equity interest in Jensen Gear, a small outdoors equipment retailer. Jensen has experienced healthy growth in earnings over the past three years. However, given its size and private status, Lutge does not expect that Jensen can be easily sold. To obtain the appropriate price multiple for the Jensen valuation, he has prepared a database of price multiples from the sale of entire public and private companies over the past ten years, organized by industry classification. Using historical data, Lutge estimates a control premium of 18.7% and discount for lack of marketability of 24%.

To obtain the cost of capital for Jensen, Lutge uses a cost of capital database that includes public company betas, cost of equity, weighted average cost of capital, and other financial statistics by industry. Given Jensen's small size, Lutge obtains a size premium using the smallest size decile of the database. McDonnell examines Lutge's cost of capital calculations and makes the following statements.

Statement 1: I am concerned about the use of this database. The estimation of the size premium may result in an undervaluation of the Jensen equity interest.

Statement 2: The use of betas and the CAPM from the database may be inappropriate, [f so, Lutge should consider using the build-up method where an industry risk premium is used instead of beta.

Which of the following income approaches would be most appropriate for valuing Balanced Metals?