Case 51_sol.docx

CASE 51

PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Teaching Note

Synopsis and Objectives In February 2000, a managing partner of a U.K.-based private equity fund, Palamon Capital Partners, faced the decision of whether to invest in an Italian software company, TeamSystem, S.p.A. The rationale for this investment was a belief in the rapid future consolidation of the Italian enterprise software industry, in combination with improvements in operating performance that were believed to arise from a stronger investor orientation after the transaction. The transaction entailed a leveraged recapitalization of the target that would significantly change its ownership, control, and leverage. The task for the student is to evaluate the attractiveness of the investment, based on a strategic appraisal, a valuation of the target with its new capitalization, and an assessment of the proposed deal structure. This case was developed to support the following teaching objectives. 

Introduce the practice, goals, and process of private equity investing and provide a basis for comparing those attributes with public market investing.



Consider the diffusion of private equity investing practices around the world.



Exercise skills in valuing a business. The case offers the student a chance to perform both a discounted cash flow and a market multiple valuation of TeamSystem. The valuation tasks confront the realistic constraints that face many private equity analysts, a lack of detailed historical and forecast financial information and few publicly traded comparable firms.



Consider the impacts of changes in leverage, control structure, and of a cross-border transaction with the attendant country risk and exchange rate bets.

Suggested

Questions

for

-2Advance Assignment

1. What is private equity investing? Who participates in it and why? How is Palamon positioned in the industry? 2. How does private equity investing compare with public market investing? What are the similarities and differences between the two? 3. Why is Palamon interested in TeamSystem? Does it fit with Palamon’s investment strategy? 4. How much is 51% of TeamSystem’s common equity worth? Use both a discounted cash flow and a multiple-based valuation to justify your recommendation. 5. What complexities do cross-border deals introduce? What are the specific risks of this deal? 6. What should Louis Elson recommend to his partners? Is it a go or not? If it is a go, what nonprice terms are important? If it’s not a go, what counterproposal would you make? Note that this case offers the instructor a choice regarding the amount of numerical analysis that the students must perform: 

Valuation from financial statements. As the case and accompanying spreadsheet model stand, the student must prepare a cash flow forecast from financial statements. This would be an appropriate assignment for degree students. The questions above are consistent with this assignment.



Valuation from appendix forecast and model. Appendix TN1 presents a forecast of free cash flows derived from the financial statements. The student must determine a terminal value and discount rate and complete the DCF valuation. Using Appendix TN1 accelerates the homework for students a little and is more appropriate for executive audiences or wherever the instructor wants to focus on issues well beyond financial modeling. In this second instance, it would be appropriate to add to assignment question 4 (above) this statement: “Note that the appendix to the instructor’s Excel spreadsheet files and associated model present a forecast of free cash flows derived from the forecasted financial statements. Please complete the analysis based on this forecast.”

Suggested Supplemental Readings The theme of cross-border private equity investing and the spread of private equity investing techniques are addressed in two technical notes, either of which the instructor might consider providing as additional background reading:

-3“Note on European Buy-Outs,” (Harvard Business School Publishing), catalogue number 9-296-051. “Practices of Private Equity Firms in Latin America,” (Darden Case Collection), catalogue number UVA-F-1336. The instructor or student interested in deeper background reading on private equity investing would benefit from The New Financial Capitalists, George P. Baker and George David Smith, (Cambridge, MA: Cambridge University Press, 1998). The authors focus on Kohlberg Kravis Roberts & Co. and the determinants of its success as a private equity investor.

Supplemental Computer Spreadsheet Models Student and instructor preparation are supported by Microsoft Excel spreadsheets containing case data (and for instructors, a completed model). These models are available from the Darden Business Publishing (toll free) at 800-246-3367 or e-mail [email protected]. Contents Full instructor’s models Student model (case Exhibits 4,5,7, and 8) Student model (with free cash flow forecast appended)

File Name UVA-S-F-1331TN.xls UVA-S-F-1331.xls UVA-S-F-1331Appendix

Hypothetical Teaching Plan This case is an excellent vehicle for team-based presentations, whereas, the teaching plan would contemplate an introduction followed by team presentations and conclude with general discussion and closing points by the instructor. The plan that follows contemplates a standard class discussion. 1. What is private equity investing? Because student background varies, it is helpful to begin this case by discussing the basics of private equity investing—the players, the goals, and the process. 2. What features of private equity investing make it unique? How does it differ from public market investing? Why might a firm like Palamon play in the private equity space? It is useful to discuss private equity in relation to the more common public market investing. The contrast will help the students discuss the TeamSystem investment opportunity in the proper context. 3. Should Palamon invest in TeamSystem? Why or why not?

-4The decision-oriented nature of this case encourages the student to take a view. This question can also offer an opportunity for an individual to make a presentation about his/her recommendation. The objective of such a question is to outline the analytical agenda and to provide a base case to serve as a benchmark for later discussion. A student who is coldcalled to present this discussion may take 5 to 10 minutes to give an adequate overview. 4. a) How much is a 51% stake of TeamSystem worth? In response to question 3, the student will most likely focus on the valuation as justification for her recommendation. As such, a discussion of the student’s valuation methodology and assumptions offers a natural continuation of the conversation. The student should discuss both the multiple method of valuation and the DCF method. Once the student has described his/her analysis, one could also poll the entire class and record the distribution of valuation estimates as a way to illustrate the different views that can result from the same set of data. b) What cash flows did you use? How did you estimate them? c) What multiples did you use? How did you come up with them? 5. What other factors (besides valuation) affect the attractiveness of this investment? The discussion here should elicit some of the less visible determinants of a successful deal including management’s ability, board composition, risk management, regulatory challenges, etc. 6. What should Louis Elson do? Returning again to the action orientation is an effective way to refocus the discussion. 7. Why does such an attractive investment opportunity exist? This fundamental question offers an excellent opportunity to review the lessons of the case related to private equity investing and the type of deals made. Case Analysis The private equity setting Private equity investing offers the investor a different risk profile and modus operandi than do the public markets. By definition, it presents investors with access Discussion questions to nonpublic companies. Investments in such companies are typically riskier, and 1 and 2 investors are rewarded with average returns greater than those in the public markets. The private nature of private equity also affects the investing process. Some implications include: 

A long-time horizon of 5–7 years since an exit opportunity (for example: an initial public offering [IPO] or trade sale) is required to cash out of an investment.

-5A lack of readily available public information by which the investment opportunity can be evaluated, and which may create market inefficiencies that can be exploited profitably.





Pricing and other deal terms are negotiated.



Large equity stakes (often 20% to 60%).



Investors are involved in the post-transaction governance of the company.



Illiquidity of investment, which induces a focus on exit strategy. The most common strategy is the sale of the whole firm through acquisition by a strategic investor or by the management group. An IPO is also a potential exit strategy, though many private equity investors do not predicate their investment on the IPO strategy.

Strategic Rationale for TeamSystem Investment The TeamSystem investment fits with Palamon’s investment strategy summarized in Elson’s quote, “we want to make money by investing in change.” 

TeamSystem operates in a fast growing and fast changing market.



It is well positioned within the industry as a leading national player.



It has a CEO who has the potential grow the business.

Discussion question 3

In addition, the economics of the business are attractive. The software business is very scalable and has high operating leverage. That is, the variable costs of selling to a new customer are very low. Further, because TeamSystem generates annual maintenance fees for product updates, new customers are a source of recurring revenue. When this revenue and cost structure is combined with a high customer retention rate, TeamSystem becomes a cash machine. In essence, each new customer becomes an annuity of cash.

Valuation of TeamSystem Investment The deal proposed in the case is 51% of the common equity for (euro) EUR25.9 million. A proper valuation of the opportunity will triangulate between a discounted cash flow (DCF) equity value and values based on earnings before interest and taxes (EBIT) and revenue multiples.

Discussion question 4

Exhibit TN1 contains a completed DCF valuation for TeamSystem. It is based on the pro forma income statement and balance sheet information in case Exhibits 8 and 9. To complete the DCF valuation, the student must make a judgment about the following variables already contained in case Exhibits 8 and 9:



-6Revenue growth rate: This is given in the case. Elson assumes near-term revenue growth at 15% per annum. This compares to the industry’s forecasted growth of 9% in the near term and TeamSystem’s historical revenue growth rate of 15%. The pattern of annual growth rates is consistent with an outlook of rapid competitive gains by TeamSystem in the near term, followed by a more mature growth rate.



EBITDA margin: The case mentions a “slight” improvement in operating margins resulting from Palamon’s value-added advisory services. Students should be challenged about what “slight” means in the context of profit margins: ordinarily a change of 1% is material. The forecast assumes 35.5%,1 which is an increase from the margins of 28% in 1998 and 33% in 1999. Unlike the past years, the projection through 2007 assumes no further margin improvement despite the fact that TeamSystem has shown steady gains over past years. Students should be encouraged to scrutinize the margin assumptions. Overall, this seems to be a fairly conservative assumption. The one-time improvement would be consistent with Palamon having a beneficial influence on TeamSystem’s margins, but only at the start of the engagement. Obviously, a steady increase in the margin is not sustainable indefinitely, so the key issue is when the margins will plateau. Given TeamSystem’s technological leadership and the highly fragmented nature of the competition, it seems reasonable to assume some margin improvement.



Depreciation and amortization expense: This variable assumes an expense equal to 25% of noncurrent assets (intangible assets, land, plant and equipment, and other assets). Historically, depreciation and amortization has ranged between 18% and 52% of the target assets, so the value hardly seems exorbitant. Practically speaking, a private equity analyst would adopt an assumption dictated by tax advisers. Given that the case gives little else with which to assess the adequacy of this assumption, a teaching strategy on this point would simply be to skirt a very detailed discussion, and to leave it for Elson to discuss with advisers.



Interest expense and nonoperating income: Interest expense is projected to be equal to 6.87% of long-term debt. The case states that Palamon expects TeamSystem to be able to borrow at 100 basis points over the Italian government bond rate (5.87% for maturities of 2007).



Tax rate: The forecast uses 48%, which happens to be TeamSystem’s average effective tax rate for 1998 and 1999. This seems to be in a reasonable range for companies in Italy.



Elimination of intercompany investments: This is another minor variable that compensates for the multicompany structure of TeamSystem under the firm’s current ownership. However, after Palamon’s restructuring and investment, it seems reasonable to assume that this item would fall to zero.

1 35.5% is calculated as 100%, less assumptions for operating costs (−0.45), personnel costs (−0.155), and other operating costs (−0.04).

-7Four other variables require analysis to convert the income statement projections into free cash flows (Note: if the Appendices are provided to students, then their analysis will begin with these assumptions): 

Increase in net working capital: The balance sheet in case Exhibit 9 suggests that TeamSystem has historically required net working capital of about 40% of sales. But much of this is due to a large cash balance. Team System proposes to execute a leveraged restructuring before Palamon buys its stake in the firm. Some students may incorrectly assume that Palamon participates in the special dividends. After the restructuring, it seems reasonable to assume tighter balances of current assets. The forecast carries forward historical trends in inventories and receivables but reduces cash to account for the restructuring. Note the large buildup in marketable securities, dictated initially by the firm’s dividend payout and corresponding takedown of debt.



Capital expenditures: The model projects capital expenditures as simply the change in the end of period, noncurrent assets plus depreciation. As mentioned above in relation to depreciation and amortization, TeamSystem is not in an asset-intensive business. Therefore, one can assume that the asset base will not need to grow with sales. Accordingly, it is reasonable to assume that capital expenditures will grow roughly in line with depreciation and amortization.



Terminal value: The terminal value is easily calculated by assuming a constant growth in the final year cash flow. The constant growth valuation formula is TV = FCF2007 × (1 + g)/(WACC − g).2 Given that software is a notoriously growth oriented-industry, 6% nominal growth in perpetuity seems realistic, though it is worth testing by sensitivity analysis.



Discount rate: The relevant discount rate is the one that matches the risks of TeamSystem’s cash flows. Elson estimated that rate to be 14%, and not by coincidence is 14% the average WACC for similarly leveraged software companies trading on the Milan exchange. Students will struggle over the 30% required return mentioned in the case as Palamon’s target for individual investments and the 20% targeted portfolio return. Upon reflection, students will see that 20% and 30% are the targeted returns on equity, while 14% is Elson’s targeted return on the enterprise or the appropriate discount rate for free cash flows.

Exhibit TN1 gives a DCF calculation that employs these assumptions and yields an estimated value of equity of (Italian lira) ITL116.1 billion, or EUR59.95 million. Given that Palamon will invest EUR25.9 million for 51% of the firm (worth 0.51 times EUR59.95 million or EUR30.57 million) the deal seems to be attractive. Students should be encouraged to test the robustness of the DCF estimate of equity value to variations in key assumptions. Exhibit TN2 presents a sensitivity table showing the value of TeamSystem’s equity to variations in discount rate and perpetual growth rate. The results show that Palamon can sustain 100 more basis points in discount rate, or about 200 fewer basis points 2 TV stands for terminal value; FCF stands for free cash flow; g is the perpetual growth rate of FCF, and WACC is the weighted-average cost of capital.

-8in perpetual growth rate, before the deal becomes a negative net present value (NPV) proposition. Elson does not have a great deal of margin for error in this investment. More advanced students will recognize that the rapid amortization of TeamSystem’s debt in years 2005 to 2007 will cause the discount rate to vary over time. The standard rate of 14% that Elson proposes may not be appropriate. Exhibit TN3 recalculates the DCF value of equity using a recursive approach that estimates the discount rate each year based on the market values of debt and equity for that year, and discounts iteratively back to the present. Line 8 of the exhibit shows that the cost of equity declines from 12.29% to 11.60%, with a corresponding increase in the weighted-average cost of capital from 10.71% to 11.60%. The resulting estimated value of equity is EUR106.87 million, implying that the value of Palamon’s investment is worth considerably more than its outlay. Exhibit TN4 presents a sensitivity table of the euro-based value of equity showing variations due to the unlevered beta and perpetual growth rate. This shows that Elson faces a reasonable margin for error on these dimensions. To complete the other parts of the valuation triangulation, the student should use the mean trading multiples for comparable software firms. Deal multiples are not relevant because this deal is a financial purchase without any synergies. A revenue multiple valuation should be chosen because it incorporates size, and an EBIT multiple valuation should be chosen because it incorporates profitability. To capture the most information, a grand average of the mean multiples from all three tiers of comparables is used. Exhibit TN5 reveals that the grand mean revenue multiple of 5.4 yields an equity value of ITL292.9 billion or EUR151.3 million; while the grand mean EBIT multiple of 25.7 yields an equity value of ITL443.5 billion or EUR229.1 million. When the multiple valuations are triangulated (or averaged) with the DCF valuation, 100% of TeamSystem’s equity is estimated to be worth EUR136.8 million. Fifty-one percent of the equity is, therefore, worth EUR69.8 million. At EUR25.9 million, Elson’s deal looks quite attractive. Louis Elson told the author that Palamon looks at prospective investments using only simulation analysis to assess the probability distribution of value. This has the virtue of skirting the nettlesome question about the appropriate discount rate (i.e., since the risk has now been reflected in the cash flows). Where the teacher and students have the capacity for this, one could prompt student analysis in this direction with some specific assignment questions. Appendix TN2 presents the results of a Monte Carlo simulation of the DCF equity value of TeamSystem. This analysis is based on simplistic assumptions as outlined. One could use it as a supplemental handout with the case for teaching executives or others who do not have the time or appetite for advanced techniques. Appendix TN2 suggests that the investment is attractive: the mean value exceeds the investment outlay over 92% of the time. When one uses it, the teaching plan necessarily focuses on the interpretation of results rather than on the mastery of analytic steps. Other Factors to Consider Beyond strategy and valuation, there are other important aspects of the investment to consider: 

Discussion question 5

Management quality: With Palamon’s investment, TeamSystem would be poised to grow dramatically and to ultimately reach the public markets. Such a transition would impose

-9new pressures and require new skills from management. Elson believed in the competence of Chief Executive Officer Giovanni Ranocchi but questioned the ability of the next lower level of management. Therefore, Elson might want to negotiate the right to replace some of management. 

Corporate governance: Palamon’s potential 51% stake justifies seats on the board. Although the case does not mention anything specific about board composition, it should be part of Elson’s consideration.



Exit strategies: Palamon must have a viable exit alternative after it has seen appreciation in its investment. The two most obvious are an IPO in the Italian market and a trade sale to another national or pan-European software company.



Regulatory approval: Little information is given on this issue, but it affects the attractiveness of the investment. A student could reason that if the Italian government is so active in payroll regulation and taxes at high rates, the odds are likely that it would want to participate in any transactions in which control, either full or partial, of an Italian company is being transferred to foreigners. Palamon’s due diligence should assess the likelihood of the deal being permitted by the Italian government.



Exchange rate risk: Students may mention exchange rate risk because the transaction crosses borders. However, the advent of the euro makes this risk minimal in the immediate term and nonexistent in the long run.

Conclusion The disparity between the price of the investment (EUR26 million) and the estimated value (EUR70 million) is stark. From a financial perspective, the investment is extremely attractive. As long as some of the other issues can be negotiated away, Elson should recommend that Palamon make this investment.

Discussion questions 6 and 7

Once this conclusion has been reached, an important question remains, “Why does such an attractive opportunity exist?” The private equity investor who is betting his career on these inefficiencies might give one of the following answers:



-10the home country for nonpublic firms an underdeveloped capital market in



a lack of foreign investors capable of or willing to make cross-border investments



scarce information about private companies

Regardless of the reason for the inefficiencies, TeamSystem illustrates that the inefficiencies do exist. It also illustrates that those investors who are willing and able to participate in the time-consuming process of finding these hidden gems can be richly rewarded.

Epilogue Palamon signed a letter of commitment on February 14, 2000, to purchase the 51% stake for EUR26 million. The deal was completed in June 2000, after receiving regulatory approval from the Italian government. Through 2001, TeamSystem performed well ahead of forecast. EBIT in calendar year 2000 was ITL27 billion (as compared with the case forecast of ITL24 billion). Palamon’s Web site (www.palamon.com) describes the firm and its investments. This information may be useful to the instructor when he offers some closing comments.

-11Exhibit TN1 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Completed DCF Valuation for TeamSystem (values in millions of Italian lira, except where indicated for millions of euros)

Earnings before interest and taxes Less taxes Net operating profit after tax Less increse in net working capital Less capital expenditures Plus depreciation and amortization Free cash flow Terminal value Free cash flow with terminal value Discount rate Enterprise value Less debt Equity value Lira/euro exchange rate Equity value in EUR

14% 162,070 (46,000) 116,070 1,936 59.95

2000 23,863 10,207 13,657 1,270 (1,582) 835 14,803

2001 27,503 12,240 15,263 1,461 1,161 900 13,541

2002 31,689 14,584 17,105 1,680 1,275 975 15,124

2003 33,614 15,811 17,803 773 1,148 1,010 16,892

2004 35,655 17,322 18,333 819 1,193 1,046 17,367

2005 37,818 18,934 18,884 868 1,240 1,085 17,861

2006 40,111 20,652 19,459 921 1,291 1,126 18,374

14,803

13,541

15,124

16,892

17,367

17,861

18,374

2007 42,542 22,584 19,958 976 14% of sales change 1,344 1,170 18,808 249,210 6% growth 268,018

-12Exhibit TN2 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Sensitivity Analysis of DCF Value of Equity by Variations in Discount Rate and Perpetual Growth Rate (values in millions of euros)

Discount Rate 12% 14% 16% 18% 20% 22% 24% 26% 30%

0% 50.43 39.15 30.75 24.26 19.10 14.90 11.43 8.50 3.87

Perpetual Growth Rate in Terminal Value 1% 2% 3% 4% 5% 53.76 57.75 62.63 68.74 76.58 41.29 43.78 46.72 50.25 54.56 32.18 33.82 35.71 37.91 40.52 25.26 26.38 27.65 29.10 30.78 19.81 20.60 21.49 22.49 23.62 15.42 16.00 16.63 17.34 18.13 11.82 12.24 12.71 13.22 13.79 8.80 9.12 9.47 9.85 10.27 4.05 4.24 4.44 4.67 4.90

6% 7% 87.05 101.70 59.95 66.89 43.64 47.46 32.73 35.04 24.91 26.40 19.02 20.02 14.42 15.12 10.73 11.23 5.16 5.44

-13Exhibit TN3 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. DCF Valuation of Equity Accounting for Time-Varying Discount Rate (values in millions of lira, except where indicated for millions of euros)

Earnings before interest and taxes Less taxes Net operating profit after tax Less increse in net working capital Less capital expenditures Plus depreciation and amortization Free cash flow Terminal value Free cash flow with terminal value Line 1 2 3 4 5 6 7 8 9 10

Enterprise value Debt Equity Debt / equity Tax rate Unlevered beta Levered beta Cost of equity Cost of debt WACC Lira/euro exchange rate Equity value in EUR

2000 23,863 10,207 13,657 1,270 (1,582) 835 14,803

2001 27,503 12,240 15,263 1,461 1,161 900 13,541

2002 31,689 14,584 17,105 1,680 1,275 975 15,124

2003 33,614 15,811 17,803 773 1,148 1,010 16,892

2004 35,655 17,322 18,333 819 1,193 1,046 17,367

2005 37,818 18,934 18,884 868 1,240 1,085 17,861

2006 40,111 20,652 19,459 921 1,291 1,126 18,374

14,803

13,541

15,124

16,892

17,367

17,861

18,374

2007 42,542 22,584 19,958 976 1,344 1,170 18,808 356,014 374,822

252,891 46,000 206,891 0.222 48.0% 1.000 1.116 12.29% 6.87% 10.71% 1,936 106.87

263,668 46,000 217,668 0.211 48.0% 1.000 1.110 12.26% 6.87% 10.74%

277,104 46,000 231,104 0.199 48.0% 1.000 1.104 12.22% 6.87% 10.79%

290,844 34,500 256,344 0.135 48.0% 1.000 1.070 12.02% 6.87% 11.02%

304,716 23,000 281,716 0.082 48.0% 1.000 1.042 11.85% 6.87% 11.23%

320,175 11,500 308,675 0.037 48.0% 1.000 1.019 11.72% 6.87% 11.42%

337,383 0 337,383 0.000 48.0% 1.000 1.000 11.60% 6.87% 11.60%

356,014 0 356,014 0.000 48.0% 1.000 1.000 11.60% 6.87% 11.60%

14% of sales change

6% growth

-14Exhibit TN4 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Sensitivity Analysis of DCF Value of Equity Estimated by Time-Varying Discount Rate Approach by Variations in Unlevered Beta and Perpetual Growth Rate (values in millions of euros)

Unlevered Beta 0.80 1.00 1.20 1.40 1.60 1.80 2.00

0.0% 69.36 60.43 53.26 47.39 42.50 38.37 34.85

1.0% 74.85 64.52 56.38 49.82 44.42 39.92 36.10

Perpetual Growth Rate 2.0% 3.0% 4.0% 81.64 90.27 101.60 69.46 75.55 83.24 60.08 64.53 70.00 52.65 56.00 60.02 46.64 49.22 52.26 41.68 43.70 46.05 37.52 39.13 40.98

5.0% 117.12 93.26 76.87 64.94 55.89 48.81 43.12

6.0% 7.0% 139.71 175.57 106.87 126.38 85.76 97.71 71.08 78.98 60.32 65.82 52.10 56.09 45.62 48.61

-15Exhibit TN5 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. Valuation Triangulation for TeamSystem (values in billions of lira or millions of euros, as indicated)

Post Deal Enterprise Value (lira billions) TeamSystem revenue (1999) TeamSystem EBIT (1999) DCF @ 14% DCF @ time-varying WACC Revenue multiplea EBIT multiplea Average Implied in current proposal Revenue multiple EBIT multiple Debt Cash balance a

Value of 51% of Equity Equity Market Equity Market Value (lira billions) Value (euro millions) (euro millions)

60.5 18.5

5.4 x 25.7 x

ITL 325.4 ITL 476.0 ITL 400.7 ITL 130.8

ITL 116.1 ITL 206.9

EUR 60.0 EUR 106.9

EUR 30.6 EUR 54.5

ITL 292.9 ITL 443.5 ITL 264.8 ITL 98.3

EUR 151.3 EUR 229.1 EUR 136.8 EUR 50.8

EUR 77.2 EUR 116.8 EUR 69.8 EUR 25.9

2.2 x 7.1 x 46.00 13.50

Jan. 2000 exchange rate (ITL/EUR)

Multiples used in valuation are an average of all three tiers of trading comparables in case Exhibit 10.

1,936

-16Appendix TN1 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A.

The following exhibit gives a calculation of free cash flow drawn from Exhibits 8 and 9 of the case. The purpose of this exhibit is to provide the start of one type of analysis (DCF valuation), rather than to suggest a solution. Please use as you deem appropriate. The basis for this exhibit may be found in the accompanying spreadsheet file (UVA-S-F-1331Appendix.xls).

Earnings before interest and taxes Less taxes Net operating profit after tax Less increase in net working capital Less capital expenditures Plus depreciation and amortization Free cash flow

2000 23,863 10,207 13,657 1,270 (1,582) 835 14,803

2001 27,503 12,240 15,263 1,461 1,161 900 13,541

(values in millions of lira) 2002 2003 2004 31,689 33,614 35,655 14,584 15,811 17,322 17,105 17,803 18,333 1,680 773 819 1,275 1,148 1,193 975 1,010 1,046 15,124 16,892 17,367

2005 37,818 18,934 18,884 868 1,240 1,085 17,861

2006 40,111 20,652 19,459 921 1,291 1,126 18,374

2007 42,542 22,584 19,958 976 1,344 1,170 18,808

14% of increase in sales

-17Appendix TN2 PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A. DCF Valuation and Monte Carlo Simulation

An analysis of the potential TeamSystem investment should include a range of estimators including: 

Relative valuation estimates, based on multiples derived from peer firms.



Intrinsic valuation estimates, based on DCF valuation.

Appendix TN2 gives a completed DCF analysis of the base case and of the range of outcomes.

-18Appendix TN2 (continued) Base-Case DCF Valuation of TeamSystem’s Equity Using the forecasts in case Exhibits 8 and 9 as a basis for a free cash flow estimate and Elson’s target required rate of return on FCF (i.e., a WACC) of 14%, yields the following calculation of the DCF value of TeamSystem equity in euros:

Earnings before interest and taxes Less taxes Net operating profit after tax Less increse in net working capital Less capital expenditures Plus depreciation and amortization Free cash flow Terminal value Free cash flow with terminal value

2000 23,863 10,207 13,657 1,270 (1,582) 835 14,803

2001 27,503 12,240 15,263 1,461 1,161 900 13,541

2002 31,689 14,584 17,105 1,680 1,275 975 15,124

2003 33,614 15,811 17,803 773 1,148 1,010 16,892

2004 35,655 17,322 18,333 819 1,193 1,046 17,367

2005 37,818 18,934 18,884 868 1,240 1,085 17,861

2006 40,111 20,652 19,459 921 1,291 1,126 18,374

14,803

13,541

15,124

16,892

17,367

17,861

18,374

2007 42,542 22,584 19,958 976 14% of sales change 1,344 1,170 18,808 249,210 6% growth 268,018

Discount rate 14% Enterprise value 162,070 Less debt (46,000) Equity value 116,070 Lira/euro exchange rate 1,936 Equity value in EUR 59.95

The base-case estimate of TeamSystem equity value is EUR59.95 million. This exceeds the break-even value of EUR50.78 million, implied by the terms of the proposed investment.1 1 Elson has been offered the opportunity to invest EUR25.9 million for 51% of the equity. This implies a total value of equity of (25.9 million/0.51 million) of EUR50.78 million.

-19Appendix TN2 (continued) Given the operating uncertainties in this situation, the next section models the value of equity as an uncertain variable, using Monte Carlo simulation.

Probabilistic Analysis: Monte Carlo Simulation Suppose we allow several assumptions to vary. What is the resulting distribution of the DCF value of equity? Sales growth years 1–3: 14%–17% Sales growth years 4–7: 5%–7% Operating cost/sales: 41%–49% Personnel cost/sales: 13%–17% Receivables/sales: 15%–18% Accounts payable/sales: 15%–18% Other payables/sales: 15/18% Results: Forecast: Equity Value in Euros (m m ) 1,000 Trials

Frequency Chart

997 Displayed

.029

29

.022

21.75

.015

14.5

.007

7.25

.000

0 45.71

52.86

60.00 Euros millions

67.15

74.29

-20Appendix TN2 (continued)

Forecast: Equity Value in Euros (m m ) 1,000 Trials

Cum ulative Chart

997 Displayed

1.000

1000

.750

750

.500

500

.250

250

.000

0 45.71

52.86

60.00

67.15

74.29

Euros millions

Mean equity value: EUR59.82 million Standard Deviation: EUR5.46

Median: EUR59.66 Probability of exceeding EUR50.78 is >92%.