Problem: In 2005 Dub Tarun founded a firm using $200,000 of his own money, $200,000 in senior (bank) debt, and an additional $100,000 in subordinated debt borrowed froma family friend. The senior debt pays 10% interest, while the sub debt pays 12% interest and is convertible into 10% of the firm's equity ownership at the option of the investor, J Martin Capital. Both debt issues have 10-year maturities. In March 2006 the firm's financial structure appears as follows:
Dub Tarun, Inc.,March 2006
| Accounts Payable |
|
|
|
|
$100,000 |
| Short-term notes |
|
|
|
|
150,000 |
| Total short-term debt |
|
|
|
$250,000 |
| Senior debt (10% interest rate) |
|
|
200,000 |
| Sub debt (12% interest rate, convertible into 10% stock) |
100,000 |
| Equity (Dub Tarun) |
|
|
|
|
200,000 |
| Total debt and equity |
|
|
|
$750,000 |
Dub has determined that he needs an additional $250,000 if he is going to continue to grow his business. To raise the necessary funds, he intends to use an 8% convertible preferred stock issue.
Dub projects that the firm's EBITDA (earnings before interest, taxes, depreciation, and amortization) in five years will be $650,000. Although Dub isn't interested in selling his firm, his banker recently told him that businesses like this typically sell for five to seven times their EBITDA. Moreover, by March 2011 Dub expects that the firm will have $300,000 in cash and the firm's pro forma debt and equity will be as follows:
Dub Tarun, Inc.,March 2006
| Accounts Payable |
|
|
|
|
$200,000 |
| Short-term notes |
|
|
|
|
250,000 |
| Total short-term debt |
|
|
|
$450,000 |
| Senior debt (10% interest rate) |
|
|
400,000 |
| Sub debt (12% interest rate, convertible into 10% stock) |
100,000 |
| Equity (Dub Tarun) |
|
|
|
|
800,000 |
| Additional financing needed |
|
|
|
250,000 |
| Total debt and equity |
|
|
|
$2,000,000 |
Q1. What would you estimate the enterprise value of Dub Tarun, Inc. to be on March 2011? (hint: Enterprise value is typically estimated for private companies using a multiple of EBITDA plus the firm's cash balance.) If the sub debt converts to common in 2011, what is your estimate of the value of the equity of Dub Tarun in 2011?
Q2. If the estimated enterprise value of the firm equals your estimate in question a, what rate of return does the sub debt holder realize if he converts in 2011? Would you expect the sub debt holder to convert to common stock?
Q3. If the new investor were to require a 45% rate of return on his $250,000 purchase of convertible preffered stock, what share of the company would he need, based on your estimate of the value of the firm's equity in 2011? What is your estimate of the ownership distribution of Dub Tarun's equity in 2011, assuming the new investor gets what he requires (to earn his 45% required rate of return) and the sub debt holder converts to common? What rates of return do each of the equity holders in the firm expect to realize by 2011 based on your estimate of equity value? Does the plan seem reasonable from the perspective of each of the investors?
Q4. What would be Dub Tarun's expected rate of return if the EBITDA multiple were five or seven?
Q5. What is the post-investment and pre-investment value of Dub Tarun's equity in 2006 based on the investment of the new investor?