Question

Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers has determined that Fast Fruit's current cost of equity is 17.5%; Fast Fruit currently has no debt outstanding. In Year 1, Juicers expects Fast Fruit to generate $9 million in NOPAT and invest $50 million in total net operating capital. Fast Fruit will borrow to finance this expansion, with the first interest payment ($5 million) due at Year 2. (There will be no interest due at Year 1.) In Year 2, Fast Fruit will generate $25 million in NOPAT and invest $10 million in total net operating capital. Fast Fruit's marginal tax rate is 25%. After the second year, the free cash flows and the tax shields each will grow at a constant rate of 4%. Assume that all cash flows occur at the end of the year. If Juicers must pay $90 million to acquire Fast Fruit, what is the NPV of the proposed acquisition? (Report your answer in millions of dollars.

Answer 1

Answer -

Statement showing computation of Free Cash Flows of Fast Fruit Company at year 1 & 2

Particulars	Year 1	Year 2
NOPAT	$9,000,000	$25,000,000
(-) Interest	0	- $5,000,000
Cash Flow	$9,000,000	$20,000,000
(-) Investment in Operating Capital	0	- $10,000,000
Free Cash Flow	$9,000,000	$10,000,000

Using Gordon growth model we can estimate the value of future cash flows with constant growth rate.

Value of Fast Fruit Company at Year 2 = Free Cash Flow at Year 3 / (Cost of capital - Growth rate)

Where-

Cost of capital is current cost of equity given as 17.5%

Growth rate is given as 4%

Free Cash Flow at Year 3 = Free Cash Flow at Year 2 + Growth rate

Free Cash Flow at Year 3 = $10,000,000 + $10,000,000 * 4%

Free Cash Flow at Year 3 = $10,400,000

On putting these figures in the above formula, we get -

Value at Year 2 = Free Cash Flow at Year 3 / (Cost of capital - Growth rate)

Value at Year 2 = $10,400,000 / (0.175 - 0.04)

Value at Year 2 = $10,400,000 / 0.135

Value at Year 2 = $77,037,037

Statement showing present value of free cash flows of Fast Fruit Company

Year	Particulars	Amount (A)	Discount Factor @ 17.5% (B)	Present Value (A * B)
1	Free cash flow	$9,000,000	0.851064	$7,659,574
2	Free cash flow	$10,000,000	0.724310	$7,243,096
2	Free cash flow	$77,037,037	0.724310	$55,798,669
	Present Value	$70,701,340

Hence,

NPV of the proposed acquisition = Present value of Fast Fruit Company - Purchase price paid by Juicers Inc.

NPV of the proposed acquisition = $70,701,340 - $90,000,000

NPV of the proposed acquisition = -$20,701,340