Calaveras Vineyards Case Study: Valuation, Acquisition, and Incentives

This case study analyzes Calaveras Vineyards, focusing on its valuation using the discounted cash flow (DCF) model. The analysis projects balance sheet and income statement values over a five-year period, incorporating assumptions about risk-free rates, market risk premiums, and beta values to calculate the cost of equity. The study determines an enterprise value of approximately $40 million, advising Dr. Martinez on a potential acquisition based on a significant discount. It highlights Dr. Martinez's competitive advantages, including brand image improvements and operational changes. The analysis also addresses incentive structures for Dr. Martinez post-acquisition, emphasizing the potential for business scalability and debt retirement. The case references key valuation methodologies and provides a comprehensive financial overview of the vineyard's potential.

Calaveras Vineyards

Calaveras Vineyards
Table of Contents
Question A: Discounted Cash Flow....................................................................................................2
Question B: Purchase Advice to Dr. Martinez..................................................................................3
Question C: Competitive advantage to Dr. Martinez.......................................................................3
Question D: Incentives to Dr. Martinez after Acquisition................................................................3
References............................................................................................................................................5
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Calaveras Vineyards
Question A: Discounted Cash Flow
In the discounted cash flow model, the future free cash flows that a firm is going to generate over a
specific period of time are taken into consideration while valuing that firm. However, the free cash
flow values are derived from the values of balance sheet and income statement projected over a
certain period of time. The valuation of Calaveras using discounted cash flow model requires taking
certain assumptions which are discussed below:
 The values of balance sheet and income statement are projected over a term of 5 years starting
from the end of the year 1993 to 1998. The certainty with which these values can be predicted
decreases when larger forecasting period is considered. 5-year period is a reasonable time
horizon in which the values can be forecasted with certainty.
 The free cash flow values are discounted at a rate of 5.85 % which is equal to the 30-year
Treasury-bond rate. It considered as a risk-free rate because the chances of default on this
instrument are very less. The U.S government issues these bonds through Federal Reserve
Bank and the interest on it is considered as a benchmark for discounting values.
 The market risk premium is an excess return on the market portfolio over the risk-free rate. It
is assumed that the future returns of Calaveras will be benchmarked against the portfolio
return comprising of all the common stock companies. It simply means that the owners of the
company will want a return more than all the companies listed on a stock exchange bunched
together in a single portfolio with respect to their proportional market capitalization. The
market risk premium using this assumption comes at 5.5 %.
 The value of Beta is taken as 1.35. It is equal to the levered beta value of Finn & Sawyer
Wine Company which functions in the same market segment which Calaveras is targeting i.e.
premium wine. The value of beta gives an idea about the volatility of a stock price of a listed
company in comparison to the market. It is assumed that the market value of Calaveras will
fluctuate in the same proportion as Finn & Sawyer. It is consistent relying on the fact that
demand and supply of the products of both the companies will change in equal magnitude.
 The values of risk-free rate, market risk premium and beta are used to calculate the cost of
equity which is the minimum return expected from the company. The cost of equity is
calculated using the Capital Asset Pricing Model which is 13.28 %. This value is used to
discount the cash flow obtained at the end of 5th year to calculate the terminal value of
Calaveras i.e. the value till infinity. The rate of 2 % is also assumed for growth of the 5 th year
free cash flow into perpetuity.
 The value of cost of equity is also used to discount the interest tax shield value of $ 51000 at
the end of 5th year into perpetuity. The interest expenses decrease into the future as the firm
retires its debt. It also decreases the tax shield value and hence the growth rate is negative.
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Calaveras Vineyards
The assumptions form an important part of DCF model since all the values are forward looking and
involve a certain period of time over which they are to be projected. The free cash flow values are
calculated by adding non-cash charges such as depreciation and amortization expenses to the earnings
after interest and taxes. The increase in working capital over previous year is subtracted from this
value. Finally, capital expenditures incurred is subtracted to arrive at free cash flows. The total of the
present value of FCFs is $ 5313000. The terminal value of Calaveras is $ 34 million which is added to
the NPV of free cash flows to arrive at enterprise value. The adjusted enterprise value is calculated by
considering the present value of interest tax shield which forms a part of cash flow earnings though it
is levered. The adjusted enterprise value is now at $ 40 million approximately. It is the fair
consideration which can be paid to buy the operations of the company.
Question B: Purchase Advice to Dr. Martinez
The company’s present value of the future worth is $ 40 million and the purchase consideration given
to Dr. Martinez to buy all the assets of Calaveras is $ 4.122 million. The enterprise is available at 90
% discount and it should be bought by Dr. Martinez. It is because the purchase consideration given is
only for the assets of the company, it does not take future earning into picture which the assets will
generate over time. Though, the funding of the purchase is from both equity and debt, the future cash
flows are enough to easily retire the debt as shown in the calculations. The enterprise value without
interest tax shield is $ 39.3 million which entirely belongs to the owners.
Question C: Competitive advantage to Dr. Martinez
Dr. Martinez has been successful in improving brand image of the company by managing quality of
the products. She introduced operational changes such as converting redwood to oak cooperage,
installing sprinkler system, and upgrading the winery with a bladder press. It resulted into increase in
average wholesale price from $ 29.52 in 1989 to $ 44.26 in 1993. This is besides the fact that Dr.
Martinez was successful in entering premium wine market segment by the introduction of Estate
wines. Calaveras sold 6133 cases of the Estate wine in 1993 up from 4436 in 1991.
Dr. Martinez has a focused work experience in the winery industry from 1980 coupled with training in
distillery. She has done numerous trips to Europe for gaining experience in champagne and white
wine technology which can be an added advantage if Calaveras managers wish to enter this segment.
Question D: Incentives to Dr. Martinez after Acquisition
As shown in the answer to question A, the acquisition of Calaveras is a bargain purchase both for
equity as well as levered purchase considering debt. The increase in the amount of inventories and
accounts receivable shows that the business has scalability enough to retire long-term debts and
increase the concentration of equity into the business. Dr. Martinez will be the direct owner of an
unlevered business 5 years down the line. Anne Clemens assumed that the maximum capacity of the
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Calaveras Vineyards
winery could be 110,000 cases per year and could not go beyond that without taking into
consideration the bigger picture of increase in real price beyond inflation. Ernst and Anderson in their
proposal also supported upside trend in the earnings of Calaveras due to strong track record of Dr.
Martinez which Clemens had ignored. Dr. Martinez can efficiently run the winery and avoid diluting
her equity by scaling its operations to produce more cases and simultaneously retire the leverage from
the business.
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Calaveras Vineyards
References
Aswath Damodaran (1996). Investment Valuation: Tools and Techniques for Determining the Value
of Any Asset. New Jersey: John Wiley & Sons. ISBN-10: 111801152X
Thomas Copeland, Tim Koller, Jack Murrin (2000). Valuation: Measuring and Managing the Value of
Companies. New Jersey: John Wiley & Sons.
Richard S. Ruback (1995). Introduction to Cash Flow Valuation Methods. Harvard Business School
Background Note 295-155.
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