ASSIGNMENT 2 QUESTIONS

Assignment 2 Questions

Problem 6.7 Common Size Financial Statements

The balance sheet and income statement for Webb Enterprises Inc. are found below:

A .Prepare a common size balance sheet for Webb Ent

B. Prepare a common size income statement for Webb Ent

C. Use your common size financial statements to respond to your boss’ request that you write up your assessment of the firm’s financial condition. Specifically, write up a brief narrative that responds to the following questions:

a. How much cash does Webb have on hand relative to its total assets?

b. What proportion of Webb’s assets has the firm financed using short term debt?

c. What percent of Webb’s revenues does the firm have left over after paying all of its expenses (including taxes)?

d. Describe the relative importance of Webb’s major expense categories, including cost of goods sold, operating expenses, and interest expenses.

Problem 7.2 Analyzing a project with back-loaded earnings

Hospital Services Inc. (HIS) provides health care services primarily in the western part of USA. The firm operates psychiatric hospitals that provide mental health care services using inpatient, partial hospitalization, and outpatient settings. In the spring of 2010, the firm was considering an investment in a new patient –monitoring system that costs $6 million per hospital to install. The new system is expected to contribute to firm EBITDA via annual savings of $2.4 million in Year 1 and 2, plus $4.25 million in Year 3.

The firm’s CFO is interested in investing in the new system but is concerned that the savings from the system are such that the immediate impact of the project may be to dilute the firm’s earnings. Moreover, the firm has just moved to an economic profit-based bonus system, and the CFO fears that the project may also make the individual economic profits of the hospitals look bad – a development that would generate resistance from the various hospital managers if they saw their bonuses being decreased.

a.       Assuming that the cost of capital for the project is 15%, that the firm faces a 30% marginal tax rate, and that it uses straight-line depreciation over three-year life for the new investment and that it has a zero salvage value, calculate the project’s expected NPV and IRR.

b.      Calculate the annual economic profits for the investment for Years 1 through 3. What is the present value of the annual economic measures discounted using the project’s cost of capital? What potential problems do you see for the project?

c.       Calculate the economic depreciation for the project, and use it to calculate a revised economic profit measure following the procedure laid out in Table 7-8. What is the present value of all the revised economic profit measures when discounted using the project’s cost of capital?(Hint: First revise the initial NOPAT estimate from your answer to Question a by subtracting the economic depreciation estimate from project free cash flow calculated in Question a. Next, calculate the capital charge for each year based on invested capital less economic depreciation.)

d.      Using your analysis in answering Questions b and c, calculate the return of invested capital (ROIC) for Years 1 through 3 as the ratio of NOPAT for Year t to invested capital for Year t-1. Compare the two sets of calculations and discuss how the use of economic depreciation affects the ROIC estimate for the project.

Problem 8.2 Valuing Commercial real estate

Building One properties is a limited partnership formed with the express purpose of investing in commercial real estate. The firm is currently considering the acquisition of an office building that we refer to simply as Building B. Building B is very similar to Building A, which recently sold for $36,960,000.

Building One has gathered general information about the two buildings, including valuation information for building A:

Building A and B are similar in size (80,000 and 90,000 sq. ft.). However, the two buildings differ both in maintenance cost and rental rates. At this point, we do not know why these differences exist. Nonetheless, the differences are real and should somehow be “accounted for” in the analysis of the Building B using data based on the sale of Building A.

Building A sold for $462 per sq. ft. or $36,960,000. This reflects a sales multiple of six times the building’s net operating income (NOI) of $6,160,000 per year and a capitalization rate of 16.67%.

a. Using the multiple of operating income, determine what value BuildingOne should place on building.

b. If the risk-free rate of interest is 5.5% and the building maintenance costs are known with a high degree of certainty, what value should Building One place on Building B’s maintenance costs? How much value should Building One place on Building B’s revenues and consequently, on the firm?

Problem 9.4 Traditional WACC Valuation

The owner of Big Boy Flea Market (BBFM), passed away on December 30, 2009. His 100% ownership interest in BBFM become part of his estate, on which his heirs must pay estate taxes. The IRS has hired a valuation expert, who has submitted a report stating that the business was worth approximately $20 million at the time of owners death. The heirs believe the IRS valuation is too high and have hired you to perform a separate valuation analysis in hopes of supporting their position.

a.       Estimate the firm free cash flows for 2010-2014, where the firm’s tax rate is 25%, capital expenditures are assumed to equal depreciation expense, and there are no changes in net working capital over the period.

b.      Value BBFm using the traditional WACC model and the following information:

–          BBFM’s cost of equity is estimated to be 20% and the cost of debt is 10%

–          BBFM’s management targets its long-term debt ratio at 10% of enterprise value

–          After 2014, the long term growth rate in the firm’s free cash flow will be 5% per year.

Problem 10.4 VC valuation and deal structuring

Chariot.com needs $500,000 in venture capital to bring a new internet messaging service to market. The firm’s management has approached Route 128 ventures, a venture capital firm located in the high-tech start-up mecca, known as route 128, in Boston, which has expressed an interest in the investment opportunity.

Cariot.com’s management made the following EBITDA forecasts for the firm, spanning the next 5 years:

Route 128 Ventures believes that the firm will sell for six times EBITDA in the fifth year of its operations and that the firm will have $1.2 million in debt at the time, including $1 million in interest –bearing debt. Finally, Chariot.com’s management anticipates having a $200,000 cash balance in 5 years.

The venture capitalist is considering three ways of structuring the financing:

1.       Straight common stock, where the investor requires an IRR of 45%.

2.       Convertible debt paying 10% interest. Given the change from common stock to debt, the investor would lower the required IRR of 35%.

3.       Redeemable preferred stock with an 8% dividend rate, plus warrants entitling the VC to purchase 40% of the value of the firm’s equity for $100,000 in five years. In addition to the share of the firm’s equity, the holder of the redeemable preferred shares will receive 8% dividends for the each of the next five years, plus the face value of the preferred stock in Year 5.

Terminology

A convertible security (debt or preferred stock) is replaced with common stock when it is converted. The principal is not repaid. In contrast, the face value of a security with warrants is repaid, and the investor has the right to receive common stock shares by remitting the warrants.

Redeemable preferred stock is typically straight preferred with no conversion privileges. The preferred always carries a negotiated term of maturity, specifying when it must be redeemed by the company (often, the sooner of a public offering or five to eight years). The preferred shareholders typically receive a small dividend (sometimes none), plus the face amount of the preferred issue at redemption, plus a share of the value of the firm in form of common stock or warrants.

a.       Based on the offering terms for the first alternative (common stock), what fraction of the firm’s shares will it have to give up to get the requisite financing?

b.      If the convertible debt alternative is chosen, what fraction of the firm’s ownership must be given up?

c.       What rate of return will the firm have to pay for the new funds if the redeemable preferred stock alternative is chosen?

d.      Which alternative would you prefer if you were the management of Chariot.com? Why?