Friendly Cards Inc Case Study Solution

HARVARD BUSINESS SCHOOL

9-293-135

Rev. June 18, 1993

Friendly Cards, Inc.

 

WACC

Assume an 8.4% risk-free rate and a 7% market risk premium.

 

For American Greetings, Asset Beta=539/ (341+539)*1.07=0.66.

For Gibson Greetings, Asset Beta=154/ (75+154)*0.93=0.63.

Estimate the Asset Beta for Creative Designs. Asset Beta= (0.66+0.63)/2=0.64.

For Creative Designs, Equity Beta= (1+Debt/Equity)*0.64= (1+1)*0.64=1.28.

I use $8 a share as the price of Friendly cards, so the P/E ratio should be 5.92.

I use this P/E ratio to estimate the market value of equity of Creative Designs.

 

For Creative Designs, market value of equity=171*5.92=$1013. (In thousands)

Cost of Equity=8.4%+1.28*7%=17.36%.

I use interest expense over long-term liabilities (why not total? I have this concern.) rate to calculate Cost of Debt, which is 100/1000=10%.

Tax rate is 38%.

WACC=17.36%*1013/ (2250+1013) + (1-38%)*10%*2250/ (2250+1012) =9.7%.

 

Income statements and Balance sheets projection

I take into account the improvements Friendly intends, because this is for the consideration of acquisition, and the cash flows projected should also based on the improvements by Friendly.

actual

projected

1987

1988

1989

1990

Net sales

5000

5000

5300

5618

COGS

3075

2921

3097

3282

Gross profit

1925

2079

2203

2336

Total expenses

1550

1395

1479

1567

EBIT

375

684

725

768

Interest

100

100

106

112

ebt

275

584

619

656

Tax

104

221

234

248

Net income

171

363

385

408

Dividends

96

96

96

96

Retained earnings

75

267

289

312

ASSET

Cash

88

358

380

413

Receivable

1600

1600

1696

1798

Inventory

1500

1425

1511

1601

Prepaid

62

59

62

66

Total current

3250

3442

3649

3878

Net fixed

1250

1250

1325

1405

Total asset

4500

4692

4974

5282

LIBILITIES

Bank loans

250

250

265

281

payable

500

475

504

534

cp of long-term d

50

50

50

50

Other

450

450

450

450

Total current

1250

1225

1269

1315

Long-term debt

1000

950

900

850

Total liabilities

2250

2175

2169

2165

Common stock

100

100

100

100

Paid-in capital

300

300

300

300

Retained earnings

1850

2117

2406

2718

Total

4500

4692

4974

5282

 

Projected Cash Flows

I project the financial statements and free cash flow from 1988 to 1997.

actual

projected

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

Net sales

5000

5000

5300

5618

5955.08

6312.3848

6691.1279

7092.5956

7518.1513

7969.2404

8447.3948

COGS

3075

2921

3097

3282

3479

3688

3909

4144

4392

4656

4935

Gross profit

1925

2079

2203

2336

2476

2624

2782

2949

3126

3313

3512

Total expenses

1550

1395

1479

1567

1661

1761

1867

1979

2098

2223

2357

EBIT

375

684

725

768

814

863

915

970

1028

1090

1155

Interest

100

100

106

112

119

126

134

142

150

159

169

ebt

275

584

619

656

695

737

781

828

878

930

986

Tax

104

221

234

248

263

279

295

313

332

352

373

Net income

171

363

385

408

432

458

486

515

546

579

613

Dividends

96

96

96

96

96

96

96

96

96

96

96

Retained earnings

75

267

289

312

336

362

390

419

450

483

517

ASSET

Cash

88

358

380

413

456

510

576

656

748

855

977

Receivable

1600

1600

1696

1798

1906

2020

2141

2270

2406

2550

2703

Inventory

1500

1425

1511

1601

1697

1799

1907

2021

2143

2271

2408

Prepaid

62

59

62

66

70

74

79

84

89

94

100

Total current

3250

3442

3649

3878

4129

4403

4703

5030

5385

5770

6187

Net fixed

1250

1250

1325

1405

1489

1578

1673

1773

1880

1992

2112

Total asset

4500

4692

4974

5282

5617

5981

6376

6803

7265

7763

8299

LIBILITIES

Bank loans

250

250

265

281

298

316

335

355

376

398

422

payable

500

475

504

534

566

600

636

674

714

757

803

cp of long-term d

50

50

50

50

50

50

50

50

50

50

50

Other

450

450

450

450

450

450

450

450

450

450

450

Total current

1250

1225

1269

1315

1363

1415

1470

1528

1590

1656

1725

Long-term debt

1000

950

900

850

800

750

700

650

600

550

500

Total liabilities

2250

2175

2169

2165

2163

2165

2170

2178

2190

2206

2225

Common stock

100

100

100

100

100

100

100

100

100

100

100

Paid-in capital

300

300

300

300

300

300

300

300

300

300

300

Retained earnings

1850

2117

2406

2718

3054

3416

3806

4225

4675

5157

5674

Total

4500

4692

4974

5282

5617

5981

6376

6803

7265

7763

8299

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

operation CF

336

528

560

593

629

667

707

749

794

842

892

change in nwc

50

267

214

232

252

273

295

319

343

370

398

capital exps.

165

165

175

185

197

208

221

234

248

263

279

free CF

121

96

171

176

180

185

191

196

202

209

216

free CF/sales

1.92%

3.23%

3.12%

3.03%

2.94%

2.85%

2.77%

2.69%

2.62%

2.55%

increase free CF

-20.66%

78.13%

2.63%

2.72%

2.80%

2.89%

2.98%

3.07%

3.15%

3.24%

 

I assume the cash flow after 1997 will increase 3.24% ever after. The terminal value in 1997 is 216,000/ (9.7%-3.24%) =$3,337,000.

 

PV=$2,410,000.

Use WACC, 9.7%, as discount rate.

 

Total expense is $9.5*198,000 shares=$1,881,000

 

NPV=$529,000

 

Creative Designs a worthwhile acquisition.

 

If I assume the cash flow after 1997 will increase 0% ever after, NPV is $87,000.

However, if the growing rate of sales is not high as I assumed in the following ten years, which is 6%, the NPV could be negative. Therefore, it really depends how the future revenue will grow.

 

1

Value to old shareholders before stock offering:

580*9.5=$5510 thousands

Value to old shareholders after stock offering:

(580*9.5+200*8-80)*580/ (580+200) =$5227 thousands

Value to old shareholders is reduced by $283 thousands.

 

Value to new shareholders before stock offering:

200*8=1600

Value to new shareholders after stock offering:

(580*9.5+200*8-80)*200/ (580+200) =$1803 thousands

Value to new shareholders is increased by $203 thousands.

 

The amounts are not equal, because there is a finder’s fee to be paid.

 

2

I didn’t found any information about stock option.

 

3

The discount rate for valuing the envelope machine should be different from the discount rate for valuing Creative Designs, because they are two investments for different projects. The discount rate for valuing the envelope machine should be the WACC of Friendly Cards.

 

For American Greetings, Asset Beta= 33.4/1.04*14/ (33.4/1.04*14+539)*1.07=0.49.

For Gibson Greetings, Asset Beta= 24.1/1.53*12.63/ (24.1/1.53*12.63+154)*0.93=0.52.

Estimate the Asset Beta for Friendly Cards. Asset Beta= (0.52+0.49)/2=0.51.

Equity Beta= (1+Debt/Equity)*0.51= (5510+6070+433+2458)/5510*0.51=1.34.

 

5510/ (5510+6070+433+2458)*(8.4%+1.34*7%) + (1-38%)*(8.5%+2.5%) =13.59%

 

4

1

2

3

4

5

6

7

8

1987

1988

1989

1990

1991

1992

1993

1994

1995

saving

218

218

218

218

218

218

218

218

exps.

-500

pv

192

218

218

218

218

218

218

218

npv

1218

Use 13.59% as discount rate.

 

NPV is positive. They should bug the envelop machine.

 

5

actual

projected

1987

1988

1989

1990

Net sales

21253

24500

28550

33618

COGS

13615

15596

18209

21482

Gross profit

7638

8904

10341

12136

Total expenses

5048

5588

6477

7587

0

0

0

0

EBIT

2590

3316

3864

4548

Interest

1050

1175

1294

1432

ebt

1540

2141

2570

3116

Tax

585

813

975

1183

Net income

955

1329

1594

1933

Dividends

96

0

0

0

Retained earnings

859

1329

1594

1933

 

ASSET

Cash

328

704

822

951

Receivable

8613

9985

11694

13838

Inventory

7088

8055

9416

11121

Prepaid

254

254

295

346

Total current

16283

18998

22226

26256

Net fixed

3683

4175

4813

5605

Other

892

905

905

905

Total asset

20858

24078

27944

32765

LIBILITIES

Bank loans

6320

7836

9586

11685

payable

3557

4180

4921

5854

accrued

1231

1463

1744

2100

cp of long-term d

483

500

500

500

Other

696

700

700

700

Total current

12287

14679

17451

20839

Long-term debt

3458

2958

2458

1958

Total liabilities

15745

17637

19909

22797

Common stock

158

158

158

158

Paid-in capital

1115

1115

1115

1115

Retained earnings

3840

5169

6763

8696

Total

20858

24078

27945

32766

 

I use three criteria to judge the company’s financial situation, interest bearing debt/equity, bank loans/accounts receivable, and liabilities/net worth.

 

1987

1988

1989

1990

interests bearing debt/equity

2.01

1.75

1.56

1.42

bank loans/receivables

0.73

0.78

0.82

0.84

liabilities/net worth

3.08

2.74

2.48

2.29

 

 

6

actual

projected

1987

1988

1989

1990

Net sales

21253

24500

28550

33618

COGS

13615

15596

18209

21482

Gross profit

7638

8904

10341

12136

Total expenses

5548

5518

6407

7517

0

0

0

0

EBIT

2090

3386

3934

4618

Interest

1050

1175

1294

1432

ebt

1040

2211

2640

3186

Tax

395

840

1003

1211

Net income

645

1371

1637

1975

Dividends

96

0

0

0

Retained earnings

549

1371

1637

1975

 

ASSET

Cash

328

704

822

951

Receivable

8613

9985

11694

13838

Inventory

7088

8055

9416

11121

Prepaid

254

254

295

346

Total current

16283

18998

22226

26256

Net fixed

4183

4613

5188

5917

Other

892

905

905

905

Total asset

21358

24515

28319

33078

LIBILITIES

Bank loans

6320

7836

9586

11685

payable

3557

4180

4921

5854

accrued

1231

1463

1744

2100

cp of long-term d

483

500

500

500

Other

696

700

700

700

Total current

12287

14679

17451

20839

Long-term debt

4268

3663

3058

2454

Total liabilities

15745

17637

19909

22797

Common stock

158

158

158

158

Paid-in capital

1115

1115

1115

1115

Retained earnings

3530

4901

6537

8513

Total

21358

24515

28319

33078

 

I use three criteria to judge the company’s financial situation, interest bearing debt/equity, bank loans/accounts receivable, and liabilities/net worth.

1987

1988

1989

1990

interests bearing debt/equity

2.31

1.94

1.68

1.50

bank loans/receivables

0.73

0.78

0.82

0.84

liabilities/net worth

3.28

2.86

2.55

2.33

 

My recommendation:

The NPV of investing in the envelop machine is $1218 thousands, so the company should invest in this machine. With the growth of equity, the company’s financial situation is getting better and better, so the company shouldn’t worry about bank loans. In addition, it is not a good time to issue stocks, given the losses of old shareholders.

 

加载中,请稍候......

RATIO ANALYSIS, PROFORMA ANALYSIS, NPV

Using the Case: "Friendly Cards Inc." (Harvard Business School case, no. 9-293-135):

1. Perform a ratio analysis of Friendly Cards for 1985-1987 and discuss the company's health. Decided if Friendly Cards should accept the West Coast investors offer and issue new equity.

2. Perform a Pro Forma Analysis for Friendly Cards' financials from 1988-1990 to show what is likely to happen the company's bond covenants if the status quo continues.

3. Perform a NPV analysis to see if Friendly Cards should purchase the envelope machine (a reasonable WACCT should be sought)

4. Perform a pro forma for Creative Designs to show what would happen if Friendly Cards purchased the company. Then do a valuation of the decision to buy Creative Designs (balance the asking price against the PV of Creative Designs free cash flows).

Solution Summary

A ratio analysis, pro forma analysis, and NPV analysis for Friendly Cards Inc are completed. Creative Designs is also compared to Friendly Cards through a pro forma analysis to see if it would be a good decision.

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