East Metro Drive In Case Analysis
1. What are the key business assumptions that drive the value of the investment? Focus on the top 3 items that drive the value of this investment.
Generally, the key business assumptions that drive the value of the business are the expected returns on the given investment. Although the investment theory is quite complicated because it deals with tens if not hundreds of various market and economy related factors, the investment making decision can be simplified to two basic steps. 1. Determining the expected return on the investment (this is the driving element of any investment) 2. Calculating the possible risk that will be incurred. Once this is done, an investor will try to eliminate some risks and reduce those that can’t be removed.
In our case, the major business assumptions that drive the value of the business are:
a. It appears to be a profitable business.
b. Real estate investments are considered to be among the safest ones.
c. There are definite predictions of real estate market increasing in value. Hence, one expects high profits to be made by selling the land to a real estate developer for commercial development.
2. Identify due diligence techniques that you would suggest to verify the assumptions in the financial forecast. What questions do you have for Mr. Berry? What documents would you ask for?
What is missing in this analysis? Where would you want more detail? What else would you add?
The purpose of the due diligence is to learn as much information about the client before making any proposals or deals with him as possible. The standard technique involves formal and informal procedures. Formal procedures include: getting the balance, sheet, income statement, and cash flow statement of the company. However, the formal annual statements do not reveal all information about the company. That’s why it is useful to perform an informal (step 2) procedure.
• Make informal inquiries. One can get information informally by speaking to experts in the client's industry, the company’s customers, and the firm’s competitors.
• Acquire information from the client. One can get a good deal of information from the firm itself, through annual reports, press releases, and collateral material. It is imperative to attempt to spend as much time beforehand speaking with the inside team on the deal. This will aid one in realization of their goals and demands, and resolve if the plans are reasonable and their expectations fair.
• Search the Web. It comes without saying that the Web is full of information, from the firm’s directories, to SEC filings, to industry magazines. The difficulty, of course, is information overload. However, this is one of the most important steps and it shouldn’t be overlooked.
3. As a sole proprietorship, how should an investor evaluate this investment (i.e. which ratios and performance measures would be most meaningful and why?) Include a short explanation/definition of the measures.
The following ratios and margins have to be analyzed. 1. Net profit Margin = Net Profit / Net Sales, it helps to determine how profitable the business has been in the past. 2. Gross Profit Margin = Gross Profit / Net Revenues (or Net Sales), it help to see the profitability of the business after COGS have been subtracted from Sales. 3. Operating Profit Margin – EBIT / Net Sales, shows proportion of Earning Before Interest and Taxes to Net Sales. The ratios include, P /E (Price to Equity) ratio, P / Book (Price to Book value) ratio, ROE (Return on Equity – shows how much the investor is getting if compared to the equity of the firm, quite a popular measure. ROI (Return on Investment) is one of the most popular measures because it helps determine the ratio or proportion of possible or expected return to the investor.
4. Discuss this investment from the standpoint of the buyer (based on the measures you have just suggested) – is this a good investment? Does it meet their investment criteria? Why or why not?
Average Return on Assets (years 2006 through 2017) is 18%. Average ROE is 20%. Average Net Profit Margin is 10%. Average Operating Profit Margin is 18%, and Gross Profit Margin is 20%. Overall, it seems to be a good investment proposal. However, it is not clear whether the business will sustain the present rate of development and what risks the business incurs in its operations.
5. Assume the investor can negotiate the purchase price – what would you recommend be paid in order to meet the requirements of both the lender and the investor?
Generally, the NPV (Net Present Value) is determined to see how much an investor should pay for the business (Rule is: accept projects with positive NPV). In our case, NPV (assuming the equity infusion of 1 287 331 and IRR of 10%) is minus 261,718. Hence, the maximum price the investor should pay for this business is technically minus 261,718. In other words, the investor is expected to gradually receive a sum of 2,979,348 (as future cash flows) during the next 12 years. However, this money is only worth 1,025,613 today (PV concept). At the same time the cash flow resulting expenses are 1,287,331.
Therefore, in order to make sense out of this deal the investor should pay the sum of 1,025,613 or less (positive NPV can only be attained if the initial sum is lower or future cash flows higher or IRR is lower).
6. What are the likely sources of debt funding for this project and why?
The likely sources of debt financing for this project is the loan financing from the bank. The bank is likely to give the new company a loan based on the positive cash flows’ projection and the value of the collateral (land and company’s assets in this case).
7. Discuss this loan from the standpoint of the lender. How will the lender evaluate this loan? Is this a good lending opportunity? Does it meet their loan criteria? Should the loan be made? Why or why not?
The lender provides a loan of 30% of the needed sum which is 551,713. The first and foremost thing the lender is interested in is whether the loan will be repaid and whether the cash flows generated by the business in the future will be large enough to cover the repayment of the loan (interest and principal in proportion). The lender makes an interest of 6.5% on the remaining balance each year. The bank will evaluate the loan based on two criteria: 1. Collateral. 2. Expected cash flows of the business. Since the land is expected to appreciate by 10% until the year 2015 and the business generates positive cash flows, it is a good lending opportunity for the bank.
8. Assume you have flexibility to change the financial plan or the lender’s terms– what would you change in order to determine a forecast that meets the requirements of both the lender and the owner?
Currently the bank is using an annuity lending scheme. It means that the company will be paying equal installments for 11 years that will cover the loan’s interest and principal. However, the peculiarity of this scheme is that the first payments made by the firm cover the greater part of interest that is based on 11 years term of the loan and only cover small part of the principal’s repayment amount. The bank uses such scheme to protect its future revenues and to reduce the risk of default (that is when company goes bankrupt the principal is likely to be repaid using the collateral, but the interest payment will be lost). At the same time, if the company decides to pay out its loan-principal earlier than in 11 years, it will not gain much in terms of savings on not having to pay interest since the largest proportion of the interest has already been covered in the early payments.
To make the deal more attractive to the client, the bank might agree to use a different lending scheme when the company pays an interest, on the remaining balance (e.g. its annual payments are not fixed but depend on the ending balance and the interest is not paid “upfront” but is charged on the remaining balance, the only thing that is fixed is principal payments).
8. Discuss the impact of the land sale on the project’s financial performance. Discuss the risk implications. How can these be mitigated?
If the company sells land, it will acquire additional finances for its operations’ expansion and increase. At the same time, it will loose a chance of attaining profits that are likely to come with the 10% annual appreciation of the land (based on market predictions). What is more, the company will have to pay the rent fee for using this land to a new owner. The company will, therefore, run a certain risk of fees’ increase since the market is expected to grow. Another risk is that the bank might not like the idea of land sale because the land serves as collateral for the loan. Even though the firm may promise to fully repay the loan when the funds from the land’s sale are received, there is no guarantee (unless a certain contract between the bank and the company is signed) that it will fulfill its promise when the cash from the land sale is received. Based on the market risks and the fact that the company will loose certain amount of money if it sells the land too early, it is best not to make such transaction.
9. Discuss some of the risks of the drive inn’s revenue. From a practical point, which revenues would be most “at risk”? Discuss the sensitivity of the project’s financial performance to changes in these assumptions. Discuss possible ways that the investor could mitigate some of the risk associated with the revenue stream.
The revenue that has the highest risk is the one where risks are least likely to be eliminated. In our case the revenue that is most at risk is concession revenue. For the concession revenue, there is a general assumption related to how much each customer spends, and what proportion of that concession revenue must be used to pay the food expense (assumed to be 55%). This type of revenue is most at risk because concessions tend to fluctuate a lot and depend on the general economic situation in the area or the country. This product has high price elasticity, meaning that if the price for snacks increases, the demand will fall sharply. It is very difficult to eliminate risks on this type of revenue.
An important rationale behind risk analysis is to avoid surprises. You may not be able to stop the hurricane that is rushing toward your home, but if you know that it is on its way and will reach your area in six hours, you can prepare to deal with it. If you are unaware of its impending arrival, you will be caught unprepared, and this may have serious consequences for your home and personal safety.
In our case, risk identification is the first step in the risk assessment process. Its purpose is to surface risk events as early as possible, thereby reducing or eliminating surprises. As a consequence of risk identification, risk analysts can develop a good sense of possible sources of problems (or opportunities) that will affect their organization's projects and operations. They then examine the quantitative and qualitative impacts of the identified risk events, which constitutes the second step of the risk assessment process. Once the impacts of the identified risk events have been reviewed, the risk analysts, working with managers and employees in the enterprise, engage in risk response planning to develop strategies to handle the risk events.
This is the third and last step of the risk assessment process. This description of risk assessment pictures the process as linear, moving from one step to the next. In practice, the process is more dynamic.
9. Assume you have flexibility to change the pricing structure (ticket prices for children, adults, etc.). What would you change in order to determine a forecast that meets the requirements of both the lender and the owner?
Appropriate pricing structure is important for the business because the well-defined pricing structure means that the company is operating at profit. In order to make the project more acceptable to the owner, the customer has to provide more definite assumptions of the number of customers that will use the drive inn’s services. It can be done through estimating the company’s share of the market. Also, securing contracts with corporate clients will help to bring more accurate revenues’ forecast.
10. Discuss some of the risks of the drive in’s expenses. From a practical point, which expenses would be most “at risk”? Discuss the sensitivity of the project’s financial performance to changes in these assumptions. Discuss possible ways that the investor could mitigate some of the risk associated with the project’s expenses.
The costs are employee costs, the cost of movie rental (which is driven by whether 2 or 3 films are showing a night) and other fixed and variable cots (attendance, hours of operation, supplies, advertising, utilities, etc.). The fixed expenses are most at risk. On the one hand it is difficult to predict how many customers exactly the business will have. However, the expenses associated with hours of operation, supplies, etc, can be more easily eliminated than fixed expenses. Supplies, advertising, fixed labor, property tax, accounting and legal expenses are most at risk because these expenses are fixed and can’t be eliminated. If the business generates lower revenues, all of the fixed costs will still have to be covered.
11. Assume you have flexibility to alter the expenses of the drive in. What assumptions would you change in order to determine a forecast that meets the requirements of both the lender and the owner?
Eliminating those risks that can be managed is one of the primary tasks for this company. For instance, securing price with movie lenders and food suppliers reduces the risk of price increase. Taking upfront payments from the corporate clients or selling season passes reduces the risk of lower demand or default on payments. Hiring more part-time workers reduces the risk of lower revenues associated with high costs that result from may factors, one of them being fixed or contracted labor.
12. Discuss why the investor may want to prepare a more detailed daily cash flow forecast for the Drive in Movie Theater. What information would this forecast provide? What issues or problems could you anticipate the forecast identifying?
The investor may want to prepare a more detailed cash flow forecast for the movie drive in to gain a better understanding of the company’s operations and to eliminate any mistakes or inefficiencies in operations that may not be evident by looking at a superficially composed cash flow forecast. Cash flow forecast may also be used for company’s valuation.
Despite its undoubted popularity as a valuation technique, one of the drawbacks of using the price/earnings ratio is that it is essentially an accounting profits-based valuation method; however, in financial management there is a preference for estimating expected future returns in terms of cash flows rather than profits. To use a model based on cash flow returns investors could convert the earnings figure in the profit and loss account to a cash flow figure by simply adding back the depreciation.
The simplest definition of cash flow is:
Cash flow=Operating profit + depreciation ± other non-cash items. Free cash flow can have different definitions, for our purposes here we will define free cash flow as:
Free cash flow = Cash flow −(investment expenditures + taxes)
This definition represents the amount of cash available for discretionary purposes such as additional investments or the repayment of loans.
13. As the financial advisor, you are asked to “bring it all together” in order to present back to your client a scenario that you believe is realistic, manages risk appropriately and also meets the criteria of both lenders and investors. Determine a new scenario that includes changes to any assumptions that you prefer (revenues, expenses, purchase price, financing assumptions). Provide an explanation as to why you made these changes and why you believe this is an optimal investment case.
The following points have to be included in the final presentation.
1. Drive in presents a good investment opportunity based on the positive future cash flows, 10% annual appreciation of the land, and favourable conditions on the market.
2. Concentrate on making informal inquiries as well as formal ones during the process of due diligence. Financial statements provide a biased picture of the company.
3. Use Price to Earnings approach to make the valuation, but also consider free cash flow method as it provides a clearer picture of the situation. In addition, concentrate on the ROI ratio as it gives an investor a very good idea what he can expect from this deal.
4. It is reasonable to accept projects that have positive NPV. Hence, the price should be reduced. The investor should pay the sum of 1,025,613 or less (positive NPV can only be attained if the initial sum is lower or future cash flows higher or IRR is lower).
5. To make the deal more attractive to the client, the bank might agree to use a different lending scheme when the company pays an interest on the remaining balance. In other words, the annual payments are not fixed but depend on the ending balance and the interest is not paid “upfront” but is charged on the remaining balance. The only thing that is fixed is principal payments. At the same time, the bank is still generating revenues from the annual interest payments.
6. It is imperative to realize that some risks can’t be eliminated, therefore, further strategies are needed to develop ways of reducing these risks. Concession revenue is most at risk because concessions tend to fluctuate a lot and depend on the general economic situation in the area or the country. To continue, provide more definite assumptions of the number of customers that will use the drive inn’s services by estimating the company’s share of the market. Also, securing contracts with corporate clients will help to bring more accurate revenues’ forecast.
7. Supplies, advertising, fixed labor, property tax, accounting and legal expenses are most at risk because these expenses are fixed and can’t be eliminated. If the business generates lower revenues, all of the fixed costs will still have to be covered.
8. Eliminating those risks that can be managed is one of the primary tasks for this company. For instance, securing price with movie lenders and food suppliers reduces the risk of price increase. Taking upfront payments from the corporate clients or selling season passes reduces the risk of lower demand or default on payments. Hiring more part-time workers reduces the risk of lower revenues associated with high costs that result from may factors, one of them being fixed or contracted labor.
9. Finally, providing more detailed daily cash flow will help to find inefficiencies and errors in the company’s operational scheme.