Question

Case Analysis 3: 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:

Before Tax Cash Flow From Operations

Year 1 $(149,000)

Year 2 $0

Year 3 $51,380

Year 4 $88,760

Year 5 $114,100

Year 6 $129,780

Year 7 $143,640

Year 8 $167,300

After Tax Net Income From Operations

Year 1 $(103,500)

Year 2 $(50,500)

Year 3 $36,700

Year 4 $63,400

Year 5 $81,500

Year 6 $92,700

Year 7 $102,600

Year 8 $119,500

After Tax Cash Flow From Operations

Year 1 $(85,600)

Year 2 $15,000

Year 3 $48,600

Year 4 $72,200

Year 5 $95,550

Year 6 $101,300

Year 7 $125,200

Year 8 $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 $15,000 in year 2 and then $15,000 in year 5.

• BSL usually spend about $275,000 per year in advertising. If you make this acquisition, you would ask that advertising spending be increased by an incremental one-time amount of $45,000 in year 0 to publicize the firm’s 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%. 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 13% rate discount. Obviously you will want to select the most appropriate discount rate for this type of project.

• At the end of 8 years, the plan is to sell this division. The estimated terminal value (the sale and the return of working capital) is conservatively estimated to be $350,000 of after-tax cash flow help.

Using the data that you need (and ignoring the extraneous information), for this potential acquisition, calculate each of the following items: the Nominal Payback, the Discounted Payback, the Net Present Value, the IRR.

In an MS Word document, in paragraph form, respond to the following questions:

1) From a purely financial (numbers) perspective, would you recommend this purchase to management? Why?

2) What are some of the non-financial elements that need to be considered for this proposal?

3) Assumptions in project economics can have a huge impact on the result. Identify 3 financial elements/assumptions in your analysis that would make this project financially unattractive? In other words, what would have to be true for this to be a bad investment?

4) If you were the CEO, would you approve this proposal? Why or why not?

Answer 1

Step 1: Calculate Annual Net Cash Flows

The value of annual net cash flows is arrived as below:

Cash Flow Year 0 = Purchase Price + Working Capital + Incremental Advertising = 200,000 + 60,000 + 45,000 = $305,000

Cash Flow Year 1 = -$85,600

Cash Flow Year 2 = Annual After-Tax Flow Inflow for Year 2 - Working Capital = 15,000 - 15,000 = $0

Cash Flow Year 3 = $48,600

Cash Flow Year 4 = $72,200

Cash Flow Year 5 = Annual After-Tax Flow Inflow for Year 5 - Working Capital = 95,550 - 15,000 = $80,550

Cash Flow Year 6 = $101,300

Cash Flow Year 7 = $125,200

Cash Flow Year 8 = Annual After-Tax Flow Inflow for Year 8 + Terminal Value = 140,200 + 350,000 = $490,200

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Step 2: Calculate Nominal Payback Period

The nominal payback period is calculated as below:

Year	Cash Flow	Cumulative Cash Flow
0	-305,000	-305,000
1	-85,600	-390,600
2	0	-390,600
3	48,600	-342,000
4	72,200	-269,800
5	80,550	-189,250
6	101,300	-87,950
7	125,200	37,250
8	490,200	527,450

As can be seen from the above table that cumulative cash flows turn positive from negative between Year 6 and Year 7. Therefore, the payback period will fall between year 6 and year 7. The formula for payback period can be derived as below:

Payback Period = Years upto which Partial Recovery is Made + Balance Amount/Cash Flow of the Year in which Full Recovery is Made = 6 + 87,950/125,200 = 6.70 years

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Step 2: Calculate Discounted Payback Period

The discounted payback period is calculated as below:

Year	Cash Flow (A)	Discount Rate @13% (B)	Discounted Cash Flows (A*B)	Cumulative Discounted Cash Flows
0	-305,000	1.0000	-305,000	-305,000
1	-85,600	0.8850	-75,756	-380,756
2	0	0.7831	0	-380,756
3	48,600	0.6931	33,685	-34,7071
4	72,200	0.6133	44,280	-302,791
5	80,550	0.5428	43,723	-259,069
6	101,300	0.4803	48,654	-210,414
7	125,200	0.4251	53,223	-157,192
8	490,200	0.3762	184,413	27,222

As can be seen from the above table that cumulative discounted cash flows turn positive from negative between Year 7 and Year 8. Therefore, the payback period will fall between year 7 and year 8. The formula for discounted payback period can be derived as below:

Discounted Payback Period = Years upto which Partial Recovery is Made + Balance Amount/Cumulative Discounted Cash Flow of the Year in which Full Recovery is Made = 7 + 157,192/184,413 = 7.85 years

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Step 3: Calculate NPV

NPV is the difference between the discounted present value of cash outflows and cash inflows. The NPV is determined with the use of following table as below:

Year	Cash Flow (A)	Discount Rate @13% (B)	Discounted Cash Flows (A*B)
0	-305,000	1.0000	-305,000
1	-85,600	0.8850	-75,756
2	0	0.7831	0
3	48,600	0.6931	33,685
4	72,200	0.6133	44,280
5	80,550	0.5428	43,723
6	101,300	0.4803	48,654
7	125,200	0.4251	53,223
8	490,200	0.3762	184,413
NPV			$27,222

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Step 4: Calculate IRR

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic for calculating IRR is provided as below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 1/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5 + Cash Flow Year 6/(1+IRR)^6 + Cash Flow Year 7/(1+IRR)^7 + Cash Flow Year 8/(1+IRR)^8

IRR is calculated with the use of EXCEL as below:

where IRR = IRR(B2:B10) = 14.25%

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Part 1)

Yes, I would recommend this purchase to the management of the company. It is because it generates a positive NPV ($27,222) and IRR (14.25%) greater than the cost of capital (13%). Also, the total cost of investment gets recovered within the estimated life of the project.

______

Part 2)

The non-financial elements that need to be considered for this proposal are provided below:

1) The time duration of the project.

2) The changes in business risks and economic conditions.

3) Impact of making the purchase on employee/staff morale.

______

Part 3)

The three financial elements that would make the project financially unattractive are given as follows:

1) The NPV of the project is zero.

2) The internal rate of return is less than the cost of capital.

3) The investment is not recovered within the estimated life of the project.

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Part 4)

Yes, I would approve the proposal. It is because the project will generate a positive NPV. NPV is considered as one of the best investment evaluation techniques while making a decision with respect to accepting/rejecting a project/investment.