PlanetTran
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Pedagogical objectives
• Valuing a company using discounted cash flow analysis (DCF); Using the concept of perpetuities to simplify DCF Calculating terminal growth rates (TGR) and terminal value (TV)
• Understanding that different parties to a transaction can have different cash flow projections, and how these different projections can lead to different subjective optimal decision paths; • Getting an initial introduction to the market for outside funding, and the interplay between venture capital firms and entrepreneurs; and • Developing an initial understanding of the separation of ideas and capital, and what this means for innovation in the economy 2
PlanetTran’s operations: A summary • The company grew rapidly in recent years Exhibit 1 for revenues Exhibit 2 for customers
• Demand varied dramatically during the day and week (exhibits 3 and 4), which made the need to optimize capacity utilization paramount. The key to profitability in PlanetTran’s employee model was labor cost 3
The problem • The founder, Seth Riney, is evaluating outside funding options in order to expand the company, and has met local venture capital (VC) firms. Both agree Three particular expansion locations: Denver, Chicago, or New York. Estimated funding needs: $1,250,000 for Denver, 2,750,000 for Chicago, and $4,250,000 for New York City. Future capital expenditures were estimated at 5% of sales, depreciation was estimated at 3% of sales, and the change in NWC was estimated at 1% of sales, per year. 4
The problem • VC: Equity capital provided to a promising new business is called venture capital. Note that the VC is planning on taking an equity stake. • The concern of Mr. Riney: whether the dilution he would have to undergo in order to accept a substantial capital investment is worth the added upside to the company that both he and the VCs envision. 5
Roadmap for financial analysis • PlanetTran must be valued from Riney’s perspective for each expansion. • The same valuation of PlanetTran as a whole should be done from the VC’s perspective for each expansion option. • Whether there exists an option that both Seth Riney and the VC can agree on.
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The PV for Seth Riney • Decides values of the firm in each of the four possible scenarios of the case Declining funding, and growing organically Getting funding, and expanding into Denver Getting funding, and expanding into Chicago Getting funding, and expanding into New York
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Riney’s Projections: Exhibit 6 • Riney’s 2009 projections • Projecting forward for the entire life of the firm Sales growth at 10% per year until the end of 2018. assuming that all other elements of the income statement remain constant percentages of sales. FCFs growing at 5% after 2018
• Riney’s discount rate is 25% • FCFs from 2009 to 2018 and PV (organic) = 3,126,496 8
Terminal value (TV) • TV is the discounted value of all future free cash flows, starting from 2018 and going to infinity. • Perpetuity: A perpetuity is a constant stream of cash flows without end. The PV of a perpetuity = C/r • A growing perpetuity: A perpetual cash flows growing at a constant rate (g) is called a growing perpetuity. The PV of a growing perpetuity = C/(r-g). • The future FCFs starting from 2018 constitute a growing perpetuity with a constant growth rate of 5%. • TV as of the end of 2018 = 2019 FCF/(rg)=1,532,666/(25%-5%)=8,046,496 9
PV of firm • PV of firm (organic)= PV of 2009-2018 FCF + PV of terminal value = 3,126,496+863,986 = $3,990,482 • PV of firm (Denver) = 7,816,239 +2,159,965 = $9,976,204 • PV of firm (Chicago) = 9,018,738 + 2,492,267 = 11,511,005 • PV of firm (New York) = 12,024,984 + 3,323,023 = $15,348,007. 10
VC’s projections • The VC is less optimistic about the near term growth rate of sales, and believes that the growth rate will be 5% from 2009-2018, in addition to being 5% from 2019 onward. • The VC is somewhat more diversified than Riney, and uses a lower discount rate of 20%. • The VC has lower expectations of PlanetTran’s ability to generate sales and profits in each of the four strategies. 11
PV of firm from the perspective of the VC • PV of firm (organic) = PV of 2009-2018 FCFs + PV of TV = 2,259,902 + 806,765 = $3,066,667 • PV of firm (Denver) = 3,635,494 + 1,297,840 = $4,933,333 • PV of firm (Chicago) = 5,060,214 + 1,806,452 = $6,866,667 • PV of firm (New York) = 4,053,084 + 1,446,916 = $5,500,000 12
A comparison of VC and Riney’s projected PV • Entrepreneurs are in general more optimistic than VCs. • From Riney’s perspective, expansion into New York yields the highest PV. The VC actually believes that expansion into New York will nevertheless generates lower sales and free cash flows than Chicago.
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PVs and NPVs Stragegy Funding need VC' Projected PV Riney's PV VC's NPV VC's preferred strategy Riney's NPV Riney's preferred strategy Organic 0 3066667 3990482 3066667 3990482 Denver 1,250,000 4933333 9976204 3683333 8726204 Chicago 2,750,000 6866667 11511005 4116667 Chicago 8761005 NYC 4,250,000 5500000 15348007 1250000 11098007 NYC
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Solving for the shares the VC and Riney will require to expand • In order for the VC to agree to fund any of PlanetTran expansion strategies, the VC must receive NPV>=0 for the given strategy. Required VC minimum share *VC’s PV – cost of expansion to VC = NPV =0 Riney’s share will be at most = 1 – required VC min. share Value to Riney = Riney’s share * Riney’s PV
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Value to Riney
Stragegy Funding need VC' PV Riney's PV VC's required share share to Riney Value to Riney Chosen strategy Organic 0 3066667 3990482 0 100.00% 3990482 Denver 1,250,000 4933333 9976204 0.253378395 0.746621605 7448449.437 Denver Chicago 2,750,000 6866667 11511005 0.400485417 0.599514583 6901015.357 NYC 4,250,000 5500000 15348007 0.772727273 0.227272727 3488183.409
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Decision and outcome • PlanetTran will end up with expanding into Denver, a sub-optimal expansion strategy from both of their perspectives. • Reason? This is due to the heterogeneous beliefs between the VC and Riney. • Implications? These differences could actually pose a negative effect on real investment and innovation in the economy. 17
Are Entrepreneurs optimistic (overoptimistic)? • Cooper et al. (1988) 68% of entrepreneurs believe the odds of their business succeeding is better than the odds for another similar business The same study finds that 5% believe their odds are worse A third of entrepreneurs project their probability of success to be 100% 72% of entrepreneurs think their probability of success is at least 80%.
• Dunne et al. (1988): survival rate in 5 years is 38.5% • Popkin and Kirchhoff (1991): survival rate in 2 years is 76.9%, and survival rate in 10 years is 34.4%. 18
