Returns (IRR) analysis of the fire business

Following on from the previous posts around IRR, this post applies it to a real example. It shows the financial returns of the fire suppression business analyzed earlier.

This post will look at the numbers themselves that form the basis of the 30-40% potential IRR. To recap the high-level assumptions:

• Sale price: $800k
• EBITDA: $300k
• Sale multiple: 2.7x EBITDA
• Assets: $200k
• Equity of $400k, debt of $400k (10% per annum, 5 year term)

Income Statement

Using the EBITDA provided for the first year, I’ve constructed the following broad income statement with 5-year forecast:

The income statement has been built off the following assumptions:

• EBITDA is at a sustainable level growing at 2% per annum in line with inflation. This is due to the long history of the company (1980s) ie mature, low to no growth.
• Revenue isn’t important for this valuation, but has been assumed. It grows in line with inflation, ie constant EBITDA margin.
• Interest is based on debt of $400k at 10% interest rate.

As can be seen from the income statement, nothing exciting really happens here as EBITDA grows from $307k per annum to $339k, 2% compounded growth.

The profit after tax (PAT) grows quite a bit quicker due to the interest payments reducing as the debt is repaid, but is actually of little interest itself.

Statement of Financial Position

The statement of financial position is a very simplified model, in line with how simple the actual business is. The debtors days are quite reasonable at 30 days, inventory is minor stock required for this industry in terms of parts and spares, some work in progress. The business pays it’s creditors as cash on delivery. Further work will need to be done to understand the working capital, but it is actually quite minor in this business.

The debt reflects purely the acquisition debt we utilized to acquire the business and it’s aggressive 5-year paydown.

For modelling simplicity we’ve assumed all cash is excess and thus paid out as dividends, once the debt payments, taxes, working capital are made, hence we’ve just assumed no growing cash balance.

Statement of Cash Flows and IRR

Now for the interesting part, the cash flow statement. We don’t worry too much with the income statement or balance sheet since these are mostly just accounting records. The cash flow statement and IRR are much more interesting because they detail our actual returns.

The cash flow statement records a free cash flow (FCF) amount (EBITDA less working capital movement, less tax, less capital expenditure to keep the business going. Tax is reduced through the interest payments we’ve been making, and capex is low as the business is a services business.

Our FCF is then used to service our debt payments, any excess is distributed to shareholders. The dividends will jump in our 6th year as the debt has been fully repaid.

This all feeds into our simplified IRR calculation now:

The IRR works out to a very respectable 37% as per our previous post on calculating IRR. A few items to notice that drive our return.

The greatest part of the return is the exit value. It has doubled from what we contributed. This makes sense since we contributed 50% of the purchase price in equity and 50% with debt. We then used the business to repay the debt. Therefore we now own 100% of the value of the business and therefore it has doubled the value of our equity. This is effectively what a debt paydown deal looks like.

Secondly, as a services business, besides the cost of staff, it is heavily cash generative. Therefore once we get to the EBITDA line, the majority is free to service debt or pay dividends. We could use the high cash flow to repay the debt quicker to reduce risk potentially, at a small cost to IRR.

Conclusion

The reason the IRR is so high for this potential investment is a combination of two factors. The one is certainly the leverage, using 50% debt to purchase such a business will result in a doubling of value over the investment term. Doubling in 5 years is 15% annual return already. The second significant driver of the return is the entry price. A 2.7x entry multiple means the business earns (pre-tax) the value of the firm in under 3 years. This equates to a return rate of 37% on EBITDA or 26% after tax. Those two factors together will drive the majority of the return of this investment.

Key point to remember though is that the exit value is only a valuation. You’d still need to sell the business to actually realize most of the value of this investment, although the dividend yield is pretty great for a buy and hold investment too. Lastly, this is an investment where you’ll need to run the business, and as such will require a significant amount of personal time to run. Those all need to be factored into the IRR requirements.

It’ll be interesting to see how this pans out, compared to just doing a quick excel valuation model of the business. It was already known that the business would provide a great return just off the current EBITDA multiple of 2.7x and gearing that. It will come down to how sustainable those earnings are really and whether there is anything missing in terms of staff/costs that have been adjusted to inflate the EBITDA. Time and some due diligence will tell.