Question

Investment Decisions for Big Spenders Inc.

Background

You are an Analyst for the professional service firm, FINACC LLP. Your firm specializes in providing a wide variety of internal business solutions for different clients. It is your first day on the job and a Manager in the Consulting area asks you for some help with an investment decision for one of your large clients, Big Spenders Inc. Ready to make an impression on your first day, you start reading the background information provided by the Manager.

Additional Information

Big Spenders Inc. has been working on diversifying its portfolio of investments and requires accounting advice for a decision between two car cleaning and detailing companies. Your responsibility is to perform a comparative analysis of the profitability of two potential equity investments. Your engagement manager on this job has given you a brief background on the operations of the two companies:

Auto Wash Bot Ltd.  (AWBL) has recently completed the research and development of a new touch screen app for all mobile devices. This new technology is both more user friendly than the current technology on the market. Auto Wash Bot Ltd has just signed a major contract to provide the Auto Wash Bot terminal to a major producer of mobile devices. The founder of the business would like to sell a 100% interest in the business for $290,000 in order to finance his new venture in AI industry.

Popeye’s Muscle Wash Ltd (PMWL) is a self-service, coin operated car wash located in a busy residential area. The company provides all of the services of a typical car wash, including soap, wax, vacuuming as well as pressure washing. PMWL has been long established and enjoys the loyalty and repeat business of many local residents. The current owner is getting up in age and would like to sell 100% ownership interest in the business for $310,000 to pursue retirement. The current year’s income statement is consistent with prior years.

One of the first tasks in the analysis of the potential equity acquisition is an assessment of each company’s current and future profitability. Your manager has provided you with copies of each company’s income statement (see below). Next, you are to calculate the expected return on the investment for each company. You have been asked to discuss any other issues that you believe are relevant to the investment decision.

The Consulting Manager would like you to prepare the report and have it on his desk for review first thing tomorrow morning. Once reviewed, this report will be submitted to Big Spenders Inc. in order to support their decision.

Auto Wash Bot Ltd.

Income Statement

For the Year Ended December 31, 2015

Revenue	$375,000
Cost of Goods Sold	86,250
Gross Profit	288,750
Other Expenses
Advertising	35,400
Office Expense	22,750
Research	45,000
Wages and Salaries	40,000
Total Other Expenses	143,150
Income Before Taxes	145,600
Income Tax	21,840
Net Income	$123,760

Popeye’s Muscle Wash Ltd

Income Statement

For the Year Ended December 31, 2015

Revenue	$375,000
Cost of Goods Sold	133,125
Gross Profit	241,875
Other Expenses
Advertising	5,200
Office Expense	17,400
Repairs and Maintenance	35,000
Wages and Salaries	50,000
Total Other Expenses	107,600
Income Before Taxes	134,275
Income Tax*	20,141
Net Income	$114,134

                                  

*Tax rate of 15% used.

Note to students: Issues are hidden within the case. It is your responsibility to read the case facts and identify the critical issues required for discussion and analysis.

Requirement

Firstly, as a financial analyst you have to analyze the profitability of both companies by using financial ratio analysis.  

Secondly, To finance this acquisition, Big Spenders Inc needs to issue bonds and common shares.  Currently, it can issue its 10 years semiannual bonds with 6% coupon rate at $990 per bond.  Big Spenders is a public company and its share is traded at Toronto Stock Exchange market.  The treasure bill earns 3% annually (Rf) and the market premium is 10%.  Big Spenders’s beta is 1.2 last year.  The investment will be financed with 40% debt and 60% equity, both based on market values. Assume the firm's tax rate is 15%.

Looking into further the investment opportunities, the accountant has forecasted the operating cash flows of both companies.  

Operating Cash Flows	Year 1	Year 2	Year 3	Year 4	Year 5
Auto Wash Bot Ltd	55,000	45,000	56,000	200,000	150,000
Popeye’s Muscle Wash Ltd	75,000	75,000	75,000	120,000	120,000

Explaining to your client which investment criteria the company can use to make its investment decision and what are the pros and cons?  Provide the calculation of the investment criteria you select and give recommendation to your client which company they should acquire.   

Answer 1

PART-1

Auto Wash Bot Ltd.	% of Sales	Amount ($)
Revenue	100%	3,75,000
Cost of Goods Sold		86,250
Gross Profit	77%	2,88,750
Other Expenses
Advertising		35,400
Office Expense		22,750
Research	12%	45,000
Wages and Salaries		40,000
Total Other Expenses	38%	1,43,150
Income Before Taxes		1,45,600
Income Tax		21,840
Net Income	33%	1,23,760

Popeye’s Muscle Wash Ltd.	% of Sales	Amount ($)
Revenue	100%	3,75,000
Cost of Goods Sold		1,33,125
Gross Profit	65%	2,41,875
Other Expenses
Advertising		5,200
Office Expense		17,400
Repairs and Maintenance		35,000
Wages and Salaries		50,000
Total Other Expenses	29%	1,07,600
Income Before Taxes		1,34,275
Income Tax*		20,141
Net Income	30%	1,14,134

	Auto Wash Bot Ltd.	Popeye’s Muscle Wash Ltd.
Gross Profit Margin	77%	65%
Net Profit Margin	33%	30%

GPM :- Auto Wash Bot Ltd. has higher GPM indicating better efficiency of operations and higher pricing.

NPM :- Higher NPM of Auto Wash Bot Ltd. tell us about the relative efficiency of the firm after taking into account all expenses and income taxes.

- The gross profit ratio of auto robot is 77% while Popey's Muscle wash is 65%. As business grows the fixed overhead expenses do not increase in same proportion. Hence, the company with higher gross margin is preferable.

- Further, the research expenses may not be incurred in future and after such adjustment the net profitability of auto robot might be 50.83% whereas Popey's Muscle wash have net profit before tax of 35.81%

R&D expense by Auto Wash Bot Ltd. might lead to superior cash flows in future as well.

PART - 2

Step 1: Calculating Cost of Capital (WACC)

Par Value	1000
Coupon rate	6%
Payment frequency	2
Time to maturity	10
Price of bond	990
YTM	6.14%

Pre-tax cost of debt = YTM = 6.14%

Risk-free rate	3%
β	1.2
Market premium	10%

CAPM: Cost of Equity = Risk-free rate + β*Market premium = 15%

% Debt	40%
Pre-tax cost of debt	6.14%
After-tax cost of debt	5.21%
% Equity	60%
Cost of Equity	15%
WACC	11.09%

Step 2: NPV & IRR Analysis

Assumption - No Terminal value for the 2 companies at the end of 5 years.

2 (A) NPV of Auto Wash Bot Ltd.

Auto Wash Bot Ltd.	0	1	2	3	4	5
Initial Capital Investment	-290000
Operating Cash flow		55000	45000	56000	200000	150000
Tax		8250	6750	8400	30000	22500
After-tax cash flow		46750	38250	47600	170000	127500
NPV	4815.52
IRR	11.61%

2 (B) NPV of Popeye’s Muscle Wash Ltd.

Popeye’s Muscle Wash Ltd.	0	1	2	3	4	5
Initial Capital Investment	-310000
Operating Cash flow		75000	75000	75000	120000	120000
Tax		11250	11250	11250	18000	18000
After-tax cash flow		63750	63750	63750	102000	102000
NPV	-27165
IRR	7.85%

Explaining to your client which investment criteria the company can use to make its investment decision and what are the pros and cons?

The company can use either the NPV method or IRR method to evaluate the suitability of both acquisition options.

NPV (Popeye’s Muscle Wash Ltd.) = negative, which indicates that this acquisition is going to be value destroying for the company and it should not acquire this option.

NPV (Auto Wash Bot Ltd.) = positive, which means acquiring this company will be value-adding to the parent firm.

Similarly, an acquisition option is suitable if IRR>WACC.

With Auto Wash Bot Ltd., IRR = 11.61% > WACC = 11.09%. Hence, this acquisition option is suitable.