# The Brown Forman Case Solution- Memo Assignment Finance Sample

QUESTION

Brown Foreman Memo Assignment

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.

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.

This gives us a WACC of 7.35%

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

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