Independence Aircraft: To Acquire or Not to Acquire?

Abstract

Independence Aircraft is a manufacturer of aircraft and currently produces only long-haul aircraft. After a strategic review, Independence has decided to begin producing regional jets and sees an acquisition as the quickest way to enter this segment. The case requires students to value a potential acquisition target, perform a due diligence analysis, and provide a recommendation about whether Independence Aircraft should acquire Packard Aircraft. To perform this analysis and formulate a recommendation, students are provided the following: historical and forecasted financial information from Packard Aircraft; information about Packard’s products as well as data on historical and projected sales; and information about Packard’s customers, including which aircraft they buy, the number of units they are projected to buy in the future, and their credit ratings. The narrative of the case explains the strategic rationale for the proposed acquisition as well as the expectations and funding constraints that the Independence board of directors has imposed concerning the acquisition.

This case was prepared for inclusion in Sage Business Cases primarily as a basis for classroom discussion or self-study, and is not meant to illustrate either effective or ineffective management styles. Nothing herein shall be deemed to be an endorsement of any kind. This case is for scholarly, educational, or personal use only within your university, and cannot be forwarded outside the university or used for other commercial purposes.

2024 Sage Publications, Inc. All Rights Reserved

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Appendix: Target Valuation Using NPV

NPV of the Deal

A common way to determine the value of a potential acquisition and financially justify the purchase is to determine the NPV of the deal. This requires the calculation of three discrete components: (1) the acquisition cost (AC), (2) the value of the free cash flows (FCF) generated during the forecasted period, and (3) the terminal value (TV). These components are adjusted by the time value of money and then summed to arrive at the NPV of the deal. Each of the components is discussed in more detail below. While revenue and cost synergies may be used to evaluate the risk, suitability, and transactability of the deal, synergies are typically not discretely modeled. Instead, they may be used to evaluate the ease of integration and to help plan for post-acquisition integration should the acquirer consummate the transaction with the target. The formula for the NPV of the deal using a five-year forecast plus terminal value window is:

N P V   = A C 0 + ( F C F 1 1 + k + F C F 2 ( 1 + k ) 2   + F C F 3 ( 1 + k ) 3 + F C F 4 ( 1 + k ) 4 + F C F 5 ( 1 + k ) 5 + T V ( 1 + k ) 6 )

where:

AC0 = Acquisition Cost of the Target at Year 0

FCF1-FCF5 = Free Cash Flows Generated During the Forecasted Periods for Years 1 Through 5

TV = Terminal Value for Year 6 and Beyond

k = Acquirer’s Weighted Average Cost of Capital (WACC)

Acquisition Cost

Acquisition cost is the stand-alone value of the entity you intend to purchase. To arrive at the AC when the target is a publicly traded company, begin with the purchase price of the deal. Typically, a premium above the current share price is offered to entice the target to sell. This premium can be expressed as a percentage or a dollar amount above the target’s current share price. Thus, if a target’s current share price is USD 5.00 and the acquirer is courting the target, the acquirer would offer an amount above USD 5.00. For example, a USD 6.00 per share offer represents a 20% premium over the current share price. The total purchase price is the amount offered per share times the number of shares outstanding and represents the total amount paid to shareholders of the target company.

Once the purchase price has been determined, the target’s cash on hand and debt must also be considered to arrive at the target’s AC. After an acquisition, the acquirer becomes liable for a target’s debt. Therefore, debt is added in the AC formula because it can be considered an additional amount that the acquirer incurs because of the deal. The acquirer also gains access to the target’s cash. Thus, cash is subtracted in the AC formula because a target’s cash is available to reduce the target’s debt or to use in any way the acquirer sees fit. The formula for AC is:

A C = ( O u t s t a n d i n g   n u m b e r   o f   s h a r e s   × ( C u r r e n t   P r i c e   p e r   S h a r e + S h a r e   P r i c e   P r e m i u m ) ) + D e b t C a s h

Note that AC0 is expressed as a negative cash outflow in the NPV formula above. This is because AC represents the cost of the transaction from the buyer’s standpoint.

Value of FCF in the Forecasted Period

To arrive at the value of FCF in the forecasted period, a “bottoms up” approach is used to model revenue; cost of goods sold (COGS); selling, general, and administrative (SG&A) expenses; taxes; interest expense; changes in net working capital (NWC); and investments in capital expenses (CapEx) on a quarterly or annual basis for some period of time. A “bottoms up” approach requires modeling the drivers that impact revenue, COGS, etc. Typically, a 5–10-year time horizon is discretely modeled to calculate FCF. Each period’s FCF is discounted by the acquiring company’s weighted average cost of capital (WACC) to calculate the NPV of the future cash flows. Note that the practitioner can begin with the income statement using net income and make certain non-cash adjustments. Depreciation expenses are excluded because depreciation is a non-cash expense.

F C F = N e t   I n c o m e + D e p r e c i a t i o n   E x p e n s e Δ N W C C a p E x

where:

ΔNWC = Change in Net Working Capital  ( ( Current Assets – Cash )  – Current Liabilities )

Note that for purposes of this case, the change in net working capital is assumed to be zero.

Terminal Value of the Target

The final component of the NPV of the deal is the terminal value (TV) of the target. The TV is an estimate of the target’s value for years beyond the forecasted period. Practitioners typically calculate the TV by multiplying the last discrete period’s EBITDA as modeled in the forecasted period by an EBITDA multiple. Multiples are typically industry-specific and can have a sizeable impact on the overall deal value. Utilizing a 5-period forecasted time horizon, the TV may be expressed as:

T V   =   E B I T D A   i n   P e r i o d   5   x   E B I T D A   M u l t i p l e

This case was prepared for inclusion in Sage Business Cases primarily as a basis for classroom discussion or self-study, and is not meant to illustrate either effective or ineffective management styles. Nothing herein shall be deemed to be an endorsement of any kind. This case is for scholarly, educational, or personal use only within your university, and cannot be forwarded outside the university or used for other commercial purposes.

2024 Sage Publications, Inc. All Rights Reserved

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