We are back with our Practice Problem Series. This is part B of our Choco – Hollick Candy Company Inc. practice problem. If you missed Part A of this Practice Problem, you can catch up and read it HERE.
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. Income Statment, Forecasting, Pro Forma, et. al.), then make sure you check out our Finance and Accounting courses to learn all about what they mean and how to apply them.
Now…on to our story.
In Part A, two enterprising Private Equity analysts (Choco and Hollick) determined the Pro Forma Income Statement to form a new confectionery company. The Pro Forma is shown here:
In Part B, they continue to finish their analysis.
The next steps of the analysis are to adjust the Net Income from the Income Statement to true cash flow projections…over the five-year proforma period. This requires several items, as shown in the following table:
- The Net Income is repeated for the year. (Line 1)
- The primary adjustment is the add back the (non-cash) depreciation that was subtracted on the Income Statement. (Line 2)
- Any dividends forecasted over the five year period need to be Subtracted. (Line 3, none for Year 1)
- A five-year capital project projection must be subtracted. (Line 4)
- The net change in Accounts Receivable must be reflected (Line 5)
- The net change is Accounts Payable must be reflected. (Line 6)
- Any debt retirements must be included. (Line 7)
These six adjustments yield the change in the balance sheet cash account for each year. (Line 8) However, for Years 2 through 5, there is a dividend planned. This adds to the free cash flow to investors. Thus, Line 9 is Line 8 with the dividend (line 3) added back.
A. Complete the Cash Flow Adjustments for Years 2 through 5. This yields a cash flow to investors for five years.
B. Does the business plan to fold after five years? Of course not. So…the analysts must also add a perpetuity after Year 5. Use the Year 5 Cash Flow to Investors and divide by the discount rate to obtain the perpetuity. This represents cash for Year 6 and beyond.
C. Present value the cash flow, then subtract the original contribution by investors to obtain the forecasted market capitalization.
D. Convert the forecasted market capitalization to a price per share by dividing by the Shares Outstanding.
E. Add 20% for intangibles that the market should reward you for.
♦ Equity Discount Rate = 17%
♦ Dividend Forecast:
• Yr. 2, $125k,
• Yr. 3, $500k,
• Yr. 4, $1million
• Yr. 5, $1million
♦ Capital Projects: $1million each year.
♦ Change in Accounts Receivable:
• Yr. 2, ($180k),
• Yr. 3, ($100k),
• Yr. 4, ($100k)
• Yr. 5, +$50k
♦ Change in Accounts Payable:
• Yr. 2, +$150k,
• Yr. 3, $50k,
• Yr. 4, $100k,
• Yr. 5, $25k.
♦ Debt Retirement:
• Yr. 3, $1.5 million,
• Yr. 4, $1million
♦ Original Contribution by Investors: $10 per share
♦ Share Issued/Outstanding: 500,000
It appears the forecasted value for this candy company is $17.49 per share. But Choco and Hollick need to be afraid of that beautiful woman, “Rosy Scenario”!
For a solution spreadsheet, click here.
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