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F ct on H NARRAGANSETT PRODUCTS ACQUISITION: MULTIPLE OPTIONS Narragansett Products is a regional producer of soft drinks and seiis mainly in the states of New Hampshire, Massachusetts and Rhode Island. Three years ago, in 1993, it made the decision to diversify into the bottled water industry, whose market enjoys a good reputation in a health~conscio us America and is es- pecially popular in areas where the quality of municipally provided water is suspect. Firms cater to businesses and homes, obtaining income mainly from the delivery of bottled water and the rental of water coolers. The market Narragansett entered has one highly successful firm, Mineral Springs, which is family owned with yearly sales of about $6 million. The next largest firm is Beaumont Water, and there are it) extremely small companies with one or two trucks, six of which have appeared in the last two years. When the decision was made to produce bottled water, nearly all of Narragansett's executives were extremely confident that the Venture would be highly profitable. This optimism was based on (1} projections showing the bot tled water market was growing; (2) cost estimates implying that Narragansett could tu'tdersell its cornpeti tors by 10 percent; and (3) Narragansett's ability to pick "winners" in the soft drink market. Unfortunately, there was a barrier to en try that few realized: businesses were not buying a product so much as a service, and the marketing strategies of mass advertising (newspaper, radio, etc.) and price discounts simply did not work. Mass advertising was ineffective because consumers believed correctly that all bottled water was really the same thing. Therefore, it is hard for a company to differentiate its product, unlike firms in the soft drink industry. Price discounts failed for two reasons. First, a company's expenditure on bottled water is a very srn all proportion of its expenses. Thus, managers were not especially attracted by price discounts. More important, however, businesses were not buying a product so much as a servicea visit 248 PART Vll 'ALU.";TlON and chat with the delivery person. All in all it was hard to convince firms to switch bottled water companies. As one manager put it: "So we save a few bucks. But that means we won't see Fred every weelt. Andmy goodnesS Fred's like family! it wouldn't be right to switch." THE CURRENT SITUATION At this point Narragansett's bottled water business has shown operatingr losses of nearly $300,000, which does not include the initial investment of more than $800,000. Management is now taking a critical look at the decision made nearly three years a go and must decide between one of four options. it can continue as is; abandon the project completely; stop producing bottled water but retain ownership of the land and lease the building; or go after the bottled water mar ket by acquiring Beaumont Water. The "as is" alternative does not require any additional expenditure and is expected to generate the situation shown in Exhibit 1. No one finds this option especially appealing. Management's think ing is, "If we stay in this market, let's do it right or give the project its pink slip." Abandoning the project has at least one vocal supporter, Clifton Willard, a plant manager, who argues that this strategy will give Narragansett "immedi ate benefit." The land that Narragansett paid $200,000 for 10 years ago has a market value of $380,000 and is not presently needed. The factory would, of course, be sold with the land and is worth about 590,000. lie admits that the trucks Narragansett purchased have relatively little market value since they are highly specialized; that is, theyr were built to carry the S-gallon jars of water and are not especially suitable for other purposes. A reasonable estimate is that they could be sold for 50 percent of their book value. The remaining equipment can also be sold at 50 percent of book. The receivables are generally of good quality, and Narragansett should obtain $72,000 when they are collected. "And, of course," notes Willard, "we could liquidate at 100 percent of book, our inven- tory of bottled water." Stan Covington, the company president, also favors abandoning the project, though his proposal is not quite as drastic as Willard's. He suggests keeping the land and renting the building. though the trucks and equipment would be sold, the receivables collected, and the inventory liquidated. leasing the huilding would be a "simple matter" and would not $40,000 a year, a figure that includes all yearly expenses but not taxes. He agrees with Willard that the land is not needed by Narragansett now, but in three to five years it might be since Narra gansett's soft drink sales have been growing, and it is very likely that the company will need additional area for expansion. The location of the current bottled water plant is considered ideal for growth. "At a minimum," argues thingttm, "if we keep the land it can always be sold in the future. The current market value is nea riy 100 percent more than we paid for it and should continue to appreciate this way. " He also points out that the factories could be used for the prod uction of soft drinks. CASE 3? NARRAGANSETT FROM JCI I'iDhLS 249 BEAUMONT WATER Beaumont Water has been in business nearly 100 years, has always been owned by the McGeary famiiy, and is the second largest bottled water firm in the area in terms of annual sales. To help evaluate the feasibility of acquiring Beaumont, Narragansett hired Fraley and Associates, a respected consulting firm, which has a bit of a national reputation. The first step in the acquisition process was to accurately determine Beaumont's most recent income sta tement. Unbelievably, this was a very difficult and time-consuming task because the current owner, Torn McGeary, simply never appreciated or liked the idea of keepingr accurate records. All sales were made in cash and then deposited. in order to estimate last year's sales, Fraley and Associates had to examine deposit records, being care ful not to count cash resulting from the sale of assets like machinery and water coolers. Expenses were estimated using canceled checks, and an on-site veri cation of Beaumont's assets was made. [See Exhibit 3 for the balance sheet esti- mate. Exhibit 4 presents Beaumont's current income statement as well as a con- solidated pro torma income statement of the two firms, and Exhibit 5 provides excerpts from the report of Fraley and Associates.) .. 'arragansett's executives feel quite confident that these estimates are accu- rate, and are pleased with the thoroughness of Fraley and Associates. Narragansett is also confident that the bottled water market is expanding. The. area's economy is projected to grow sharply in the next five years and this means more businesses to serve (and households as well should Narragansett decide to enter that market). And then there is the result oi a survey done by Elizabeth Lonon, the director of marketing. At the end of each business day for three full months, Lonon faithfully queried the cooler installation man at Beaumont and. determined that, based on the number of new coolers they in- stalled, Beaun'tont's sales should have doubled. The problem, Lonon was aston ished to learn, was that they removed as many old coolers as they installed. The service of Beaumont was the major problem. Apparently some new orders were never processed, others were processed literally months after they were initially placed, and missed deliveries were common. "Refresh my mind," Willard says, somewhat sa rcast-ically. "Exactly why are we interested in buy ing this company? Certainly not for its bookkeeping, system or its management policies. And certainly not for its assets. I mean, the market value of all it owns is only about $800,000, and we're considering paying $2 mil lion for the firm. it all sounds crazy to me. The difference of 1.2 million repre~ sents goodwill, which we can't even depreciate." Lindsay Carter, the chief finance officer, then proceeds to address this ques tion at some length. Our original idea that the industry is growing wasn't wrong, only our ideas about marketing the product. Believe it or not, we're buying Beaumont's name and loyal customers. After all, it has been around for nearly a century and only recently has it gone downhill. Acquiring Beaumont will give us a toehoiri in the market. 250 PART VII VALUATION We know how to deliver a product and provide quality service. I believe that Beaumont has been a victim of its inability to sen-e all its new customers of the last few years. If you think about it, you'll notice that based on Elizabeth's research, Beaumont apparently had new sales of well over $2 million in the last two years. How much new business clid we get during the same period with our heme y advertising and lower prices? About $800,000, that's all! And keep in mind the area's expansion will bring in new business and may well strain local water supplies and cause a re- duction in water quality. Lonon a grees that Willard has raised a good question but tends to side with Carter. "We can't look at what Beaumont is," she says, "we have to look at what it can be." She also points out that the acquisition contains an "attractive financ ing package." MeGeary wants 52 million for Beaumont but only $1 million up front. McGeary would finance the remainder with a F'-percent, 5-year loan, though the current market rate of interest on this type of debt is 12 percent. The terms of the loan allow Narragansett to pay only the interest each year and the entire principal can be deferred for five years; that is, a balloon payment of $1 million would be due in five years. At this point discussion returns to other issues in the investigation of Fraley and Associates. Their report ind iea tes that a consolidation of the companies will result in an increase in profitability even if there is no change in the sales oI each firm from the acquisition. {See Exhibits 4 and 5.) And the report also suggests one reason that the firm has been losing customers. Beaumont's delivery men were actually responsible for loading their own trucks. M an y would frequently not begin deliveries until 11 or 11:30 in the morning and exhausted at that. The result was that many customers were not served or received late deliveries. A consolidation would easily correct this. Idle equipment of Narragansett's could be moved to Beaumont's plant to automate the loading. Only one night shift op- eratorloader need be hired and the trucks could be ready to go by 8 AM. (Note: The cost of this extra person has already been considered in Exhibit 4.} It also is obvious to Narragansett's management that the actual cost of Beaumont could differ, and perhaps substantially, from the asking price of $2 million. There is, of course, the attractive financing arrangements surrounding the purchase. On the other hand, it is clear that Beaumont's ( net) working capital policy has hurt sales, and this will require funding to change. In addition, \Tarragansett will need $100,000 to buy equipment that Beaumont is currently leasing. After further discussion a consensus is reached on a number 01' issues rele- vant to the choice. 1 The projections shown in Exhibit 1 should continue indefinitely. 2. the consolidated pro forma income statement in Exhibit 4 is quite reason- able; the net income projection is relatively low risk because it depends mainly on the merger, which management believes would easily bring about greater efficiency. '3. Lt Beaumont is acquired, annual sales could easily reach $4 million during year 3 and might top $5 million in four to five years. CASE E 3? \ AltliGAN SETT PRODL lt'f'l'i ON 5 25 1 4. Cost of goods sold will be 25 percent of sales; selling expenses will change by 20 percent of sales exceeding $2.8 million; and general and adrrunistrativc and miscellaneous fixed expenses will both change by 5 percent of sales ex- ceeding $2.8 million. Narragansett's current net working capital situation (CACL} is reasonable. The appropriate tax rate is 40 percent. 5495-" The acquisition would enable Narragansett to handle annual sales of 55 mil lion to $6 million without any increase in fixed assets. 9'3 Any lease would last five years and could be renewed indefinitely. 9. The yearly cash flow with each option will equal EBIT adjusted for taxes less any change in working capital requirements. (Any cash flow resulting from depreciation is assumed to be used to maintain existing equipment.) A final problem involves the appropriate discount rate. The lease option is considered a lower risk than either the "as is" or acquisition options. The yearly cash flows from the "as is" option should be discounted at 13 percent and those from the lease at 10 percent. With the acquisition alternative, management has identified three distinct cash ow streams. Management will use a 13 percent rate on the cash flow generated by sales of $2.8 million or less. It feels 16 percent is the appropriate cost of capital (required return) for the incremental cash flow on sales between $2.8 million and $4 million. Finally. a 22 percent rate will be used on the incremental cash flow generated by sales above $4 million. (Note: All rates are on an after-tax basis.) QUESTIONS 1. How relevant to the decision are the $800,000 initial cost of the project and the operating losses of $300,000? 3' (a) Calculate the incremental cash flows for the "abandon completely" al ternative. {Be sure to consider the tax effects from the sale of the land _. trucks, equipment, and factory. Use the cash flows item the "as is" op tion as the base position to calculate these incremental amounts.) (b) What would the incremental ca sh ows be from the "abandon ~but-lea se" alternative? {lfse the "as is" option as the base position.) to) Calculate the NPV's of these options. (d) Based on these calculations and other information in the case, are these alternatives superior to the "as is" position? Which of the two is more consistent with the objective of value inaxirniya ti on? Explain. 3. What will be the cost of Beaumont after considering the financing surround ing, the purchase, Beaumont's (not) working capital situation, and the addi~ tional equipment that would be purchased? 252 l-'All'l' VII VA [ .l J ATION 4. Fraley and Associates estimated that net income after the merger will exceed the sum of the net incomes both firms achieved individually. Does this seem reasonable? Explain. I 5. (a) Develop pro forma {consolidated} income statements for annual sales 0t 84 million and $5 million. (b) Calculate the relevant incremental cash flows. {Use the "as is" cash flows as the base position to calculate these incremental amounts.)' (c) What is your estimate of Beaumont's value? Explain. 6. Does it make sense for Narragansett's management to use so many discount rates in its evaluation? Explain. 7. Based on you previous answers, any other calculations you feel are relevant, and information provided in the case, which alternative do you recommend? Fully support your position. 8. "that additional information would you like to have to make a more in- formed decision? if" ll:t SOFTWARE QUESTION 9. Some of Narragansett's managers are having second thoughts on a number of estimates relevant to the Beaumont acquisition. For example, Lindsay Carter, the CEO, thinks that the discount rates used are too high. And Clifford Willard, a plant manager, believes the cost estimates are too low. After some disc ussion, the following scenarios were generated. Each rep- resents the. personal favorite of a Narragansett executive. Perform the appropriate analysis. Based on these results, do you recom mend that Narragansett Produt'ts purchase Beaumont Water? S I S 2 S - 5 S - 4 A. Sales-[$000) year 1 2,807] 2,800 2,800 2,800 year 2 2,800 2,800 2,500 2,600 year 3 3500 3,100 3.500 3.500 year 4 3500 3,300 3,500 4,000 year 5 8: beyond 4,200 3,600 3.500 4,500 B. Discount rate-s1 .l2;'.15,".2 .12,".15,t'.20 .le'.'13,'_l'}' .lOHl/QE C. CGS,'saJes .25 .25 .28 .29 D. Adm. expenses .05 .08 .0? .08 E. Selling expm'tse' .20 .22 .22 .22 F. Misc. fixed axp' .05 .35 .05 .ns C. NWfr'sales .13 .12 .12 .15 ___..._....__- ' Items D, E and F apply to annual sales aim-m $2.8 million, and are expressed as a proportion catsales. f Foch set of three refers to the appropriate discount rate to use on the increment or cash ows resuihng= from [1} sales less than $2.8M, (2] sales ixtwt'r-II "GEM and 34M and :3) sales above 54M. CASE 3? NARRAOANSETT PRODUCTIONS 233 EXHIBIT 1 Pro Forma "As Is" Income. Stammcnt for Narragansett's Bottled "Eater Division {$000533 Sales $800 Cost of gooas sold 200 Gross margin 600 General administrative expenses 150 Selling expenses 290 Miscellaneous fixed 10 Depreciation m Hill 50 'l'axes {-10%} 20 Net income $30 *Management [eels this situation CUUIlI [.'i'l'ai; indefinilely, EXHIBIT 2 Narragansett's Bottled 'Wa rer Division Balance Sheet (1996): Book Value {$uoosl* Assets Inll-2615 uml Fri-41:} Cash $8 Accounts; rpmivable 80 Accounls payable $23 Inventory 50 Accr L] a | s _1_b Current asaets 138 Current liabilities 44 Fartnry 100 Fquiprnent 50 Fquity 564 Truck: 120 Lama" g Total asaeta 3:08 Total liabilities and equity _$E_>_U_.3 _._. The net working capital Situation aSsurnL-5 annual sales am 99812-300