Investment Action Evaluation

We will use an example to illustrate investment action evaluation for joint ventures, acquisitions, and equity investments.

De Monte

De Monte is a company that makes and sells vintage brandy and cognac. For the past five years, the company has been experiencing a decline in its sales due to increased competition from emerging brandy and cognac distillers in France. Nevertheless, strong pricing and customer loyalty have made  De Monte’s revenues more stable. De Monte is dominant in France as the leading brandy and cognac distiller, with returns on invested capital exceeding 32% and operating margins exceeding 34%.

Two events have occurred in recent years that have challenged De Monte’s market dominance.

1. Reduced excise duty on imported brandy from other countries.
2. Global demand for copper ore has increased, leading to a sharp increase in the cost of constructing copper stills used to manufacture cognac.

At the year-end of 20X3, De Monte announced they had closed a $ 1.1 billion investment in Caprice Ltd, a canned cocktail manufacturer based in the UK. The investment in Caprice Ltd will enable De Monte diversify the concentrated cognac industry and increase revenue. De Monte’s investment in Caprice Ltd represents a 40% interest in the company, valuing the company at 3.8 billion on an enterprise value basis.

De Monte will finance the transaction using borrowings from its credit facility with an interest rate of 5% and expects to maintain an investment-grade credit rating. Caprice does not intend to pay dividends for the foreseeable future and will use proceeds from its transaction to market its products. Exhibit 1 and Exhibit 2 present a summary of historical and forecasted financial data for De Monte and Caprice Ltd. De Monte expects amortization expense associated with the transaction, related to fair value adjustments of $9 million per annum.

$$ \textbf{Exhibit 1 De Monte Summary Financial Data (USD Millions)} \\ \begin{array}{l|c|c|c|c} & \textbf{20X1} & \textbf{20X2} & \textbf{20X3} & \textbf{20X4} \\ \hline \text{Net revenues} & 46,850 & 47,101 & 46,820 & 46,920 \\ \hline \text{EBITDA} & 10,656 & 11,192 & 11,829 & 12,021 \\ \hline \text{EBIT} & 10,406 & 10,928 & 11,529 & 11,820 \\ \hline {\text{Interest expense} } & (885) & (984) & (980) & (980) \\ \hline \text{Income tax} & (2380) & (2486) & (2637) & (2710) \\ \hline \text{Net income} & 7,141 & 7,428 & 8,182 & 8,130 \\ \hline \text{Diluted EPS} & 2.8 & 3.2 & 3.4 & 3.6 \\ \hline { \text{Diluted shares outstanding}} & 2550 & 2321.25 & 2406.47 & 2258.3 \\ \hline \text{Total debt} & 14,487 & 15,981 & 15,996 & 15,996 \\ \hline { \text{Cash &cash equivalents}} & 6,787 & 6,659 & 3,343 & 4,000 \end{array} $$

$$ \textbf{Exhibit 2 Caprice Ltd. Summary Financial Data (USD Millions)} \\ \begin{array}{l|c|c|c|c} & \textbf{20X1} & \textbf{20X2} & \textbf{20X3} & \textbf{20X4} \\ \hline \text{Net revenues} & 500 & 620 & 870 & 1,160 \\ \hline \text{EBITDA} & (250) & (300) & (400) & (650) \\ \hline \text{EBIT} & (250) & (420) & (470) & (550) \\ \hline \text{Interest expense} & 0 & 0 & 0 & 0 \\ \hline \text{Income tax} & 0 & 0 & 0 & 0 \\ \hline \text{Net income} & (250) & (420) & (470) & (550) \\ \hline \text{Diluted EPS} & (0.34) & (0.58) & (0.65) & (0.76) \\ \hline \text{Diluted shares outstanding} & 720 & 720 & 720 & 720 \end{array} $$

Questions

1. Which other action could De Monte take concerning Caprice to achieve the same objectives?

   Solution

   De monte can achieve the same objective either through an acquisition or a joint venture action.

2. Which benefit would De Monte enjoy if it acquired Caprice Ltd instead of making an equity investment in the company?

   Solution

   By acquiring Caprice, De Monte can exercise control over the company, effectively stopping Caprice from entering into partnerships with competitors.

3. From the case above, what is the most likely motivation for De Monte’s equity investment in Caprice Ltd?

   Solution

   De Monte is looking to diversify away from the saturated brandy and cognac manufacturing industry after increased competition reduced its sales and profits. The canned cocktail industry has been on an upward trend, and De Monte believes its investment in Caprice Ltd will have a positive return.

4. Based on the information from exhibits 1 and 2, the effect of the transaction on De Monte’s diluted EPS and debt-to-EBITDA is closest to? Assume De Monte maintained its tax rate.

   Solution

   $$ \begin{array}{l|c|c|c} & \textbf{20X4} & \textbf{Investment} & \textbf{After} \\ & \textbf{Before} & & \textbf{Investment} \\ & \textbf{Investment} & & \\ \hline & \text{20X4} & \text{20X4} & \text{20X4} \\ \hline \text{Net revenues} & 46,920 & & 46,920 \\ \hline {\text{Income from} \\ \text{associates}} & & (229) & (229) \\ \hline \text{EBITDA} & 12,021 & (229) & 11,792 \\ \hline \text{EBIT} & 11,820 & (229) & 11,591 \\ \hline \text{Interest expense} & (980) & (55) & (1,035) \\ \hline \text{Income tax} & (2710) & 71 & (2,639) \\ \hline \text{Net income} & 8,130 & (213) & 7,917 \\ \hline \text{Diluted EPS} & 3.6 & & 3.51 \\ \hline {\text{Diluted shares} \\ \text{outstanding} } & 2258.3 & & 2258.3 \\ \hline \text{Total debt} & 15,996 & 1,100 & 17,096 \\ \hline {\text{Cash &cash} \\ \text{equivalents} } & 4,000 & & 4,000 \\ \hline \text{Debt to EBITDA} & 1.33 & & 1.45 \end{array} $$

   The income from associates is calculated by multiplying the net income from Caprice in 20X4 by De Monte’s 40% investment in Caprice. This represents the share of Caprice’s profits that De Monte is entitled to. So, (40% × -550= -220) then we add the $ 9 million annual amortization to get -229.

   The diluted EPS decreased from 3.6 to 3.51, while the debt-to-EBITDA increased from 1.33 to 1.45 because of the debt-financed equity investment in Caprice.

5. Suppose De Monte opens a joint venture with Caprice Ltd called Monte Caprice Ltd that will operate in the UK and specialize in canned Gin and Tonic cocktails. What benefit will De Monte gain from this joint venture?

   Solution

   Because Caprice and De Monte have governance representation in Monte Caprice Ltd, the risk to De Monte will be greatly reduced.

Reading 21: Corporate Restructuring

LOS 21 (e) Evaluate corporate investment actions, including equity investments, joint ventures, and acquisitions.