Please explain and show all work
Question 2: Risk and Financial Analysis
There is always uncertainty when we forecast or estimate future revenues and costs. The totality of the uncertainty can roughly be captured as:
UTot = U{UE1, UE2, UI1, UI2, UI3, UIS}
Where:
UTot Constructed estimate of the total uncertainty related to a decision based on typical financial analysis approaches
UE1 Unknown factors not considered in our financial models
UE2 Factors that are known but not incorporated into our financial models
UI1 Factors that are known and incorporated into our financial models that have a known degree of uncertainty surrounding them
UI2 Factors that are known and incorporated into our financial models for which we fail to recognize the full nature of their uncertainty
UI3 Factors that are known and incorporated into our financial models that have little or no uncertainty, but we erroneously assume to have a significant degree of surrounding them
UIS Uncertainty related to the structure of the financial models that we use in out analysis
How will these differing "sources" of uncertainty impact our decision-making ability?
How might we deal with the different forms of uncertainty?
Please explain and show all work
Question 2: Risk and Financial Analysis
There is always uncertainty when we forecast or estimate future revenues and costs. The totality of the uncertainty can roughly be captured as:
UTot = U{UE1, UE2, UI1, UI2, UI3, UIS}
Where:
UTot Constructed estimate of the total uncertainty related to a decision based on typical financial analysis approaches
UE1 Unknown factors not considered in our financial models
UE2 Factors that are known but not incorporated into our financial models
UI1 Factors that are known and incorporated into our financial models that have a known degree of uncertainty surrounding them
UI2 Factors that are known and incorporated into our financial models for which we fail to recognize the full nature of their uncertainty
UI3 Factors that are known and incorporated into our financial models that have little or no uncertainty, but we erroneously assume to have a significant degree of surrounding them
UIS Uncertainty related to the structure of the financial models that we use in out analysis
How will these differing "sources" of uncertainty impact our decision-making ability?
How might we deal with the different forms of uncertainty?
Related questions
According to the information below please answer the following questions:
ENTR 187 Business Plan App Translator
Industry Analysis
INDUSTRY SIZE
When you talk into your phone in any of the Worldâs major languages there is a suite of applications that can turn your words into a foreign language, either in text or electronic form. Mobile translation helps get rid of barriers worldwide. The top current mobile translation apps available for both iOS and Android are Google Translate, iTranslate Voice, SayHi, WayGo, and TripLingo. In addition to apps, there are two new devices that will translate in live time. The user speaks in their native tongue and the device will output the desired target language. These devices are The ili and The Pilot.
Industry at a Glance
The statistics above are listed from 2016. The industry that we have decided to incorporate our product into is âSpeech and Voice Recognition Software Development.â The entire Industry saw Revenue of almost $25 Billion USD. In total, there is over 900 companies involved in the industry.
The biggest company involved is Nuance Communications Inc. which holds a 2.1% market share of the industry. After Nuance Communications Inc., the next biggest company involved is Google Inc. Google participates in the industry through its development of voice and speech recognition software for mobile and online services. This includes the âGoogle Translateâ app available for any mobile device. Current market share data is not available. Apple is another World renowned company involved in the industry through their Siri services. Siri is available in 40 dialects of several different languages.
Industry Growth Rate and Sales Projections
The industry has been steadily growing over the past decade averaging an 8% growth rate in terms of revenue. Through 2021, annualized revenue growth is supposed to grow at a rate of 7%. The industry continues to grow as the widespread adoption of mobile phones continues to grow. The number of mobile internet connections is expected to surpass 331 million in the year 2021. Not every cellphone user actually needs a mobile translation app. However, as the demand for Speech and Voice Recognition Software continues to rise. The apps available on the market will continue to improve.
The potential rise of wearable smartwatches and other smart appliances is also expected to bring about growth opportunities in the industry. Speech and Voice Recognition Software is being implemented into these devices now and will continue in the future. Language is processed by machines as data. Machines are indiscriminate towards what languages they can handle. As long as data is being captured by devices, the software will improve in the future.
The industry is broken up into products and services. 50% of the industry is dedicated to PCs and Macs (such as Rosetta Stone) the other half of the industry is for Mobile devices and Automobiles. The Auto industry doesnât necessarily use translators but they still use Voice Recognition Software.
Nature of Participants
In 2017, mobile apps have now became a key piece to a new way of doing business, a new way of communicating, and simply a new way of conducting life on a day to day basis. With the Play and App store housing hundreds of thousands of apps, competition remains very innovative as more and more developers (or developer studios, who provide application development for third party companies, entrepreneurs and so forth) continue to flood the market with free or purchasable applications. Also, with the vast changes in technology, the app has crossed over from the smart phone over to televisions, media players, and cars, allowing the app industry evolve into a broader economy. With that said, this plays into the ability for more doorways for different creative purposes that apps can be used for. As with every form of technology, what we thought apps were capable of just 5 years ago have soared way beyond those capabilities today.
Key Success Factors
There are many success factors that we have taken into consideration to assure that our product meets its highest potential. The number one factor should always be the experience that the customer receives from the product. Therefore, we will provide users a very friendly and easy-to-use interface, keeping it simple, while making sure that the features give them a complete and total experience so not one need is left unaddressed or unattended to. Focus groups will be conducted even after launch, to allow the customer experience to not only be the best it can be, but to also evolve that experience over time, keeping the app and its content and functions relevant to the users.
Secondly, the app will be universal for all mobile devices, including iOS and Android. The app will be able to function on all mobile devices, tablets, chromebooks, smartwatches, and any other portable smart device.
Third, we will provide easily accessible customer service and reliability. Our support team will be available seven days a week by either phone or via live chat. Updates and maintenance will keep content fresh and any back end issues at bay.
Compatibility: Our app will be compatible with other apps and programs, allowing the user to easily share, store and access files outside of the app itself. Files can be shared via bluetooth, email, NFC technology, text message and social media. Files can be converted to wav. and mp3 format.
INDUSTRY TRENDS
-Business Trends
-According to smashingmagazine.com, consumers are evolving more rapidly than businesses. Today, the mobile Internet has clearly become a necessity for many users.
-According to App Annie reports, in 2015, the mobile app industry generated a whopping $41.1 billion in gross annual revenue and that this figure will rise to $50.9 billion
-According to Statista, a Windows Phone app fetches $11,400 on average per month, whereas iOS app generates $8,100. Android makes $4,900 in average monthly revenue
-According to Smashingmagazine.com, the subscription app model generates predictable, long-term revenue flow for the owner by keeping customer loyalty high.
-According to techcrunch.com, in 2016, worldwide downloads were up 15 percent year-over-year, time spent in apps was up 25 percent, and the revenue paid to developers increased by 40 percent.
Long Term Prospects
In the short-term, our success will tie into the success of the app market as it stands today. The same industry growth and advancement in technology will also be key for our long-term success. During our first year we will see success through free user downloads, building revenue through advertising. Subscription use will build towards the end of year one and continue to double as more revenue that is brought in through advertising, will then be used for marketing purchases, growing our impressions and gaining more and more subscription members.
-Growing Millennial population
-Growing percentage of individuals that own mobile smart phones or smart devices
-Growing percentage of travelers worldwide
-Advances in technology will continue to evolve the functions and features of the app
-Build on residual revenue through long-term subscribers
Company Description
History
The translation of natural languages by machine, first dreamt of in the seventeenth century, has become a reality in the late twentieth. Computer programs are producing translations - not perfect translations, for that is an ideal to which no human translator can aspire; nor translations of literary texts, for the subtleties and nuances of poetry are beyond computational analysis; but translations of technical manuals, scientific documents, commercial prospectuses, administrative memoranda, medical reports.Machine translation is not primarily an area of abstract intellectual inquiry but the application of computer and language sciences to the development of systems answering practical needs. After an outline of basic features, the history of machine translation is traced from the pioneers and early systems of the 1950s and 1960s, the impact of the ALPAC report in the mid-1960s, the revival in the 1970s, the appearance of commercial and operational systems in the 1980s, research during the 1980s, new developments in research in the 1990s, and the growing use of systems in the past decade.
A translation system allowing the Japanese to exchange conversations with foreign nationals through mobile phones was first developed in 1999 by the Advanced Telecommunications Research Institute International-Interpreting Telecommunications Research Laboratories, based in Kansai Science City, Japan. Words spoken into the mobile device are translated into the target language and then sent as voice to the other user's mobile phone. Machine translation software for handheld devices featuring translation capabilities for user-input text, SMS and email, was commercially released in 2004 by Transclick and a patent was issued to Transclick for SMS, email and IM translation in 2006.
In November 2005, another Japanese company, NEC Corporation, announced the development of a translation system that could be loaded in mobile phones. This mobile translation system could recognize 50,000 Japanese words and 30,000 English words, and could be used for simple translations when travelling. However, it was not until January 2009 that NEC Corporation officially demonstrated their product. Technological advances within the miniaturization of computing and communication devices have made possible the usage of mobile telephones in language learning. Among the early projects were the Spanish study programs which included vocabulary practice, quizzes, and word and phrase translations.
Soon after, projects were developed using mobile phones to teach English at a Japanese university. By 2005, they shifted their focus to providing vocabulary instruction by SMS. A similar program was created for learning Italian in Australia. Vocabulary phrases, quizzes, and short sentences were sent via SMS.
Now, Google Translate is the online translation leader. See also Info scope, which is a handheld device composed of a digital camera and wireless internet access, developed at IBM's Almaden Research Center. As well as Duolingo application has been develop to not only translate but also teach the consumers of today to read, write and speak the language, and finally the LLI has been introduced.
The ili is a new innovative technology that helps business professionals or travelers to communicate with other cultures, by simply by the push of a button. It allows the consumer to speak into the device and it will project it back in whatever language chosen by the consumer.
Mission Statement:
Striving to continually improve the language translation services by bringing convenience, quickness, ease, quality and reliability to our customers while bridging language barriers and bringing people with different languages together.
Product and Services
Consumers of today are now more interested in the new high tech gadgets, yet more than anything consumers are obsessed with their mobile device. And in now a dayâs millennials are the consumer taking the initiative to be more diverse and have more experiences in life. Thatâs why we believe that combining both the ili translator and duolingo into one app would be the perfect product for the everyday person of today.
By combining both products, the app can be used in an everyday setting or in a professional setting. It will allow professionals to converse with clients from around the globe in a more personable level. And it will allow the everyday person to become more diverse and intuitive in more cultures.
The app will give the consumer the ability to understand another language, by having it translated directly back to the consumerâs language and vice versa. It will allow different cultures to communicate with one another. It will not only allow consumers of different culture to communicate with one another but it will also allow consumers to learn a new language. Each app will have a minimum of 3 free languages that will allow you to translate or will allow you to learn the language. Learning the language is taken from the aspect of duolingo, by having consumers learn how to read, write, and speak different languages by different game levels and educational readings. And every time, a consumer wishes to learn different languages they will have the ability to purchase more upgrades which will offer such languages.
Current Status and Ownership: We are a Partnership as there are five partners in ownership who are personally liable for all business debts.
Legal Status and Ownership
Key Partnerships: None at this time.
Market Analysis
Market Segmentation and Target Market Selection: This App translator will be an innovative tool in the travel and the translation industry. The market segment the app will target will be the younger generations such as the millennials, which is considered to consist people within the ages of 16-34. One reason why the app should target the younger generations is because they are more interested in traveling abroad than the older generations. The United Nations estimates that this demographic of the younger generation generates more than $180 billion in annual tourism revenue, which is an increase of nearly 30 percent since 2007. The American Express Business Insights also stated that millennials are the fastest growing age segment in terms of money spent on travel. Millennials are also considered to be always connected to the internet with mobile devices and continuously on the move. Millennials do not spend their vacations similar to the older generation on the beach but they tend to spend their time traveling through cities and getting to know the country they are in. These factors of the younger generations traveling more, different way of traveling and an increase in spending while traveling are the textbook conditions for the App translator. Younger people always have their smart phones on them which is why it will be easier for younger people to have translation through an app instead of getting a translator or carrying an extra device. Since younger people like to travel in cities and immerse themselves in the culture, it is again just much simpler and more accessible to have their translation service on their phones.
Buyer Behavior:
Millennials have a lot of influence over older generations and are trendsetters across most of the industries from food to fashion. For millennials reviews of a product from friends and other like-minded people carry a lot of weight. Which means that if people from a certain group do not like the product than other people in that same group are less likely to buy the product. The fear of debt has been instilled in millennials because of student loan debt and the soft job market. This fear has led less and less millennials to purchase using credit cards and going into debt, which why is a recent Bankrate study revealed that over 65% of millennials donât even have a credit card. That is why millennials try to save up to make the purchase with cash or debit. This does not mean that millennials are buying less, it just means that they are finding alternative ways of purchasing. An example of a different way of purchasing that millennials are doing is financing, this allows them to buy an item now and spread out their payments over several months. One of the best ways to see the buying behaviors of millennials is to watch the social media outlets. Research shows that 81% of millennials are on Facebook, and they also check their social media apps on their mobile devices around 43 times a day. An example of how social media is working well for consumers is popular unboxing videos on YouTube, where an individual films the process of unpacking new products and letting viewers know what they can expect from the product when they purchase it. Most business miss with some of their products because the products did not have innovation with purpose. This means that millennials are more likely to try new products but only if the new product makes their lives easier in some way.
Competitor Analysis:
Currently there is no product like this in the market, that utilizes an app to translate as smoothly as device that translate in live time. A person can use google translate, iTranslate Voice, SayHi, WayGo and TripLingo, but they are not as smooth/accurate. The product that is closest to the app translator would be âiliâ and this product has not even been released yet, it is set to be released this year. âiliâ offers the users real time translation by speaking into a handheld device in 0.2 seconds; but the drawbacks are that you have to purchase and extra device and also that it can only support three languages on one device for different languages a consumer would need to buy an another âiliâ device. The reason why there are no real competitors for the app translator is because the app translator will be combining real time translation of âiliâ and language teaching capabilities of Duolingo and Rosetta Stone.
Estimates of Annual Sales and Market Share:
Looking at the trend of the rapidly growing app usage we can assume that more people are likely to download the app than carry an extra device that will help with the translation. Not just the technological part but the entire translation industry is very fragmented; which means there are a lot of firms providing either regular translators or devices/apps to help with translation.The market of the translation industry is expected to grow to $37 billion by 2018. Since the market is highly fragmented it is hard to tell how much of the market is allocated to each of the firms. Which is why we can only estimate that we will attain around 5-10% of the market share in the first couple of years. We can estimate that we can get at least 40 customers a month but the goal is to try to reach at least 50 a month on the first couple of months. Most of the assumptions are based on estimations because there is relatively no data on how the market share is distributed in this market and what is the expected growth rate for the massive number of firms in the translation market.(Translation, n.d.)
Economics of the business
Revenue Drivers and Profit Margins
In the first twelve months in developing the application, our goal is to convert consumers to the subscription and have a minimum of 50 customers per month with the ad block included. We would be selling the one time subscription fee for $24.99 per customer as well as the one time adblock for $9.99 and the monthly fee would vary and is not included in the table below. In just the subscription fees the App would have 3 language software subscriptions and if the consumer pays more the prices would vary. Our total expenses to begin the business would be $25,080 in the first year including everything from advertising to the manufacturing of the app. In the first year out net income would be at a negative $4,092. In some businesses in order to increase the profit you have to lose money to begin with. At first we might lose some money if you want to look at it but our long term revenue is sure to surpass the net income of the first year.
| Year | 1 | 2 | 3 | |
| Revenues | ||||
| Software Subscription | 20,988 | 35,500 | 53,500 | |
| Total Revenues | 20,988 | 35,500 | 53,500 | |
| Expenses | ||||
| Advertising/Marketing | 1,500 | 2,000 | 3,000 | |
| Attorney Fees | 2,000 | 2,000 | 2,000 | |
| Employees | 10,000 | 10,000 | 15,000 | |
| Internet | 125 | 125 | 125 | |
| License and Permits | 375 | 375 | 375 | |
| Office Equipment Lease | 280 | 280 | 280 | |
| Office Space | 0 | 0 | 0 | |
| Office Supplies | 1,000 | 1,000 | 1,000 | |
| Phone | 200 | 200 | 200 | |
| Software Development | 5,000 | 5,000 | 5,000 | |
| Software Manufacturing | 3,000 | 3,000 | 3,000 | |
| Technical Maintenance | 1,500 | 1,500 | 1,500 | |
| Travel/Entertainment | 0 | 0 | 1,500 | |
| Utilities | 0 | 0 | 0 | |
| Website/Webhosting | 100 | 100 | 100 | |
| Total Expenses | 25,080 | 25,580 | 33,080 | |
| Net income | -4,092 | 9920 | 20420 |
Fixed and Variable Cost:
The companyâs fixed costs will mainly be Attorney fees, Internet, Licence/Permit fees, Office equipment lease, phone bills, software development, software manufacturing, technical maintenance and web hosting. This is because all of these expenses are expected to stay the same throughout the first couple of years. These costs are expected to stay the same because the company will be relatively new and the expected growth is not exponentially high in the first couple of years. The costs that are variable are the marketing, employee wages, and travel. These costs are the variable cost because these costs can change very fast as the needs of the company change over time, compared to fixed cost which only change after a large effect on the business such as increase in funding or growth over the years forces the company to expand.
Operating Leverage and Its Implications
Operating Leverage
Implications
Start-up Costs:
The company I-lingo will be a brand new business with startup expenses as every other company does. In producing the app, partnering with Doulingo the company will be able to expand on Doulingoâs original application and venture out to a more advanced application. The companyâs total expenses in the first year would be an estimated $25,080. This estimated number was calculated by the estimated amount it would cost to develop the app, the amount of money we would need to pay employees, advertising/marketing, etc. The financial sector of I-lingo found an app develop estimator online that gave us a really rough estimate on where to start our expenses in just producing the app itself, which would have cost us twice as much with an average price of $100K. The estimate of $15,000 to produce the app led us to think of other expenses such as paying employees, licenses, permits, utilities, advertising and etc.
Break-even Chart and Calculation:
I.Marketing Plan:
A.Overall Marketing Strategy
B.Product, Price, Promotion, and Distribution
C.Sales Process (or Cycle)
D.Sales Tactics
Proprietary Issues:
The company will have to get a patent on the way app delivers the translation at a fast and accurate pace, because the technology that will be used in the app will be new and innovative in that field. The type of patent the company will need to get will be a utility patent from the US Patent and Trademark Office, this is because a utility patent covers the creation of a new improved/useful product, process/machine. After filing for the utility patent the company will be able to hold the patent in the United States for up to 20 years.
The name of the company ilingo will be trademarked in order to create an exclusive identity of the companyâs product/services and the recognition of the companyâs ownership of the brand. To file a for a trademark in the United States the company will have to file with the US Patent and Trademark Office. The trademark in the US will be renewable every 10 years as long the the company remains the use of the name.
The other licenses that the company ilingo will need to acquire will be patents and trademarks in other countries around the world. Since ilingo will be a new startup it would not make sense to start applying for patents and trademarks in other countries in the first couple of years. However, when ilingo gets a large enough customer base in the United States and it is considering marketing to potential customers in other countries ilingo will need to secure their intellectual property in other countries at that point.
Operations Plan
General Approach to Operations
Day to day operations will mainly consist of back stage activities, as our tangible capital will remain very limited. The five founders provide sound and efficient staffing for maintaining business needs as well as customer demands.
-Labor: There is currently no need to operate outside of the five founders, which will keep labor costs down and keep activities within day to day operations very close-knit. Future planned marketing campaigns may consist of volunteers or interns, in attempts to spread awareness of our brand and product. Small incentive programs may become available, as in a free 3 month membership to our app, but all interns will be cost free and 100% volunteer work.
-Roles of the 5 founders:
-CEO:
-
Remain focused on people, product, and market.
Brand management and increase market credibility.
Maintaining relationships with partners and investors.
-COO:
-Designing and implementing business strategies, plans and procedures.
-Establishing policies that promote company culture and vision.
-Overseeing operations of the company and the work of executives (IT, Marketing, Sales, Finance etc.).
-Evaluate performance by analyzing and interpreting data and metrics
-Write and submit reports to the CEO in all matters of importance
-Assist CEO in fundraising ventures
-Participate in expansion activities (investments, acquisitions, corporate alliances etc.)
-Manage relationships with partners/vendors
-CFO (CTO):
-All financial overseeing will be done in house, but the more important role of the CFO related to day to day operations is their duty as the head of Technology. The CFO lead the development of the app, and will continue to work as our IT and technical support, and will work directly with customer inquiries, and pushing through timely updates for the app.
-CMO:
-Evolve product for consistent market fit, adapt to market changes.
-Continually collect new data to test changing demand.
-Track customer acquisitions and lifecycle to improve and expand demand.
-Work directly with advertising partners, building outside relationships.
-Works directly with CFO/CTO on maintaining image and brand.
-Builds new partnerships to increase and expand target market, customer use, and customer engagement by creating new marketing channels worldwide.
-CHO (Head of HR): Not applicable at this time.
- Materials and equipment: All materials and equipment will be personally funded and incur zero cost to the company.
Business Location/Facilities
A key element of keeping costs down with more flexibility to maintain profits is that there are no overhead costs for business location. All business will be operated out of in house facilities that will not incur any fixed or variable costs. If any costs are involved in the area of location, these costs will be personal costs and will not fall under the companyâs finances. Ultimately, much of our operations could take place in any facility that has basic internet and wifi access.
Section VIII: Design and Development Plan
CURRENT STATUS:
Our product is currently under development by our information systems engineers and our software development engineers. The app will use the GNMT data base. The GNMT database is owned and powered by Google. GNMT stands for Google Neural Machine Translation system. It essentially takes into consideration source words and phrases, but also broader contexts of where they appear in sentences, and what are the other words and phrases around them.
For example, when translating Spanish-English, French-English, we are able to then code the system from translations of pairs it has not seen before. It is a self-learning algorithm. The database will then âlearnâ how to translate between French-Spanish by using the base language of English.
Our Company is partnering with Nuance Communications to help develop our translation software. Nuance focuses on server and client side speech recognition. They have helped companies such as, Apple, when they came out with Siri.
Similar to Siri, we need our product to be able to combine speech recognition with advanced natural-language processing. The hardest part about this process is normally translators require an internet connection, which allows the client to connect to the server. We want to change the game by storing the base language and the target language directly on the client for faster translation. The amazing part about not needing an internet connection is that our users will be able to go to rural vacation destinations and assimilate with the natives of that country.
CHALLENGES AND RISKS:
The team is working diligently to introduce the product into the market. We need more funding for our software development and overall costs. Creating an application that can be independent of an internet connection is very expensive. However, we are not paying ourselves a salary until we become profitable.
1.What Are the legal status and ownership process to this new app?
2.What would be the ideal operating leverage and its implications?
3. What is the desired profit margin?
4. what are the sources and uses pf funds statement?
Taylor Brands
Cost of Capital or Required Rate of Return
The management of Taylor Brands has a philosophy of "better to be safe than sorry" when selecting a discount rate. At present the firm uses a 30 percent rate, which many company executives feel is unreasonably high and results in the following difficulties. First, some projects considered to be worthwhile and important are rejected because their expected return is close to, but still below, the 30 percent minimum. Second, managers have a tendency to be overly optimistic in their cash flow projections in order to get their pet projects accepted. Third, there is the feeling that the rate is at best arbitrarily determined and at worst something that Trevor Unruh-Taylor's general manager-has "pulled out of a hat."
ROBERT WEST
Robert West is one of Taylor's more innovative and thoughtful executives. A few years ago he correctly perceived that a successful firm in the food wholesalers industry-Taylor's main industry-would have to expand into nonfood items. After extensive study, West recommended that Taylor add such products as light hardware and paper plates to the variety of goods it sells to grocery stores. This strategy worked remarkably well. Taylor's customers benefited because they dealt with fewer vendors and invoices. Taylor gained customers (many were referrals) and also reduced its unit cost by making more efficient use of its trucking capacity.
West has developed an interest in the financial side of the business. During the past year he attended two seminars on cost-of-capital estimation, using his personal leave time and at his own expense. He has been eager to apply this newly acquired knowledge, and after a number of discussions Unruh told West to "determine Taylor's cost of capital and make a formal report on your findings." It seemed to West that this was a major coup since Unruh paid little attention to the financial side of the business. He was told privately, however, that Unruh is "really unimpressed and bored with the entire idea; he assigned you this project because he knew that you were eager to do it, and Unruh admires your initiative." West was told quite bluntly that "nothing will come of your efforts."
Initially deflated, West became determined to do a thorough evaluation, and he felt sure that he could convince Unruh of the importance of obtaining an accurate cost of capital. "At the very least," West thought, "a formal investigation of our cost of capital will eliminate the perception that it is arbitrarily determined."
In preparation for making the estimate West reviewed his notes from one of the seminars he had attended. (See Exhibit 1.) He recalled the instructor emphasizing that estimating the required return on equity was especially delicate; and although the instructor gave two models for measuring this return, he emphasized there was "no substitute for good judgment."
FINANCIAL INFORMATION
West also collected some financial information that he felt was relevant to the analysis. He knows the company has recently obtained a bank note at 7 percent and that the company's bonds were originally issued at 7 percent but are currently selling at a discount with a yield to maturity of about 8 percent.
Taylor's EPS has grown quite impressively in the last five years (see Exhibit 3), but West knows Unruh encouraged a relatively constant dividend per share over this period since he preferred to reinvest much of the company's earnings. West doesn't believe this will continue since Unruh is under pressure from major stockholders to bring dividend growth in line with earnings growth. Nor is it likely that past EPS growth can be maintained. First, during this period the industry itself had unusual prosperity. Second, some of this past growth was a result of the firm's movement into nonfood items, and these opportunities are virtually exhausted. Third, many corporate insiders felt Taylor had been a bit lucky.
West decides it is reasonable to suppose that Taylor will implement a 70 percent payout ratio; after all, it makes no sense to retain a large proportion of earnings when investment opportunities are not as plentiful as in the past. He also feels that the company will achieve an average return of 12 percent on any retained earnings. Though these figures on payout and return are something of "guesstimates," West was able to find support for these numbers among Taylor's managers.
Most financial analysts consider the industry to be of average risk, and in fact, beta estimates for Taylor range from .8 to 1.2. West decides, however, that these estimates are a bit high, because the firm is in the process of altering production techniques that will reduce the company's degree of operating leverage.
And there is another difficulty. At present Taylor has no preferred stock in its capital structure. But West knows that there are plans to issue some in the next few months, though the price and dividend per share have not yet been determined. However, he does have some information on the preferred stock of three of Taylor's competitors. (See Exhibit 6.) These companies are much larger than Taylor and are considered less risky because they have a more diversified product line and customer base and enjoy a lower degree of operating leverage (even after the change in Taylor's production techniques). He is also aware that the yield difference on the preferred stock of firms in roughly the same industry is 75 to 100 basis points.
"I've got quite a bit of info," West thought. "I hope I can put it all together to make a report that will impress Unruh."
EXHIBIT 1
Excerpts from West's Notes on the Cost of Capital Seminars
1. The instructor said the cost of capital is really the required rate of return or hurdle rate that should be used to evaluate capital budgeting projects of average risk for the company. (Indeed, he much prefers the term "required rate of return" to the more common but potentially misleading "cost of capital.")
2. The cost of capital is a weighted average of the required return on each financing source. Theoretical accuracy requires these weights be obtained at the market values of debt, equity, and (if applicable) preferred stock. The instructor said, however, that most firms use book values because (1) it is easier, and (2) market values tend to vary widely.
3. The instructor recommended that all debt that does not require an explicit return be excluded when calculating the weights described in part 2. (Usually this means excluding accounts payable and accruals.)
4. The required return on each financing source should be based on current market conditions.
5. The instructor recommended that flotation costs be ignored. While theoretically incorrect this omission simplifies the calculations and does not significantly alter the estimate.
EXHIBIT 2
| Historical Estimates of Yearly Returns on Various Investments: 1926-1992 | |
| Investment | (Arithmetic Average) Average Yearly Return (%) |
| Common stocks | 12.1 |
| Small capitalization stocks | 17.1 |
| Long-term government bonds | 4.9 |
| Long-term corporate bonds | 5.5 |
EXHIBIT 3
| EPS and DPS Information on Taylor | ||||
| Year | EPS | Change (%) | DPS | Change (%) |
| 1991 | $0.73 | $0.40 | ||
| 1992 | 0.82 | 12.3 | 0.40 | 0 |
| 1993 | 1.14 | 39.0 | 0.40 | 0 |
| 1994 | 1.85 | 62.3 | 0.41 | 2.5 |
| 1995 | 2.35 | 27.0 | 0.43 | 4.9 |
| 1996 (present) | 2.83 | 20.4 | 0.45 | 4.7 |
EXHIBIT 4
| Financial Information Compiled by West | |
| Treasury bill rate | 5.5% |
| Long-term government bond rate | 7% |
| Long-term corporate bond rate | 8% |
| Current annual yield on Taylor's long-term debt | 8% |
| Current dividend on Taylor's stock | $0.45 |
| Price range of Taylor's stock, previous year | 28-36 |
| Rate on recent short-term loan (note) | 7% |
| Taylor's tax rate | 40% |
EXHIBIT 5
| Taylor's Financial Structure at Book Values ($000s) | |
| Accounts payable | 45,000 |
| Notes payable | 16,000 |
| Accruals and other current liabilities | 8,000 |
| Bonds | 89,000 |
| Common stock | 58,000 |
| Retained earnings | 72,000 |
| Total liabilities and equity | 288,000 |
EXHIBIT 6
| Preferred Stock Information on Taylor's Competitors | |||
| Firm | Original Price of Preferred | Current Price of Preferred | Dividend |
| Super Foods | $50 | $40 | $3.00 |
| Easton | $41 | $31 | $2.25 |
| Westgate | $46 | $45 | $3.00 |
Please Answer 1, 2a, 2b, 4, 6, 7d, 9a, 9b, 10a, 10b
Question 1
West intends to adjust Taylor's beta estimates slightly downward in view of the fact that the firm's degree of operating leverage is decreasing. Does such an adjustment seem appropriate? Explain.
Question 2
The required return on equity (cost of equity), Ke, can be estimated in a number of ways.
(a) Estimate Ke using a risk premium approach.
(c) In your view, what is Ke? Justify your choice.
Question 4
Preferred stock is a riskier investment than a bond. Yet companies have been known to issue preferred stock at a lower yield than they issue bonds. How can this be, assuming investors are rational?
Question 6
What additional information would you like in order to make more informed estimates about the cost of equity and the cost of preferred stock?
Question 7
(d) Estimate Taylor's cost of capital or required return assuming that these market values are consistent with the financing weights desired by management. (You may ignore preferred stock.)
Question 9
(a) Apparently the 30 percent hurdle rate used by Taylor exceeds its actual cost of capital or required rate of return. Let us suppose a company errs in the other direction and chooses a hurdle rate considerably less than its actual cost of capital. What difficulties could this cause?
(b) West believes that Taylorâs high cost of capital encourages managers to develop overly optimistic cash flow forecasts. Is a more accurate cost-of-capital estimate likely to reduce this bias, as he apparently thinks? Explain your answer.
Question 10
(a) Suppose that West will present a summary of his findings to senior management. Would you recommend that he presents his estimate or Taylorâs required return (cost of capital) as XX percent, XX.X percent or XX.XX percent? That is, how- if at all- would you suggest the estimate be rounded off? (Keep in mind that he is likely to be questioned thoroughly by Unruh, who appears skeptical of Westâs efforts.)
(b) Would you recommend that West use market or book values in his presentation? Defend your recommendation.
