FABRICARE Inc. 1. If Roy Tyson were to acquire Fabricare, what is the maximum amount that he could pay for the firm, assuming that the acquisition is effective at the beginning of 1993? ating the purchase price of Fabricare: CASE 36 FABRICARE, INC. VALUATION C In early 1986, Roy Tyson purchased Professional Building Maintenance, Inc. (PBM), a building maintenance and cleaning firm located and operating in the Darwille, Virginia area. The firm specialized in providing cleaning services in commercial and professional offices, such as banks, law offices, and medical practices. Over the next 5 years, revenues increased more than 400 percent, from $212,100 to $851430 in 1991 (see Exhibit 1 and 2). The revenue growth rate slowed in 1991 as PBM's market share (currently 40 percent) in the area expanded and the potential new prospect pool declined. Roy was confident that O the expertise he had gained while operating PBM could be applied successfully to similar firms in other geographical markets that possessed greater growth potential than Danville. In 1992, he leamed that a building maintenance firm, Fabricare, Inc., located in Lynchburg, Virginia, was for sale. Fabricare's most recent (year- end 1991) revenues were less than one-half of those of PBM, but Roy believed the growth potential to be much greater because Fabricare had only a small share (approximately 10 percent) of the Lynchburg market. As he looked over the 1991 income statement and balance sheet for Fabricare, Roy was try ing to decide (1) if he should purchase the company and (2) if so, at what price. Fabricare, like PBM, was in the building maintenance business, but approxi- mately one-half of its revenues came from commercial establishment carpet cleaning. The owner of Fabricare was approaching retirement age and no prepa ration had been made for management succession in the small firm. On investigation, Roy leamed that Fabricare had about $384,000 in revenues in 1991, a figure that had grown only modestly over the previous three yours. (Exhibit 3 is a 1991 income statement, derived from Fabricare's 1991 tax retum. Exhibit 4 is an unaucited 1991 balance sheet for Fabricare) Fabricare's cument owners were not much on keyping careful records. Past income records were not reliable in Roy's judgment. Hence, the decision nyanding acquisition of Fabricare had to be ailings Review View Help Picture Format Tell me what you want to do based primarily on Roy's own projections of cash flows from Fabricane and on an appealal of the quality of the assets that would be acquired. In assessing Fabricare's madet position, Roy visited the competitors' prem ises noting, in particular, the number of service vehicles that each business had available. Although a relatively crude method of measuring the business activ ity level of each firm and relative market shams, he had found this to be a fairly accurate indicator in the Danville areas From these observations, Roy believed that Fabricare had only a 10percent share of the building maintenance business in Lynchburg, In addition, Roy leamed from some of the local firms that made use of building maintenance services in Lynchburg that the bidding techniques and performance standards were similar to those he had experienced from his competitors in Danville. Lynchburg had a larger business and professional community than Danville and offered greater immediate growth potential than existed in the saturated Danville market. Upon a closer examination of Fabricare, Roy saw a firm whose business could be expanded from its current customer base into a more success ful, full-service building maintenance firm like PBM. Roy felt strongly that he could capture about the same market share (40 percent) in Lynchburg as he had in Danville. Beyond that level, Roy found additional market share difficult to obtain from customers who often were more concemed about cost considera- tions than quality of performance. Roy also considered a startup operation, but he concluded that the pur- chase of an existing firm would give him quicker access to the market. In addition to the current customer base, he would also obtain employees who were familiar with the business and the area. Based on an estimate of the cur rent and future total market for building maintenance services in Lynchburg and a projection of Fabrican's market penetration that matched the historical performance of PBM, Roy estimated that sales revenues under his manage- ment could be 1993: $400,000 1994: $600,000 1995: $900,000 1996: $1,200,000 1997: $1,500,000 1998 and beyond: $1,600,000 To develop pro forma statements that could assist in the valuation of the firm, Roy made the following assumptions, based on his experience at PBM 1. Prelax operating profit equals 13.5 percent of sales 2. Taxes computed using 30 percent combined (state and federal) tax rate. 3. Additional net working capital investment equal to $8450 in 1993 and there after 16.9 percent of incremental sales. - Word Mailings Review View Help Picture Format Tell me what you want to do 242 BART VII VALLIATION 4. Capital investment requirements equal to $25,000 in 1993, $30,000 in 1994, $40,000 in 1995, $60,000 both in 1996 and 1997, and $70,000 per year there- after. These capital outlays are needed to replace and recondition vehicles, sweepers, carpet cleaning equipment, and equipment and furnishings used in the main company office 5. Annual depreciation was expected to total $5,000 in 1993, $11,000 in 1994, $20,000 in 1995, $45,000 in 1996, and $70,000 per year thereafter. 6. If the acquisition is completed, the effective date will be January 1, 1993. Under its present management, sales and profit growth was expected to be sub stantially less than under Roy's management and ownership. Based on what he knew about the past performance of Fabrice, Roy felt that the current managers would be lucky if they could grow their 1991 yearly after-tax ash flows of $30,654 ($28,615 net income after tax plus depreciation of $2,099) by 5 percent per year. As a starting point in estimating a required retum on equity, Roy used data from publicly held building maintenance and deaning firms. This analysis led Roy to conclude that a 15 percent retum on equity was suitable for firms in that industry. However, because PBM and Fabricare were privately held and suf fered from a lack of liquidity for their owners, because of the increased risk associated with locationally nondiversified firms, and because the owners were not well-diversified with respect to their own portfolio of assets, Roy concluded that a 20 percent retum on equity was appropriate for valuing both PBM and any potential acquisition in the industry. A similar analysis of publicly held fimms and data from Robert Morris Associates for smaller finns in the industry indicated that a 20 percent retum requirement was reasonable and achievable. This analysis also led Roy to con clude that a capital structure containing up to 30 perant debt was typical However, Roy did not wish to assume any liabilities associated with the Fabricare operation, because he was unsure of the business reputation of the current owners and did not want to have to deal with any outstanding claims against the current owners. Hence, he planned only to acquire the assets of Fabricare and to negotiate a "nonampel agreement with the current owners The assets to be acquired included fixed assets (trucks and equipment), leased property improvements, and working capital, including cash, inventories, and accounts receivable. These assets had a cinent book value of $154,088, but Roy felt a more usonable liquidation value was $10000, Roy and the Fabricare owners agreed that if an agreement to purchase was completed, the final sales apital accounts from price would be adjusted to reflect changes in the s the amounts outstanding at year-end 1991, as shown in Exhibit 4 Roy's first problem was a valuation of Fabricare. If he sought to acquire the firm, he did not want to overpay Fabricane did have some good contracts on which Roy felt his fimm auk build. These contracts, although not long-term, wat with customers who had used Fabricate for several yonis and were thought tobe rice of $5000 Roy loyal customers. The owners of Fabricare were asking a intuition told him that this asking pria was too high given the performance of Review VIEW Help Picture Format Tell me what you want to do CASE 36 FABRICARE, INC. 243 Fabricam and Roy's own experienen at PEM. Publicly traded building maints rance service firms were currently selling at a multiple of 65 percent of sales, and 8 times aument eamings, Roy had recently Immed about the concept of free cash Blows and wanted to apply this valuation technique as well, Roy knew that he wanted to purchase Fabricare as an entry into the Lyndburg market. The basic questions were (1) to determine a valuation for Fabricure; (2) to determine a valuation for the combined fine; and (3) to decide how to finance the purchase of Fabricare After these questions were answered, Roy still had to negotiate a price with the current owners of Fabricare. With these thoughts in mind, Roy got out his calculator and began his analysis. QUESTIONS 1. Roy Tyson were to acquire Fabricare, what is the maximum amount that he cou pay for the firm, assuming that the agestion is effective at the beginning of 1932 2. In the valuation of Fabricates trying to decide the price he is willing to pay for the firm. In a propevaluate of Fabricare, what role should (1) the book value of the assetso be acquired frces Fabricare, (2) price-to-eamings ratios for publicly titled building maintenance Gims, (3) market value as a percentage of sales analysis for publicly traded fins, and (4) an estimate of the value of Fabricare under current management pay in the analysis? Are there an actors that might lead you to recommend that yson pay less for Fabcare than the amount computed in question 1? 3.What value would you recommend as a starting point for negotiation EXHIBIT 1 PBM, Inc. Statement of Income 1991 2200 1999 Sales Operatingopene 5851430 $748,880 $550.140 Salarie 45402 341,543 Fa 359 3673 27577 Supplies 6.4 3424 28.716 Subcontractor los EMDS 118H 10.181 Repain/minnan 5862 5.122 2,721 1:04 1297 Vickepene 7280 1180 Tend 405 4612 45 Dpcion 24262 Total operating T S 507312 SAVERS Cross margangss $177866 S (avatinas) ngs Review View Help Picture Format Tell me what you want to do 14 PART VII VALLIATION EXHIBIT 1 (Contr 1991 1990 1989 General and administrative experie Accounting/professional Adverthing Bark chungs $12,704 10,180 9,308 1571 1,410 1,270 3.705 2918 2312 Conventions/extings Contributions sune Office supplies Rent 1265 1771 2,115 1810 35,700 20684 49 7.112 6579 10.00 90DS 8283 Retirement 10325 9717 9412 Tes/licenses 2,110 1,962 3,545 Utilities 8413 763 6412 Total gemal and administrative epos $97,683 $74654 50,171 Iname bebe tes 518445 X914 535467 Iname toas 31438 31772 56 Net income after tas $72.137 S985 "In 1991, salaries indude92,4Dampmation to offions of PEM, Inc. (Roy and his wife) EXHIBIT 2 PBM, Inc. Balance Sheet Dember 31, 199 Dmber 31, 1990 Cumet at Cas $4763 $25666 mentory Notewable Accounts movable Total cab 3416 102830 2997 79651 $256450 S173734 Fumin and fixtus 95741 7298 1984 1514 3066 Netid act 5 3178 SVIZZI Cument liabilities: SUTA payable FUTA payable State withholding Federal withholding FICA withhdd-mployee FICA accrued employer EXHIBIT 2 (Con) CASE 36 FABRICARE, INC. 245 December 31, 1991 December 31, 1990 $1,063 (450) $1.570 3,008 1640 32,468 25,127 34040 27299 33611 Payroll unc deposits (10428 (233) Miscellaneous deductions 15467 5296 Accrued wages payable 16922 19.179 Income tax provision (580) (143 Total current abilities $34863 $19,699 Long-term debe Note payable-CHB 574 Note payable-Hint Virginia 99 Total long-term debt Total liabilities Shantholders' equity $1065 5034 Common stock $38400 Retained coming $198.3m Toul sharholdes equity SALA $23,70 Total liabilities and shareholders' equity 257044 EXHIBIT 3 Fabricare, Inc. Statement of Income, 1991 (nadited) Soks Operating, geral and administrative expense Salaries and wap Rat Expiation Asting O SNLKS 50286 388 54763 2485 2009 8956 54305 TE petal, and administrat S 1994 Mailings Review View Help Picture Format Tell me what you want to do 246 PART VII VALLIATION EXHIBIT 4 Fabricare Inc. Balance Sheet, December 31, 1991 (radited) Cument assets Cash Accounts cuivable Inventory Total curent acts Fonda Fumiture focus and equipment Automobiles and trucks Low Accumulad depreciation Net food ach Total acts Current liabilities SUTA payable FUTA payable Sete withhoking Fockeral withholding $29,052 56167 SISLORS HCA withhdd-employee HCA aamuad-mployer 18643 Payroll tacckposib (51.90) Misalas dahctions 11342 Aarvel was payable 9918 Iname teprv (3312) Ttal cunt liabilities Long-nndde Note payable Total slities Shadlokker equity SN745 $12.50 $41318 Common stock Retained amin tal shahokkeepity $25/00 $112840 Tallialites and shandelen opiny a CF valuation: PV of future stream of CF from the point of view of Fabricare's management; b CF valuation: PV of future stream of CF from the point of view of Roy; Revenuee valuation. D/F b VALUE OF FABRICARE: using the assumptions of Roy: 1993 1994 1995 Revenues EBIT 400.000 54.000 600.000 81.000 Taxes 37.800 56.700 121.500 85,050 162.000 113.400 1996 2997 900.000 1.200,000 1,500,000 202.500 1996 1999-Ongoing 1.600.000 1,600,000 216.000 216.000 141.750 151.200 151.200 Depreciation 5.000 11.000 20.000 45.000 70.000 70.000 70.000 After tax profit 42.800 67.700 105.050 158.400 211.750 221.200 221.200 NWC 8.450 33.800 50.700 50.700 50.700 16.900 Capex 25.000 30.000 40.000 60.000 60.000 70.000 70.000 Net cash flow 9.350 3.900 14.350 47.700 101050 134.300 151.200 t 1 2 3 4 5 6 7 WACC 1,20 1,44 1,73 2,07 2,49 2,99 3,58 PV CF 7.792 2.708 8.304 23.003 40.610 44.977 756.000 PV of 1999-Ongoing 210986 Sum of PV 338.380 C VALUE OF FABRICARE HOW IS THE ANSWER CALCULATED IN EXCEL? WHAT ARE THE FORMULA'S