AFTER TAX ANALYSIS

profilerosita0210
CASESTUDY2.pdf

EMGT 6225 | CASE STUDY 2

AFTER-TAX ANALYSIS FOR BUSINESS EXPANSION

BACKGROUND

Charles was always a hands-on type of person. Within a couple of years of graduating from college, he started his

own business. After some 20 years, it has grown significantly. He owns and operates Pro-Fence, Inc. in the

Metroplex, specializing in custom-made metal and stone fencing for commercial and residential sites. For some

time, Charles has thought he should expand into a new geographic region, with the target area being another large

metropolitan area about 500 miles north, called Victoria.

Pro-Fence is privately owned by Charles; therefore, the question of how to finance such an expansion has been, and

still is, the major challenge. Debt financing would not be a problem in that the Victoria Bank has already offered a

loan of up to $2 million. Taking capital from the retained earnings of Pro-Fence is a second possibility, but taking

too much will jeopardize the current business, especially if the expansion were not an economic success and Pro-

Fence were stuck with a large loan to repay.

This is where you come in as a long-time friend of Charles. He knows you are quite economically oriented and that

you understand the rudiments of debt and equity financing and economic analysis. He wants you to advise him on

the balance between using Pro-Fence funds and borrowed funds. You have agreed to help him, as much as you can.

INFORMATION

Charles has collected some information that he shares with you. Between his accountant and a small market survey

of the business opportunities in Victoria, the following generalized estimates seem reasonable:

Initial capital investment = $1.5 million

Annual gross income = $700,000

Annual operating expenses = $100,000

Effective income tax rate for Pro-Fence = 35%

Five-year MACRS depreciation for all $1.5 million investment

The terms of the Victoria Bank loan would be 6% per year simple interest based on the initial loan principal.

Repayment would be in five equal payments of interest and principal. Charles comments that this is not the best

loan arrangement he hopes to get, but it is a good worst-case scenario upon which to base the debt portion of the

analysis. A range of D-E mixes should be analyzed. Between Charles and yourself, you have developed the

following viable options:

Options Debt Equity

Percentage Loan Amount, $ Percentage Investment Amount, $

1 0 100 1,500,000

2 50 750,000 50 750,000

3 70 1,050,000 30 450,000

4 90 1,350,000 10 150,000

EMGT 6225 | CASE STUDY 2

CASE STUDY EXERCISES

1. For each funding option, perform a spreadsheet analysis that shows the total ATCF and its present worth over

a 6-year period, the time it will take to realize the full advantage of MACRS depreciation. An after-tax return

of 10% is expected. Which funding option is best for Pro-Fence? (Hint: For the spreadsheet, sample column

headings are: year, GI − OE, loan interest, loan principal, equity investment, depreciation rate, depreciation,

book value, TI, taxes, and ATCF.)

2. After deciding on the 50-50 split of debt and equity financing, Charles wants to know what additional bottom-

line contributions to the economic worth of the company may be added by the new Victoria site. What are

the best estimates at this time?

Note on “additional bottom-line contributions to the economic worth of the company”:

• Bottomline is another term for net income (NI, NI = taxable income – taxes); whereas revenue or

sales is sometimes referred as the topline. The names come from the locations or positions of these

two items in the income statement.

• Net income is different from ATCF because the NI includes depreciation, a non-CF item, where the

depreciation is specifically removed in ATCF so that only actual cash flow estimates are used.

• In this course where we adopt the discounted cash flow approach in performing economic analysis,

you may use the after-tax PW or after-tax AW as a measurement on “additional bottom-line

contributions to the economic worth of the company”.

• For some large corporations and financial institutions, a modified AW analysis is used to estimate

the wealth-increasing potential that an alternative offers a corporation. For those of you who are

interested, you may continue:

• In the modified approach, instead of ATCF, economic value added (EVA) is used

▪ EVA is a service mark of Stern Value Management

▪ EVA = NOPAT – interest on invested capital

o NOPAT (net operating profit after tax) = TI - taxes

o Interest on invested capital in year t = interest rate x BV at the end of year (t – 1)

▪ BV = book value of a depreciable asset

▪ In this problem, invested capital at time 0 = $1.5 million

• The AW of EVA at the required 10% return is the additional bottom-line contributions of the site to

the economic worth of the company.