Sinatra Inc., a privately-owned company, has 2022 after-tax earnings of $65 million, which are expected to grow at 9% annually into the foreseeable future. The firm is debt-free, capital spending equals the firm's rate of depreciation; and the annual change in working capital is expected to be minimal. The firm's beta is estimated to be 3.75, the 10-year Treasury bond is 5.5%, and the historical risk premium of stocks over the risk-free rate is 7.5%.
Publicly traded Cole Inc., a direct competitor of Sinatra's, was sold recently at a purchase price of 7 times its 2022 after-tax earnings, which included a 40.0% premium over its current market price. Aware of the premium paid for the purchase of Cole, Sinatra's CFO wanted to estimate the value of their firm in the event they are approached by a possible acquirer. The CFO chose to value the firm using the discounted cash flow (DCF) method and comparable recent transactions methods. Given the nature of Sinatra Inc., the CFO expects the recent transactions method to be more accurate in gauging Sinatra's current market value, and thus weights it at 75% when arriving at a combined estimate of the firm value from the two valuation methods used.
a)
What is the value of Sinatra (including premium) using the DCF method?
b)
What is the value using the comparable recent transactions method?
c)
What would be the value of the firm if we combine the results of both methods?
d)
What are some possible reasons the CFO places more trust in the comparable
transactions method of valuation?
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