You have just been hired to assist the CFO of anIT Group (ITG), a family-owned IT service group which owns and manage 4 small branches scattered in the Kingdom. The ITG headquarter is in Jeddah. The company is owned by non-Saudi resident liable to income tax. ITG plans to sell 2 branches outside Jeddahto focus on its core business in Jeddah.ITG employs 66 full-time employees.

To accelerate its development in Jeddah, ITG plans to buy another family-owned IT company (called MH) with2 offices based in Jeddah.

For this purpose, the ITGboard asks you to briefly diagnose the MH company performance and assess its value.

All questions can be handled independently with the information provided in the appendices.

**1.1 MH company performance ( Appendix 1)**

From the consolidated financial statements, you will determine the return on capital employed (ROCE)and the return on equity (ROE) for theMH Company. You will also computethe operating margin rate for the last three years. A 20% corporate tax rate willbe used.You will justify, explain and interpret each calculation.

To calculate the ROCE, we will divide the EBIT of the company by the total capital invested. In order to get the total capital invested we will substrate total current debt from the total assets.

For ROE, we will divide the net income by the total provided equity. And for operating margin, we will divide the EBIT by the total turnover.

N | N-1 | N-2 | |

ROCE | 10.64% | 8.10% | 11.18% |

ROE | 14.41% | 13.34% | 14.30% |

Operating Margin | 7.93% | 7.32% | 7.58% |

**1.2 The MH Company weighted average cost of the capital(***Appendix 2*)

*Appendix 2*)

Since the MH company is not listed on a stock market, it is not possible to easily compute its cost of capital. Using data provided in appendix 2, you will estimate the weighted average cost of capital (WACC) of the MH Company based on data from comparable listed companies.

For the calculation of WACC, we first need to determine the weightage of debt and equity in the respective capital structure. For the weightage, divide the amount of debt and equity by the total sum of debt and equity.

After getting the portions of debt and equity, we will use the following equation to calculate the WACC.

WACC = (Cost of Debt * Portion of debt) * (1- Tax %) + (Cost of Equity * Portion of Equity)

Cost of equity | 16 | ||

Cost of Debt | 8 | ||

Tax | 20.00% | ||

Rounded off debt | 50% | 60% | 50% |

Rounded off Equity | 50% | 40% | 50% |

WACC | N | N-1 | N-2 |

11.20 | 10.24 | 11.20 |

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**1.3 The MH company business Plan (***Appendix 3*)

*Appendix 3*)

Based on the financial data projections, you will estimate the free cash flow to the firm (FCFF) over the next five years.

In this question, we have used the following formula to calculate the FCFF

FCFF = EBIT (1-Tax %) + Depreciation Expense – CAPEX – Working Capital Expense

N+1 | N+2 | N+3 | N+4 | N+5 | |

Turnover | 4400000 | 5060000 | 5566000 | 5844300 | 5961186 |

Operating Income | 176000 | 253000 | 333960 | 350658 | 357671 |

Tax Expense | 35200 | 50600 | 66792 | 70131.6 | 71534.23 |

EBIT After Tax | 140800 | 202400 | 267168 | 280526.4 | 286136.9 |

Add: Depreciation | 176000 | 202400 | 222640 | 233772 | 238447.4 |

Minus: CAPEX | 176000 | 202400 | 222640 | 233772 | 238447.4 |

Working Capital | 440000 | 506000 | 556600 | 584430 | 596118.6 |

Minus: ChangeWorking Capital | 24000 | 66000 | 50600 | 27830 | 11688.6 |

FCFF | 116800 | 136400 | 216568 | 252696 | 274448 |

**1.4 The MH company valuation with the DCF method(***Appendix 4*)

*Appendix 4*)

Following multiple meetings and exchanges, MH’s weighted average cost of capital and its business plan are reviewed. Using Appendix 4 assumptions, you are asked to assess the MHequity value using the discounted cash-flowsmethod (calculations in thousands of SAR).

The first step for the DCF Valution, we need to discount back the projected FCFF by the provided WACC. After getting the discounted values, we need to project the Terminal value of the company as we assume that the company will grow till eternity. For terminal value, we used the following formula:

TV = FCFF(last Year) *(1+Growth rate%) / (WACC – Growth Rate)

After calculating TV, discount it back. After discounting all the cash flows, add all the values and subtract the net value of debt.

WACC | 12 | % | |||

Growth Rate | 2 | % | |||

Net Debt | 1380000 | ||||

N+1 | N+2 | N+3 | N+4 | N+5 | |

FCFF | 150,000 | 170,000 | 200,000 | 240,000 | 280,000 |

Discounted FCFF | 133,929 | 135,523 | 142,356 | 152,524 | 158,880 |

Terminal Value | 2,856,000 | ||||

Discounted TV | 1,620,571 | ||||

Total value of the firm | 2,343,783 | ||||

Total value of the equity | 963,783 |

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**1.5 The MH company valuation with multiples (Appendix 5)**

You are also asked to assess the equity value of the MH Companywith the multiples of its operating income and net income using Appendix 5.

Multiple method is based on the assumption that the peer companies tend to perform similarly; hence we use the average multiple of industry to predict the value of equity of our company.

A | B | C | Average | MH | MH | |

Operating income | 60 | 70 | 80 | 350 | ||

Net income | 50 | 64 | 45 | 230 | ||

Value of Debt (M SAR) | 200 | 300 | 400 | 1380 | 1380 | |

Value of Equity (M SAR) | 400 | 500 | 400 | 2194 | 1894 | |

Enterprise Value | 600 | 800 | 800 | 3667 | 3241 | |

EV/Operating income | 10.00 | 11.43 | 10.00 | 10.48 | ||

EV/ Net income | 12.00 | 12.50 | 17.78 | 14.09 | ||

Ve/Operating Income | 6.67 | 7.14 | 5.00 | 6.27 | ||

Ve/Net Income | 8.00 | 7.81 | 8.89 | 8.23 |

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**1.6 Conclude on the opportunity for the Group ITG to acquire the MH company. Write a brief note for the members of the Board of Directors in the form of a summary note to explain if ITG Group should buy or not the MH company (1-page max).**

Based on the analysis performed, in my opinion, buying MH Company is a good opportunity.

As per the data provided, the company’s turnover is expected to grow by good percentages in next five years and also the free cash flow to the firms are positive numbers for the next five years. Moreover, the equity value we have calculated from three methods are very good and we expect that the company will do great in future. So ITG should acquire MH Company.

Furthermore, the decision to sell other branches of company which were outside Jeddah is a good and recommended step. Acquiring of MH Company will not only prove viable financially but also it will help ITG in its operations in terms of probable synergies.

Also, if we discuss the industry with regard to its multiples, it seems to be a very attractive industry. EV multiples are high which shows the further growth potential.

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**Appendix 1**

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__Financial statements–MH company(in KSAR)__

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**Note: Provisions for pensions can be considered as a Financial Debt to compute the Net Debt.**

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**Appendix 2**

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__Estimated Weighted Average Cost of Capital for the MH company__

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To estimate the weighted average cost of capital of the MH company, a cost of equity of approximately 12% plus a 4% illiquidity premium will be usedsince the company is not listed.Given its financial situation, the MH company management estimates that it can borrow at an interest rate of 8% before tax.The financial structure will be rounded to the nearest (for example, we will retain 40% instead of 38%).The corporate tax rate is 20%.

**Appendix 3**

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__Assumptions for the MH company Business Plan__

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The forecasted turnover for the year N+1 is estimated at 4.4 million SAR. You anticipate an increase in turnover in N+2 of +15%, +10% in N+3, +5% in N+4, then a stabilization of growth at 2% per year. The projected operating margin rate is +4% for N+1, +5% for N+2 and +6% for subsequent years. Depreciation expense is estimated at 4% of revenues, as well as CAPEX. The working capital requirement is assumed to equal 10% of the current yearly revenues.

**Appendix 4**

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__Business valuation using the discounted free-cash-flows method__

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After a complete analysis, it was decided to use a 12% weighted average cost of capital and the following free-cash-flows projections:

Beyond the year N+5 (and over an infinite horizon), it will be retained a constant growth rate of 2% per year for the FCFF. The net debt value will be equal to the accounting (balance sheet) value.

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**Appendix 5**

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__Business Valuation using multiples__

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Asample of three comparable companies (A, B and C) has been selected to evaluate theMH company.

The value drivers (or multiples) used for comparison are following:

- the forecasted(N+1) operating income,
- the forecasted (N+1) net income.

Concerning the MH company, the forecasted operating income is estimated to be 350 kSARand the net income part of the group is estimated at 230 kSAR.