MGTF 407 Final Exam Practice - Valuation question

(No short questions are included in this practice exam but they will be included in the

actual final)

NovaTech (NT) is a start-up in nanotechnology based in Austin, Texas which has hired Goldman Sharks (GS)

as its leading underwriter to conduct its Initial Public Offering (IPO) at the Nasdaq Stock Exchange. The

IPO is scheduled for January 2017, and all money raised in the IPO will go to NT (i.e. not to investors).

You are working for an investment bank that wants to know how much a share of NT is worth as of December

31st, 2016. The results of your analysis will be circulated among institutional investors in a bulletin with

buy/sell recommendations for Nasdaq stocks, including NT’s IPO.

Start-ups in nanotechnology pay no income tax in the state of Texas. The current financial statements of NT

show that NT is currently unlevered. Given the current tax regime in Texas, the CEO of NT does not plan

on issuing any debt in the foreseeable future.

The pro-forma statements of NT contain the following information:

• The revenues of NT are expected to be USD 40 million in 2017.

• The operating cost of NT is 10% of its revenues. Other administrative expenses are equal 5% of

NT’s revenues. Both proportions are expected to remain the same in the foreseeable future.

• The capital expenditures of NT are 10% of its revenues. NT will reinvest the same fraction of its

revenues as capital expenditures in the subsequent years.

• The depreciation of fixed assets from 2017 onwards amounts to 60% of NT’s capital expenditures.

• NT will spend USD 16 million in Research and Development (R&D) in 2017. R&D expenses are

expected to grow proportionately to sales.

• NT requires no working capital to operate.

Three comparable firms have gone public in the Nasdaq Stock Exchange during the past five years. You

have the following data on these firms:

AstraZen Phylos ProTech

Equity Beta 2.50 2.10 2.00

Market Leverage Ratio [D/(D+E)] 10% 3% 0%

Market Capitalization (in USD millions) 20 20 20

AstraZen and Phylos are based in California, whereas Protech is based in Texas. Start-ups in

nanotechnology in California face a marginal income tax rate of 30%. The long term debt contracts of

AstraZen and Phylos have investment grade credit ratings. Assume all three firms are at their target

D/(D+E) ratios.

There is some disagreement among GS’s industry analysts about the expected growth rate of NT’s cash

flows. While some analysts say that NT’s revenues will grow by 2% annually, others say that they will

grow by 15%.

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Current US treasury rates for 1, 8 and 20-year horizons are 2%, 3% and 4%, respectively. Based on

historical estimates, the market risk premium is estimated at 7%.

You should answer the following questions for the sake of writing a weekly report which will be circulated

among the institutional investors of your investment bank.

1. Calculate the free cash flows and the appropriate discount rate for NT. What is the expected value

of NT under the two possible growth forecasts for NT’s revenues? Carefully explain your analysis.

[15 points]

2. NT currently has 9 million shares outstanding and is planning to issue another 1 million at the IPO.

GS, NT’s underwriter, has set an offering price of USD 30 per share for NT's stock. Is this a positive

NPV investment for the institutional clients of your investment bank? Carefully explain your answer.

[15 points]

Assume now that institutional investors expect the State of Texas to eliminate the “no-tax” incentive for

start-ups immediately (before NT goes public), setting the tax rate at 30%.

3. Given a corporate tax rate of 30%, how would the change in the tax regime affect the free cash

flows and the value of NT? Explain your answer in detail. [15 points]

Finally, you are informed that NT will raise debt before the IPO if the corporate tax rate is set to 30%.

NT will raise bank debt worth 10% of the market value of NT’s assets, in line with the financing policy of

AstraZen, and will keep the leverage ratio (D/V) at 10% in the long run. Note that to do this the firm will

convert 10% of its shares into debt (at market interest rates) by negotiating this with a large equityholder

that already expressed an interest in this transaction. Thus there will be no increase in the size of total

assets associated with this change in capital structure. At such a leverage ratio, the debt’s yield to maturity

will be 5%.

4. Given a corporate tax rate of 30%, compute the pre-IPO market value of NT’s assets with financial

leverage. Does financial leverage add value to NT? Carefully explain your answer. [20 points]

5. Given a corporate tax rate of 30% and having raised bank debt before the IPO, should the

institutional clients of your investment bank buy NT stocks at USD 30 per share? What is the value

of a share of NT? Carefully explain your answer taking into account the new tax regime, the

financial leverage of NT and the NT’s analysts’ growth forecasts. [25 points]

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