URGENT :NPV Case- Need your help

Bluejay Corporation: An Application of NPV

Earlier today, you were unexpectedly contacted by J.J. Bluejay, IV, the newly appointed treasurer of the Bluejay Corp. Although publicly traded, Bluejay Corp. is 35% controlled by the Bluejay family which in turn is 100% controlled by J.J. Bluejay, III, Chairman and CEO of the corporation. The new treasurer brings emminent qualifications to the task: he has 1) studied at various undergraduate institutions for ten years, 2) managed the financial budget of a Tibetan monastery, and 3) most importantly, is a Bluejay. J.J. contacted you this morning because he needs the advice and discretion that only you, his lender and trusted financial advisor, can provide. J.J. has been asked to approve funding for a proposed acquisition of Cardinal, Inc., a firm serving the birdbath fixture industry. Bluejay’s Business Planning and Development Department (BPDD) has recommended this purchase for various strategic reasons. Foremost among the reasons, was the result of BPDD’s independent valuation analysis. This study showed that Cardinal’s calculated value of $531 million was substantially higher than its current market value of $375 million. (The BPDD calculated the $531 million by using the birdbath industry’s average P- E (price earnings) ratio of 10 multiplied by Cardinal’s earning this year of $53 million) Assuming a purchase price 15% over the market value, the analysts in the BPDD see a chance to create approximately $100 million in value ($531 million – $431.5 million) even without considering synergies!

Although J.J. lacks the requisite financial acumen for his job, he is quite cautious about investing corporate funds. In your telephone conversation, he commented “We’re not talking chickenfeed! No decision involving $431.5 million can be as easy as the business planning and development department wants it to seem, especially when it involves cash that my family controls. Please remember, every dollar that I lose will mean $.35 less in inheritance to me. Can you help me value Cardinal? Oh, by the way, I need the value within an hour and if my dad ever hears a chirp about this, I’ll fly the coop and we’ll cancel our banking relationship with you.”

Subsequently, he faxed the following “fact sheet” about Cardinal and the proposed merger:

Cardinal Inc. Fact Sheet

Birdbath industry P/E ratio 10
Birdbath industry cost of capital 12%
Cardinal’s cost of capital 12%
Bluejay’s cost of capital 8%
========================================================================================================================== Proforma Income Statement:

(in millions) 1989 1990 1991 1992 1993 1994 1995 1996

Revenues 900 960 987 970 1,010 1,015 1,015 1,030

Cost of Sales 603 643 661 650 677 680 680 690
Operating Expenses 243 259 266 262 273 274 274 278

Income 54 58 59 58 61 61 61 62

* After 1996, Cardinal should earn approximately $55 million per year (on average). ========================================================================================================================== Proforma Cash flow Statement:
1989 1990 1991 1992 1993 1994 1995 1996

Income 54 58 59 58 61 61 61 62
Depreciation 20 24 26 28 30 33 45 45
Work Cap from Operations 74 82 85 86 91 94 106 107

Working investment 15 16 16 16 17 17 11 11
Cash flow from Operations 59 66 69 70 74 77 95 96

Capital expenditures 39 40 45 40 20 32 18 36 Residual Cash flow to BJC 20 26 24 30 54 45 77 60
————————————————————————————————————————————————————————————————————
* From 1997 through 2003 we expect that cash flows will remain constant $50 million per year. Subsequently, we expect that cash flows will grow by 3% per year. BJC
will receive the residual cash at the end of each year listed.

TOTAL Cash flow:
1989 20
1990 26
1991 24
1992 30
1993 54
1994 45
1995 77
1996 60
When J.J. telephones again –in less than an hour from now– he will probably have the following questions:

1. What cost of capital should be used to value Cardinal? Why? That is, why is that rate the appropriate one?

2. Assuming the purchase price of $431.5 million, what is the net present value of this transaction? Should Bluejay Corp. make the acquisition?

3. Under the current scenario, if Bluejay did make the acquisition, what should happen to its own stock price?

Now, assume that once Bluejay takes control, it will close Cardinal’s prefab birdhouse business. This segment has been losing money for several years. Cash losses of $18 million are expected to continue for seven years at which point it was expected to generate $3 million in cash per year, forever. (Cardinal kept the segment for undisclosed strategic reasons.)

4. What is the net present value of acquiring Cardinal, now?

5. J.J. wants to borrow $125 million to help finance the purchase and repay principal and interest of $20 million per year for 10 years solely from the cash flow generated by the acquisition (assume no tax effect). Would you grant the credit? Why or why not? (Note: the payment of $20 million is an ordinary annuity at a 10% lending rate.)

6. A week has past since J.J. first contacted you. Since then inflation fears have subsided. Thus, the long- term required rates of return have declined by 3 percentage points (across the board). What is the net present value now?

7. Given this change in rates, J.J. now wishes to finance most of the purchase with a loan of $300 million payable in installments of $50 million (principal and interest) over 8 years. Repayment will come solely from Cardinal’s cash flows. Should you make the loan? (Note: the $50 million payment is an ordinary annuity at a 7% lending rate.)