Question

Please complete this table pertaining to a case study

In December 2018, Steve Baily, the owner of California Coast General Stores announced the highest sales, $50, and profitability of $10 to its employees.

Founded in 1980, California Coast General Stores (CCGS), a regional west coast chain, owns several gas stations, mini-marts, and Auto rentals.

Explaining the original long-term success of the company, a financial analyst commented that the success of the company is due to its sustained growth rate, efficiency and cost savings. As a result, the company is cash rich and is looking to expand its operation.

One of the options that the company considered is to acquire a complementary company. John Marks, the company’s CFO and treasurer was asked to find the suitable acquisition. John identified Prestige Auto Shops, a chain which operates in several adjacent States. Prestige is a privately held company managed by three Johnson’s brothers. They own 10 million shares of the company and they have priced the stock price of the company internally at $20 per share.

Table-1 indicates John’s estimates of Prestige’s earnings potential if it came under CCGS’s management (in millions of dollars). The interest expense is based on Prestige’s existing debt, which is $20 million at a rate of 8 percent. It is expected new debt at rate of 8% to be issued over time to help finance investment in operating capital.

Security analysts based on comparable companies estimate the Prestige’s beta to be 1.28. The acquisition would not change Prestige capital structure, which is 25 percent debt-to value. John realizes that Prestige business plan requires investment in operating capital (net working capital and capital expenditures). The growth rate for operating capital is listed in table (1).

John estimates the risk-free rate to be 3 percent and the market risk premium to be 6 percent. He also estimates that free cash flows after 2023 will grow at a constant rate of 5 percent. Following are projections for sales and other items.

Table -1		Year	2018	2019	2020	2021	2022	2023
Sales growth rate				50%	30%	20%	10%	5%
Net sales			$40
Cost of goods sold	60%		$24
Selling/administrative expense	10%		$4
EBIT			$12
Taxes on EBIT	30%		($3.60)
NOPAT			$8.40
Initial investment in operating capital (NWC +Capex)			$100
Growth in Operating Capital				6%	5%	4%	3%	3%
Interest expense			$1.60

Answer 1

Table-1		Year	2018 ($)	2019 ($)	2020 ($)	2021 ($)	2022 ($)	2023 ($)
Sales growth rate				50%	30%	20%	10%	5%
Net Sales			40	60	78	93.60	102.96	108.11
Cost of goods sold	60%		24	36	46.80	56.16	61.78	64.87
Selling/administrative expense	10%		4	6	7.80	9.36	10.30	10.81
EBIT			12	18	23.40	28.08	30.88	32.43
Taxes on EBIT	30%		(3.60)	(5.40)	(7.02)	(8.42)	(9.26)	(9.73)
NOPAT			8.40	12.60	16.38	19.66	21.62	22.70

• As the expected growth rates of sales are given in the case study, we have to find out Net Sales by the following way:

(Sales growth rate x Net Sales of previous year) + Net Sales of previous year

For example, for 2019, Net Sales is expected to be = (50% of $40 million) + $40 million

= $20 million + $40 million = $60 million.

• Cost of goods sold is 60% of net sales of that particular year

For example, for 2019, Cost of goods sold = 60% of $60 million = $36 million.

• Selling/administrative expense is 10% of net sales of that particular year

For example, for 2019, selling/administrative expense = 10% of $60 million = $6 million.

• EBIT = Net Sales - Cost of goods sold - Selling/administrative expense

For example, for 2019, EBIT = $60 million - $36 million - $6 million = $18 million.

• Taxes on EBIT = Tax Rate @ 30% on EBIT of that particular year

For example, for 2019, Taxes on EBIT = 30% of $18 million = $5.40 million.

• NOPAT = EBIT - Taxes on EBIT

For example, for 2019, NOPAT = $18 million - $5.40 million = $12.60 million.

	Year	2018 ($)	2019 ($)	2020 ($)	2021 ($)	2022 ($)	2023 ($)
Initial investment in operating capital (NWC + Capex)		100	106	111.30	115.75	119.22	122.80
Growth in Operating Capital			6%	5%	4%	3%	3%
Interest expense		1.60	2.08 (8% of $26 million)	2.50 (8% of $31.30 million)	2.86 (8% of $35.75 million)	3.14 (8% of $39.22 million)	3.42 (8% of $42.80 million)

It is given in the case study that new debt is to be issued @ 8% to finance investment in operating capital. Therefore, any increase in the operating capital represents increase in debt.

It is also given in the case study that the acquisition by CCGS would not change the capital structure of Prestige, which is 25% debt-to value. The share capital of the company is: 10 million shares x $20 per share = $200 million. The existing debt of Prestige is $20 million. To maintain the capital structure, maximum amount of debt that can be raised = 25% of $200 million = $50 million. Therefore, they can issue another $30 million ($50 million - $20 million existing) new debt. The capital structure will not be changed as over the years, fresh debt that will be issued is $22.80 million ($122.80 million - $100 million), which adds up to a total of $42.80 million ($20 million + $22.80 million), which is still less that $50 million.

• We calculate investment in operating capital in the following way:

(Growth in operating capital x operating capital of previous year) + operating capital of previous year

For example, for 2019, investment in operating capital = (6% of $100 million) + $100 million = $106 million.

• Any increase in operating capital is financed by issue of debt @ 8%. Out of $100 million operating capital in 2018, $20 million is debt. So, debt of 2019 = $20 million + ($106 million - $100 million) = $20 million + $6 million = $26 million.

In 2020, debt will be = $26 million + ($111.30 million - $106 million) = $26 million + $5.3 million = $31.30 million.

In 2021, debt will be = $31.30 million + ($115.75 million - $111.30 million) = $31.30 million + $4.45 million = $35.75 million.

In 2022, debt will be = $35.75 million + ($119.22 million - $115.75 million) = $35.75 million + $3.47 million = $39.22 million.

In 2023, debt will be = $39.22 million + ($122.80 million - $119.22 million) = $39.22 million + $3.58 million = $42.80 million.

The calculations for interest expense is shown in the table itself.