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.
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Suggested Questions for Advance 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:
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“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
sales@dardenbusinesspublishng.com.

Contents File Name

Full instructor’s models
Student model (case Exhibits
4,5,7, and 8)
Student model (with free cash
flow forecast appended)
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?
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The 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 cold-
called 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.
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 A 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

Discussion
summarized in Elson’s quote, “we want to make money by investing in change.” question 3

 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.

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)
Discussion
EUR25.9 million. A proper valuation of the opportunity will triangulate between a question 4
discounted cash flow (DCF) equity value and values based on earnings before
interest and taxes (EBIT) and revenue multiples.

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:
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 Revenue 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).
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Four 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.
 -8-
in 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 Discussion
investment to consider: 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
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new 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 Discussion
estimated value (EUR70 million) is stark. From a financial perspective, the investment questions
is extremely attractive. As long as some of the other issues can be negotiated away, 6 and 7
Elson should recommend that Palamon make this investment.

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:
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 an underdeveloped capital market in the home country for nonpublic firms
 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.
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Exhibit 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)

2000 2001 2002 2003 2004 2005 2006 2007

Earnings before interest and taxes 23,863 27,503 31,689 33,614 35,655 37,818 40,111 42,542
Less taxes 10,207 12,240 14,584 15,811 17,322 18,934 20,652 22,584
Net operating profit after tax 13,657 15,263 17,105 17,803 18,333 18,884 19,459 19,958
Less increse in net working capital 1,270 1,461 1,680 773 819 868 921 976 14% of sales change
Less capital expenditures (1,582) 1,161 1,275 1,148 1,193 1,240 1,291 1,344
Plus depreciation and amortization 835 900 975 1,010 1,046 1,085 1,126 1,170
Free cash flow 14,803 13,541 15,124 16,892 17,367 17,861 18,374 18,808
Terminal value 249,210 6% growth
Free cash flow with terminal value 14,803 13,541 15,124 16,892 17,367 17,861 18,374 268,018

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
 -12-

Exhibit 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 Perpetual Growth Rate in Terminal Value
0% 1% 2% 3% 4% 5% 6% 7%
12% 50.43 53.76 57.75 62.63 68.74 76.58 87.05 101.70
14% 39.15 41.29 43.78 46.72 50.25 54.56 59.95 66.89
16% 30.75 32.18 33.82 35.71 37.91 40.52 43.64 47.46
18% 24.26 25.26 26.38 27.65 29.10 30.78 32.73 35.04
20% 19.10 19.81 20.60 21.49 22.49 23.62 24.91 26.40
22% 14.90 15.42 16.00 16.63 17.34 18.13 19.02 20.02
24% 11.43 11.82 12.24 12.71 13.22 13.79 14.42 15.12
26% 8.50 8.80 9.12 9.47 9.85 10.27 10.73 11.23
30% 3.87 4.05 4.24 4.44 4.67 4.90 5.16 5.44
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Exhibit 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)

2000 2001 2002 2003 2004 2005 2006 2007

Earnings before interest and taxes 23,863 27,503 31,689 33,614 35,655 37,818 40,111 42,542
Less taxes 10,207 12,240 14,584 15,811 17,322 18,934 20,652 22,584
Net operating profit after tax 13,657 15,263 17,105 17,803 18,333 18,884 19,459 19,958
Less increse in net working capital 1,270 1,461 1,680 773 819 868 921 976 14% of sales change
Less capital expenditures (1,582) 1,161 1,275 1,148 1,193 1,240 1,291 1,344
Plus depreciation and amortization 835 900 975 1,010 1,046 1,085 1,126 1,170
Free cash flow 14,803 13,541 15,124 16,892 17,367 17,861 18,374 18,808
Terminal value 356,014 6% growth
Free cash flow with terminal value 14,803 13,541 15,124 16,892 17,367 17,861 18,374 374,822

Line
1 Enterprise value 252,891 263,668 277,104 290,844 304,716 320,175 337,383 356,014
2 Debt 46,000 46,000 46,000 34,500 23,000 11,500 0 0
3 Equity 206,891 217,668 231,104 256,344 281,716 308,675 337,383 356,014
4 Debt / equity 0.222 0.211 0.199 0.135 0.082 0.037 0.000 0.000
5 Tax rate 48.0% 48.0% 48.0% 48.0% 48.0% 48.0% 48.0% 48.0%
6 Unlevered beta 1.000 1.000 1.000 1.000 1.000 1.000 1.000 1.000
7 Levered beta 1.116 1.110 1.104 1.070 1.042 1.019 1.000 1.000
8 Cost of equity 12.29% 12.26% 12.22% 12.02% 11.85% 11.72% 11.60% 11.60%
9 Cost of debt 6.87% 6.87% 6.87% 6.87% 6.87% 6.87% 6.87% 6.87%
10 WACC 10.71% 10.74% 10.79% 11.02% 11.23% 11.42% 11.60% 11.60%
Lira/euro exchange rate 1,936
Equity value in EUR 106.87
 -14-

Exhibit 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 Perpetual Growth Rate
0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0%
0.80 69.36 74.85 81.64 90.27 101.60 117.12 139.71 175.57
1.00 60.43 64.52 69.46 75.55 83.24 93.26 106.87 126.38
1.20 53.26 56.38 60.08 64.53 70.00 76.87 85.76 97.71
1.40 47.39 49.82 52.65 56.00 60.02 64.94 71.08 78.98
1.60 42.50 44.42 46.64 49.22 52.26 55.89 60.32 65.82
1.80 38.37 39.92 41.68 43.70 46.05 48.81 52.10 56.09
2.00 34.85 36.10 37.52 39.13 40.98 43.12 45.62 48.61
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Exhibit TN5
PALAMON CAPITAL PARTNERS/TEAMSYSTEM S.P.A.
Valuation Triangulation for TeamSystem
(values in billions of lira or millions of euros, as indicated)

Value of 51%
Post Deal Enterprise Equity Market Equity Market of Equity
Value (lira billions) Value (lira billions) Value (euro millions) (euro millions)
TeamSystem revenue (1999) 60.5
TeamSystem EBIT (1999) 18.5
DCF @ 14% ITL 116.1 EUR 60.0 EUR 30.6
DCF @ time-varying WACC ITL 206.9 EUR 106.9 EUR 54.5
Revenue multiplea 5.4 x ITL 325.4 ITL 292.9 EUR 151.3 EUR 77.2
EBIT multiplea 25.7 x ITL 476.0 ITL 443.5 EUR 229.1 EUR 116.8
Average ITL 400.7 ITL 264.8 EUR 136.8 EUR 69.8
Implied in current proposal ITL 130.8 ITL 98.3 EUR 50.8 EUR 25.9
Revenue multiple 2.2 x
EBIT multiple 7.1 x
Debt 46.00 Jan. 2000 exchange rate (ITL/EUR) 1,936
Cash balance 13.50
a
Multiples used in valuation are an average of all three tiers of trading comparables in case Exhibit 10.
 -16-

Appendix 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).

(values in millions of lira)

2000 2001 2002 2003 2004 2005 2006 2007
Earnings before interest and taxes 23,863 27,503 31,689 33,614 35,655 37,818 40,111 42,542
Less taxes 10,207 12,240 14,584 15,811 17,322 18,934 20,652 22,584
Net operating profit after tax 13,657 15,263 17,105 17,803 18,333 18,884 19,459 19,958
Less increase in net working capital 1,270 1,461 1,680 773 819 868 921 976 14% of increase in sales
Less capital expenditures (1,582) 1,161 1,275 1,148 1,193 1,240 1,291 1,344
Plus depreciation and amortization 835 900 975 1,010 1,046 1,085 1,126 1,170
Free cash flow 14,803 13,541 15,124 16,892 17,367 17,861 18,374 18,808
 -17-

Appendix 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.
 -18-

Appendix 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:

2000 2001 2002 2003 2004 2005 2006 2007

Earnings before interest and taxes 23,863 27,503 31,689 33,614 35,655 37,818 40,111 42,542
Less taxes 10,207 12,240 14,584 15,811 17,322 18,934 20,652 22,584
Net operating profit after tax 13,657 15,263 17,105 17,803 18,333 18,884 19,459 19,958
Less increse in net working capital 1,270 1,461 1,680 773 819 868 921 976 14% of sales change
Less capital expenditures (1,582) 1,161 1,275 1,148 1,193 1,240 1,291 1,344
Plus depreciation and amortization 835 900 975 1,010 1,046 1,085 1,126 1,170
Free cash flow 14,803 13,541 15,124 16,892 17,367 17,861 18,374 18,808
Terminal value 249,210 6% growth
Free cash flow with terminal value 14,803 13,541 15,124 16,892 17,367 17,861 18,374 268,018

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.
 -19-

Appendix 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 67.15 74.29

Euros millions
 -20-

Appendix 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 Median: EUR59.66

Standard Deviation: EUR5.46 Probability of exceeding EUR50.78 is >92%.