FIN 3901 Lecture Notes - Lecture 1: Capital Structure, Sole Proprietorship, Income Statement

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30 Oct 2016

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Answers 3 main questions: what long-term investments should the firm choose? (main focus of this course) Working capital management (short term assets and liabilities of the firm) Current assets- current liabilities= net working capital. Biggest value you can add to a firm is make good investment decisions. Financial manager primary goal is to increase the value of the firm by: selecting value creating projects, making smart financing decisions. Cash flow from firm must be greater than firm issues securities (a). firm must generate more than it takes in or it will go out of business. Forms of business organization: the sole proprietorship. Can take in all of the profits solely: the partnership, general partnership, limited partnership, the corporation. Can go to the public for money. If you want to grow fast, be a corporation because you can go to the public for money. Most liquid form of business organization (get out of your shares the fastest)

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Page 1
Chapter 4: Measuring Corporate Performance
Case Study: Corporate Lending Group: The Hobby Horse
Company, Inc. (HH)
Burchetts Green had enjoyed the bank training course, but it was good to
be starting his first real job in the corporate lending group. Earlier that
morning the boss had handed him a set of financial statements for The
Hobby Horse Company, Inc. (HH). "Hobby Horse," she said, "has a $45
million loan from us due at the end of September, and it is likely to ask us
to roll it over. The company seems to have run into some rough weather
recently, and I have asked Furze Platt to go down there this afternoon and
see what is happening. It might do you good to go along with her. Before
you go, take a look at these financial statements and see what you think
the problems are. Here's a chance for you to use some of that stuff they
taught you in the training course."
Mr. Green was familiar with the HH story. Founded in 1990, it had rapidly
built up a chain of discount stores selling materials for crafts and hobbies.
However, last year a number of new store openings coinciding with a poor
Christmas season had pushed the company into loss. Management had
halted all new construction and put 15 of its existing stores up for sale.
Mr. Green decided to start with the 6-year summary of HH's balance sheet
and income statement (Table 4-1). Then he turned to examine in more
detail the latest position (Tables 4-2 and 4-3).
Source: Brealey, R.A.; Myers, S.C.; Marcus, A.J. (2009): Fundamentals of
Corporate Finance, 6th ed., New York: McGraw Hill, p. 107.
Questions:
What appear to be the problem areas in HH? Do the financial ratios
suggest questions that Ms. Platt and Mr. Green need to address?
1. Calculate financial ratios to interpret HHâs profitability, efficiency,
leverage, and liquidity. Use flow measures for the calculation of the
profitability and efficiency ratios (averages of the year).
2. For the preparation of the meeting with the bank, calculate also the
development of the leverage and liquidity ratios over the past years.
3. Interpret the calculated ratios and give suggestions for the management
how to proceed or how to (possibly) solve the problems.
Fachbereich Elektrische
Energietechnik
Prof. Dr. Valerie Wulfhorst
Betriebswirtschaftslehre,
insb. Controlling
Telefon
02921 378-451
Telefax
02921 378-409
E-Mail
[email protected]
Standort Soest
LÃ¼becker Ring 2
59494 Soest
Fachhochschule
SÃ¼dwestfalen
Sitz: Iserlohn
Hagen
Iserlohn
Meschede
Soest
www.fh-swf.de
Page 2
Tables:
Table 4- 1: Finance highlights for The Hobby Horse Company, Inc., year
ending March 31
Table 4- 2:
2008 2007 2006 2005 2004 2003
Net sales 3,351 3,314 2,845 2,796 2,493 2,160
EBIT -9 312 256 243 212 156
Interest 37 63 65 58 48 46
Taxes 3 60 46 43 39 34
Net profit -49 189 145 142 125 76
Earning per share -0.15 0.55 0.44 0.42 0.37 0.25
Current assets 669 469 491 435 392 423
Net fixed assets 923 780 753 680 610 536
Total assets 1,592 1,249 1,244 1,115 1,002 595
Current liabilities 680 365 348 302 276 320
Long-term debt 236 159 297 311 319 315
Stockholderâs equity 676 725 599 502 407 324
Number of stores 240 221 211 184 170 157
Employees 13,057 11,835 9,810 9,790 9,075 7,825
INCOME STATEMENT FOR
THE HOBBY HORSE COMPANY, INC.,
FOR YEAR ENDING MARCH 31, 2008
(all items in millions of dollars)
Net sales 3,351
Cost of goods sold 1,990
Selling, general, and administrative expenses 1,211
Depreciation expense 159
Earnings before interest and taxes (EBIT) -9
Net interest expense 37
Taxable income -46
Income taxes 3
Net income -49
Allocation of net income
Addition to retained earnings -49
Dividends 0
Page 3
Table 4- 3:
CONSOLIDATED BALANCE SHEET FOR THE HOBBY HORSE COMPANY, INC.
(figures in millions of dollars)
Assets Mar. 31, 2008 Mar. 31, 2007
Current assets
Cash and marketable securities 14 72
Receivables 176 194
Inventories 479 203
Total current assets 669 469
Fixed assets
Property, plant, and equipment (net of depreciation) 1,077 910
Less accumulated depreciation 154 130
Net fixed assets 923 780
Total assets 1,592 1,249
Liabilities and Shareholders' Equity Mar. 31, 2008 Mar. 31, 2007
Current liabilities
Debt due for repayment 484 222
Accounts payable 94 58
Other current liabilities 102 85
Total current liabilities 680 365
Long-term debt 236 159
Stockholders' equity
Common stock and other paid-in capital 155 155
Retained earnings 521 570
Total stockholders' equity 676 725
Total liabilities and stockholders' equity 1,592 1,249

Modern Furnitures was established in 2000. Its products include household and office furniture. It has grown organically with new designs of furniture as well as through acquisition of other furniture companies. It has high cash balance in order to provide funds for these opportunities. Its financial statements are shown in Exhibit 1 and 2. Exhibit 1 Income Statement for the year ending December 31, 2016

Sales Revenue 6,000,000

Cost of goods sold (-1,800,000)

Gross Profit 4,200,000

Operating expenses (-2,000,000)

Depreciation (-200,000)

EBIT 2,000,000

Interest (-120,000)

Earnings before tax 1,880,000

Tax (20%) (-376000)

Net income 1,504,000

Dividend payment (-601600 )

Addition to retained earnings 902,400

Exhibit 2 Balance Sheet as at December 31, 2016

Assets

Cash and Cash Equivalents 1,200,000

Receivables 560,000

Inventory 500,000

Total current assets 2,260,000

Gross Fixed assets 1,350,000

Accumulated Depreciation (-550,000)

Net fixed assets 800,000

Total assets 3,060,000

Liabilities and Shareholder equity

Payables 400,000

Short-term debt 150,000

Current Liabilities 550,000

Long-term debt 1,000,000

Total Liabilities 1,550,000

Paid up capital 1,000,000

Retained Earnings 510,000

Total equity 1,510,000

Equity + Liabilities 3,060,000

The number of shares outstanding is 1,000,000. The company expects that its dividend will grow at 6% every year indefinitely. The long- term debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 9% The beta of furniture industry is 1.2; the risk-free rate is 4% and the expected market risk premium is 7%. The market price per share is $9.50. Modern Furnitures is planning to launch a new bedroom suite. They have been doing research for this product for the past 8 months and have spent $200,000 in research expenses. This project will last for 4 years. The manufacture and sale of new bedroom suites will begin in January 2018 and the expected demand for the next 4 years will be:

Year

2018 Demand in units 3,200

2019 Demand in units 4,000

2020 Demand in units 4,800

2021 Demand in Units 5,600

The variable cost is estimated as 50% of sales. Other operating expenses are fixed costs which will be $600,000 a year. The unit price at which the suite can be sold is $1,800. The cost of the new machinery is $9,000,000. The machinery will be fully depreciated over its useful of 5 years. At the end of the project, the machinery has a salvage value of $2,500,000. The working capital needed for each year is 30% of the sales.

Modern Furnitures is considering three options to raise the needed funds for the investment.
Modern Furnitures feels that the true value of their shares is $9.94. Modern Furnitures also
would like to keep the debt ratio at a maximum of 50% of total capital. The three options are:
1. Issue convertible bond for $9 million with a coupon rate of 3% at a par value of $100.
The YTM on this bond is 4%. The maturity of the bond is 5 years. Coupon will be
paid at the end of every year. The bond can be converted with a conversion price of
$10.2 after 1 year. The management believes that the price of shares will increase
causing all convertible bond to be converted.
2. Issue a bond with no convertible provision. The coupon rate will be 3% at a par value
of $100. Coupon will be paid at the end of every year. The YTM of this bond is 4.3%.
These bonds will also mature after 5 years.
3. Issue equity at a discount of 10% to the current market price.
(a) Discuss why the YTM on convertible bond is lower than that of a bond with no
convertible provision when coupon rate and maturity are the same.
(5 marks)
(b) Assess the funds needed to be raised from outside sources to take up the project using
the values from your answer to Question 2 and the information in financial
statements.
(5 marks)
(c) Explain why Modern Furnitures should not go with debt issue for the whole amount
needed.
(5 marks)
(d) If the company wants to issue addition shares to finance the need, calculate the issue
price and the number of new shares to issue.
(5 marks)

(e) Calculate the number of bonds that the company needs to issue to finance the needs.

(f) Explain why issue of convertible is a better choice as compared to issue of new stock.

Exhibit 1 Income Statement for the year ending December 31, 2016

Exhibit 2 Balance Sheet as at December 31, 2016

The number of shares outstanding is 1,000,000.

The company expects that its dividend will grow at 6% every year indefinitely. The longterm debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 9%

The beta of furniture industry is 1.2; the risk-free rate is 4% and the expected market risk premium is 7%. The market price per share is $9.50.

Modern Furnitures is planning to launch a new bedroom suite. They have been doing research for this product for the past 8 months and have spent $200,000 in research expenses. This project will last for 4 years.

The manufacture and sale of new bedroom suites will begin in January 2018 and the expected demand for the next 4 years will be:

1. Issue convertible bond for $9 million with a coupon rate of 3% at a par value of $100. The YTM on this bond is 4%. The maturity of the bond is 5 years. Coupon will be paid at the end of every year. The bond can be converted with a conversion price of $10.2 after 1 year. The management believes that the price of shares will increase causing all convertible bond to be converted.

2. Issue a bond with no convertible provision. The coupon rate will be 3% at a par value of $100. Coupon will be paid at the end of every year. The YTM of this bond is 4.3%. These bonds will also mature after 5 years.

3. Issue equity at a discount of 10% to the current market price.

(a) Discuss why the YTM on convertible bond is lower than that of a bond with no convertible provision when coupon rate and maturity are the same. (5 marks)

(b) Assess the funds needed to be raised from outside sources to take up the project using the values from your answer to Question 2 and the information in financial statements. (5 marks)

(d) If the company wants to issue addition shares to finance the need, calculate the issue price and the number of new shares to issue. (5 marks)

(e) Calculate the number of bonds that the company needs to issue to finance the needs. (4 marks)

(f) Explain why issue of convertible is a better choice as compared to issue of new stock. (6 marks)

Kindly assist with the calculations. TIA

brownsheep952

In March 2015 the management team of Londonderry Air (LA) met to discuss a proposal to purchase five short haul aircraft at a total cost of $25 million. There was general enthusiasm for the investment, and the new aircraft were expected to generate an annual cash flow of $4 million for 20 years.

The focus of the meeting was on how to finance the purchase. LA had $20 million in cash and marketable securities (see table), but Ed Johnson, the chief financial officer, pointed out that the company needed at least $10 million in cash to meet normal outflow and as a contingency reserve. This meant that there would be a cash deficiency of $15 million, which the firm would need to cover either by the sale of common stock or by additional borrowing. While admitting that the arguments were finely balanced, Mr. Johnson recommended an issue of stock. He pointed out that the airline industry was subject to wide swings in profits and the firm should be careful to avoid the risk of excessive borrowing. He estimated that in market value terms the long-term debt ratio was about 59% and that a further debt issue would raise the ratio to 62%.

Mr. Johnson's only doubt about making a stock issue was that investors might jump to the conclusion that management believed the stock was overpriced, in which case the announcement might prompt an unjustified selloff by investors. He stressed therefore that the company needed to explain carefully the reasons for the issue. Also, he suggested that demand for the issue would be enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management's confidence in the future.

These arguments cut little ice with LA's chief executive. "Ed," she said, "I know that you're the expert on all this, but everything you say flies in the face of common sense. Why should we want to sell more equity when our stock has fallen over the past year by nearly a fifth? Our stock is currently offering a dividend yield of 6.5%, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. What's more, I don't see the point of paying out more money to the stockholders at the same time that we are asking them for cash. If we hike the dividend, we will need to increase the amount of the stock issue; so we will just be paying the higher dividend out of the shareholders' own pockets. You're also ignoring the question of dilution. Our equity currently has a book value of $12 a share; it's not playing fair by our existing shareholders if we now issue stock for around $10 a share.

"Look at the alternative. We can borrow today at 6%. We get a tax break on the interest, so the after-tax cost of borrowing is .65*6 = 3.9%. That's about half the cost of equity. We expect to earn a return of 15% on these new aircraft. If we can raise money at 3.9% and invest it at 15%, that's a good deal in my book.

"You finance guys are always talking about risk, but as long as we don't go bankrupt, borrowing doesn't add any risk at all. In any case my calculations show that the debt ratio is only 45%, which doesn't sound excessive to me.

"Ed, I don't want to push my views on this after all, you're the expert. We don't need to make a firm recommendation to the board until next month. In the meantime, why don't you get one of your new business graduates to look at the whole issue of how we should finance the deal and what return we need to earn on these planes?"

Evaluate Mr. Johnson's arguments about the stock issue and dividend payment as well as the reply of LA's chief executive. Who is correct? What is the required rate of return on the new planes?

Balance sheet
bank Debt	50	cash	20
other current liabilities	20	other current assets	20
10% bond, due 2032*	100	Fixed assets	250
Stockholders' equity**	120
Total liabilities	290	Total Assets	290
Income statement
Gross Profit	$57.5
Depreciation	20.0
Interest	7.5
Pretax profit	30.0
Tax	10.5
Net profit	19.5
Dividend	6.5

*the yield to maturity on LA debt is currently 6%

**LA has 10 million shares outstanding, with a market price of $10 a share. LA's equity beta s estimated at 1.25, the market risk premium is 8%, and the Treasury bill rate is 3%

FIN 3901 Lecture Notes - Lecture 1: Capital Structure, Sole Proprietorship, Income Statement

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