Mercury Athletic Case

David Petru-Catalin (10824618)

1a. What are the free cash flows from 2007 until 2011? Create a table. Check exhibit 6 for elements of
the calculation that are relevant but not in that table, and elements which you might need to remove.
Argue your choices (two or three lines of text / item)
Year
Total Revenue
Operating Expenses
Corporate Overhead
EBIT
Taxes
Depreciation
Capital Expenditure
Change in Working Capital
Free Cash Flow

2007
479,329
(423,837)
(8,487)
47,005
(18,802)
9,587
(11,983)
(11,084)
14,723

2008
489,028
(427,333)
(8,659)
53,036
(21,214)
9,781
(12,226)
(2,614)
26,763

2009
532,137
(465,110)
(9,422)
57,605
(23,042)
10,643
(13,303)
(9,434)
22,469

2010
570,319
(498,535)
(10,098)
61,686
(24,674)
11,406
(14,258)
(8,359)
25,801

2011
597,717
(522,522)
(10,583)
64,612
(25,845)
11,954
(14,943)
(5,998)
29,780

Assumptions:
-

All items necessary to determine EBIT for Mercury in the upcoming years were extracted from
Exhibit 6.
I used the tax rate of 40% which is provided in the text as the one used by Liedtke.
Depreciation and Capital Expenditure were also provided in Exhibit 6.
For determining the Change in WC I used Exhibit 7 (which provides forecasts for 2007 2011)
and Exhibit 4 (this was necessary to compute the change in WC between 2006 and 2007):

Accounts Receivable
Inventory
Prepaid Expenses
Current Assets
Accounts Payable
Accrued Expenses
Current Liabilities
Net Working Capital
Change in NWC

2006
45,910
73,149
10,172
129,231
16,981
18,810
35,791
93,440

2007
47,888
83,770
14,474
146,132
18,830
22,778
41,608
104,524
11,084

2008
48,857
85,465
14,767
149,089
18,985
22,966
41,951
107,138
2,614

2009
53,164
92,999
16,069
162,232
20,664
24,996
45,660
116,572
9,434

2010
56,978
99,672
17,222
173,872
22,149
26,792
48,941
124,931
8,359

2011
59,715
104,460
18,049
182,224
23,214
28,081
51,295
130,929
5,998

1b. Explain what it means to have a depreciation that is smaller than capital expenditures, and which
elements of the NPV calculation this might affect.
In such a situation, the company is investing strongly in its asset base in order to obtain higher growth in
the future. Even though the effect on cash flows will be negative in the short term (the capex outflow is
higher than depreciation), it is expected that the future growth rates in cash flows will also be higher
than in the case when less investments were made. Therefore, in my opinion, it is probable that the net
effects on NPV will be positive as long as the return on these investments exceeds the cost of capital.
1c. The womans casual line will be discontinued (that decision has been made and is irreversible).
Suppose that it emerges that in 2008, the will be an additional cash outflow of $130,000 to settle a
claim against this line based on an event in 2004. How will this affect the NPV calculation of Mercury
Athletic as a company? Does it matter if the company is acquired, continues as a daughter of West
Coast Fashions, or becomes a stand-alone company?

Mercury Athletic Case

David Petru-Catalin (10824618)

I assume that 130,000$ is actually 130,000$ * 1000$ as it is the case for all amounts listed in the case.
Because of the $130,000 cash outflow, the NPV will be lower than in the base case. If this outflow may
be treated as a deductible expense, then it will probably have a smaller impact if the company is
acquired, as long as the acquirers earnings exceed this amount due to the tax shield that arises with
deductible expenses. If the outflow is not deductible, then the net impact will be higher but a large
company may still absorb it easier than a small company.
If Mercury will continue as a stand-alone company, the 130,000$ will probably erase all its income and
the tax shield will be not available starting from a certain threshold. Such a high outflow at a given point
in time may even pose going-concern issues because it represents almost 50% of the shareholders
equity reported for 2006 270,592$.
1d. Argue which differences will be made to the projected cash flows if Mercury is acquired by a
competitor, as the case suggests.
Because of the synergies that are expected to arise in the case Mercury is acquired by a competitor
(such as a more efficient inventory system), the cash flows will increase and therefore, the NPV of
Mercury will be positively impacted. Because of the synergies expected after the acquisition which
translate into higher future cash flows, the competitor may pay a higher price for the company than
other investors (such as the management in the MBO scenario) which do not have capabilities of
increasing future cash flows through synergies.
2a. Determine the asset beta for each of the competitors mentioned in exhibit 3. Use a beta for debt
of zero, except for Kingsley Coulter, Surfside and general Shoe Corp., use a beta of debt of 0.2 for
those companies.
For each company in Exhibit 3, I first computed the debt weight in total invested capital as D/D+E =
D/E/1+D/E. For example, for D&B Shoe Company D/D+E = 29.9% / (29.9% + 1) = 23.02%
Then, I gathered all the other necessary inputs from Exhibit 4 and computed the asset beta for each
competitor.
Company
D&B Shoe Company
Marina Wilderness
General Shoe Corp.
Kinsley Coulter Products
Victory Athletic
Surfside Footwear
Alpine Company
Heartland Outdoor
Footwear
Templeton Athletic

Equity Beta
(E)
2.68
1.94
1.92
1.12
0.97
2.13
1.27

76.98%
108.23%
75.64%
66.80%
82.17%
74.46%
77.82%

0
0
0.2
0.2
0
0.2
0

23.02%
-8.23%
24.36%
33.20%
17.83%
25.54%
22.18%

Asset Beta
(U )
2.1
2.1
1.5
0.8
0.8
1.6
1.0

1.01

107.18%

-7.18%

1.1

0.98

70.13%

29.87%

0.7

E/(D+E)

Debt Beta
(D )

D/(D+E)

For example D&B Shoe Company:

Asset Beta (u) = E/(E+D)*E+D/(E+D)* D= 76.98%*2.68 + 23.02%*0 = 2.1
The average of the competitors is 1.28.

Mercury Athletic Case

David Petru-Catalin (10824618)

2b. Calculate the equity beta of Mercury Athletic after the MBO, for various levels of debt. (use the
following percentages for debt/total value: 0%, 10%, 25%, 40% , 50%, 60%, 75%)
Asset Beta
(U )
1.28
1.28
1.28
1.28
1.28
1.28
1.28

D/(D+E)
0%
10%
25%
40%
50%
60%
75%

D/E
0.11
0.33
0.67
1.00
1.50
3.00

Debt Beta
(D )
0
0
0
0
0
0
0

(U ) less
(D )
1.28
1.28
1.28
1.28
1.28
1.28
1.28

Equity Beta
(E)
1.28
1.42
1.71
2.13
2.56
3.20
5.12

For each debt level: E = u + (D/E)* (u - D). I assumed that D is equal to zero, since there is no data to
this variable in the text.
For example at the 11% level: E = 1.28 + 11% * (1.28 0) = 1.42
2c. Calculate the WACC for each scenario of 2b, assuming a cost of debt of 6%.
First of all, I estimated the unlevered cost of equity. We can use the CAPM model for this purpose:
rE = rf + u * (rM - rf ) = 4.93% + 1.28 * 5% = 11.3% (I used the 20 yr US bond as the risk free rate because
of the long term horizon of the company)
Unlevered Cost
of Equity (rU)
11.3%
11.3%
11.3%
11.3%
11.3%
11.3%
11.3%
11.3%

D/E
0.11
0.25
0.33
0.67
1.00
1.50
3.00

D/(D+E)
0%
10%
20%
25%
40%
50%
60%
75%

Cost of Debt
(rD )
6%
6%
6%
6%
6%
6%
6%
6%

(U ) less Cost of
WACC
WACC
E/(D+E)
Tax Rate
Equity (rE)
(unlevered)
(levered)
(D )
5%
11.3%
100%
11.330%
40%
11.3%
5%
11.9%
90%
11.330%
40%
11.1%
5%
12.7%
80%
11.330%
40%
10.9%
5%
13.1%
75%
11.330%
40%
10.7%
5%
14.9%
60%
11.330%
40%
10.4%
5%
16.7%
50%
11.330%
40%
10.1%
5%
19.3%
40%
11.330%
40%
9.9%
5%
27.3%
25%
11.330%
40%
9.5%

According to the text, the cost of debt remains at 6% at all levels of leverage. The cost of equity
increases as the debt levels increase. For example, at 10% debt, rE = rU + D/E * (rU rD) = 11.3% +
11.1% * (11.3% - 6%) =11.9%. Overall, the WACC (unlevered) will be the same at all debt levels in a
world without taxes and without costs of financial distress.
The WACC (levered) will decrease the more debt the company contracts because of the tax shield and
because the cost of debt remains constant. For example, at 75% debt, WACC (levered) = rE*E/(D+E) +
rD*(1-t)*D/(D+E) = 25% * 27.3% + 75%*6%*(1-40%) = 9.5%.
2d. Explain if your results would be different in the US (tax rate of 40%, as given in the case) compared
to the Netherlands (with a tax rate of 25%). Reflect on the likelihood that a MBO would be successful
in both countries.
US has a higher tax rate and therefore the value of the tax shield provided by debt exceeds the one in
the Netherlands. This results is a lower WACC and consequently in a higher firm value. Therefore in the
case of an MBO in the US, the managers (acquirers) would be able to justify paying a higher price for the
firm in comparison to the Netherlands where the lower tax rate decreases the value of the tax shield.

Mercury Athletic Case

David Petru-Catalin (10824618)

3a. Based on your answers at 1a and 2c (assume 40% debt), calculate the (sum of the) present value of
the cash flows for 2007-2011.
Period
Year
Free Cash Flow
Terminal Value
WACC (levered, 40% debt)
Discount factor
Discounted cash flows
Enterprise Value

1
2007
14,723

2
2008
26,763

3
2009
22,469

4
2010
25,801

5
2011
29,780

0.91
13,340

0.82
21,970

0.74
16,712

0.67
17,387

0.61
18,183

10.4%

87,592

3b. Construct a terminal value, based on the following growth rates: 1%, 3%, and 5%.
For growth rate 1%: TV = 29,780 * (1.01) / (10.4% - 1%) = 321,003
For growth rate 3%: TV = 29,780 * (1.03) / (10.4% - 3%) = 416,195
For growth rate 5%: TV = 29,780 * (1.05) / (10.4% - 5%) = 582,294
3c. Argue which growth rate you find most reasonable, and why.
I believe that the 5% growth rate is most reasonable due to the following arguments:
-

The growth rate of the companys revenues since the acquisition was 10.5%
The revenue growth rate of similar companies between 2000 and 2006 averaged 9.7% (Exhibit
3)
The company is diversified both in terms of product lines and geographically in terms of sales
and therefore is both stable and connected to global GDP growth rate which historically has
averaged around 4% according to http://www.worldeconomics.com/

3d. Determine the value of Mercury Athletic, based on your answers for 3a-c.
Period
Year
Free Cash Flow
Terminal Value
WACC (levered, 40% debt)
Discount factor
Discounted cash flows
Enterprise Value

1
2007
14,723

2
2008
26,763

3
2009
22,469

4
2010
25,801

5
2011
29,780
582,294

0.91
13,340

0.82
21,970

0.74
16,712

0.67
17,387

0.61
373,722

10.4%

443,131

Taking into account the assumptions resulted from questions 3a-c, the enterprise value of Mercury
Athletic at The beginning of 2007 is approx. 443 mln $.