EcoBite, Inc is a rapidly growing organic food store chain that sells prepared meals in the metropolitan New York City area. Founded in 1991 by native New Yorker, Stuart Pidasso, EcoBite had expanded from a single store in lower Manhattan to a chain of 150 stores spanning the five boroughs of New York. By providing a more extensive list of organic meals prepared with high quality ingredients and by maintaining a reputation for superior customer service, EcoBite was able to compete directly with the industry leaders. Unlike national chains like Chipotle, however, EcoBite had no desire to expand the business beyond the metropolitan New York area. As Pidasso and other members of the board of directors conducted their annual review of the business in January of 2018, they were concerned with three issues. First, EcoBites recent growth had dramatically altered its capital structure. While EcoBite had once been a debt-free, cash-rich company, it now carried enough debt that the companys debt rating had fallen from AAA to AA. Although the board viewed the costs of financial distress as negligible at the current debt level (due to the ease of liquidation of inventory and real estate), Pidasso and the other board members had a strong preference for maintaining a AAA debt rating. Second, the companys recent growth had reduced the companys cash balance well below its target level of $10 million. Third, the recent entry of European competitors into the healthy food restaurants (e.g. Pret a Manger) market had eroded some of EcoBites revenue. These foreign competitors offered loyalty programs that were enabling customers to collect points in multiple destinations to get free meals easier. Restructuring Idea To address these issues, the board was considering acquireing the equity of Karma, one of EcoBites main competitors. Currently, EcoBites shares are priced at $26 per share in the market. Over the past two months, Pidasso had carefully amassed a large amount of data that he considered relevant to the restructuring idea. These data include data on current yields on debt securities and historical rates of return on various financial instruments (Exhibit 1), financial data for other local food chains and multinational competitors (Exhibit 2). His plan was to conduct a thorough analysis of this alternative. Acquisition of Karma Of the two healthy food restaurant chain competitors operating in the New York City area, Pidasso felt that Karma was a superior acquisition candidate since it focused its strategy on serving vegan customers (growing market). To date, this strategy had been quite effective, as evidenced by Karmas large share of the market. By acquiring Karma, EcoBite would gain entry into the growing market for strictly vegan restaurants. Vegan competitors such as Karma had already substantially eroded the sales of local regular food chains. Exhibit 4 contains income statement data for Karma. Based on Pidassos projections, Karmas sales could be expected to grow at an annual rate of 15% for the next two years (2018-2019), then at 10% for the following two years (2020-2021). Beyond that point, Pidasso expected the companys cash flows (not sales) to grow at a constant rate. Pidassos assistant estimated the value of cash flows from year 2022 onwards to be $50milion (in dollars as of 2021). In addition, Pidasso envisioned several other benefits to the acquisition. First, by combining corporate headquarters, several administrative positions within Karma could be eliminated. Pidasso estimated that these staff cuts would permanently reduce Karmas selling and administrative expenses as a percent of sales by 4%. Second, by combining the inventory of EcoBite and Karma, Pidasso estimated that Karmas net working capital could be reduced to 5% of its sales and remain at that percentage of sales in the future.

In 2021, Karma holds the NWC in the value of $4 milion. Third, Pidasso expected to alter Karmas financial structure so that only 10% of the companys total capital would come from debt sources. By Pidassos estimates, this would raise Karmas debt rating from its current level of A to AAA, thereby reducing Karmas borrowing costs. (Of course, any debt issued by EcoBite to finance the acquisition would be rated AA as per their current bond rating.) Pidasso expects that Karmas cost of goods sold as a percent of sales will remain constant even if the company is acquired. Exhibit 3 contains projections of capital expenditures and depreciation for Karma over the next four years. If EcoBite pursues the acquisition of Karma, Pidasso expects that the transaction will be structured so that EcoBite purchases the equity of Karma and assumes responsibility for the companys outstanding debt.

Estimate separately each of the components of the WACC for the valuation, and then the WACC itself. Assume that beta D is 0. Provide explanation of each input to WACC and final value (number) of the input here. a) Decide on the risk-free rate. Explain your reasoning. b) Decide on the Market risk premium. Explain your reasoning. c) What is the Karma's current D/E ratio? What is the assumed D/E ratio for Karma? Provide explanation and calculations if needed. d) Decide on the Karma's cost of debt. Explain your reasoning. e) Decide on the cost of equity. Explain your reasoning and provide all necessary calculations describing what you are doing in each step. [Hint: is Karma's current equity beta from exhibit 2 the proper one to calculate the cost of equity?] f) Compute the WACC.

Estimate the Equity value of Karma to EcoBite (remember about terminal value!) a) Calculate FCFs for each year and the present value of all the FCFs. Calculate the Enterprise value (NPV) and equity value using the 15% cost of capital. b) Should EcoBite pursue the acquisition of Karma? If so, what price per share should they offer?

Exhibit 4 Karma Income Statement (in $ thousands) 2017 Sales 41,850 Cost of Goods Sold -31,388 Selling and Administrative Expense -3,348 Operating Income 7,115 Depreciation -1,150 Earnings before Interest and Taxes 5,965 Interest Expense -676 Net Income before Taxes 5,288 Taxes -2.115 Net Income 3,173 Earnings per share 2.54 The company's marginal tax rate is 40%