You work for Netflix and have been asked to evaluate a potential acquisition of

Question

You work for Netflix and have been asked to evaluate a potential acquisition of a smaller privately owned competitor. The acquisition candidate produces an EBITDA of 10% of Netflix's EBITDA and is offered to your firm at a price of multiple of 8 times EBITDA. Assume the following:

Current debt costs you 8% and you can raise additional debt at this rate today. The loan is to be amortized over 7 years.

Current return on equity is 15%

Current WACC is 10%

Tax rate is 30% (constant)

80% of the purchase price is considered depreciable assets – to be depreciated over ten years on a straight-line basis with no residual values.

Residual value for this operation is to be 2x current EBITDA in year ten.

Create an after-tax cash flow analysis which includes the answer to the following:

a. Economic analysis: is this a fundamentally sound investment?

b. Using the tax cash flows and no debt (pure equity), is the prospect a positive NPV using ROE as the hurdle rate?

c. Using the after tax cash flows and the firm’s WACC, is this project desirable? Explain how you came to this conclusion.

Explanation / Answer

Let us quantify the given situation:

Suppose EBITDA    is    12,500

Price offered : 12,500 * 8              =   100,000/-

The Company can raise 100,000 @ 8 % Interest

The WACC of Company is 10 %

80 % of purchase price is depreciable Assets:   Depreciation:   80,000 /10 = 8,000

EBITD                  =     12,500

lees Interest (100,000* 8% )             8,000

        Depreciation                           8,000

PBT                                              -3,500

Free Cash profit : -1000+ 8,000    = 4,500

a) Fundamentally it is not a sounfd investment. The WACC is 10 % and return on equity is 15 % but the project will give only 10 % EBITDA

b) Using 100 % equity finance:

    Let us examine with above quantified example:

           EBITDA                =          12,500

           Depreciation         =            8,000

           PBT                      =           4,500

           Tax @ 30 %           =          1,350

           PAT                       =          3,150

Add Depreciation               =         8,000

Cah inflows                                 11,150

Residual value       (12,500*2)    25,000

ROE is 15 %. Let us examine NPV.

   Present value of cash inflow for 10 years @ 15 % 11,250 *   5.0187    =   56,461

   Terminal cash flow @ 15 %    25,000 * .24718                                 =   6,044

            Present value of cash inflows                                                                   = 62,505

            Initial Investment                                                                                   = 100,000

             NPV                                                                                                    = (37,494)

Since return on Equity is 15 %. The 100 % equity finance will not give a positive NPV

c. Using after tax cash flows at WACC.   Assume 100 % Equity Finance

               Present value of cash inflow for 10 years @ 10 % 11,250 * 6.1446    =   69,126

   Terminal cash flow @ 10 %    25,000 * .3855                               =     9,638

            Present value of cash inflows                                                                   =    78,764

            Initial Investment                                                                                   = 100,000

             NPV                                                                                                      = (21,236)

Even at WACC also project is not desirable. It will give negative NPV

Related Questions

Navigate

• Browse (All)
• Browse Y
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.