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Active Gear is a profitable firm in the industry; however Active Gear is a smaller firm than many other competitors and its small size is becoming a competitive disadvantage. The rise of large retailers has also endangered Active Gear s growth. Mercury Athletic Footwear designs and distributes athletic and casual footwear dominantly to the youth market. Mercury competes in four main product lines: men s and women s athletic and casual footwear. Men s athletic footwear is the leading product for Mercury Athletic. Women s casual footwear is Mercury s worst performing product and post-acquisition the line may be discontinued by Active Gear. The acquisition of the Mercury Athletic division has sources of potential including an increase in Active Gear s revenue, an increase in leverage with contract manufacturers, boosting capacity utilization and expanding its presence with retailers and distributors. Upon the review of the opportunity to acquire Mercury Athletic Footwear, the results of the financial analysis below indicate Active Gear should proceed with the acquisition. Based on the Free Cash Flow Method, considering the financial projections and assumptions for Mercury Athletic, indicate the acquisition has a positive net present value of $112,778,000 [Present Value of Future Cash Flows (59,440,000) + Terminal Value ($276,921,000) Purchase Price ($223,583,000)]. There are also possible synergies that could make the project even more financially favorable, which are discussed below in the analysis. Introduction John Liedtke, the head of business development for Active Gear, Inc. is responsible for developing the financial projection for the acquisition of Mercury Athletic. Below is a summarized comparison of Active Gear and Mercury Athletics current operations: | Active Gear, Inc. | Mercury Athletic | 2006 Revenue | $470 million | $431 million | % of Revenue Product | 42% athletic shoe 58% casual footwear | 79% athletic shoe 21% casual footwear | 2006 Operating Income | | | Revenue Growth | 2-6% | 12.5% | Average Industry Revenue Growth | 10% | 10% | Mr. Liedtke used historical performance information to project future operating income. To estimate a discount rate, Liedtke assumed the same degree of leverage (20%) for Mercury that is currently used by Athletic Gear. Given current credit market conditions, Liedtke expected the degree of leverage to imply a cost of debt of 6%. According to the case at the time of the analysis, U.S. treasury bills with maturities of 1,5,10 and 20 years were yielding 4.50%, 4.69%, 4.73% and 4.93%, respectively.

Problem Liedtke must capture, analyze, and compare an accurate body of financial data for the acquisition of Mercury. A thorough analysis of this data will further expose the strengths and weaknesses of the acquisition. In order to complete this analysis the following questions must be answered: 1. What are the cash flows? 2. What are the cash flows worth today? 3. What is the NPV of the acquisition? 4. To what degree does the acquisition strengthen the company as a whole? 5. What happens after 2011? 6. How or will synergies improve the value of the acquisition? Analysis Mercury Athletic s EBIT margin for 2006 was 9.8%. Liendke s 2007 projected EBIT reflects a conservative increase in EBIT of 9% compared to the average industry growth rate of 10%. Based on the information given in the case, Liendke s EBIT projections for 2007 through 2011 reflect an accurate growth in earnings for Mercury Athletic. In order to determine the NPV of the acquisition, the first step is to calculate the free cash flows. The Earnings before Interest after Taxes (EBIAT) cash flows of Mercury s operations was determined using the projected EBIT calculated by Liedtke minus the assumed corporate tax rate (40%). The free cash flows from Mercury s business operations were determined using the Free Cash Flow Method (EBIT + Depreciation - Net Working Capital Capital Expenditures). The free cash flows are demonstrated in the chart below: The next step was to determine the cost of debt and cost of equity. Case assumptions made by Liedtke of a 40% corporate tax rate, 6% estimated cost of debt, and 20% leverage were used in calculating the cost of debt. The cost of debt was determined to be 3.6% (= Debt*(1-Tax Rate). The cost equity was determined using the CAPM approach. Looking at the last 78 years, the historical S&P market returns would suggest using a 10.5% to 11.0% rate to project future returns. The average industry revenue growth rate in footwear is 10%. However, to be more conservative, a market return rate of 8% was used. The risk free rate was determined to be 4.69% using the 10 year US Treasury Bills yield given in the case footnotes on page 7 of the case. This results in a market risk premium of 3.31%. The cost of equity was determined to be 12.80% (Risk free rate + Beta x Market Risk Premium) (See Exhibit 1). The cost of equity and debt was used to calculate an estimate of Mercury s Working Assumption Cost of Capital (WACC) to discount the free cash flows. Applying the cost of equity with the cost of debt resulted in a WACC of 10.67% (See Exhibit 1). Using the discounted rate of 10.67% results in the present value of cash flows of the acquisition is $59,440,000 (See Exhibit 1). Typically its assumed businesses will continue on in perpetuity unless information relevant to future revenue projections and returns are available. Since we can t make specific projections about product line growth for Mercury Athletic and the projected cash flows stop at year 2011, terminal value was calculated to estimate what would happen after 2011. To calculate the terminal value, a 3% growth rate was assumed based on historical U.S. inflation. This results in a terminal value of $276,921,000 (Cash flows in year 1 / Rate Growth).

The purchase price of the acquisition ($157,290,000) was estimated using the price per earnings ratio of a comparable company in the footwear industry given in case Exhibit 3. The price per earnings ratio was then applied to the 2006 Mercury net income. The price per earnings ratio was used because it is the most accurate reflection of the market s view of Mercury Athletic. Surfside Footwear s price per earnings was used as the comparable company because it has a 9.3% EBIT margin, which is equivalent to Mercury s 2006 EBIT margin. The value of the acquisition ($336,361,000) minus the purchase prices ($223,583,000) yields a net present value of $112,778,000 (See Exhibit 1). Synergies could be realized after the acquisition. By adopting Active Gear s inventory system, this will reduce the Days Sales Inventory (DSI) from 60 to 42.5, adding potential value to the acquisition. If Mercury women s casual line turns around with the adoption of Active Gear s inventory system it has the potential to increase revenue growth by 3% and EBIT by 9%. If this were to occur, Active Gear could reap the rewards financially. However, even without the possibility of synergies, the acquisition still has a positive net present value. A sensitivity analysis of the results indicates that the acquisition would remain a positive NPV project for Active Gear, using considerably different assumptions regarding Mercury s capital structure and equity beta. The comparable company Surfside Footwear s equity beta of 2.68 was used as a measure of sensitivity. Using the equity beta of Surfside Footwear results in a NPV of $22,259,000 (See Exhibit 2), which reflects the risk among similar industry peers. Changing the capital structure of Mercury Athletic also results in a positive NPV. Assuming Mercury Athletic is an all equity firm using a 0% debt capital structure, the NPV of the acquisition would be $48,968,000 (See Exhibit 3). Summary and Recommendation Given the financial projections above, Liedtke has sufficient evidence to recommend moving forward with the acquisition of Mercury Athletic. The project has a positive NPV for Athletic Gear given the conservative market risk premium used in the WACC calculation and the different assumptions made in the capital structure. Synergies discussed above will potentially add value to the acquisition. With the successful acquisition of Mercury Athletic, Active Gear could increase revenue, increase leverage with contract manufacturers, boost capacity utilization, and expand its presence with retailers and distributors. These positive effects addresses the concerns of Active Gear executives regarding the size of the company s operations compared to other firms in the footwear industry, resulting in a higher competitive advantage in the footwear industry. 2)))))))))) TO: Lecturer FROM: Student RE: Mercury Athletic Footwear Acquisition Net Present Value of Mercury Athletic Enterprise The results of my financial analysis based on the Free Cash Flow Method considering the base case of financial projections and assumptions for Mercury

Athletic Footwear collated and developed by John Liedtke indicate that that the project to acquire Mercury Althletic has a positive net present value at $243,025 (in thousands) [ given by PV(FCF)=86,681+ PV (Terminal Value) =156,343] which is also greater than the recommended acquisition price of $186,216 (in thousands),therefore Active Gear Inc. should proceed with the acquisition of Mercury s operation. Free Cash Flow The free cash flow from Mercury s business operations was determined using the base case for the consolidated operating income, expenses, tax rate and depreciation to determine the net operating profits after tax (NOPAT) for the years 2007-2011. Free cash flow was then calculated using the formula (FCF= NOPAT + Depreciation- Net Working Capital - Fixed Assets) which was evaluated at $21,240, $26,727, $ 22,097, $25,473 and $29,545 for the years 2007, 2008, 2009, 2010 and 2011 respectively. The Cost of Debt and the Cost of Equity The next step was to determine the coast of debt, using the assumptions made by Mr. Liedtke which outlines a tax rate of 40%, the cost of debt of 6% for a leverage of 20% debt. The after-tax cost of debt (RD) was determined to be 3.6% [using RD =(R*(1-Tax Rate), where RD =after rate cost of debt, R= cost of debt] The cost equity estimated using the CAPM approach, Surfside Footwear was selected as a comparable company since its EBIT Margin of 9.3% was the same as the average consolidated EBIT Margin of Mercury Athletic for period 20042006, the Equity Beta for Surfside from Exhibit 3 was 2.13. The risk free was determined to be 4.69% using US Treasury Bills Yield given in the case Footnotes on page 7. The 5 year T-bill yield was selected as this period would correspond with the 5 year period of foreseeable cash flows. The expected return from the market was calculated at 9.7% using average compound annual growth return (CAGR) for the list of publicly traded footwear companies in Exhibit 3. The cost of equity (RE ) was then calculated at 13.0% using the CAPM formula [RE= RRF + (RM - RRF), where RE=cost of equity, RRF =risk free rate= 4.69%, =equity beta=2.13, RM =expected market return] Weighted Average Cost of Capital The weighted average cost of capital (WACC) was then determined at 13.0% using the debt leverage ratio of Active Inc. as stated in the case of 20%[Given by: WACC= RD *(D/V)+ RE*(E/V) where RD =after rate cost of debt =3.6%,RE=cost of equity=15.4%, D/V=debt to total value=20%, E/V=equity to total value =80%]. Discount Rate and Present Value of FCF This estimated value of the Mercury s weighted average cost of capital was the selected as the appropriate discount rate for evaluating the Mercury s business operations. The individual values for each year s foreseeable(projected) cash flows for period 2007-11 were then discounted using the discount rate of 13.0% which yielded the discounted free cash flows of $ 18,795, $20,928 , $15,311, $15,618 and $16,029 for the years 2007, 2008, 2009, 2010 and 2011 respectively Growth Rate, Terminal Value and Acquisition Price After 2011 it was assumed that the Mercury s cash flow would conform to constant growth perpetuity. The average free cash flow growth rate for the foreseeable 5 years (2007-11) was calculated at 10% however it was not believed that this growth rate could be sustained in perpetuity therefore a more

modest growth rate of 2.5% was selected . The terminal value of enterprise was then computed as a constant growth perpetuity at $288,168 [given by CFH+1/(R-g), where CFH+1 is the cash flow in first year of perpetuity =$30,284, R=discount rate=13%, g=growth rate=2.5%] .This was discounted for 5 years at 13.0% to determine the present value of the terminal value which was $156,343. The acquisition price of $186,216 (in thousands) was determined using the P/E of a Surfside (8.6x) and comparable company and the average historical net profit of Mercury Athletic $21,653 Synergy and Sensitivity Analysis If synergy outlined by Mr. Liedtke were achieved then the total net present value of Mercury s Enterprise would increase significantly to approximately to $436,856 (PV (FCF)=$148,999 +PV (Terminal Value)=$287,857 ). Additionally the sensitivity analyses conducted indicated that the project to acquire Mercury Athletic would remain positive with drastically different assumptions such as debt leverage (even 100% debt) and growth projections (even -0.5% growth). However changes in the present value of the free cash flows were not always adequate to cover the above stated acquisition price particularly under negative growth projections.

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