Capital for the worlds buildings
MEMORANDUM TO: FROM: DATE: SUBJECT:
Venture Capital Committee Ryland Hamlet, Analyst, CIC November 17, 2011 Newco Investment Recommendations
I received your request to assess the viability and provide a recommendation “for or against” investing in the Newco Project Company (Newco). Newco seeks $15 million in expansion funding. Their proforma income projections for investment Year 1 is $35,250,200. Their plan is to use the funds to expand operations into the hot West Coast residential home building market. Before making my recommendation, I performed a legal due diligence analysis of Newco. The result of the analysis is attached for your review. This memorandum describes the legal due diligence approach, the recommendation, legal aspects, the rationale, and conclusion. Legal Due Diligence Approach
Due diligence often makes or breaks a deal--making the process of combing through projections, balance sheets and contracts all the more crucial (Posnock, 2002). For this deal, my analysis went beyond legal and financial by considering potential issues facing Newco. A review of the literature (Witkowski, 2001; Himelstein, 2003 & Nax, 2003) and of CIC project historical files yielded a list of 13 potential issues categories. Using the checklist probabilities and potential loss values were assigned to each issue. The risks inherit in each potential issue was classified using a risk classification matrix adapted from Wallace-Wells (2004). The risk probability (P) and expected value of the loss (V) is listed in Appendix C. A risk adjusted cash flow of $20,812,500 was computed by totaling the expected values of loss from all possible issues. This discounted, risk adjusted cash flow is the basis of the recommendation.
Newco Recommendation Recommendation
There are many legal, financial, and other categories of issues to consider in an investment recommendation. The potential issues reviewed are found on page 5 of the attached analysis. Based on the analysis of the checklist items (see Appendix B) and the risk associated with potential issues, my recommendation is not to invest in the Newco Project Company. Table 1 summarizes the basis of my recommendation: Projected Cash Flow Risk Adustments Risk Adjusted Cash Flow Investment Break-Even Point ROE
$ 35,250,200 $ 20,812,500 $ 14,437,700 $11,286,000 21.83%
Table 1: Newco Investment Break-Even Point - 1st Year
Legal Aspects. The legal aspects of the risks accessed included environmental threats, bad accounting practices, poor reputation, and negative government actions. Each of the categories entail some legal challenges and risk. By reviewing Newco documentation checklist items, an assessment of the risks was made. Below is an example of checklist items reviewed to assess the potential issue “Poor reputation”: •
Most recently obtained good standing certificates for all states and jurisdictions where Newco is qualified to do business
•
List of states and jurisdictions in which qualified to do construction and in which Newco has offices, holds property or conducts business
The remaining checklist items can be found in Appendix B. Rationale. CIC bases its investment recommendations on the 1st year return on equity (ROE) projections for the target firm. The investment must yield a ROE of 15% above the weighted average cost of capital (WACC) for the industry. According to Damodaran (2003) of the Stern School of Business, the WACC for the homebuilding industry is 6.83%. This means, the analysis must show that Newco’s cash flow can exceed this projection. As an additional safety net, the income projected by Newco is discounted based on the risk classification of each issue as described
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Newco Recommendation in the legal due diligence section above. standard ROE formula:
Using the
ROE
The discounted cash flow is plugged into the net income to compute the adjusted ROE. By using a what-if scenario, I change the equity denominator until the ROE is 21.83%, our required value. The equity value at 21.83% represents the maximum possible investment. If the maximum possible investment is less than the investment requested by the target, I recommend against the investment. This is the case with Newco. The $15 million in funding required by Newco exceeds CIC’s maximum investment based on the risks. The detailed figures used can be found in Appendix C.
Conclusion
According to Modern Portfolio Theory (MPT), it's possible to construct an optimal portfolio with the maximum expected return for a given level of risk (Investopedia.Com, 2004). To create an optimal portfolio, CIC must balance the expected returns with the risk. My recommendation against investing in the Newco Project Company is based on my analysis of issues and associated risks described in the attached report: “Investment Analysis using a Legal Due Diligence Checklist.” Please contact me for clarifications to this memorandum or attached analysis.
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Newco Recommendation References Cited
Damodaran, A. (2003, December 24). WACC.XLS . Retrieved May 24, 2004, from www.stern.nyu.edu/~adamodar/pc/datasets/wacc.xls Investopedia.Com. (n.d.). Terms - modern portfolio tTheory - MPT . Retrieved May 25, 2004, from
http://investopedia.com/terms/m/modernportfoliotheory. asp Nax, S. (2003, October 5). Low interest rates, strong resale market contribute to construction boom. The Fresno Bee. Retrieved May 24, 2004 from
http://web2.infotrac.galegroup.com Posnock, S. T. (2002, January). Due diligence: The buyer's perspective; Appraising a potential acquisition involves more than the scrutiny of balance sheets. Folio: the Magazine for Magazine Management, 31, SS77-
79. Retrieved May 24, 2004, from University of Phoenix Apollo Library Web Site: http://web2.infotrac.galegroup.com Wallace-Wells, B. (2004, April). There goes the neighborhood. Washington Monthly, , 1-8. Witkowski, T. (2001, November 16). Sexy is out: Startups, urged by nervous VCs, shift gears in push for immediate, viable products. Boston Business Journal, 21, 1-2. Retrieved May 23, 2004, from University of
Phoenix Apollo Library Web Site: http://web2.infotrac.galegroup.com
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