Case Analysis 3: You are the General Manager at the Bicker, Slaughter, and Lynch

Question

Case Analysis 3: You are the General Manager at the Bicker, Slaughter, and Lynch Law Firm. There is an opportunity to buy out a small law firm that was just started by a young MBA/JD, and you believe the firm can be grown and become a lucrative part of your Firm. With help from your finance leader, you have estimated the following benefit streams for this new division:

Before Tax Cash Flow From Operations

Year 1 $(149,000)

Year 2 $0

Year 3 $51,380

Year 4 $88,760

Year 5 $114,100

Year 6 $129,780

Year 7 $143,640

Year 8 $167,300

After Tax Net Income From Operations

Year 1 $(103,500)

Year 2 $(50,500)

Year 3 $36,700

Year 4 $63,400

Year 5 $81,500

Year 6 $92,700

Year 7 $102,600

Year 8 $119,500

After Tax Cash Flow From Operations

Year 1 $(85,600)

Year 2 $15,000

Year 3 $48,600

Year 4 $72,200

Year 5 $95,550

Year 6 $101,300

Year 7 $125,200

Year 8 $140,200

• You estimate that the purchase price for this firm would be $200,000 and that additional net working capital would be needed in the amount of $60,000 in year 0, an additional $15,000 in year 2 and then $15,000 in year 5.

• BSL usually spend about $275,000 per year in advertising. If you make this acquisition, you would ask that advertising spending be increased by an incremental one-time amount of $45,000 in year 0 to publicize the firm’s expansion.

• Your finance leader has indicated that the firm has access to a credit line and could borrow the funds at a rate of 6%. He also mentions that when he runs project economics for capital budgeting (such as a new copier or a company car), he recommends a standard 10% rate discount, but the one other time they looked at an acquisition of a smaller firm, he used a 13% rate discount. Obviously you will want to select the most appropriate discount rate for this type of project.

• At the end of 8 years, the plan is to sell this division. The estimated terminal value (the sale and the return of working capital) is conservatively estimated to be $350,000 of after-tax cash flow help. Using the data that you need (and ignoring the extraneous information), for this potential acquisition, calculate each of the following items:

- the Nominal Payback

- the Discounted Payback

- the Net Present Value

- the IRR

1) From a purely financial (numbers) perspective, would you recommend this purchase to management? Why?

2) What are some of the non-financial elements that need to be considered for this proposal?

3) Assumptions in project economics can have a huge impact on the result. Identify 3 financial elements/assumptions in your analysis that would make this project financially unattractive? In other words, what would have to be true for this to be a bad investment?

4) If you were the CEO, would you approve this proposal? Why or why not?

Explanation / Answer

Soln : We here considering the after tax cash flows from operations, as it will give real picture of the cash generated in real terms:

To calculate nominal payback , that can be calculated using the incremental cash flows to equalise the initial cost invested

When summing up the cash flows calculated here, it is showing that in the year 7 , the net cash flow will be greater than 0

So, we can say that Nominal Payback = 6 + sum of cash flows upto year 6/cash flow in year 7 = 6 + 87950/125200 = 6+0.70 = 6.70 years

Now, again discounted payback period will be calculated in similar manner and cash flows become positive in 8th year i.e. Discounted payback period = 7 +sum of cash flows upto year 7/cash flow in year 8 = 7 + 157195.19/184393.60 = 7 + 0.8525 = 7.8525 years

Adding all discounted cash flows will give NPV = $27198.37

IRR can be calculated using the excel function for discounted cash flows , IRR = 1.11%

1) From the financial perspective, NPV>0, while IRR is lower than the cost of capital , i.e. 6%

Based on IRR method, project is not viable, but NPV seems to be positive, but if funds will be borrowed the NPV would be negative. hence based on these 2 things project is not viable.

2) Non- financial elements : i. If this small firm is affecting the brand image negatively/positively

ii. If the project would be failure at the end of term, it will dent law firm image badly and ratings can be affected.

iii. In any case if the acquisition is helping the BSL in their process or business.

3) If Initial cost is borrowed, it will be bad investment ..................(I)

If the cash flows expected from the operations shown would not materialise actually.........(II)

If the terminal value would be lesser than, what is expected after 8 years..................(III)

4) If I were the CEO, would not approve it , even the cost is not borrowed. As there are very slight chances of the project to get success, because of the thin margin, which can be failure anytine if the terminl value will be little less than what is expected .

Also, if this small firm will fail here, it will give negative image to the brand. And ratings can be affected.  

Year 0 1 2 3 4 5 6 7 8 After Tax cash flow -85600 15000 48600 72200 95550 101300 125200 140200 Purchase price -200000 Net working capital -60000 -15000 -15000 Advertising cost -45000 Net of cash flows -305000 -85600 0 48600 72200 80550 101300 125200 140200

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