Mercury Athletic Footwear: Joel L. Heilprin Harvard Business School © 59 Street Partners LLC

Mercury Athletic
Footwear
Harvard Business School Joel L. Heilprin © 59th Street Partners LLC

Explicit forecast period is based on the analyst’s judgment TV is the going concern value at the end of
the explicit forecast period
Mercury Athletic Footwear
Firm Value & Cash Flows:
 As a starting point, let’s start with a basic valuation
𝐸(𝐹𝐶𝐹 (1 + 𝑔) 𝑛
paradigm 𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒 = 𝐸(𝐹𝐶𝐹 ) + 𝐸(𝐹𝐶𝐹 ) + ⋯ + 𝐸(𝐹𝐶𝐹 ) +
1 (𝑟 − 𝑔)2 𝑛
(1 + 𝑟)1 (1 + 𝑟)2 (1 + 𝑟)𝑛 (1 + 𝑟)𝑛
Annual Forecasts Terminal Value
 Note that the sole determinant of value is the generation of

cash flow
 Further the only relevant factors are the amounts, timing and
risks of the cash flows
NOPAT Net reinvestment

 Determination of FCF
 To begin, the preceding equation led to a value of the entire
enterprise, meaning V = D + E
 Thus, we are interested in what the total business is worth
irrespective of who gets the cash or how it’s financed
 In turn, this means we are interested in the un-levered FCF
Un-Levered FCF = EBIT(1-t) + Depr’ - ∆WC – Cap-x

 In case Exhibit 6, Liedtke provides a set of projections for
each of the operating segments – Thus,
Consolidated Segment Revenue
 Multiplying EBIT by (1-t) yields Less: Segment Operating Expenses
the first term in the FCF equation Less: Corporate Overhead
Operating Income = EBIT
 Question: Are taxes being overstated?
‫ ־‬It is true that interest expense creates a tax shield
‫ ־‬However, the value of the tax shield is acknowledged in the
WACC
 Having calculated NOPAT, we should have the following results,
and are now in a position to proceed to the next step in FCF
determination
Operating Results: 2007 2008 2009 2010 2011
Revenue 479,329 489,028 532,137 570,319 597,717
Less: Divisional Operating Expenses 423,837 427,333 465,110 498,535 522,522
Less: Corporate Overhead 8,487 8,659 9,422 10,098 10,583
EBIT 47,005 53,036 57,605 61,686 64,612
Less: T axes 18,802 21,214 23,042 24,675 25,845
NO PAT 28,203 31,822 34,563 37,012 38,767
 To move from NOPAT to FCF we will simply subtract all of the net
reinvestment in the firm’s operations
‫־‬ (Cap-x + Depr’ – ΔWC)

Liedtke’s Projections:
 Using the information contained in Exhibit 6, the
following set of FCF projections can be developed:
Operating Results: 2007 2008 2009 2010 2011
Revenue 479,329 489,028 532,137 570,319 597,717
Less: Divisional Operating Expenses 423,837 427,333 465,110 498,535 522,522
Less: Corporate Overhead 8,487 8,659 9,422 10,098 10,583
EBIT 47,005 53,036 57,605 61,686 64,612
Less: T axes 18,802 21,214 23,042 24,675 25,845
NO PAT 28,203 31,822 34,563 37,012 38,767
Plus: Depreciation 9,587 9,781 10,643 11,406 11,954
Less: Changes in Working Capital 4,567 2,649 9,805 8,687 6,233
Less: Capital Expenditures 11,983 12,226 13,303 14,258 14,943
Unlevered Free Cash Flow (FCF) 21,240 26,727 22,097 25,473 29,545
 Are Liedtke’s projections reasonable?

‫ ־‬Consider the revenue growth rates & operating margins
‫ ־‬What about the changes in working capital?
 To begin with, the EBIT Growth Rates: 2007 2008 2009 2010 2011
margins are highly Men's Athletic 15.0% 12.0% 10.0% 8.0% 5.0%
simplified – though not Men's Casual

Women's Athletic
1.0%
12.0%
2.0%
11.0%
2.0%
9.0%
3.0%
7.0%
3.0%
5.0%
unreasonable Women's Casual 0.0% 0.0% 0.0% 0.0% 0.0%

EBIT Margins:
There is a tapering off of Men's Athletic
Men's Casual
13.3%
16.0%
13.3%
16.0%
13.3%
16.0%
13.3%
16.0%
13.3%
16.0%
growth in athletic shoes Women's Athletic 10.2% 10.2% 10.2% 10.2% 10.2%
Women's Casual -1.3% 0.0% 0.0% 0.0% 0.0%
 Men’s casual is assumed to Corp Overhead/Revenue 1.8% 1.8% 1.8% 1.8% 1.8%
grow at what might be the
long-term rate of the The relatively high growth rates in athletic shoes
industry for the early years are presumably a result of
continued expansion into large discount retailers
 Women’s casual is to be
discontinued
 Changes in net working capital
2007 2008 2009 2010 2011
Changes in Working Capital 4,567 2,649 9,805 8,687 6,233
 Notice that the increase in 2008 is smaller than that of 2007, and
that the rate of ∆ increases again in 2009 and falls in 2010-2011
 Liedtke has based his WC projections on historical cash cycle
ratios Working Capital Ratios:
Days Sales Outstanding 36.0x 36.0x 36.0x 36.0x 36.0x
Days Sales Inventory Outstanding 62.9x 62.9x 62.9x 62.9x 62.9x
Days Prepaid Outstanding 10.9x 10.9x 10.9x 10.9x 10.9x
Days Payable Outstanding 16.0x 16.0x 16.0x 16.0x 16.0x
Days Accrued Outstanding 19.4x 19.4x 19.4x 19.4x 19.4x
‫־‬ The volatility is the result of discontinuing the women’s casual line
along with a lagging effect from changes in revenue growth
Cost of Capital:
 Exhibit 3, provides some comparable company
information that includes observed equity betas along
with the market values for debt and equity
 Using that information each comparable firm’s asset beta
can be obtained using one of the following
βasset = (E/V)βequity or βasset = (E/(E + net Debt(1-t)))βequity
Assumes a constant D/V ratio

Assumes a changing capital structure with a βdebt
and a βdebt of zero
of zero
Cost of Capital:
 Based on the preceding, the following average un-
levered beta can be obtained
Equity Net Equity Asset
Casual & Athletic Shoe Companies: Market Value Debt D/E Beta Beta
D&B Shoe Company 420,098 125,442 29.9% 2.68 2.06
Marina Wilderness 1,205,795 (91,559) -7.6% 1.94 2.10 If a changing capital
General Shoe Corp. 533,463 171,835 32.2% 1.92 1.45
Kinsley Coulter Products 165,560 82,236 49.7% 1.12 0.75 structure had been
Victory Athletic 35,303,250 7,653,207 21.7% 0.97 0.80 assumed, the un-levered
Surfside Footwear 570,684 195,540 34.3% 2.13 1.59
Alpine Company 1,056,033 300,550 28.5% 1.27 0.99 beta would have been 1.37
Heartland Outdoor Footware 1,454,875 (97,018) -6.7% 1.01 1.08
T empleton Athletic 397,709 169,579 42.6% 0.98 0.69
Average 24.9% 1.56 1.28
 A constant capital structure was used based on Liedtke’s

choice of a WACC based on a 20% D/V ratio
If the βd > 0
𝑉 𝐷
𝛽𝑒 = 𝛽𝑎 − 𝛽𝑑
𝐸 𝐸

Cost of Capital:
 With an average asset beta in hand, a new equity beta
can be obtained based on Liedtke’s assumed 20% D/V
βequity = βassets(V/E) => 1.28(1/.8) = 1.6
 Using CAPM, the required return on equity is
re = rf + βe(EMRP) => 4.93% + (1.6)(5%) = 12.92%
 The complete WACC is
Assumes the Equity Market
Debt/ Debt/ Asset Equity Cost of Cost of
Value Equity Beta Beta Equity Debt WACC
Risk Premium is 5% and the
20.0% 25.0% 1.28 1.60 12.92% 6.00% 11.06% tax rate is 40%
Terminal Value:
 If Mercury has indeed reached a steady state by 2011,
then we can envision the firm as providing a stream of
cash flows that grows at a constant rate forever
 This would imply that the going concern could be valued as
a growth perpetuity
PV2011 = (FCF2011)(1+g)/(r – g)
 Given that we have already developed estimates for FCF
and WACC, an estimate of the long-term growth rate needs
to be calculated
Terminal Value:
 Estimating the long term growth rate
 As a starting point, no business can grow faster than the macro
economy on a continuous basis
‫־‬ Thus, an upper-bound equal to the long-run macro economic growth
rate must exist
 In terms of lower bounds, the long-term growth rate must be
positive or else the firm would not be a going concern (i.e. it
would have a finite life)
 A growth rate equal to the long-run rate of inflation would
suggest a zero real growth rate
‫־‬ In the case of Mercury, this would seem to be the lower bound
Completed Valuation:
 Below is a completed valuation of Mercury based on a
WACC of 11.06% and a long run growth rate of 2.78%
Unlevered Free Cash Flow: 2006 (t=0) 2007 2008 2009 2010 2011
NO PAT 28,203 31,822 34,563 37,012 38,767
Plus: Depreciation 9,587 9,781 10,643 11,406 11,954
Less: Changes in Working Capital 4,567 2,649 9,805 8,687 6,233
Less: Capital Expenditures 11,983 12,226 13,303 14,258 14,943
Unle ve re d Fre e Cash Flow 21,240 26,727 22,097 25,473 29,545
PV Factor 0.900 0.811 0.730 0.657 0.592
PV FCF 19,125 21,671 16,133 16,746 17,490
Sum, PV FCF 91,165 19,125 21,671 16,133 16,746 17,490
T erminal value 3,67,070

PV T V 2,17,292
Enterprise Value 3,08,457

Completed Valuation:
 The table below shows the sensitivity to growth rates
and discount rates
Enterprise Value: Sensitivity Table
TV Growth rate
0% 2.78% 3% 4% 5% WACC
3,50,302 4,95,099 5,13,175 6,21,758 8,02,728 8.00%
2,77,194 3,63,679 3,63,110 4,11,725 4,78,991 10.00%
2,49,359 3,08,457 3,14,785 3,48,957 3,94,414 11.06%
2,28,658 2,75,900 2,80,814 3,06,893 3,40,422 12.00%
1,94,144 2,25,143 2,28,222 2,44,124 2,63,561 14.00%
Note the extreme variance of results even if the range is tightened to a

growth rate of 2.78% - 4% and a discount rate from 10% - 12%

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Mercury Athletic

Harvard Business School Joel L. Heilprin © 59th Street Partners LLC

Annual Forecasts Terminal Value

 Note that the sole determinant of value is the generation of