1 - Angelfire



Introduction

Advanced Fuels Corporation was established five years ago by Dr.Aplin. After 3 years of work, Dr. Aplin and his two-member staff developed a process to convert waste products into ethanol, a compound that can be blended with gasoline to produce a cleaner automobile fuel. Producing ethanol from waste products would lower its cost dramatically, hence greatly increase the market potential of the blended fuel. AFC obtained a patent for this unique production process. However in producing the ethanol, it require a substantial amount of capital. Dr. Aplin cannot put in additional capital into the company. Therefore he developed a business plan and is now seeking for finance. The company requires $55m in total.

1. What type of financing might your bank be willing to provide to AFC?

The type of financing largely depends on 3 factors:

- Financial status of AFC

- Amount of upside gain in a diversified portfolio

- Record of past banking involvement in corporate venturing

Financial status

It is important to note that AFC is still at the early stage of formation, thus it is unlikely to break even in the future years and its probability of bankruptcy is high.

Liquidity ratio

Current ratio = Current Assets/Current Liabilities

Due to the difficulty in classifying loans to friends into either current or non-current liabilities, the exact ratio cannot be calculated. If the ratio is less than 1, then this means AFC will have trouble paying interest repayments if business suddenly fails. This is the most likely outcome as AFC only has $1000 cash which is highly insufficient to account for the liabilities. Hence it is likely that there’s a high probability of default.

Risky portfolio

Investment banks are unlikely to invest or lend in the form of debt to corporate ventures. This is due to the fact that there is a high probability of failure, but also a small probability of rich rewards. Generally, investment banks cannot achieve their desired results by forming portfolios of risky debt securities because it cannot share fully in upside gains beyond the stated interest rate.

Example:

Given that 3 out of 4 firms fail within a year. If a lender invests in the 4 firms in equal amounts (charging a high 25% on each loan), he will lose 100% on the 3 loans and make 25% on the profitable loan, even though its payoff is 400%. Thus lose on the overall operation, meaning that portfolio theory works well only if investors can fully share in upside results.

History

The banks have entered the 1990s with many bad real estate loans and the savings-and-loan crisis, meaning that start-up companies now find it difficult to obtain bank financing.

Loans would be mostly restricted to short term loans:-

Short term debt

This could be used by AFC as a bridging loan to provide finance until a permanent investor appears. This would primarily consist of bank loans or bank loans with a collateral on the assets of the firm such as the patent.

Long term debt

In the unusual circumstance that the bank would provide long term capital, other debt instruments would be appropriate. These would include convertible debt, warrants or straight debt with the assets of the firm such as collateral. However, US banks are prohibited from participating in these types of debt instruments. A straight debt issue would only be appropriate when the bank charges high interest rates to reflect the high risk of the venture.

2. How would you as a banker go about preparing for your meeting with Dr. Aplin and his consultants?

1) Study and analyse the business plan

This would mean finding out all the advantages and disadvantages of the proposal. This involves looking at all the components of the business plan to see if it is reliable and that the information is reasonable.

2) Do a background research

Find out what Dr. Aplin’s work and education history to establish what his skills are and if the skills are related to the firm he proposes to start.

The research into the line of business such as a proxy firm can establish the risk of the business and the expected cash flow return. It can also provide insight into the payback period, level of competition and rate of failure of business. Therefore research into other business such as Ampol, or Shell who provides fuel mixtures can provide information into profit margins, capital requirements and operational costs of the business.

3) Talk to other venture capitalists

This can mean talking to other entrepreneurs who have started business with an innovative idea and have now established themselves as a mature company.

Talking to these individuals can provide the bank with information regarding the financial needs of AFC, problems with the capital provider, and provide a balanced view of both sides of the project.

4) Conduct a scenario or sensitivity analysis of the projected cash flow and profit/loss statements to see the outcomes and if the outcomes are favourable enough for the bank to enter.

5) Questions and conclusion

Prepare a list of questions based on the above information about the proposed project, raising any concerns and doubts over the current proposal and suggest any necessary changes during review of the information.

3. Assume that you view ACF's venture positively and have decided to make a financing proposal for the equipment, land, and facilities. What valuation method would you use to decide how much to lend to AFC? Explain.

Discounted Cash Flow Method

The timing and amounts of cash flows and riskiness are the factors taken into account in valuing the firm under this approach. In the DCF approach, historical and financial data and current trends are used to forecast the firm's future cash flow. A discount rate based on riskiness of the cash flow is then determined. The present value of the cash flows could then be calculated.

The pros of using this approach is that it takes into account the growth potential of the business. The value obtained is also based on timing and size of cash flows and risks involved. They directly relate to the debt servicing ability of the firm and hence the amount that should be lent by the bank.

The disadvantage of using this approach is that it is based on assumptions on profitability, risks and market conditions. The greatest assumption is that the laboratory experiment could be transposed to a mass factory manufacturing process. From the data available, there is no information on how figures on the balance sheet or the discount rate were arrived at, or assumptions behind the figures. There would be great risks for the bank in depending on such figures.

Liquidation Value

The liquidation value is the value if the business is liquidated. All existing liabilities including costs associated with liquidation is deducted from the value obtained from selling off all the businesses' assets. Assets are valued at "fire-sale" value and thus gives a minimum estimation. Liquidation value is therefore a measure of the minimum worth of the firm.

The advantage of using this approach is that it gives a very conservative valuation of the firm. As Advanced Fuels is seeking the loan for acquisition of equipment, land and facilities, a liquidation value could be obtained for these assets and used in deciding the amount of the loan. This minimises the risk for the bank as very few assumptions are made. It also avoids the difficulty and risks in including a value for intangibles.

The disadvantage of using this approach is that it neglects the growth potential of the firm. The key value of Advanced Fuels is the potential of capitalisation of its patented rights. This is hard to value and liquidation value would underestimate the value of the firm as it is founded on the worst case scenario.

Earnings Multiple Method

This method involves multiplying the earnings of the firm by proxy price earnings ratio. The proxy price earnings ratio is found by taking the P/E ratios of a group of public companies in the same industry and of a similar size.

This method is not applicable as Advanced Fuels is an innovative company developing a patented manufacturing process. It is therefore impossible to find a proxy firm.

Replacement Value

This method determining the total cost incurred if the business were started from scratch. This method is not appropriate as it Advanced Fuels is practically starting from scratch.

Adjusted Tangible Book Value

This method involves adjusting the book values for market values for all assets and liabilities on the balance sheet. Intangible assets not included in the balance sheet are added onto the net market value to obtain the adjusted tangible book value.

The advantage of this method is that market values are taken into account instead of book values. This may give a fairer value of the company's worth. Moreover, it includes intangibles such as patent, which is a significant component of Advanced Fuel's assets.

The disadvantage of this method is that intangibles are hard to value. The value of the patent that Advanced Fuel owns lies in its contribution to the firm's growth potential. However there is great subjectivity involved in valuing the patent. The adjusted tangible book value is therefore subjective and highly dependent on assumptions being correct. This would involve risks to the bank. Moreover, it is questionable whether the market value of the firm is the relevant measure for the bank. Market values has no reflection on the firm's ability to service its debt as it makes no indication on either cash flows or the value the bank would obtain if the firm fails.

Conclusion

The liquidation value is the most appropriate valuation method for the bank. This is because the gives the most conservative estimation with least assumptions. It is also based on concept of collateral which should be in line with the bank's lending policies. The rate of return for the bank is fixed at the beginning of the loan. Hence, the growth potential has less relevance to the bank than equity investors.

4. List three questions which you might ask Dr. Aplin in your meeting with him.

i) Justify your projected cash flows and explain assumptions involved.

As this is a new business, the accuracy of the projected cash flows is extremely important for us to assess AFC’s ability to generate the promised required return. We must understand the underlying assumptions of those predictions, and how confident is Dr. Aplin about this projection.

ii) Identify risks involved with this venture and how would you reduce them?

We must understand how much risk is involved with this business. This helps us to determine the rate of return of our investment. Asking how those risks can be reduced can help us identify the risk management ability of Dr. Aplin.

iii) What is your business strategy to ensure success?

This tell us their business view, what quality employees they will employ, how do they ensure the completion of the five plants on time, how would they market their product, etc! This may give us hints about how well they will perform and whether they are prepared for the venture. Most importantly this can tell us how would they allocate the $55m addition capital.

5. What is the forecasted value of AFC to its equity holders?

Discounted Cash Flow Approach

Given that: Discount rate = 30%, Terminal growth after Year 6= 10%

(In Million of Dollars)

|Cash Flow Statements: | | | | | | | |

| | |Year 1 |Year 2 |Year 3 |Year 4 |Year 5 | |

|Net sales | |$20 |$53 |$102 |$117 |$129 | |

|Cost of goods sold | |10 |26 |51 |59 |65 | |

| | |--- |--- | |---- |---- | |

| Gross margin | |$10 |$27 |$51 |$58 |$64 | |

|General/admin expenses | |5 |10 |19 |23 |25 | |

|Debt service | |5 |5 |5 |5 |10 | |

| | |--- |--- | |---- |---- | |

| Pre-tax earnings | |$0 |$12 |$27 |$30 |$29 | |

|Taxes | |0 |5 |12 |13 |14 | |

| | |--- |--- |---- |---- |---- | |

| Net income | |$0 |$7 |$15 |$17 |$15 | |

|Depreciation/amort | |2 |6 |6 |6 |6 | |

|Terminal value | | | | | |116 | |

| | |--- |--- |---- |---- |---- | |

|Net cash flow to equity | |$2 |$13 |$21 |$23 |$137 | |

| | |=== |=== |==== |==== |==== | |

Forecasted value of AFC to its equity holders

= PV of net cash flows + Bank loan

= 20 + 2/(1.3) + 13/ (1.3)2 + 21/ (1.3)3 + 23/ (1.3)4 + 137/ (1.3)5

=$83.74 million

Terminal Value = D(1+ g)/ (K-g)

D= net cash flow in Year 5 ($21), K= Discount rate (30%), g= growth rate (10%)

Therefore, TV= 21 (1+0.1)/(0.3-0.1)= $116

6. What percentage of the common stock would you require in exchange for the needed $35 million? How likely is it that Dr. Aplin would be willing to offer you this percentage ownership of AFC?

Percentage of the common stock required in exchange for the needed $35 million will be:

= Equity investment required/ Total equity value

= Percentage of equity value

= 35/ 83.74

= 41.80%

It is likely that Dr.Aplin will offer me as the Venture Capitalist 41.80% of AFC stocks, because he will still maintain the majority ownership of AFC

7. Under new conditions, what is the smallest percentage of common stock you would require for your $45 million? Is it likely that Dr. Aplin be willing to give up this percentage ownership of AFC?

New assumptions

Terminal growth rate is only 5%. Bank is only lending $10 million

Under such assumptions, the new terminal value is:

= (17.7 + 6)(1+ 0.05)/ (0.3- 0.05)

=99.5

| | | | | | | |

|Cash Flow Statements: | | | | | | |

| | |Year 1 |Year 2 |Year 3 |Year 4 |Year 5 |

|Net sales | |$20 |$53 |$102 |$117 |$129 |

|Cost of goods sold | |10 |26 |51 |59 |65 |

| | |--- |--- | |---- |---- |

| Gross margin | |$10 |$27 |$51 |$58 |$64 |

|General/admin expenses | |5 |10 |19 |23 |25 |

|Debt service | |2.5 |2.5 |2.5 |2.5 |5 |

| | |--- |--- | |---- |---- |

| Pre-tax earnings | |$2.5 |$14.5 |$29.5 |$32.5 |$34.0 |

|Taxes | |1.0 |6.1 |13.0 |14.0 |16.3 |

| | |--- |--- |---- |---- |---- |

| Net income | |$1.5 |$8.4 |$16.5 |$18.5 |$17.7 |

|Depreciation/amort | |2 |6 |6 |6 |6 |

|Terminal value | | | | | |99.5 |

| | |--- |--- |---- |---- |---- |

|Net cash flow to equity | |$3.5 |$14.4 |$22.5 |$24.5 |$123.2 |

| | |=== |=== |==== |==== |==== |

Therefore the equity value of AFC is:

= PV of net cash flow + bank loan

= 10 + 3.5/(1.3) + 14.4/ (1.3)2 + 22.5/ (1.3)3 + 24.5/ (1.3)4 + 123.2/ (1.3)5

= $73.21

Thus the smallest percentage of common stock for $45 million is:

= 45/73.21

= 61.47%

In this case, for my $45 million of common stock, Dr. Aplin needs to give up 61.47% of ownership of AFC. He will lose his controlling power. Therefore he would be wise to raise funds in various source.

8. Use the earnings multiple method to estimate the value of AFC’s equity.

To use the Earnings Multiple method, firstly we have to find the price-to-earnings ratio (P/E ratio) of a group of public companies in the same industry and similar in size to the firm being valued. Eg. The S&P Industry index provides information about expected multiples for various industries. The second step is to compare the firm being valued to the public companies and a P/E ratio can be established to apply to the firm’s earnings. Then we multiply the firm’s earnings by the appropriate P/E ratio to get the value of the firms’ equity.

Applying to the AFC’s case, since we do not have past record of AFC’s earnings we have to estimate the normalised earnings of the firm by taking the average projected earnings over the first 5 years of operation. This can be done by adding up the net income of year 1 to year 5 and dividing this by 5:

| |Year 1 |Year 2 |Year 3 |Year 4 |Year 5 |

|Net Income ($m) |0 |7 |15 |17 |15 |

|Sum of earnings |54 |

|Ave. earnings |10.8 |

Similarly since AFC is a new industry it is hard to get the P/E ratio from public companies operating in same industry. Here we assume the appropriate P/E ratio of 8 (given by question). Thus:

Value of AFC equity = $10.8m*8

= $86.4m

It should be noted that this earnings multiple method has many underlying assumptions for it to give reliable results. Firstly, it assumes that past results are indicative of future, though in this case, past records are not available and we use average projected earnings as the basis, the accuracy really depends on reliability of the projected earnings. Also, a proxy P/E ratio has to be derived from public companies operating in the same industries. It is difficult to find the P/E ratio for this particular industry as it is a new one, thus adding to the uncertainty in calculation. Furthermore judgement is needed to arrive at an appropriate adjusted P/E ratio to apply to the firm being valued. This is a subjective step and judgement made may be biased.

9. If you used the adjusted tangible book value method to value AFC, how would you determine the market value of the patent?

Adjusted tangible book value is another valuation method which can be used to get he value of equity of a company. The essence is to adjust the book value of items on balance sheet to reflect fair market value. For example, while valuing tangible assets like land and buildings, adjustments are made to allow for appreciation and uncollectible accounts receivables. For valuation of intangibles like patents, the following methods can be used:

1) Find proxy firms with similar patents

We can look to some public companies with similar patents to AFC and use their valuation method as appeared in published report as a reference in determining AFC’s patent.

2) NPV method

Compare the NPV of firm operating with the patent and NPV without the patent. The difference will be an approximate of the value of the patent. The rationale is that there will be loss of sales and reduction in revenue when competitors can use AFC technology for free whereas with the patent registered AFC retains the unique technology of producing ethanol from waste.

These 2 methods are not without difficulties. For the first method, it is hard to find proxy companies which are listed and possess similar patent as AFC. If such proxy can be found AFC’s technology would not be unique. For the NPV method, calculations get complicated when we have to estimate for the amount lost in sales. Judgement is needed to determine these estimates and to get the appropriate discount rate to reflect the level of risk involved.

Another option to value patent can be summing the expenditure on development and production before succeeding in this new technology. This may include research and development expenses, time consumed, etc.

10. In your opinion, what are the two most important segments of a business plan? Why?

The two segments we chose are

1. Financial Segment

This is obviously the most important segment. The project is only made possible with sufficient finance and the major purpose of the business plan is to attract funds. This provides important data for potential fund provider to evaluate the project.

The source of finance comes from either equity or through debt. From an investor’s point of view, their fundamental concern in any finance problems is that whether the project is profitable, or whether the project can earn sufficient return to the investor. These are information disclosed in the financial segment of a business plan. To the parties providing finance/funds for the project, their concern will shift to the liquidity of the company. Hence expected cash flow and the forecasted balance sheet will be essential to the granting of finance.

2. Critical Assumptions

Given our first choice of an important segment is the financial segment, the reliability, accuracy and reasonableness of the forecasted data is dependant on the assumptions behind it. This section should always be read in conjunction with the financial data.

Quality/accuracy of the project evaluation of the project is always as good as the assumptions you made. With this segment investors can use their own judgement to evaluate the trustworthiness and risk of the project’s data.

3. Other possible considerations.

One may also suggest the summary at the beginning of the document should be the most important, as it is the first basis the venture capitalist will read and make the judgement of the project. However, we feel that investors/venture capitalists will too be looking for investment opportunities thus they might exercise more care and patience when come to judging these business plans. Hence they would look for more details than the summary.

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