Solution: Clean Water Discussion

The Excel file Clean Water Financial Plan contains a detailed solution of the management case. Let's look at some of the main takeaways.

Cash flow projections

• The operating business is projected to be fairly stable and very profitable. This is consistent with the firm's past. For example, in Year 2, the projections imply an EBIT of roughly 700'000. Given projected net revenues of roughly 3.4 million, this corresponds to a healthy EBIT margin of 20%.
• The exception is Year 1, where extraordinary restructuring charges lead to substantially lower profitability.
• Given the low capital intensity of the business, investment outlays are moderate. Therefore, the firm's free cash flows are also very stable and rather attractive. Looking at year 2, the numbers imply that for every EUR of net revenues, the firm generates a free cash flow of 16 cents.
• The following table summarizes the firm's operating and investment cash flows and derives the projected free cash flows:
  
  

  	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9
  EBIT	318	698	722	757	804	861	871	880	890
  - Adjusted taxes	67	147	152	159	169	181	183	185	187
  NOPLAT	251	551	570	598	635	680	688	695	703
  + Depreciation	80	78	76	76	75	75	75	75	75
  - Increase op. assets	-18	9	17	26	34	43	7	7	7
  + Increase op. liabilities	-87	4	8	11	15	19	3	3	3
  Operating cash flow	262	624	637	659	691	731	759	766	774
  - Net investments	100	75	75	75	75	75	75	75	75
  Free cash flow	162	549	562	584	616	656	684	691	699

The buyer's cash needs

• Remember from before that the buyer will need substantial dividend payments from Clean Water to service the debt he has assumed to finance the purchase price. The question is whether the cash flows from the previous table will cover these cash needs. The answer is "not quite." The following table shows the debt payments the buyer will have to make (see the case intro for details):
  
  

  	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9
  Total debt payments	110	610	600	590	580	570	560	540	520

• Interpretation:
• In Year 1, the firm is expected to generate a FCF of 162. The dividend requirements are 110. Hence, the firm should be able to pay the dividend and retain 52 [=162 - 110] as excess cash for future dividend payments.
• In Year 2, the FCF is 549 and the dividend is 610. Hence, the dividend exceeds the FCF by 61 [= 610 - 549]. Part of this liquidity gap can be bridged with the excess cash (52) from Year 1. To cover the remaining liquidity gap of 9 [=61 - 52], Clean Water will need to draw on its Revolving credit line. So the sources of funds for the dividend payment of 610 in Year 2 are:
• Free cash flow: 549
• Excess cash: 52
• Revolving credit: 9
• We proceed accordingly for the following years.
• The following table summarizes the full cash flow statement of Clean Water:
  
  

  	Year 1	Year 2	Year 3	Year 4	Year 5	Year 6	Year 7	Year 8	Year 9
  EBIT	318	698	722	757	804	861	871	880	890
  - Adjusted Taxes	67	147	152	159	169	181	183	185	187
  NOPLAT	251	551	570	598	635	680	688	695	703
  + Depreciation	80	78	76	76	75	75	75	75	75
  - Increase op. assets	-18	9	17	26	34	43	7	7	7
  + Increase op. liabilities	-87	4	8	11	15	19	3	3	3
  Operating cash flow	262	624	637	659	691	731	759	766	774
  - Investments	100	75	75	75	75	75	75	75	75
  Free cash flow	162	549	562	584	616	656	684	691	699
  - Interest exp. (after taxes)	0	0	0.4	2	3	1	0	0	0
  - Repayment Revolver loan	0	0	9	47	55	22	0	0	0
  + New Revolver loan	0	9	47	55	22	0	0	0	0
  Residual cash flow	162	558	600	590	580	634	684	691	699
  + New equity	0	0	0	0	0	0	0	0	0
  - Net dividend	110	610	600	590	580	570	560	540	520
  Change in cash	52	-52	0	0	0	64	124	151	179

• As we can see, the firm will just be able to meet the owner's cash requirements. To do so, however, it will have to draw on its credit line.
• Given a credit line of 100'000, the numbers also show that there is very little margin of error. According to the financial plan, Clean Water will need to use 55'000 of that credit line in order ot survive. So the proposed financing structure really goes to the firm's limits.
• The following figure illustrates this graphically. 

Next steps

Given that the proposed financing structure goes to the limits of what the business can support, the logical next step is to revisit some of the key assumptions. Are these assumptions realistic? How likely is it that the firm will be able to exceed the projections? What happens if it misses the projected values?

 Let's look at two of the many additional analysis that one might want to conduct in such a situation: A zero-growth scenario and a scenario with less favorable revenue margins.