Case-1-16 Harrod’s Sporting Goods – Foundations of Financial Management : Book Guide

This Document Contains Cases 1 to 16 Harrod's Sporting Goods Case 1 Ratio Analysis Purpose: The case allows the student to examine ratio analysis within the context of a customer-banking arrangement. The firm has a disagreement with the bank over how much it should be paying in relation to prime (no prior knowledge of banking is required for the case). An item of particular interest is the impact of an extraordinary loss on the firm's income statement. It has a major effect on the analysis of the company. Industry comparisons also are utilized. Relation to Text: The case should follow Chapter 3. Complexity: The case is moderately complex. It should require 1 to 1½ hours. Solutions 1. Ratios 2007 2008 2009 1. Net income 4.52 5.42% 3.99% Sales 2a. Net income 6.09% 7.23% 5.71% Total assets b. Net income sales x sales / total assets 4.52 x 1.35 5.42% x 1.33 3.99% x 1.43 3a. Net income 16.04% 18.55% 15.02% Stockholder's equity b. Net income / total assets 6.09% 7.23% 5.71% (1 – debt / total assets) (1 – .620) (1 – .610) (1 – .620) 2. Harrod's has suffered a sharp decline in its profit margin, particularly between 2008 and 2009 (5.42% down to 3.99%). Return on assets is also down, but not quite as much due to a slight increase in asset turnover. Return on stockholders' equity is also down. 3. 2007 2008 2009 1. Net income 4.522 5.42% 6.19% Sales 2a. Net income 6.09% 7.23% 8.85% Total assets b. Net income sales x sales / total assets 4.52 x 1.35 5.42% x 1.33 6.19% x 1.43 3a. Net income 16.04% 18.55% 23.30% Stockholder's equity b. Net income / total assets 6.09% 7.23% 8.85% This Document Contains Cases 1 to 16 (1 – debt / total assets) (1 – .620) (1 – .610) (1 – .620) 4. After eliminating the effect of the nonrecurring extraordinary loss, the trend is clearly up over all three years. Particularly impressive is the increase in return on stockholders' equity from 16.04% in 2007 to 23.30% in 2009 . 5. Harrod has a clear superiority in the profit margin (6.19% vs. 4.51%). This is further enhanced by a more rapid asset turnover (1.43 vs. 1.13) to give an even more superior return on total assets (8.85% vs. 5.1%). Finally, return on stockholders' equity greatly benefits from a higher debt ratio (62% vs. 48%) to provide an even larger gap between the firm and the industry (23.30% vs. 9.80%). While debt is not necessarily good, it has hiked up the return on equity to well over twice the industry figure. 6. Ratios 2009 Industry 1. Sales 6.31 5.75 Receivables 2. Sales 4.75 3.01 Inventory 3. Sales 2.77 3.20 Fixed assets Harrod's is clearly superior to the industry in receivables turnover (6.31 vs. 5.75) and inventory turnover (4.75 vs. 3.01) and this more than compensates for a lower sales to fixed assets ratio (2.77 vs. 3.20). 7. Becky would appear to have strong grounds for a complaint. It appears that the banker was using unadjusted income statement numbers to arrive at the conclusion that Harrod's was on a downward trend in terms of the profitability ratios. Also, using unadjusted data the profit margin was below the industry average. However, the inferior performance was due to an extraordinary, nonrecurring loss. In terms of normal operating performance, the company is clearly on an upward trend and well above the industry averages on all counts. One percent over prime appears to be much more reasonable than 2½ percent over prime. Chem-Med Company Case 2 Ratio Analysis Purpose: The case allows the student to go into financial analyses in more depth than in possible with end-of-chapter problems. In addition to computing a series of ratios, the student must consider industry data and trends for the purpose of evaluating relative performance. The student must also make use of the Du Pont system of analysis. Of special interest are the debt and performance covenants established by the potential financier. Finally, the student is forced to identify the impact of extraordinary income on ratio analysis and how it can distort one year’s performance. Relation to Text: The case should follow Chapter 3. Complexity: The case is moderately complex. It should require 1-1½ hours. Solutions 1. Sales Growth = (Sales this year – Sales last year) / Sales last year for 2007 $ 3,814 – $3,051 / $3,051 = + 25% for 2008 5,340 – 3,814 / 3,814 = + 40% for 2009 7,475 – 5,340 / 5,340 = + 40% for 2010 10,466 – 7,475 / 7,475 = + 40% 2. Net income growth = (Net income this year – Net income last year) / Net Income last year for 2007 $1,150 – $ 766 / $ 766 = + 50% for 2008 1,609 – 1,150 / 1,150 = + 40% for 2009 1,943 – 1,609 / 1,609 = + 21% for 2010 2,903 – 1,943 / 1,943 = + 49% According to Dr. Swan’s estimates net income growth will exceed sales growth in 2007, match sales growth in 2008, then slack off and rebound in 2010. However, Dr. Swan’s figures are misleading: in 2008 they include $500,000 worth of extraordinary income expected to be received from the settlement of the suit with Pharmacia. The astute analyst will realize that this amount should be excluded from his/her calculations because (1) receiving the amount is by no means certain, and (2) it is a one-time event which has nothing to do with the operations of the company. When the amount is excluded from 2008’s figures we see that net income growth for 2008 is actually considerably less than 40%. Aftertax effect of removing $500,000 from gross income = $500 x (1 – tax rate) = $500 x (1 – .33) = – $335 New net income = $1,609 – $335 = $1,274 Appropriate net income growth for 2008 = ($1,274 – $1,150) / $1,150 = + 11% Also changes 2009 net income growth = 1,943 – 1,274 = + 53% 1,274 Failing to exclude the extraordinary amount has the effect of obscuring the “real” profitability ratios—ROE in 2008 would be 23%, not 29%. Net profit margin would be 24%, not 30%. These are facts a potential investor would want to know. 3. Chem-Med’s current ratio = Current Assets / Current Liabilities: for 2007 = $1,720 / $ 593 = 2.90 for 2010 = $3,261 / $1,647 = 1.98 Pharmacia had a current ratio in 2007 of 2.8, and the industry average was 2.4. Chem-Med, therefore, in 2007 was slightly more liquid than the average company. This would probably be looked upon favorably by someone considering loaning money to the company; however, the banker with whom Dr. Swan had lunch would have a problem with Chem-Med’s current ratio for 2010: it falls below the 2.25 to 1 limit he would establish as a restrictive covenant. In view of that, Dr. Swan needs to revise his financial plan for 2010 in such a way that less money is invested in fixed assets, and more is held in cash & equivalents (or, alternatively, shift some current liabilities to long-term debt and/or equity). 4. Chem-Med’s total debt to assets ratio = total liabilities / total assets for 2007 = $ 614 / $ 4,491 = .137 for 2008 = $ 857 / $ 6,343 = .135 for 2009 = $1,212 / $ 8,641 = .140 for 2010 = $1,664 / $11,995 = .139 The variation from year to year is small—no trend can be established, except, of course, that the ratio remains nearly constant, indicating that Chem-Med is doing a good job in managing its debt. It was doing especially well in 2007 compared to other companies in the industry, where the average debt to assets ratio was .52 (and Pharmacia’s was .55). A potential investor in Chem-Med’s stock might be pleased or displeased depending on his/her tolerance for risk and outlook for the future. (Chem-Med has much less financial risk than average, but the company, which is in a growth situation, might be considered to be underleveraged.) 5. Chem-Med’s average accounts receivable collection period = accounts receivable / sales per day for 2007 = $ 564 / ($ 3,814/360) = 53 days for 2008 = $ 907 / ($ 5,340/360) = 61 days for 2009 = $1,495 / ($ 7,475/360) = 72 days for 2010 = $2,351 / ($10,466/360) = 81 days This is not a good sign. The average length of time that Chem-Med’s customers are taking to pay for products they’ve bought is increasing steadily every year. If Chem-Med’s credit policy is, say, 2/10, net 30, it is clear that very few customers are adhering to it, and the situation is getting worse. Not only is Chem-Med, in effect, granting free credit to those customers by allowing them to delay payment for so long, it is paying for such credit itself. The company’s higher balances of accounts receivable must be financed in some way, either through additional debt or equity, and these additions have a cost. 6. Chem-Med’s return on equity ratio = net income / total equity for 2007 = $1,150 / $3,877 = 29.7% Pharmacia’s ROE in 2007 was 29.7%, and the industry average was only 12.3%. A potential investor in Chem-Med would be very pleased; Chem-Med is offering a handsome return that’s almost two and a half times that of the average company in the industry. Now, the investor will want to use the Du Pont method to look further at Chem-Med and Pharmacia to determine the source of this return. ROE = Profit Margin x Asset Turnover / (1 – Debt to Assets) Chem-Med, 2007 .2970 = .3015 x .85 / (1 – .137) Pharmacia: .2956 = .07 x 1.9 / (1 – .55) Note the drastic difference in the operation of the two companies, even though their ROEs are nearly the same. Chem-Med makes relatively few sales (low asset turnover), but makes a lot of money on each one (30%). Pharmacia is just the opposite: it makes a lot of sales, and only a little profit (7%) on each one. Pharmacia’s ROE is also being propped up by greater use of debt than Chem-Med (Pharmacia has relatively less equity; so the same amount of income will represent a greater return to Pharmacia’s equity holders than Chem-Med’s). All other considerations being equal, a potential investor would probably prefer Chem-Med’s position, but it’s by no means certain (for example, it’s much more serious for Chem-Med to lose a sale). Glen Mount Furniture Company Case 3 Financial Leverage Purpose: The potential impact of changes in the debt level on earnings per share is the central focus of the case. However, the instructor can derive educational benefits that go well beyond this point. The central figure in the case is frustrated by security analyst’s short-term emphasis on earnings per share and their lack of concern for the long-term fundamentals associated with his firm. This rather common situation can be drawn upon to make for a more dynamic discussion process. The student is given ample opportunities to calculate EPS under different financial leverage strategies and to examine debt ratios, and degrees of leverage. Relation to Text: The case should follow Chapter 5. Because the case has some elementary valuation considerations as well, it also could be used later in the course. Complexity: The case is moderately complex. It should require 1 hour. Solutions 1. Sales ($45,500,000 + $500,000................................................ $45,500,000 Fixed costs .......................................................................... 12,900,000 Variable costs (58% of sales) ............................................... 26,390,000 Operating income (EBIT) ........................................................ 6,210,000 Interest ................................................................................ 1,275,000 Earnings before taxes (EBT) ................................................... 4,935,000 Taxes (34%) ........................................................................ 1,677,900 Earnings after taxes (EAT) ...................................................... 3,257,100 Shares ..................................................................................... 2,000,000 Earnings per share ................................................................... $1.63 2. Earnings per share, 2011 ............................................ $1.63 Earnings per share, 2010 ............................................ 1.56 Increase...................................................................... $ .07 Increase $ .07 = 4.5% Earnings per share, 2010 1.56 3. Sales ....................................................................................... $45,500,000 Fixed costs .......................................................................... 12,900,000 Variable costs (58% of sales) ............................................... 26,390,000 Operating income (EBIT) ........................................................ 6,210,000 Interest* .............................................................................. 2,400,000 Earnings before taxes (EBT) ................................................... 3,810,000 Taxes (34%) ........................................................................ 1,295,400 Earnings after taxes (EAT) ...................................................... 2,514,600 Shares** ................................................................................. 1,375,000 Earnings per share ................................................................... $1.83 *Interest Old debt 10.625% x $12,000,000 = $1,275,000 New debt 11.250% x $10,000,000 = +1,125,000 Total interest $2,400,000 **Shares outstanding 2,000,000 – 625,000 = 1,375,000 4. Earnings per share, 2011 (based on more debt) ........................ $1.83 Earnings per share, 2010 ......................................................... 1.56 $ .27 17.3% $1.56 $.27 Earnings per share,2010 Increase = 1.26 $4,935,000 $6,210,000 $6,210,000 $1,275,000 $6,210,000 EBIT - I EBIT 5. DFL (1) = = = = = − 1.63 $3,810,000 $6,210,000 $6,210,000 $2,400,000 $6,210,000 EBIT I EBIT DFL (3) = = = = − = − 3.87 $ 4,935,000 $19,110,000 $45,500,000 $26,390,000 $12,900,000 $1,275,000 $45,500,000 $26,390,000 S TVC FC I S TVC 6. DCL(1) = = − − − − = − − − − = 5.02 $ 3,810,000 $19,110,000 $45,500,000 $26,390,000 $12,900,000 $2,400,000 $45,500,000 $26,390,000 S TVC FC I S TVC DCL (3) = = − − − − = − − − − = 7. From Figure 2: 43.2% $40,500,000 $17,500,000 Total assets Total debt = = After new debt issue: 67.9% $40,500,000 $27,500,000 $40,500,000 $17,500,000 $10,000,000 Total assets Total debt = + = = 8. There are two conflicting factors that could influence the stock price. On the positive side, earnings per share would be twenty cents higher with more debt ($1.83 versus $1.63). Based on a current price-earnings ratio of about 10 (the repurchase price for the shares is for $16 ($10,000,000 / 625,000) and EPS are currently $1.56), the stock might go up by approximately $2.00 as a result of a $.20 increase in EPS. Two dollars represents a healthy 12.5% increase from the current value of $16 per share. However, the student must keep in mind that the debt ratio is increasing from 43.2% to 67.9%, which probably would have a negative effect on the price-earnings ratio. The net effect of the increase in earnings per share versus the likely decrease in the price-earnings ratio can only be conjectured. Security analysts following Glen Mount Furniture Company seem to be highly sensitive to earnings per share performance, but there may be some question about whether the type of financial engineering used to increase the earnings per share will satisfy them. Of course, the firm can argue that the share repurchase is a strong sign of confidence by management in future company performances. One clue to the eventual reaction of the market to the recapitalization might lie in the data on the debt ratios of other firms in the industry. If 67.9% is perceived to be on the high end, there might be little positive gain associated with the increase in earnings per share. However, if other companies are in this range and the firm is merely taking advantage of underutilized debt capacity, the market reaction might be positive. Genuine Motor Products Case 4 Combined Leverage Purpose: The case illustrates the potential impact on a company when it goes from dependence on labor intensive variable costs to fixed cost automation. The effects are further highlighted when the new equipment is heavily financed by debt. The upside is emphasized through increased earnings per share, while the downside is related to a higher break-even level (an expanded definition of cash flow break- even is introduced and very carefully explained). Not only are earnings per share and break-even covered, but so are all the various measures of degree of leverage. In addition to numerous calculations, the student is called upon to make judgmental decisions as an aggressive industrial engineer comes into conflict with a conservative chief financial officer. Relation to Text: The case should follow Chapter 5. Complexity: The case is moderately complex. It should require 1 – 1½ hours. Solutions 1. Figure 4 Sales (1,000,000 units @ $30 per unit) ............................................................................ $30,000,000 Fixed costs* ................................................................................................................ 5,800,000 Total variable costs (1,000,000 units @ $18.80 per unit).............................................. 18,800,000 Operating income (EBIT) ................................................................................................ 5,400,000 Interest (10.75% x $12,000,000) .................................................................................. 1,290,000 Earnings before taxes ...................................................................................................... 4,110,000 Taxes (35%) ................................................................................................................ 1,438,500 Earnings after taxes ......................................................................................................... 2,671,500 Shares ............................................................................................................................. 2,320,000 Earnings per share ........................................................................................................... $1.15 *Fixed costs include $2,800,000 in depreciation. 2. The first reason earnings per share has increased from $.91 to $1.15 relates to automation. That is even though fixed costs have gone up, total variable costs have gone down by even more. Thus, automation has lead to an increase in operating income from $3,000,000 to $5,400,000. This first reason relates to the use of operating leverage. A second reason is that the $14 million increase in fixed assets was heavily financed by debt rather than equity. Out of $14 million of new financing, $10 million was in debt and only $4 million in new stock. The second reason relates to the use of financial leverage. ( ) 3. DOL ( ) Q P VC Q P VC FC − = − − Before (Figure 2) After (Figure 4) 1.67 $3,000,000 $5,00,000 1,000,000 ($5) 2,000,000 1,000,000 ($5) 1,000,000 ($30 $25) $2,000,000 1,000,000 ($30 $25) = = = − − − − 2.07 5,400,000 $11,200,000 1,000,000 ($11.20) $5,800,000 1,000,000 ($11.20) 1,000,000 ($30 $18.80) $5,800,000 1,000,000 ($30 $18.80) = − − − − EBIT - I EBIT DFL = Before (Figure 2) After (Figure 4) 1.08 $2,785,000 $3,000,000 $3,000,000 $215,000 $3,000,000 = = − 1.31 4,110,000 $5,400,000 $5,400,000 $1,290,000 $5,400,000 = = − DCL ( ) ( ) Q P VC Q P VC FC I − = − − − Before (Figure 2) After (Figure 4) 1.80 $2,785,000 $5,000,000 1,000,000 ($5) $2,215,000 1,000,000 ($5) 1,000,000 ($30 $25) $2,000,000 $215,000 1,000,000 ($30 $25) = = = − − − − − 2.73 4,110,000 $11,200,000 1,000,000 ($11.20) $7,090,000 1,000,000 ($11.20) 1,000,000 ($30 $18.80) $5,800,000 $1,290,000 1,000,000 ($30 $18.80) = = − − − − − 4. Operating BE FC = P −VC Before (Figure 2) After (Figure 4) 400,000 units $5 $2,000,000 $30 $25 $2,000,000 = − 517,857 units $11.20 $5,800,000 $30 $18.80 $5,800,000 = − Financial BE = Interest rate % × Assets financed Before After new assets purchased BE = 10.75% ($24,000,000) = 10.75% ($38,000,000) = $2,580,000 EBIT = $4,085,000 EBIT (Fixed costs Depreciation) Interest 5. Revised BE Price (P) (VC) Variable cost per unit − + = − Before (Figure 2) After (Figure 4) 243,000 units $5 $1,215,000 $5 1,000,000 $215,000 $30 $25 ($2,000,000 $1,000,000) $215,000 = = + = − − + 383,036 units $11.20 $4,290,000 $11.20 $3,000,000 $1,290,000 $30 $18.80 ($5,800,000 $2,800,000) 1,290,000 = = + = − − + 6. Using the revised break-even analysis from question 5, the company would be in trouble. It requires 383,036 units to cover all cash outflows, and at 300,000 units, this is not possible. While 300,000 units represents only 30 percent of current sales volume of 1,000,000 units, the auto parts industry is highly cyclical. 7. Earnings per share at 1,500,000 units Sales (1,500,000 units @ $30 per unit) ................................................................. $45,000,000 Fixed costs ....................................................................................................... 5,800,000 Total variable costs (1,500,000 units @ $18.80 per unit)................................... 28,200,000 Operating income ................................................................................................. 11,000,000 Interest (10.75% x $12,000,000) ....................................................................... 1,290,000 Earnings before taxes ........................................................................................... 9,710,000 Taxes (35%) ..................................................................................................... 3,398,500 Earnings after taxes .............................................................................................. $ 6,311,500 Shares .................................................................................................................. 2,320,000 Earnings per share ................................................................................................ $2.72 8. There is no correct answer as to who is right. The changes that Mike Anton suggests will definitely increase profitability. At 1,000,000 units, earnings per share are $.91 under the old plan and $1.15 under the new plan. At 1,500,000 units, the gap is even wider. Earnings per share are $1.72 under the old plan and $2.72 under the new plan. On the other hand, the new plan exposes the firm to more risk of not covering its cash obligations. As computed in question 6, the revised break-even point is 383,036 units under the new plan and a somewhat safer 243,000 units under the old plan. For example, at a volume of 300,000 units, the company could meet its cash obligations under the old plan, but not under the new plan. The key variable in determining the success or failure of the new plan is volume. As long as volume stays the same or goes up, the new plan is definitely going to be a success (even if volume declines somewhat, it may still be desirable). However, if volume falls sharply in a recession, the new plan could be a failure. As is almost always true with leverage, volume is quite important in determining success or failure. Another alternative would be to finance the additional assets with more equity financing to reduce the DCL and overall risk of the company. Gale Force Surfing Case 5 Working Capital—Level vs. Seasonal Production Purpose: The case forces the student to view the impact of level versus seasonal production on inventory levels, bank loan requirements, and profitability. It also considers the efficiencies (or inefficiencies) covered by the different production plans. The computations in the case are parallel to Table 6-1 through Table 6-5 in the text, with the only difference being that seasonal production rather than level production is being utilized. The case allows the student to properly track the movement of cash flow through the production process. Relation to Text: The case should follow Chapter 6. Complexity: The case involves numerous computations and may require 2 hours. Solutions 1. New Tables 1 through 5, with Tim’s suggestion implemented, are shown in the following pages. Observe that the inventory level is now constant at 400 units or $800,000 a month because all units produced are sold. As a side point, note that there may be no apparent need now to maintain the 400 units a month in inventory that were on hand at the start of the cycle. The inventory level could be reduced to the level that management feels would be sufficient to cover emergencies (or maybe to zero, which is what the Japanese do in a “just-in-time” production concept). Though not required, you may wish to refer to the old and new Table 4 to make a special point. Note that Tim’s suggestion causes inventory balances to remain constant and much lower over the time period and total current assets to fluctuate less, but the same balances occur at the end of September for inventory and total current assets. 2. New Table 5 shows the new cumulative loan balances and the interest expenses incurred each month. Under the old system (level production), total interest expense (at 1% a month on the cumulative loan balance) was $254,250. Under the proposed system it decreases to $50,750 for a savings of $203,500. 3. The first step is to compute total sales. Using the second row of Table 3 (either the old or new table), the total is $14,400,000. With an added expense burden of .5%, expenses will go up by $72,000. This is still far less than the interest savings of $203,500 computed in question 2, so the seasonal production plan is justified. Interest savings................................. $203,500 Added production expense ............... –72,000 Net savings ...................................... $131,500 Note: Values are assumed to be computed on a pretax basis. GALE FORCE SURFING (With Tim’s suggestion implemented) TABLE 1. SALES FORECAST (in units) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter October 150 January 0 April 500 July 1,000 November 75 February 0 May 1,000 August 500 December 25 March 300 June 1,000 September 250 TABLE 2. PRODUCTION SCHEDULE AND INVENTORY (seasonal production) Beginning Inventory Production this Month Sales Ending Inventory Inventory ($2,000 per unit) October .............. 400 + 50 – 150 = 400 $800,000 November .......... 400 75 75 400 $800,000 December .......... 400 25 25 400 $800,000 January .............. 400 0 0 400 $800,000 February ............ 400 0 0 400 $800,000 March ................ 400 300 300 400 $800,000 April .................. 400 500 500 400 $800,000 May ................... 400 1,000 1,000 400 $800,000 June ................... 400 1,000 1,000 400 $800,000 July .................... 400 1,000 1,000 400 $800,000 August ............... 400 500 500 400 $800,000 September .......... 400 250 250 400 $800,000 TABLE 4. TOTAL CURRENT ASSETS, FIRST YEAR Cash Accounts* Receivable Inventory Total Current Assets October ................... $125,000 + $ 225,000 + $800,000 = $1,150,000 November ............... $125,000 $ 112,500 $800,000 $1,037,500 December ............... $125,000 $ 37,500 $800,000 $ 962,500 January ................... $125,000 $ 0 $800,000 $ 925,000 February ................. $125,000 $ 0 $800,000 $ 925,000 March ..................... $125,000 $ 450,000 $800,000 $1,375,000 April ....................... $125,000 $ 750,000 $800,000 $1,675,000 May ........................ $125,000 $1,500,000 $800,000 $2,425,000 June ........................ $125,000 $1,500,000 $800,000 $2,425,000 July ......................... $300,000 $1,500,000 $800,000 $2,600,000 August .................... $350,000 $ 750,000 $800,000 $1,900,000 September ............... $775,000 $ 375,000 $800,000 $1,950,000 *Equals 50 percent of monthly sales TABLE 5. CUMULATIVE LOAN BALANCE AND INTEREST EXPENSE (17% per month) October November December January February March April Cumulative Loan Balance ... $50,000 $62,500 $162,500 $475,000 $675,000 $1,025,000 $1,175,000 Interest Expense at 12.00% ............ $ 500 $ 625 $ 1,625 $ 4,750 $ 6,750 $ 10,250 $ 11,750 (Prime, 8.0%, + 4.0%) May June July August September Cumulative Loan Balance $1,125,000 $ 325,000 $0 $0 $0 Interest Expense at 12.00% $ 11,250 $ 3,250 $0 $0 $0 (Prime, 8.0%, + 4.0%) Total Interest Expense for the Year: $50,750 Modern Kitchenware Co. Case 6 Cash Discount Purpose: The case illustrates how the offering of a cash discount can affect the profitability of the firm. Three different cash discount policies are evaluated in terms of cost, freed up funds and the associated profitability. The impact of a cash discount on sales volume is also considered and has an impact on the final decision in the case. Relation to Text: The case should follow Chapter 7. Complexity: The case is moderately complex. It should require 1 hour. Solutions 1. Midpoint of Days Outstanding Weights Weighted Number of Days 5 .010 .050 15 .075 1.125 25 .200 5.000 35 .325 11.375 45 .215 9.675 55 .175 9.625 1.000 36.850 Average Collection Period 2. 1/10, net 30 Policy 10% x 10 days = 1 day 90% x 30 days = 27 days 28 days Average Collection Period 2/10, net 30 Policy 25% x 10 days = 2.5 days 75% x 30 days = 22.5 days 25.0 days Average Collection Period 3/10, net 30 Policy 60% x 10 days = 6 days 40% x 30 days = 12 days 18 days Average Collection Period 3. Accounts receivable = average collection period x average daily credit sales 1/10, net 30 policy 28 days x $54,274 = $1,519,672 2/10, net 30 policy 25 days x $54,274 = $1,356,850 3/10, net 30 policy 18 days x $54,274 = $976,932 It should be pointed out that if total credit sales billed remained the same under the three cash discount policies, average daily credit sales would go down due to the subtraction of the cash discount. However, for simplicity in the calculations, this point is not explicitly considered. 4. Cost of cash discount: Total credit sales x percent using the discount x % discount. Cash Discount Total Credit Sales Percent Using the Discount Percent Discount Cost of Cash Discount 1/10, net 30 policy $18,000,000 x 10% x 1% = $ 18,000 2/10, net 30 policy $18,000,000 x 25% x 2% = $ 90,000 3/10, net 30 policy $18,000,000 x 60% x 3% = $324,000 5. Old accounts receivable – new accounts receivable = freed up funds 1/10, net 30 policy $2,000,000 – $1,519,672 = $480,328 2/10, net 30 policy $2,000,000 – $1,356,850 = $643,150 3/10, net 30 policy $2,000,000 – $976,932 = $1,023,068 6. The return is equal to the freed up funds times 18% 1/10, net 30 policy $ 480,328 x 18% = $ 86,459 2/10, net 30 policy $ 643,150 x 18% = $115,767 3/10, net 30 policy $1,023,068 x 18% = $184,152 7. Returns on freed up funds – cost of cash discounts = profit or loss Return on Freed up Funds Cost of Cash Discount Profit (loss) 1/10, net 30 policy $ 86,459 – $ 18,000 = $ 68,459 2/10, net 30 policy $115,407 – $ 90,000 = $ 25,767 3/10, net 30 policy $184,152 – $324,000 = ($139,848) The 1/10, net 30 policy provides the largest profit. The cost is too high for the 2% and 3% discounts relative to the return potential from freed up funds. 8. Increased profitability of Alternative 2 (2/10, net 30) under the assumption of a $1,000,000 increase in sales. Increased Sales...................................................................... $1,000,000 Profit Margin ........................................................................ 9% Profit..................................................................................... $90,000 – Cost of cash discount (2% x $1,000,000) ............................... –20,000 – Lost profit on funds committed to accounts receivable (20% x $27,750) ................................................................... –5,550 Profit on new sales ................................................................ $64,450 Previously computed Profit from freed up funds (Question 7) +25,767 Total profit on Alternative 2 (2/10, net 30) ............................ $90,217 The total profit on Alternative 2 (2/10, net 30) of $90,217 now exceeds the profit of Alternative 1 (1/10, net 30) of $68,459 as computed in Question 7. The 2/10, net 30 policy should now be chosen. Landis Apparel Co. Case 7 Current Asset Management Purpose: The case illustrates the relationship between profitability and required investment. The turnover ratio for accounts receivable is particularly important, with an investment in inventory also included in the analysis. Sensitivity analysis is further considered in this case. Relation to Text: The case should follow Chapter 7. Complexity: The case is reasonably straight forward and requires 30-45 minutes. Solutions 1. Additional sales $1,000,000 Accounts Uncollectible (5% of new sales) 50,000 Annual incremental revenue 950,000 Collection costs (4% of new sales) 40,000 Production and selling costs (85% of new sales) 850,000 Annual income before taxes 60,000 Taxes (35%) 21,000 Annual incremental income after taxes $39,000 2. Accounts Receivable = Sales = $1,000,000 = $333,333 Turnover 3 3. Return on accounts receivable investment = Annual incremental income after tax = $39,000 = 11.70% Accounts receivable $333,333 4. No. The return on investment is only 11.70%, versus a required rate of return of 14%. 5. New Accounts Receivable = Sales = $1,000,000 = $250,000 Turnover 4 Return on accounts receivable investment = Annual incremental income after tax = $39,000 = 15.60% Accounts receivable $250,000 Yes. The return on investment is 15.60%, versus a required rate of return of 14%. 6. First compute the total investment Accounts receivable $250,000 Inventory 200,000 Total Investment $450,000 Return on total investment = Annual incremental income after tax = $39,000 = 8.67% Total investment $450,000 No. The return on investment is 8.67%, versus a required rate of return of 14%. 7. First compute the revised aftertax income Additional sales $1,000,000 Accounts Uncollectible (5% of new sales) 50,000 Annual incremental revenue 950,000 Collection costs (4% of new sales) 40,000 Production and selling costs (75% of new sales) 750,000 Annual income before taxes 160,000 Taxes (35%) 56,000 Annual incremental income after taxes $104,000 Then compute return on total investment. Return on total investment = Annual incremental income after tax = $104,000 = 23.11% Total investment $450,000 The sale should be made. The return on investment is 23.11% versus the required return of 14%. Fresh & Fruity Foods, Inc. Case 8 Current-Asset Management Purpose: The student must focus on accounts receivable as an investment (use of funds) and the financial advantages of reducing the commitment to this asset. At the same time the firm is also considering reductions to its accounts payable balance in order to take cash discounts. This alternative will call for additional bank financing, and comparative costs must be carefully assessed. The case utilizes many calculations that are covered in the text, but places them in a more complex, decision oriented framework. Relation to Text: The case should follow the completion of Part Three (Working Capital) in the text. It primarily relies on material from chapters 7 and 8. Complexity: The case is moderately complex. It should require 1-1½ hours. Solutions 1. Average collection period = accounts receivable / average daily credit sales Accounts receivable = $209,686 Average daily credit sales = $1,179,000 / 360 = $3,275 Average collection period = $209,686 / 3,275 = 64.03 days 2.04% 6.32 12.89% vs. 8% bank loan 67 10 360 100% 2% 2% Final due date - Discount percent 360 100 percent - Discount percent Discount percent 2. Cost of failing to take a cash discount =  = = −  −  = The formula tells us that Fresh & Fruity is effectively paying 12.89% interest to delay paying the discounted amount for 57 days (the 67 days on which it pays less the 10 day discount period). 3. New accounts receivable = Average collection period × Average daily credit sales $104,800 = 32 × $3,275 Freed-up cash = Old accounts receivable ............................................. $209,686 – New accounts receivable ........................................... 104,800 $104,886 New accounts payable = Old accounts payable ................................................. $180,633 – Funds from accounts receivable ................................. 104,886 New accounts payable ............................................... $ 75,747 4. Accounts payable = average payment period x purchases per day Average payment period = 10 days Purchases per day = [969,000 – (.02 × 969,000)] / 360 = ($969,000 – $19,380) / 360 = $949,620 / 360 = $2,638 Accounts payable = 10 × $2,638 = $26,380 required AIP balance to take cash discount in 10 days Old accounts payable from question 3 ................................................................. $75,747 New accounts payable from question 5 ................................................................. –26,380 Size of bank loan required ................................................................. $49,367 This is the size of the bank loan required to take all cash discounts in 10 days. 5. The cost is the 8 percent interest on the bank loan of $49,367 or $3,949. The gain is the cash discounts taken of $19,380. The net gain before tax is $15,431 ($19,380 – $3,949). On an aftertax basis this translates to a gain of $10,339 ($15,431 × .67). 6. First determine the amount of funds on which interest must be paid. a) Note: Alert students may point out that Fresh & Fruity still needs $49,367 in cash no matter what kind of loan it is. Therefore, if the interest is to be charged on a discounted basis, and a compensating balance is required, Fresh & Fruity must borrow a larger amount to make up for it. Solve for the larger amount using algebra where L is the loan amount. L – (.08 × L) – (.20 × L) = $49,367 L – .08L – .20L = $49,367 L – .28L = $49,367 .72L = $49,367 L = $49,367 / .72 = $68,565 need to borrow to net $49,367 Interest cost = .08 ($68,565) = $5,485 interest Effective rate = $5,485 = 11.1% $49,367 The cost goes up from 8% to 11.1%. However, this rate is still less than the cost of not taking the cash discount of 12.89% computed in question 2. Thus, it is advantageous to borrow and take the cash discount. Pierce Control Systems Case 9 Bank Financing Purpose: The case allows the student to compare the cost of floating rate bank financing with longer-term fixed rate financing. The relative cost of each under different economic scenarios is considered and expected values are computed. There is also a brief consideration of the term structure of interest rates and the expectations hypothesis. Another feature is that the student considers the trade-off between compensating balance requirements and lower quoted interest rates. Relation to Text: The case draws on material from both Chapter 6 and Chapter 8 and should follow Chapter 8. Complexity: This case is reasonably straightforward and requires 30-45 minutes to solve. Pierce Control Systems Solutions Amount needed 1. Amount to be borrowed (1 ) $10,000,000 (1 .1) $10,000,000 $11,111,111 .9 = −C = − = = 2. $11,111,111 Loan requirement with compensating balance .055 (prime rate minus 1/2%) $ 611,111 Interest cost on loan with compensating balance OR 5.5% = 6.11% effective rate 1 – .1 $10,000,000 Straight bank loan x .06 Prime rate $ 600,000 Interest cost on straight bank loan OR 6% rate The compensating balance loan would be more expensive. 3. $11,111,111 Compensating balance loan –10,000,000 Actual funds needed $ 1,111,111 Compensating balances 4% Interest rate earned $ 44,444 Return on compensating balances $611,111 Interest cost on loan with compensating balance –44,444 Return on compensating balances $566,667 Net dollar interest cost of the compensating loan requirement The compensating balance loan would be less expensive than the 6% prime interest rate loan. ($566,667 vs. $600,000). 4. The term structure of interest rate curve is upward sloping. Under the expectations hypothesis, this would indicate that the next major move in interest rates is likely to be upward. Long-term rates reflect the average of expected short-term rates. 5. Total interest cost with borrowing at prime over the next five years. Short-Term Projected Year Amount Interest Rate Interest Cost 2007 $10,000,000 6% $ 600,000 2008 10,000,000 8% 800,000 2009 10,000,000 9% 900,000 2010 10,000,000 9% 900,000 2011 10,000,000 4% 400,000 $3,600,000 Total interest cost of the five year, 8% insurance company loan. Amount x Long-Term Interest Rate Interest Cost Years Total Cost $10,000,000 8% $800,000 5 $4,000,000 The cost of the prime rate loan ($3,600,000) would be less than the five year insurance company loan ($4,000,000). Note the time value of money is not considered in this exercise. 6. Total interest cost with borrowing at prime over the next five years (Second Scenario). Short-Term Projected Year Amount Interest Rate Interest Cost 2007 $10,000,000 6% $ 600,000 2008 10,000,000 10% 1,000,000 2009 10,000,000 15% 1,500,000 2010 10,000,000 13% 1,300,000 2011 10,000,000 13% 1,300,000 $5,700,000 The cost of the prime rate loan ($5,700,000) would be greater than the five year insurance company loan ($4,000,000). 7. Expected Value of Scenarios Outcome Probability Expected Value Scenario 1 (Question 5) $3,600,000 .70 $2,520,000 Scenario 2 (Question 6) 5,700,000 .30 +1,710,000 $4,230,000 The expected value of dollar interest costs of short-term borrowing ($4,230,000) would be higher than the five year insurance company loan ($4,000,000). 8. Probability of the scenarios that produces an indifference point between short-term and long-term borrowing. Scenario 1 outcome (X) + Scenario 2 outcome (1 – X) = Interest cost under long-term borrowing. Note: X represents the probability of the outcome. Thus $3,600,000X + $5,700,000 (1 – X) = $4,000,000 $3,600,000X + $5,700,000 – $5,700,000X = $4,000,000 –$2,100,000X = –$1,700,000 $1,700,000 $2,100,000 80.95% and 1 19.05% X X X − = = − = − = With an 80.95% probability of scenario 1 and a 19.05% probability of scenario 2, the firm would be indifferent between short-term and long-term borrowing. Proof: Outcome Probability Expected Value Scenario 1 $3,600,000 .8095 $2,914,200 Scenario 2 5,700,000 .1905 +1,085,850 Total expected value $4,000,050 The total expected value ($4,000,050) of short-term borrowing is virtually the same as the cost of long-term borrowing ($4,000,000). The slight difference is due to rounding. 9. Through hedging, the firm can reduce or eliminate the risk associated with rising interest rates. If interest rates do rise, the extra cost of borrowing money to actually finance the business can be offset by the profit on a futures contract. Allison Boone, M.D. Case 10 Time Value of Money Purpose: The case brings the time value of money into a legal settlement context, where present value concepts are frequently utilized. Many professors may also be able to draw on their own personal expertise to enhance the discussion of the case. The case deals with a high earning medical doctor and the loss to her family as a result of an accident. Relation to the Text: The case should follow Chapter 9. Complexity: The case is moderately complex and should require 1 hour. Solutions 1. Proposal Number One $300,000 a year for the next 20 years PV PV ( 20, 6%) (Ap.D) PV $300,000 11.470 $3,441,000 A IFA A = A  n = I = =  = Also $500,000 a year for the remaining 20 years Step 1 PV PV ( 20, 6%) (Ap.D) PV $500,000 11.470 $5,735,000 2 PV FV PV ( 20, 6%) (Ap.B) PV $5,735,000 .312 $1,789,320 A IFA A IF A n I Step n I =  = = =  = =  = = =  = Total present value 1st 20 years $3,441,000 Remaining 20 years +1,789,320 Present value $5,230,320 Proposal Number Two Present value $5,000,000 Proposal Number Three $50,000 a year for the next 40 years PV PV ( 40, 6%) (Ap.D) PV $50,000 15.046 $752,3000 A A A = A  n = I = =  = Also $75 million at the end of 40 years PV FV PV ( 40, 6%) (Ap.B) PV $75,000,000 .097 $7,275,000 =  IF n = I = =  = Total present value 40 year payment $ 752,300 Payment at end of 40 years +7,275,000 Present value $8,027,300 At a discount rate of 6 percent, proposal three has the highest net present value of $8,027,300. 2. Change the discount to 11 percent Proposal number one $300,000 a year for the next 20 years PV PV ( 20, 11%) (Ap.D) PV $300,000 7.963 $2,388,900 A IFA A = A  n = I = =  = Also $500,000 a year for the remaining 20 years Step 1 PV PV ( 20, 11%) (Ap.D) PV $500,000 7.963 $3,981,500 2 PV FV PV ( 20, 11%) (Ap.B) PV $3,981,500 .124 $493,706 A IFA A IF A n I Step n I =  = = =  = =  = = =  = Total present value 1st 20 years $2,388,900 Remaining 20 years +493,706 Present value $2,882,606 Proposal Number Two Present value $5,000,000 Proposal Number Three $50,000 a year for the next 40 years PV PV ( 40, 11%) (Ap.D) PV $50,000 8.951 $447,550 A IFA A = A  n = I = =  = Also $75 million at the end of 40 years PV FV PV ( 40, 11%) (Ap.B) PV $75,000,000 .015 $1,125,000 =  IF n = I = =  = Total present value 40 year payment $ 447,550 Payment at end of 40 years +1,125,000 Present value $1,572,550 At a discount rate of 11 percent, proposal two has the highest value of $5,000,000. 3. At a relatively high discount rate of 11 percent in question 2, the later payments lose much of their value. For example, the $75 million payment as part of proposal three only has a present value of $1,125,000 at a discount rate of 11 percent as compared to $7,275,000 at six percent. At higher discount rates, the opportunity cost of not receiving payments earlier is greater. For this reason, the $5 million immediate payment in proposal two is the most favorable at the higher discount rate. 4. Punitive damages are added on to the economic damages. With the likelihood of $4 million in punitive damages, Sloan Whitaker may well want to take the case before a jury. However, we should keep in mind that offers for the out-of-court settlement have likely been influenced by the potential for punitive damages. Also, a jury verdict may be appealed and actual payment may be deferred many years into the future. Because attorneys in cases such as this often get 1/3rd of the out-of-court settlement (or the jury determined value) as their fee, Sloan Whitaker is likely to consider this matter quite seriously. Of course, the final decision will rest with the Boone family, but Samuel Boone will be strongly influenced by the attorney’s recommendation. Although this question is not a financial one, it has financial implications for the student doing the case. The Boone family may also be influenced by the timing of the payments and their need for current inflow. Billy Wilson, All American Case 11 Time Value of Money Purpose: The case provides the student with an interesting opportunity to examine the time value of money. Pro football contractual issues are frequently in the news so the student will be dealing with a contemporary situation. The student also will become familiar with deferred annuity payments. Relation to Text: The case should follow Chapter 9. Complexity: The case is moderately complex. It should require 1 hour. Solutions 1. Contract offer number one • Immediate signing bonus .......................................................................................................... $ 900,000 • $850,000 at the end of each year for the next five years PVA = A x PVIFA (n = 4, i = 10%) (Ap.D)* PVA = $850,000 x 3.791 = 3,222,350 Total present value $4,122,350 *indicates appendix designation Contract offer number two • Immediate signing bonus .......................................................................................................... 200,000 $100,000 at the end of each year for four years PVA = A x PVIFA (n = 4, i = 10%) (Ap.D) PVA = $100,000 x 3.170 = +317,000 • $150,000 at the end of years five through 10) Step 1 PVA = A x PVIFA (n = 6, i = 10%) (Ap.D) PVA = $150,000 x 4.355 = $653,250 Step 2 PV = FV x PVIF (n = 4, i = 10%) (Ap.B) PV = $653,250 x .683 +446,170 • $1,000,000 a year at the end of years 11 through 40 Step 1 PVA = A x PVIFA (n = 30, i = 10%) (Ap.D) PVA = $1,000,000 x 9.427 = $9,427,000 Step 2 PV = FV x PVIF (n = 10, i = 10%) (Ap.B) PV = $9,427,000 x .386 +3,638,822 Total present value $4,601,992 Contract offer number three • Immediate signing bonus .......................................................................................................... 1,000,000 • $500,000 at the end of year one PV = FV x PVIF (n = 1, i = 10%) (Ap.B) PV = $500,000 x .909 +454,500 • $1,000,000 at the end of year two PV = FV x PVIF (n = 2, i = 10%) (Ap.B) PV = $1,000,000 x .826 +826,000 • $1,500,000 at the end of year three PV = FV x PVIF (n = 3, i = 10%) (Ap.B) PV = $1,500,000 x .751 +1,126,500 • $2,500,000 at the end of year four PV = FV x PVIF (n = 4, i = 10%) (Ap.B) PV = $2,500,000 x .683 +1,707,500 • Bonus for Pro Bowl $200,000 x .25 = $50,000 expected value per year PV = A x PVIFA (n = 4, i = 10%) (Ap.D) PVA = $50,000 x 3.170 +158,500 Total present value $5,273,000 2. Contract offer by the Canadian football team • Immediate signing bonus .......................................................................................................... 1,100,000 • $2,000,000 at the end of each year for three years x .80 probability the amount will be paid $1,600,000 expected value of the payment PVA = A x PVIFA (n = 3, i = 10%) (Ap.D) PVA = $1,600,000 x 2.487 3,979,200 Total present value $5,079,200 3. The third contract proposal from the U.S. team ($5,273,000) 4. The second contract proposal from the U.S. team with the late cash flows would become much more attractive relative to the other contracts. Though the computation is not required, the value of the second contract proposal goes up to $7,388,055. 5. $5,273,000 Third contract proposal from the U.S. team x .90 $4,745,700 Remaining value after the agent’s 10 percent fee x .67 $3,179,619 Aftertax value 6. They would put an even greater benefit and emphasis on early payments. 7. The value of an annuity: A = PVA (n = 40, i = 10%) (Ap.D) PVIFA A = $5,273,000 = $539,217 9.779 8. Answers might include: • Possible extra revenues from commercials, personal appearances • The competition for his position on whatever team he signs a contract • Of course, many other answers also are possible. • Risk = Canadian team probability of being picked up and timing of cash flows. Sandra Gilbert, Retiree Case 12 Time Value of Money Purpose: The case provides the student to a very important issue in the age of baby boomers. Although retirement is not an issue directly affecting students, it is one in which they are likely to be called on for advice by parents and relatives. For those students who become financial planners, the case will have particular importance. Relation to Text: The case should follow Chapter 9. Complexity: The case is relatively straightforward and should require 30-45 minutes. Solutions 1. Retirement Funds $400,000 Tax Rate 35% Taxes $140,000 Net Retirement Funds $260,000.00 2. Annual Funds $35,000 Tax Rate 15% Taxes $5,250 A/T Income $29,750 PV Factor for n = 20, i = 8% 9.818 NPV of Funds $292,085.50 3. Annual Funds $31,000 Tax Rate 15% Taxes $4,650 A/T Income $26,350 PV Factor for n = 25, i = 8% 10.675 NPV of Funds $281,286.25 4. Initial Payout $200,000 Tax Rate 35% Taxes 70,000 Net Retirement Funds $130,000 Plus Annual Funds (200,000/10) $20,000 Tax Rate 15% Taxes $3,000 A/T Income $17,000 PV Factor for n = 10, i = 8% 6.710 NPV of Funds $114,070 Total Net Present Value $244,070 5. Option 2 has the highest NPV. $292,085.50 6. Option 2 A/T Income $29,750 PV Factor for n = 20, i = 4% 13,590 NPV of Funds $404,302.50 Option 3 A/T Income $26,350 PV Factor for n = 25, i = 4% 15.622 NPV of Funds $411,639.70 The lower discount rate favors the longer-term option (Option 3). Gilbert Enterprises Case 13 Stock Valuation Purpose: This case gives the student an opportunity to examine valuation concepts from both a theoretical dividend valuation model approach and a price-earnings ratio approach. Because an initial period of supernormal growth is assumed, a review of Appendix 10C is necessary for the case. However, this appendix is not difficult to follow. The case also makes strong use of ratios as part of the comparative P/E ratio analysis and should help the student better appreciate how ratios influence valuation. Relation to Text: The case should follow Chapter 10. Complexity: The overall case is moderately complex and should require 1 hour. Solutions 1. There are two steps involved in using the valuation of a supernormal growth firm. A. Find the present value of supernormal dividends. D0 = $1.20 D1 = $1.20 x 1.15 = $1.38 D2 = $1.38 x 1.15 = $1.59 D3 = $1.59 x 1.15 = $1.83 Supernormal Dividends Discount Rate Ke = 10% Present Value of Dividends During the Supernormal Period D1 $1.38 x .909 = $1.25 D2 1.59 .826 1.31 D3 1.83 .751 1.37 $3.93 B. Find the present value of the future stock price. 4 3 4 3 3 4 3 (1 ) 1.83, 6% $1.83(1.06) $1.94 with .10 $1.94 $1.94 $48.50 .10 .06 .04 e e D P K g D D g D g D K P = − = + = = = = = = = − The present value of the future stock price is: Stock Price after Three Years Discount Rate 10% Present Value of Future Stock Price $48.50 x .751 = $36.42 Adding together, the values found in Step 1 and Step 2, the valuation is $40.35. Step 1 $ 3.93 Step 2 +36.42 $40.35 Because the stock is only selling in the market for 35 1/4, it appears to be undervalued. 2. Gilbert Enterprises has the second lowest P/E ratio of the four firms. Based on the financial infor- mation provided in Figure 1, this does not appear to be appropriate. First of all, Gilbert Enterprises has the fastest growth rate in earnings per share of any of the four firms. Furthermore, the growth is expected to accelerate to 15 percent over the next three years (as explained earlier in the case). Gilbert Enterprises also has the second highest return on stockholder’s equity. Only Reliance Parts has a higher return, but its return is achieved solely as a result of its high debt ratio of 68 percent. As we learned in Chapter 3, it is possible to generate a high return on equity using debt, but still have relatively low profitability. In fact, Reliance Parts has the lowest return on total assets of any firm in the industry. In evaluating debt utilization as a separate item, Gilbert Enterprises once again looks attractive with a debt to total assets ratio of 33 percent. Only Standard Auto has a lower ratio. We get further insight by evaluating market value to book value as well as market value to replacement value. In terms of market value to book value, Gilbert Enterprises appears to be overvalued relative to other firms in the industry. It’s market value to book value ratio is 2.15 ($35.25 / $16.40). For the other three firms, the ratios are more conservative. Market Value Book Value Market Value to Book Value Gilbert Enterprises $35.25 $16.40 2.15 Reliance Parts 70.50 50.25 1.40 Standard Auto 24.25 19.50 1.24 Allied Motors 46.75 50.75 .92 But keep in mind that book value is a relatively meaningless concept because it is based on historical cost. A more meaningful analysis relates market value to replacement value. In this instance, we see that Gilbert Enterprises is the most conservatively valued of the four firms. Market Value Replacement Value Market Value to Replacement Value Gilbert Enterprises $35.25 $43.50 .81 Reliance Parts 70.50 68.75 1.03 Standard Auto 24.25 26.00 .93 Allied Motors 46.75 37.50 1.25 What about dividends? In terms of dividend yield, only Standard Auto provides a higher return to its stockholders. In summarizing the variables under consideration, it appears that Gilbert Enterprises may be undervalued relative to its competitors. While it has the second lowest P/E ratio, it has the fastest growth rate in earnings per share, the highest return on assets, and the lowest ratio of market value to replacement value. The average P/E ratio for the four firms in the industry is 18.3. A strong case can be made that Gilbert Enterprises belongs at least at that level. 3. Since the answer to questions 1 and 2 indicate the firm may undervalued, Albert Roth should seriously consider recommending that the firm repurchase part of its shares in the marketplace. There are two possible caveats. One is that the market tends to be efficient in the pricing of securities so that one could possibly argue that there is some missing information that justifies Gilbert Enterprises’ relatively low valuation. While an extended discussion of this point goes beyond the scope of this case, it probably should be brought up. Secondly, even if the stock is undervalued in the marketplace, the management of Gilbert Enterprises must make sure this is the best possible use of its funds. While the justification for a repurchase decision is not covered until Chapter 18 of the text, the instructor should at least make mention of the alternative uses of funds that must be considered in a stock repurchase decision. Baines Investment, Inc. Case 14 Stock Valuation Purpose: The case illustrates the use of the capital asset pricing model (CAPM) in valuing stock. Because of the detailed explanations given in the case, it can be introduced after Chapter 10 even though the CAPM discussion is in Chapter 11. The author of the case covers this gap. Also, the issue of determining a beta for a privately held company is discussed and illustrated. The liquidity discount for a non-public company is further illustrated and there are ample opportunities for computing the P/E ratio under different scenarios. Relation to Text: The case should follow Chapter 10 or Chapter 11. Complexity: The case is moderately complex and should require 30-45 minutes. Solutions 1. Average beta Company Beta Armour Holdings 1.40 BE Aerospace 1.65 General Dynamics .85 Lockheed Martin .80 Northrop Gruman .80 5.50 /5 = 1.10 2. Kj = Rf + β (Km - Rf ) = 6% + 1.10 (11% - 6%) =6% + 1.10 (5%) =6% + 5.5% = 11.5% 3. $30 .06 $1.80 .115 .055 1 $1.80 0 = = = K −g = − D P j 4. P/E ratio = Price/EPS = $30 / $2.40 = 12.5 x 5. $30 Stock price 6 20% Liquidity discount $24 Adjusted stock price Adjusted P/E ratio = Adjusted stock price / EPS = $24 / $2.40 = 10 x 6. New Stock price = $30 × 1.40 = $42 New P/E ratio = $42 / $2.40 = 17.5 x 7. The liquidity discount would approach zero as the company begins to enter the public market. This, of course, assumes the shares can be successfully sold. Atlantic Airlines Case 15 Bond Valuation Purpose: The case is intended to increase the student’s skills in bond valuation. To make matters more interesting the top of junk bonds is introduced and becomes the central focus of the discussion and the calculations. The student is asked to consider whether the higher yield on the bonds is adequate to cover potential downside exposure. Relation to Text: The case should follow Chapter 10. Complexity: The case is moderately complex and should require 45 minutes to an hour. Solutions 1. Find the bond price Present value of interest payments PVA = A x PVIFA (n = 18, i = 15%) Appendix D PVA = $120 x 6.128 = $735.36 Present value of principal payment at maturity PV = FV x PVIF (n = 18, i = 15%) PV = $1,000 x .081 - $81 $735.36 81.00 $816.36 2. Decline in value $1,000.00 - 816.36 $183.64 Interest rate advantage $1,000.00 x 8% $ 80 Per year 2 Years $ 160 The interest rate advantage does not cover the decline in value. Tom would come out behind. 3. Find the new bond price Present value of interest payments PVA = A x PVIFA (n = 18, i = 13%) PVA = $120 x 6.840 = $820.80 Present value of principal payment at maturity PV = FV x PVIF (n = 18, i = 13%) PV = $1,000 x .111 = $111 $820.80 111.00 $931.80 Decline in value $1,000.00 - 931.80 $ 68.20 The interest rate advantage of $160 covers the $68.20 decline in value. 4. Tom definitely comes out ahead. The bonds will increase in value due to the decline in yield in the market. He also will enjoy an interest rate advantage. 5. No. Tom will merely collect the initial $1,000 par value at maturity. Changes in the value of the bond over the 20 year time period will have no effect on the final payoff. Berkshire Instruments Case 16 Cost of Capital Purpose: The case gives the student additional opportunities to work with issues related to cost of capital. It focuses on the irrelevance of historical cost and the close relationship of retained earnings and new common stock in supplying equity capital. The concept of the marginal cost of capital is heavily stressed, and the use of the capital asset pricing model as an alternative to computing the cost of equity capital is also introduced. Relation to Text: The case should follow Chapter 11. Complexity: The case tends to be reasonably straightforward and requires about ½ hour. Solutions 1. First determine the percentage composition in the capital structure. Dollar amount Percentage composition Bonds ............................ $ 6,120,000 34 Preferred stock 1,080,000 6 Common equity 10,800,000 60 $18,000,000 100 Then determine the aftertax cost of each component (for now assume common equity is in the form of retained earnings). Cost of Debt Kd =Y (Yield) (1−T ) Annual Principal payment Price of the bond interest Approximate payment Number of years to maturity yield to maturity (Y ') .6 (Price of the bond) .4 (Principle payment) − + = + $1,000 -$890 $93 ' 20 .6 ($890) .4 ($1,000) $110 $93 20 $534 $400 $93 $5.50 $98.50 ' 10.55% $934 $934 10.55% (.65) 6.86% d d Y Y K K + = + + = + + = = = = = Cost of preferred stock $4.80 $4.80 8.36% $60 2.60 $57.40 P P P D K = P −F = = − Cost of common equity (Retained earnings) 1 0 1 0 1 0 Earnings per share .4 $3.00 .4 $1.20 $25 The growth rate that will allow $.82 to grow to $1.20 over 4 years. FV $1.20 FV 1.463 PV $.82 The growth rate is approximately 10%. $1.20 e IF e D K g P D P g D K g P = + =  =  = = = = = = = + = 10% 4.80% 10% 14.80% $25 + = + = Now combine the weights and the costs. Cost (aftertax) Weights Weighted Cost Bonds ......................................................................... Kd 6.86% 34% 2.33% Preferred stock ......................................................................... KP 8.36 6 .50 Common equity (retained earnings) ......................................................................... Ke 14.80 60 8.88 Weighted average cost of capital ......................................................................... Ka 11.71% 2. First compute the cost of new common stock. 1 0 $1.20 10% 5.22% 10% 15.22% $25 $2 n D K g = P −F + = + = + = − Then recompute the cost of capital. Cost (aftertax) Weights Weighted Cost Bonds ................................................................. Kd 6.86% 34% 2.33% Preferred stock ................................................................. KP 8.36 6 .50 Common equity (new common stock) ................................................................. Kn 15.22 60 9.13 Weighted average cost of capital ................................................................. Kmc 11.96% The size of the capital structure at which the cost of capital goes up is $7,500,000. $7,500,000 .60 $4,500,000 Percent of common equity in the capital structure Retained earnings = = 3. Based on the capital asset pricing model, the cost of common stock (required return) is 14.75 percent. This is quite close to the value derived using the dividend valuation model (Ke) in question 1 of 14.8 percent. K = Rf + ß (Km – Rf) 6% + 1.25 (13% – 6%) 6% + 1.25 (7%) = 6% + 8.757 = 14.75% Solution Manual Case for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160