We are back with question #2 of our series of Practice Problems. This practice problem uses Net Present Value. It is too long for one post, so divided into Part A and Part B. We will post Part B next week.
These Practice Problems will put to use the skills and concepts taught in our BizBasics Online courses and will reinforce your learning. If you start quaking in your boots when you read some of these terms (i.e. NPV, variable cost, depreciation, et. al.), then make sure you check out our Finance courses to learn all about what they mean and how to apply them.
If you would like to submit a problem that we can use for our Practice Problem series, email us at comments@BizBasicsOnline.com.
Now…on to our story.
Charley Choco and Harry Hollick first met as junior investment bankers of a large New York bank. Now in their late 30’s, they have each become well known in the private equity investment industry. Recently, Charley noticed a bankruptcy sale of a national candy company. All the plant assets were up for sale. The brand had failed, the expenses were uncontrolled, and funds were not available to upgrade the aging plant to meet new regulatory demands. This was key to realizing their mutual dream. When they first met, Harry once jokingly said, “Hey, why don’t we start a candy company and call it “Choco-Hollick”?
The idea stuck and as their expertise grew in private equity funding, they occasionally would talk about how the venture could be formed. Now with the availability of a plant, in an adjoining state, Charley and Harry have become serious. They know nothing about candy manufacturing, but they have recruited a world renown retail marketer and a successful CEO who recently retired at an early age and is looking to build something from scratch. The two of them begin developing a pro forma which is a long-range forecast of key financial statements. These include an income statement, a balance sheet, and a statement of cash flow.
The result of this pro forma will provide a cash flow forecast for five years that will be the basis for establishing the viability of the new venture. That cash flow forecast will be “present valued” using a risk-adjusted discount rate to obtain a stock price. If the projected stock price is substantially larger than the proposed individual equity contributions from investors, the venture may take off. That is the end game.
Let’s start now with the first step:
Part A: The Pro Forma Income Statement.
This is an electronic spreadsheet for five years.
Charley and Bill have found Melissa Marketour who is an experienced retail marketing wizard. She has signed on with the venture. Melissa believes that because this is January 2, 2012, that she can have a national marking campaign viable before Halloween. That would give the company income from two of the three main candy holidays. (Valentines Day would be lost, but Halloween and Christmas would be revenue boosters the first year.)
Based on Melissa’s projections, the five-year revenue projection is $3million, $7million, $10million, 12.5million, and $15million, respectively.
The proposed CEO, Bucks Boyer, has studied the confectionary industry and believes he can produce product at a 40% variable cost.
The total of the fixed cost is $750,000 for each of the first two years, and twice that during each of the next three years. This includes the marketing campaign for each year.
The depreciation expense is forecasted to be $500,000 the first year and increasing $100,000 each year for the next four years.
The company will have a capital infusion from investors of $5million. That equity will be sufficient for the company to borrow $4million initially. The interest on the debt will be 8% for the first three years. The company plans to pay off much of this high-coupon debt starting in Year 3. Because of its improved debt ratio, the interest is forecasted to be 6% for the final two years. The debt will be reduced to $1.5million in Year 3 and another $1million in Year 4. So for year-end for Year 4 and Year 5, the debt will be $1.5million.
The effective tax rate is 40% each year.
Develop an electronic spreadsheet for the forecasted (proforma) income statement. Put the five years as columns to the right of the first column. The first column will have each of the red bolded items in the case study write-up.
The Income Statement should have totals for EBIT, Pre-Tax Margin, and Net Income. The Biz Bucks Guy gets $138,000 for Year 1 and $1,518,000 for Year 2.
To see the answers to years 3, 4, and 5, and the rest of the completed spreadsheet, click here.
And because we haven’t seen enough chocolate in this post, we will leave you with one more picture…