Question

This question has two parts

Part 1

You are CFO of a major chain of restaurants called Chipotle. In an increasingly challenging business environment, Chipotle is considering an acquisition of its major competitor, Los Pollos Hermanos (LPH). Your research indicates that LPH is expected to generate a positive cashflow of $186 million per year for each of the next 20 years. The first of the annual cashflows will be received one year from today. You estimate that an appropriate opportunity interest rate (required return) for this transaction is 11%.

Part 2

During preliminary negotiations with the owners of Los Pollos Hermanos, you have been offered the opportunity to acquire LPH for $1.35 billion (to be paid today). Using time value of money concepts, show whether you should accept the deal.

Some recent questions have been raised about operational risk involving certain product offerings of Los Pollos Hermanos. You know that valuation models primarily incorporate risk through the estimation of the interest rate (required return). Explain how an increase in the interest rate would affect your decision (from part a).

Answer 1

Part 1

we need to calculate present value of future cash flows and then compare that sum of present value of future cash flows to offer price to determine whether you should accept the deal or not.

Years	Cash flows	Present value
1	$186,000,000	$167,567,567.57
2	$186,000,000	$150,961,772.58
3	$186,000,000	$136,001,596.92
4	$186,000,000	$122,523,961.19
5	$186,000,000	$110,381,947.02
6	$186,000,000	$99,443,195.51
7	$186,000,000	$89,588,464.43
8	$186,000,000	$80,710,328.31
9	$186,000,000	$72,712,007.49
10	$186,000,000	$65,506,313.05
11	$186,000,000	$59,014,696.44
12	$186,000,000	$53,166,393.19
13	$186,000,000	$47,897,651.52
14	$186,000,000	$43,151,037.41
15	$186,000,000	$38,874,808.48
16	$186,000,000	$35,022,349.98
17	$186,000,000	$31,551,666.65
18	$186,000,000	$28,424,924.91
19	$186,000,000	$25,608,040.46
20	$186,000,000	$23,070,306.72
Total		$1,481,179,029.83

Calculation

Part 2

you should accept the deal because sum of present value of cash flows is $1.48 billion which is higher than the offer price of $1.35 billion. so you will make a profit of $1.48 - $1.35 = $0.13 billion from this deal.

increase in interest rate would increase opportunity interest rate (required return). higher opportunity interest rate (required return) will reduce sum of present value of cash flows which can make this deal unprofitable and you may have to reject the deal.