Review of Investment Proposals for RTI and MGMT

The report provides guidance to RTI leaders on choosing the proper investment instrument between equity investment and convertible debenture while investing in MGMT. It includes analysis of the importance of IPO investment, operating cash flow forecast, estimated weighted average cost of capital, DCF model, and suggestions for buying GY apps and investment in equity or convertible subordinated debenture.

Review of investment Proposals

Executive summary:
The assignment is a representation of a comprehensive report about how the chosen organization
RTI(Raju Technology, Inc) which is looking for asking some profitable investment in some
small scale companies just like MGT 2700, Inc. (MGMT) by describing the positive and
negative aspects of the chosen investment proposal. The main objective of preparing the report is
to provide some guidance to the leaders of RTI so that they can choose the proper investment
instrument between equity investment and convertible debenture while investing in the chosen
company MGMT. The report also analyse the importance of IPO investment in comparison to
private invest to explain to the leaders of IRFT to describe that to what extent the company
MGMT will be interested to accept the private investment offerings. The report also makes a
comprehensive discussion regarding the future operating cash generating capacity of MGMT so
that the leader of RTI can properly understand the pros and cons of the investment proposal of
making investment in MGMT.

Table of Contents
Q1....................................................................................................................................................4
Advantages and disadvantages for MGMT to seek private equity financing from RTI rather than
undertaking an IPO..........................................................................................................................4
Q2....................................................................................................................................................5
Operating cash flow forecast for MGMT for years 2018 to 2022 (five years) using the
Projections of the investment bank, Appendix-1.............................................................................5
Q3.Justification of underlying assumptions of the Investment bank...............................................6
Q4....................................................................................................................................................7
Estimated weighted average cost of capital for MGMT assuming that the business is an all-equity
business entity, Appendix-2.............................................................................................................7
Q5 Calculation of DCF model using the concept of OCF, Appendix-3..........................................8
Q6 Suggestions regarding buying the GY apps by MGMT, Appendix-4.......................................9
Q7..................................................................................................................................................10
Advantages and disadvantages of investment in equity or a convertible subordinated debenture10
Reference:......................................................................................................................................11
Appendix:......................................................................................................................................12

Q1.
Advantages and disadvantages for MGMT to seek private equity
financing from RTI rather than undertaking an IPO
If the MGMT seek private financing from RTI then it is going to enjoy the following advantages:
The company MGMT is choosing a well-known investor RTI knowing its efficiency and return
generating capacity.
The private investment will save MGMT from the risk of IPO failure
The other benefit of staying private is to minimize the down side risk by investing in a specific
company and thus the company MGMT will only be answerable to RTI at the event of loss
instead of being answerable to thousands of outside investors which will be the case if IPO
investment is done(Levis, 2011)
The major disadvantages of staying private can be identified as follows:
On the other hand IPO investment will allow the company MGMT to raise lot of cash and to
enhance the financial image of the company which is, not possible from accepting private
investment.
Acceptance of private investment will not allow MGMT to use its stock as currency where the
benefit is available under IPO investment where the stocks are being traded in the exchange like
currency and generates money(Bruton et al.,2010).
The other major disadvantage of private investment is that it does not offer the scope to the
company MGMT to promote the company in public which can easily be done by IPO investment

Q2.
Operating cash flow forecast for MGMT for years 2018 to 2022 (five
years) using the Projections of the investment bank, Appendix-1
Here the EBITDA has been calculated for the projected years of the 2018-2022 for a 5 years
period on the basis of the following assumptions:
Growth in sales is 20% per annum until 2022, after OCF will grow at 4% indefinitely
Gross margin 80% of sales
R&D expenses 10% of sales
SG&A expenses 33% of sales
Depreciation expense 20% growth per annum
Capital expenditures and intangibles annual investment 6% of sales
The sum or cumulative value of the EBITDA for the duration of 5 years projection is
YEAR 2018 2019 2020 2021 2022
EBITDA,USD million
44.3422
8
53.21073
6
63.852883
2
76.6234598
4
91.9481518
1
329.977
5
The cumulative EBITDA is close to the estimated enterprise value of the company MGMT.
Valuation based on 7 times forward (2018) EBITDA = $44.34 × 7 + $26.2 (cash) = $336.60
million.

The enterprise value can be defined as the total value of a firm’s equity and debt. And can also
be described as the total market value of a company’s expected cash flow stream. A company’s
EBITDA is assumed to be measure of that stream. Furthermore, EBITDA is a company’s net
income with tax, interest, depreciation, and amortization expenses that are being added back.
Thus EBITDA is not an exact measure of a company’s cash flow but it is considered as an
important proxy measure of the cash flow which if earned will be able to pay the tax interest and
depreciation in future in smooth manner.
Thus Enterprise Value = Multiple * EBITDA
However the assumption of working capital has not being used for the calculation of cash flow as
the working capital is the difference between current asset and current liabilities and gives a brief
picture of the present financial situation of the company where as the cash flow is a
demonstration of the company's ability to generate cash over a specific period of time. Thus a
sound cash flow demonstrates that the business is having a strong source of generating working
capital (Acharya et al.,2012).
YEAR 2018 2019 2020 2021 2022
Net cash flow, USD
million
14.74055
6
17.828667
2 22.23440064 26.68128077 32.01753692
113.502
4
Thus the company is capable to generate estimated positive cash flow for each of the year of the
projected duration and net cash flow is net off “Capital expenditure and investment in intangible
asset”. Thus the projection defines that investment in MGMT is a profitable
venture(Jennergren, 2011.).
Q3.Justification of underlying assumptions of the Investment bank
Looking at the assumptions it can be said that the assumption of “Capital expenditures and
intangibles annual investment 6% of sales” and “Working capital reduction is 30% of sales in
2018 only but it is increased back on year 2022” are not justified. As a business has to make
substantial investment for capital expenditure for attaining substantial growth and cash flow

which should not be as low as 6% of the estimated values of sales and if this level of investment
increases then the cash that will be generated from investment will decrease.
Again the assumption of working capital is not relevant to the cash flow projection and therefore
is not justified at all and the sudden reduction in working capital by 30% in 2018 is not justified
at all.
Q4.
Estimated weighted average cost of capital for MGMT assuming that the
business is an all-equity business entity, Appendix-2
Here it has been assumed that MGMT is an all equity capital firm and therefore there is no debt
in the capital structure of the company
WACC = (E/V * Ke) + (D/V) * Kd * (1 – Tax rate)
And the calculated WACC of the company is 12% assuming that the market value of equity is
$215 million USD and it is the total value of the firm as the firm is not raising any debt capital
(thus there is no debt or cost of debt present in the calculation)
For the calculation of the cost of equity the following formula is being used
Cost of equity= risk free return+ Estimated firm-size risk premium for this company +
β*(Estimated market risk premium)
Where β = Estimated systematic risk (beta) for the video game sector
The “Estimated firm-size risk premium for this company” has been added to the risk free return
as the company Raju Technology, Inc. Is investing in to a small company MGMT and
investment in a small company is very risky as it may fail to generate the estimated return

because of its small scale operation. So the company is paying a premium return for its small
scale that is being added to the risk free return(Brooks & Mukherjee, 2013).
Estimated market risk premium = Market return – risk free return
Q5 Calculation of DCF model using the concept of OCF, Appendix-3
Operating cash flow (OCF) is a measure regarding the amount of cash generated by a company's
regular business activities. The importance of generating the operating cash flow is to assess the
capability of the business in generating positive cash that will be required for maintaining the
growth of the business
OCF(Operating
cash flow) EBIT + Depreciation - Taxes
Here the DCF has been calculated on the basis of the yearly OCF for the projection period under
consideration and the calculated DCF on the basis of OCF is 240.7460463, USD
Value per share
as per DCF, USD
million 0.559874526 559874.5263
Again the estimated proposed investment per the proposal of the investment bank is $500,000
Therefore DCF recommends that the company MGMT is undervalued as according to DCF each
share will be sold at around $560000 but the estimated investment per share being proposed is
$500000(Kaplan & Atkinson, 2015).

Q6 Suggestions regarding buying the GY apps by MGMT, Appendix-4
Here the calculation has been done on the basis of the assumption that the company GY is an all
equity entity and there4fore there is no debt in the capital structure of the company.
In order to calculate the cumulative present value of the given neutral cash flows the DCF
method has been used where the cost of equity of 12% has been used as the rate of discounting
he estimated periodic or annual neutral cash flow.
Assumptions of the model are as follows:
Probability of neutral scenario = 50%(P1)
Probability of best case scenario = 35%(P2)
Probability of worst case scenario = 15%(P3)
Best case cash flow is 150% more than neutral scenario cash flow
Worst case cash flow is (-15%) less than neutral scenario cash flow
The maximum estimated suitable price to be paid for buying GY app is 88 million USD
Estimated price to be paid (88 million USD) = P1*DCF1 + P2*DCF2 + P3*DCF3; which is the
probability weighted fair values of investments with respect to different scenarios
So if the app is being offered at 25 million USD then it should be considered as economic
investment as it is much lower than the maximum level of investment and therefore the
investment proposal should be accepted(Easley et al.,2010).

Q7.
Advantages and disadvantages of investment in equity or a convertible
subordinated debenture
If RTI is making one time investment in MGMT then choosing the option of investment in
equity will be easy and comprehensive for the company RTI as equity investment gives a
specific figure regarding by investing how much capital how much share value the RTI is
owning in the company and being an equity investor RTI is supposed to get the share of profit of
the company either in the form of dividend or capital growth.
On the other hand if RTI invest in MGMT in terms of convertible debenture instrument then RTI
will receive the return on inversed debenture as per debenture contract and after the specified
time the debenture investment will automatically used in purchasing the equity of the same
company probably at a discounted price as per the terms of the convertible debenture.
Here the analysis reveal that the company MGMT is going to attain huge growth in future and
therefore it is expected that the price of share as well as performance of the company will grow
in future (Levin & Light, 2015).
Thus it is suggested that the option of investing in convertible debenture is suggested to RTI for
investing in MGMT as this option will offer the opportunity to RTI to get a secured return under
debenture contract and to observe the performance of MGMT and will accordingly take the
decision of converting the debenture in to equity.
So it is recommended that the RTI should make private equity investment in MGMT by using
the instrument of convertible debenture for the said projection period of 2018-2022.

Reference:
Acharya, V.V., Gottschalg, O.F., Hahn, M. & Kehoe, C., (2012). Corporate governance &value
creation: Evidence from private equity. The Review of Financial Studies, 26(2), pp.368-
402.
Brooks, R. &Mukherjee, A.K., (2013). Financial management: core concepts. Pearson.
Bruton, G.D., Filatotchev, I., Chahine, S. &Wright, M., (2010). Governance, ownership
structure, &performance of IPO firms: The impact of different types of private equity
investors &institutional environments. Strategic management journal, 31(5), pp.491-509.
Easley, D., Hvidkjaer, S. &O’hara, M., (2010). Factoring information into returns. Journal of
Financial &Quantitative Analysis, 45(2), pp.293-309.
Jennergren, L.P., (2011). A tutorial on the discounted cash flow model for valuation of
companies. SSE/EFI Working paper series in business administration, (1998), p.1.
Kaplan, R.S. &Atkinson, A.A., (2015). Advanced management accounting. PHI Learning.
Levin, J.S. & Light, R.S. eds., (2015). Structuring venture capital, private equity
&entrepreneurial transactions. Wolters Kluwer Law & Business.
Levis, M., (2011). The performance of private equity‐backed IPOs. Financial
Management, 40(1), pp.253-277.

Appendix:
Appendix-1
YEAR 2018 2019 2020 2021 2022
USD,
million
USD,
million USD, million USD, million USD, million
Total Revenue 119.844 143.8128 172.57536 207.090432
248.508518
4
cost of goods sold 23.9688 28.76256 34.515072 41.4180864
49.7017036
8
gross margin 95.8752 115.05024 138.060288
165.672345
6
198.806814
7
R&D 11.9844 14.38128 17.257536 20.7090432
24.8508518
4
SG& A 39.54852 47.458224 56.9498688
68.3398425
6
82.0078110
7
EBITDA 44.34228 53.210736 63.8528832
76.6234598
4
91.9481518
1
329.977
5
Depreciation and amortization 12.012 14.4144 17.29728 20.756736 24.9080832
Interest expenses 1 1 0 0 0
Income before tax 31.33028 37.796336 46.5556032
55.8667238
4
67.0400686
1
Income tax@ 30% as[ average
effective tax rate from
given income statement from 2015-
2017] 9.399084 11.3389008
13.9666809
6
16.7600171
5
20.1120205
8
Net Income 21.931196 26.4574352
32.5889222
4
39.1067066
9
46.9280480
3
167.012
3
Capital expenditure and investment
in intangible asset 7.19064 8.628768 10.3545216
12.4254259
2 14.9105111

Net cash flow 14.740556 17.8286672
22.2344006
4
26.6812807
7
32.0175369
2
113.502
4
Appendix-2
Risk-free rate (current 10-year
Government bond yield) 3%
Estimated market risk premium 7%
Estimated systematic risk (beta) for
the video game sector 1.5
Estimated firm-size risk premium for
this company 3%
cost of Equity(Ke) 17%
million USD
E = Market Value of Equity $215.00
V = Total market value of equity &
debt $215.00
Ke = Cost of Equity 17%
D = Market Value of Debt 0
Kd = Cost of Debt 0
Tax Rate = Corporate Tax Rate 30%
WACC or say cost of equity 12%
Appendix-3
Year 2018 2019 2020 2021 2022
EBITDA 44.34228 53.210736 63.8528832 76.62345984 91.94815181
Depreciation and
amortization 12.012 14.4144 17.29728 20.756736 24.9080832

Taxes 9.399084 11.3389008 13.96668096 16.76001715 20.11202058
OCF/Annual operating
cash flow 46.955196 56.2862352 67.18348224 80.62017869 96.74421443
WACC or say cost of
equity 12%
discounted cash flow,
DCF 42 45 48 51 55
fair value of investment
as per DCF 240.7460463
Value per share as per
DCF, USD million 0.559874526 559874.5263
total equity
investment
$215,000,00
0
investment by a
share holder 500,000
estimated
number of shares
issued 430
estimated
investment per
share 500,000
Appendix-4
Scenario
Probabili
ty

neutral
Scenario 50%
Best
scenario
35%
worst
scenario
15%
Neutral
case
Year 0 1 2 3 4 5 6 7 8 9 1
0
estimated
after tax
cash flow,
USD
million 0 0
1
5
12.
5
1
1 10.5
1
6
14.
5 13
1
3
cost of
equity 12%
present
value of
estimated
cash 0 0
1
1
7.9
4 6 5.32
7.
2
5.8
6
11.
6 4
total
present
value of
investmen
t, USD
million,DC
F1 58.624
Best case
Year 0 1 2 3 4 5 6 7 8 9
1
0
estimated 0 0 3 31. 2 26.2 4 36. 32. 3

after tax
cash flow,
USD
million 8 3 6 5 0 3 5 1
cost of
equity 12%
present
value of
estimated
cash 0 0
2
7
19.
9
1
5 13.3
1
8
14.
6 29
1
0
total
present
value of
investmen
t, USD
million,DC
F2 146.56
Worst case
Year 0 1 2 3 4 5 6 7 8 9
1
0
estimated
after tax
cash flow,
USD
million 0 0
1
3
10.
6
8.
9
8.92
5
1
4
12.
3
11.
1
1
1
cost of
equity 12%
present
value of
estimated
cash 0 0
9.
1
6.7
5
5.
1
4.52
2
6.
2
4.9
8
9.8
7
3.
4
total
present 49.83

value of
investmen
t, USD
million,
DCF3
maximum
value
should be
invested
for buying
GY app ,
USD
million 88.083