UVA-F-1094TN Rev. Apr. 26, 2016

This teaching note was prepared by Professor Robert F. Bruner. Copyright 1995 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

Calaveras Vineyards

Teaching Note

Synopsis and Objectives

In March 1994, a commercial-loan officer at a West Coast financial institution must assess the opportunity to provide up to $4.5 million in credit to finance the acquisition of a California vineyard and winery. The tasks for the student are to assess the creditworthiness of this business, to perform an independent valuation as a means of testing the appropriateness of the purchase price, and to recommend possible changes in the structure of the deal.

This case was developed to hone students’ skills in two areas:

Valuing a business: The case presents a financial forecast and data appropriate for estimating discount rates—these may be used as the basis for estimating a discounted cash flow (DCF) value of the firm. The case also presents information regarding valuation multiples and liquidation values of the firm. Thus, the relative merits of different valuation estimates may be discussed.

Credit analysis: Including ratio analysis of coverage and capitalization, sensitivity analysis of a financial forecast, and general schemes of credit analysis, such as the “Five Cs of Credit.”

Suggested Questions for Advance Assignment

This case assignment is easily configured for an introductory assignment by distributing Exhibit TN1 along with the case—this exhibit presents certain financial ratios and a forecast of free cash flows drawn from case Exhibits 7–9. Advance distribution of Exhibit TN1 abbreviates the “number crunching” required and helps students focus on the interpretive aspects of their valuation analyses.

1. What is the value of Calaveras Vineyards? Is the proposed purchase price for Calaveras Vineyards appropriate?

Suggestions for complementary cases about leveraged acquisitions and/or private-equity investing: “Rocky Mountain Advanced Genome” (UVA-F-1136); “Mirth Press, Inc.” (UVA-F-1196); “MediMedia International, Ltd.” (UVA-F-1032); “Rosario Acero S.A.” (UVA-F-1211); and “Planet Copias & Imagem” (UVA-F-1182). Complementary cases dealing with credit analysis: “Bayern Brauerei” (UVA-F-1027) and “Polaroid Corporation, 1996” (UVA-F-1181)

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Prepare a DCF valuation of Calaveras, using the attached supplemental exhibit and your estimate of Calaveras’s weighted-average cost of capital. Do you have any concerns about the suitability of the listed “pure-play” comparable companies? Might those concerns bias your estimate of value in any direction? Perform a sensitivity analysis on assumptions that you suspect to be “key value drivers”—what are the insights you derive from that analysis?

Consider other methods of estimating Calaveras’s value, including book, liquidation, and multiples methods.

2. Would Calaveras be a creditworthy borrower? What are the principal risk factors in this prospective credit? Can Calaveras adequately service the proposed amount of debt? What other considerations might influence your evaluation of this firm as a prospective borrower?

3. What should Anne Clemens do? Prepare a recommendation for action by Goldengate Capital. If you are inclined to participate in the loan, identify any issues that will warrant careful continued monitoring. If you are not inclined to participate on the terms as outlined in the case, then prepare a counterproposal to NationsBank indicating terms on which you would be willing to participate.

Clarification to students of two minor points: (1) At the moment of closing of the deal, Calaveras will have no receivables as Stout PLC will keep them. This reflected Dr. Lynna Martinez’s dissatisfaction with the former marketing company and her uncertainty about the actual value of those receivables; (2) Case Exhibit 6 presents the historical performance of Calaveras as if it were a “stand-alone” company, and excludes intercompany sales of wine to Stout PLC for corporate-entertainment purposes. Case Exhibit 10 gives the actual historical price and volume record of Calaveras (i.e., including sales to Stout), and thus implies higher historical revenues for the firm than reported in case Exhibit 6. Martinez was confident that either Stout PLC would continue to be a customer of the vineyard, or that Calaveras would succeed in finding customers to replace Stout. The financial forecasts in the case are consistent with her outlook.

In addition to this introductory configuration, the case offers at least three other teaching configurations:

1. Using the case as a basis for team projects or term papers, the instructor would refrain from distributing Exhibit TN1. In that setting, students could be requested to assess and reforecast free cash flows, as well as address the other assignment questions.

2. For advanced students, question 1 could be modified to direct their attention to the time-varying capital structure. This note offers some comments on the possible influence of the time-varying capital structure.

3. As a final alternative, the instructor could configure the case assignment to ask students to prepare a probabilistic estimate of default and value. Standard add-in software, such as @ Risk!, can be used to automate the associated spreadsheet program to give a Monte Carlo simulation. The case offers distributional information on four key forecasting parameters.1 The results of this analysis are not presented here in detail, though they will show a relatively high probability of default (defined as EBIT-coverage ratio less than 1.0) and a material probability associated with negative net present values.

Supplemental Computer Spreadsheet Models

1 The key parameters are inflation (normal distribution, mean of 3.1%, standard deviation of 4.7%); real growth rate (uniform distribution, 1% to +3%);

annual change in prime rate of interest (normal distribution, mean of 0%, standard deviation of 1.75%); and gross margins by products (normal distribution, means as given in case Exhibit 9, standard deviation on all of 2%).

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Preparation by students and instructor is supported by the Excel spreadsheets listed in Table 1, which contain case data (and, for instructors, a completed model). Please do not distribute UVA-F-1094TNX to students.

Table 1.

Excel Models

Full instructor’s models

UVA-F-1094TNX

Student models of case Exhibits 7, 8, 9, and 11

UVA-F-1094X

Hypothetical Teaching Plan

1. What is your assessment of Calaveras Vineyards, and what should Clemens do?

The decision-oriented focus of the case presents a natural opportunity to open the class with a presentation by an individual or a team of students. The objective of such an opening should be to outline the analytical agenda leading to a decision and to present one analysis to serve as a benchmark for later discussion. A student who is “cold-called” to present this discussion may take 5 to 10 minutes to give a presentation. A student or team given adequate forewarning may take 20 to 30 minutes and would likely lay out a much more detailed analysis.

2. What is the estimated value of Calaveras?

One could open this segment by calling on one student or, alternatively, by taking a poll of all students’ “best-guess” values of the firm and listing the results on the chalkboard. The wide variance in results will motivate students to pay careful attention to assumptions and points of methodology in the discussion that follows.

a. What cash flows did you use? Did you modify the cash flows given in the supplement? What terminal value did you use?

b. At what rate did you discount the cash flows? How did you estimate that rate?

c. What is your estimated DCF value? Which assumptions prove to be the “key value drivers”?

The discussion here should explore in detail the process and results of a DCF analysis, as well as the insights to be obtained from exercising a spreadsheet model.

d. Do you have value estimates based on methods other than DCF? What might explain those differences?

The DCF value could be compared with estimates based on accounting values, liquidation values, or values derived from well-known market multiples.

e. What, then, do you conclude is a reasonable “high” and “low” value range for Calaveras?

This concluding question helps reassert the need to avoid point estimates of value and to use valuation ranges instead.

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3. Would Calaveras be a creditworthy borrower?

In this part of the class, students should be challenged to exercise simple tests of debt- service ability (such as the coverage ratio) and financial-statement analysis. The case affords numerous opportunities for credit analysis: (1) risk factors should be clearly identified; (2) cash-flow coverage of interest and principal should be assessed; (3) liquidation values should be estimated and critiqued; and (4) the suitability of the borrowing-base formula should be examined. Closure on this part of the discussion could be obtained by drawing on some credit-evaluation scheme such as the five Cs of credit (i.e., capital, coverage, conditions, character, and collateral).

4. What should Clemens do?

Returning once again to the action orientation is an effective means of gaining closure. The instructor could take a vote of the class. Those students eager to participate in the loan should be questioned on how they would monitor the loan going forward and on any risk factors to which they would pay attention in the future. The students not inclined to participate should be challenged to offer terms of a counterproposal to NationsBank.

The class discussion may be ended with some general comments on the wide range of tools applied in this case, and the comparative insights afforded by credit analysis and valuation analysis. The instructor might also present some comments from the epilogue of the case.

Case Analysis

Valuation analysis: assessment of cash flows

A DCF valuation of Calaveras Vineyards is relatively straightforward. Case Exhibits 7–9 present a financial-statement forecast and a summary of key underlying assumptions. A simplistic acceptance of the forecasts in the case exhibits will lead to high estimated internal rates of return and large positive net present values. The case is first and foremost a lesson in critical assessment of assumptions. Students should be pressed to critique the assumptions of the forecast, along the lines of the following examples:

Unit growth: Comparing case Exhibits 10 and 11, one sees a buoyant forecast of performance following the management buyout as compared with performance under Stout’s ownership. Some students will defend this performance as consistent with the turnaround that has taken place in the past two years. Others will make a classic agency argument: ownership by managers stimulates keener management of the business—the upturn is simply the result of excluding various agency costs. For the purpose of illustration, the base-case DCF valuation in this note takes the forecast unit growth as given.

Real growth rate of prices beyond the forecast horizon: Real growth is assumed to be 2% per year ad infinitum in an industry whose growth is flat if not declining. Notwithstanding the fact that wine growth has been robust vis-à-vis the stagnation in the rest of the alcoholic-beverages industry, simply projecting this growth straight-line into the future may be overly optimistic. In the analysis that follows, the 2% real growth rate assumption is maintained. Sensitivity analysis, discussed below, reveals that material variations in real growth rate of prices is a significant driver of estimated DCF values.

Sales growth and operating constraints: Students should be skeptical of the “hockey-stick” projections given by Martinez, for reasons outlined in the previous two bullet points. Whatever they decide, however, many students will simply extrapolate that forecast performance to infinity. Yet, in the case, Clemens hints at the possible limits to growth. First, the firm cannot continue to impose real price increases

Discussion Question 2a

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indefinitely—eventually, it will price itself out of the market. Second, the unit volume eventually will exceed the manufacturing capacity of the firm. Clemens proposes to relax this constraint by increasing capital spending by $100,000 per year (i.e., over the $250,000 base-line assumption in the forecast), starting in 1996. The DCF valuation in this note (Exhibit TN3) makes this adjustment, as does the supplemental free cash flow forecast in Exhibit TN1. (However, the forecast income statement and balance sheet are not adjusted.)

Gross margins: The total gross margin of the firm is projected to rise to about 40%,2 which is dramatically higher than the 28% for 1993 and is probably the key assumption in the forecast. Martinez would probably argue that the winery’s gross profit margins have been improving since 1990 and that, once freed from Stout’s constraints, more improvement is possible. One source of improvement is the increase in unit prices (see the preceding bullet points). Martinez might also point to the industry’s average gross profit margin of 39.6%, given in case Exhibit 12—lifting Calaveras’s profitability to the industry average may not be an unreasonable goal. The “stair-step” increase from 28% to 40%, however, seems a bit heroic; students may decide to spread this improvement over several years. For the purpose of illustration in the base case of this note, the gross margin improvement is taken as projected in the case.

Selling, general, and administrative expenses: The financial forecast assumes a ratio of SGA/sales of 14%, a decrease from the historical 15% under Stout’s ownership. Because changes of 1% produce significant changes in forecast, students may debate the reasonableness of this assumption—some will argue that the presence of an owner-manager will produce tighter cost controls. Others may argue that some of Calaveras’s costs may have been carried by Stout. The base-case valuation in this note uses the 14% assumption.

Terminal value: Consistent with the discounted cash flow approach highlighted in this note, one could employ a terminal value based on the familiar constant growth valuation formula TV = FCF(1998) × (1 + g)/(WACC − g), where g is the growth rate of free cash flows in perpetuity and is also the sum of the assumed inflation rate and real growth rate. The base-case valuation given in this note takes the inflation and real growth rate as given in case Exhibit 9, although the real growth assumption should be challenged along the lines offered in the preceding bullet points. Students could be encouraged to consider other estimators for terminal value such as liquidation value, book value, and multiples of earnings.

Valuation analysis: weighted-average cost of capital

The discount rate is somewhat more problematic. The trap some students fall into is to use the 30% rate required by venture capitalists—but it should be emphasized that this is an equity rate of return and should be blended with the cost of debt to produce a weighted-average cost appropriate for discounting free cash flows. Although the vineyard is small, it is an established operation (i.e., not a start-up) and has a manager with a successful track record. For those reasons, the analysis here dispenses with the target venture-capital return, except to use it as a possible upper bound in the valuation analysis. Plainly, dismissing the venture capitalist’s target is a major judgment call—the instructor should anticipate that at least a few students will vociferously argue for the venture capitalist’s required return and thus estimate much lower DCF values.

Many students will try to estimate a weighted-average cost of capital, drawing on a cost of equity using the capital asset pricing model. In that calculation, students may debate three choices:

2 This is a rough blend of gross margins by product line, given in case Exhibit 9.

Discussion Question 2b

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Arithmetic versus geometric mean equity-market premium: Both measures are used in practice and have their adherents in firms and business schools.3 Adherents of the geometric mean cite its accuracy in describing historical experience. Adherents of the arithmetic mean cite its property of being the expected value of a distribution, thus summarizing expected returns well. For illustrative purposes, the geometric mean is used in the analysis that follows.

All-company versus small-company premium: Many students are tempted to use the small-company premium. Yet, as case Footnote 7 indicates, the betas are estimated using the all-company market samples—those betas already impound a small-company effect. To use the small-company equity-market premium would double-count the impact of small size. The all-company premium is used in this analysis.

Beta from comparable firms: The case gives beta information on three comparable firms, among which students must choose in deriving a beta for Calaveras. Canandaigua is a significant player at the low-price end of the wine market. Frogg’s Jump is smaller, but specializes in private-label wines. Finn & Sawyer is perhaps the most comparable firm: it is the smallest in the peer sample and produces only ultrapremium and superpremium wines, a segment toward which Martinez is moving Calaveras. One alternative would be to recognize that Calaveras’s business mix covers all three segments represented by those firms (see percentages in case Exhibit 2): 64% in the ultra- and superpremium categories (i.e., the Estates and Selected Vineyards segments); 17% in the private-label segment (i.e., “special accounts”); and the balance, 19%, in the low-end segment (i.e., California and Generic). Estimating a weighted average of the three comparable firms’ unlevered betas yields a composite unlevered beta of 1.1.4 For the sake of possible sensitivity analysis, this note presents estimates based on all three firms’ betas individually as well as on the composite.

Drawing on those assumptions, Exhibit TN2 estimates WACC to vary between 8.69% and 12.72%. In the discussion that follows, a WACC of 13% will be used as the base-case assumption, perhaps justified by the belief that the most weight should be given to the closest peer, Finn & Sawyer—students will debate this, however. In any event, the instructor should encourage students to conduct sensitivity analyses of their DCF estimates based on a range of WACCs.

Valuation analysis: base-case DCF valuation and sensitivity analysis

As shown in Exhibit TN3, discounting the estimated free cash flows at a constant WACC of 13% yields a value of the firm of $6.852 million, just at Stout PLC’s own upside valuation. The net present value is $2.730 million—this is a lucrative deal for Martinez and Newsome; they are paying $1 million for securities worth $3.730 million. The internal rate of return is 26%.

Given the natural skepticism one might have toward the optimistic assumptions, some type of scenario, breakeven, or sensitivity analysis would be appropriate. Exhibits TN4 and TN5 present sensitivity analyses of net present value under two different sets of variation.

Real growth in prices and WACC: Exhibit TN4 gives a two-way table varying the DCF value of the firm by real growth rate and WACC. Here, we observe material swings in net present value with relatively small variations in real growth rate. Plainly, the DCF estimate is sensitive to joint and single variations

3 For a survey of practice, see R. F. Bruner, K. M. Eades, R. S. Harris, and R. Higgins, “Best Practices in Estimating the Cost of Capital: Survey and

Synthesis,” Financial Practice and Education 8, no. 1 (1998): 13–28. 4 This estimate is equal to 19% times Canandaigua’s unlevered beta, 64% times Finn & Sawyer’s, and 17% times Frogg’s Jump’s, or

(0.17 × 0.54) + (0.64 × 1.312) + (0.19 × 0.867) = 1.096.

Discussion Question 2c

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in WACC and growth. It must be emphasized that “real growth” refers to price changes only and not to unit-volume increases. In the model, unit volume is handled directly from the case shipment forecasts. Thus, when we vary “real growth,” we are, in effect, varying the assumption that Calaveras can continue to raise prices at a rate above inflation. The practical implication of Exhibit TN4 is that Clemens should scrutinize Martinez’s ability to raise prices faster than inflation, which involves questioning a host of marketing issues including branding, positioning, segmentation, and elasticity of demand. Detailed market analysis is beyond the scope of this case, but the instructor could stimulate students to list questions to be addressed in this regard.

Forecast EBIT and WACC: Exhibit TN5 shows the variations in NPV with WACC and with variations from EBIT forecast. The EBIT variation attempts to illuminate the impact of the nonoccurrence of “stair-step” cost improvements. Case Exhibit 6 reveals an operating profit of $0.26 million in 1993; Martinez forecasts an EBIT of $0.93 million in 1994 (case Exhibit 7). Perhaps Martinez is an optimist. Exhibit TN5 shows that a 15% shortfall from forecast EBIT almost eliminates the positive NPV where WACC equals 20%, and reduces NPV by a third where WACC equals 13%. The significance of Exhibit TN5 for Clemens is the importance of understanding Martinez’s optimism about sales growth (i.e., through both unit increases and price increases) and margin improvement.

More advanced students will see opportunities to tinker with the basic DCF model in order to reflect the expected changes in the firm’s capital structure over time. When capital structure is expected to vary in a predictable way (e.g., in a leveraged buyout or recapitalization), the interaction among capital mix, discount rates, and market values seems to create an interdependency that is impossible to solve. But with the aid of a personal computer, it can be solved. Exhibit TN6 presents the valuation of Calaveras assuming a time-varying market-value capital structure, which incorporates a circularity among market-value capital, the levered-beta formula, the market-value WACC formula, and the value of the firm. The instructor’s model automatically iterates to resolve the circularity among these factors. Teaching students how to resolve the circularity might be an appropriate lesson for a more advanced treatment of valuation. The difference in value estimates in this case is moderate. Using the time-varying capital-structure assumption, one can see that the value of the firm is $7.120 million (as compared with $6.852 million under the simpler calculation).5

Comparison of valuation estimates

Students should be encouraged to augment their analyses with estimates produced by other methods. Doing so will yield the following kinds of values:

Liquidation value: The liquidation value of Calaveras’s assets will consist of the market value of land, the cash balance, the collection value of receivables (85% of the balance) and inventories (75% of the balance), and 40% of gross plant. The discount percentages are drawn from discussions of Clemens’s and NationsBank’s rules of thumb. The land value may be estimated by multiplying the number of acres times an estimated value per acre (see case Footnote 1). Students will vary in their estimate of land value because of varying price and number of acres (the company owns 220 acres, but only 175 acres are planted with grapevines). Using the high and low land values to bound the range of liquidation value gives the estimates shown in Table 2:

5 The difference between the two estimates of firm value is due to their differing capital-structure assumptions. The simple estimate assumes that the

proportion of debt to capital (13.8%) prevails ad infinitum. The time-varying model assumes that debt is reduced to zero by the forecast horizon.

Discussion Questions 2d and 2e

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Table 2.

Low Estimate High Estimate

Land value6 at closing $875,000 $2,200,000

Cash at closing $50,000 $50,000

Collection value of accounts receivable (85%) at closing 0 0

Collection value of inventories (75%) at closing $1,647,000 $1,647,000

Liquidation value of gross plant (40% of $0.582 mm) at closing

$232,800 $232,800

Total liquidation value $2,804,800 $4,129,800

The conclusion is that, at the high estimate, the liquidation value easily clears the debt balance at closing, $3.122 million. At the low estimate, the liquidation value falls well below. The land-value assumption appears to be a key value driver of liquidation value.

Multiples of EBIT: One can apply multiples against the optimistic projection of EBIT for 1994 of $0.93 million. Applying a “standard” multiple of 6 yields a value of the firm of $5.58 million. A multiple of 5 yields a value of $4.65 million.

Multiple of net income plus debt: A final approach would be to value Calaveras’s equity by using some well-known multiples and then adding the value of debt to give the value of the firm. Calaveras’s closely comparable peer, Finn & Sawyer, shows a P/E multiple of 13 and a market-to-book multiple of 2.5. At the multiple of earnings ($393,000 forecast for 1994), Calaveras’s equity would be worth $5.109 million. At the multiple of book at closing ($1 million), the equity would be worth $2.5 million. Adding the debt at closing ($3.122 million), the value of the firm would range between $8.23 million and $5.62 million. To summarize, the analysis suggests a range of possible values shown in Table 3:

Table 3.

Estimator Value of the Firm ($ millions)

Base-case forecast DCF, WACC = 13% (Exhibit TN3) 6.852

Base-case forecast DCF, WACC = 20% (Exhibit TN4) 5.162

Base-case forecast DCF, WACC = 30% (Exhibit TN4) 3.552

15% shortfall in EBIT, WACC = 13% (Exhibit TN5) 5.827

Liquidation value of assets 2.80–4.13

Multiples of EBIT 5.58–4.65

Value of equity plus debt, using P/E, M/B multiples 8.23–5.62

In most estimates, there appears to be sufficient value to cover the initial loan, although the huge variability implies considerable uncertainty in the estimates. The sensitivity analyses suggest that Clemens should focus her research on the foundations of Martinez’s price and unit growth projections, and margin improvements.

6 The low estimate of land value is the product of 175 acres and $5,000 per acre. The high estimate is the product of 220 acres times $10,000 per acre.

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If the forecast comes true, Martinez and Newsome will earn a high return on their investment. It may be useful to explore with students the possible explanations for the value created. One is Stout’s haste to sell. Another must be Martinez’s familiarity with the business—in some sense, she may be exploiting an information asymmetry between herself, as operating manager of the winery, and the owner, Stout PLC. A third factor may be the lack of bidding competition. As usual in such cases, no one wants to bid against the insider, on whose skills and knowledge any new buyer would have to depend.

Credit analysis

Shown in Exhibit TN1 are debt coverage, liquidity, and capitalization ratios for the forecast years, as well as the DuPont system of ratios. The EBIT-to-debt-service-coverage ratio begins at 1.32× and rises to 2.48× over the forecast period, suggesting a narrow margin for error initially and a very comfortable one toward the end. The capitalization ratio (debt/assets) falls from 0.67 to 0.25 as the debt is repaid—by the forecast horizon, the firm has reduced its debt capitalization below the industry average. The current ratio shows that liquidity is relatively low in the first two years and increases slowly thereafter. The DuPont ratios show improving margins and asset utilization. Despite those improvements, the book-value returns on equity decline because of the falling financial leverage.

Students should be encouraged to compare Calaveras’s financial condition with the financial condition of other firms in the industry. Case Exhibit 12 presents average comparative information on 81 manufacturers of wine and brandy (i.e., wineries such as Calaveras). On most of those dimensions, the forecast performance of the firm compares reasonably—once again, one must emphasize that Calaveras is a firm just emerging from a difficult period; the strength of its recovery is not yet fully established. One is, in effect, betting on Martinez’s optimism.

Using a credit-analysis scheme such as the five Cs of credit, the instructor can ask students to summarize their assessment of Calaveras’s creditworthiness:

Character: Martinez is an experienced manager, both with Calaveras and, more generally, in the wine industry. She has a record of success in managing the winery through the difficult period under Stout’s ownership.

Capital: The capitalization ratios suggest that, after the first two years, the firm will be reasonably capitalized in comparison with other firms in the industry.

Cash flow: Relative to the volume of capital employed to acquire Calaveras, the free cash flow stream is large. The low EBIT-coverage ratios, however, will give seasoned lenders serious qualms.

Collateral: A conservatively estimated liquidation value of $2.8 million was calculated above. This does not cover the loan principal. Students may obtain different estimates depending on the percentages they use to estimate a collectible value.

Conditions: Wine demand is relatively impervious to cyclical variations. Some changes in consumer tastes are possible, however, suggesting that the product mix bears monitoring.

Student decisions on this loan proposal will vary widely. On the face of it, the deal looks acceptable. But case facts and case analysis offer considerable ammunition for opponents. Skeptics tend to be the most vociferous, so it may be useful to reach a decision with a vote of the class.

Discussion Question 3

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If optimists win the vote, it may be useful to close the discussion by asking them what they might like to explore with Martinez on a “due-diligence” visit to the winery. If the skeptics win, one could press them to suggest alternative terms—rather than turn down the loan proposal altogether, are there other terms on which Goldengate Capital might be willing to participate? Creative and thoughtful students will offer suggestions such as the following:

More equity: Increase the initial equity from $1 million to $1.5 million or $2 million, and reduce the term loan and revolver by the amount of equity added. This action will materially improve the coverage ratios and capital “cushion” and is thus risk reducing.

Warrants to Goldengate: If this is such a good deal for equity investors and if Goldengate is providing most of the capital for the deal, why not let the lender participate in some of the upside? Doing so will increase Goldengate’s returns, perhaps in compensation for the risk in the deal. Absent a liquid market for Calaveras’s equity, the winery may have to offer to repurchase any shares acquired under the warrants. Thus, Goldengate would gain both a call option and a put option. Skeptics will point out that the put option creates credit exposure for Calaveras.

Personal guarantees: The case offers no information on the personal wealth of Martinez and Newsome. If it is material, a personal guarantee from them might mitigate Goldengate’s credit risk on the winery.

Other proposals might call for selling preferred stock or subordinated debt to another investor—ideally, those proposals would carry pay-in-kind provisions for a few years, thus permitting the firm’s operating earnings to cover fully the senior-loan requirements. The point of this financial-engineering discussion is to strengthen students’ ability to find structural solutions to financing problems rather than to think in binary yes/no terms.

Epilogue

The acquisition was completed along the lines presented in the case, with Goldengate Capital providing the senior financing. As case Exhibits 10 and 11 suggest, Martinez’s strategy was to shift Calaveras’s production heavily into white wines. Unfortunately, large producers also moved into this segment. The firm’s operating profits fell significantly below forecast. The firm sought to reschedule its principal payments. Upon meeting strong resistance from the banker, the owner sold the business to a neighboring winery at approximately the original purchase price. Martinez retrieved her initial investment but earned no economic premium.

Discussion Question 4

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Exhibit TN1

Calaveras Vineyards Clemens’s Ratio Analysis and Forecast of Free Cash Flows

* In computing the EBIT coverage ratio, interest expense includes interest on both the revolving loan and term loan; principal payments include only the scheduled annual payments necessary to amortize the term loan

**The forecast of capital expenditures reflects Anne Clemens’ belief that they would amount to $350,000 (not $250,000) in the years 1996–1998.

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Exhibit TN2

Calaveras Vineyards Calculation of Weighted-Average Cost of Capital

Notes:

1. The source of unlevered betas is the table in case text. The weighted-average unlevered beta is the average of the three peer firms’ unlevered betas weighted by Calaveras’s business mix: 64% in superpremium and ultrapremium wines (Finn & Sawyer); 19% in generic wines (Canandaigua); and 17% in private-label wines (Frogg’s Jump).

2. The “Industry Avg. D/E” is the average of the market-value debt to equity ratios for the three peer firms given in the text of the case. The data given in case Exhibit 12 are less appropriate for this purpose as they are book values.

3. The marginal tax rate is given in case Exhibit 9.

4. The levered beta is calculated as Bl = Bu[1 + (1 − t)D/E].

5. The equity-market premium and risk-free rate are given in case Exhibit 14.

6. The pretax cost of debt is given in the case text. Clemens assumes a blended cost of 9.5%.

7. The weights of debt and equity are calculated from the market-value debt/equity ratio. For example, Wd = 0.16/(1.00 + 0.16) = 0.14.

Source: Author’s analysis.

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Exhibit TN3

Calaveras Vineyards Discounted Cash Flow Valuation, “Base Case”

(values in thousands)

This analysis reflects the following:

1. WACC = 13%.

2. Capital expenditures = $350,000 per year, 1996–1998.

3. Terminal-value growth rate = 4.04%.

Source: Author analysis.

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Exhibit TN4

Calaveras Vineyards Sensitivity Analysis of Net Present Value to Variations in WACC and Real Price Growth

N.B.: The shaded area indicates values consistent with the base-case assumptions of 13% WACC and 2% real growth rate in prices.

Source: Author analysis.

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Exhibit TN5

Calaveras Vineyards Sensitivity of Net Present Value to Variations in WACC and Forecast EBIT

N.B.: The shaded area indicates values consistent with the base-case assumption of EBIT and of 13% WACC.

Source: Author analysis.

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Exhibit TN6

Calaveras Vineyards Discounted Cash Flow Valuation: WACC Varies to Reflect Actual Market Value of Debt and Equity

This analysis reflects the following:

1. WACC varies with changing market-value debt/equity.

2. Capital expenditures = $350,000 per year.

3. Terminal-value growth rate = 4.04%.

Source: Author analysis.

1994 1995 1996 1997 1998

WACC 11.9% 11.9% 12.1% 12.2% 12.4%

MV Assets (Beginning of Year) $7,120 $7,972 $8,564 $9,100 $9,633

Debt (MV=BV) (Start-of-Year Balance) 3,122 3,322 3,158 2,738 2,206

MV Equity 3,998 4,650 5,406 6,361 7,427

% Debt/Assets 43.8% 41.7% 36.9% 30.1% 22.9%

% Equity/Assets 56.2% 58.3% 63.1% 69.9% 77.1%

MV Debt/Equity 78.1% 71.5% 58.4% 43.0% 29.7%

Unlevered Beta 1.312 1.312 1.312 1.312 1.312

Levered Beta 1.927 1.874 1.772 1.651 1.546

Risk-Free Rate 5.9% 5.9% 5.9% 5.9% 5.9%

Equity Market Risk Premium 5.5% 5.5% 5.5% 5.5% 5.5%

Cost of Equity 16.4% 16.2% 15.6% 14.9% 14.4%

Pretax Interest Rate 9.5% 9.5% 9.5% 9.5% 9.5%

Marginal Tax Rate 0.37 0.37 0.37 0.37 0.37

After-Tax Cost of Debt 6.0% 6.0% 6.0% 6.0% 6.0%

WACC 11.9% 11.9% 12.1% 12.2% 12.4%

DCF Value of the Enterprise at Closing $7,120

Debt at Closing 3,122

Value of Equity at Closing 3,998

Equity Investment 1,000

Net Present Value $2,998