The CEO of the company you are following has asked you to analyze the possibilit

Question

The CEO of the company you are following has asked you to analyze the possibility of acquiring a smaller business operation from another company.

The purchase will cost $95 million in year zero and will also require $3 million of net working capital. The purchase can be depreciated using a four year straight-line depreciation to $10 million. (Note: SL depreciation is (purchase price – ending book value) / years. Assume you can sell the business in four years for $12 million.

The new business operation will generate $71 million in revenue each year, which will take $42 million in costs annually.

Use the 35% marginal tax rate.

(1) Compute the cash flows for the project.

(2) Use the cost of capital from your firm (14.59%) and a payback benchmark of 3.5 years. Compute the following decision statistics and their accept/reject conclusion.

A. NPV

B. IRR

C. Payback

(3) Make your recommendation to the CEO.

Explanation / Answer

1) Cash flows for the project

All values are in millions

2) NPV

NPV = -$14.03

IRR = 8%

Payback period

payback period = 3+(19.1/40.6)

= 3.47 years

3) The company should NOT go ahead to acquire the small business operation from another company as the NPV of the project is negative. even though the payback period is lower than the benchmark, however if the NPV is negative the project should be rejected.

0 1 2 3 4 Revenue $71 $71 $71 $71 Costs $42 $42 $42 $42 Depreciation $21 $21 $21 $21 Operating income $8 $8 $8 $8 Tax@35% $3 $3 $3 $3 Income after tax $5 $5 $5 $5 Operating cash flows $26 $26 $26 $26 Initial investment -$98 Terminal value $14 Net cash flows -$98 $26 $26 $26 $41

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