Please Answer Question 2.

2. In the valuation of Fabricare, Roy is trying to decide the price he is willing to pay for the firm. In a proper valuation of Fabricare, what role (i.e., how should each method be used, if at all, by Roy) should each of the following play in the analysis? Explain. (a) the liquidation value (b) the book value of the assets to be acquired from Fabricare; (c) price-to-earnings ratio for publicly-traded maintenance firms; (d) market value as a percentage of sales analysis for publicly-traded firms; and (e) an estimate of the value of Fabricare under current management. In addition to explaining the roles, if any, for each option, be sure to provide the dollar value under each option, and explain how you determined each number. Note: The value of Fabricare under current management can be estimated using the formula for the present value of a growing perpetuity (see Chapter 6), also known as the constant growth model. Also note that the " C " in the growing perpetuity model must be the next cash flow. Hint: Don't assume that all five of the methods would play useful roles. Hint for c,d, and e: The purchase of Fabricare is to be for 1993, not 1991 or 1992, so you might need to adjust some inputs to put them in 1993. Hint for c and d : You are being asked to calculate the value under two different multiples/comparables methods using industry multiples provided in the case. And then you need to consider how reliable these would be as estimates of the value of Fabricare. You are not being asked to evaluate the concepts of percentage of sales or PE ratios, except in the context of the usefulness of using them to estimate the value of Fabricare. By John Dunkelberg, School of Business and Accountancy, Wake Forest University, and R. Charles Moyer, Babcock Graduate School of Management, Wake Forest University. Originally presented at a meeting of the North American Case Research Association, November 1993. This case was written with the cooperation of management, solely for the purpose of stimulating student discussion. Data are based on field research in the organization. All events and individuals are real, but names have been disguised at the company's request. In early 1986 Roy Tyson purchased Professional Building Maintenance, Inc. (PBM), a building maintenance and cleaning firm located and operating in the Danville, 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 $851,430 in 1991 . 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 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 learned that a building maintenance firm, Fabricare, Inc., located in Lynchburg, Virginia, was for sale. Fabricare's most recent (yearend 1991) revenues were less than one-half of those of PBM, but Roy believed the growth potential to be much greater because Fabricare only had 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 trying to decide (1) if he should purchase the company and (2) if so, at what price. Roy was also concerned about how he would manage the two firms that were located in two different cities, about 55 miles apart. This was a critical issue because Roy was very much a hands-on type of managera managerial style that had served him very well at PBM and which had assured quality service and tight cost controls. Background When Roy Tyson graduated from William and Mary in 1976 with a degree in social sciences, he went to work for a large, well-known consumer products firm. Roy moved rapidly and successfully through several managerial positions, and, in the process, had been moved six times in 10 years with the firm. In late 1985, Roy was thinking about settling down and becoming his own boss. Although he had received excellent evaluations and raises, the frequent moves and the politics that went along with being part of a large firm were not things that he enjoyed. He and his family liked living in Danville, where they had been for the past 2 years. Furthermore, because of Roy's school-age children, the thought of future moves to larger cities and eventually to the corporate headquarters in Chicago was unappealing. Through an accountant friend he learned that a local building maintenance and cleaning firm, PBM, Inc., was for sale. The current owner was tired of managing an employee group that traditionally had low levels of education and high turnover. Furthermore, the current owner had lost the competitive drive needed to aggressively compete for new clients in a business in which customer loyalty was fleeting. After weighing the pros and cons of the corporate versus the entrepreneurial life, Roy and his wife decided to purchase PBM and to settle into the Danville community. Traditionally, building maintenance businesses in towns the size of Danville had been run by individuals with low levels of business expertise. They often relied on rough rules of thumb to determine the price to charge when contracting to clean commercial and professional office buildings. After a contract was won, many of these firms would adjust the quality of the work they performed if they found the bid was too low to be profitable. If the bid was on the high side relative to actual costs, they enjoyed the "windfall" profits that accrued until another competitor underbid them. Thus many competitors would place a low bid in order to obtain the initial contract and then attempt to make a profit by lowering the quality of work. The resulting inconsistent and often poor quality standards led to frequent switching of companies by purchasers of maintenance services. Roy felt that he could solve this problem, maintain a steady group of clients, and be profitable if he applied some of what he had learned from his previous corporate job. Growth of PBM After purchasing PBM in early 1986, Roy found ample challenges associated with being an entrepreneur. During the first year of business, Roy did not attempt to expand. Rather, he chose to work with the existing customer base and to learn the day-to-day operational aspects of the business. He worked with his cleaning crews to determine how long individual tasks took and to appreciate the problems that different buildings and cleaning assignments presented. During this period Roy also concentrated on improving the quality of the service he provided and on learning to manage his employees effectively. Reliable employees were rewarded and unreliable employees were replaced. By paying better attention to his employees' needs and by paying higher wages than typically prevailed in this industry, Roy was able to improve quality and reduce turnover and training costs. These changes were reflected in higher salary and wage expenses along with higher productivity and gross margins. With the information he gathered from the first full year of operation, Roy built a database containing the time and cost figures for completion of individual cleaning tasks. This database was used by Roy to "scientifically" determine bids for new contracts. He was convinced that the rules of thumb used by many in the business were nearly useless. For example, he found that the time required to clean professional office space was often as much as 50 percent greater than the time required to clean low-traffic, commercial space. He developed office space classifications on which bid rates were set. He carefully calculated the number of square feet in the building, the number of rooms, and the number of desks and chairs that needed to be moved and cleaned regularly. Flooring type was also an important determinant of the bid. The number and square footage of rest rooms-and their frequency of use-were also determined, because it generally took longer to clean them than to clean other areas. If window cleaning services were to be provided, the number, location, and the square footage of window space were computed. Using the database, Roy felt that he could provide an accurate estimate of the time required to perform a quality job and the cost of supplies needed, for each service requested by a customer. In effect, when Roy prepared a bid, his customers knew exactly what they were paying for and what would be cleaned each time his crews visited the premises. As simple as this system sounds, it represented a major improvement over the way competitors in the market area at that time ran their businesses. Roy also found that he could increase profits significantly by controlling costs. For example, during the second year of operation Roy found that he could cut his cost of supplies by nearly 40 percent by concentrating purchases and negotiating price discounts. Roy discovered other opportunities to cut costs during the early years in the business. For example, he learned that he could acquire reliable company vehicles at a much lower cost by buying used trucks. Engine maintenance costs increased with vehicle age, but Roy also found it cheaper to replace an engine than to buy a new vehicle. This strategy also resulted in substantial insurance savings for PBM. In 1989, Roy opened a new employee training and office facility. All new employees went through three days of training at the facility before going out on their first job. They learned the proper use of cleaning equipment and supplies. In addition, the training established quality and quantity standards for performance. This training program, together with Roy's precise bidding system, was highly effective. At about the same time, Roy began to aggressively expand the business. When he went out to bid for a new con tract, Roy would walk through the facility noting important characteristics, services requested, the areas to be cleaned, and the frequency of cleaning. He priced each specific service based on the estimated time to perform each task. If a customer questioned an estimated time quotation, Roy invited the customer to visit the premises during the cleaning time and confirm the accuracy of the estimate. Roy's "menu" approach to building maintenance proved to be successful with his clients. With PBM's system they could, for example, specify how often they wanted to have the floors swept, vacuumed, mopped, polished, waxed, and/or buffed, in order to remain within their budget constraints. PBM's sales revenues increased by 259 percent between 1986 and 1989. PBM prospered as customers learned to appreciate knowing what they could expect from a cleaning company in terms of both the quantity and quality of services provided. After 1990, as PBM increased its market share to about 40 percent, the annual growth rates in sales declined substantially. The income statement for 1991 was about what Roy expected, considering that both he and his wife drew a salary from the business. (See Exhibit 1.) His balance sheet indicated a financially healthy company with virtually no debt and owner's equity of $314,000. (See Exhibit 2.) Roy's personal net worth, excluding his home equity, was $350,000. Most of this net worth was invested in municipal bonds and bank certificates of deposit. Although Roy was satisfied with the performance of the PBM operation, he realized that growth potential in the Danville area was limited. In 1990, with the business well established, Roy began thinking about future prospects. Could he run the business more efficiently? Should he expand into another line of business in the Danville area? Should he expand the building cleaning and maintenance business into another area? Roy had learned much about business, both from his time in a large corporation and from his experiences at PBM. However, he felt that he could now benefit from a more formal level of management education. Roy pondered the prospect of obtaining an M.B.A. The Executive M.B.A. Program offered by Wake Forest University seemed like a perfect fit. The program was designed for experienced managers, such as himself. He felt that he could learn both from the formal classes and from his student colleagues. In addition, Wake Forest was only an hour and a half drive from Danville and the courses were offered on Fridays and Saturdays. Furthermore, Roy's wife was an important part of the PBM management team and she was fully capable of running the business in his absence. maintenance business, but approximately one-half of its revenues came from carpet cleaning for commercial establishments. The owner of Fabricare was approaching retirement age, and no preparation had been made for management succession in the small firm. On investigation, Roy learned that Fabricare had about $384,000 in revenues in 1991 , a figure that had grown only modestly over the previous 3 years. (Exhibit 3 is a 1991 income statement derived from Fabricare's 1991 tax return. Exhibit 4 is a 1991 [unaudited] balance sheet for Fabricare.) Fabricare's current owners were not much on keeping careful records, and past income records were not reliable in Roy's judgment. Hence the decision regarding an acquisition of Fabricare had to be based primarily on Roy's own projections of cash flows from Fabricare and on an appraisal of the quality of the assets that would be acquired. In assessing Fabricare's market position, Roy visited the Lynchburg competitors' premises noting, in particular, the number of service vehicles that each business had available. Roy had used this seemingly crude method of measuring the business activity level of each competitor in Danville, and its relative market share, and had found it to be a relatively accurate indicator. These observations led Roy to estimate that Fabricare had only about a 10 percent share of the building maintenance business in Lynchburg. In addition, Roy learned from some of the local firms that made use of building maintenance services in Lynchburg that Fabricare's bidding techniques and performance standards were similar to those he had seen in Danville. Lynchburg had a larger business and professional community than Danville and offered greater immediate growth potential than did 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 successful, 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. However, he felt that market share beyond that level would be difficult to obtain, since many customers were more concerned about cost considerations than quality of performance. Roy also considered a startup operation, but he concluded that purchase 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 current and future total market for building maintenance services in Lynchburg and a projection of Fabricare's market penetration that matched the historical performance of PBM, Roy estipard that sales revenues under his management could be: Roy felt a more reasonable liquidation value was $140,000. Roy and the Fabricare owners concurred that if an agreement to purchase was completed, the final sales price would be adjusted to reflect changes in the working capital accounts, from 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. Fabricare did have some good contracts on which Roy felt his firm could build. These contracts, although not long-term, were with customers who had used Fabricare for several years and were thought to be loyal. The owners of Fabricare were asking a price of $275,000. Roy's intuition told him that this asking price was too high, given the performance of Fabricare and Roy's own experience at PBM. Publicly traded building maintenance service firms were currently selling at a multiple of 65 percent of sales, and 8 times current earnings. Roy had recently learned about the concept of free cash flows and wanted to apply this valuation technique as well. Ig the Acquisition Assuming that Roy and Fabricare's owners could come to an agreement about price, a bigger problem faced Roy. How would he manage the two firms? While attending the M.B.A program, Roy had become good friends with Stuart Rogers, one of the members of his study group. Stuart worked for a large textile firm, but was seriously considering a career change for himself. He was even considering going into business himself. Like Roy, Stuart had been moved several times and had seen several of his friends lose their jobs after a major corporate restructuring. Roy and Stuart had several talks about the pros and cons of entrepreneurial life versus a career with a large corporation. Concerning Stuart, Roy had two major questions: (1) Should he ask Stuart to enter into the business with him? (2) If he did, how could he structure Stuart's entry so that he could build equity in the business? Other concerns were how to finance an acquisition of Fabricare, and how the ownership of the new company could be split to satisfy both Stuart and Roy. One evening after class, Stuart was complaining about his current job. Roy said, "Why don't you just 'cash it in' and join me in the building maintenance business? I've been considering acquiring another firm and I need a competent partner to manage that firm." Stuart asked for time to considered the proposition. This was a very big decision. After thinking about it for a month and discussing it with his wife, Stuart told Roy, "I've given your proposal serious consideration and I'd like to learn more about the opportunity. I'm concerned, however, about the amount of equity investment that would be required." Roy was ecstatic. They shook hands and vowed to work out the details. Then they went off to the Village Tavern to celebrate their new partnership. Both Roy and Stuart agreed that they should establish a baseline value for PBM before Stuart bought into the firm and before they pursued the acquisition of Fabricare. Roy felt that the profit (13.5 percent) and tax (30 percent) assumptions he had used in analyzing Fabricare should apply equally to PBM projections. Additionally, he felt that capital investments should equal depreciation, and that sales should rise to $1.2 million in 1992 , $1,350,000 in 1993,$1,500,000 in 1994,$1,600,000 in 1995 , and $1,700,000 per year thereafter. Pretax operating profits would be the same as for Fabricare-13.5 percent of sales. He projected that there would be an additional net working capital investment equal to $40,560 in 1992 and 16.9 percent of incremental sales thereafter. cing and Managing the Combined Firms Roy sat at his desk and began to estimate the value of both PBM and Fabricare. He also began to ponder the alternatives for bringing Stuart into an active management role in the combined firm. Stuart confided in Roy that he had savings of $110,000 that he could draw upon to help finance the venture. Roy felt that it was important for him to maintain majority ownership control in the new, combined firm. He initially decided that he would like to maintain at least 55 percent control of the new firm. However, Roy felt that it was important for Stuart to have a significant ownership stake so that he would have a strong incentive to work hard for the success of the firm. If Fabricare were purchased by Roy, and Stuart joined the combined firm with primary responsibility for the operation and performance of Fabricare, Stuart would have to come up with a substantial amount to fund his ownership interest. Roy preferred that Stuart arrange for the financing of his ownership interest in the new firm. A third member of their Wake Forest study group, Mike, was a senior banking executive with a major North Carolina bank, and they thought he might be helpful in arranging financing. However, they realized that banks were often reluctant to provide long-term financing for this type of venture. Roy felt that as a last resort, he could lend Stuart any funds needed (over a 10-year period at an interest rate of 10 percent) beyond the $110,000 that Stuart already had available. Another possibility that Roy considered was selling Stuart whatever portion of the business his $110,000 would buy and granting him an option to purchase a greater interest in the future. Roy knew that he wanted to purchase Fabricare as an entry into the Lynchburg market. He also knew that he needed a partner to manage the Fabricare operation. The basic tasks were (1) to determine a valuation for Fabricare; (2) to determine a valuation for the combined firms; and (3) to decide how to finance the purchase of Fabricare, In addition, Roy reflected on the prospect of working closely with Stuart and maintaining a productive and friendly relationship, while retaining control of the firms. After these problems had been solved, Roy still had to negotiate a price with the current owners of Fabricare and then work out a management agreement with Stuart. With these thoughts in mind, Roy turned on his calculator and began his analysis. EXHIBIT 1 PBM, INC. Statement of Income IBIT 2 PBM, INC. EXHIBIT 3 FABRicabe a... EXHIBIT 4 FABRICARE, INC. Balance Sheet December 31, 1991 2. In the valuation of Fabricare, Roy is trying to decide the price he is willing to pay for the firm. In a proper valuation of Fabricare, what role (i.e., how should each method be used, if at all, by Roy) should each of the following play in the analysis? Explain. (a) the liquidation value (b) the book value of the assets to be acquired from Fabricare; (c) price-to-earnings ratio for publicly-traded maintenance firms; (d) market value as a percentage of sales analysis for publicly-traded firms; and (e) an estimate of the value of Fabricare under current management. In addition to explaining the roles, if any, for each option, be sure to provide the dollar value under each option, and explain how you determined each number. Note: The value of Fabricare under current management can be estimated using the formula for the present value of a growing perpetuity (see Chapter 6), also known as the constant growth model. Also note that the " C " in the growing perpetuity model must be the next cash flow. Hint: Don't assume that all five of the methods would play useful roles. Hint for c,d, and e: The purchase of Fabricare is to be for 1993, not 1991 or 1992, so you might need to adjust some inputs to put them in 1993. Hint for c and d : You are being asked to calculate the value under two different multiples/comparables methods using industry multiples provided in the case. And then you need to consider how reliable these would be as estimates of the value of Fabricare. You are not being asked to evaluate the concepts of percentage of sales or PE ratios, except in the context of the usefulness of using them to estimate the value of Fabricare. By John Dunkelberg, School of Business and Accountancy, Wake Forest University, and R. Charles Moyer, Babcock Graduate School of Management, Wake Forest University. Originally presented at a meeting of the North American Case Research Association, November 1993. This case was written with the cooperation of management, solely for the purpose of stimulating student discussion. Data are based on field research in the organization. All events and individuals are real, but names have been disguised at the company's request. In early 1986 Roy Tyson purchased Professional Building Maintenance, Inc. (PBM), a building maintenance and cleaning firm located and operating in the Danville, 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 $851,430 in 1991 . 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 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 learned that a building maintenance firm, Fabricare, Inc., located in Lynchburg, Virginia, was for sale. Fabricare's most recent (yearend 1991) revenues were less than one-half of those of PBM, but Roy believed the growth potential to be much greater because Fabricare only had 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 trying to decide (1) if he should purchase the company and (2) if so, at what price. Roy was also concerned about how he would manage the two firms that were located in two different cities, about 55 miles apart. This was a critical issue because Roy was very much a hands-on type of managera managerial style that had served him very well at PBM and which had assured quality service and tight cost controls. Background When Roy Tyson graduated from William and Mary in 1976 with a degree in social sciences, he went to work for a large, well-known consumer products firm. Roy moved rapidly and successfully through several managerial positions, and, in the process, had been moved six times in 10 years with the firm. In late 1985, Roy was thinking about settling down and becoming his own boss. Although he had received excellent evaluations and raises, the frequent moves and the politics that went along with being part of a large firm were not things that he enjoyed. He and his family liked living in Danville, where they had been for the past 2 years. Furthermore, because of Roy's school-age children, the thought of future moves to larger cities and eventually to the corporate headquarters in Chicago was unappealing. Through an accountant friend he learned that a local building maintenance and cleaning firm, PBM, Inc., was for sale. The current owner was tired of managing an employee group that traditionally had low levels of education and high turnover. Furthermore, the current owner had lost the competitive drive needed to aggressively compete for new clients in a business in which customer loyalty was fleeting. After weighing the pros and cons of the corporate versus the entrepreneurial life, Roy and his wife decided to purchase PBM and to settle into the Danville community. Traditionally, building maintenance businesses in towns the size of Danville had been run by individuals with low levels of business expertise. They often relied on rough rules of thumb to determine the price to charge when contracting to clean commercial and professional office buildings. After a contract was won, many of these firms would adjust the quality of the work they performed if they found the bid was too low to be profitable. If the bid was on the high side relative to actual costs, they enjoyed the "windfall" profits that accrued until another competitor underbid them. Thus many competitors would place a low bid in order to obtain the initial contract and then attempt to make a profit by lowering the quality of work. The resulting inconsistent and often poor quality standards led to frequent switching of companies by purchasers of maintenance services. Roy felt that he could solve this problem, maintain a steady group of clients, and be profitable if he applied some of what he had learned from his previous corporate job. Growth of PBM After purchasing PBM in early 1986, Roy found ample challenges associated with being an entrepreneur. During the first year of business, Roy did not attempt to expand. Rather, he chose to work with the existing customer base and to learn the day-to-day operational aspects of the business. He worked with his cleaning crews to determine how long individual tasks took and to appreciate the problems that different buildings and cleaning assignments presented. During this period Roy also concentrated on improving the quality of the service he provided and on learning to manage his employees effectively. Reliable employees were rewarded and unreliable employees were replaced. By paying better attention to his employees' needs and by paying higher wages than typically prevailed in this industry, Roy was able to improve quality and reduce turnover and training costs. These changes were reflected in higher salary and wage expenses along with higher productivity and gross margins. With the information he gathered from the first full year of operation, Roy built a database containing the time and cost figures for completion of individual cleaning tasks. This database was used by Roy to "scientifically" determine bids for new contracts. He was convinced that the rules of thumb used by many in the business were nearly useless. For example, he found that the time required to clean professional office space was often as much as 50 percent greater than the time required to clean low-traffic, commercial space. He developed office space classifications on which bid rates were set. He carefully calculated the number of square feet in the building, the number of rooms, and the number of desks and chairs that needed to be moved and cleaned regularly. Flooring type was also an important determinant of the bid. The number and square footage of rest rooms-and their frequency of use-were also determined, because it generally took longer to clean them than to clean other areas. If window cleaning services were to be provided, the number, location, and the square footage of window space were computed. Using the database, Roy felt that he could provide an accurate estimate of the time required to perform a quality job and the cost of supplies needed, for each service requested by a customer. In effect, when Roy prepared a bid, his customers knew exactly what they were paying for and what would be cleaned each time his crews visited the premises. As simple as this system sounds, it represented a major improvement over the way competitors in the market area at that time ran their businesses. Roy also found that he could increase profits significantly by controlling costs. For example, during the second year of operation Roy found that he could cut his cost of supplies by nearly 40 percent by concentrating purchases and negotiating price discounts. Roy discovered other opportunities to cut costs during the early years in the business. For example, he learned that he could acquire reliable company vehicles at a much lower cost by buying used trucks. Engine maintenance costs increased with vehicle age, but Roy also found it cheaper to replace an engine than to buy a new vehicle. This strategy also resulted in substantial insurance savings for PBM. In 1989, Roy opened a new employee training and office facility. All new employees went through three days of training at the facility before going out on their first job. They learned the proper use of cleaning equipment and supplies. In addition, the training established quality and quantity standards for performance. This training program, together with Roy's precise bidding system, was highly effective. At about the same time, Roy began to aggressively expand the business. When he went out to bid for a new con tract, Roy would walk through the facility noting important characteristics, services requested, the areas to be cleaned, and the frequency of cleaning. He priced each specific service based on the estimated time to perform each task. If a customer questioned an estimated time quotation, Roy invited the customer to visit the premises during the cleaning time and confirm the accuracy of the estimate. Roy's "menu" approach to building maintenance proved to be successful with his clients. With PBM's system they could, for example, specify how often they wanted to have the floors swept, vacuumed, mopped, polished, waxed, and/or buffed, in order to remain within their budget constraints. PBM's sales revenues increased by 259 percent between 1986 and 1989. PBM prospered as customers learned to appreciate knowing what they could expect from a cleaning company in terms of both the quantity and quality of services provided. After 1990, as PBM increased its market share to about 40 percent, the annual growth rates in sales declined substantially. The income statement for 1991 was about what Roy expected, considering that both he and his wife drew a salary from the business. (See Exhibit 1.) His balance sheet indicated a financially healthy company with virtually no debt and owner's equity of $314,000. (See Exhibit 2.) Roy's personal net worth, excluding his home equity, was $350,000. Most of this net worth was invested in municipal bonds and bank certificates of deposit. Although Roy was satisfied with the performance of the PBM operation, he realized that growth potential in the Danville area was limited. In 1990, with the business well established, Roy began thinking about future prospects. Could he run the business more efficiently? Should he expand into another line of business in the Danville area? Should he expand the building cleaning and maintenance business into another area? Roy had learned much about business, both from his time in a large corporation and from his experiences at PBM. However, he felt that he could now benefit from a more formal level of management education. Roy pondered the prospect of obtaining an M.B.A. The Executive M.B.A. Program offered by Wake Forest University seemed like a perfect fit. The program was designed for experienced managers, such as himself. He felt that he could learn both from the formal classes and from his student colleagues. In addition, Wake Forest was only an hour and a half drive from Danville and the courses were offered on Fridays and Saturdays. Furthermore, Roy's wife was an important part of the PBM management team and she was fully capable of running the business in his absence. maintenance business, but approximately one-half of its revenues came from carpet cleaning for commercial establishments. The owner of Fabricare was approaching retirement age, and no preparation had been made for management succession in the small firm. On investigation, Roy learned that Fabricare had about $384,000 in revenues in 1991 , a figure that had grown only modestly over the previous 3 years. (Exhibit 3 is a 1991 income statement derived from Fabricare's 1991 tax return. Exhibit 4 is a 1991 [unaudited] balance sheet for Fabricare.) Fabricare's current owners were not much on keeping careful records, and past income records were not reliable in Roy's judgment. Hence the decision regarding an acquisition of Fabricare had to be based primarily on Roy's own projections of cash flows from Fabricare and on an appraisal of the quality of the assets that would be acquired. In assessing Fabricare's market position, Roy visited the Lynchburg competitors' premises noting, in particular, the number of service vehicles that each business had available. Roy had used this seemingly crude method of measuring the business activity level of each competitor in Danville, and its relative market share, and had found it to be a relatively accurate indicator. These observations led Roy to estimate that Fabricare had only about a 10 percent share of the building maintenance business in Lynchburg. In addition, Roy learned from some of the local firms that made use of building maintenance services in Lynchburg that Fabricare's bidding techniques and performance standards were similar to those he had seen in Danville. Lynchburg had a larger business and professional community than Danville and offered greater immediate growth potential than did 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 successful, 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. However, he felt that market share beyond that level would be difficult to obtain, since many customers were more concerned about cost considerations than quality of performance. Roy also considered a startup operation, but he concluded that purchase 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 current and future total market for building maintenance services in Lynchburg and a projection of Fabricare's market penetration that matched the historical performance of PBM, Roy estipard that sales revenues under his management could be: Roy felt a more reasonable liquidation value was $140,000. Roy and the Fabricare owners concurred that if an agreement to purchase was completed, the final sales price would be adjusted to reflect changes in the working capital accounts, from 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. Fabricare did have some good contracts on which Roy felt his firm could build. These contracts, although not long-term, were with customers who had used Fabricare for several years and were thought to be loyal. The owners of Fabricare were asking a price of $275,000. Roy's intuition told him that this asking price was too high, given the performance of Fabricare and Roy's own experience at PBM. Publicly traded building maintenance service firms were currently selling at a multiple of 65 percent of sales, and 8 times current earnings. Roy had recently learned about the concept of free cash flows and wanted to apply this valuation technique as well. Ig the Acquisition Assuming that Roy and Fabricare's owners could come to an agreement about price, a bigger problem faced Roy. How would he manage the two firms? While attending the M.B.A program, Roy had become good friends with Stuart Rogers, one of the members of his study group. Stuart worked for a large textile firm, but was seriously considering a career change for himself. He was even considering going into business himself. Like Roy, Stuart had been moved several times and had seen several of his friends lose their jobs after a major corporate restructuring. Roy and Stuart had several talks about the pros and cons of entrepreneurial life versus a career with a large corporation. Concerning Stuart, Roy had two major questions: (1) Should he ask Stuart to enter into the business with him? (2) If he did, how could he structure Stuart's entry so that he could build equity in the business? Other concerns were how to finance an acquisition of Fabricare, and how the ownership of the new company could be split to satisfy both Stuart and Roy. One evening after class, Stuart was complaining about his current job. Roy said, "Why don't you just 'cash it in' and join me in the building maintenance business? I've been considering acquiring another firm and I need a competent partner to manage that firm." Stuart asked for time to considered the proposition. This was a very big decision. After thinking about it for a month and discussing it with his wife, Stuart told Roy, "I've given your proposal serious consideration and I'd like to learn more about the opportunity. I'm concerned, however, about the amount of equity investment that would be required." Roy was ecstatic. They shook hands and vowed to work out the details. Then they went off to the Village Tavern to celebrate their new partnership. Both Roy and Stuart agreed that they should establish a baseline value for PBM before Stuart bought into the firm and before they pursued the acquisition of Fabricare. Roy felt that the profit (13.5 percent) and tax (30 percent) assumptions he had used in analyzing Fabricare should apply equally to PBM projections. Additionally, he felt that capital investments should equal depreciation, and that sales should rise to $1.2 million in 1992 , $1,350,000 in 1993,$1,500,000 in 1994,$1,600,000 in 1995 , and $1,700,000 per year thereafter. Pretax operating profits would be the same as for Fabricare-13.5 percent of sales. He projected that there would be an additional net working capital investment equal to $40,560 in 1992 and 16.9 percent of incremental sales thereafter. cing and Managing the Combined Firms Roy sat at his desk and began to estimate the value of both PBM and Fabricare. He also began to ponder the alternatives for bringing Stuart into an active management role in the combined firm. Stuart confided in Roy that he had savings of $110,000 that he could draw upon to help finance the venture. Roy felt that it was important for him to maintain majority ownership control in the new, combined firm. He initially decided that he would like to maintain at least 55 percent control of the new firm. However, Roy felt that it was important for Stuart to have a significant ownership stake so that he would have a strong incentive to work hard for the success of the firm. If Fabricare were purchased by Roy, and Stuart joined the combined firm with primary responsibility for the operation and performance of Fabricare, Stuart would have to come up with a substantial amount to fund his ownership interest. Roy preferred that Stuart arrange for the financing of his ownership interest in the new firm. A third member of their Wake Forest study group, Mike, was a senior banking executive with a major North Carolina bank, and they thought he might be helpful in arranging financing. However, they realized that banks were often reluctant to provide long-term financing for this type of venture. Roy felt that as a last resort, he could lend Stuart any funds needed (over a 10-year period at an interest rate of 10 percent) beyond the $110,000 that Stuart already had available. Another possibility that Roy considered was selling Stuart whatever portion of the business his $110,000 would buy and granting him an option to purchase a greater interest in the future. Roy knew that he wanted to purchase Fabricare as an entry into the Lynchburg market. He also knew that he needed a partner to manage the Fabricare operation. The basic tasks were (1) to determine a valuation for Fabricare; (2) to determine a valuation for the combined firms; and (3) to decide how to finance the purchase of Fabricare, In addition, Roy reflected on the prospect of working closely with Stuart and maintaining a productive and friendly relationship, while retaining control of the firms. After these problems had been solved, Roy still had to negotiate a price with the current owners of Fabricare and then work out a management agreement with Stuart. With these thoughts in mind, Roy turned on his calculator and began his analysis. EXHIBIT 1 PBM, INC. Statement of Income IBIT 2 PBM, INC. EXHIBIT 3 FABRicabe a... EXHIBIT 4 FABRICARE, INC. Balance Sheet December 31, 1991