Contents
Background/Purpose_____________________________________________________________________________________1
Analysis__________________________________________________________________________________________________2-4
Conclusions/Recommendations_________________________________________________________________________5
Tables/Exhibits _______________________________________________________________________________________6-19
Background/Purpose
background
Collectibles Inc. is a producer of consumer goods that current makes products such as dolls and jewelry. Their products are produced in China and sold in numerous small shops as well as on the Television Shopping Network (TSN). Although Collectibles is currently operating at a profit, they have recently become interested in acquiring the assets of Starlight Jewelry Manufacturing Inc. (thus resulting in a merger of the two companies).
Starlight is a company that currently manufactures and sells low-end jewelry in the United States. Through this merger, both companies would achieve numerous operating efficiencies including reductions in cost of goods sold of 1% and $600,000 in salary savings. In addition to these synergies, Collectibles also expects the acquisition to complement the higher-priced custom jewelry it currently sells (thus appealing to the buying habits of its existing customers) and to eliminate capital expenditures in the foreseeable future.
If the merger is approved, the acquisition will be paid for through a loan (accounting for 60% of the acquisition price) and additional equity from venture capitalists (accounting for the remaining 40%). In addition to this, the accounts payable of the target would be assumed. However, in order for the purchase to be viable, Collectibles Inc. (which would now include Starlight Inc.) would have to maintain a Quick Ratio of at least 1.25 and a Debt Service Coverage Ratio of at least 1.75 to satisfy Eastern Seaboard Bank’s loan requirements.
Purpose
The nature of this report is to communicate what the value of the company is calculated to be, whether or not this purchase is feasible, and if it is, what the financing structure would look like. In the analysis section, the assumptions made are presented as well as what financial statements are expected to look like post-acquisition. The report then concludes with a recommendation on whether or not merging with Starlight (i.e. the target) is in Collectibles’ (i.e. the buyer) best financial interest. Analysis
General Assumptions Made
In determining the value of the target the following basic assumptions were made:
1. Only the assets of Starlight Inc. will be assumed (excluding cash).
1. The accounts payable of the target will be assumed.
The purchase will be financed through 60% debt and 40% equity.
Pro forma financial statement numbers will be calculated based on historical data using the percentage of sales approach (e.g. cost of goods sold will be forecasted using the average percent o.
2. through a loan (accounting for 60% of the acquisition price) and
additional equity from venture capitalists (accounting for the
remaining 40%). In addition to this, the accounts payable of the
target would be assumed. However, in order for the purchase to
be viable, Collectibles Inc. (which would now include Starlight
Inc.) would have to maintain a Quick Ratio of at least 1.25 and
a Debt Service Coverage Ratio of at least 1.75 to satisfy Eastern
Seaboard Bank’s loan requirements.
Purpose
The nature of this report is to communicate what the value of
the company is calculated to be, whether or not this purchase is
feasible, and if it is, what the financing structure would look
like. In the analysis section, the assumptions made are presented
as well as what financial statements are expected to look like
post-acquisition. The report then concludes with a
recommendation on whether or not merging with Starlight (i.e.
the target) is in Collectibles’ (i.e. the buyer) best financial
interest. Analysis
General Assumptions Made
In determining the value of the target the following basic
assumptions were made:
1. Only the assets of Starlight Inc. will be assumed (excluding
cash).
1. The accounts payable of the target will be assumed.
The purchase will be financed through 60% debt and 40%
equity.
Pro forma financial statement numbers will be calculated based
on historical data using the percentage of sales approach (e.g.
cost of goods sold will be forecasted using the average percent
of COGS from 2011 to 2014 over total sales for the year
projected), unless otherwise noted below.
If the aforementioned ratios are not met, the merger will not be
recommended to Collectibles Inc.
3. Projected INcome Statements
Through the merger of Collectibles and Starlight Inc., net
income after taxes is expected to increase from $6,157,743 to
$10,974,207 by 2018 (see Exhibits I-III). This is attributable to
operating synergies, as demonstrated by the line item Synergies
from Cost Reductions on the income statement. The line item
represents $600,000 of annual salary savings and a reduction of
1% in cost of goods sold at the consolidated level. The 78% in
net income is also attributable in part to the fact that no more
capital expenditures will occur as operating synergies will occur
with the combination of both entities fixed assets.
As asset lives and historical costs were not provided and
net fixed assets are presented at a negative balance in
Starlight’s historical financial statements, depreciation is set at
$0 for subsequent years for both firms in order to depict a more
accurate balance in net fixed assets. A similar situation arose
for amortization expense.
Other administrative expenses were calculated based on
the percentage sales approach as outlined in greater detail in the
section above. However, if expenses had remained constant for
two or more years, the value was carried forward as the
projected value (except when dealing with taxes). Commissions
& Royalties/Fees were also zeroed out for Starlight as we
determined this line item could be eliminated due to the
consolidation. In other words, commission's costs will be
reduced due to a reduction in workforce (specifically relating to
the sales department).
Interest expense was also zeroed at the firm level as the
target’s debt was not to be assumed. However, in the
consolidated income statement is based on a 7.75% rate applied
to both the new long-term debt and the revolving line of credit
(explained in more detail in the Conclusions/Recommendations
section).
Taxes were calculated based on a corporate tax rate of
40%. As information regarding carryforwards was not provided,
it was disregarded.
4. Projected Balance Sheets
Assets were determined on varying bases on the balance
sheet and were projected to increase from $33,355,212 to
$55,436,953 by 2018.
Cash was zeroed out for Starlight Inc. as it was expected to
be paid out as a dividend to existing shareholders. In the
consolidated statements, cash was set as the necessary amount
needed to support projected sales after other assets were
projected (see Exhibits IV-VI).
The balances in accounts receivable were projected based
on the historical average collection period of 43 days for
Collections and 58 days for Starlight (see Table 1) based on
total sales. A similar approach was taken in calculating the
inventory levels for both firms. The values were based on
inventory turnover ratios of 6.54 for Collectibles and 2.37 for
Starlight Inc. (see Table 2) and them summed at the
consolidated level. As the consolidated firm becomes more
stable, we anticipate the average collection period to drop and
the turnover ratio to increase by year 2020.
As no further capital expenditures will be required and we
stopped depreciating fixed assets due to previous accounting
errors, net fixed asset balance are expected to remain constant
in the foreseeable future.
Accounts payable are once more calculated based on the
percentage of sales method. Since they are to be assumed by the
buyer they are included in the consolidated balance sheet.
Unlike accounts payable, Accrued Expenses on the
consolidated balance sheet includes only the buyer’s portion of
the expenses as this liability will not be assumed. Accrued
Income/Other Tax include both firms and have been maintained
constant as these figures are not expected to fluctuate.
Due to the merger, financing will be restructured using
60% debt (consisting of both long-term debt and a revolving
credit line) and 40% equity; see the Financing Alternatives
section for a breakdown of the financing structure and the
5. balances. Once again, the balances of liabilities and
stockholder’s equity reflect the buyer’s prior balances as well as
the amounts necessary to finance the asset requirements of the
firm as a whole.
For the first few years, the consolidated firm will not be
paying out dividends. This is because management plans on
building up the equity before dividends begin being paid out
(beginning in year 2020 if the firm’s position remains
favorable). Due to this, retained earnings will increase
exponentially from $3,831,954 to $40,238,853 by 2018.
Statement of Cash Flows
The statement of cash flows indicated that virtually all
cash inflows stem from operations; more specifically from net
income and a reduction in current liabilities for years 2014
through 2018 (see Exhibits VII-IX). There are no investing
activities that occur for any of the years, but the balances in the
financing section are primarily due to repayment of long-term
debt and preferred stock. Due to these activities, and the lack of
dividend payouts, the cash balance increases significantly from
$2,721,329 to $16,135,654.
Financing Alternatives
Our analysts have determined the Net Present Value of the
target to be $7,849,026 with a weighted average cost of capital
of 14.79% based on the table below:
As has been mentioned throughout the report, the merger is
to be financed with 60% debt and 40% equity (provided by
venture capitalists). In regards to the debt financing portion it
is our recommendation that 75% be financed via long-term debt
($6,140,880) to be paid over a 5 year period and that the
remaining 25% ($2,046,960) be financed using the revolving
line of credit extended by Eastern Seaboard Bank (both having a
6. 7.75% interest rate); see the table below for a breakdown.
Conclusions/Recommendations
Based on the analysis provided in previous sections and
the valuation of Starlight Inc., it is our recommendation that the
merger of the two firms is in Collectible Inc.’s best financial
interest. The merger would lead to significant operating
efficiencies which would in turn lead to an unprecedented
growth in both net income and total assets. By structuring the
financing as proposed in the previous section, the newly
consolidated firm would meet the Quick Ration and Debt
Service Coverage Ratios of at least 1.25 and 1.75 respectively;
see table below for projected ratios.
However, although financing the debt portion relying
primarily on long term debt provides the desired ratios, our cash
balance suffers as a result of having to pay out such large
amounts due to loan repayment on an annual basis (for a 5 year
period after the acquisition). Nevertheless, this remains the
optimal recommendation.
Exhibits/Tables
Page 6
Operating Cash Flow($409,041)$536,152$689,820$1,087,260
Cash Flow from Investing$0$0$0$0
Terminal Value$11,661,116
Total Cash Flow($409,041)$536,152$689,820$12,748,376
7. NPV @ 14.79% =$7,849,026
Financing:Sources:Uses:
A/P1,702,226 Assets8,512,695Net of Cash
Debt for Acq4,709,415 Goodwill1,038,557
New Equity3,139,610
Total Sources =9,551,252Total Uses =9,551,252
New Debt Package
Debt for Acq4,709,415LOC2,046,96025%
Existing Revolver0LT Debt6,140,88075%
Existing LTD3,478,424
Total Debt
Package8,187,839YearPaymentInterestPrincipalBalance
20146,140,880
20151,527,902475,9181,051,9845,088,895
20161,527,902394,3891,133,5133,955,383
20171,527,902306,5421,221,3602,734,022
20181,527,902211,8871,316,0161,418,007
20191,527,902109,8961,418,0070
Key Bank Ratios2015201620172018
Quick Ratio1.351.632.002.48
Debt Service Coverage Ratio7.468.9010.4711.50
20102011201220132014Average
AR$1,502,000$2,446,000$2,258,017$2,680,112
Sales$11,011,549$14,108,695$14,517,014$15,968,716
Days365365365365
CP5063576158
20102011201220132014Average
AR$3,370,451$4,567,295$5,750,259$6,421,451
Sales$32,886,109$33,497,044$49,732,345$54,705,579
Days365365365365
CP3750424343
Starlight
Collectibles
Table 1
Determining the average collection period
20102011201220132014Average
8. COGS$9,108,667$10,219,260$10,835,186$11,918,704
INV$5,686,000$5,655,000$3,723,000$4,086,600$4,086,600
Inv Ratio1.612.182.772.922.37
20102011201220132014Average
COGS$16,447,863$18,024,814$24,335,337$26,768,871
INV$5,083,700$5,293,306$2,215,248$2,614,444$3,986,147
Inv Ratio3.174.8010.088.116.54
Starlight
Collectibles
Determining inventory turnover ratios
Table 2
COLLECTIBLES, INC.
Collectibles, Inc., produces a variety of consumer
products, including dolls and jewelry. It's primary products are
manufactured in China and sold through gift shops throughout
the United States as well as via the Television Shopping
Network (TSN). The television marketing also involves the use
of a well-known celebrity whose name has become associated
with the various dolls that she “pitches” on six different days
during the year.
Prior to 2015, Collectibles (formerly, Knicknacks, Inc.)
had concentrated solely on the gift items categories. In late
2014, Knicknacks completed the acquisition of the Bock
Company. Bock was a designer and manufacturer of custom
jewelry that was sold in a variety of Asian and Middle Eastern
countries but had encountered financial difficulties
necessitating that it seek protection in bankruptcy court.
Knicknacks was able to structure a merger with Bock that
resulted in the formation of Collectibles. The merger resulted
from a combination of new equity infusion and the restructuring
of supplier debt, both in the form of preferred stock that carried
a zero percent dividend rate but was payable over a five-year
9. period (an equity “kicker” was included as part of the preferred
stock). The proposal was viewed as superior to a competing bid
and won approval from the bankruptcy court.
The result of the business combination proved to be quite
successful as a result of the synergies realized by relocation of
the jewelry manufacturing to the Asian continent and the ability
to introduce one line of jewelry to the U.S. market through the
Television Shopping Network. Collectibles was also beginning
to make in-roads into the European market as a result of the
distribution channels of the Bock jewelry line. The European
market proved to be receptive to the dolls and other collectible
product lines of the company and was expected to provide a
significant source of sales growth over the next three years.
Collectibles currently is in negotiations with Starlight
Jewelry Manufacturing, Inc., a company that manufactures and
sells low-end jewelry throughout the United States. The appeal
of Starlight to Collectibles is two-fold: first, it provides a
complement to the higher-priced custom jewelry lines that it
currently sells and is expected to allow certain synergies to be
realized through consolidation of facilities. The CFO
anticipates the consolidations to produce savings of
approximately $600,000 per year. Moreover, the resulting
surplus productive capacity would be such that no capital
expenditures were considered necessary in the foreseeable
future. Even then, the use of subcontracted Asian
manufacturing facilities was expected to result in the shifting of
the burden of equipment purchases to the subcontractors. In
addition to the annual consolidation savings, the CFO felt that
the Cost of Goods Sold of the combined entity could be reduced
by one percent by pressuring suppliers to pass along some of the
economies of scale that the larger volume of purchasing would
provide.
The second incentive for acquiring Starlight was the fact
10. that TSN had been pressuring Collectibles to develop a low-end
jewelry line that was more in line with the buying habits of its
customers. Although the sales of Collectibles' Bock jewelry
line had been favorable, the relatively high price of the custom
jewelry line was seen as being quite limiting in the ability of
the network to fully develop a customer base for the jewelry.
Starlight Jewelry appeared to be a means by which Collectibles
could produce a low-cost, low profit margin line that would
bolster the Bock brand name on TSN while being affordable to
the viewers. The added distribution channel of TSN was,
therefore, viewed as a means of significantly expanding the
sales of Starlight over the next two-to-three years.
The acquisition of Starlight would be through an asset
purchase and would necessitate that Collectibles restructure its
own financing as well as finance the acquisition. The long-term
debt of Collectibles contained a clause that dictated no
additional debt (other than a revolving line of credit secured by
inventories and receivables) was allowed. The revolving line of
credit utilized by Collectibles was from Econova Bank and
carried an interest rate of prime plus 4½% (the prime rate is
currently 3.25%). The revolver was limited to 70% of accounts
receivable plus 18% of inventories based upon the historical
breakdown of an aging of accounts receivable and the work-in-
process versus finished goods inventories. Econova Bank was
also the provider of the current $4½ million of long-term debt
of Collectibles and indicated a willingness to refund the current
debt as well as providing some of the funding for the
acquisition of Starlight Jewelry. The new long-term debt would
be at the same rate as the revolving line of credit (currently
7.75%) and payable over a five-year period on a fully amortized
basis. The refunding of the long-term debt at a lower interest
rate than the current long-term debt was agreed upon in order to
reflect the new equity as well as the threat to move the
company’s financing to the Eastern Seaboard Bank which had
made a competitive offer of financing. The restrictions would
11. be similar to the restrictions on the current debt: 1) no new
debt would be allowed except for revolving debt secured by
receivables and inventories; 2) the firm must maintain a Quick
Ratio of at least 1.25; and 3) the company must maintain a
Debt Service Coverage Ratio [EBITDA/(Interest + Principal)]
of at least 1.75.
Your task:
Determine the value that Collectibles should be willing to
pay for Starlight Jewelry. Note that Collectibles will not
assume any of Starlight's debt (i.e., it is buying the assets of
Starlight debt-free). Once a value has been determined, assume
that the acquisition will be at the price that you determined and
will be paid for through a loan and additional equity from
venture capitalists. The venture capitalists like to see 50-60%
of the purchase be financed through debt and want a rate of
return of 25-30% on their equity investment. Since Collectibles
will be acquiring the financing, assume that the terms of the
line of credit for Starlight's receivables and inventories will be
those of Collectibles. Also, assume that a completely new loan
package will have to be structured that will refinance all of
Collectible's existing debt in addition to the 50-60% acquisition
price. The new loan will be payable over five years and have
similar restrictions to Collectible's current debt.
Finally, write up your analysis as a concise, coherent
report. I should be able to read through the report and have a
good understanding of what you have done in your analysis.
Your projections should be attached as exhibits and referred to
in the report as needed. Your ability to clearly communicate
what you have done is at least as important as your analysis.
COMMENTS ON WRITING A BUSINESS REPORT
12. A good report is crucial to communicating what you have done
and instilling confidence in the reader that you have done a
thorough analysis. A report should be well-organized with a
definite path that leads the reader from an introduction to a
conclusion. Outlining your report in advance could aid you in
this endeavor. A typical outline might look something like this:
I.
Introduction
The purpose of the analysis and report
II.
Background
A brief summary of the company does and how the business is
changing. (Outlook for increased sales due to more focused
marketing efforts, larger customer accounts, etc.)
III.
Analysis
A. Projected Income Statements
a. Sales
b. Cost of goods sold
c. Administrative expenses
d. Depreciation expense
e. Interest expense
f. Taxes
13. B. Projected Balance Sheets
a. Projected asset requirements to support projected sales
i. Cash
ii. Accounts Receivable
iii. Inventories
iv. Fixed Assets
b. Financing of asset requirements
i. Accounts Payable
ii. Accruals
iii. Long-term Debt
iv. Retained Earnings (Dividend policy)
v. Additional Financing Required
C. Statement of Cash Flows (This would show the annual needs
versus the cumulative needs indicated on the balance sheets)
D. Financing Alternatives
a. Debt
i. Bank restrictions
ii. Total debt availability
14. iii. Short-term debt availability
b.
Required equity financing
III.
Conclusions/Recommendations
Advantages and Disadvantages of financing alternatives. What
you would recommend and why.
In writing up the report, be as concise as possible. Remember,
the person who is reading the report is a busy person and all
“fluff” does is waste their time. Also, the report should be
written so that a non-technical person can get a basic
understanding of what you have done. For example, in
describing the projection of accounts receivable, one might
write
“Accounts receivables are projected to increase from their
current level of $110,800 to $351,435 by 2018 (See Exhibit II).
The tripling of receivable balances over this period, when sales
are anticipated to only double in volume, is due to more of our
customers demanding more advantageous credit terms. The
result is an expected increase in the average collection period
from approximately 32 days to just over 40 days (See Exhibit
IV for calculations).”
You have communicated to the reader what your numerical
analysis reveals and why it does so without burdening them with
the detail of how it was calculated. Thus, a non-numbers person
15. can understand what is anticipated to occur in terms of
increased asset (receivables) requirements and the cause of the
increase. A more technically-oriented person (such as myself)
has been directed to Exhibit II to see the actual balance sheets
and to Exhibit IV in order to see how you have derived the
average collection periods using ratios, probabilities, or
whatever.
The report itself should only quote key figures from the exhibits
such as the beginning and ending accounts receivable balances
used in the above example. (Obviously, in some cases, such as
the amount of financing needed, you will want to quote the
amount required for each year.) The bulk of the numbers should
otherwise be restricted to exhibits. Exhibits should be
numbered. In general, an exhibit that is not referred to in the
report is not needed for the report and should not be included.
(There can be exceptions to this, but they are relatively rare.)
The result of a good report is that the reader can understand
what you have done without having to look at the exhibits
specifically, feel confident in your abilities to analyze the
circumstances, and be persuaded into accepting your
conclusions.
I strongly encourage you to proofread your report very
carefully. While some errors will inevitably be missed, you
want to minimize them. The spell-checker and grammar-
checker in Word are notoriously bad and cannot tell that the
word “in” should have been “is”. Mistakes in your spelling and
grammar cast serious doubt upon the quality of the analysis
itself.