Recommendation Under the two circumstances presented, I recommend that Harriet Burns and Richard Irvine should finance the purchase of Harmonic Hearing Co. through the deal proposed by the private equity firm, Comet Capital. This proposal best aligns with Burns and Irvine’s goal to select an option that offers the “best combination of cost, expected return of their ownership interest and financial flexibility.
” To evaluate the two alternatives, a comparison based on IRR was assessed. Harrison Price’s proposal, which relies almost entirely on debt financing, offers an IRR of 215.
% (Appendix A). On the other hand, Joe Fowler’s proposal, which consists of equity financing, offers an IRR of 402. 5% and also fulfills Comet Capital’s required rate of return of 27% (Appendix B). The main advantage of equity financing over debt financing, displayed in this case and in the real world, is the financial freedom and stability offered by the private equity firm. Burns and Irvine do not have to deal with the large burden of paying back debt.
This report will compare the two financing alternatives proposed and highlight the pros and cons of each scenario.
In addition, potential risks will be addressed and possible scenarios that may affect the valuation in the future will be looked at. Harrison Price’s Proposal (Debt) The proposal put forth by Harrison Price used a combination of the individual alternatives identified by Burns and Irvine. The heavy majority of the financing would come through debt, which would allow the duo to “retain 100% ownership of Harmonic. ” This is a significant advantage of this proposal as Burns and Irvine will not have to worry about keeping investors happy and will also have full control of the operations and direction of the company.
Another advantage of debt financing presented in this case is the reduced income tax. The interest being paid on the loans is tax-deductible meaning that part of the business income is shielded from taxes and therefore lowers the tax liability. This really is a double edged sword as there is no interest expense at all in the equity alternative. A drawback of the proposal is the overall burden of debt. The greatest risk this proposal entails is the possibility that Burns and Irvine are unable to keep up a sufficient cash flow and ultimately will have to give up the company to their creditors.
Another drawback, being particular to Harmonic Hearing Co. , is that the lack of sufficient internal cash would cause the release of their new hearing aid to be delayed by one year. This one year delay would “reduce their market share when it entered the market” and ultimately lead to lower gross profit margins. Furthermore, when comparing the two alternatives, the increased financial burden is heavily apparent when looking at the income statement. The fixed lease and rent payments greatly impact the net income as they slash the operating income by about 20% each year.
In comparison, the interest expensed in the equity scenario usually only cut into the operating income by about 6 or 7%. Subsequently, there are a number of very realistic scenarios that would put a lot of pressure on Burns and Irvine if they were to unfold. Firstly, an interest rate hike would cause many problems. In order to make up for the rise in interest rates, their investor may decide to transfer the burden down the chain to them. This may cause higher rent payments or higher interest rates on their personal guarantee. Another realistic risk is the possibility of a real estate boom.
The property had “significantly appreciated in value” since Otis Wren has purchased the land and building and if that were to happen again in a short amount of time; the IRR would be greatly reduced. For example, if the land and building were to double in market value, the IRR would drop to a mere 3% (Appendix C). A third scenario would be if Burns and Irvine decided to invest more money into Research and Development (R&D). As mentioned in the case, Burns and Irvine believe that in to be successful, they must have continuous investment in the company and in the development of new technology so a rise in R&D is quite realistic.
If R&D were to grow 15% annually instead of staying constant at $600,000 after year one, the terminal value would drop drastically to $14. 5 million from the original prediction of $45. 3 million (a drop of 68%). In addition, Burns and Irvine would yield a measly IRR of 22. 6% in comparison to the 215. 5% originally projected (Appendix D). The global industry in hearing aids is dominated by six multinational giants and many small companies like Harmonic are still allowed to operate successfully in the industry.
In order to flush out these smaller companies, the six giant companies may decide in the future to cut costs and offer cheaper alternatives which may result in decreased sales for Harmonic. If existing sales were to then fall by 10% annually, Burns and Irvine would be in a lot of trouble. The cash flow would become negative at year five and Burns and Irvine would either be unable to purchase their equipment or would not be able to make sufficient payments on their loans (Appendix E). In order to fulfill obligatory payments, they would be forced to postpone purchasing equipment, cut costs in other areas, take a reduction in salary, etc.
None of these options would be advantageous to their profitability or happiness. Another scenario that could occur is that the delay of the launch of the new hearing aid could allow competitors enough time to come up with an equal or superior product. This would greatly reduce the sales of the new hearing aids. If new sales projections fell by 10% each year, the company’s terminal value would be only $8. 1 million and they would be unable to fulfill their loan requirements by the end of year seven (Appendix F).
An even worse case scenario would be if the new hearing aid didn’t pan out and was delayed indefinitely. The terminal value would fall even further to $5. 5 million and a substantial amount of cash would be needed to pay back their loans which would most likely lead to bankruptcy (Appendix G). Scenarios like the ones presented above must be evaluated if this path is the one Burns and Irvine are leaning towards. When taking the path of debt financing, it is wise for the company to have sufficient cash on hand in order to make all their final payments as a lot of leverage is required.
With little cash on hand, Burns and Irvine are heavily relying on their revenue stream and any shakeup of their sales projections could cause them to lose their initial investment and eventually the company. Overall, Burns and Irvine will receive an IRR yield of 215. 5% on their initial investment of $200,000 which is quite a good return especially when the IRR for the loan is only 7. 4%. Joe Fowler’s Proposal (Equity) The proposal put forth by Joe Fowler would fund the financing via Comet Capital, a private equity firm. The main drawback of this proposal would be the reduction in ownership.
Burns and Irvine would only receive one-third of the cash flows and Comet Capital would receive the remaining two-thirds. In addition to the ownership split, the agreement put forth by Comet Capital states that the terminal cash flow is split in a way that they are ensured an IRR of 27%. If the IRR isn’t very high, this would greatly reduce the incentive of selling the company for Burns and Irvine in year seven as their share in the profit would be greatly reduced. The disadvantages presented are greatly outweighed by the advantages of equity financing.
Firstly, under the equity structure, there is a sufficient amount of cash at hand presented by Comet Capital allowing Harmonic to release their new hearing aid in year one. Sales forecasts show that once the new hearing aid is introduced, sales of the existing hearing aids start to decrease slightly and then rapidly by years six and seven. The new hearing aids sales are then projected to compensate for all the lost revenue from the existing hearing aids. The extra year in the release of the hearing aid makes a tremendous effect on sales.
Another advantage to this proposal is that Cost of Goods Sold (COGS) falls to 38% from the existing 44%. In the first proposal, Burns and Irvine would have to subcontract the production of hearing aids causing COGS to rise to 48% of revenues. Furthermore, there are no loan, rent, and lease payments. In the first proposal, these payments greatly diminish the terminal value in the final year after the loans need to be paid off and the building and land are re-purchased. Through this scenario, the IRR for Burns and Irvine on their $250,000 investment is a whopping 402% which is almost double what they receive in the debt alternative.
In my opinion, the biggest advantage to this deal is the financial security the duo will receive from Comet Capital. If additional funding is needed in the future, they can always ask for more money, albeit at the expense of giving up more ownership in the company. However, this would allow them to still have some ownership in the company as opposed to losing all of it if they were to default on their payments in the first proposal. Given how much money Burns and Irvine have personally contributed to the financing scheme, it is apparent that they are not overly wealthy ndividuals. In addition, they’re minimum six years of experience show that they aren’t very young individuals. Taking these two factors into consideration, it can be assumed that these two individuals are not looking for a high risk investment. This makes this proposal even more sensible as it is less risky than the first scenario. There a few scenarios which could cause problems for Burns and Irvine in an equity financing deal. For example, the company is situated in a highly competitive industry which means that companies are always looking for a competitive edge.
The chance of a superior product coming out in the future is quite high and this would reduce Harmonic’s market share. If sales for the new hearing aid fall by 10% annually following year two, Burns and Irvine would yield an IRR of 0% as Comet Capital would be forced to retain all the cash flow in Year seven so that they can maximize their own return. Another possible scenario is if the company was forced to subcontract production of their product and COGS shot up to the same percentage as the debt structure. The terminal value would drop to $84. million from $116. 9 million and in order for Comet Capital to receive the 27% IRR that was agreed upon; Burns and Irvine would receive none of the cash flows and lose their initial investment as well (Appendix G).
Another possibility is if the company decided to start investing more money in R&D. As alluded to earlier, a constant re-investment into the company is needed if the company is to be successful according to Burns and Irvine. A 20% increase in R&D following year one would drop the terminal value to $75. million which would once again drop Comet Capital’s IRR to below 27% and Burns and Irvine would lose their initial investment to compensate (Appendix H). Another possible scenario is the chance that the new hearing aid requires reworking and a one year delay is required in order to successfully launch the product. If the year one sales projections are removed and the debt financing sales forecasts are used for the remaining years, terminal value drops to $83. 9 million (Appendix I). Once again, Comet Capital’s IRR yields fewer than 27% and Burns and Irvine would lose their initial investment.
The same drawback keeps occurring and that is that Burns and Irvine may lose their initial investment and not generate positive cash flow for themselves. Again, this is the risk associated with financing by using a private equity firm and that is your investor’s required return is more important than your own. Burns and Irvine need to be certain that if things don’t go as forecasted, they are okay with losing their initial investment. However, after looking over the two proposals, both qualitatively and quantitatively, it is quite apparent that the second proposal offers more benefits and is more aligned with Burns and Irvine’s interests.
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