You are the executive officers of Big Buns, Inc. (BBI). BBI manufactures different types of chairs and accessories. You have had several good years and have decided to expand. BBI is looking at acquiring another company as a subsidiary.
As executives (financially savvy and adept in capital budgeting procedures :-)) you have narrowed your choices to two possible acquisitions; Hineys R Us, a seat cushion manufacturer, and Flaberific, a heavy duty lawn chair manufacturer. You only have $500,000 to spend, which happens to be the price tag for each of the companies.
It is your job to determine which company you should acquire. BBI's cost of capital is 10%.
The raw data for each company is as follows: Hineys R Us (HRU) ----------------- HRU is projected to sell 50,000 units (seat cushions) in year one at a retail price of $15 per unit with an increase of 30% per year. Variable costs consist of Cost of goods sold, estimated at 25% of sales; advertising, estimated at 10% of sales; other variable costs, estimated at 5% of sales.
Fixed costs consist of labor for year one estimated at $200,000 with an increase of 10% per year; rent for year one estimated at $60,000 with an increase of 5% per year; depreciation estimated at $10,000 per year; and other fixed costs for year one estimated at $5,000 with an increase of 5% per year. HRU's tax rate is estimated at 30%.
You also project that you will have to spend an additional $20,000 in year 2 and $50,000 in year 5 in capital expenditures. To be conservative you are using a discount rate 2 points above BBI's cost of capital. Flaberific (FLB) ---------------- FLB is projected to sell 40,000 units (lawn chairs) in year one at a retail price of $25 per unit with an increase of 30% per year.
Variable costs consist of Cost of goods sold, estimated at 30% of sales; advertising, estimated at 15% of sales; other variable costs, estimated at 5% of sales. Fixed costs consist of labor for year one estimated at $250,000 with an increase of 10% per year; rent for year one estimated at $80,000 with an increase of 5% per year; depreciation estimated at $20,000 per year; and other fixed costs for year one estimated at $5,000 with an increase of 5% per year. FLB's tax rate is estimated at 30%. You also project that you will have to spend an additional $75,000 in year 2 and $175,000 in year 5 in capital expenditures.
You consider FLB to be slightly more risky than HRU so you will use a discount rate 3 points above BBI's cost of capital.
1) A 5 year projected Income Statement.
2) A 5 year projected Cash Flow.
3) Net Present Value
4) Internal Rate of Return
5) Payback Period
6) Profitability Index
7) Discounted Payback
8) Modified Internal rate of Return
9) Breakeven for year 1
10) Based on items 1 through 7, which company should BBI acquire?