For this Case Analysis, are the calculations and answer correct?

Case Analysis 3 Weight 40% of total assignment

You are the General Manager at the Bicker, Slaughter and Lynch Law Firm. There is an opportunity to buy out a small law firm that was just started by a young MBA/JD and you believe the firm can be grown and become a lucrative part of your Firm.

With help from your Finance leader, you have estimated the following benefit streams for this new division:

Year 1

Year 2

Year 3

Year 4

Year 5

Year 6

Year 7

Year 8

Before Tax

Cash Flow

From

Operations

$(149,000)

$-

$51,380

$88,760

$114,100

$129,780

$143,640

$167,300

After Tax

Net Income

From

Operations

$(103,500)

$(50,500)

$36,700

$63,400

$81,500

$92,700

$102,600

$119,500

After Tax

Cash Flow

From

Operations

$(85,600)

$15,000

$48,600

$72,200

$95,550

$101,300

$125,200

$140,200

You estimate that the purchase price for this firm would be $200,000 and that additional net working capital would be needed in the amount of $60,000 in year 0, an additional $20,000 in year 2 and then $20,000 in year 5.

In addition to the purchase price, you would ask that your Advertising budget of $275,000 be increased by an incremental one time amount of $50,000 in advertising in year 0 to publicize the firms expansion.

Your Finance leader has indicated that the firm has access to a credit line and could borrow the funds at a rate of 6%. (Assume the cash associated with this interest is included in the above benefit numbers). He also mentions that when he runs Project economics for Capital budgeting (such as a new copier or a company car), he recommends a standard 10% rate discount but the one other time they looked at an acquisition of a smaller firm he used a 12% rate discount.

At the end of 8 years, the plan will be to sell this division. The estimated terminal value (the sale and the return of working capital) is conservatively estimated to be $300,000 of cash flow help.

Calculate the N Nominal Payback, the Discounted Payback, the Net Present Value and the IRR for this potential acquisition.

For the purpose of capital budgeting, we always consider after-tax cash flow from operations and not net income.

Cash outflow, Year 0 = Purchase price + Working capital + Incremental Advertising

= $(200,000 + 60,000 + 50,000) = $310,000

Cash outflow, Year 2 = Yearly cash inflow - working capital

= $(15,000 - 20,000) = - $5,000

Cash inflow, Year 5 = $(95,550 - 20,000) = $75,550

Cash inflow, Year 8 = Yearly cash inflow + Terminal value (inclusive of working capital)

= $(140,200 + 300,000) = $440,200

We shall take the discount rate as 12%, which is the rate used by a similar project (with similar risk) in the past.

The cash flow analyses now as follows.

(a) Nominal Payback period is the time period when the initial investment is recovered from the cash inflows.

Nominal PBP

Year

Cash Flow

Cumulative Cash Flow

0

-3,10,000

-3,10,000

1

-85,600

-3,95,600

2

-5,000

-4,00,600

3

48,600

-3,52,000

4

72,200

-2,79,800

5

75,550

-2,04,250

6

1,01,300

-1,02,950

7

1,25,200

22,250

8

4,40,200

4,62,450

From above table we see that nominal PBP falls between years 6 & 7.

So, PBP = 6 + (Absolute cumulative cash flow of year 6) / (Annual cash flow of year 7)

= 6 + (102,950 / 125,200) = 6.82 years

(b) Discounted PBPis the time period when the initial investment is recovered from the discounted cash inflows.

Discounted PBP

Year

Cash Flow

Discount Factor @12%

Discounted CF

Cumulative Discounted CF

0

-3,10,000

1.0000

-3,10,000

-3,10,000

1

-85,600

0.8929

-76,429

-3,86,429

2

-5,000

0.7972

-3,986

-3,90,415

3

48,600

0.7118

34,593

-3,55,822

4

72,200

0.6355

45,884

-3,09,938

5

75,550

0.5674

42,869

-2,67,069

6

1,01,300

0.5066

51,322

-2,15,747

7

1,25,200

0.4523

56,634

-1,59,113

8

4,40,200

0.4039

1,77,789

18,677

From above table we see that discounted PBP falls between years 7 & 8.

So, PBP = 7 + (Absolute cumulative cash flow of year 7) / (Annual cash flow of year 8)

= 7 + (159,113 / 177,789) = 7.89 years

(c) NPV is the sum of present values of all cash inflows and outflows.

Year

Cash Flow

Discount Factor @12%

Discounted CF

0

-3,10,000

1.0000

-3,10,000

1

-85,600

0.8929

-76,429

2

-5,000

0.7972

-3,986

3

48,600

0.7118

34,593

4

72,200

0.6355

45,884

5

75,550

0.5674

42,869

6

1,01,300

0.5066

51,322

7

1,25,200

0.4523

56,634

8

4,40,200

0.4039

1,77,789

IRR

12.85%

NPV

18,677

As we see, NPV = 18,677

(d) IRR is that discount rate which makes NPV = 0. Using Excel IRR function, we see that IRR = 12.85%.

Discussion in a Word Document in paragraph form, respond to the following:

1)From a Financial perspective, would you recommend this purchase to Management? Why?

This investment is worth undertaking, since it has a positive NPV and its IRR is higher than the project's chosen rate of discount (12%).

2)What are some of the non-financial elements that would change your initial recommendation made in question #1.

• The length to undertake the project
• The changes in economic conditions
• Additional tax benefits

3)Assumptions in Project Economics can have a huge impact on the result. Identify 3 elements/assumptions in your analysis that would make this project not be financially attractive? (E.g. Answer the question, what would have to be true for this to be a bad investment?)

The NPV is below zero

The rate of return is low

The PBP is not achieved