FINA 470 Chapter Notes - Chapter 3: Preferred Stock, Special Purpose Entity, Financial Statement
Document Summary
Get access
Related Documents
Related Questions
1. Define the terms capital structure, cost of capital, and working capital. Focus on how they are different from each other and impact both profitability and risk.
2. Determine Grounds Keeper’s capital structure and working capital.
3. If Grounds Keeper has a required rate of return on its long-term debt of 9% (before taxes) and a required rate of return on its common stock, a tax rate of 40%, what is its weighted average cost of capital (WACC) for 2012? How could Grounds Keeper lower its WACC? (HINT: you will need to look at the balance sheet to determine the weight of debt to equity.
4. What are the advantages to Grounds Keeper in using money market instruments as financing? How does this related to financing net working capital?
| Grounds Keeper | ||
| Consolidated Balance Sheets | ||
| (Dollars in thousands) | ||
| 2012 | 2011 | |
| Assets | ||
| Current assets: | ||
| Cash and cash equivalents | 78,240 | 44,395 |
| Receivables | 399,891 | 340,062 |
| Inventories | 844,737 | 736,677 |
| Total current assets | 1,322,868 | 1,121,133 |
| Fixed assets, net | 1,244,384 | 889,613 |
| Other long-term assets | 1,048,537 | 1,187,141 |
| Total assets | 3,615,789 | 3,197,887 |
| Liabilities and Stockholders’ Equity | ||
| Current liabilities: | ||
| Accounts payable | 309,222 | 319,465 |
| Accruals | 201,017 | 145,240 |
| Notes payable | 9,748 | 6,669 |
| Total current liabilities | 519987 | 471374 |
| Long-term debt | 834574 | 814298 |
| Total liabilities | 1,354,561 | 1,285,672 |
| Stockholders’ equity: | ||
| Common stock, $0.10 par value: | 15,268 | 15,447 |
| Additional paid-in capital | 1,464,560 | 1,499,616 |
| Retained earnings | 781400 | 397152 |
| Total stockholders’ equity | 2,261,228 | 1,912,215 |
| Total liabilities and stockholders’ equity | 3,615,789 | 3,197,887 |
| Grounds Keeper | |||||
| Consolidated Statements of Operations | |||||
| (Dollars in thousands except per share data) | |||||
| 2011 | ||||
| Net sales | 3,889,426 | 2,642,390 | |||
| Cost of sales | 2,589,799 | 1,746,274 | |||
| Gross profit | 1,299,627 | 896,116 | |||
| Selling and operating expenses | 481,493 | 348,696 | |||
| General and administrative expenses | 219,010 | 187,016 | |||
| Operating income | 599,124 | 360,404 | |||
| Interest expense | 22,983 | 57,657 | |||
| Income before income taxes | 576,141 | 302,747 | |||
| Income tax expense | 212,641 | 101,699 | |||
| Net Income | 363,500 | 201,048 | |||
| Basic income per share: | |||||
| Average shares outstanding | 154,933,948 | 146,214,860 | |||
| Earnings per common share | 2.35 | 1.38 |
Below is the provided information/scenario.
Grounds Keeper is considering adding fair trade coffee to their line of products. Other larger coffee companies are now including it, at consumers’ insistence. At a recent strategic management meeting, the company’s officers identified the following points:
Fair trade coffee may attract new customers.
Fair trade coffee would allow Grounds Keeper to demonstrate its social responsibility.
Fair trade coffee would require more paperwork to meet certification and contract requirements.
The higher cost of Fair Trade Coffee would require a higher price or a reduced profit margin.
If coffee prices worldwide continue to increase, consumers may be reluctant to pay extra for Fair Trade Coffee.
Current suppliers of coffee to Grounds Keeper might be in competition with Fair Trade Coffee cooperatives.
One officer present asked the following question: Should we as a company have a good reason to try to influence actions in other parts of the world? Don’t we have governments to do that?
Fair Trade Coffee
What is fair trade certification?
Much like organic certification, fair trade certification lets you know about the origin of a product. Fair trade certified products come from all over the world, but share a common history. Farmers who grow fair trade products receive a fair price, and their communities and the environment benefit as well.
Fair trade certified coffee directly supports a better life for farming families in the developing world through fair prices, community development and environmental stewardship. Fair trade farmers market their own harvests through direct, long-term contracts with international buyers, learning how to manage their businesses and compete in the global marketplace. Receiving a fair price for their harvest allows these farmers to invest in their families' health care and education, reinvest in quality and protect the environment. This empowerment model lifts farming families from poverty through trade, not aid, creating a more equitable and sustainable model of international trade that benefits producers, consumers, industry and the Earth. The Fair for Life label is backed by IMO, one of the third-party certifiers of fair trade products for the U.S. market.
The Fair for Life label guarantees:
Fair price: Family farmers receive fair prices for their harvest, and premiums specifically earmarked for community development projects; even higher premiums are given for certified organic products. Farmer organizations are also eligible for pre-harvest credit.
Environmental sustainability: Harmful agrochemicals and GMOs are strictly prohibited in favor of environmentally sustainable farming methods that protect farmers' health and preserve valuable ecosystems for future generations. Fair trade farmers protect the land and wildlife habitat by intercropping plant species to improve soil fertility and protect against erosion. Stringent environmental management programs, including water conservation, proper waste disposal and prohibitions on planting in protected areas further encourage environmental stewardship.
Fair labor conditions: Workers on fair trade farms enjoy freedom of association, safe working conditions and fair wages. Forced child labor is strictly prohibited.
Direct trade: Importers purchase from fair trade producer groups as directly as possible, eliminating unnecessary middlemen and empowering farmers to develop the business capacity needed to compete in the global marketplace.
Democratic and transparent organizations: Fair trade farmers and farm workers decide how to invest fair trade revenues, and proof of a democratic process is required.
Community development: Fair trade farmers and workers invest fair trade premiums in social and business development projects like scholarship programs, healthcare services and quality improvement training.
Examples of community projects include:
Members of the COSURCA coffee cooperative in Colombia successfully prevented the cultivation of more than 1,600 acres of coca and poppy used to produce illicit drugs.
In the highlands of Guatemala, indigenous Tzutuhil Mayans in the La Voz cooperative are sending local kids to college for the first time.
Near Lake Titicaca, in Peru, the CECOVASA cooperative is assisting members from Quechua and Aymara indigenous groups in improving coffee quality and transitioning to certified organic production.
The CECOCAFEN cooperative in Nicaragua established a reproductive health program providing tests for the virus that causes cervical cancer.
What is IMO "Fair for Life" fair trade certification?
"Fair for Life" is a brand neutral third party certification program for social accountability and fair trade in agricultural, manufacturing and trading operations. The program complements existing fair trade certification systems. Social accountability and fair trade have become important indicators to select business partners in a global market place. The Fair for Life Social & FairTrade Certification Program offers operators of socially responsible projects a solution for objective inspection and certification by a highly qualified external verifier. It combines strict social and fair trade standards with adaptability to local conditions.
Why is fair trade certification needed today?
Throughout the global south, family farmers follow generations of tradition to cultivate food products we enjoy every day. Yet many family farmers in the developing world don't receive a fair price for their crops. These isolated rural communities lack direct market access, often selling their premium crops below the cost of production to local middlemen who misrepresent global prices. This cycle of debt forces many to abandon their land and years of agricultural heritage, destroying the social and cultural fabric of these communities. When farming communities in the developing world suffer, the whole world suffers - forced immigration, inferior-quality products and large-scale farming methods that often compromise the environment.
Who benefits from fair trade certification?
Producers: Beyond receiving a fair, stable price, fair trade also empowers producers to invest in their organizations, improve their communities and protect the environment.
Consumers: Fair trade certification enables consumers to "vote with their dollar" by providing an independent guarantee that products were produced and traded fairly. We all lead busy lives, and we want to do the right thing, but we're busy. What if we could make a positive impact just with the purchases we make every day? And not have to go out of our way to do this? That's the compelling proposition of fair trade.
The Earth: Fair trade certification requires and rewards environmentally sustainable farming practices that protect farmers' health and preserve valuable ecosystems for future generations, and provides the resources and technical assistance needed for organic certification.
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 Taylor’s 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 Taylor’s 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 West’s efforts.)
(b) Would you recommend that West use market or book values in his presentation? Defend your recommendation.
