Question

Problem #1​ ​The Pierced Ear, Inc. The Pierced Ear, Inc. has been solicited by an owner of five stores within the greater Los Angeles area who is contemplating the sale of his company and exploring the possibility of The Pierced Ear as a potential buyer. Listed below are the five stores and the sales volume for their most recent fiscal year: GLENDALE ​WEST SIDE ​ MONTEBELLO ​ FOX HILLS ​SHERMAN GALLERIA​PAVILION ​TOWN CENTER​ MALL ​OAKS ​$452,000 ​ $350,000 ​ $325,000​$365,000 ​ $311,000 The Pierced Ear feels that the annual sales volume most recently generated by the existing company is a basis for projecting its own sales. As a guideline, the merchandising department feels that there is a 40% probability that the stores will do last year's business....a 40% probability that they will do 5% more volume than last year...and lastly, a 20% probability that they will do 10% more volume than last year. Given the projected first year's sales volume (from above) that The Pierced Ear anticipates generating; it is projected that the sales will thereafter experience a compound annual growth rate of 3% per year until all leases expire. Each of the stores has 6 years left on their respective leases with no provision for renewing the leases at their intended expiry date. The Pierced Ear feels that each store will initially require a $50,000 remodeling cost immediately upon purchase of the stores, as well as an immediate required inventory investment of $50,000 in each of the five locations, with an additional amount of required inventory in the following year of $20,000 for each of the locations. The Pierced Ear estimates that the Gross Profit will approximate 60% of Sales and Total Operating Expenses are estimated at 44% of Sales. Aggregate depreciation, for all of the stores, (the provision of which, is already included in Operating Expenses), is estimated at $100,000 per year. The combined Federal and State marginal tax rate is 25%. The Pierced Ear, Inc. explores each potential location it opens through a "Net Present Value" analysis. The acquisition, if undertaken, will be all equity financed. Thus, as to its Cost of Equity Capital, The Pierced Ear utilizes an industry proxy of 18%. The owner of the five stores is seeking $650,000 for all the assets and rights of all of his five stores under the respective leases. It is assumed that The Pierced Ear could immediately sell off the present owner’s inventory (which has an estimated retail value of $150,000), for 50% of its original retail (disregard any tax considerations in connection with the salvage value of the seller’s inventory). The deal is essentially all five stores or nothing at all. With consideration to the above, should The Pierced Ear, Inc. undertake the acquisition? Does the deal make sense as it stands OR if it does not appear viable, what might you counter-propose to the seller? Please quantify the results of your recommendation(s). Note…because it is an all or nothing at all deal, there is no need to individualize each store, but to view the value of the proposal in its entirety.

Answer 1

We will do all the analysis at the consolidated level (5 stores put together).

Collective revenue last year = $452,000 ​+ $350,000 ​ + $325,000 + ​$365,000 ​ + $311,000 =  1,803,000

As a guideline, the merchandising department feels that there is a 40% probability that the stores will do last year's business....a 40% probability that they will do 5% more volume than last year...and lastly, a 20% probability that they will do 10% more volume than last year.

Expected revenue next year = Sum of (Probability x revenue) = 40% x 1,803,000 + 40% x (1 + 5%) x 1,803,000 + 20% x (1 + 10%) x 1,803,000 =  1,875,120

Annual growth rate, g = 3%

Expected revenue in subsequent year will grow by g = 3%. Hence next year's revenue will be 1,875,120 x (1 + 3%) =  1,931,374 and revenue in third year will be =  1,931,374 x (1 + 3%) =  1,989,315 and so on.....

The Pierced Ear estimates that the Gross Profit will approximate 60% of Sales and Total Operating Expenses are estimated at 44% of Sales.

Pre tax profit margin = 60% - 44% = 16%

Aggregate depreciation, for all of the stores, (the provision of which, is already included in Operating Expenses), is estimated at $100,000 per year.

Please see the table below. Please be guided by the second column titled “Linkage” to understand the mathematics. The last row highlighted in yellow is PV of all future cash flows, a very relevant figure. Figures in parenthesis, if any, mean negative values. All financials are in $. Adjacent cells in blue contain the formula in excel I have used to get the final output.

The owner of the five stores is seeking $650,000 for all the assets and rights of all of his five stores under the respective leases.

With consideration to the above, should The Pierced Ear, Inc. undertake the acquisition?

Yes, this acquisition should be undertaken, as PV of all future cash flows = 806,247 > Purchase consideration of $ 650,000 thus resulting into a positive NPV = 806,247 - 650,000 = $ 156,247. Since it's a positive, the acquisition should be undertaken.

Does the deal make sense as it stands OR if it does not appear viable, what might you counter-propose to the seller?

The deal makes sense at the desired price of $ 650,000 as it results into positive NPV for the acquirer.