Question

Assessment of an Acquisition in Thailand

Recall that Ben Holt, Blades’ chief financial officer (CFO), has suggested to the board of directors that Blades proceed with the establishment of a subsidiary in Thailand. Due to the high growth potential of the roller blade market in Thailand, his analysis suggests that the venture will be profitable. Specifically, his view is that Blades should establish a subsidiary in Thailand to manufacture roller blades, whether an existing agreement with Entertainment Products (a Thai retailer) is renewed or not. Under this agreement, Entertainment Products is committed to the purchase of 180,000 pairs of Speedos, Blades’ primary product, annually. The agreement was initially for three years and will expire two years from now. At this time, the agreement may be renewed. Due to delivery delays, Entertainment Products has indicated that it will renew the agreement only if Blades establishes a subsidiary in Thailand. In this case, the price per pair of roller blades would be fixed at 4,594 Thai baht per pair. If Blades decides not to renew the agreement, Entertainment Products has indicated that it would purchase only 5,000 pairs of Speedos annually at prevailing market prices.

According to Holt’s analysis, renewing the agreement with Entertainment Products and establishing a subsidiary in Thailand will result in a net present value (NPV) of $2,638,735. However, if the agreement is not renewed and a subsidiary is established, the resulting NPV will be $8,746,688. Consequently, Holt has suggested to the board of directors that Blades establish a subsidiary without renewing the existing agreement with Entertainment Products.

Recently, a Thai roller blade manufacturer called Skates’n’Stuff contacted Holt regarding the potential sale of the company to Blades. Skates’n’Stuff entered the Thai roller blade market a decade ago and has generated a profit in every year of operation. Furthermore, Skates’n’Stuff has established distribution channels in Thailand. Consequently, if Blades acquires the company, it could begin sales immediately and would not require an additional year to build the plant in Thailand. Initial forecasts indicate that Blades would be able to sell 280,000 pairs of roller blades annually. These sales are incremental to the acquisition of Skates’n’Stuff. Furthermore, all sales resulting from the acquisition would be made to retailers in Thailand. Blades’ fixed expenses would be 20 million baht annually. Although Holt has not previously considered the acquisition of an existing business, he is now wondering whether acquiring Skates’n’Stuff may be a better course of action than building a subsidiary in Thailand.

Holt is also aware of some disadvantages associated with such an acquisition. Skates’n’Stuff’s CFO has indicated that he would be willing to accept a price of 1 billion baht in payment for the company, which is clearly more expensive than the 550 million baht outlay that would be required to establish a subsidiary in Thailand. However, Skates’n’Stuff’s CFO has indicated that it is willing to negotiate. Furthermore, Blades employs a high-quality production process, which enables it to charge relatively high prices for roller blades produced in its plants. If Blades acquires Skates’n’Stuff, which uses an inferior production process (resulting in lower quality roller blades), it would have to charge a lower price for the roller blades it produces there. Initial forecasts indicate that Blades will be able to charge a price of 4,500 Thai baht per pair of roller blades without affecting demand. However, because Skates’n’Stuff uses a production process that results in lower quality roller blades than Blades’ Speedos, operating costs incurred would be similar to the amount incurred if Blades establishes a subsidiary in Thailand. Thus Blades estimates that it would incur operating costs of about 3,500 baht per pair of roller blades.

Holt has asked you, a financial analyst for Blades, Inc., to determine whether the acquisition of Skates’n’Stuff is a better course of action for Blades than the establishment of a subsidiary in Thailand. Acquiring Skates’n’Stuff will be more favorable than establishing a subsidiary if the present value of the cash flows generated by the company exceeds the purchase price by more than $8,746,688, the NPV of establishing a new subsidiary. Thus Holt has asked you to construct a spreadsheet that determines the NPV of the acquisition. To aid you in your analysis, Holt has provided the following additional information, which he gathered from various sources, including unaudited financial statements of Skates’n’Stuff for the last three years:

Blades, Inc., requires a return on the Thai acquisition of 25 percent, the same rate of return it would require if it established a subsidiary in Thailand.

If Skates’n’Stuff is acquired, Blades, Inc., will operate the company for 10 years, at which time Skates’n’Stuff will be sold for an estimated 1.1 million baht.

Of the 1 billion baht purchase price, 600 million baht constitutes the cost of the plant and equipment. These items are depreciated using straight-line depreciation. Thus 60 million baht will be depreciated annually for 10 years.

Sales of 280,000 pairs of roller blades annually will begin immediately at a price of 4,500 baht per pair.

Variable costs per pair of roller blades will be 3,500 per pair.

Fixed operating costs, including salaries and administrative expenses, will be 20 million baht annually.

The current spot rate of the Thai baht is $.023. Blades expects the baht to depreciate by an average of 2 percent per year for the next 10 years.

The Thai government will impose a 25 percent tax on income and a 10 percent withholding tax on any funds remitted by Skates’n’Stuff to Blades, Inc. Any earnings remitted to the United States will not be taxed again in the United States. All earnings generated by Skates’n’Stuff will be remitted to Blades, Inc.

The average inflation rate in Thailand is expected to be 12 percent annually. Revenues, variable costs, and fixed costs are subject to inflation and are expected to change by the same annual rate as the inflation rate.

In addition to the information outlined above, Holt has informed you that Blades, Inc., will need to manufacture all of the 180,000 pairs to be delivered to Entertainment Products this year and next year in Thailand. Because Blades previously only used components from Thailand (which are of a lower quality but cheaper than U.S. components) sufficient to manufacture 72,000 pairs annually, it will incur cost savings of 32.4 million baht this year and next year. However, because Blades will sell 180,000 pairs of Speedos annually to Entertainment Products this year and next year whether it acquires Skates’n’Stuff or not, Holt has urged you not to include these sales in your analysis. The agreement with Entertainment Products will not be renewed at the end of next year.

Holt would like you to answer the following questions:

Using a spreadsheet, determine the NPV of the acquisition of Skates’n’Stuff. Based on your numerical analysis, should Blades establish a subsidiary in Thailand or acquire Skates’n’Stuff?

If Blades negotiates with Skates’n’Stuff, what is the maximum amount (in Thai baht) Blades should be willing to pay?

Are there any other factors Blades should consider in making its decision? In your answer, you should consider the price Skates’n’Stuff is asking relative to your analysis in question 1, other potential businesses for sale in Thailand, the source of the information your analysis is based on, the production process that will be employed by the target in the future, and the future management of Skates’n’Stuff

Answer 1

Cash Inflow
	Gross Profit
	Sales - Variable cost	Fixed Cost	Net Profit	35% tax	Cash Inflow	Tax Saving On Depreciation	Cash Inflow	Discount @25%		$ rate	Cash inflow in$
1	280,000,000	20,000,000	260,000,000	91,000,000	169,000,000	15000000	184,000,000	0.8	147,200,000	0.023	3,385,600
2	313,600,000	22,400,000	291,200,000	101,920,000	189,280,000	15000000	204,280,000	0.64	130,739,200	0.02254	2,946,862
3	351,232,000	25,088,000	326,144,000	114,150,400	211,993,600	15000000	226,993,600	0.512	116,220,723	0.022089	2,567,223
4	393,379,840	28,098,560	365,281,280	127,848,448	237,432,832	15000000	252,432,832	0.4096	103,396,488	0.021647	2,238,267
5	440,585,421	31,470,387	409,115,034	143,190,262	265,924,772	15000000	280,924,772	0.32768	92,053,429	0.021214	1,952,864
6	493,455,671	35,246,834	458,208,838	160,373,093	297,835,744	15000000	312,835,744	0.262144	82,008,013	0.02079	1,704,961
7	552,670,352	39,476,454	513,193,898	179,617,864	333,576,034	15000000	348,576,034	0.209715	73,101,693	0.020374	1,489,401
8	618,990,794	44,213,628	574,777,166	201,172,008	373,605,158	15000000	388,605,158	0.167772	65,197,127	0.019967	1,301,784
9	693,269,689	49,519,264	643,750,426	225,312,649	418,437,777	15000000	433,437,777	0.134218	58,175,034	0.019568	1,138,343
10	776,462,052	55,461,575	721,000,477	252,350,167	468,650,310	15000000	483,650,310	0.107374	51,931,557	0.019176	995,850
Add: Sale after 10 year							1,100,000	0.107374	118,112	0.019176	2,265
											19,723,419
Cash Outflow											23,000,000
NPV											(3,276,581)

As per the calculation above the NPV is negative and hence its better for Blade to open a subsdiary in Thailand.