Question

Jason Kidwell is considering whether to acquire a local toy manufacturing company, Toys 'n'
Things Inc. The company's annual income statements for three years are as follows:
2014

2013

2012

Revenues

$2,243,1 $2,001,5 $2,115,0

55
01
02

Cost of goods sold

(1,458,0 (1,300,9 (1,374,7

51)
76)
51)

Gross profits

$785,10 $700,52 $740,25

4
5
1

Depreciation and
administrative
expenses

(574,316 (550,150 (561,500

)
)
)

Net operating income

$210,79 $150,37 $178,75

8
5
1

a. Jason has learned that small private companies such as this one typically sell for EBITDA
multiples of three to four times. Depreciation expense equals $50,000 per year. What value
would you recommend Jason put on the company?
b. The current owner of Toys 'n' Things indicated to Jason that he would not take less than five
times 2014 EBITDA to sell out. Jason decides that, based on what he knows about the company,
the price could not be justified. However, upon further investigation, Jason learns that the
owner's wife is paid $100,000 a year for administrative services that Jason thinks could be done
by a $50,000-per-year assistant. Moreoever, the owner pays himself a salary of $250,000 per
year to run the business. In addition, Jason thinks that, by outsourcing raw materials to Asia, he
can reduce the firm's cost of good sold by 10%. After making adjustments for excessive salaries,
what value should Jason place on the business? Can Jason justify the value the owner is placing
on the business?
Assume that Jason Kidwell is able to purchase Toys 'n' Things Inc. for $2.2 million. Jason
estimates that after initiating his changes in the company's operations (i.e., the salary savings
plus outsources savings), the firm's cost of goods sold are 55% of firm revenues, and operating
expenses are equal to a fixed component of $250,000 plus a variabl cost compoment equal to
10% of revenues.

a. Under these circumstances, estimate the firm's net operating income for revenue levels of $1
million, $2 million, and $4 million. What is the percentage change in operating income if
revenues go form $2 million to $4 million? What is the percentage change in operating income if
revenues change form $2 million to $1 million?
b. Assume now that Jason is able to modify the firm's cost structure such that the fixed
component of operating expenses declines to $50,000 per year but the variable cost rises to 30%
of firm revenues. Answer part a, above, under this revised cost structure. Which of the two cost
structures generates the highest level of operating leverage? What should be the effect of the
change in cost structure on the firm's equity beta?
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