Background You are the Director of Accounting & Controls for Company XYZ and you
ID: 2626960 • Letter: B
Question
Background
You are the Director of Accounting & Controls for Company XYZ and your boss the VP/Controller has asked you to review a pending
transaction that has two potential targets. Your company is trying to decide which target is a better fit both financially and culturally.
Below, you will find the facts of the case and the question that needs to be addressed.
Facts
Section I - Financials & Metrics as of 12/31/XX
In $000's Target A Target B
Sales $ 535,500 $ 698,000
COS $ 485,700 $ 489,000
Margin $ 49,800 $ 209,000
SG&A $ 30,000 $ 15,000
EBIT $ 19,800 $ 194,000
Weight Average Cost of Capital 10% 10%
Net Present Value - Discounted Cash Flow $ 225,000 $ 434,000
Payback Period 10 years 8 years
Collection Days 45 days 30 days
Inventory Turnover 12 4
Working Capital Turnover 8.5 5
Cash $ 50,000 $ 150,000
Accounts Receivable, net $ 100,000 $ 120,000
Debt $ 10,000 $ 100,000
Equity $ 100,000 $ 50,000
Section II - Due Diligence Findings
Financial Control Environment Excellent Poor
Pending Legal Issues (likelihood >50%) Properly Accrued Under Accrued
Environmental Issues - Properly Accrued Lack of Documentation
HR Involvement & Responsiveness Poor Average
Operational Environment Poor Excellent
Business Practices & Ethics Poor Average
Question for Discussion
Which target would you recommend and why?
Explanation / Answer
In order to decide which target company to acquire, the purchaser should do business valuations of the target companies. This helps in better decision regarding acquisition of Target Company.
With the given financials and metrics of the target companies, it is visible that the NPV of Target B ($434,000) is higher as compared to Target A ($225,000), payback period, that is, the length of the time required to recover the cost of the investment is also less in company B (8 years) as compared to A (10 years). This shows that Company B creates more wealth for its shareholders. However, other factors like Inventory turnover which indicates the number of times inventory has been converted into sales in a year, and working capital turnover which indicates the relationship between the money used to fund operations and sales generated from these operations also tells us a lot about the target companies.
The following table shows the financial environment of both the target companies:
FACTS
TARGET A
TARGET B
Inventory Turnover
12
4
Working Capital Turnover
8.5
5
Cash
50,000
150,000
Accounts Receivables
100,000
120,000
Debt
10,000
100,000
Equity
100,000
50,000
Debt Equity Ratio
0.1
2
The above financial data speaks that financial control environment of Target A is excellent, which is also evident from due diligence findings. Target B seems to aggressively finance its growth by debt. But a debt equity ratio of 2, for B, is moderate. Target B has a low inventory turnover ratio, which it needs to work on. The reason for low ratio may be old stocks being piled up. Old and obsolete inventories should be discarded. Target A very effectively utilizes its fund for generating sales, apparent from working capital turnover.
The purchaser, along with financial statistics, should also focus on work culture. Due diligence findings shows that work culture, business ethics and practices, HR involvement and Responsiveness of Target B is better as compared with Target A. This means that the personnel of Target B are aware of their duties and responsibilities. Less effort will be made by the purchaser company to educate them regarding their new goals, unlike Target A. Environmental issues are not documented in case of Target B, unlike A, which can be handled. Pending legal issues can also be properly accrued in case of Target B.
Considering the maximized returns for the shareholders and excellent work culture, purchaser should acquire Target B. There are few loopholes, which are not major, can be taken care of as detailed above.
FACTS
TARGET A
TARGET B
Inventory Turnover
12
4
Working Capital Turnover
8.5
5
Cash
50,000
150,000
Accounts Receivables
100,000
120,000
Debt
10,000
100,000
Equity
100,000
50,000
Debt Equity Ratio
0.1
2
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