Question

Your employer, a mid-sized human resources management company, is considering expansion into related fields, including the acquisition of Temp Force Company, an employment agency that supplies word processor operators and computer programmers to businesses with temporary heavy workloads. Your employer is also considering the purchase of Bigger staff & McDonald (B&M), a privately held company owned by two friends, each with 5 million shares of stock. B&M currently has free cash flow of $24 million, which is expected to grow at a constant rate of 5%. B&M's financial statements report short-term investments of $100 million, debt of $200 million, and preferred stock of $50 million. B&M's weighted average cost of capital (WACC) is 11%. Using this information answer the following question:

Your employer also is considering the acquisition of Hatfield Medical Supplies. You have gathered the following data regarding Hatfield, with all dollars reported in millions: (1) most recent sales of $2,000; (2) most recent total net operating capitol OpCap=$1,120; (3) most recent operating profitability ratio, OP=NOPAT/Sales =4.5% and (4) most recent capital requirement ratio, CR=OpCap/Sales=56%. You estimate that the growth rate in sales from year 0 to Year 1 will be 10%, from Year 1 to Year 2 will be 8%, from Year 2 to Year 3 will be 5% and from Year 3 to Year 4 will be 5%. You also estimate that long-term growth rate beyond Year 4 will be 5%. Assume the operating profitability and capital requirement ratios will not change.

What is the horizon value at year 4? What is the total net operating capital at year 0? How does the value of operations compare with the current total net operating capital?

Answer 1

Sales of Hatfield in Million Dollars calculated as per the growth rates given

Sl No	Year	Sales ( increasing at 10,8,5,5 % YOY respectively)	OP Cap (56 % of sales)
1	Year 0	2000	1120
2	Year 1	2200	1232
3	Year 2	2376	1330.56
4	Year 3	2494.8	1397.1
5	Year 4	2619.54	1467

Free cash flow at Year 4 will be

Nopat - Change in Net Capital

Nopat = Sales X Profitability Ratio = 2619.54*4.5% = $ 117.88 mn.

Change in Net Capital =1467-1397 = $ 70 mn

FCF @ Year 4 = $ 47.88 mn

Assuming that this company is similar to B&M the WACC could be taken as 11% and growth rate given is 5%

hence horizon value is 47.88/(11%-5%) = $ 798 mn

Value of operations is Nopat = $ 117.88 mn (4.5% of sales) and Total Net Operating Capital = $ 1467 mn (56% of sales)

hence the ratio of Value of operations and Total Net Operating Capital is fixed at 0.08( 4.5/56).