Valuing Calaveras Vineyards
Added on 20190930
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CALAVERAS VINEYARDS
Calaveras VineyardsTable of ContentsQuestion A: Discounted Cash Flow....................................................................................................2Question B: Purchase Advice to Dr. Martinez..................................................................................3Question C: Competitive advantage to Dr. Martinez.......................................................................3Question D: Incentives to Dr. Martinez after Acquisition................................................................3References............................................................................................................................................51
Calaveras VineyardsQuestion A: Discounted Cash FlowIn the discounted cash flow model, the future free cash flows that a firm is going to generate over aspecific period of time are taken into consideration while valuing that firm. However, the free cashflow values are derived from the values of balance sheet and income statement projected over acertain period of time. The valuation of Calaveras using discounted cash flow model requires takingcertain assumptions which are discussed below:The values of balance sheet and income statement are projected over a term of 5 years startingfrom the end of the year 1993 to 1998. The certainty with which these values can be predicteddecreases when larger forecasting period is considered. 5year period is a reasonable timehorizon 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 30yearTreasurybond rate. It considered as a riskfree rate because the chances of default on thisinstrument are very less. The U.S government issues these bonds through Federal ReserveBank 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 riskfree rate. Itis assumed that the future returns of Calaveras will be benchmarked against the portfolioreturn comprising of all the common stock companies. It simply means that the owners of thecompany will want a return more than all the companies listed on a stock exchange bunchedtogether in a single portfolio with respect to their proportional market capitalization. Themarket 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 & SawyerWine 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 listedcompany in comparison to the market. It is assumed that the market value of Calaveras willfluctuate in the same proportion as Finn & Sawyer. It is consistent relying on the fact thatdemand and supply of the products of both the companies will change in equal magnitude.The values of riskfree rate, market risk premium and beta are used to calculate the cost ofequity which is the minimum return expected from the company. The cost of equity iscalculated using the Capital Asset Pricing Model which is 13.28 %. This value is used todiscount the cash flow obtained at the end of 5th year to calculate the terminal value ofCalaveras i.e. the value till infinity. The rate of 2 % is also assumed for growth of the 5th yearfree cash flow into perpetuity.The value of cost of equity is also used to discount the interest tax shield value of $ 51000 atthe end of 5th year into perpetuity. The interest expenses decrease into the future as the firmretires its debt. It also decreases the tax shield value and hence the growth rate is negative.2
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