Case-17-35 Galaxy Systems, Inc. – Foundations of Financial Management : Book Guide

This Document Contains Cases 17 to 35 Galaxy Systems, Inc. Case 17 Divisional Cost of Capital Purpose: The case combines risk analysis with discount rate considerations. To emphasize how many multidivisional corporations operate, the case actually gets into the topic of divisional hurdle rates. The student is able to see how different divisions in a corporation might have different required rates of return based on their risk exposure. In this particular case, a key risk measure for the consideration is beta. The student does not have to actually compute betas, only observe how they might be used. A simple definition of beta is also included in the case. Calculations related to net present value and internal rate of return are purposely simple to emphasize more conceptual items. Actually the IRRs can be found as exact values from Appendix D after only one calculation. There also is additional emphasis on how financial decisions are made in a corporate culture. Relation to Text: The case should follow Chapter 13. It also draws on material from many of the capital budgeting chapters. Complexity: The overall case is moderately complex and should require 1 hour. Solutions 1. Proposal A a) Investment (PV ) IRR Annuity ( ) $2,355,600 5.889 n 10 $400,000 IRR 11% A = A = = = = Appendix D b) NPV (10% discount rate for the auto airbags production division) Cost $2,355,600 Present value of inflows = A x PVIFA A = $400,000, n = 10, i = 10% Appendix D Present value of inflows = $400,000 x 6.145 = $2,458,000 Present value of inflows ................................................................................................................................... $2,458,000 Cost ................................................................................................................................... –2,355,600 This Document Contains Cases 17 to 35 Net present value ................................................................................................................................... $ 102,400 Proposal B a) $2,441,700 IRR 5.426 10 $450,000 IRR 13% = = n = = Appendix D b) NPV (15% discount rate for the aerospace division) Cost $2,441,700 A = $450,000, n = 10, i = 15% Present value of inflows = $450,000 x 5.019 = $2,258,550 Present value of inflows .......................................................................................................................... $2,258,550 Cost .......................................................................................................................... –2,441,700 Net present value .......................................................................................................................... ($ 183,150) Proposal C a) $145,680 IRR 9.712 15 $ 15,000 IRR 6% = = n = = Appendix D b) NPV (10% discount rate for the auto airbags production division) Cost $145,680 A = $15,000, n = 15, i = 10% Present value of inflows = $15,000 x 7.606 = $114,090 Present value of inflows ........................................................................................................................... $ 114,090 Cost ........................................................................................................................... –145,680 Net present value ........................................................................................................................... ($ 31,590) Proposal D a) $1,262,100 IRR 4.207 8 $300,000 IRR 17% = = n = = Appendix D b) NPV (15% discount rate for the aerospace division) Cost $1,262,100 A = $300,000, n = 8, i = 15% Present value of inflows = $300,000 x 4.487 = $1,346,100 Present value of inflows ........................................................................................................................... $1,346,100 Cost ........................................................................................................................... –1,262,100 Net present value ........................................................................................................................... $ 84,000 2. Proposal A should be accepted IRR > discount rate (11% > 10%) NPV is positive $102,400 Proposal B should be rejected IRR < discount rate (13% < 15%) NPV is negative ($183,150) Proposal C should be rejected IRR 15%) NPV is positive $84,000 3. While the decisions related to Proposals A and B appear to be straightforward, Proposals C and D require further discussion. Proposal C has a negative net present value and the internal rate of return of 6% is well below the required rate of return of 10%. Nevertheless, it calls for the development of special equipment to be used in the disposal of environmentally harmful waste material created in the manufacturing process. Given that the auto airbags production division is located in California, which has tough environmental laws, the project should probably be accepted. We are not told whether the installation is mandatory under the law, but there probably is adequate motivation to move forward with the project. Of course, if the installment of the equipment is required by law, then Galaxy must move forward regardless of the numbers. Proposal D has a positive net present value and the internal rate of return of 17 percent is well above the required rate of return of 15 percent for the division. However, the proposal appears to have even greater risk than projects normally undertaken in the aerospace division. While the high required rate of return for this division is supposed to cover the risk exposure of dealing in federal government contracts, Project D calls for the development of a microelectric control system for fighter jets that are still in the design stage. Even if the microelectric systems are successfully developed, there may not be a need for them if the other aerospace company cannot successfully develop fighter jets. Furthermore, the target market for the jets is in underdeveloped countries, which increases the uncertainty associated with this project. In the final analysis, top management might require an anticipated return of 20 percent or more to take on this highly speculative project. 4. The $300,000 that has already been spent on the initial research for Proposal B (radar surveillance equipment) is a sunk cost. The money has already been spent and should have no influence on subsequent decisions. Sometimes in the real world, egos get in the way of corporate decisions, and division heads (or other executives) push hard for the continuance of projects that they spent funds on to explore; but that is not justification to continue on. This is somewhat like buying stock in an underperforming company in the stock market. Sometimes, you just have to take your losses. Of course, even if we considered the $300,000 that had already been spent, it would raise the total cost of the project and make it even less economical. Further Overall Comments Companies that use divisional required rates of return often do have difficulties in finding betas for firms that produce products comparable to a division. That is, finding a “pure play” comparison is difficult. Therefore, using the average beta for an entire industry may be the next best alternative. For example, if a division produces machine tools, its beta may be inferred from the entire machine tool industry rather than from a given firm in the industry. This case also demonstrates the “politics” involved in the capital budgeting process by managers in their respective divisions desiring to attract capital to their budgets and maximize their individual performance. Aerocomp, Inc. Case 18 Methods of Investment Evaluation Purpose: The emphasis is on comparing the payback method, the internal rate of return, and the net present value approaches for a series of investments. As the student progresses through the calculations, the various advantages and disadvantages of the different approaches become evident. The reinvestment assumption of a high return project under the internal rate of return can be highlighted and evaluated. Capital rationing is also introduced into the case and plays a part in the analysis. Finally, the issue of reported earnings to stockholders versus sophisticated capital budgeting techniques is brought up and makes for interesting classroom discussion. Are stockholders and upper-level managers more concerned with next quarter’s earnings or long-term benefits? Relation to Text: The case should follow Chapter 12. The internal rate of return calculations can be tedious and may be simplified by the use of calculators, such as the Hewlett-Packard 12C Model, described in Appendix E of the text, or other appropriate calculator models. Complexity: The case is fairly straightforward. The computation of the internal rate of return can be time consuming if done by hand. Solutions 1. Total Reported Earnings increases for each projects: Project A Project B Project C Project D Year 1: $(13,250) $ 29,313 $(60,000) $ 192,206 Year 2: $ (450) $ 87,938 $(16,000) $ 129,846 Year 3: $ 25,494 $146,563 $ 61,640 $ (43,350) Year 4: $101,003 $234,500 $162,140 $ (62,475) Year 5: $ 63,315 $322,438 $262,640 $ (94,350) Total: $176,112 $820,752 $410,420 $ 121,877 We are told in the case that Kay Marsh is sensitive to Aerocomp’s level of earnings. Therefore, Project B, with over $820,000 in reported earnings increases (twice as much as any of the other projects), will be the one that attracts Kay’s attention. (She may initially be swayed by the $192,206 that Project D brings in during the first year, but the losses in years three through five will probably cause her to reject that alternative quickly.) Note that Projects A and C both produce earnings decreases for the first two years. We would suspect that if Emily thinks that either of these two should be selected (on the basis of some other ranking method, such as NPV), she had better have some convincing arguments prepared! 2. Payback Period, IRR, and NPV of each alternative: Project A Project B Project C Project D Payback Period: 4 years 5 Years 5 Years 2 Years IRR: 14.08% 7.18% 11.95% 12.48% NPV @ 10%: $39,920 ($63,927) $52,073 $20,457 (Students may get slightly different values due to rounding.) Note: A few students may question the fact that Project B’s cost has not been completely recovered in the five-year period shown, as the cost of the other projects has been. Therefore, they will claim, we are not using the proper time frame for our comparison of the projects. Of course, they are correct, and deserve extra points for their astute observation. In the case, Project B’s amortization, or depreciation, was limited on purpose to highlight the effect of depreciation on reported income and cash flows. 3. a. According to the Payback Method, Project D should be selected. The initial investment of $510,000 is recovered in the second year. b. The chief disadvantage of the Payback Method is obvious at once: the method ignores cash flows occurring after the payback period. In this case such an omission is disastrous, since Project D’s reported earnings and cash flows fall off significantly after the payback period and never recover. Another disadvantage of the Payback Method is that it does not consider the timing of cash flows during the payback period. c. In general, the Payback Method should not be used. However, it is used from time to time because it is easy to understand, and because it favors projects which pay off quickly. This can be an important factor in some fast-paced industries where a quick return is important. The Payback Method may have some justification as a backup method, but not as the primary analytical tool. 4. a. According to the IRR method, Project A should be chosen. It returns nearly two percent more than the closest competing project. b. Remember, that to achieve the IRR during a project’s life, the project’s cash inflows must be reinvested at the IRR rate. This may be difficult or impossible to accomplish when high IRR’s are involved. (Suppose you were Aerocomp’s financial manager, and you were getting the cash flows from Project A. What would you do with them: Pay dividends? Put them in a money market account at 7%—that was the going rate at that time? You might encounter a great deal of difficulty locating an investment that would pay you back the IRR rate of 14.08%.) As a matter of interest (no pun intended) if Project A’s cash flows were reinvested at 7% annually instead of the IRR rate of 14.08%, the project’s total return for the five-year period would drop to 11.84%. c. Another disadvantage of the IRR method is that it does not give any consideration to project size. For example, the IRR method would select a project which returned $10 on a $1 investment over any of the projects in this case, even though the dollar return to the firm was only $9. This is not a problem when all projects with IRRs over the cost of capital can be selected, but when the projects are mutually exclusive, or when capital rationing is in effect (as it is in this case), the IRR method may lead the firm to make an incorrect choice. (Note: It is important to avoid confusion on this point. The IRR and NPV methods will both accept and reject the same investments, but they will not give them the same ranking. In this case, projects A, C, and D are all acceptable per IRR and NPV. However, the IRR method would choose projects A, D, and C, in that order, while the NPV method would choose C, A, and D.) d. If the size of Aerocomp’s capital budget were not limited, the IRR method would accept projects A, C, and D. Project B, with an IRR of 7.18%, nearly three percentage points less than the cost of capital, would be rejected anyway. 5. a. According to the NPV method, Project C, with an NPV of over $52,000, will be chosen. It will add to the present value of the firm over $12,000 more than the next best project. Of course, under the IRR, Project A will be selected. Actually Project C is only a third place finisher under the IRR method. b. If the size of Aerocomp’s capital budget were not limited, the NPV method would accept projects A, C, and D. Project B, with an NPV of -$63,848, would be rejected anyway. Note that both the NPV and IRR methods rejected project B. This is because its return is less than the cost of capital. c. The likely selection is Project C because of its high net present value. This is partly attributable to the fact that only one project can be selected. Had there not been capital limitations, one might put more emphasis on the IRR or use a profitability index approach. Of course, some instructors might select Project A as being preferable using other criteria, and that is fine. There may be some interesting opportunities for a classroom debate or discussion on these points. Kay may be persuaded by explaining the benefits of taking a long-term vs. short-term perspective, explaining the concept of depreciation as a non-cash outflow expense, and overall use of capital budgeting techniques to maximize shareholder wealth. Phelps Toy Company Case 19 Capital Budgeting and Cash Flow Purpose: The case gives the student a good opportunity to do cash flow analysis. The use of variable discount rates based on project risk gives insight into how some corporations adjust for risk exposure. Also, the use of an appropriate time horizon for analysis is highlighted. Some students may take a special interest in the case because of the discussion of the profitable world of baseball card collecting. Relation to the Text: Though the case is closely related to Chapter 12, it should probably follow after Chapter 13 because of the risk dimensions in the discussion. Some instructors, however, may prefer to gloss over the latter and present the case after Chapter 12. Complexity: The case is relatively straightforward and should require approximately 1 hour. Solutions 1. First determine the expected value of the first year’s sales. Assumption Sales Probability Expected Value Pessimistic ..................................... $1,100,000 x .25 = $ 275,000 Normal ..................................... 2,000,000 .40 800,000 Optimistic ..................................... 3,750,000 .20 750,000 Highly optimistic ..................................... 4,500,000 .15 675,000 1.00 $2,500,000 Then project sales for the next 5 years. Year 2 .................................. $2,500,000 x 1.20 = $3,000,000 Year 3 .................................. 3,000,000 x 1.20 = 3,600,000 Year 4 .................................. 3,600,000 x 1.20 = 4,320,000 Year 5 .................................. 4,320,000 x 1.10 = 4,752,000 Year 6 .................................. 4,752,000 x 1.10 = 5,227,200 Then determine operating expenses and EBDT for the 6 years. Year Sales Operating expenses (.70) EBDT Year 1 ............................... 2,500,000 – 1,750,000 = 750,000 Year 2 ............................... 3,000,000 2,100,000 900,000 Year 3 ............................... 3,600,000 2,520,000 1,080,000 Year 4 ............................... 4,320,000 3,024,000 1,296,000 Year 5 ............................... 4,752,000 3,326,400 1,425,600 Year 6 ............................... 5,227,200 3,659,040 1,568,160 Next determine the annual depreciation over the 6 years. Year Depreciation Base Percentage Depreciation Annual Depreciation 1 ................................... $2,800,000 x .200 = $560,000 2 ................................... 2,800,000 .320 896,000 3 ................................... 2,800,000 .192 537,600 4 ................................... 2,800,000 .115 322,000 5 ................................... 2,800,000 .115 322,000 6 ................................... 2,800,000 .058 162,400 Then combine the data into a table similar to Table 12-11. Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 EBDT $750,000 $900,000 $1,080,000 $1,296,000 $1,425,600 $1,568,160 – Depreciation 560,000 896,000 537,600 322,000 322,000 162,400 EBT 190,000 4,000 542,400 974,000 1,103,600 1,405,760 – T (34%) 64,600 1,360 184,416 331,160 375,224 477,958 EAT 125,400 2,640 357,984 642,840 728,376 927,802 + Depreciation 560,000 896,000 537,600 322,000 322,000 162,400 Cash flow $685,400 $898,640 $ 895,584 $ 964,840 $1,050,376 $1,090,202 2. The discount rate will be based on the coefficient of variation of the first year’s sales. The standard deviation was given as $1,226,000 and the expected value is $2,500,000. The coefficient of variation is: .4904 2,500,000 $1,226,000 = V D  = Examining Figure 3 for a coefficient of variation of .4904, the discount rate should be 14 percent. 3. We next determine net present value. Year Cash flow (inflows) Present Value Factor (14%) Present Value 1 .............................. $ 685,400 .877 $ 601,096 2 .............................. 898,640 .769 691,054 3 .............................. 895,584 .675 604,519 4 .............................. 964,840 .592 571,185 5 .............................. 1,050,376 .519 545,145 6 .............................. 1,090,202 .456 497,132 Present value of inflows ...................................................................................... $3,510,131 Present value of inflows ...................................................................................... 3,510,131 Present value of outflows (cost) ...................................................................................... –2,800,000 Net present value ...................................................................................... $ 710,131 Based on the positive net present value of $710,131, the project appears to be feasible. The firm would be justified in going ahead with the investment. 4. A six year time horizon may be too short a time frame to fully assess the project. It assumes there will be no cash flow from the seventh year on. While many firms utilize a time frame of 5-10 years for conservative purposes, this may sometimes result in the rejection of a potentially profitable project that requires a longer time period for analysis. In this particular case, this was not a problem for the Phelps Toy Company as the project had a positive net present value over six years. Nevertheless, it could lead to an inappropriate decision for a long-life project in the future. Global Resources Case 20 Risk-Adjusted Discount Rates Purpose: The case covers the process of adjusting the discount rate to account for the risk in a project. It clearly demonstrates that the risk-adjusted discount rate approach can affect (and change) the ranking of investments. It further brings an international dimension into the decision making process and encourages the student to address the issue of whether international investments increase risk because of uncertainty or decrease risk because of diversification. The concept of mutually exclusive investments is also incorporated in the case. Relation to Text: The case should follow Chapter 13. Complexity: The case is moderately complex and should require one hour. Solutions 1. Investment A ($200,000 investment) PV Factor Year Inflows 10% PV of Inflows 1 $ 40,000 x .909 = $ 36,360 2 60,000 .826 49,560 3 90,000 .751 67,590 4 120,000 .683 81,960 5 140,000 .621 86,940 Present value of inflows $322,410 Investment –200,000 Net present value $122,410 Investment B ($200,000 investment) PV Factor Year Inflows 10% PV of Inflows 1 $ 50,000 x .909 = $ 45,450 2 20,000 .826 16,520 3 100,000 .751 75,100 4 130,000 .683 88,790 5 195,000 .621 121,095 Present value of inflows $346,955 Investment –200,000 Net present value $146,955 Project B is superior. ($146,955 vs. $122,410). 2. Investment A ($200,000 investment) PV Factor Year Inflows 13% PV of Inflows 1 $ 40,000 x .885 = $ 35,400 2 60,000 .783 46,980 3 90,000 .693 62,370 4 120,000 .613 73,560 5 140,000 .543 76,020 Present value of inflows $294,330 Investment –200,000 Net present value $ 94,330 3. Investment B ($200,000 investment) PV Factor Year Inflows 17% PV of Inflows 1 $ 50,000 x .855 = $ 42,750 2 20,000 .731 14,620 3 100,000 .624 62,400 4 130,000 .534 69,420 5 195,000 .456 88,920 Present value of inflows $278,110 Investment –200,000 Net present value $ 78,110 4. Investment A ($94,330 vs. $78,100) 5. Under a mutually exclusive assumption, only one project can be accepted, so select Investment A. 6. With non-mutually exclusive investments and no capital rationing, any projects with positive net present values should be accepted, so select both Investment A and Investment B. 7. Tai Ming introduces a classic debate in international financial management. Although international investments are generally riskier than domestic investments, they do provide important international diversification because different global economies are not perfectly correlated (though they have become more correlated in recent times through international trade, the rapid transmission of information, and so on). The authors are of the opinion that the impact of international diversification is more important than the riskiness of individual investments. Taken to its logical conclusion, foreign investments may justify a lower discount rate rather than a higher one. This, of course, is a surprise to many people and a debatable point. Inca, Inc. Case 21 Capital Budgeting with Risk Purpose: The student goes through the statistical procedure of determining risk for investments. Though one investment alternative provides the higher net present value, is also has a much higher coefficient of variation and the student must take this into consideration in describing his or her results. The case is then expanded into six alternatives for which the student is asked to select the lowest risk option. Relation to Text: This case should follow Chapter 13. Complexity: This case is straightforward and should require 30-45 minutes to solve. Solutions 1. Expected value of the net present value (standard) Outcome Probability Expected Value $1,050 x .40 = 420 630 .40 252 (200) .20 (40) 632 Expected value = $632,000 2. Expected value of the net present value (expanded) Outcome Probability Expected Value $2,812 x .40 = 1,124.8 740 .40 296 (900) .20 (180) 1,240.8 Expected value = $1,240,800 3. The expanded size restaurant alternative clearly has the higher net present value. ($1,240,800 vs. $632,000). 4. Standard deviation ( )2 Outcome Expected value Probability D D P D D P =  − = = = D – D = (D −D) (D −D)2 x P = (D −D)2 P 1,050 632 418 174,724 .40 69,889.6 630 632 –2 4 .40 1.6 –200 632 –832 692,224 .20 138,444.8 208,336.0 208,336.0 =456.4  = $456,400 vs. $1,415,800 expanded Standard deviation 5. Coefficient of variation ( ) V = Expected value Standard size restaurant Expanded restaurant Standard deviation Expected value .722 632,000 $456,400 = 1.141 $1,240,800 $1,415,800 = 6. Based on the coefficient of variation, the standard size restaurant is much less risky (.722 versus 1.141). Earlier in question two, the preference was clearly for expanded size restaurants. The general principle is that you may not wish to always go with the highest return. Risk must be considered as well. 7. Coefficient of variation 4 standard, 1 expanded $ 641,630 / 753,760 = .851 3 standard, 2 expanded 832,460 / 875,420 = .951 2 standard, 3 expanded 1,025,800 / 997,280 = 1.028 1 standard, 4 expanded 1,220,400 / 1,119,040 = 1.091 Based on the answer to question five as well as this question, the lowest-risk alternative is still the five standard restaurants with a coefficient of variation of .722. Robert Boyle & Associates, Inc. Case 22 Going Public and Investment Banking Purpose: The pros and cons of going public are considered in this case. Although the firm is a fictitious company, it is compared to a number of actual companies in the Real Estate Investment Trust (REIT) industry in order to establish the initial evaluation. The problem of capital shortage for the small private firm is the catalyst for considering the new offering. The potential dilution of new stock issues on earnings per share is carefully considered. In order to bring added interest to the case, there is a slightly nagging spouse who serves as a devil’s advocate. Relation to Text: This case should follow Chapter 15. Complexity: The case is moderately complex and should require 1 hour. Solutions 1. Computation of Robert Boyle & Associates P / E ratio: Industry P/E 14.0 Return on equity: Boyle Industry 35.5% 12.8% +.5 Return on assets: Boyle Industry 19.5% 8.7% +.5 Debt to assets: Boyle Industry .45 .31 –.5 Asset turnover: Boyle Industry .30 .22 +.5 Net profit margin: Boyle Industry 64.1% 37.5% +.5 5-yr EPS growth: Boyle Industry 9.7% 5.3% +.5 Net additions and subtractions: +2.0 Minus 1 to ensure a good sale: –1.0 Final P/E Ratio for Robert Boyle & Associates: 15.0 vs. 14.0 Industry P/E 2. Total size of the stock issue necessary to yield $10 million in net proceeds: The size of the issue – the size times the spread percentage – out-of-pocket expenses = net proceeds X = the size of the issue X – .065(X) – $60,000 = $10,000,000 .935(X) = $10,060,000 X = $10,759,358.29, round to $10,800,000 3. Required rate of return on net proceeds: Let X = the amount of income necessary to be earned: (Old net income + X) / Total number of shares outstanding = old EPS ($4,100,000 + X) / 4,699,029* = $1.03 $4,100,000 + X = $1.03 x 4,699.029 $4,100,000 + X = $4,840,000 X = $740,000 *4,00,000 old shares + 699,029 new shares = 4,699,029 Next compute the percent dollar return on the net proceeds. $740,000 / $10,000,000 = 7.4% Note that Robert Boyle & Associates earned a 19.5% return on assets in 2005, so we would expect that the company should have no problems producing a 7.4% return on the new assets to be obtained. 4. The total number of shares to be issued will be the two million from the existing stockholders plus the 699,029 originally planned. The decision by some of the existing stockholders to sell some of their shares makes no difference in this case—the company still needs to issue enough new shares to net $10,000,000. The two million shares from the existing stockholders are simply transferred from one set of people to another; the total number outstanding is not affected. 5. Summary of the advantages of going public: — Provides access to capital, which, in this case, appears difficult to obtain in any other way. — Provides a method by which the existing stockholders may liquidate their holdings to raise cash or to buy other securities (in order to diversify their portfolios). — Establishes a market value for the firm. — Potentially increase profit margin and EPS via new investment and growth. Summary of the disadvantages: — Relatively high cost (over $759,358 in this case to raise $10 million). — Additional paperwork and reporting requirements. — Necessity to deal with the public (Mr. Boyle will spend more of his time in public relations). — Pressure for short-term results. — Possible loss of control of the firm if enough shares are issued, or if a hostile suitor attempts a takeover. — Potential dilution of earnings if return goals not achieved or mall not approved = risk. Conclusion: Robert Boyle & Associates is doing perfectly well as it is, and could conceivably continue doing so without getting involved in the new shopping center on Nantucket Island. However, the need to provide a market for the firm’s shares and the need to provide a way for the existing stockholders to diversify their portfolios are strong arguments for going public (the shopping center development business is, after all, not without risk). Further, if the investors have any desire for growth, it appears they must go public to obtain the needed capital. From the limited information we have, the Nantucket Center project appears to be attractive. Therefore, it is probable that Robert Boyle and Associates will not be able to take the conservative approach—save up for years until they have enough to build it—because another firm will step in and build it themselves. All in all, it appears that the time for Robert Boyle & Associates to go public may have arrived. Glazer Drug Company Case 23 Initial Public Offering Purpose: The case deals with computing the cost of going public, the dilutive effects of an IPO, and the return that must be earned on the net proceeds in order to avoid dilution. The case involves the generic drug industry, which has an ever-increasing visibility. Of particular interest is the fact that the stock skyrocketed in value after the IPO and the effect this has on a major selling stockholder who was one of the founders of the company. It is up to the students to identify his potential displeasure with the managing investment banker. Relation to Text: This case should follow Chapter 15. Complexity: The case is moderately complex and should require 1 hour. Solutions 1. Spread = $37.50 – $36.68 = $ .82 % underwriting spread = $ .82 / $37.50 = 2.19% 2. Earnings per share before stock issue $150 million / 100 million shares = $1.50 Earnings per share after stock issue $150 million / 110* million shares = 1.364 Dilution $ .136 * Note: Out of 20 million shares sold in the IPO, only 10 million are newly issued shares. The rest are Mr. Glazer’s currently existing shares. 3. $ 36.68 Net price to the corporation x 10 million New shares $366,800,000 Proceeds before out-of-pocket loses – $ 2,000,000 Out-of-pocket costs $364,800,000 Net proceeds 4. To maintain EPS of $1.50, total earnings must be $165 million after the issue. The calculations follow: x = $1.50 110 million shares x = $1.50 x 110 million shares x = $165,000,000 This indicates an increase in earnings of $15 million. ($165 million new required earnings – $150 million old earnings) The ratio of the increased earnings to the net proceeds is 4.11%. Net proceeds Increased earnings = $364,800,000 $15,000,000 = 4.11% 5. EPS (original) Stock price = $1.50 $61.75 = 41.17 P/E ratio 6. Mr. Glazer is likely to be quite unhappy! It appears the investment banker priced the stock at way too low a value in the initial public offering. Mr. Glazer sold 85 percent of his shares at $37.50 (net $36.68), and a few months later the market was valuing the company at $61.75. This indicates he left $25.07 a share on the table. Based on the 10 million shares he sold, this represents $250,070,000 in foregone value. Since there is no indication of an unusual event causing the stock price to rise, it appears the investment banker mispriced the issue. Leland Industries Case 24 Debt Financing Purpose: The case gives the student a chance to understand the many factors influencing bonds. Initially the student concentrates on the variables affecting a bond rating and actually makes a basic bond rating decision. The relationship of bond ratings to yield to maturity also is stressed through various computations. The case also covers such innovative debt products as floating rate and zero-coupon rate bonds. Finally the use of hedging to cover interest rate exposure is explored. Relation to Text: The case draws on material from Chapters 8, 10, 11 and primarily Chapter 16. It integrates cost of capital, hedging and long-term issues. The case should follow Chapter 16. Complexity: The case is moderately complex. It should require 1-1½ hours. Solutions 1. A potential bond issue by Leland would definitely not qualify for the AA1 rating that International Bakeries enjoys and would be well above the B3 rating of Savanah Products. The bond would undoubtedly fall somewhere between AA3 and A2. A comparative analysis with the three most similar firms is presented below. Dyer Pasteries Gates Bakeries Nolan Bread Leland Industries Rating AA3 A1 A2 ? Debt to Total Assets 35% 42% 47% 44% Times interest earned 6.0X 5.5X 4.9X 5.7X Fixed charge coverage 3.6X 4.2X 3.8X 3.7X Current ratio 2.8X 2.3X 2.1X 2.0X Return on equity 19% 17.1% 15% 16.8% Leland generally falls below Dyer Pasteries on all measures except fixed charge coverage, so it is unlikely to qualify for an AA3 rating. The firm appears to fall between the A1 and A2 categories. Its debt ratio, times earned and return on equity ratios indicate it falls closer to the A1 category than the A2. However, its fixed charge coverage and current ratio are more in line with an A2 rating. On balance, A1 is probably the most appropriate answer. 2. The approximate yield to maturity (Y’) formula is: 9.39% $1,060 $99.50 $1,060 $103.50 $4 $660 $400 25 $100 $103.50 .6($1,100) .4($1,000)) 25 $1,000 $1,100 10350 0.6 (Price of the bond) 0.4 (Principal payment) Number of years to maturity Principal payment Price of the bond Annual interest payment = − = = + − + = + − + = + − + $ . International Bakeries 10.35% $952 $98.50 $952 $94.50 $4 $552 $400 20 $80 $94.50 .6($920) .4($1,000) 20 $1,000 920 94 50 = + = = + + = + − + = $ . Gates Bakeries $1,000 $1,150 $157.50 15 .6($1,150) .4($1,000) $150 $157.50 15 $690 $400 $157.50 $10 $147.50 13.53% $1,090 $1,090 Savanah Products − + = +  −  +  =   + − = = = 3. Kd (cost of debt) = Y (Yield) (1 – T) International Bakeries 9.39% (1 – .35) = 9.39% (.65) = 6.10% Gates Bakeries 10.35% (1 – .35) = 10.35% (.65) = 6.73% Savanah Products 13.53% (1 – .35) = 13.53% (.65) = 8.79% 4. Debt Outstanding Year 1 $20,000,000 X .95 = $19,000,000 Year 2 $19,000,000 X .95 = $18,050,000 Year 3 $18,050,000 X .95 = $17,147,500 Interest Payment on Debt Debt outstanding $17,147,500 Interest expense (10%) 1,714,750 Aftertax cost (1 – .35) .65 Aftertax interest expense $ 1,114,588 This repayment method reduces interest expense over the life of the bond. 5. Interest savings on $20 million debt outstanding Size of issue ........................................................................................ $20 million Interest savings (1 1/4%) ........................................................................................ x 1.25 Interest savings ($) ........................................................................................ $250,000 Taxes (.35) ........................................................................................ –87,500 Aftertax benefit ........................................................................................ $162,500 Since the aftertax cost of hedging is $120,000, there is a net aftertax benefit of $42,500 per year Aftertax interest savings ........................................................................................ $162,500 Aftertax cost of hedging ........................................................................................ –120,000 Net aftertax benefit ........................................................................................ $ 42,500 6. a) Present value of $1,000 zero-coupon rate bond. PV = FV X PVIF (Appendix B) FV = $1,000, n = 20, i = 11% PV = $1,000 x .124 = $124 The bond price would be $124 b) The number of bonds to be issued is: 161,290 bonds $124 $20,000,000 = vs. $1,000 par $20,000,000 = 20,000 bonds c) The danger is that the corporation is not paying any interest on an annual basis, and for this reason, the repayment obligation expands beyond the initial capital received. Thus, the firm must be sure that it is accumulating adequate funds to meet its future obligations (or will be able to issue new securities to refund the debt when it comes due). Warner Motor Oil Company Case 25 Bond Refunding Purpose: The case gives the student a clear insight into the refunding process. The importance of the call privilege is emphasized. Clearly, a refunding would not be feasible if the old issue had to be reacquired at market value. The case also provides an example of when a positive net present value may not be sufficient justification for taking action if the NPV is likely to be even larger in the future. There is also an optional question which allows the student to compare accounting implications with cash flow and net present value considerations. Normally, a refunding decision hurts accounting profits in the first year, and increases them in all subsequent years. Relation to Text: The case draws primarily on material from Chapter 16. However, the student should be familiar with computing bond prices as presented in Chapter 10. Complexity: The case is moderately complex. It should require 1 – 1½ hours. Solutions 1. Price of Previously Issued Bonds Present value of interest payments PVA = A x PVIFA (n = 30, i = 5%) Appendix D (A = 11.5%/2 x $1,000 = 5.75% x $1,000 = $57.50) PVA = $57.50 x 15.372 = $883.89 Present value of principal payment at maturity PV = FV x PVIF (n = 30, i = 5%) Appendix B PV = $1,000 x .231 = $231 Total present value Present value of interest payments .................................................................................................................................... $ 883.89 Present value of payment at maturity .................................................................................................................................... + 231.00 Total present value of price of the bond .................................................................................................................................... $1,114.89 2. Market price................................................................................................................... $1,114.89 Par + 8% call premium ................................................................................................... –1,080.00 Savings per $1,000 bond ................................................................................................ $ 34.89 Added comment—On 30,000 bonds, this represents total savings of $1,046,700. 3. Refunding Analysis Outflows 1. Payment of call premium $30,000,000 x 8% x $2,400,000 $2,400,000 x (1 – .3) = $1,680,000 net cost of call premium 2. Underwriting cost on new issue $30,000,000 x 2.8% = $840,000 Amortization of cost ($840,000/15) (.3) = $56,000 (.3) = $16,800 tax savings per year Actual expenditure .......................................................................................................................... $840,000 PV of future tax savings $16,800 x 9.108* .......................................................................................................................... –153,014 Net cost of underwriting expense on new issue .......................................................................................................................... $686,986 *PVIFA for n = 15, i = 7% (Appendix D) Inflows 3. Cost savings in lower interest rates 11.5% (interest on old bond) x $30,000,000 = $3,450,000/year 10.0% (interest on new bond) x $30,000,000 = –3,000,000/year Savings per year = $ 450,000 Savings per year $450,000 x (1 – .3) = $ 315,000 aftertax $ 315,000 x 9.108 PVIFA (n = 15, i = 7%) Appendix D $2,869,020 PV of A/T cost savings in interest rates 4. Underwriting cost on old issue Original amount ..................................................................................................................................... $400,000 Amount written off over 5 years at $20,000 per year ..................................................................................................................................... –100,000 Unamortized old underwriting cost ..................................................................................................................................... $300,000 Present value of deferred future write-off $20,000 x 9.108 (n = 15, i = 7%) ..................................................................................................................................... –182,160 Immediate gain in old underwriting cost write-off ..................................................................................................................................... $117,840 Tax rate ..................................................................................................................................... x .30 Aftertax value of immediate gain in old underwriting cost write-off ..................................................................................................................................... $ 35,352 Summary Outflows Inflows 1. $1,680,000 3. $2,869,020 2. + 686,986 4. + 35,352 $2,366,986 $2,904,372 PV of inflows .................. $2,904,372 PV of outflows ................ 2,366,986 Net of present value ......... $ 537,386 The potential refunding has a positive net present value. 4. Gina and Al must consider whether interest rates will go even lower. If this is likely to be the case, they should wait to refund the old issue. It would be unwise to refund an issue, and then attempt to refund it again shortly thereafter if rates go down even further because of the large costs involved. Furthermore, if there is a deferred call provision on the new bonds issued after refunding, it may not be feasible to refund the new issue in any event. 5. With rates at 10.4 percent instead of 10 percent, the interest savings will be less. We need to recompute the interest savings from step 3. Cost savings in lower interest rates: 11.5% (interest on old bond) x $30,000,000 = $3,450,000/year 10.4% (interest on new bond) x $30,000,000 = –3,120,000/year Savings per year = $ 330,000 Savings per year = $ 231,000 aftertax $ 231,000 x 9.108 PVIFA (n = 15, i = 7%) Appendix D $2,103,948 PV of A/T savings in interest rates We now plug this figure into our summary of outflows and inflows. All prior values are the same. Summary Outflows Inflows 1. $1,680,000 3. $2,103,948 2. 686,986 4. 35,352 $2,366,986 $2,139,300 PV of inflows.................. $2,139,300 PV of outflows ................ –2,366,986 Net of present value ........ $ (227,686) The potential refunding has a negative net present value and should not be undertaken. Midsouth Exploration Company Case 26 Preferred Stock Purpose: The case allows the student to examine many of the attributes of preferred stock. Particularly important is the cumulative feature when the company is in arrears, as well as a potential solution to that problem. The tax consequences of preferred stock to the corporate recipient is also considered. The case also provides a good opportunity to examine the comparative theoretical costs to the issuing corporation of preferred stock and common stock. Relation to Text: The case draws on material from Chapters 11, 15, and 17. Because some material is related to dividends, the instructor may wait until after Chapter 18 to introduce the case (although such a delay is not really necessary). Complexity: The case is moderately complex and should require 1 hour. Solutions 1. No, payment of dividends on preferred stock is not a contractual obligation (as is the payment of interest on bonds). The only obligation is that the preferred stock dividends must be paid before common stock dividends. 2. The annual dividend is $8.50 per share and the firm is 2 ½ years behind on the payment. The answer is $21.25 ($8.50 + $8.50 + $4.25) Arrearage per share $21.25 Shares outstanding x 200,000 Total arrearage $4,250,000 3. Arrearage per share $21.25 Premium x 150% Price per new share $31.875 Share price $31.875 Percent dividend 9.2% Cash dividend $2.9325 4. Aftertax preferred yield = Before-tax preferred stock yield [1 – (Tax rate)(.30)] = 9.2% x [1 – (.15)(.30)] = 9.2% x (1 – .045) = 9.2% x .955 = 8.79% 5. Cost of preferred stock $2.9325 9.2% (this value was previously stipulated) $31.875 0 p p p D K = P −F = − = Cost of new common stock 1 0 $.50 9.75% $25 $1.20 $.50 9.75% 2.10 9.75% 11.85% $23.80 n D K g = P −F + = − = + = + = There are no tax benefits to the issuing corporation for either security (as would be true of the payment of interest on debt). 6. Number of new shares of common stock: Net price to the corporation Funds needed out - of - pocket costs Number of new shares of common stock = + 1,271,008 new shares $23.80 $30,250,000 $25 $1.20 $30,000,000 $250,000 = = − + = Alpha Biogenetics Case 27 Poison Pill Purpose: The case gives the student exposure to the poison pill and the entire issue of antitakeover amendments. Through running the numbers in the case, the student is able to view how poison pills can protect the current position of management. There is also dialogue in the case in which the virtues and drawbacks of poison pills are discussed. The student begins to get a feel for the issues of management entrenchment versus stockholder rights. Because there is also a venture capital investment and an IPO, the student is exposed to other areas of corporate finance as well. Relation to Text: The case draws on material from Chapter 15 and Chapter 17. To a certain extent it goes beyond material in the text, but any new material is carefully explained within the context of the case. Complexity: The case is moderately complex. It should require 1 – 1½ hours. Solutions 1. Values for 2005 30x $.32 $9.60 EPS Stock price P/E $.32 5,000,000 $1,600,000 Shares Earnings Earnings per share = = = = = = 2. Public price $ 9.60 – Underwriting spread (5%) – .48 Net price $ 9.12 x Shares (new shares sold) x 2,000,000 Total proceeds $18,240,000 – Out-of-pocket expense – 120,000 Net proceeds $18,120,000 3. Profit on sale of shares Sales price $ 9.60* x Shares x 1,200,000 Total proceeds 11,520,000 – Purchase price – 4,000,000 Profit $ 7,520,000 *This assumes no underwriting spread on the secondary offerings of the venture capitalist shares. If the spread is included, the net sales price is $9.12 and the profit is $6,944,000. We are assuming the underwriter waives the spread. 188% $4,000,000 $7,520,000 Investment Profit Rate of return = = Given the risk that a venture capitalist takes in early stage financing, it is probably a reasonable return. Also, keep in mind that the venture capitalist had its funds tied up for a number of years to achieve the 188% total return. 4. Values for 2008 35x $.96 $33.60 EPS Stock price P/E $.96 5,000,000 $4,800,000 Shares Earnings Earnings per share = = = = = = 5. Shares outstanding 5,000,000 x Percent ownership 25% Number of Shares 1,250,000 x Price per share x $33.60 Total cost $42,000,000 6. The inside control group owns 1.8 million shares. An unfriendly, outside party could acquire the remaining 3.2 million shares out of the 5 million shares outstanding. In order to maintain their majority position, the inside control group would need to buy 1,400,001 shares. This would give them a total of 3,200,001 shares. Old shares 1,800,000 New shares + 1,400,001 3,200,001 This represents one more share than the unfriendly, outside party owns. The total dollar cost would be: Stock price $33.60 x Percent of price at which shares may be purchased 70% Net stock price $23.52 x Number of shares 1,400,001 Total cost $32,928,023 7. In many cases, it appears that poison pills are intended to provide management with job security rather than maximize stockholder wealth. In fact, research indicates that poison pill announcements are often met with a slightly negative response in the stock market. Of course, the counter argument is that poison pills allow management to take a long-term perspective without fear of being ousted and also puts the firm in a strong bargaining position in the event of a potential tender offer. Although there is no one correct answer to this question and either side of the issue can be justified, most large institutional investors do not like poison pill provisions. Montgomery Corporation Case 28 Dividend Policy Purpose: The key issue is whether the firm’s cash dividend should be considered an active or residual variable in setting the actual payment. There is enough bickering between directors and officers of the firm to give the student plenty of insight into this issue. Though Montgomery Corporation is a fictitious firm in the retail industry, the student is given enough information to compare its dividend policy to Dillard’s, J.C. Penney, Wal-Mart, and others. The student is also asked to use the dividend valuation model, to consider capital structure issues, and also evaluate the suitability of a stock dividend versus a cash dividend. Relation to Text: The case should follow Chapter 18. It is also assumed that the student is familiar with capital structure considerations (Chapter 11) and common stock (Chapter 17). Complexity: The case is moderately complex. It should require 1 hour. Solutions 1. a. From Figure 1, we note that dividends per share for the years 1999-2005 were: 1999 2000 2001 2002 2003 2004 2005 $1.36 $1.36 $1.48 $1.70 $1.76 $1.76 $1.96 The firm is following a constant dividend policy with increases as the company grows. Note that the total amount committed to common dividends has increased each year, but it’s the dividend per share figure that counts. Given the increasing number of shares outstanding each year, the directors have been sure that DPS has remained constant or increased slightly on an annual basis. b. In Figure 2, we see that all of Montgomery’s competitors are either following the same policy that Montgomery is, or they are striving to increase the dividend every year. Dollar General held to a $.20 dividend in 2004 even though EPS decreased over 75%! In 2003 Dollar General actually increased the dividend by over 17% in spite of a 14% decrease in EPS. Clearly, dividend stability and growth is perceived as important in the retailing industry. Even Wal-Mart, a growing company which might be expected to emphasize capital growth over dividends, follows the general trend. (It is interesting to note that Montgomery generally has the highest average payout ratio in the industry. That’s to be expected of an old firm that has been paying and increasing dividends for many years.) 2. a. Given that D1 = $2.10, g = 7.1%, and P0 = $35, Ke, the expected return to the common stockholder is: 13.1% 6% 7.1% 7.1% $35 $2.10 = = + Ke = + b. If Don’s proposal is adopted, and next year’s dividend is zero, but g rises to 14%, the expected return to the stockholders is: 14% 0 14% 14% $35 0 = = + Ke = + It appears that if Montgomery adopted Don’s suggestion, the stockholders would realize a 0.9% increase in their expected return. By this calculation alone, then, we might conclude that Don’s idea is a good one; the firm should adopt a residual dividend policy. However, note that the stockholders would only realize Don’s 14% gain if they sell their shares, while the firm’s current dividend policy gives the stockholders 13.1%. Given that situation, and the fact that the 1986 Tax Reform Act and subsequent legislation eliminated almost all the advantages of a capital gain at the time of this case, one might well argue that the stockholders are better off under the current policy. Further, note that the stockholders only appear to be better off under the new policy if g does, in fact, rise to 14%, which is speculative at best. If g turns out to be less than 13.1%, for example, the old policy will appear to be superior. It is reasonable to assume that if the dividend is retained and invested, g will increase, and intuitively we believe it should increase sufficiently to produce a total return greater than before, but there is no hard evidence that it will do so. 3. Don’s argument rests on the principle that the capital budget, as well as the dividend, must be paid for solely out of net income for the current year, and, of course, this is not so. It is the amount of cash available that is the limiting factor. Referring to Figure 1, we see that Montgomery’s cash balance for 2005 is $3,235 million, so that is the maximum size that the capital budget plus dividend payment can be without selling off assets or seeking outside financing. (This is an important point.) We often speak of financing the capital budget, or indeed, paying dividends, out of retained earnings. We tend to speak of retained earnings as if they were cash. They are not, of course; only claims on assets, of which cash is but one. If retained earnings were to be entirely used up in financing the capital budget, then some of the firm’s assets would have to be sold in the process. 4. a. The cost of internal equity financing is, of course, 13.1%, which was computed in question 2a, above. The cost of external equity financing would be slightly higher due to flotation costs. b. Given that the firm can sell bonds priced to yield 13%, the aftertax cost of debt is 13% x (1 – .25) = 9.75%. c. This might throw the debt-equity mix out of proportion. Excessive use of debt might not only increase the cost of debt financing, but all other sources of financing as well. 5. Mr. Autry’s comments strike at the heart of the residual dividend policy. That policy presumes that the stockholders have no preferences about the form of repayment they receive from their investment—only that the highest possible return be achieved. If, on the other hand, the stockholders do have a preference, then the residual policy may not be the best. There is no hard and fast rule on establishing whether or not the stockholders have a preference, or how strong it might be. Strong cases can be argued for either point of view and the subject remains controversial. It does appear from a study of Figure 2 that the managers of firms in the retailing business do believe that their stockholders have a preference, and that preference is for current income in the form of dividends. 6. The firm could pay a stock dividend in place of the cash dividend, and some stockholders might be satisfied with that. However, the majority would probably recognize that they had not received anything at all. A stock dividend is merely a paper entry creating more shares. It would only be perceived as beneficial if total stockholders’ cash dividends increased as a result. (This, of course, would defeat the proposed purpose of the stock dividend—to conserve funds.) 7. As we mentioned in question 5, there is no universal agreement on this question. Some would argue that dividends do not matter and some would argue that they do. Most would agree, however, that if the firm does pay taxes, and if there are flotation costs associated with outside equity financing, and if there are costs associated with bankruptcy, then capital structure does matter, and dividend policy matters. Intuitively, and in the face of the obvious custom in the retailing industry, we would view a decision by a mature firm such as Montgomery to go to a residual dividend policy with some misgivings. Such a policy is perhaps best left to a younger firm. Orbit Chemical Company Case 29 Dividend Policy Purpose: This case has a completely different emphasis from the prior dividend case, Montgomery Corporation. The Orbit Chemical Company case stresses the critical emphasis of the statement of cash flows in determining whether a company has the ability to make dividend payments. The emphasis is away from the relation of earnings to dividends, and toward the importance of cash flow. It truly forces the student to do insightful financial analysis, as the answer to question one is not obvious. Some instructors may want to give clues to help the students. There is also an interesting side issue related to the repurchase of shares in the open market, and the associated impact on earnings per share and stock price. Executive stock options are also included in the analysis. Relation to Text: This case should follow Chapter 18. Complexity: The case is moderately complex. It should require 45 minutes. Solutions 1. If the student properly analyzes the financial statements, he or she will see there is no need to reduce the cash dividend. The dividend payout ratio is relatively high at 61.3% ($.65 dividends per share/$1.06 earnings per share). However, this presents no real cause for concern. Furthermore, the firm only has $35 million in cash and marketable securities at year-end 2012, but that also should not be a problem. The real key to the analysis can be found in Figure 3, the statement of cash flows. Here, we see the firm had $181 million in net cash flows from operating activities. More specifically, net income plus depreciation was equal to $166 million. This was available to cover cash dividends of $65 million and increases in plant and equipment of $50 million. Net income plus depreciation ..................................................................................................................................... $166 million – Cash dividends ..................................................................................................................................... 65 million – Increase in plant and equipment ..................................................................................................................................... 50 million Excess funds ..................................................................................................................................... $ 51 million The firm could not only cover the dividends, but use the excess funds (a term roughly the equivalent to free cash flow) to almost double the dividend. The problem was that Robert Osborne had used these funds and part of a high beginning cash balance to reduce $120 million of long-term debt that was not due until 2025 (see financing activities under statement of cash flows). This action was probably ill advised and hopefully a one time occurrence. The firm’s total debt to total assets ratio was down to 42.5 percent ($370 million/$870 million) by year-end 2012. Even if the $120 million portion of debt due in 2025 had not been paid off, and $120 million was added to the numerator and denominator of the above ratio, the total debt to total assets ratio would have still been a relatively healthy 49.5% ($490 million/$990 million) at year-end 2012. With $500 million in equity, total debt would have still been less than equity and long-term debt considerably less. The firm clearly generates enough cash flow to meet its dividend obligations. This should have been a higher priority for the firm than partially retiring debt that is not due for 13 years. The true capability of a firm to pay its dividends can normally be found in the operating activities section of the statement of cash flows and not in the income statement or balance sheet. 2. To determine the number of shares that can be repurchased with $30 million, you first must determine the market price of the stock. Earnings per share .............................................................................. $1.06 Price-earnings ratio .............................................................................. x 7 Stock price .............................................................................. $7.42 By dividing $30 million by $7.42, we see that 4,043,127 shares can be repurchased. 3. The earnings are $106,000,000 The shares outstanding are 100,000,000 – 4,043,127 = 95,956,873 $1.10 95,956,873 $106,000,000 Shares Earnings Recomputed earnings per share are : = = 4. Earnings per share ............................................................................................................ $1.10 Price-earnings ratio .......................................................................................................... x 10 Stock price ....................................................................................................................... $11.00 5. Stock price ....................................................................................................................... $11.00 Option price ..................................................................................................................... – 5.00 Profit per share ................................................................................................................. $6.00 Shares .............................................................................................................................. x 50,000 Total before tax profit ...................................................................................................... $300,000 6. The stock market’s reaction is quite likely to be negative to Robert Osborne exercising his options. By using 50,000 of his options to buy and resell stock now, he is indicating that he thinks $11.00 might represent the current upside potential for the stock for now. Actually investors are getting mixed signals. One is positive in that Orbit Chemical Company repurchased over four million of their own shares; the other is negative in that the CEO is selling ¼ of his shares covered by stock options. The insightful investor might ask further questions such as, “Does Robert Osborne have a particular need to exercise ¼ of his stock options now?” If he is using the profits to pay off personal debt, that might be acceptable. If he merely thinks this is a good time to take a profit, it would not be acceptable to other investors. Hamilton Products Case 30 Convertibles Purpose: The case encourages the student to more fully appreciate the financial characteristics of convertible bonds. It also allows the student to see that the pure bond value is not necessarily stable, but may change because of changing interest rates or business risk. The student not only views upside potential, but increasing downside exposure as well. Relation to Text: The case should follow Chapter 19. However, the student will also need to utilize material from Chapter 10 for a bond value computation. Complexity: The case tends to be reasonably straightforward and requires about ½ hour. Solutions 1. Conversion value = Conversion ratio x Common stock price $884.25 = 27 x $32.75 Conversion premium = Convertible bond price – Conversion value $115.75 = $1,000.00 – $884.25 2. First determine the conversion value: Conversion value = Conversion ratio x Common stock price $1,228.50 = 27 x $45.50 Then determine the conversion premium: Conversion premium = Convertible bond price – Conversion value $21.50 = $1,250.00 – $1,228.50 3. First determine the conversion value: Conversion value = Conversion ratio x Common stock $803.25 = 27 x $29.75 Then determine the price of the convertible bond: Convertible bond price = Conversion value + Conversion premium $901.25 = $803.25 + $98 4. Pure Bond Value Present value of interest payments PVA = A x PVIFA (n = 17, i = 10%) PVA = $65 x 8.022 = $521.43 Present value of principal payment (par value) at maturity PV = FV x PVIF (n = 17, i = 10%) PV = $1,000 x .198 = $198.00 Present value of interest payments $521.43 Present value of principal payment at maturity +198.00 Total present value or pure bond price $719.43 5. Andre should probably not take too much comfort in the pure bond price. The convertible bond is selling for $901.25 as indicated in question 3 and the pure bond value is $719.43. That indicates a potential loss of $181.82 or 20.2 percent ($181.82/$901.25). Furthermore, there is always the danger of interest rates on comparable bonds going even higher. Originally, the pure bond value was $853.17, which certainly would have provided more comfort. Acme Alarm Systems Case 31 Merger Terms and Stock Price Purpose: The case is structured so that the student can analyze the effect of a merger on earnings per share and stock price. In doing the analysis, the student will see that a high premium over market value for a target company will dilute earnings per share. The question then becomes, will there be a potentially higher P/E ratio for the acquiring company due to improved growth prospects? Also, what part will synergy play in the analysis? Relation to Text: The case should follow Chapter 20. Complexity: The case is moderately complex. It should require 45 minutes to an hour. Solutions 1. Becky should argue that the initial dilution in earnings per share can be justified by the acquisition of a company with superior growth prospects. The initial dilution may be overcome by a higher postmerger P/E ratio for Acme due to an enhanced image in the marketplace and because of potential synergistic benefits. 2. New stock price. EPS $ 2.11 x New P/E ratio (16 x 1.15) 18.4 New stock price $38.82 Since the new stock price of $38.82 is below the premerger stock price of $40, Andrew should not be satisfied. 3. New earnings per share. $60 million x 1.10 = $66 million new total earnings. EPS = $66 million (Total earnings) = $2.32 28.4 million (Shares) Stock price = New EPS x new P/E ratio = $2.32 x 18.4 = $42.69 Since the new stock price of $42.69 is above the premerger stock price of $40, Andrew should be satisfied. 4. New price per share for Internet Security. Internet Security’s current price $30 60 premium $18 New offer price $48 New total price New offer price $ 48 Number of shares 8 million New total price $384 million Number of premerger Acme shares that must be issued. New total price $384 million Acme premerger share price $ 40 Number of new Acme shares 9.6 million Postmerger earnings per share for Acme. EPS = $66 million (total earnings) = $2.23 29.6 million shares* *20 million original Acme shares plus 9.6 million new shares. New stock price New EPS $2.23 P/E ratio 18.4 New stock price $41.03 Since the new stock price of $41.03 is above the premerger stock of $40, Andrew should be satisfied. Carlson Airlines Case 32 Merger Analysis and Cash Flow Purpose: The case demonstrates the use of capital budgeting techniques in a merger analysis. There are a number of tax implications the student must consider. The student will also evaluate the impact of terminal value on the analysis. This factor is frequently omitted in cases of this nature. The importance of the growth rate is demonstrated as are the overall dimensions of the merger analysis. Relation to Text: The case should follow Chapter 20. Complexity: The case is of moderate difficulty and should require 45 minutes. Solutions 1. 2. 3. Year Projected Cash Flow 10% Discount Rate Present Value 1 8,292,000 .909 $7,537,428 Sales $33,000,000 Cost of Goods Sold 19,440,000 Gross Profit 13,560,000 Selling and Administrative Expense 3,600,000 Depreciation Expense 4,400,000 Earnings before Taxes 5,560,000 Taxes (30%) 1,668,000 Earnings after Taxes 3,892,000 Plus Depreciation 4,400,000 Cash Flow $8,292,000 Year Projected Cash Floor (12% Growth) 2 9,287,040 3 10,401,484 4 11,649,662 5 13,047,621 6 14,613,335 7 16,366,935 8 18,330,967 9 20,530,683 10 22,994,364 2 9,287,040 .826 7,671,095 3 10,401,484 .751 7,811,514 4 11,649,662 .683 7,956,719 5 13,047,621 .621 8,102,573 6 14,613,335 .564 8,241,921 7 16,366,935 .513 8,396,238 8 18,330,967 .467 8,560,562 9 20,530,683 .424 8,705,001 10 22,994,364 .386 8,875,825 Sum of Present Value $81,858,876 4. Sales Price $140,000,000 Taxes (15%) 21,000,000 A/T Sales Proceeds 119,000,000 PV Factor (n = 10, i = 10%) .386 PV of A/T Sales Proceeds $45,934,000 5. Total Proceeds Sum of Present Value $81,858,876 PV of A/T Sales Proceeds 45,934,000 Total Proceeds $127,792,876 Total Proceeds $127,792,876 - Purchase Price 100,000,000 Positive Return 27,792,876 The company should be purchased based on present value analysis. Security Software, Inc. Case 33 Convertibles Purpose: The case allows the student to view the hybrid nature of convertible securities. While it would be very difficult for the firm to issue either equity or bonds in a post-recession bear market, convertible securities offer the opportunity to enter the market at a lower interest rate and at a higher conversion price than the stock price the firm currently has. However, the case also illustrates the potentially downward effect of convertibles on earnings per share. An interesting feature of the case is that it traces stock price declines during the Internet bust. Relation to Text: The case should follow Chapter 19. Complexity: The case is moderately complex. It should require 1 to 1½ hours. Solutions 1. a. $30 Million .............................. .............................. Par value 7.5% .............................. .............................. Interest rate $2.25 Million .............................. .............................. Interest b. $30 million total issue / $1,000 par value = 30,000 bonds 30,000 bonds x 40 conversion ratio = 1,200,000 potential new shares of common stock. 2. $30 million total issue / $19.50 stock price = 1,538,462 new shares 3. $30 million total issue / $35 stock price = 857,143 new shares This is not very realistic. First of all, there is no assurance the stock price will get up to $35 from its current level of $19.50. Secondly, SSI needs the $30 million now to remain competitive so it is unlikely the firm can wait until the stock price gets up to the $35. 4. $30 Million .................... .................... Total issue 3.5% .................... .................... Interest savings $1,050,000 .................... .................... Annual interest savings ` 5. With a conversion ratio of 40, the bonds will go up to a value of at least $1,400 (40 x $35). A conversion premium may call for even a slightly higher value. The bondholders do not need to convert immediately. They can merely ride the price of the bond up with the common stock. 6. The corporation could force a conversion through calling in the bonds at close to par when they are trading well in excess of par. In order to avoid the call at close to par, the bondholders would convert to common stock at the stock's advanced value (perhaps 40 shares at $35 or $1,400.) Also, a step-up in the conversion price after a specified period of time would tend to force bondholders to convert. If the conversion price went from $25 to $30, the conversion ratio would decline from 40 to 33.33 ($1,000 par value / $30 conversion price = 33.33 conversion ratio). The bondholder would have a strong incentive to convert before the step-up in the conversion price and the accompanying reduction in the conversion ratio. This assumes that the actual price of the common stock in the market has gone up enough to make a conversion desirable. 7. a. Earnings before interest and taxes ........................................................................................................................ $15,000,000 Interest ($1,000,000 from the table in Question 7 plus $2,225,000 from the answer to Question 1 ........................................................................................................................ 3,225,000 Earnings before taxes ........................................................................................................................ $11,775,000 Taxes (30%) ........................................................................................................................ 3,532,500 Earnings after taxes ........................................................................................................................ $ 8,242,500 Basic earnings per share = Earnings after taxes = $8,242,500 = $.824 Shares of common stock 10,000,000 b. Diluted earnings per share = $8,242,500 + $1,557,500* = $9,800,000 = $.875 10,000,000 + 1,200,000 11,200,000 * $2,225,000 (Question 1) .70 (1– tax rate or 1– .30) $1,557,500 8. The convertibles increase basic earnings per share by slightly over $.12 from $.70 to .824. Diluted earnings per share are also up by $.175 from the initial value of $.70 to $.875. Although in this case, assumed additional earnings and the add back of bond interest compensate for potential diluted earnings per share, the need to show diluted earnings per share can be a serious drawback to convertibles. Security analysts will be provided with both basic EPS and diluted EPS, but they tend to put more emphasis on the latter. National Brands vs. A-1 Holdings Case 34 Merger Analysis Purpose: This case features a surprise attack tender offer. The acquisition candidate decides to counter with a Pac Man defense in which they make an offer for the potential acquiring company. Both firms are considering various financing packages to establish their strategy including heavy leverage and the use of acquired assets as collateral. The student must consider the feasibility of the plans as well as the impact on stockholder wealth maximization. The student is also asked to consider social responsibility (good guy versus bad guy) issues related to the merger. Relation to Text: The case should follow Chapter 20. Because the case covers many important questions in corporate finance, it may be used as an integrating exercise for many of the prior chapters. Complexity: The case is somewhat complex. It is likely to require 2 hours. Solutions 1. a. According to Figure 1, there are 113,640,000 shares of National Brands outstanding. But, A-1 already owns 5% of them, or 5,682,000, so it will only have to buy the remaining 107,958,000. At $55 each, the total price will be $5,937,690,000 (a little over $5.9 billion). b. The amount of liquid assets (i.e., cash and equivalents) on hand at National is $1,153,000,000. If A-1 can use this amount to offset the amount of borrowing required, the total amount it will have to borrow is $5,937,690,000 – $1,153,000,000 = $4,784,690,000 c. After the purchase, A-1’s total debt will consist of: A-1’s old debt: $1,899,500,000 National’s debt: $2,110,300,000 Amount borrowed: $4,784,690,000 Total: $8,794,490,000 Since all the funds to make the purchase were borrowed, A-1’s total equity remains $395,000,000 after the purchase. Its debt to equity ratio after the purchase, therefore, is: $8,794,490,000 / $395,000,000 = 22.26 to 1! This is astonishing. Such high debt to equity ratios are not normally encountered except in financial institutions, such as banks. (In fact, A-1’s balance sheet resembles that of a bank—over 75% of its assets are in cash and equivalents, lending credence to the charge that corporations such as A-1 aren’t “real” corporations after all, merely shells, or deposit accounts used by their owners to make acquisitions.) Given such a high debt to equity ratio, it is difficult to imagine how Mr. O’Brien could finance the purchase of National using debt sources. d. In b, above, we computed that $4,784,690,000 was needed to make the purchase. If A-1 issues stock at $13 a share to raise the funds, it will need to issue 368,053,077 new shares. e. The total number of shares outstanding at A-1 after the purchase will be the 61,800,000 old shares plus 368,053,077 newly issued ones. Total expected earnings are the $152,000,000 A-1 originally expected plus $400,000,000 from National. So, A-1’s EPS after the purchase will be: ($152,000,000 + $400,000,000) / (61,800,000 + 368,053,077) = 552,000,000 / 429,853,077) = $1.28 f. $1.28 represents a 48% decline from A-1’s previous expected EPS of $2.46 (the decline, of course, was caused by the fact that National’s P/E is much higher than A-1’s). A-1’s stockholders will not be pleased, unless Mr. O’Brien can convince them that they will be better off in the long run (unlikely—National’s growth rate is not high enough), or he has some other plan in mind, such as selling off pieces of National at a profit. National’s stockholders, on the other hand, will realize an immediate 15% capital gain. ($7.12 / $47.88) = 15 percent based on the difference between the $55 offer and the current price of $47.88. They may be more satisfied, though 15 percent is a relatively small premium. 2. a. Employing the Pac Man defense will cost National $17 a share times the 61,800,000 shares of A- 1 outstanding, or $1,050,600,000. b. A-1 has $1,736,800 of liquid assets available. Using this amount to offset the amount of National stock to be issued brings the total amount of cash needed to be raised down to: $1,050,600,000 – $1,736,800,000 = –$686,200,000 It’s a rather surprising result that National could buy A-1 without spending any of its own money at all! The cash and equivalents balance on hand at A-1 is more than enough to cover the cost of the company. Of course, National will have to assume all of A-1’s debt too, which is rather substantial. See the next answer, below. c. National’s total debt after the purchase will be its old debt plus A-1’s debt: National’s old debt: $2,110,300,000 A-1’s old debt: $1,899,500,000 National’s new debt: $4,009,800,000 National’s total equity after the purchase will simply be its old equity, $3,050,000,000. Therefore, National’s debt to equity ratio after the purchase will be: $4,009,800,000 / $3,050,000,000 = 1.31 to 1 The new ratio of 1.31 to 1 is nearly double National’s old ratio of .69 to 1, so the company will probably want to use at least some of A-1’s cash to reduce its debt load instead. This situation illustrates why companies with large cash balances (and small debt balances) are attractive takeover targets. d. If National uses A-1’s $1,736,800,000 cash and equivalents balance to pay down A-1’s $1,899,500,000 debt balance, it will not have any left to apply to the stock issue. Therefore National will have to issue enough of its own shares at $47.88 each to cover A-1’s entire cost of $1,050,600,000: $1,050,600,000 / $47.88 = 21,942,356 shares e. The total number of shares outstanding at National after the purchase will be the 113,640,000 old shares plus 21,942,356 newly issued ones. Total expected earnings are the $400,000,000 National originally expected plus $152,000,000 from A-1. So National’s EPS after the purchase will be: ($400,000,000 + $152,000,000) / (113,640,000 + 21,942,356) = $552,000,000 / 135,582,356 = $4.07 f. Yes, Mr. Hall is correct. The purchase of A-1 will not dilute National’s earnings, at least in the coming year. They actually increase from $3.52 to $4.07. 3. If National’s P/E remains at its previous value of 13.6, its stock price can be expected to rise to $4.07 x 13.6 = $55.35. Of course, it is highly unlikely that its P/E will remain at its previous value. A-1’s old P/E was only 5.3, less than half that of National. It is likely, therefore, that investors will lower their expectations for National somewhat, despite its higher earnings. If National’s P/E drops only as far as 11.76, its stock price will remain at $47.88. Note—students may question why A-1 has a higher growth rate than National, yet its P/E is much lower. The answer lies in the fact that the P/E ratio does not depend on investors’ growth expectations alone. In this case the P/E is inhibited by A-1’s extremely high debt ratio. 4. a. As a result of A-1’s offer to buy National, National’s stockholders stand to realize a 15% capital gain, but National’s management is against the move and will try to convince the stockholders to reject it. On the other hand, A-1’s stockholders stand to realize a 31% capital gain ($4 to $13) if National buys A-1, and nothing in the case indicates that Mr. Kelly O’Brien would resist such a deal. Therefore, it seems likely that National’s bid to purchase A-1 will prevail. It is tough to dismiss the suggestion that he may have engineered the entire situation merely to elicit the Pac Man response from National. In fact, this suggestion was reported in the press concerning the companies upon which this case is based. b. It is difficult to say whether or not National’s stockholders are better off as a result of their company’s employment of the Pac Man defense. On the one hand they have been denied the chance for a 15% capital gain. On the other, they have gained a set of assets which may or may not achieve an equal gain, even in the long term. Further, the assets were not purchased as a part of an integrated capital budgeting program, but were obtained under duress. On balance, it would appear that A-1’s stockholders would be the big winners in this situation. c. Those who take sides with the corporate “raiders” would say that they provide a valuable function in the economy—weeding out inefficiency. They do this by buying inefficiently managed companies and restructuring them into more effective units. In the long run, they say, the economy as a whole is strengthened. Opponents charge that the practice is unfair to employees who are uprooted and often lose their jobs in the restructurings, and they maintain that businesses ought to concentrate on making money by producing quality products rather than making it by trading companies. In the long run, they say, the economy as a whole is weakened. The issue goes far beyond a case in finance, essentially becoming one of ethics and point of view. The truth is probably a blend of the two views, or the classic “it depends.” At the very least we can probably say that such decisions should not be made purely on the basis of the financial aspects of the situation. KFC and the Colonel Case 35 General Business Considerations Purpose: This case is different from the prior 34 and may only appeal to certain instructors. It is a real- world documentation of the process that Colonel Harland Sanders went through in selling out Kentucky Fried Chicken to John Young Brown, Jr. in 1964. It is really part management and part finance. The student also views the early trials and tribulations of the Colonel as well as the enormous success of his company after he sold it for the very modest price of $2 million. The student is asked to consider whether the Colonel acted prudently in accepting the offer based on the information he had at the time and what additional steps he might have taken in the negotiations. Relation to Text: The case can be introduced at any point as interesting reading, but should probably follow the material on long-term financing and mergers. Complexity: The case involves the absorption of information rather than complex analysis and should probably require 45 minutes. Solutions A number of issues can be raised concerning Sanders’ approach in connection with the sale to Brown and Massey. First of all, it would appear that he should have consulted with more than one individual (Harman) before he made a proposal to sell at $2,000,000. He should have discussed the matter with Claudia, who had been his business partner and later his wife, before coming to a final decision. As a matter of courtesy, he should also have advised his office staff that he was considering the sale and perhaps asked for their advice. Most important, he should have reviewed the proposed sale with a CPA firm and with an attorney familiar with this type of transaction. Although Brown served earlier as Sanders’ attorney, Brown was now on the other side of the fence, representing his own interests. Finally, when Sanders did decide to consult with Harman, he should have gone to discuss the matter with him alone—not with Brown and Massey. While there is no reason to suspect that Harman may have acted improperly, it is still apparent that as the largest franchisee at the time, his advice to Sanders may not have been made from a disinterested point of view. What are some of the other options that Sanders may have considered other than the $2,000,000 cash price? Initially, $2,000,000 “cash” turned out not to be exactly $2,000,000 as of the date of the sale since the balance of $1,500,000 was to paid over five years after the down payment of $500,000. It was, therefore, a discounted “$2,000,000.” Was there a provision in the agreement to compensate Sanders for the use of capital during the five-year period? Also, was there some guarantee—perhaps on the part of Massey, the “Nashville millionaire”—to make sure that Sanders would get the balance of $1,500,000? In addition to the sale for cash, other options may have been considered: a. Part cash payment; part stock, with Sanders to get, say, 49% interest in the new company. Although Sanders shied away from stock, he may, if he had consulted with others, have found this option desirable. It would have given him a share in the possible future success of the company and have given him capital gains which would have been taxable at the special rates at the time of the eventual resale of the firm. b. A royalty arrangement, say 25% up to 50% of the franchise fees over the next five or ten years—or whatever time he continued to act as goodwill and P.R. man. This, too, would have given him a share in the future earnings. c. A profit-sharing arrangement with profits to be distributed to Sanders over and above an agreed rate of return on capital of the new firm. Again, the time period could be set based on the time that Sanders would actively promote the company. Some form of the royalty or profit-sharing arrangement could be combined with a payment of, say, $1,000,000 to satisfy Sanders’ desire for cash in hand. The price that Sanders set apparently came off the top of his head, since he commented, “I think that $2,000,000 sounds about right.” If he had made any calculations, he may have figured that the current profits, estimated at $300,000, capitalized at 15% would come to $2 million. He apparently did not take into account the potential growth of the company. Even from 1960 to 1963, when he was running the company, estimated profits had grown from $100,000 to $300,000, which should have given him an inkling that future increases could be anticipated. Advice from a CPA, financial manager, or banker might have alerted him to make some provision for possible future gains even though the outlook at the time of the sale could not be predicted with any degree of accuracy. In conclusion, it may be said that Sanders was a remarkably successful person. He was a great salesman and promoter, but he did not seek adequate advice when he got into an area outside of his own expertise. Solution Manual Case for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160