EXERCISE 4
Construct 20-year ERM model for valuation of case below.
Pear, Inc., a competitor to Apple in the handheld electronic device market, manufactures SmartPhones and similar devices, and sells them through retail outlets in the United States. It hopes to expand operations into Canada, someday, but has no specific plans as of yet. Pear’s main competitive advantage is a service called InfinityG, which allows for better reception and faster data transfer rates than its competitors. Pear’s advertising also claims that InfinityG is much better at protecting customer data through enhanced encryption on data transfers, and other proprietary techniques.
At the end of last year, Pear had 1,000 salespeople, producing an average of $155,000 in annual sales per salesperson, based on a $250 purchase price per unit, which in the past has just kept pace with inflation. Pear tends to lose 15% of its salespeople each year. Last year, Pear hired an additional 100 new salespeople; starting this year, Pear plans to increase the number of additional new salespeople hired by 100 each year (i.e., 200 this year, 300 next year, etc.).
Other revenues last year included net investment income of 3.5% net earned rate on assets of $139,971,292. Other assets of $30,000,000 are non-depreciating and non-income generating.
Other liabilities are a constant $50,000,000.
Last year, expenses were:
§ Cost of goods sold (CGS): $112,220,000 (variable costs) (costs are variable directly with sales)
§ Selling, General & Administrative (SG&A): $18,347,826 (fixed costs)
§ Research & Development (R&D): 5% of revenues (semi-variable costs)
There is a $100,000,000 debt on which Pear pays debt service of 4.50% annually. There are no plans to pay down the debt, and the debt is expected to be renewed indefinitely at the same rate.
Going forward, Pear expects inflation of 2.5%.
Income taxes are generally 21% of Earnings Before Income Tax (EBIT).
Management uses 12% as a hurdle rate to estimate returns expected by shareholders.
There are 88 million shares outstanding. The stock price is $7.50 per share.
Assume:
§ GAAP = TAX basis for taxes
§ Net income = shareholder dividends
§ There are no non-cash items (distributable cash flow = net income)
§ Company value = present value of distributable cash flow through 20 years, plus the discounted value of remaining equity at the end of year 20.