Question

This question has two parts

Part 1

You are CFO of a major chain of restaurants called Chipotle. In an increasingly challenging business environment, Chipotle is considering an acquisition of its major competitor, Los Pollos Hermanos (LPH). Your research indicates that LPH is expected to generate a positive cashflow of $186 million per year for each of the next 20 years. The first of the annual cashflows will be received one year from today. You estimate that an appropriate opportunity interest rate (required return) for this transaction is 11%.

Part 2

During preliminary negotiations with the owners of Los Pollos Hermanos, you have been offered the opportunity to acquire LPH for $1.35 billion (to be paid today). Using time value of money concepts, show whether you should accept the deal.

Some recent questions have been raised about operational risk involving certain product offerings of Los Pollos Hermanos. You know that valuation models primarily incorporate risk through the estimation of the interest rate (required return). Explain how an increase in the interest rate would affect your decision (from part a).

Answer 1

P = Annual Cash Flow = $186 million

n = 20 years

r = interest rate = 11%

Present Value of Cash flows = P * [1 - (1+r)^-n] / r

= $186 million * [1 - (1+11%)^-20] / 11%

= $186 million * 0.875966093 / 0.11

= $1,481 million

= 1.481 billion

Acquring Opportunity cost = $1.35 billion

Hence it is better to acquire since Present value of cash flows are more than acquiring cost

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If the interest rate goes up, the present value of cash flows will go down, acquiring cost will be more than present value of cash flows hence they should not acquire the opportunity