1. Based on the given information in the case, what amount would you recommend that Atwood and Juarez submit as an opening bid price for the Mary Washington Pediatrics? (Hint: Calculate the enterprise value using discounted cash flow approach and you need to write down all your assumptions used in building this valuation model.) 2. Explain the pros and cons of using debt financing in this deal. Show your workings to justify why they should or should not use debt financing in this deal. Dr. Natalia Juarez put down her phone and took a deep breath. It was May 2017, and she had just finished a call with longtime friend and fellow pediatrician Kirsten Atwood. The two friends had talked about partnering for years. Now they were on the verge of doing it. Juarez and Atwood had visited Mary Washington Pediatrics last week and met with the three physicians who owned it. The visit had gone well and both had come away feeling that this was the right practice for them. Still, the decision to buy it not only entailed a lot of money but also meant a relocation for both Atwood and Juarez. Since they were still pretty early in their careers, flexibility was important to them. As such, they were determined not to overpay for the practice, as they expected they might sell it in five to seven years. Juarez had promised to get back to Atwood by the end of the day with her recommendation for a bidding strategy. The strategy entailed determining both their opening bid and their walkaway price. As this was the practice that best met their objectives, their plan was to bid aggressively. With a bid in by tomorrow, it was possible that by the end of the week they would both be the proud owners of a pediatric practice in Northern Virginia. Although the thought was arresting, she fired up her laptop and got to work. Mary Washington Pediatrics was a well-established pediatric practice in the growing community of Fredericksburg, Virginia. Located on Jefferson Davis Highway, not far from Fredericksburg's Mary Washington Hospital, the practice focused on comprehensive health care for children. The practice employed three pediatricians: Patrick Dunnan, Sam Nelson, and Tessa Nelson. Dunnan owned 60% of the practice and was retiring. The other two pediatricians were married and had decided to relocate to be near a set of aging parents. Over the past few years, Dunnan had worked full time and the Nelsons both had worked part time whilc raising their young family. The practice was incorporated as a C corporation. This provided limited liability to the physician owners for all business liabilities and for the liabilitics crcated by their partners. The doctors were liable for professional negligence, which was protected through insurance contracts. Federal income taxes were filed by the practice at the prevailing business rate of 32%. The physicians and other employees were taxed on their salary at their own respective personal tax rates. Exhibit 1 provides the financial statements for the practice. Fredericksburg was an established community less than an hour south of Washington, DC. The population of the city was niearly 30,000, with 270,000 additional residents in the surrounding Spotsylvania and Stafford counties. At the fall line of the Rappahannock River, Fredericksburg had been an important regional city since colonial times. In 2017, major employers included the University of Mary Washington and large insurer GEICO, but Fredericksburg was also a growing bedroom community for the extensive number of employers to the north. Over the past five years, the community population had increased by 14%. The public schools were known to be relatively strong. In 2017, US economic growth was expanding at an annual rate of 3%. Interest rates were low. The yield on the one-year US Treasury bond was less than 1%, and the ten-year bond was at 3%. The national unemployment rate was estimated at 5.2%. Longer-term expected inflation was 1.5%. There were limited data on other medical practice transactions. In the past year, however, an internal medicine practice of five physicians in Fredericksburg had been purchased by Mary Washington Hospital for what was believed to be $4.2 million. At the time of the acquisition, it was estimated that the practice had been earning $3.5 million in net revenue and $0.4 million in operating profit. Atwood and Juarez had not been raised in homes with medical backgrounds. Juarez was raised by parents who were both New York investment bankers. Atwood's father had worked in the consulting industry. As such, neither of them was new to business turnaround stories. Their motivation in working together was based on their friendship and their mutual interest in applying their business upbringings to a poorly run medical practice. Juarez and Atwood agreed that pediatric practices were rife with financial waste and mismanagement. They believed that Mary Washington Pediatric fit that profile and provided substantial opportunities for improved efficiency and growth. As evidence of the practice's underperformance, the pair compared its financial performance to that of Atwood and Juarez's current employers, Green Hills Pediatrics and Harpeth Group (see Exhibit 2). Atwood had prepared a financial forecast for Mary Washington Pediatrics based on their expectations for financial improvement (see Exhibit 3). The plan included the following assumptions: (1) revenue would grow above expected inflation for the next seven years with a peak of 5%; (2) operating margins would be improved with careful attention to wasteful and unnecessary expenditures; and (3) investment in current assets could be reduced dramatically with better cash, upgraded inventory supplies management, and improved bill collection, such that the investment in working capital would decline from a net working capital turnover of 5 to over 10 times by 2019.1 Atwood recognized that the equipment used in the practice was wildly out of date. She had included large investments for office equipment in the projection. Lastly, her assumption for physician salary was that it would grow with net revenue. It was now Juarez's turn to put a value on the forecast. She had spent some time earlier working through a cost of capital estimate. A 9% rate resonated with her, and was confirmed with an email from her parents. An additional concern was financing the deal. She and Atwood each had $250,000 in savings that they could combine for the purchase. The rest of the deal, however, they expected to finance with debt. With all that she knew from growing up in her parents' household, Juarez believed she had the wherewithal to put the financing together and expected that she could get a seven-year note at a 5% interest rate to fund the deal. Net working capital was defined as current assets less current liabilities. Net working capital turnover was defined as net revenue divided by net working capital. Financial Statements for Mary Washington Pediatrics (in thousands of US dollars) 2015 2016 1,547 882 Net revenue Operating expenses* Physician salary Depreciation Operating profit Taxes Net profit 468 13 184 59 125 1,555 893 496 10 155 50 105 106 89 244 31 Cash Accounts receivable Medical supplies Other current assets Total current assets 286 17 381 43 24 459 733 Gross equipment Accumulated depreciation Net equipment Total assets 733 397 337 718 407 326 785 31 32 126 Accounts payable Wages payable Other payables Total current liabilities 24 181 96 15 143 Owners' equity 537 642 * Operating expenses included office salary, medical expenses, office supplies and expenses, rent and other building expenses, and insurance costs. Financial Ratios for Select Pediatric Practices (financial figures in thousands of US dollars) Mary Washington Pediatrics Green Hills Pediatrics Harpeth Group Net revenue Operating profit Net profit 1,555 155 2,535 276 3,296 399 105 183 264 Accounts receivable 286 361 497 459 552 830 Total current assets Net equipment Total assets 326 785 634 1,186 646 1,476 Total current liabilities 143 178 296 10.0% Operating margin Net profit margin 10.9% 7.2% 12.1% 8.0% 6.8% 2.0 2.1 2.2 67 52 55 Total asset turnover Accounts receivable days Working capital turnover Net equipment turnover 4.9 6.8 6.2 4.8 4.0 5.1 Return on assets 13.4% 15.4% 17.9% Exhibit 3 Atwood's Financial Forecast for Mary Washington Pediatrics (financial figures in thousands of US dollars) 2016 0.5% 2017 3.0% 2018 5.0% 2019 5.0% 2020 5.0% 2021 3.0% 2022 3.0% 2023 2.0% Revenue growth Operating expenses/ revenue Net working capital Net equipment Depreciation Capital expenditures 57.4% 315.9 326.3 10.4 4.1 57.4% 272.1 375.1 14.0 62.8 57.0% 214.2 415.1 20.0 60.0 56.5% 176.5 455.1 28.0 68.0 56.0% 181.9 475.1 37.0 57.0 54.0% 185.5 498.2 42.0 65.1 53.0% 189.2 484.2 42.9 28.9 53.0% 193.0 464.6 42.9 23.3 1,602 920 Net revenue Operating expenses Depreciation Physician salary Operating profit 1,682 959 20 525 178 14 1,766 998 28 551 189 1,854 1,038 37 579 200 1,910 1,031 42 596 240 1,967 1,043 43 614 2,007 1,064 43 626 274 500 168 268 1. Based on the given information in the case, what amount would you recommend that Atwood and Juarez submit as an opening bid price for the Mary Washington Pediatrics? (Hint: Calculate the enterprise value using discounted cash flow approach and you need to write down all your assumptions used in building this valuation model.) 2. Explain the pros and cons of using debt financing in this deal. Show your workings to justify why they should or should not use debt financing in this deal. Dr. Natalia Juarez put down her phone and took a deep breath. It was May 2017, and she had just finished a call with longtime friend and fellow pediatrician Kirsten Atwood. The two friends had talked about partnering for years. Now they were on the verge of doing it. Juarez and Atwood had visited Mary Washington Pediatrics last week and met with the three physicians who owned it. The visit had gone well and both had come away feeling that this was the right practice for them. Still, the decision to buy it not only entailed a lot of money but also meant a relocation for both Atwood and Juarez. Since they were still pretty early in their careers, flexibility was important to them. As such, they were determined not to overpay for the practice, as they expected they might sell it in five to seven years. Juarez had promised to get back to Atwood by the end of the day with her recommendation for a bidding strategy. The strategy entailed determining both their opening bid and their walkaway price. As this was the practice that best met their objectives, their plan was to bid aggressively. With a bid in by tomorrow, it was possible that by the end of the week they would both be the proud owners of a pediatric practice in Northern Virginia. Although the thought was arresting, she fired up her laptop and got to work. Mary Washington Pediatrics was a well-established pediatric practice in the growing community of Fredericksburg, Virginia. Located on Jefferson Davis Highway, not far from Fredericksburg's Mary Washington Hospital, the practice focused on comprehensive health care for children. The practice employed three pediatricians: Patrick Dunnan, Sam Nelson, and Tessa Nelson. Dunnan owned 60% of the practice and was retiring. The other two pediatricians were married and had decided to relocate to be near a set of aging parents. Over the past few years, Dunnan had worked full time and the Nelsons both had worked part time whilc raising their young family. The practice was incorporated as a C corporation. This provided limited liability to the physician owners for all business liabilities and for the liabilitics crcated by their partners. The doctors were liable for professional negligence, which was protected through insurance contracts. Federal income taxes were filed by the practice at the prevailing business rate of 32%. The physicians and other employees were taxed on their salary at their own respective personal tax rates. Exhibit 1 provides the financial statements for the practice. Fredericksburg was an established community less than an hour south of Washington, DC. The population of the city was niearly 30,000, with 270,000 additional residents in the surrounding Spotsylvania and Stafford counties. At the fall line of the Rappahannock River, Fredericksburg had been an important regional city since colonial times. In 2017, major employers included the University of Mary Washington and large insurer GEICO, but Fredericksburg was also a growing bedroom community for the extensive number of employers to the north. Over the past five years, the community population had increased by 14%. The public schools were known to be relatively strong. In 2017, US economic growth was expanding at an annual rate of 3%. Interest rates were low. The yield on the one-year US Treasury bond was less than 1%, and the ten-year bond was at 3%. The national unemployment rate was estimated at 5.2%. Longer-term expected inflation was 1.5%. There were limited data on other medical practice transactions. In the past year, however, an internal medicine practice of five physicians in Fredericksburg had been purchased by Mary Washington Hospital for what was believed to be $4.2 million. At the time of the acquisition, it was estimated that the practice had been earning $3.5 million in net revenue and $0.4 million in operating profit. Atwood and Juarez had not been raised in homes with medical backgrounds. Juarez was raised by parents who were both New York investment bankers. Atwood's father had worked in the consulting industry. As such, neither of them was new to business turnaround stories. Their motivation in working together was based on their friendship and their mutual interest in applying their business upbringings to a poorly run medical practice. Juarez and Atwood agreed that pediatric practices were rife with financial waste and mismanagement. They believed that Mary Washington Pediatric fit that profile and provided substantial opportunities for improved efficiency and growth. As evidence of the practice's underperformance, the pair compared its financial performance to that of Atwood and Juarez's current employers, Green Hills Pediatrics and Harpeth Group (see Exhibit 2). Atwood had prepared a financial forecast for Mary Washington Pediatrics based on their expectations for financial improvement (see Exhibit 3). The plan included the following assumptions: (1) revenue would grow above expected inflation for the next seven years with a peak of 5%; (2) operating margins would be improved with careful attention to wasteful and unnecessary expenditures; and (3) investment in current assets could be reduced dramatically with better cash, upgraded inventory supplies management, and improved bill collection, such that the investment in working capital would decline from a net working capital turnover of 5 to over 10 times by 2019.1 Atwood recognized that the equipment used in the practice was wildly out of date. She had included large investments for office equipment in the projection. Lastly, her assumption for physician salary was that it would grow with net revenue. It was now Juarez's turn to put a value on the forecast. She had spent some time earlier working through a cost of capital estimate. A 9% rate resonated with her, and was confirmed with an email from her parents. An additional concern was financing the deal. She and Atwood each had $250,000 in savings that they could combine for the purchase. The rest of the deal, however, they expected to finance with debt. With all that she knew from growing up in her parents' household, Juarez believed she had the wherewithal to put the financing together and expected that she could get a seven-year note at a 5% interest rate to fund the deal. Net working capital was defined as current assets less current liabilities. Net working capital turnover was defined as net revenue divided by net working capital. Financial Statements for Mary Washington Pediatrics (in thousands of US dollars) 2015 2016 1,547 882 Net revenue Operating expenses* Physician salary Depreciation Operating profit Taxes Net profit 468 13 184 59 125 1,555 893 496 10 155 50 105 106 89 244 31 Cash Accounts receivable Medical supplies Other current assets Total current assets 286 17 381 43 24 459 733 Gross equipment Accumulated depreciation Net equipment Total assets 733 397 337 718 407 326 785 31 32 126 Accounts payable Wages payable Other payables Total current liabilities 24 181 96 15 143 Owners' equity 537 642 * Operating expenses included office salary, medical expenses, office supplies and expenses, rent and other building expenses, and insurance costs. Financial Ratios for Select Pediatric Practices (financial figures in thousands of US dollars) Mary Washington Pediatrics Green Hills Pediatrics Harpeth Group Net revenue Operating profit Net profit 1,555 155 2,535 276 3,296 399 105 183 264 Accounts receivable 286 361 497 459 552 830 Total current assets Net equipment Total assets 326 785 634 1,186 646 1,476 Total current liabilities 143 178 296 10.0% Operating margin Net profit margin 10.9% 7.2% 12.1% 8.0% 6.8% 2.0 2.1 2.2 67 52 55 Total asset turnover Accounts receivable days Working capital turnover Net equipment turnover 4.9 6.8 6.2 4.8 4.0 5.1 Return on assets 13.4% 15.4% 17.9% Exhibit 3 Atwood's Financial Forecast for Mary Washington Pediatrics (financial figures in thousands of US dollars) 2016 0.5% 2017 3.0% 2018 5.0% 2019 5.0% 2020 5.0% 2021 3.0% 2022 3.0% 2023 2.0% Revenue growth Operating expenses/ revenue Net working capital Net equipment Depreciation Capital expenditures 57.4% 315.9 326.3 10.4 4.1 57.4% 272.1 375.1 14.0 62.8 57.0% 214.2 415.1 20.0 60.0 56.5% 176.5 455.1 28.0 68.0 56.0% 181.9 475.1 37.0 57.0 54.0% 185.5 498.2 42.0 65.1 53.0% 189.2 484.2 42.9 28.9 53.0% 193.0 464.6 42.9 23.3 1,602 920 Net revenue Operating expenses Depreciation Physician salary Operating profit 1,682 959 20 525 178 14 1,766 998 28 551 189 1,854 1,038 37 579 200 1,910 1,031 42 596 240 1,967 1,043 43 614 2,007 1,064 43 626 274 500 168 268