QUESTION
During Class 05, we will cover the Brown-Forman Case, which deals with the proposed acquisition of Southern Comfort Distillers by Brown Forman.
Your task is to recommend whether or not to purchase Southern Comfort, based upon a discounted-cash-flow analysis of Southern Comfort using WACC. Exhibit 9 provides the information you will need to create a ten-year cash-flow forecast. Exhibit 1 provides information for calculating the project’s cost of equity. Other exhibits provide information you need to calculate the project’s WACC.
The grading rubrics focus exclusively on the discounted cash-flow analysis using WACC, so your memo should do the same. Be sure to create a supporting worksheet showing your cash-flow forecast, WACC calculations and NPV analysis. You will be evaluated based upon what incremental cash flows you choose to include in your analysis step-by-step, e.g., revenues, expenses, depreciation, etc.; as well as how you calculate WACC. Your memo should identify these steps in your accompanying Excel workbook.
ANSWER
For the purpose to come to a decision whether to buy Southern Comfort or not we have to address the biggest issue which is what to take as weighted average cost of capital (WACC). The management of Brown Forman has decided to keep the hurdle rate for new projects at 14% and old projects at 12%, but as per our calculation the WACC of the project is coming around 7.35%.
The NPV at various rate is
WACC |
NPV (in $ ‘000) |
7.35% |
102228 |
12% |
9338 |
14% |
-7061 |
If the management of Brown Forman takes Southern Comfort as new project than it should reject the project, but in reality it is not a new project, rather it is an old business that is being acquired by Brown Forman, therefore the hurdle rate of this project should be taken as 12%, which gives us positive NPV therefore Brown Forman should go ahead with the acquisition.
For calculating cash flow from the project following steps were followed
First gross profit per case was calculated from different geographical segments of US domestic sales, export sales and Canada sales. Than the next thing taken into consideration was number of cases sold per year per segment. Multiplying the above two will give us the total gross profit made by the company per year. From this gross profit expenses such as general & administrative expenses, transition, settlement and interest were deducted to give earning before tax. Here it has been assumed that the depreciation is part of general and administrative expenses.
The tax rate as been assumed to be 50%, the tax rate of Brown Forman, instead of taking industry average as post acquisition the tax rate of Brown Forman would be applicable in Southern Comfort.
Once we obtained earning after tax, depreciation is not added back as it would set off the capital expenditure. Therefore, nor depreciation is added back neither capital investment is reduced. For the purpose of working capital, the average of the ratio of working capital and gross profit was calculated which came around 61.17% and thus the working capital requirement was calculated in the basis of this.
This gave us the free cash flow for the project over the course of 10 years. For calculating terminal value a terminal growth rate of 2% was assumed after 10 years.
Coming to the calculation of WACC, risk free rate has assumed equivalent to 10 year US treasury bond which is 8%. For the purpose of market risk premium we could have taken arithmetic mean or the geometric mean as both correct. We took the arithmetic mean for the purpose of calculation. The beta of Brown Forman was given at 1.1.
The interest rate for debt was given to be 8.75%, tax rate being 50% gives us the cost of debt around 4.38%. Company plans to invest $20 million cash and rest it plans to borrow $ 68.7 million at the rate of 8.75%. Therefore, the capital structure of this project is 23% in equity and 77% in debt.
SC
Risk Free Rate | 8.00% |
Market Risk Premium | 8.70% |
Beta | 1.1 |
Cost of Equity | 17.57% |
Interes Rate | 8.75% |
Tax Rate | 50% |
Cost of Debt | 4.38% |
Capital Structure | |
Debt | 77% |
Equity | 23% |
WACC | 7.35% |
Terminal Growth Rate | 2.00% |
Hurdle Rate | |
New Project | 14% |
Old Project | 12% |
Cash Flow
(all figures in $ ‘000) | ||||||||||||
Particulars | 1978 | 1979 | 1980 | 1981 | 1982 | 1983 | 1984 | 1985 | 1986 | 1987 | 1988 | |
Profit per Case | ||||||||||||
US | 10.77 | 11.59 | 12.13 | 12.73 | 12.34 | 12.48 | 12.59 | 12.62 | 13.24 | 13.3 | 12.92 | |
Export | 7.89 | 8.48 | 9.07 | 9.35 | 9.43 | 9.29 | 9.81 | 9.92 | 9.94 | 9.89 | 9.74 | |
Canada | 5.03 | 5.03 | 5.03 | 5.03 | 5.03 | 5.03 | 5.55 | 5.55 | 5.55 | 5.55 | 5.55 | |
Cases | ||||||||||||
US | 1140 | 1225 | 1315 | 1410 | 1510 | 1615 | 1725 | 1835 | 1923 | 1984 | 2015 | |
Export | 325 | 350 | 380 | 405 | 425 | 445 | 463 | 480 | 490 | 500 | 500 | |
Canada | 115 | 125 | 138 | 150 | 160 | 170 | 180 | 190 | 200 | 210 | 220 | |
1580 | 1700 | 1833 | 1965 | 2095 | 2230 | 2368 | 2505 | 2613 | 2694 | 2735 | ||
Gross Profit | ||||||||||||
US | 12278 | 14198 | 15951 | 17949 | 18633 | 20155 | 21718 | 23158 | 25461 | 26387 | 26034 | |
Export | 2564 | 2968 | 3447 | 3787 | 4008 | 4134 | 4542 | 4762 | 4871 | 4945 | 4870 | |
Canada | 578 | 629 | 694 | 755 | 805 | 855 | 999 | 1055 | 1110 | 1166 | 1221 | |
Total Gross Profit | 15420 | 17795 | 20092 | 22491 | 23446 | 25144 | 27259 | 28975 | 31442 | 32498 | 32125 | |
Expenses | ||||||||||||
G&A Expenses | 1655 | 1800 | 1944 | 2100 | 2268 | 2449 | 2645 | 2857 | 3086 | 3332 | 3599 | |
Transition | 430 | 380 | 180 | |||||||||
Settlements | 400 | 400 | 400 | 400 | ||||||||
Interest | 113 | 122 | 132 | 142 | 154 | 166 | 179 | 194 | 209 | 226 | 244 | |
Total Expenses | 2598 | 2702 | 2656 | 2642 | 2422 | 2615 | 2824 | 3051 | 3295 | 3558 | 3843 | |
EBT | 12822 | 15093 | 17436 | 19849 | 21024 | 22529 | 24435 | 25924 | 28147 | 28940 | 28282 | |
Tax @ 50% | 6411 | 7547 | 8718 | 9925 | 10512 | 11265 | 12218 | 12962 | 14074 | 14470 | 14141 | |
EAT | 6411 | 7546 | 8718 | 9924 | 10512 | 11264 | 12217 | 12962 | 14073 | 14470 | 14141 | |
Depreciation | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | |
Working Capital | 2447 | -1452 | -1406 | -1467 | -584 | -1039 | -1294 | -1049 | -1509 | -646 | 228 | |
Free Cash Flow | 8858 | 6094 | 7312 | 8457 | 9928 | 10225 | 10923 | 11913 | 12564 | 13824 | 14369 | |
Assuming WACC to be 7.35% (Calculated) | ||||||||||||
Terminal Value | 273941 | |||||||||||
Free Cash Flow | -88700 | 8858 | 6094 | 7312 | 8457 | 9928 | 10225 | 10923 | 11913 | 12564 | 13824 | 288310 |
NPV at 7.35% | 102228 | |||||||||||
Assuming WACC to be 14% (new project) | ||||||||||||
Terminal Value | 122137 | |||||||||||
Free Cash Flow | -88700 | 8858 | 6094 | 7312 | 8457 | 9928 | 10225 | 10923 | 11913 | 12564 | 13824 | 136506 |
NPV at 14% | -7061 | |||||||||||
Assuming WACC to be 12% (old project) | ||||||||||||
Terminal Value | 146564 | |||||||||||
Free Cash Flow | -88700 | 8858 | 6094 | 7312 | 8457 | 9928 | 10225 | 10923 | 11913 | 12564 | 13824 | 160933 |
NPV at 14% | 9338 | |||||||||||
WACC | NPV | |||||||||||
7.35% | 102228 | |||||||||||
12% | 9338 | |||||||||||
14% | -7061 | |||||||||||
Working Capital Calc
1976 | 1977 | Average | |||||||||
Gross Profit | 16399 | 18369 | |||||||||
Working Capital | 9457 | 11880 | |||||||||
57.67% | 64.67% | 61.17% | |||||||||
1978 | 1979 | 1980 | 1981 | 1982 | 1983 | 1984 | 1985 | 1986 | 1987 | 1988 | |
Total Gross Profit | 15420 | 17795 | 20092 | 22491 | 23446 | 25144 | 27259 | 28975 | 31442 | 32498 | 32125 |
Working Capital | 9433 | 10885 | 12291 | 13758 | 14342 | 15381 | 16675 | 17724 | 19233 | 19879 | 19651 |
Requirement | -2447 | 1452 | 1406 | 1467 | 584 | 1039 | 1294 | 1049 | 1509 | 646 | -228 |
Looking for best Finance Assignment Help. Whatsapp us at +16469488918 or chat with our chat representative showing on lower right corner or order from here. You can also take help from our Live Assignment helper for any exam or live assignment related assistance