# Financial Analysis

## Abstract / Executive Summary

Fireman's Brew, Inc., a California Corporation (the "Company," "we," "us") is Offering (the "Offering") to sell shares of its Series A Common Stock (the "Common Stock") for cash up to a total of $2,000,000.

## Financial Analysis' – Financial Forecasting

Below is Fireman's Brew 5-year Income Statement forecast and Cash Flows forecast. The company is expecting an annual growth rate of 232.91% within the first 5 years. We are assuming the company will grow very aggressively with the largest growth in beer and coffee retail with 85% increase in 2012 and 75% in 2013. The following 2 years will still grow but not like the first years, so we forecasted them with a growth at 65% for 2014 and 50% 2015.We are assuming the following growth rate for coffee wholesale and soda at a lower rate of 2012-55%, 2013-50%, 2014-45%, and 2015-30%. As for the restaurant venture, we are assuming lower growth rates at 2012-35%, 2013-40%, 2014-42%, and 2015-48%. The cost of goods sold will also increase with more sales so we are assuming the following rates 2012-25%, 2013-45%, 2014-55%, and 2015-65%.' We have assumed all the expense at a 10% increase for each year. The company's tax is at 35%.

## Financial Analysis' – Capital Budget

The capital budget consists of some procedures such as Net Present Value (NPV), Internal Rate of Return (IRR), Modified Interest Rate of Return (MIRR), Profitability Index (PI), Payback Period, and Discounted Payback Period. In this section, these procedures are applied to the capital equipment investment of Fireman's Brew.'

- Net Present Value (NPV)

Net Present Value regards the time value of money. It can be calculated as follows;''

(NPV)= FCF2011/(1+WACC)1+ FCF2012/(1+WACC)2+ FCF2013/(1+WACC)3+ FCF2014/(1+WACC)4+ FCF2015/(1+WACC)5+ Present Value of Release of Working Capital-Capital Expenditure- Working Capital Needed.

This formula requires some data such as Free Cash Flow (FCF), Weighted-Average Cost of Capital (WACC), Capital Expenditure and Working Capital Needed.'

- Free Cash Flow

FCF represents the cash that a company is able to generate from its operating activities. FCF is calculated as Free Cash Flow (FCF) = Net Income After Tax+ Amortization-Change in Working Capital-Capital Expenditure.

By using this formula, Free Cash Flow amounts of Fireman's Brew are below.'

FCF2011=-1,011,325-245,000= (1,256,325)

FCF2012= 37,975,

FCF2013= 1,500,423,

FCF2014= 2,327,874 and

FCF2015= 3,405,438.

- Weighted-Average Cost of Capital (WACC)

WACC is calculated as follows;

WACC= wd*rd*(1-T) + wp*rp + ws*rs

The company has not long term debt and preferred stock. Therefore, WACC= rs (cost of equity).

rs= risk free rate + risk premium*beta= 0.045+0.05*0.79= 0.0845= WACC

(Risk free rate, risk premium and beta are data of a similar company)

- Working Capital Needed and Capital Expenditure

Fireman's Brew plans to purchase equipment of $245,000 in 2011. This is called as capital expenditure. We assume that the equipment has 5 year useful life and there is no salvage value after 5 year.' Moreover, this project requires working capital and it is assumed as $1,035,000. Total initial investment of the company is (245,000+1,035,000=) $1,280,000.

The company will not require working capital of $1,035,000 after 5 year. Therefore, present value of money of $1,035,000 should be considered as Release of Working Capital in NPV calculation. It can be calculated as follows;

Present Value of Release of Working Capital after 5 years= Working Capital Needed/ (1+WACC)^{5}

NPV= (1,256,325)/(1+0.0845)^{1}+ 37,975/(1+0.0845)^{2}+ 1,500,423/(1+0.0845)^{3}+ 2,327,874 /(1+0.0845)^{4}+ 3,405,438/(1+0.0845)^{5}+1,035,000/(1+0.0845)^{5}-245,000-1,035,000

NPV= (1,158,437.07) +32,262.31+1,176,318.82+1,682,833.87+2,269,996.55+690,000-245,000-1,035,000= $3,412,974.48.

Net Present Value of this project is higher than zero and this project can be accepted.

- Internal Rate of Return (IRR)

FCF2011/(1+IRR)1+ FCF2012/(1+IRR)2+ FCF2013/(1+IRR)3+ FCF2014/(1+IRR)4+ FCF2015/(1+IRR)5+ Present Value of Release of Working Capital- Capital Expenditure- Working Capital Needed=0

IRR= 37% by using IRR function on excel.

IRR of 37% is bigger than WACC of 8.45%. It is another reason why this project should be accepted.

- Modified Interest Rate of Return (MIRR)

MIRR can be calculated by using excel function. Period=5, Values= {-1,280,000, -1,256,325, 37,975, 1,500,423, 2,327,874, 4,440,438), reinvest rate= 8.45%. MIRR= 28%.

- Profitability Index (PI)

PI= PV of Future Cash Flow/Total Initial Investment= 4,002,974.48/1,280,000= 3.13

- Payback Period

Payback Period= Number of Years Prior to Full Recovery+ (Unrecovered Cost at the Start of Year/Cash Flow During Full Recovery Year) = 2+ (1,242,005/1,500,423) = 2,83 year.

- Discounted Payback Period= Number of Years Prior to Full Recovery+ (Unrecovered Discounted Cost at the Start of Year/Discounted Cash Flow During Full Recovery Year)

Discounted Payback Period= 3+ (71,418.87/1,682,833.87)= 3.04 year.

## Financial Analysis' – Optimal Capital Structure

Optimal capital structure determines the optimal debt-equity composition to reach the highest value of operation. Value of operation is calculated as follows;

Value of operation= FCF_{2011}/(1+WACC)^{1}+ FCF_{2012}/(1+WACC)^{2}+ FCF_{2013}/(1+WACC)^{3}+ FCF_{2014}/(1+WACC)^{4}+ FCF_{2015}/(1+WACC)^{5}+ {FCF_{2015}*(1+g)/(WACC-g)}/ (1+WACC)^{6}

According to financial statements, the company has not long term debt and therefore WACC is equal to cost of equity. However, different debt-equity compositions change WACC value via beta. In other words, the changes in debt-equity portion affect beta (b), cost of equity (r_{s}), WACC and value of company respectively. They are calculated as follows;

Beta= Unlevered Beta*[1+(1-T)*(w_{d}/w_{s})]

rs= risk free rate + risk premium*beta

WACC= wd * rd*(1-T) +ws*rs

In these formulas above, we use similar company data as beta (unlevered) = 0.79, risk free rate= 4.5%, cost of debt= 6.7%, risk premium= 5%. Furthermore, constant growth rate of the company after 5^{th} year is assumed as 4%.

In this project, we can use these formulas above to calculate optimal capital structure for different debt-equity composition. The point that the WACC is the lowest is the optimum point for company because company value is the highest in contrast to other options. According to our calculation, the optimum capital structure is 30% debt and 70% equity. The optimum point is calculated as follows;

wd =30%

ws= 70%'

Beta= Unlevered Beta*[1+(1-T)*(wd/ws)]= 0.79*[1+(1-0.35)*(30/70)= 1.01

rs= risk free rate + risk premium*beta= 0.045+0.05*1.01= 9.55%

WACC= wd*rd*(1-T)+ws*rs=0.30*0.075*(1-0.35)+0.70*0.0955=8.15%.

Value of operation= (1,256,325)/(1+0.0815)1+ 37,975/(1+0.0815)2+ 1,500,423/(1+0.0815)3+ 2,327,874 /(1+0.0815)4+ 3,405,438/(1+0.0815)5+{3,405,438*(1+04)/(0.0815-0.04)}/ (1+0.0815)6= $55,626,262.45. Intrinsic value of equity is (55,626,262.45*0.70=) $38,938,383.72 and stock intrinsic value of share is (38,938,383.72/10,476,046=) $3.72.

## Valuation

Through its initial private equity offering of 4,000,000 shares of Series A Common Stock offered at $0.50 per share, Fireman's Brew, Inc. is offering a 40% equity stake to potential investors. This gives the corporation an initial value of $5,000,000. $4,000,000 x $0.50 = $2,000,000. $2,000,000(1.60) = $5,000,000. As stated in the Determination of Price section of the Placement Memorandum, "The price at which the Shares are being offered was arbitrarily determined by the Company, and bears no relationship to assets, earnings, book value, or any other criteria of value." Basically, this is stating that the company has placed this value on the initial share offering and it does not necessarily reflect the actual valuation of Fireman's Brew, Inc. This is a method often utilized by new companies seeking initial capital for growth and expansion. As a new company that has had limited time to reach its full potential, an in fact needs this capital infusion to do so, the actual intrinsic valuation of Fireman's Brew, Inc. may vary greatly from this initial $5,000,000 valuation. We will attempt to utilize intrinsic valuation methodologies taking into account Fireman's Brew, Inc. current and projected financial data to create a fair market valuation for the company.

Based upon the intrinsic valuation model, Fireman's Brew, Inc. would have an expected horizon value at the end of 2014 of $2,658,924. This figure was derived utilizing the Optimum Capital Structure WACC of 8.15% and the initial growth rate of 232.91% per year over the next 5 years. This is obviously a very aggressive growth rate that is most likely to decline once manufacturing and distribution levels have reached a peak. However, for a young, aggressively growing company these growth rates do seem plausible. This is actually a very good valuation for an infant company such as Fireman's Brew Inc, while revenues steadily increased from 2011 – 2015 so have expenses. This is very common with young, expanding companies. The fact that Fireman's Brew, Inc. will be able to achieve such a strong short-term growth rate shows great market potential. At this stage in life, many companies are still struggling and operating at a loss. From the calculations above it would appear that Fireman's Brew, Inc. is a strong, viable entity with great upside potential.

## Distribution

The text defined distribution policy as, "The policy that sets the level of distributions and the form of distributions (dividend and stock repurchases)." The two main types of distributions to shareholders are dividends and stock repurchases. These are actually two of the five positive uses of FCF. These five uses are payment of interest expense, pay down the principal on debt, pay dividends, repurchase stock, and purchase non-operating assets such as marketable securities.

Dividends and repurchases are essentially ways of paying shareholders for their investment in a company. As equity owners, shareholders are technically entitled to the financial appreciation that comes from the successful operation of the company they own. The first form of this appreciation is capital gains. This is essentially the increase share price of a stock. If a business is operating effectively and profitably an investor should expect to see an increase in the value of the company. To capitalize off these gains a shareholder would usually have to sell their shares to realize the capital gains. Another form of "paying" the shareholders for their investment is through the distributions.

Dividends are payments in the form of cash or additional shares made to shareholders usually on a quarterly basis. The amount of these dividends on an annual basis divided by the share price is the dividend yield. Stock repurchases occur when a company buys back its own outstanding stock. This repurchase can be made in the open market or through a tender offer to existing shareholders. By repurchasing shares a company is essentially depleting the supply of shares in the marketplace and therefore increasing the price of shares.

The relative mix of dividend yields and capital gains is determined by a company's target distribution ratio. This is the total amount of net income that will be distributed to shareholders through dividends and stock repurchases. The target payout ratio determines the percentage of net income that will be paid to investors in the form of a cash dividend. A company must take into account its optimum capital structure in determining its target distribution ratio. It must ensure that it is able to maintain the appropriate amounts of debt and equity after these payments are made. There are four main factors to consider when setting an optimum distribution ratio. These include the investors' preference for dividends versus capital gains, investment opportunities, target capital structure, and the availability and cost of external capital. The last three quantitative elements of this list are used in the residual distribution model. Under this model Distributions = Net Income – Retained earnings needed to finance new investments. Basically, the distributions made to shareholders are the leftover earnings after other obligations have been met. (Bingham, 2010)'

For a young company such as Fireman's Brew, Inc. there would not be much of a current necessity for a distribution policy. The reason for this is that the most important things for young companies to do with their FCF include servicing debt and investing cash back into the company for growth and expansion. The first priority of any young company should be its debt service. The company must be able to make all principal and interest payments in order to remain in business. Secondly, they should be focused on growth and expansion. For Fireman's Brew, Inc. this will most likely consist of increasing production capabilities, expanding distribution and increasing marketing. As new shareholders, Fireman's Brew investors would most likely not expect immediate distributions trough dividends or share repurchases. They would much rather see the cash go to the activities listed above. This will result in the long-term growth of the company and therefore greater capital appreciation. Many young companies, especially in high-growth environments do not implement a distribution policy for years or even decades. In fact, some of the world's largest most well-established companies such as Apple, Inc. and Google, Inc. have either discontinued the distribution policies or never paid a dividend at all. Similar to Fireman's Brew, Inc. these companies are better off seeking other investment opportunities for their cash rather than repay it to the shareholder. Within the same industry, The Boston Beer Company, Inc. (NYSE:SAM) does not pay a dividend. This is likely one of the reasons for its staggering appreciation in share value over the past 15 years. I would assume that The Boston Beer Company, Inc. has been utilizing their excess FCF to increase production, distribution, and marketing just as Fireman's Brew, Inc. will need to do. In the future, after a long period of growth and stability, it may make sense for Fireman's Brew, Inc. to implement a distribution policy but for the time being, they have much more beneficial uses of their free cash.

## Alternative to raising capital

The goal of business finance is to raise sufficient capital at the least cost for the level of risk that management is willing to live with. Diagram explain sources of external funding available for small businesses.

For Firemen's Brew we are considering to take SBA loan from Bank of America for the full amount of 2 Millions, for 7 years @ 9%.

## Keys Statistics

### Lease vs. 'Financing Analysis

Fireman's Brew, Inc has capital equipment requirement of $ 245000.00 to raise this capital equipment requirement Firemen Brew can take 100% loan or Lease the capital equipment with early payment of $ 55000.00 for 4 years. Below analysis shows the calculation for the 2 options – Buying vs. Loan Analysis.

It is an important question for any business these days, "should we purchase or lease? There are benefits to each of these options. Leases are usually created for properties, cars, machines, or kind of expensive assets. Fireman's Brew as several different business ventures and they have a plan to expand the company's operational infrastructure, so they will need to explore which lease financing options will be best for them.

Operating leases are defined as "A lease in which the lessee maintains residence or usufruct of the leased property or asset while the lessor may claim a tax deduction for depreciation." (Farlex Financial Dictionary) There are four benefits to an operating lease. It is less capital intensive, shifts the residual value risk to the lessor, is better than financing if your company does not need the tax write-off from tax depreciation and they can be for a short period of time (Sanders-Stubbs, 2007). Most of the time company's want to keep leases and the risks off their financials, so operating leases are preferred over capital leases. To conclude, Fireman's Brew should not purchase any assets since more than likely sell the company and the acquiring company they will have access to all the equipment or space the company will need.

## Working Capital Financing Policies

The working capital policy is basically about how much working capital the company should maintain. Different working capital policies are:-

- Matching Working Capital Policy – Simple and straightforward, this working capital policy works in an arrangement where the current assets of the business are used perfectly to match the current liabilities. It is a medium risk proposition and requires a good amount of attention.
- Aggressive Working Capital Policy – High risk, and often high return, the aggressive working capital policy sees the company keep a really low amount of current assets. The idea here is very simple. Collect payments on time, leaving no debtors and invest that amount in the business. And pay the creditors as late as possible. This means that the business uses very little of its own cash, paying the creditors' as late as it possibly can. It is a high-risk arrangement because creditor comes asking for money, and when not paid will lead to sell a costly asset to pay off debt to creditors. 3. Conservative Working Capital Policy – In this policy, you not only match the current assets and the current liabilities, but you also keep a little safety net just in case of any uncertainty. Undoubtedly, this is the lowest risk working capital policy, but it reduces the money used in increasing the production.

## Recommendations for the Executive Committee

There are several recommendations from this report, which the executive committee needs to know. One of the fundamental elements of ensuring proper methods are used by the company to sell shares is analyzing the financials revolving around the entire process of sale. It is recommended for the committee to consider the three aspects of analysis i.e. financial budgeting, capital budgeting, and optimal capital structure. By considering these aspects, the committee will be able to know the inflows and the outflows of the entire shares, which will be sold to the public. Understanding the return on an investment is a critical aspect of any business since it determines the actual cost of the investment, which can be made.

I recommended that the intrinsic method of valuation needs to be adopted by the executive committee at all times. This is because the intrinsic method takes into consideration the projected financial data, a process, which will ensure that the market valuation of the company is made in a fair manner. By using the intrinsic model, for instance, Fireman's Brew, Inc. has an expected value, which is derived from both the initial growth rate as well as the optimal capital structure. The committee should, however, be careful while considering this model because it poses an aggressive company growth rate, which might pose a danger to the stability of the company in future.

I also recommend that the committee should consider the mixed distribution policy. This policy involves the mix of the capital gains and the dividend yields in a fair manner. This is because this is a growing company and for it to compete effectively in the market, it needs to stabilize at a faster rate. In order to do this, the company needs to consider the extent of the indebtedness of the company.

'Other sources of funds may deem necessary in the organization. From the above statistics, I recommend that Fireman's Brew should consider the loans from the bank as the primary source. This is because of a loan from the bank is more stable and has a certain interest, which fixed and regulated by the government. Finally, I consider the aspect of leasing as the most appropriate for the company. This is because it will not cost the company a lot of money and as well, the risks will remain in the hands of the leaders.