Alice Waters is the new CEO of Magic Makers, Inc. (MMI), taking over on April 15, 2020. Alice planned a meeting with MMI's accountant, Sam Herman, to make some financial decisions for the future.

Magic Makers and the Exercycle Industry

Magic Makers was founded as a joint venture between Modern Electronics Co., and a private equity firm, Solid Ventures. Alice Waters, a portfolio manager at Solid Ventures, was sent to MMI when its CEO resigned without notice. As its technology prowess improved, Magic Makers became a leading supplier in the industry.

Prize-winning patented electro-mechanical gear system for exercycles

Competition cut market share and reduced prices

Eventually, technology lagged competitors

Capital spending needed to reduce manufacturing cost

Magic Makers survived as some of its competitors went out of business

Magic Makers management believed that with its continued investment in production efficiency, the company could improve its performance.

Financial Questions Facing Susan Rogers

That evening, Alice Waters met with Sam Herman. Her brief discussion with Sam went as follows:

Alice:Back at Solid Ventures, we looked at Magic Makers as one of our most promising investments. Now it seems that such optimism may not be warrantedat least until we get a solid understanding of the firm's past performance and its forecast performance. Did you have any success on this?

Sam:Yes, the bookkeeper gave me the historical income statements and balance sheets. The accounting system here is still pretty primitive. However, I checked a number of the accounts, and they look orderly. So I suspect that we can work with these figures. From these statements, I calculated a set of diagnostic ratios.

Alice:I see you have been busy. Unfortunately, I can't study them right now. I need you to review the historical performance of Magic Makers for me, and to give me any positive or negative insights that you think are significant.

Sam:When do you need this?

Alice:At 9:00 am tomorrow. I want to call our banker tomorrow and try to get the loan extended.

Sam: The banker, Mr. Brewster, said that Magic Makers was "growing beyond its financial capabilities". He probably means that he doesn't think we can repay the loan within a reasonable period.

Alice: I would like you to build a financial forecast of our performance for the next three years, and show me what our financing requirements will be at the years ending 2020, 2021 and 2022. I think it is reasonable to expect that Magic Makers's sales will grow at 4% each year. Also, you should assume capital expenditures of $8,000,000 for production equipment, depreciated over five years. Use whatever other assumptions seem appropriate to you, based on your analysis of historical results.

Sam:But, what if the forecasts show that Magic Makers can't repay the loan?

Alice: Then we'll have to go back to Magic Makers's owners, Solid Ventures and Modern Electronics, for an injection of equity. Of course, Solid Ventures would rather not invest more funds unless we can show that the returns on such an investment would be very attractive and/or that the survival of the company depends on it. Thus, my next request is for you to examine what returns Magic Makers will offer in the next three years and to identify the "key-driver" assumptions of those returns. Finally, let me have your recommendations regarding operating and financial changes I should make based on the historical analysis and the forecasts.

Sam: The plant manager revised his request for new production equipment, which would add $8,000,000 to the 2020 capital expenditures budget. Approving the project may depend on the discount rate. The joke in business school was that the discount rate was always 10%.

Alice: (laughing) That's not what my business school taught me! Solid Ventures always uses a 40% discount rate to value equity investments in risky companies. But Magic Makers is well established now and shouldn't require such a high risk premium.

Sam: I managed to pull together some data on peer companies.

Alice: Fine. Please estimate Magic Makers's weighted average cost of capital and assess the packaging-machine investment. I would like the results of your analysis tomorrow morning at 9:00.

Now that his meeting with Alice is over, Sam Herman reviews his notes and lists his to-do items:

1.Review historical performance, identifying positives and negatives.

2.Prepare 3-year financial forecast.

3.Calculate a debt vs. equity analysis to estimate MMI's debt capacity.

4.Evaluate the production equipment proposal to see if it is justified...what is the correct k-wacc to use.

5.Identify the key drivers that will determine MMI's future rate of return...what operating and financial changes might be needed to accomplish this.