Make or Acquire? By John Rutledge (Rutledge Capital) Every growing company event
ID: 2435930 • Letter: M
Question
Make or Acquire?
By John Rutledge (Rutledge Capital)
Every growing company eventually faces the make-versus-buy decision. Should it develop a new product inside or acquire a company that can design, manufacture and distribute the product? Just recently I had to deal with this question in one of our companies. My experience may be instructive to others.
In order to become the dominant company in the industry, we needed to expand our product line to include all the products our customers buy. We had to do this in a way that would enhance our already strong reputation for engineering, durability and service. We agreed that product X would be the first piece we would seek for the puzzle.
After a thorough review of the market, we concluded there were a few companies whose products were good enough to wear our brand name. We found one that was interesting, with people we respect, where the company was available at a fair price.
We could make the product ourselves. But it would take time. Which way to go?
As with just about everything else in business, the answer depends on cash-flow implications. Let's start with the buy alternative.
Since this exercise requires extensive financial modeling, many companies assign the analysis to finance people. This won't work. There are too many variables that are not easily quantifiable. This is a job for top management. It requires business plans for the new subsidiary, quarter by quarter, over five years. In modeling for acquisition, factor in any savings you think you might make on production costs and overhead. Factor in, too, additional sales you might win by moving existing product lines through new sales channels. The more detail and the more interaction among managers the better. Make sure the managers believe in it, for they are the ones who must deliver.
The first check on the plan is whether it creates value for the company. We calculate the intrinsic value of the acquisition by taking the present value of the cash-flow numbers in our plans. In this case they showed the new subsidiary would be worth $46 million in five years, a present value of about $17 million. Since we could buy the company for $12 million, the acquisition would increase the intrinsic value of the overall company by $5 million. Even using a very high cost of capital, 40%, this one made sense.
Had we set the hurdle rate too high? I don't think so. Finance professionals can argue about the right number for the cost of capital -- i.e., the opportunity cost of the money -- through lunch and dinner and long into the night. This is a waste of time. If you have to worry about the right hurdle rate you are looking at the wrong project.
This acquisition made sense, but the exercise wasn't finished. Before we got out our checkbook we needed to look at the second choice -- making the product internally.
The in-house effort should be evaluated as a venture capital project. There will be development, engineering and tooling costs, rather than a purchase price. It will likely take longer to bring to market. Again, sit with your managers and work up a business plan for five years and evaluate the cash flows.
In our case the present value of the cash flows from developing product X internally turned out to be $19 million at the 40% hurdle rate. Deduct the $4 million spent in the early days on bringing the new product to market and you get a present value of $15 million for developing the product inside.
Conclusion: We make an immediate net gain of $5 million if we buy, but we increase the value of the company by three times as much by developing the product ourselves.
Of course we decided to go in-house with the new product effort.
The largest risk is that internal development is slower than planned. Using a similar analysis we concluded that the present value of accelerating the product introduction by three months was over $2 million. We decided to hire more people or work with outside vendors to speed things up.
A complex problem, but one with a clear answer, making all the thought and planning worthwhile. I love it when a plan comes together.
INSTRUCTIONS: Please read the article above, and in a half page, summarize the key points/ ideas in the article ( emphasizing the Present Value of Cash Flows)
Explanation / Answer
This is a decision for make or buy Is it better to produce the product inside or acquire a company that can design, manufacture and distribute the product. To have dominance and reputation in the industry, we need to expand our product line,as per the tastes of the custmers. After through survey few companies in the industry whose products are good enough to use our brand name to sell the products with fair price. We can even produce our product which is time taking. This exercise requires more financial implications, normally these things will be analyzed by financial persons. But this is the job of the Top management to analyse the required b usiness plan, to acquire a new subsidiary. To acquire a subsidiary whose woth 46 millions, in 5 years with a present value of 17 million.Since we buy the same for 12 millions, the acquisition will increase the intrinsic value of the company by 5 million,by using with high cost of capital of 40%. Finance professionals will argue about the cost of acquisition and opportunity cost. Before acquisition we need to look at the second choice of making the product internally. Evaluation of the in house effort as a venture capital project, there will be development, engineering and tooling costs rather than purchase price. To bring the product into the market sit with the managers and work out for business plan. present value of cash flow from developing product internally fixed at 19 million, at 40% hurdle rate, by deducting 4 million to bring the new product to market, the present value of product is 15 million for developing the product inside. we make an immediate gain of 5 million by buying outside, but we increase the value of the company by three times by producing internally. The largest risk is only slower process. By taking similar exercise to increase present value of the product by increasing the production by hiring people outside by investing 2 million. Though this is a complex problem but one with a clear answer to make the thoughts and planning with while.
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