Reference no: EM133557879

Mini Case #2: Capital Budgeting at Neuquén, Inc.

Assignment Overview:

Neuquén, Inc., a publicly traded firm, is considering the acquisition of a private company, Artforever.com, which specializes in restoring damaged artwork and vintage photographs for high net worth individuals. Neuquén's CEO and chairman of the board, Willie Ray, described the motivation for the acquisition as follows: "We are running out of profitable investment opportunities in our core vintage shoe restoration business, and our shareholders expect us to continue to grow. Therefore, we must look to acquisitions to expand into growing markets." Neuquén, Inc.'s common stock is currently trading at $50 per share, and the firm has 100,000 shares outstanding. The book value of the common stock is $20 per share. However, as mentioned by Mr. Ray, sales had been slowing recently and the board was concerned that soon the share price would also begin to flag as investors figured out that the firm was running out of positive NPV investments. The firm has $2,000,000 market value of bonds trading at a yield to maturity of 6.2%. You have been hired as a consultant to Neuquén to evaluate the proposed acquisition of Artforever.com. There is considerable dissension among senior management and the board about whether the acquisition should be undertaken. Your job is to perform a thorough analysis of the merits of the proposed acquisition and make a recommendation to senior management. After several meetings with Neuquén management and a review of Artforever's financial performance and industry structure, you gathered the data shown in Table 1 below. 

Forecast Data for Artforever.com (in $'000) 

	2018	2019	2020	2021	2022
Sales Revenue	1,000	1,250	1,875	2,100	3,750
Investment in CapEx and NWC	25	55	170	80	80
Depreciation	15	30	50	72	80
Interest payments	94.4	101.4	108.6	115.9	122.4

Artforever.com currently has $1,475,000 (market value) in long-term debt, with a coupon rate of 7%. Its cost of goods sold (COGS) is expected to be 42% of sales revenues, and selling, general and administrative (SG&A) expenses are expected to be 15 percent of revenues. The depreciation numbers listed above are already included in COGS percentage estimates. The firm's corporate tax rate is 40% and its current cost of borrowing is 6.2%. 

Your research indicates that Artforever has a target debt to value ratio of 15%, based on its assessment of the probability and costs of financial distress. You note that this is different from the capital structure of Neuquén and wonder how this would factor into your analysis. 

Although Artforever.com is a rapidly growing company, your analysis of industry structure suggests that competition in the art restoration market is likely to increase in the next few years. Thus, you forecast that the perpetual growth rate for free cash flows beyond 2022 will be a more modest 2.0% per year. 

Your analysis of market data yielded the information in Table 2 below.

Market Data

Current yield to maturity on 30 year treasury bonds	2.50%
Current yield to maturity on 3 month treasury bills	2.0%
Most recent 1-year return on the S&P 500	5.3%
Estimate of expected average return on the S&P 500 over the next 30 years	8.0%

Your analysis of Artforever.com's industry reveals that most of the firms in the industry, like Artforever, are private firms. However, you find a close competitor, ArtToday.net, that is in the same line of business and is publicly traded. ArtToday has a long-term target debt to equity ratio of 0.75, and has been historically quite close to that target. Your analysis of ArtToday's historical returns against the market returns yields an equity beta of 1.5. ArtToday currently has 50,000 common shares outstanding trading at $12 per share. Assume that both companies face a similar tax rate. 

Guidelines for Case Analysis: 

The following aids are permitted for this analysis: You may use internet sources, books, all posted materials (including Discussion Board Q&A), and your notes. Any other aids are unauthorized and their use constitutes a violation of academic integrity. This includes face-to-face or electronic correspondence concerning the specific details of the case with any other person that is not a member of your assigned group, whether or not they have current or past affiliation with Texas A&M University Corpus Christi. The case is due on the date indicated on the course schedule. Late papers may be accepted with a reasonable excuse, but will be assessed a 20% grade reduction penalty. Cases should be typed in 12-point font, double-spaced, with a minimum of 1 inch margins. The case report should be written according to the following format:

1. Introduction 

2. Analysis 

3. Conclusion 

The introduction sets the stage for the work to follow and should consist of a short paragraph of the key problem(s) or issue(s) that your analysis addresses. The analysis will constitute the bulk of the written presentation and will be a direct response to the questions below. Use clear, concise, and complete sentences. Do not use bullet points or numbered paragraphs. The conclusion should be a short paragraph that summarizes the key points of the analysis. 

Your analysis of "Neuquén, Inc." should include answers to the questions below. Do not write the questions verbatim in your report. 

1. What discount rate is appropriate for finding the value of Artforever.com? 

Explain your reasoning and computations in detail; show detailed computations in your Excel spreadsheet labeled Exhibit 1. 

2. What are the relevant cash flows for valuing Artforever.com? Assume that your valuation is performed at the end of 2017, and that the values shown in Table 1 are end-of-year forecasts. 

Explain your reasoning your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 2. 

3. Based on your answers to questions (1) and (2) above, what is the maximum price that Neuquén should pay to equity shareholders for Artforever.com? Explain your reasoning and computations; show detailed computations in your Excel spreadsheet labeled Exhibit 3. 

4. Under what conditions might you consider recommending that management make a higher offer than your recommended price in (3) above? 

No computations are necessary, just a short discussion. Your report is intended for the senior management of Neuquén, Inc.,