AFTER TAX ANALYSISrosita0210
EMGT 6225 | CASE STUDY 2
AFTER-TAX ANALYSIS FOR BUSINESS EXPANSION
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.
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.