Warute Phanthumkmol
Calaveras Vineyards Case

Dear Dr. Lynna Martinez,

After reviewing your projections of Calaveras Vineyards, I used the adjusted present value method to come up with the value of the company. With this method, I assume that the whole firm is financed only through equity. Therefore, when calculating the free cash flow, debt was not taken into account. Despite that, the net present value of interest shields is added back to compensate the debt in the capital structure. With this method, the company is valued at $9.62 million.

In order to assess Calaveras’ value, I calculated the free cash flow from 1994 to 1998. The free cash flow from each year derived from adding Earnings before Interest and Taxes, Depreciation, and Amortization and subtracting the Change in Net Working Capital, and Capital Expenditure. Earnings before Interest and Taxes were calculated from subtracting tax rate of 37% from Earnings before Interest (EBIT), which was projected in the Income Statement. Other values were based off of the spreadsheet attached with this memo.

Once I got the free cash flow for each year, I used the Cost of Equity or the CAPM rate to discount it to present value. The rate is calculated by adding the risk-free rate with the product of market risk premium and beta. The risk-free rate of 5.85% is based off of the interest rate of 30-year T-bonds. As for the market risk premium, I chose the geometric mean premium of returns on small-company stocks less returns on long-term government bonds, which is 7.4%. I calculated the beta by using the unlevered beta of three comparable companies and their revenue weights. You can see the calculation in details on the spreadsheet.

The present value of the free cash flow is then used to find the total firm value. Other values that are included in the summation are the net present value of interest tax shield, terminal value of free cash flow, and the terminal value of interest tax shield. The net present value of interest tax shield is computed by using the interest tax rate of 9.5% with the interest tax shield in 1994-1998. For the terminal value of free cash flow, I used the free cash flow of 1998, multiplied it with 1 plus the growth rate of unit prices (2%), divided by the difference in cost of equity and the growth rate. The terminal value of interest tax shield is calculated the same way, but with the interest tax shield value in 1998. The total firm value is then calculated by adding all of those four values together.

As you mentioned, you would purchase 85% of the equity of the new company. That is $8.16 million. I would advise you to purchase the company at the proposed price because the company seems to be able to satisfy its debt along with maintaining the positive cash flow. Although the company structure doesn’t seem too well due to the high debt holdings and the risk associated with it, there are other factors that help compensate for that. The special agreement that Calaveras has with Winston-Fendall will also relieve the Calaveras of credit risk because it will collect all receivables on behalf of the company and remit them back. Furthermore, the firm’s debt will decline over time and it will become more equity heavy, which will improve the ratio of equity and debt. The increase in demand and successful marketing strategy will definitely be beneficial for you in paying off the debt. Calaveras also has great market opportunity because it has the ability to be present in both the markets of premium wines and private-label wines.

From my perspective, you should buy the company because you have competitive advantage in running Calaveras relative to others, including the current owners because you have been working at the company since 1987. You were hired back then to develop and implement a strategy to lift the company out of the bulk-wine category and into the premium-brand segment of the market. In addition to that, your resume is stronger than the others. Your education is better than the others and you had a lot of experience in directing the making of wine. Not only that you trained in family-owned winery and distillery, but you also gained a lot of experience in champagne and white-wine technology at the Moet et Chandon installation in Epernay when you took trips to Europe.

Please note that if you decide to buy the company, you might become more conservative. Currently, you are the vice president/general manager and winemaker of Calaveras. If you buy the company as proposed, you will own 85% of the company. This means that you will relate to the company in two ways; as a manager, and also an owner. Therefore, I am assuming that you will become more conservative because it’s always better to expect less, so you wouldn’t forecast too positively. A reduction in forecasted real growth rate from 2% to 1-1.5% is what I am expecting you might do.

Thank you. Please do not hesitate to ask if you have any further questions.
Best regards,

Warute Phanthumkomol