Question

Hillsdale Media is a specialty kitchen cabinet maker that produces cabinets to order. It is a mature business that earned EBITDA of $900,000 on revenues of $ 5 million in the most recent year and is expected to continue to generate these figures in perpetuity. The company is considering carrying some of its most popular models in inventory, with an eye on increasing sales and operating profits. It has collected the following information: • To carry inventory, the company will have to invest $2.25 million in a storage facility, which will be depreciated straight line over ten years down to a salvage value of $250,000. • With the inventory, the company expects its annual revenues to increase to $7.5 million and its overall EBITDA margin (EBITDA as % of sales) to increase to 20%. • For the next decade, the inventory will be maintained at 10% of total revenues, with the investment made at the start of each year. The inventory will be sold for book value at the end of ten years. • The cost of capital for the company is 10% and it faces a 40% tax rate

a. Estimate the NPV of the project (carrying inventory) assuming at ten-year life for the investment. (4 points)

b. Estimate the breakeven EBITDA margin for the company, for the investment to have a zero NPV, if you now assume that the project lasts forever. (2 points)

Answer 1

Answer a:

Annual Revenue from Year 1 to Year 10 = $7,500,000

Increase in working capital required at start of year 1 or at the end of year 0 = $7,500,000 * 10% = $750,000

This additional inventory will be released at the end of year 10.

PV Interest Factors for a One-Dollar Annuity Discounted at 10% for 9 Periods = 5.75902

PV Interest Factors for One Dollar Discounted at 10% for 10 Periods = 0.38554

The cash flows in 'Year 0', 'Year 1 to 9' and in 'Year 10', discounted cash flows and NPV are calculated as follows:

NPV of the project (carrying inventory) = $3,407,219

Answer b:

If we assume project lasts forever.

Then depreciation = 0 and salvage value = 0

The additional working capital invested will remain invested forever.

Annual cashflows will remain same forever.

Hence Investment = Investment in storage facility + additional working capital required

= $2,250,000 + $10% * $7,500,000

= $3,000,000

Cost of capital required = 10%

Hence to get NPV = 0 , we will need a perpetual cash flow = $3,000,000 * 10% = $300,000

EAT required = $300,000

EBT/EBIDTA required = $300,000 / (1 - Tax %) = $300,000 / (1- 40%)

= $500,000

EBIDTA % required = $500,000 / $7,500,000 = 6.67%