CASE

3
Glen Mount Furniture Company
Fumiture magnate Carl Thompson distribution capabilities, and yet all the
couldn't believe the amount of pressure questions seemed to deal with near term
security analysts could put on a fumo eamings performance. He felt that he
The Glen Mount Fumiture Company was a would eventually have an opportunity to
leading manufacturer of fine home discuss the above-mentioned management
furnishings and distributed its product initiatives and their impact on the company
directly to departrnent stores, independent for the next decade, but current eamings
home furnishing retailers, and a few regional per share seemed to gather the attention of
furniture chains. The firm specialized in the analysts.
bedroom, dining room, and living room Carl knew only too well from past
furniture and had three plants in North experience that the eamings performance of
Carolina and two in Virginia. Its home the fum would affect the company's price-
office was in High Point, North Carolina. earnings ratio and its market value.
In a recent presentation to the Atlanta Furthermore, before Carl became president
chapter of the Financial Analysts of Glen Mount Fumiture Company, he had
Federation, Carl Thompson barely had attended a six-week Executive Development
taken a bite out of his salad when two Program at the Harvard Business School in
analysts from Smith Bamey, Harris Upham which he heard a number of professors
& Co., a stock brokerage firm, began stress the importance of the goal of
asking questions. They were particularly stockholder wealth maximization. He often
concemed about Glen Mount's growth rate wondered if other iterns were not equally
in eamings per share. important to the company, such as
Carl was aware that security analysts cornmunity service (the fum donated
considered earnings performance to be $60,000 ayear to a local university to help
important, but he was somewhat distressed supplement faculty salaries for outstanding
by the fact that this seemed to be their professors). He also had a sense of pride that
overriding concem. It bothered him that the his fum provided employment to over 500
fum had just spent over $10 million to people in the area. He was not sure that the
develop exciting new product lines, security analysts would consider these items
modemize production facilities, and expand to be of particular importance.
12 Case 3

With all ofthese thoughts in mind, his upcoming meeting with ChiefFinancial
Officer Barbara Bainesworth became particularly important.
When Barbara arrived, she had a number of financial documents to review for
the purpose of making key decisions. In Figure 1, she showed the eamings
performance of the company over the last five years. Figure 2 provided a current
balance sheet, and Figure 3 represented an abbreviated income statement for 2010.
The firm was considering buying back 625,000 shares of stock outstanding at
$16 per share. This would represent $10 million in total. The funds to purchase
the shares would be acquired from a new bond issue that would carry an interest
rate of 1l.25 percent. The bond would have a 15-year life. The firm was in a 34
percent tax bracket.

Figure 1 Earnings per share for the last five years

Year t" Quarter 2/1d Quarter 3rd Quarter 41h Quarter Yearly Total
2003 . $.23 $.25 $.19 $.34 $1.01
2004 . .26 .28 .27 Al 1.22
2005 . .34 .36 .33 A8 1.51
2006 . .35 .37 .34 A9 1.55
2007 . .35 .36 .36 A9 1.56

Figure 2
GLE MOUNT FURNITURE COMPANY

Balance Sheet

December 31,2010
Assets
Current assets:
Cash . $ 350,000
Marketable securities . 90,000
Accounts receivable . 5,000,000
lnventory . 7.000,000
Total current assets . 12,440,000

Other Assets:
Investments . 5,000,000
Fixed Assets
Plant and equipment . 27,060,000
Less: Accumulated depreciation . 4,000.000
Net plant and equipment . 23,060,000
Total assets . $ 40,500 000
Gle Mount Fumiture Company 13

Liabilities and Stockholder ' Equity

Current liabilities: .
Accounts payable . $ 4,400,000
Wages payable . 150,000
Accrued expenses . 950.000
Total current liabilities . 5,500,000
Long-terrn liabilities .
Bonds payable, 10.625% . 12,000,000
Stockholders' equity .
Common stock, $1 par value, 2,000,000 shares . 2,000,000
Capital in excess of par . 8,000,000
Retained earnings . 13,000,000
Total stockholders' equity . 23,000,000
Totalliabilities and stockholders' equity ..;,::.; . 40500000

Figure 3
GLEN MOUNT FURNITURE COMP ANY
Abbreviated Income Statement
For the Year Ended December 31, 2010
Sales $45,000,000
Less: Fixed Costs 12,900,000
Less: Variable Costs (58% of sales) . 26,100,000
Operating income (EBIT) . $ 6,000,000
Less: Interest 1,275,000
Eamings before taxes (EBT) . $ 4,725,000
Less: Taxes (34%) 1,606,500
Eamings after taxes (EA T) . $ 3,118,500
Shares 2,000,000
Eamings per share $ 1.56
14 Case 3

Required 1. Project eamings per share for 2011 assuming that sales increase
by $500,000. Use Figure 3 as the model for the calculation.
Further as sume that the capital structure is not changed.
2. By what percent did eamings per share increase from 2010 to
2011?
3. Now assume that $10 million of debt replaces 625,000 shares of
common stock as described in the case. The interest on the new
debt will be 11.25 percent. What will projected eamings per
share be for 2011 based on the anticipated sales increase of
$500,000?
4. Based on your answer to question 3, by what percent would
eamings per share increase from 2010 to 2011 ?
5. Compute the degree of financial leverage (DFL) for the answer
to question 1 and for the answer to question 3.
6. Using the formula in footnote 3 of Chapter 5, compute degree of
combined leverage (DCL) for the answer to question 1 and the
answer to question 3.
7. What is the total debt to assets ratio as shown in the 2010
balance sheet (Figure 2)? What will it be if $10 million worth of
stockholders' equity is replaced with debt?
8. What do you think might happen to the stock price as a result of
replacing $10 million worth of stockholders' equity with debt?
Consider any relevant factors.
 CASE

4
Genuine Motor Products

Genuine Motor Products, located highly labor intensive as indicated by the

in Northem Ohio, manufactures precision fact that fixed assets (net plant and
measuring devices to monitor exhaust equipment) represented only $8 million
emission systems for new and used out of total assets of $24 million (Figure
automobiles. Its products are soId 1) and that variable costs per unit were
worldwide. $25 in comparison to a sales price of $30
The firm hired Mike Anton in January per unit (Figure 2).
of 2009 as vice president in charge of Although he thought the pro forma
manufacturing operations. Mike had a income statement for 2009 as shown in
bachelor's degree in industrial Figure 2 looked reasonably good, he be-
engineering from Case Westem Reserve lieved retums could be better if the firm
University and an MBA from Ohio State went to greater automation and was less
University. He had spent the last 15 years dependent on labor and expensive
working for General Motors (Arlington, materials.
Texas division). Toyota Motor Corp., and When he shared his thoughts with
Volvo. At age 38, he had established a Harry Engle, the chief financial officer,
good reputation for innovation within the the response he received was lukewarm.
auto and auto parts industry. Harry had been with the firm in good
Upon being hired, he began looking times as well as bad over the last 20 years
over the financial statements, particularly and was quick to point out the advantages
the balance sheet as of December 3 1, of not being tied up with a lot of fixed
2008 and the pro forma income statement costs and debt during a slowdown in sales
for 2009 as shown in Figure 1 and 2, in the auto industry. As Harry was fond of
respectively. His immediate reaction was saying, "Genuine Motor Products does
that the firm had not made the move to not have a labor union and when business
automation that others in the industry hado is bad, we lay people off. By gosh, you
The company's manufacturing process was can't lay machinery and equipment off."
16 Case 4

Figure 1
GE VINE MOTOR PRODVCTS
Balance Sheet
As ofDecember 31, 2008
Assets
Current assets . $16,000,000
Fixed assets
Plant and equipment . $20,000,000
Less: accumulated depreciation . 12,000,000
et plant and equipment.. . 8,000,000
Total assets . $24,000,000
Liabilities and Stockholders' Equity
Current liabilities . 10,000,000
Long-term liabilities:
Bonds payable 10.75% . 2,000,000
Totalliabilities . $12,000,000
Stockholders' equity:
Common stock, $1 par value, 2,000,000 shares . $ 2,000,000
Capital in excess of par.. . 4,000,000
Retained earnings . 6,000,000
Total stockholders' equity . $12,000,000
Totalliabilities and stockholders' equity . $24,000,000

Figure 2
GE VINE MOTOR PRODVCTS

Pro forma Income Statement

For 2009
Sales (1,000,000 units @ $30 per unit) . $30,000,000
- Fixed costs* . 2,000,000
- Total variable costs (1,000,000 units @ $25 per unit 25,000,000
Operating income (EBIT) . $ 3,000,000
- Interest (10.75% x $2,000,000) . 215,000
Earnings before taxes . $ 2,785,000
- Taxes (35%) . 974,750
Earnings after taxes . $ 1,810,250
Shares . 2,000,000
Earnings per share . $ .91
* Fixed costs incJude$I,OOO,OOOin depreciation
Genuine Motor Products 17

In spite of Harry's arguments, Mike Anton was determined to show the

impact of both operating and financial leverage on Genuine Motor Products
operations. He reconstructed the year-end balance sheet for 2008 (previously
shown in Figure 1), and the results are shown in Figure 3 based on the following
assumptions.

l. That the firm would increase fixed assets by $14 million dollars.
2. That $10 million of the $14 would be funded through long-term debt in the
form ofadditional bonds payable at an interest rate of 10.75%.
3. The remaining $4 million would come from the sale of additional common
stock at a net price to the corporation of $12.50. This would require the
issuance of320,000 new shares ($4 million/$12.50 = 320,000 shares).

The impact of these values on the balance sheet in Figure 3 shows

substantially greater leverage both on the asset and liability side.

Figure 3
GENUINE MOTOR PRODUCTS
Revised Balance Sheet
For the year ended December 31, 2008
Assets
Current assets . $16,000,000
Fixed Assets
Plant and equipment . $34,000,000
Less: Accumulated depreciation . 12,000,000
Net plant and equipment... . 22,000,000
Total assets . $38,000,000
Liabilities and Stockholders' Equity
Current liabilities . 10,000,000
Long-term liabilities:
Bonds payable 10.75% . 12,000,000
Totalliabilities . $22,000,000
Stockholders' equity:
Cornmon stock, $1 par value, 2,320,000 shares . $ 2,320,000*
Capital in excess of par.. . 7,680,000**
Retained earnings . 6,000,000
Total stockholders' equity . $16,000,000
Totalliabilities and stockholders' equity . $38,000,000

*2,000,000 old shares + 320,000 new shares = 2,320,000 shares

** 4,000,000 old capital in excess ofpar + 320,000 new shares x ($12.50 price - $1 par value) =
4,000,000 + 320,000 ($1l.50) = $7,680,000
18 Case 4

The intent of using more leverage was to increase the potential profitability
of the firmo You are called in as a financial analyst to rework the 2009 pro forma
income statement based on the assumptions stated in Table l. These prirnarily
relate to the fact there are now more fixed assets, long-term debt, and shares
outstanding.

Table 1
Assumptions for Revised Pro Forma Income Statement
1. Sales will remain constant at 1,000,000 units at $30 per unit.
2. Fixed costs will increase from 2,000,0000 to 5,800,000, a gain of $3,800,000.
(Depreciation expense will be 2,800,000 and this will be shown as a footnote in the 2009
pro forma income statement).
3. Variable cost per unit will be reduced from $25 to $18.80. A total of 1,000,000 units will
still be sold. The reduction in variable costs per unit is a direct result of the increased fixed
costs and the associated automation.
4. Interest expense will reflect that there is now $12 million in long-term debt in the form of
bonds payable at 10.75%. Ten million dollars of new debt is being added to $2 million of
old debt.
5. Shares outstanding are now at a level of2,320,000. Three hundred and twenty thousand new
shares are being added to the 2,000,000 old shares currently outstanding.

Required 1. Complete the revised pro forma income statement below. In the
process, refer back to Figure 2, the original pro forma income
statement for 2009 and the assumptions in Table 1. The new
statement you are developing below will be referred to as Figure 4
for purposes of reference.

Figure 4
GE VI E MOTOR PRODVCTS
Revised Pro forma Income Statement
For 2009

Sales (1,000,000 units @ $30 per unit) . $30,000,000

- Fixed costs* . 5,800,000
- Total variable costs (1,000,000 units @ $18.80 per unit
Operating income (EBIT) .
- Interest (10.75% x $12,000,000) .
Eamings before taxes .
- Taxes (35%) .
Eamings after taxes .
Shares . 2,320,000
Eamings per share . $ 1.15
* Fixed costs include $2,800,000 in depreciation
Genuine Motor Products 19

Required
2. Explain the primary reasons for the change in eamings per share between
Figure 2 and Figure 4.
3. To determine the extent the company is more leveraged than it was prior
to changes suggested by Mike Anton, compute degree of operating
leverage (DOL), degree of financial leverage (DFL), and degree of
combined leverage (DCL) both for Figure 2 (before changes) and Figure
4 (after changes). Use equations 5-3, 5-5, and 5-7 from the text.
4. Using the same financial statements (Figure 2 and Figure 4), compute
the breakeven point before and after the changes. Use equation 5-1 from
the text.
5. Assume you use a different measure of break-even analysis. The answer
to question 4 tells you the number of units the firm needs to sell to cover
fixed costs. Assume you are interested in covering all cash outflows and,
furthermore, will use only cash flow numbers rather than accounting
numbers. The cash outflows to be covered are (Fixed costs -
depreciation) plus interest payments.

The formula for the revised break-even (BE) point is:

. d (Fixed costs - depreciation) + Interest

Revise BE = -'----:--:---:-----:--"-------'-----
Price (p) - (VC) variable cost per unit

Apply this formula to Figure 2 to get the revised break-even point before
the changes and Figure 4 to get the revised break-even point after the
changes. (Note the value for depreciation can be found as a footnote at
the bottom of the two figures).
6. Harry Engle suggests that the company could be in trouble if Mike
Anton's changes are put in place (as reflected in Figure 4) and sales
volume is only 300,000 units. Using your revised break-even answers
from question 5, do you agree?
7. Finally, assume sales volume reaches 1,500,000 units after Mike Anton's
changes are put into place. What will the new figure be for eamings per
share? Under the old plan, eamings per share at 1,500,000 units would be
$1.72.
p

20 Case 4

Sales (1,500,000 units @ $30 per unit) . $45,000,000

- Fixed costs . 5,800,000
- Total variable costs (1,500,000 units @ $18.80 per unit)
Operating income .
- Interest (10.75% x $12,000,000) .
Earnings before taxes .
- Taxes (35%) .
Eamings after taxes .
Shares . 2,320,000
Eamings per share .

8. After computing all the numbers in the case, are you inclined to agree with
Mike Anton that the changes to automation would be a good idea or Harry
Engle, the chief financial officer, that they would not be? What is likely to
be the key variable in determining the success or failure of the new plan?
 CASE

5
Gale Force Surfing

During mid-September 2008, the top for interest expense. Look here, we paid
managers of the Gale Force Corporation, a over $250,000 last year to the bank just to
leading manufacturer of windsurfing finance our short-term borrowing. -If we
equipment and surfboards, were gathered in could have kept that money instead, our
the president' s conference room reviewing profit margin ratio would have been 4.01
the results of the company's operations percent, which is higher than any other
during the past fiscal year (which runs from firm in the industry."
October 1 to September 30). "But, Tim, we have to borrow like
''Not abad year, on the whole," that," responded Roy ("Pop") Thomas,
remarked the president, 32-year-old age 35, the vice president for production.
Charles ("Chuck") Jamison. "Sales were "After all, our sales are seasonal, with
up, profits were up, and our retum on almost all occurring between March and
equity was a respectable 15 percent. In September. Since we don't have much
fact," he continued, "the only dark spot money coming in from October to
I can find in our whole annual report is the February, we have to borrow to keep the
profit margin, which is only 2.25 percent. production line going."
Seems like we ought to be making more "Right," Tim replied, "and it's the
than that, don't you think, Tim?" He production line that's the problem. We
looked across the table at the vice president produce the same number of products
for finance, Timothy Baggit, age 28. every month, no matter what we expect
"1 agree," replied Tim, "and I'm glad sales to be. This causes inventory to build
you brought it up, because I have a up when sales are slow and to deplete
suggestion on how to improve that when sales pick up. That fluctuating
situation." He leaned forward in his chair inventory causes all sorts of problems,
as he realized he had captured the interest including the excessive amount of
of the others. "The problem is, we have borrowing we have to do to finance the
too many expenses on our income inventory accumulation." (See Tables 1
statement that are eating up the profits. through 5 for details of Gale Force's
Now, I've done some checking, and the current operations based 00 equal
expenses all seem to be legitimate except monthly production.)
 Table 1 Sales Forecast (in units)
First Quarter Second Quarter Third Quarter Fourth Quarter
October 2007 150 January O April 500 July l,OOO
November. 75 February O May l,OOO August 500
December 25 March 300 June 1,000 September 250

Table 2 Production Schedule and Inventory (equal rnonthly production)

Production lnventory
Beginning This End ($2,000
lnventory Month Sales lnventory per unit)
October 2007 .................. 400 + 400 150 650 $1,300,000
November ....................... 650 400 75 975 1,950,000
December ....................... 975 400 25 1,350 2,700,000
January ........................... 1,350 400 O 1,750 3,500,000
February ......................... 1,750 400 O 2,150 4,300,000
March ............................. 2,150 400 300 2,250 4,500,000
April ............................... 2,250 400 500 2,150 4,300,000
May ................................ 2,150 400 1,000 1,550 3,100,000
June ................................ 1,550 400 1,000 950 1,900,000
July ................................. 950 400 1,000 350 700,000
August ............................ 350 400 500 250 500,000
September ....................... 250 400 250 400 800,000

Table 3 Sales Forecast, Cash Receipts and Payrnents, and Cash Budget
October
2007 November December January February March

Sales Forecast
Sales (units) .................................... 150 75 25 O O 300
Sales (unit price: $3.000) ................ $ 450.000 $ 225.000 $ 75.000 O O $ 900,000
Cash Receipts Schedule
50% cash ......................................... $ 225.000 $ 112.500 $ 37.500 $ 450,000
50% from prior month's sales" ...... $ 375.000 $ 225.000 $ 112,500 $ 37,500 O O
Total cash receipts .................... $ 600,000 $ 337,500 $ 150,000 $ 37,500 O $ 450.000
Cash Payments Schedule
Production in units . 400 400 400 400 400 400
Production costs (each = $2,000) . $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800.000 $ 800,000
Overhead . $ 200,000 $ 200,000 $ 200.000 $ 200,000 $ 200.000 $ 200.000
Dividends and interest . O O O O O O
Taxes . $ 150,000 O O $ 150,000 O O
Total cash payments . $ 1.150.000 $ 1,000.000 $ 1.000.000 $ 1,150,000 $ 1.000.000 $ 1.000,000
Cash Budget; Required Minimum Balance is $125,000
Cash flow ........................................ $ -550,000 --662,500 -850,000 -1.112.500 -1.000.000 -550.000
Beginning cash ............................... 125,000 125,000 125,000 125.000 125,000 125.000
Cumulative cash balance ................ -425.000 -537,500 -725,000 -987.500 -875,000 -425.000
Monthly loan or (repayment) ......... $ 550.000 $ 662,500 $ 850,000 $ 1.112.500 $ 1,000.000 $ 550.000

Cumulative loan .............................. $ 550.000 $ 1.212.500 $ 2.062.500 $ 3,175,000 $ 4.175,000 $ 4.725.000

Ending cash balance ....................... $ 125.000 $ 125.000 $ 125.000 $ 125,000 $ 125.000 $ 125,000

September sales assumed to be $750.000.

Gafe Force Surfing 23

"Now, here's my idea," said Tim. "Instead of producing 400 items a month,
every month, we match the production schedule with the sales forecast. For
example, if we expect to seU 150 windsurfers in October, then we only make
150. That way we avoid borrowing to make the 250 more that we don't expect to
sell, anyway. Over the course of an entire year the savings in interest expense
could really add up."
"Hold on, now," Pop responded, feeling that his territory was being
threatened. "That kind of scheduling really fouls up things in the shop where it
counts. It causes a feast or famine environment-nothing to do for one month,
then a deluge the next. It's terrible for the employees, not to mention the
supervisors who are trying to run an efficient operation. Your idea may make the
income statements look good for now, but the whole company will suffer in the
long run."
Chuck intervened. "OK, you guys, calm down. Tim may have a good idea or he
may not, but at least it's worth looking into. 1 propose that you al! work up two sets
of figures, one assuming level production and one matching production with sales.
We'lIlook at them both and see ifTim's idea really does produce better results. If it
does, we'l! check it further against other issues Pop is concemed about and then
make a decision on which altemative is better for the fmn."

Table 3 (continued)
April May June July August September

Sales Forecast
Sales (units) ..................................... 500 1,000 1,000 1,000 500 250
Sales (unit price: $3,000) ................ $1,500,000 $3,000,000 $3,000,000 $3,000,000 $1,500,000 $ 750,000
Cash Receipts Schedule
50% cash ......................................... $ 750,000 $1,500,000 $1,500,000 $1,500,000 $ 750,000 $ 375,000
50% frorn prior month's sales ......... $ 450.000 $ 750,000 $1.500.000 $1.500,000 $1.500,000 $ 750,000
Total cash receipts .................... $1,200,000 $2,250,000 $3,000,000 $3,000,000 $2,250,000 $ 1,125,000
Cash Payments Schedule
Production in units . 400 400 400 400 400 400
Production costs (each = $2,000) . $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000
Overhead . $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000
Dividends and interest . O O O O $1,000,000 O
Taxes . $ 150,000 O O $ 300,000 O O
Total cash payrnents . $1,150,000 $1,000,000 $1,000,000 $1,300,000 $2,000,000 $1,000,000
Cash Budget; Required Minimum Balance is $125,000
Cash tlow . 50,000 1,250,000 2,000,000 1,700,000 250,000 125,000
Beginning cash . 125,000 125,000 125,000 125,000 400,000 650,000
Cumulative cash halance . 175,000 1,375,000 2,125,000 1,825,000 650,000 775,000
Monthly loan or (repayrnent) . ($ 50,000) ($1,250,000) ($2,000,000) ($1,425,000) O O
Curnulative loan . $4,675,000 $3,425,000 $1,425,000 O O O
Ending cash balance . $ 125,000 $ 125,000 $ 125,000 $ 400,000 $ 650,000 $ 775,000
24 Case 5

Table 4
Total
Total Current Assets Accounts Current
First Year Cash Receivable" lnventory Assets

October $125,000 + $225,000 + $1,300,000 $1,650,000

November 125,000 112,500 1,950,000 2,187,500
December............. 125,000 37,500 2,700,000 2,862,500
January................. 125,000 O 3,500,000 3,625,000
February............... 125,000 O 4,300,000 4,425,000
March................... 125,000 450,000 4,500,000 5,075,000
April..................... 125,000 750,000 4,300,000 5,175,000
May...................... 125,000 1,500,000 3,100,000 4,725,000
June...................... 125,000 1,500,000 1,900,000 3,525,000
July....................... 400,000 1,500,000 700,000 2,600,000
August.................. 650,000 750,000 500,000 1,900,000
September 775,000 375,000 800,000 1,950,000
* Equals 50 percent of monthly sales

Table 5 Cumulative loan balance and interest expense (1% per month)
Oclober November December January February March

Cumulative loan balance ....................... $ 550,000 $1,212,500 $2,062,500 $3,175,000 $4,175,000 $4,725,000
Interest expense at
(prime, 8.0%, + 4.0%) 12.00% .............. $ 5,500 $ 12,125 $ 20,625 $ 31,750 $ 41,750 $ 47,250

April May June July August September

Cumulative loan balance ....................... $4,675,000 $3,425,000 $1,425,000 O O O

Interest expense at
(prime, 8.0%, + 4.0%) 12.00% .............. $ 46,750 $ 34,250 $ 14,250 O O O
Total interest expense for the year: $254,250

Required 1. Tables 1 through 5 contain the financial information describing the

effects of level production on inventory, cash flow, loan balances,
and interest expense. Reproduce these tables if Tim's suggestion
were implemented; that is, change the Production This Month
column in Table 2 from 400 each month to 150, 75, 25, and so on,
to match Sales in the next column. Then recompute the remainder
of Table 2, and Tables 3, 4, and 5 based on the new production
numbers. Beginning inventory is still 400 units. Beginning cash is
still $125,000 and that remains the mnimum required balance.
2. Given that Gale Force is charged 12 percent annual interest (1 percent
a month) on its cumulative loan balance each month (Table 5), how
much would Tim's suggestion save in interest expense in ayear?
3. Up until now, we have not considered any inefficiencies that have
been introduced as a result of going from level to seasonal
production. Assume that there is an added expense for each sales
dollar of .5 percent (.005). Based on this fact and the information
computed in question 2, is seasonal production justified?
 CASE

6
Modern Kitchenware Co.

Modem Kitchenware Co. specializes in Historically, the firm shipped out its goods
the manufacturing and distribution of items with a 30-day pay period allowed, with no
used in the kitchen. Among its many cash discount offered. An analysis of
products are microwave ovens, toasters, current accounts receivable indicated the
electric can openers, etc. Its home base is in pattem of receivables shown in Table l.
Kansas City and the firm sells to retailers In looking over the numbers, Beth felt
throughout the U.S. and Canada. Its the customers, on average, were taking
customers range from small retail outlets in over 30 days to pay. The receivables were
strip shopping centers to major customers based on average daily credit sales of
such as Sears and J. C. Penney. In the most $54,274 throughout the year.
recent fiscal year, its sales were $18 miliion Beth called in Al Becker, the chief
with $2,500,000 in aftertax profits. financial officer, and asked him what he
The firm's CEO is Beth Graham, who thought the problem was. He said that
holds a B.A. in economics from St. Louis because no cash discount was being offered
University. Beth has moved up through for early payment, customers were
the ranks as both a product manager and sometimes lax in their payment pattem.
VP of marketing.
She has implemented an inventory A Potential Cash Discount
control system that was thought by many
to be the finest in the kitchen supply Beth told Al to consider the impact of
industry. The computer-based system kept a cash discount on the accounts receivable
hourly tabs on inventory in stock at balance of the firm as well as its
profitability .
Kansas City as well as the ten distribution
centers throughout the country. Following Beth's instructions, Al
evaluated the effect of the three
Management of Accounts Receivable altemative cash discount policies shown
in Table 2.
Beth felt a good deal less confident He ran some pilot studies among
about the firm's ability to control and customers and determined the results
manage the level of accounts receivable. below.
26 Case 6

Ten percent of the customers would take advantage of the 1 percent discount
by paying within 10 days. If the two percent discount were offered, 25 percent
would take it, and if the 3 percent discount were offered, 60 percent of the
customers would take advantage of it. In each case, it was assumed that those
who do not take the discount would pay at the end of 30 days.

Table 1. Accounts Receivables Outstanding, December 2006

Days Outstanding Amount

0- 10 days 20,000
10 - 20 days 150,000
20 - 30 days 400,000
30 -40 days 650,000
40 - 50 days 430,000
50 - 60 days 350,000
Total A/R 2,000,000

Table 2. New Terms for Cash Discounts

Alternative Terms
1 1/10, net 30
2 2110, net 30
3 3110, net 30

He then computed the new average collection period(s) based on the data in
the prior paragraph. With an assumption of average daily credit sales remaining
at $54,274 per day, he also computed the anticipated new accounts receivable
balance based on the three different cash discount policies.
He was informed by his corporate treasurer that any freed up funds from
accounts receivable could be used elsewhere in the corporation to eam a retum of
18 percent.
All this information was reported back to Beth, and she suggested that a
thorough analysis be conducted of all the implications of the cash discount
policies.
Madern Kitchenware ea. 27

Required 1. Compute the current average collection period based on the data in
Table 1. In doing this, multiply the midpoint of the days outstanding,
by the weight assigned to that category. For example, the midpoint of
the second company is 15 days and the category represents 7.5
percent of total accounts receivable ($150,000/$2,000,000). Its value
is 1.125 days (15 days x .075). After this process is followed for all
six categories, add up the total to get the average collection periodo
2. Compute the new average collection period based on the terms in
Table 2 and the results of the pilot study. Use the simplifying
assumption that under the new policies all customers will all pay at
the end ofthe io" day or the end of the 30th day.
i.e., for the 1/10, net 30 .
10% x 10 days = 1 day
90% x 30 days = 27 days
28 days average collection period
3. Assuming average daily credit sales remain at $54,274 per day, what
will be the new accounts receivable balance based on the three new
cash discount policies?
Accounts receivable = average collection period x average daily
credit sales
4. Compute the cost of the cash discount based on the three policies
under consideration. Recall that total credit sales were $18 million.
Multiply total credit sales times the percent that use the discount for
each new discount policy times the size ofthe discount.
5. Compute the amount of freed up funds based on the three different
cash discount policies based on the following:
Old accounts receivable (given in table 1)
New accounts receivable (Question 3)
Freed up funds
6. Assuming an 18 percent retum can be eamed on the freed up funds,
what is the retum that can be eamed under the three cash discount
policies?
7. Subtract the cost of the cash discount (Question 4) from the retum on
the freed up funds (Question 6) to determine the actual profitability or
loss under the three cash discount policies.
Which ofthe three policies is the most profitable?
8. After looking at all the data, Beth decides to only consider
Altematives 1 and 2. She decides that the 2/1 O, net 30 cash discount
could increase credit sales by $1 million. The 1/10, net 30 is assumed
to have no impact on sales. Assume a" 9 percent before tax profit
margin on the new sales. * Also assume the 2 percent cash discount
must be subtracted. Further, assume the new sales will require a new
investment in accounts receivable of $27,750. These funds could eam
20% if invested elsewhere. (The 20% is retum on investment,
whereas the 9% referred to above is retum on sales.)
28 Case 6

Required Under the new set of facts, is the 2/10, net 30 policy now superior
to the 1/10, net 30 policy?

Take the profitability computed for the 2/10, net 30 policy in

Question 7, and add to that the increased profitability (9% retum
minus costs) detailed above. Compare your new total answers for
the profitability of the 2/1 O, net 30 policy to the answer for the 1/10,
net 30 policy in Question 7.

Which policy should the firm choose?

You do not have to include taxes for any ofthe ca\culations in this case.
 CASE

7
Landis Apparel Co.
Ruth Landis was carefully considering On routine decisions the credit
the firm's sales prospects for 2011. Her department determined what accounts
firm, located in Southern California, did were acceptable, but on more involved
slightly over $100 million in sales. She and situations the final call rested at the top
her husband, Jim, started the women with Ruth and Jim Landis.
clothier's company two decades ago and
has watched it grow from five employees to The Potential Account
over 500. Ruth was the CEO and Jim was
the chief financial officer. Landis produced The account under consideration was
its own brand of dresses, sweaters, and Monique Fashion Stores. They were
other apparel, and also soId brands licensed asking for $1 million for credit purchases.
by Tommy Hilfiger, Givenchy, Espirit, and Based on Monique's Dun & Bradstreet
others. Landis' dress manufacturing plants rating and other industry data, there
were located in Southern California, South appeared to be a five percent probability
America, and Asia. of non-payment if credit were extended.
Among the many hundreds of decisions The collection costs to service the account
Ruth and Jim Landis had to make was were four percent of sales and the
what customers were acceptable for credit production and selling costs were
extension. In the retail fashion business, 85 percent of sales. Any profits would be
virtually no customer paid cash, so the taxed at a 35 percent rateo Ruth and Jim
extension of credit to retailers was critical determined that accounts receivable
in doing business. tumover would be three times. The firm
A potential account has been brought had a required retum on investment of
to their attention by the credit department. 14 percent.
30 Case 7

Required 1. Using techniques similar to that under "An Actual Credit

Decision" in Chapter 7 ofthe Block and Hirt text, determine the
"Annual Incremental Income after Taxes," from making the
sale to Monique Fashion Stores.
2. Assume the only new investment would be in accounts
receivable. Based on the turnover ratio of three times, what
would the investment in accounts receivable be?
3. Compute the return on accounts receivable based on your
answers to questions one and two.
4. Given that the firm has a required return on investment of
14 percent, should Landis Apparel Co. sell to Monique Fashion
Stores?
5. If the accounts receivable turnover ratio were four times and the
other percentages were the same, should Landis Apparel Co.
make the sale?
6. Now assume that $200,000 in inventory must be maintained
throughout the year in addition to the accounts receivable
balance you computed in question 5. Should Landis Apparel
Co. make the sale?
7. Continue to assume the same facts in question 6, but with one
other change. By manufacturing the merchandise overseas,
Landis Apparel Co. can cut back production and selling costs to
75 percent of sales. Now recompute "Annual Incremental
Income after Taxes." Then divide the number by the total
investment found in question 6. Should Landis Apparel Co.
make the sale?
 CASE

9
Pierce Control Systems

In 2006, Sam Fenton was extremely Control System, he was promoted to vice
pleased to pick up The Wall Street Journal president of finance in 2006. At age 36,
and see that the prime rate had fallen to he was quite proud of his new title and
6 percent. As vice president of finance for $120,000 salary.
Pierce Control Systems, he know he would
have to refinance some major long-term The Financing Decision
debt coming due and he wanted to consider
all the possible options. With $10 million in debt coming due,
Pierce Control Systems is a manufacturer Sam Fenton was considering two options.
of material handling, accessory, and control One was to reborrow the money on a five-
equipment for the printing industry. Pierce's year basis with Prudential Insurance
products are designed to improve the Company, a major lender to emerging
productivity and cost-efficiency of printing firms. The loan would carry a flat
presses. Products include automatic 8 percent rate over the next five years.
cleaning systems, fountain solution and ink The principal would be due at the end of
control systems, press and web control the life of the loan.
systems, and web and material handling Sam considered the first option
systems. The business started in 1995 and described above as relatively long term in
over the past decade has grown to a sales nature. It would ensure that the firm
volume of $40 million. would have adequate financing through
Sam Fenton had joined the company in 2011. A second option would be to
1998. His background included a borrow the money from a bank on a short-
bachelor's degree in finance and term basis. Although banks normally lend
accounting from the University of funds for 90 to 180 day periods, he
Memphis, two years with Ernst & Young intended to ask for a one-year loan. He
as an auditor, and a three-year stint with then would renew the loan each year over
First Wachovia Bank Corporation as a the five-year periodo The loan officer at
loan officer. After eight years with Pierce Bank of America had told Sam that the
36 Case 9

'\ bank always floats the interest rate on its loans with the prime interest rateo Right
now, the prime interest rate was 6 percent or a full 2 percent less than the rate
Sam would have to pay on the longer-term insurance company loan.
Furthermore, if Sam maintained compensating balances on 10 percent of the
loan outstanding, the interest rate charge would be reduced to Y2 percent below
prime, or to 5 Yz percent. Clearly, there appeared to be a financial advantage to
borrowing the money short term, but Sam also remembered that the prime
interest rate could be quite volatile and had reached 20 percent back in 1981. He
would look pretty foolish to his boss, William Pierce I1I, if he were being forced
to pay that kind of interest at some point in the future.
Sam Fenton was also concemed about the danger of a future credit crunch in
the economy, as was witnessed in 1990 and 1991. At times banks become very
hesitant to make loans because of an overabundance of bad loans already on their
books and fears of federal regulators criticizing them. This is particularly true
when the economy is in a recession and bank loan officers are fearful about
future business conditions.

Required 1. Based on the 10 percent compensating balance requirement, how

much would Pierce Control Systems have to borrow to acquire
$10 million in needed funds?
2. Would the cost of the bank loan with the 10 percent compensating
balance requirement and a 5 Yz percent rate applied to the total loan
outstanding be more or les s than the 6 percent prime rate loan on
$10 million? Work this in terms of total dollar interest payments and
compare the two answers.
3. What if 4 percent interest could be eamed on all funds kept in excess
of the $10 million under the compensating balance loan
arrangement? What would be the net dollar interest cost of the
compensating balance loan arrangement? How does this compare to
the 6 percent prime interest rate loan total dollar cost?
4. Based on the difference between the 6 percent prime (short-term)
interest rate charged by the bank and the 8 percent longer-term
interest rate charged by the insurance company, what does this tell
you about the likely current shape of the term structure of interest
rates? Based on the expectations hypothesis, what might you infer is
the next most likely move in interest rates?
 Pierce Control Systems 37

Required 5. Assume the following projected interest rates for the prime rate
over the next five years; what would be the total interest cost on the
$10 million loan over that period? (Disregard the compensating
balance altemative for purposes of this question.) How does this
compare to the total dollar cost of the five-year,
8 percent insurance company loan?

Projected Prime
Year Interest Rate
2007 6%
2008 8%
2009 9%
2010 9%
2011 4%
6. As a second scenario, assume the prime rate would move more
dramatically, as shown below:

Projected Prime
Year Interest Rate
2007 6%
2008 10%
2009 15%
2010 13%
2011 13%
What would be the total dollar cost under the five-year bank loan?
How does this compare to the total dollar cost of the five-year
insurance company loan?
7. With a probability of 70 percent of the interest rate scenario in
question 5 and a 30 percent probability of the interest rate scenario
in question 6, what is the expected value of the dollar interest costs
of short-term borrowing? Is this higher or lower than the total dollar
interest cost of the five-year insurance company loan?
8. At what relative probability between the two scenarios would the
firm be indifferent between short-term and long-term borrowing?
9. Briefly explain how hedging can help the firm reduce the risk
associated with the short-term borrowing arrangement.

~ - ~ ---~--
 CASE

13

Baines Investments, Inc.

Baines Investments, Inc. is a private ships for the U.S. govemment. It also
equity investment company located in produces automatic flight control radar
Dallas, Texas. The firm specializes in systems and intercept missiles. It is
investing in privately owned firms that it privately traded.
feels it can sell in the future at a higher price Joel's firm normally took the present
or eventually take pub lic. In most cases, the value of future dividends, eamings, or
firm engages in leveraged buyouts, in which cash flow to determine value. In Joel's
it borrows money to buy a public1y traded first analysis he decided to take the
company with the intention of taking it present value of future dividends.
private. After restructuring the firm by Because dividends appeared to be
selling off unnecessary assets and tightening growing at a constant rate for the
budgets to increase profitability, Baines foreseeable future, he decided to use the
Investrnents and other participating constant growth rate dividend valuation
investing firms eventually hope to take the model in which the price (Po) or value
company back to the public market at a was equal to
much higher price than they paid to take it
D _ DI
private. FO -
Ke-g
An Upcoming Deal A careful analysis of company data
indicated that DI, or the next period's
Joel Horlen recently received his dividend would be $1.80. The growth rate g
MBA from Baylor University and was appeared to be 5.5 percent. K, was
hired by Baines Investment, Inc. In his supposed to represent the cost of cornmon
first six months on the job, he assisted equity and was normally given to him in
other analysts in evaluating companies, his c1assroom exercises while working on
but now he had an assignment of his own. his MBA. However, his employer, Baines
The company he was to assess is Investment, Inc., insisted that he use the
United Defense Systems (UDS). The capital asset pricing model to compute the
firm manufactures warships and cargo cost (or required retum) on cornmon equity.
52 Case 13

The term K, in the formula above represents the cost of common equity, but can
easily be replaced by K, the required retum on comrnon equity under the capital
asset pricing model. Once K, is computed it is merely substituted for K, in the
prior formula.

Now the formula for K;

Kj is equal to R + f3(Km - R)
where:
Kj Required retum on common stock
R Risk-free rate - use 6%
Km Market rate of retum - use 11%
f3 Beta. The volatility of a stock's
retum relative to the market's retum.
To be determined.

A stock with a beta of one would be as volatile as the market. A stock with a
beta of 1.20 would be 20 percent more volatile than the market, and a stock with
a beta of .80 would be 20 percent less volatile than the market and so on. The
beta was normally computed over a five-year period for a publicly traded
company.
Because the company (UDS) that Joel Horlen was evaluating was private and
had no public stock price, Joel decided to use an altemative method to compute
beta. He would take the average beta of five publicly traded companies in the
same industry as UDS (Aerospace/defense). The betas for the five companies are
as follows:
Company Beta
Armour Holdings 1.40

BE Aerospace 1.65

General Dynamics .85

Lockheed Martin .80
N orthrop Gruman .80
Baines Investments, Ine. 53

Required 1. Compute the average beta for the five firms in the aerospace/defense
industry.
2. Now, compute the required rate of retum (Kj) using the capital
asset pricing model. R is equal to 6 percent and Km is equal to
11 percent.
Use the formula:
Kj is equal to R + f3(Km - R).
3. Next, compute the stock price (Po) using the formula:
D _ DI
ro -
Kj-g
Note K, (the required retum on common stock) is being substituted
for K, (the cost of common equity). They both represent the same
thing, the retum that stockholders demando
4. Using your answer from question 3 and assuming eamings per
share are $2.40, what is the PIE ratio?
5. Because the firm is privately he Id and thus there is no public
market for its securities, there will be a liquidity discount of 20
percent from the stock price computed in question 3. What will the
adjusted stock price be? What will the adjusted PIE be?
6. Assume that Joel Horlen discovers that UDS is about to win a
major new defense department contract on combat radar systems
and the Company's value will increase by 40 percent. Ignoring the
liquidity discount for this calculation, what will the new stock price
and PIE ratio be?
7. Discuss the impact of the company deciding to go public sometime
in the future on the liquidity discount.
 CASE

14

Atlantic Airlines
Atlantic Airlines issued $100 million because of exposure to volatile energy
in bonds in 2008. Because ofthe firm's prices and the high debt level that
low credit rating (B3), the bonds were many airlines carry. He further
considered to be junk bonds. At the explained that they frequently were
time of issue, the 20 year bonds were labeled "junk bonds" because their
paying a yield of 12 percent. rating did not fall into the four highest
Investor Tom Phillips thought the categories of ratings by the bond
yield on the bonds was particularly rating agencies of Moody's and
attractive and called his broker, Roger Standard and Poor's.
Brown, to ask for more information
on the debt issue. Tom currently he Id Questions from Tom Phillips
Treasury bonds paying four percent
interest and corporate bonds yielding This explanation did not deter Tom
six percent. He wondered why the from showing continued interest. In
debt issue of Atlantic Airlines was fact, he could hardly wait to get his
paying twice that of his other hands on the 12 percent yielding
corporate bonds and eight percent securities. But first, he asked Roger,
more than Treasury securities. "What is the true risk and is it worth
His broker, Roger Brown had been taking?"
a financial consultant with Merrill Roger explained there was a higher
Lynch for la years and was risk of default on junk bonds. It
frequently asked such questions about sometimes ran as high as 2-3 percent
yield. He explained to Tom that the during severe economic downturns
bonds were not considered investment (compared to .5 percent for more
grade because of the industry they conventional issues). Roger also
were in. Bonds of airlines are indicated that although the yield at the
considered to be inherently risky time of issue appeared high, it could go
56 Case 14

considerably higher should conditions worsen in the airline industry.

This would take place if the price of oil moved sharply upward or people
began flying less due to a downtum in the econorny. Roger explained that
if the yield (required retum) on bonds of this nature went up, the price of
the bonds would go down and could potentially wipe out the high interest
payment advantage,

Required lo If the yield in the market for bonds of this nature were to go up
to 15 percent due to poor economic conditions, what would the
new price of the bonds be? They have an initial par value of
$1,0000 Assume two years have passed and there are 18 years
remaining on the life ofthe bonds. Use annual analysis.
20 Compare the decline in value to the eight percent initial interest
advantage over Treasury bond s (12 percent versus four percent)
for this two year holding periodo Base your analysis on a
$1,000 bond. Disregarding tax considerations, would Tom
come out ahead or behind in buying the high yield bonds?
30 Recompute the price of the bonds if interest rates went up by
only one percent to 13 percent with 18 years remaining. Does
the 8 percent interest rate advantage over the two year holding
period cover the loss in value?
40 Now assume that economic conditions improve and the yield on
similar securities goes down by 2 or 3 percent over the two
years. How does Tom come out? Merely discuss the answer.
No calculation is necessary.
50 If Tom holds the bonds to maturity (and there is no default),
does the change in the required yield in the market over the life
of the bond have any direct effect on the investment?
 CASE

15

Berkshire Instruments

Al Hansen, the newly appointed vice the current cost of funds, not the historical
president of finance of Berkshire cost. The banker suggested that a
Instruments, was eager to talk to his comparable firm in the industry, in terms
investment banker about future financing of size and bond rating (Baa), Rollins
for the firmo One of AI's first assignments Instruments, had issued bonds ayear and
was to determine the firm's cost of a half ago for 9.3 percent interest at a
capital. In assessing the weights to use in $1,000 par value, and the bond s were
computing the cost of capital, he currently selling for $890. The bonds had
examined the current balance sheet, 20 years remaining to maturity. The
presented in Figure 1. banker also observed that Rollings
In their discussion, Al and his Instruments had just issued preferred
investment banker determined that the stock at $60 per share, and the preferred
current mix in the capital structure was stock paid an annual dividend of$4.80.
very close to optimal and that Berkshire In terms of cost of common equity, the
Instruments should continue with it in the banker suggested that Al Hansen use the
future. Of some concem was the dividend valuation model as a first
appropriate cost to assign to each of the approach to determining cost of equity.
elements in the capital structure. Al Based on that approach, Al observed that
Hansen requested that his administrative earnings were $3 a share and that
assistant provide data on what the cost to 40 percent would be paid out in dividends
issue debt and preferred stock had been in (DI). The current stock price was $25.
the past. The information is provided in Dividends in the last four years had
Figure 2. grown from 82 cents to the current value.
When Al got the data, he felt he was The banker indicated that the under-
making real progress toward determining writing cost (flotation cost) on a preferred
the cost of capital for the firmo However, stock issue would be $2.60 per share and
his investment banker indicated that he $2.00 per share on common stock. Al
was going about the process in an Hansen further observed that his firm was
incorrect manner. The important issue is in a 35 percent marginal tax bracket.
58 Case 15

With all this information in hand, Al Hansen sat down to determine his firm's
cost of capital. He was a little confused about computing the firm's cost of
common equity. He knew there were two different formulas: one: one for the cost
of retained eamings and one for the cost of new common stock. His investment
banker suggested that he follow the normally accepted approach used in
determining the marginal cost of capital. First, determine the cost of capital for as
large a capital structure as current retained eamings will support; then, determine
the cost of capital based on exclusively using new common stock.

Figure 1 BERKSHIRE INSTRUMENTS

Statement of Financial Position
December 31,2010

Assets
Current assets:
Cash . $ 400,000
Marketable securities . 200,000
Accounts receivable . $ 2,600,000
Less: Allowance for bad debts 300,000 2,300,000
Inventory . 5,500,000
Total current assets . $ 8,400,000
Fixed Assets:
Plant and equipment, original cost . 30,700,000
Less: Accumulated depreciation . 13,200,000
Net plant and equipment . 17,500,000
Total assets . $25,900,000
Liabilities and Stockholders' Equity
Current liabilities: .
Accounts payable . $ 6,200,000
Accrued expenses . 1,700,000
Total current liabilities . 7,900,000
Long-term financing:
Bonds payable . $ 6,120,000
Preferred stock . 1,080,000
Common stock }C . 6,300,000
Retained earnings ommon equity 4,500,000
Total common equity . 10,800,000
Totallong-term financing . 18,000,000
Totalliabilities and stockholders' equity . $25900000
Berkshire Instruments 59

Figure 2
Coupon
Cost of prior issues Security Year of Issue Amount
Rate
ofdebt and
preferred stock Bond . 1998 $1,120,000 6.1%
Bond . 2002 3,000,000 13.8
Bond . 2008 2,000,000 8.3
Preferred stock . 2003 600,000 12.0
Preferred stock . 2006 480,000 7.9

Required l. Determine the weighted average cost of capital based on using

retained earnings in the capital structure. The percentage
composition in the capital structure for bonds, preferred stock,
and common equity should be based on the current capital
structure of long-term financing as shown in Figure 1 (it adds
up to $18 million). Common equity will represent 60 percent of
financing throughout this case. Use Rollins instruments data to
calculate the cost of preferred stock and debt.
2. Recompute the weighted average cost of capital based on using
new common stock in the capital structure. The weights remain
the same, only common equity is now supplied by new common
stock, rather than by retained earnings. After how much new
financing will this increase in the cost of capital take place?
Determine this by dividing retained earnings by the percent of
common equity in the capital structure.
3. Assume the investment banker also wishes to use the capital asset
pricing model, as shown in Formula 11.5 in the text, to compute
the cost (required return) on common stock. Assume R = 6
percent, 13 is 1.25, and Km is 13 percent. What is the value of 1<0?
How does this compare to the value of K, computed in question 1?
 CASE

18
Phelps Toy Company

The Phelps Toy Company was product not only among youngsters but
considering the advisability of adding a new also among adults who were trying to
product to its line. Ike Barnes was in charge recapture the experience of their youth.
of new product development. Since the A market survey by Ikes Barnes
founding of the company in 1990, he had indicated that the Topps Chewing Gum
seen sales grow from $150,000 ayear to Company was the largest competitor in
almost $40 million in 2010. Although the the industry. The company actually had a
firm had initially started out manufacturing public distribution of its common stock in
toy trucks, it had diversified into such items 2003. Other major sellers in 2011 were
as puzzles, stuffed animals, wall posters, Upper Deck, Fleer, Leaf, and Donruss.
rniniature trains, and board games. In 2004, All produce millions of baseball cards on
it developed the third most popular board an annual basis. The cards can be
game for the year, based on a popular purchased in packs of 15-20 cards for
television quiz show, but the show was $1.00-$3.00 at drug or convenience
canceled two years later. Nevertheless, the stores* or in boxes of 700-800 cards for
firm learned its lesson well and continued to $20 and up. These larger quantities of
produce board games related not only to cards were usually purchased from sport
quiz shows but to situation comedies and card specialty stores or at baseball card
even a popular detective series. conventions (over 1,000 such conventions
However, by January of 2011, the throughout the country took place ayear).
need to generate new products was In doing his analysis, Mr. Barnes
becoming evident. As can be seen in discovered that the appeal of baseball
Figure 1, sales and net income were cards was not only in opening a wrapper
beginning to level off after the previously and finding a favorite player enclosed
cited phenomenal growth. After doing a but also that any baseball cards initially
market analysis of possible products, Mr. purchased for pennies had gained
Barnes decided that the baseball card substantially in value. Once a player
market was a good area for potential new achieved star status, his rookie card (first
sales. Baseball cards were a popular issued) might greatly increase in worth.

*Some packs are more expensive than others due to quality and buyer preference.
70 Case 18

Figure 1
Year Sales Nef Income
Phelps Toy Company
1992 . $ 150,000 $ (16,000)
1993 . 240,000 (5,000)
1994 . 756,000 72,000
1995 . 1,340,000 91,000
1996 . 2,680,000 175,000
1997 . 3,320,000 198,000
1998 . 5,580,000 248,000
1999 . 6,792,000 387,000
2000 . 5,941,000 291,000
2001 . 9,237,000 439,000
2002 . 11,622,000 566,000
2003 . 12,140,000 621,000
2004 . 17,165,000 850,000
2005 . 22,838,000 1,221,000
2006 . 27,762,000 1,437,000
2007 . 32,437,000 1,628,000
2008 . 38,911,000 1,762,000
2009 . 39,750,000 2,002,000
2010 . 39,860,000 1,950,000

For example, the 1968 rookie card of Nolan Ryan was selling for $2,000 in
early 2010. The 1963 Pete Rose rookie card was valued at $500 and, finally, the
first Topps card of Mickey Mantle issued in 1952 at 1 cent carried a trading value
of $30,000 five decades later. While the card manufacturer did not directly
participate in this price appreciation, the hope for such gains in the future keeps
youngsters and adults continually active in buying cards as they come out.
To convince management that the manufacturing and selling of baseball cards
was a suitable activity for his firm, Mr. Bames had to make a thorough capital
budgeting analysis for the executive committee ofPhelps Toy Company.

The Analysis In evaluating the market potential, Mr. Bames determined that there
was no way he could firmly predict the market penetration potential for
a new set of baseball cards.

The sales for the set, which would be called Baseball Stars, would depend on
the quality of the final product as well as the effectiveness of the promotional
activities. There is al so the danger of a number of errors when a set is initially
issued. With approximately 750 cards in the set, there is the possibility of
misquoting batting averages, misspelling names, and so on. When Fleer and
Donruss introduced their new sets in 1995, they were highly criticized by
collectors for the numerous errors. Mr. Bames hoped to avoid this fate for the
Baseball Stars set by making heavy expenditures on quality control. He also
intended to hire a number of employees from other card companies so he would
have experienced people who could identify potential problems at a very early stage.
Phelps Toy Company 71

Over the years, Phelps Toy Company had developed a manual to evaluate
capital budgeting projects. As a first step, Ike Barnes was required to predict
anticipated sales over the next six years. While he thought this was too short a
time period to evaluate the full potential of the project, he knew he had no choice
but to go along with company policy. He decided to project a range for potential
sales in 2011 (the first new year of business) and assign probabilities to the
outcomes. The information is shown in Figure 2.

Figure 2
Assumpfion Sales Probabilify
Projected first-year sales
Pessimistic . $1,100,000 0.25
Normal . 2,000,000 0.40
Optimistic . 3,750,000 0.20
Highly optimistic . 4,500,000 0.15
1.00

It was his intention to determine the expected value for sales for the first year
and then project a 20 percent growth rate for the next three years and 10 percent
for the final two years. Operating expenses, which were expected to average 70
percent of sales, would then be subtracted to determine earnings before
depreciation and taxes. The primary investment to be made was in printing and
production equipment, which would fall into the five-year MACRS depreciation
category. The equipment, which represents the investment for the project, costs
$2.8 million.
Mr. Barnes looked into the capital budgeting manual to determine the
appropriate discount rate (as shown in Figure 3). The discount rate for the project
is based on the coefficient of variation of the first year's sales. One of the
accounting assistants informed him that the standard deviation of first year's
sales was $1,226,000. He knew he could easily determine the expected value
from the data previously presented (in Figure 2).
Mr. Barnes thought that it was now time to call his assistants together to do
the appropriate analysis.

Figure 3
Discount rate Coefficienf of Variafion Discounf Rafe
determination
0-.20 8%
.21-.40 10
.41-.60 14
.61-.80 16
Over .80 20
72 Case 18

Required 1. Use the basic data in the case to put together an analysis similar
to Table 12.11 in the text. To determine earnings before
depreciation and taxes (EBDT), subtract projected operating
expenses from projected sales. Use a tax rate of 34 percent.
2. Determine the appropriate discount rate for the firmo
3. Make a decision on whether the project is feasible, based on net
present value analysis.
4. What is the drawback to using a six-year time horizon for the
project?
 CASE

19

Global Resources
Roger Mills, the Vice President of Jennifer said, "There are several ways
Finance of Global Resources, was to account for risk in the capital budgeting
concemed about the fact that Global process, but the most widely used method
Resources used one discount rate to by Fortune 500 companies is the risk-
evaluate all projects. Currently that rate adjusted discount rate approach. You set
was 10 percent. He knew certain projects up different risk categories in the
were riskier than others, and he felt they corporate capital budgeting manual and
should carry a higher discount rate (hurdle specify an appropriate discount rate for
rate) than more conservative projects. each."
The firm had just hired Jennifer One of the case studies she had used
Morrison, an MBA from the Wharton at the Wharton school actually specified
School at the University of Pennsylvania risk categories as shown in Figure 1.
(at a starting salary of 150,000 ayear). Jennifer also added discount rates based
Roger felt with her education and on the risk level that might be
training, she should be able to provide appropriate for Global Resources.
some meaningful suggestions.
74 Case 19

Figure 1

Risk-Adjusted Discount Rates for Global Resources

Risk Category Discount Rate

Low risk (equipment repair) 5%
Low to moderate risk (new equipment) 7%
Moderate risk (expansion ofproduct line) 10%
Moderate to high risk (new product in the 13%
domestic market)
Risky (established product in a foreign market) 17%
High risk (new product in a foreign market) 20%

She proposed that Roger compare the current method and the risk-adjusted
discount rate approach based on two pending proposals. Project A called for
introducing a new high grade fuel in the domestic market and would require a
discount rate of 13 percent based on Figure 1. Project B called for the
introduction of a well-established automatic wheel adjustor in the Asian markets
and would require a discount rate of 17 percent based on Figure 1.
The cash flows from the two projects are shown in Figure 2.

Figure 2

Risk-Adjusted Discount Rates for Global Resources

Investment A Investment B
($200,000 investment) ($200,000 investment)
Year Inflows Year Inflows
$40,000 $50,000

2 60,000 2 20,000

3 90,000 3 100,000

4 120,000 4 130,000

5 140,000 5 195,000

Roger was very pleased with Jennifer's suggestion and prepared to compute
the returns. Just as he was beginning, Tai Ming, the Director of Foreign
Operations, walked into the room and examined the new proposal.
Global Resources 75

Tai explained, "Foreign investments should not have a higher discount rate
than domestic projects simply because they are riskier." He suggested that
foreign investment brought diversity into the firm's portfolio of investments and
actually reduced total corporate risk. He went so far as to suggest they might
justify a 'Iower discount rate.' As an example, he suggested that while the
U.S. economy was in a recession in 2001-2002, many Asian economies were
booming and investments there reduced risk.
Roger was appreciative of Tai's input but decided to run the numbers first
based on current practices and Jennifer's suggestions and then further evaluate
the merits ofTai's international diversification arguments.

Required 1. Compute the present value of the two investments in Figure 2

based on the current non risk-adjusted discount rate of
10 percent. Which of the two is superior?
2. Compute the present value of Investment A based on a risk-
adjusted discount rate at 13 percent as applied to a new product
in the domestic market.
3. Compute the present value of Investment B based on risk-
adjusted discount rate of 17 percent as applied to introducing an
established product in a foreign market.
4. Which of the two is superior under the risk-adjusted discount
rate approach as utilized in questions two and three?
5. If the two projects were mutually exclusive, what would your
decision be based on the analysis under the risk-adjusted
discount rate approach?
6. If the two projects were non-rnutually exclusive, and there was
no capital rationing, what would your decision be based on the
analysis under the risk-adjusted discount rate approach?
7. Do you agree with Tai Ming's arguments about the impact of
international diversification on the discount rate? Note: there is
no anticipated correct answer to this question. Please just give
your opimon.
 CASE

20
Inca, Inc.*

Inca, Jnc., operated and licensed others 81 persons, and included a pickup
to operate quick-service restaurants under window for drive-through service.
the name Pedro's. The menu featured Locations were chosen in heavily
chiliburgers, along with a limited populated areas, since success depend-ed
selection of Mexican foods. The walls of upon serving a large number of customers.
each restaurant were decorated with the All of the restaurants offered the same
exploits ofMexican heroes. menu. Three sizes of chiliburgers were
The first Pedro's was opened in featured: the Gaucho (quarter pound), the
Santa Fe, New Mexico, on June 9, 2000. Soldado (half pound), and the Matador
Ten years later there were 298 (three-quarter pound). The names were
restaurants in operation in 27 states, of integrated into the company's advertising.
which 111 were operated by the On television each cornmercial gave
company and 187 by franchisees. In special attention to one of the three themes.
addition, 4 restaurants were under The prospective franchisee signed a
construction by the company, and 64 by document that included the option of
franchisees. A balance sheet as of June operating a specified number of Pedro's
30, 2010, is included in Figure 1. restaurants in a prescribed geographical
Each Pedro's restaurant was built to area. Each new location required an initial
the same specifications for exterior style payment of $18,000. In addition, a royalty
and interior dcor. The buildings, of 5 percent of gross sales was specified.
constructed of yellow brick, were located It was also stipulated that franchisees
on sites of approximately one acre. The must spend at least 2 percent of gross
parking lots, depending on the exact size receipts on local advertising. lnca, Inc.,
and shape of the land, were designed for believed that properly trained employees
30 to 35 cars. The standard restaurant were the key to success. Therefore,
contained about 1,900 square feet, seated managers and company trainees were

* From Henry R. Kuniansky and William H. Marsh, Case Prob!ems in Financia! Management (Englewood Cliffs, N.J.;
Prentice-Hall).
78 Case 20

required to attend a three-week program eovering all aspeets of eompany operations.

More than 600 people were graduated from the sehool during 2009.
Inea, Ine., planned to begin eonstruetion on five new eompany - owned restaurants
during 2011. The exaet size of the buildings had not been determined, although the
had not been determined, although the speeifie sites had already been seleeted.

Figure 1 INCA,INC.
Balance Sheet
As of June 30, 2010
(in thousands)

Assets
Current assets:
Cash . $12,026
Accounts receivable . 1,646
lnventory . 512
Other current assets . ~
Total current assets . 16,056
Equipment and property:
Buildings . 10,208
Leasehold improvements . 4,826
Restaurant equipment . 11,630
Motor vehicles . 1,188
Office equipment . 464
Lease rights . ~
Less: Accumulated depreciation . ---.1J..Q1
Total equipment and property . 25,754
Land 10,606
Construction in progress . 434
Other assets . ~
Total assets . $54.416
Liabilities and Stockholders' Equity
Current liabilities:
Notes payable to banks . $ 316
Accounts payable . 3,846
Income taxes . 1,754
Accrued liabilities . 1,314
Current portion, term debt . ~
Total current liabilities . 8,794
Long-term debt, less current portion . 17,742
Deferred:
Income taxes . 982
Franchise fees . ~
4,712
Stockholders' equity: .
Common stock, $0.10 par . 676
Capital in excess of stated value . 9,726
Retained earnings . 12,766
Total stockholders' equity . 23,168
Totalliabilities and stockholders' equity ~
Inea,lne. 79

Figure 2
INCA,INC.
Present Value of Cash Flows
(in thousands)

Restaurant Size Level of Demand Outcomes (NPV)

High (.40) . $1,050

Standard Medium (.40) . 630
Low (.20) . (200)

High (.40) . 2,812

Expanded Medium (.40) . 740
Low (.20) . (900)

Management believed that restaurants with a capacity of 144 persons would be

more profitable than the present size of 81.
The company faced two choices: continuing with the smaller-size units or
going to the larger size. The initial cost for five smaller restaurants was
$2.1 million, and it was $3.7 million for five larger ones. Demand expectations
over the years were 40 percent for high demand, 40 percent for medium demand,
and 20 percent for low demando The net present values of cash flows for the two
proposals are given in Figure 2.
John H. Porter had been president and chief executive officer of Inca, Inc.,
since July of 2002. Prior to that time he had worked for a competitor. He knew
the decision conceming the size of new restaurants could be a major turning
point for the company. Mr. Porter wondered ifthe potential higher returns for the
larger units justified the increased risk. In any event, the strategy would have to
be sold to the board of directors.

Required 1. Determine the expected value of the net present value for the
standard-size restaurants. Use the data in Figure 2. To get
the expected value, multiply the outcomes (NPV) times the
appropriate probability (040 for high demand, etc.). Do this for
high demand, medium demand, and low demand, and sum to
answer this question. Remember to state your final answer in
thousands.
2. Follow the same procedure for the expanded-size restaurants to
arrive at the expected value of the net present value.
3. Which altemate appears to be the more desirable?
4. Next, determine the standard deviation for the standard size
restaurants. Remember to state your final answer in thousands.
The standard deviation for the expanded-size restaurant is
$1,415,800.
5. Now determine the coefficient of variation for the two altematives.
80 Case 20

Required 6. Based on the coefficient of variation, which of the two altematives is

more desirable? Comment on the relationship of your answer to
question 3 and your answer to this question. What general principie
is being demonstrated?
7. Assume, in addition to considering the building of five restaurants
that are all standard or all expanded, Inca evaluates possible
combinations of the two. The following values will apply for the
expected values and the standard deviations.

Standard
Expected Value
Deviation

4 standard, 1 expanded $ 641,630 $ 753,760

3 standard, 2 expanded 832,460 875,420
2 standard, 3 expanded 1,025,800 997,280
1 standard, 4 expanded 1,220,400 1,119,040
If the firm wishes to minimize risk, which of the six altematives
should it choose? (Refer to your answer to question 5 as well as this
question.) .
 CASE

21
Robert Boyle & Associates, Inc.

On a Saturday aftemoon in May 2008, develop real estate just as easily from here
Robert Boyle and rus wife Janet were sitting as in the city, you know. Which reminds
on the porch of their house on Nantucket me, what's the latest on the Nantucket
Island, Massachusetts, watching the fog roll Center project? You've been quiet about
in. The couple frequently spent weekends it for about a week now." Janet referred to
on the island, when the demands of a proposal Robert had made a few months
Robert's business and Janet's teaching job ago to build the first shopping center on
would permit. Robert was the president of Nantucket Island.
Robert Boyle & Associates, a closely held Robert sighed. "Well, it's on the back
real estate investment trust (REIT) located bumer right now for lack of financing.
in Auburn, Massachusetts. From a small I'm convinced that it would make us a lot
office there, Robert had been managing the of money; but, the trouble is, it will take a
development of shopping centers for a little lot of money to get it built-about
over eight years. Robert conducted most of $10 million, in fact, and that's more than
.the business himself, and the "associates," a we've ever had to raise before."
group of about 40 friends, family members, "Oh, come on," Janet said. (She had
and business colleagues, provided most of always been an active participant in the
the fmancing. The trust had been quite business.) "You've built two shopping
successful, and today it owned two centers, so far, and didn't have any
shopping centers, which produced rental trauble getting the money for them. Why
income of almost $6 million in 2007. (See don 't you just borrow some more?"
Figures 1 and 2 for Boyle & Associates' "Too much borrowed already, I'm
financial statements for 2005.) afraid," Robert replied. "Our debt-to-
"You know, Janet," Bob said assets ratio is quite a bit over the average
wistfully, "we ought to move out here for REITs now, and our investment
permanently. There's just no comparison banker says that another loan, or even a
between life here and on the mainland." bond issue, would be quite expensive in
"You get no argument from me," Janet terms of interest cost." (See Figure 3 for
replied. "I've been telling you that ever comparisons between Boyle & Associates
since we bought this house. You could and a sample of other REITs.)
82 Case 21

Figure 1 ROBERT BOYLE & ASSOCIATES, INC.

Income Statement
For the year 2007
(in millions)

Loan income . $0.240

Rental income . 5.992
Other income . 0.168
Total income . 6.400
Depreciation . 0.920
General and administrative expenses . 0.435
Operating income . 5.045
lnterest expense . 0.945
Net income . -, $4100

Dividend paid . $3.915

Note: Boyle & Associates qualifies as a RElT so it pays no income tax.

Figure 2 ROBERT BOYLE & ASSOCIATES, INC.

Balance Sheet
As of December 31, 2007
(in millions)
Assets:
Cash and equivalents . $ 2.100
Land development and construction loans . 2.000
Property owned, net of depreciation . 16.000
Other assets . 0.900
Total assets . $21 000
Liabilities and equity:
Bank borrowings . $ 2.000
Mortgages on property . 7.000
Other liabilities . 0.450
Total liabilities . 9.450
Common stock (4 million shares, $1 par) . 4.000
Additional paid-in capital . 7.450
Retained earnings . ~
Total equity . 11.550
Totalliabilities and equity . $2.Llliill.

"Well, what about the shareholders?" Janet insisted. "Can't they contribute
some more equity money?" (Boyle & Associates' 40 existing stockholders held 4
million shares with a book value of$2.89 each.)
Robert responded with a smile. "You know the answer to that already," he
said. "You and 1 are the biggest stockholders. But even if all 40 stockholders put
in an equal amount it would cost each of us $250,000. You and 1 don 't have that
kind of cash, and I'm sure the rest ofthe stockholders don't, either."
Rabert Bayte & Assaciates, lnc. 83

"Well, then," Janet continued unperturbed, "you need some more

stockholders. Why don't you sell stock to the public? I'm sure it would be a great
success once people knew what the company's plans were."
"Yes, that's what our investment banker said, too," Robert replied. "But I
have some reservations. For instance, look at the dilution effect. You know, to
qualify as a REIT, and, therefore, to pay no income tax at the corporate level, we
pay out 95 percent of earnings every year as dividends. Anything that affects
earnings per share, then, affects the shareholders' dividends. Ifwe issue a whole
lot of new stock, earnings per share will be diluted severely, and the existing
stockholders will be most unhappy!"
"But, Robert," Janet said, "aren 't you ignoring the money you will make on
the proceeds of the stock issue? It seems to me that the income from the
investment ought to more than offset the initial dilution, producing even more
eamings-and dividends-than before. Surely the stockholders will see that."
"Maybe so," Robert said, "but that's not the only problem. Suppose, for
example, that the whole shopping center deal falls through?" (It was not certain
at this time that the residents and govemment authorities on antucket would
approve the project.) "If it does, the price of our company's shares, now publicly
traded, will surely fall, to the dismay and embarrassment of us al!. You know,
managing a publicly traded company is not at all like managing a private one.
The pressure for short-term performance is terrific. If I don 't produce, 1'11 be
voted out of office at the next shareholders' meeting."
"And that's another thing," Robert continued, warming up, "shareholders'
meetings. Look what you have to go through as a publicly traded company:
shareholders' meetings, annual reports, SEC filings, disclosure notices, regulators
poking around; why, the administrative tasks alone will require a couple offull-time
people! Besides that, look at the cost of the issue itself. The investrnent banker will
take a cut ofabout 6.5 percent ofthe issue, and we'll have to pay about $60,000 out-
of-pocket for legal and accounting fees and printing expenses. 1 bet we'd have to
issue almost $11 million in stock just to get $10 million in cash. Pretty expensive!"
"Y es, that's so," Janet agreed. "But even so, the benefits might outweigh the
costs. One thing you haven 't mentioned is the increase in liquidity for the
company's shares you would get ifthey were publicly traded. You know most of
our existing shareholders have been with us for the whole eight years, and they
have quite a bit of money tied up in this one basket. How can they diversify their
portfolios or sell their holdings outright? 1 bet they'd love to see the shares
publicly traded in the market with an established price."
"AII right, you may have a point," Robert conceded. "Tell you what, 1'11write
a letter to our existing stockholders outlining the pros and cons, and ask them to
respond with recommendations. If the prevailing sentiment is to go public, we'lI
do it, and if it's not, we won't. In the end, though, the whole discussion may
depend on how badly we want to build the antucket Center. Ifwe want it, we'll
probably have to go public to build it."
"1 knew you would have it all figured out," Janet said, approvingly. "Now,
how about a martini?"
84 Case 21

Figure 3
Industry data and
comparisons Total Net Numberof
(in millions) Company Revenue Income Shares
JNB Realty Trust... . 4.3 2.6 1.423
USP REIT . 7.8 1.5 2.500
Cousins Properties. Ine . 52.5 29.6 17.165
Bradley REIT . 7.1 1.3 3.360
Mortgage Growth Investors. Ine . 14.0 9.9 7.730
Oial REIT (newly established) . 1.736

Average of eompanies listed . 14.3 7.5 5.653

Robert Boyle & Assoeiates . 6.4 4.1 4.000

Retum on Retum on Oebt to

Company Equity Assets Assets
JNB Realty Trust. . 10.8% 9.6% 0.11

USP REIT . 12.2 4.5 0.63

Cousins Properties. Ine . 26.7 23.7 0.11
Bradley REIT . 19.2 7.3 0.62
Mortgage Growth Investors. Ine . 8.0 6.9 0.14
Dial REIT (newly established) . 0.25

Average of eompanies listed . 12.8 8.7 0.31

Robert Boyle & Assoeiates . . 35.5 19.5 0.45

Earnings Dividend Book Value

Long-Term Total Total Per Per Per
Debt Equity Assets Share Share Share

$3.1 $24.0 $27.1 $1.83 $1.75 $16.84

21.2 12.3 33.5 0.60 0.57 4.92
14.1 110.7 124.8 1.72 1.64 6.45
I 1.0 6.8 17.8 0.39 0.37 2.01
19.8 123.9 143.7 1.28 1.23 16.03
~ 2l.d 41.6 ~ 18.02
13.3 51.5 64.7 0.97 1.20 10.71
9.5 11.6 21.0 1.03 0.98 2.89

Price-
Asset Net Protit" 5-YearEPS Dividend Earnings Reeent
Turnover Margin Growth yield Ratio Stock Price

0.16 60.5% 1.1% 11.7% 8.2 $15.00

0.23 19.2 8.1 5.8 16.3 9.75
0.42 56.4 2.9 9.8 9.7 16.75
0.40 18.3 12.3 2.8 34.2 13.25
0.10 70.9 7.1 6.2 15.5 19.88
~ 19.25
0.22 37.5 5.3 7.5 14.0 $15.65

0.30 64.1 9.7

* This figure tends lo be high for RE1Ts because of relatively low expenses relative to revenue.
Robert Boyle & Assoeiates, Ine. 85
~I ,/

Required l. Refer to Figure 3 for comparisons between Boyle & Associates and other
REITs. Note the industry average price-earnings ratio. The investment
banker will set Boyle's PIE ratio based on how the company compares to
the industry average in six areas: return on equity, return on assets, debt to
assets, asset turnover, net profit margin, and five-year earnings per share
growth. The investment banker will start with the industry average PIE, and
will add one-half point for each of the areas in which Boyle is superior to
the industry, and will subtract one-half point for each area in which Boyle is
inferior to the industry. After tabulating the results, the investment banker
will subtract one point for good measure to ensure the issue presents an
attractive opportunity. On this basis, what will the banker determine to be
the proper PIE ratio for Boyle & Associates?
2. Considering that the banker's spread will be 6.5 percent of the total issue
size, and Boyle will have to pay $60,000 out-of-pocket expenses, what is
the total issue size necessary to yield $10 million in cash to the company?
Use the formula: X - .065X - $60,000 = $10,000,000. X is the issue size.
Round your answer upward to the nearest $100,000. ,,--
3. Assume 699,029 shares will be sold at a public price of $15.45 to provide
approximately $10.8 million. What dollar return on the net proceeds of the
offering must Boyle & Associates earn to bring earnings per share u,2 to
what it was before the offering? ($1.03) After you compute the dollar return
on the netprnceeds, convert this toaratio.Ipercentage of.net proceeds).
Compare this answer to Boyle's return on assets in 2005 (Figure 3).
Based on the company's performance in 2005, do you think the required
return can be earned?
4. Ifhalf ofBoyle's associates decide to sell their existing shares in addition to
the initial offering, how many total shares will have to be issued by the
company to yield $10 million in cash to the company?
5. Summarize the pros and cons of Boyle & Associates going public from the
information in the case and your reading of the text, Chapter 15. If you were
one of the existing stockholders and you received Robert Boyle's letter,
would you recommend going public or not? What would be the major
reason affecting your opinion?
 CASE

22
Glazer Drug Company

Generic Drug Industry Health Systems, to increasingly direct their

clients to buy more and more generics.
Generic drugs are the equivalents of
brand-name drugs, typically sold under The Going Public Transaction
their generic chemical names at prices
below those of their brand-name Glazer Drug Co. is the fourth largest
equivalents. Generic drugs may be generic drug company in the world, with
manufactured and marketed only if annual sales of over $3 billion. It trails
relevant patents on their brand-name only Norvatis AG, Teva Pharmaceutical,
equivalents have expired, been challenged and Mylan Labs in sales and profits. Its
or invalidated, or otherwise validly home office is in St. Louis, with its
ircumvented. laboratories and sales outlets in the U.S.
Future generic industry growth can be and 30 foreign countries, with the largest
attributed to both a large number of foreign operations in Great Britain and
branded drugs losing patent protection in Australia. Tts generic brand labels cover
the coming years and a strengthened desire medication for heart disease, diabetes,
by healthcare payers to increase generic acute infections, and many other ailments.
drug utilization. The generic industry has In the fall of 2007, the company decided
seen rapid growth since the mid-80's. to go public. Its investrnent banker was
Accompanying this growth has been a Aaron, Barkley, and Company.
growing desire within the industry to Glazer Drug Co. 's most, recent
challenge the legality of branded drug 12 month eamings were 150 rnillion
patents in court, often enabling patents to with one bundred million shares,
be overtumed years ahead of schedule. providing an EPS figure of $1.50. After
Also attributing to the rapid generic growth conducting a careful aoalysis of the
id the appeal of Healthcare payers, such as generic drug industry, the investment
large employers like GM and pharmacy banker decided a PIE of 25 would be
benefit managers (PBMs) like Medco appropriate, giving the stock a value of
88 Case 22

37.5VAllowing for the-nde riting speed, the net to the corporation and
se ling stockholders wat $36.68. he out-of-pocket underwriting expense was
$2 million on the 20 million chares that were to be soId to the publico Ten million
of tbe 20 million shares in the IPO were new corporate shares and the remaining
10 mili ion were shares currently owned by Larry Glazer, one of the founders of
the company. The 10 million shares sold by Glazer represented 85 percent of his
holdings.
On the day of the offering, the stock price shot up from $37.50 to $51.10 a
share, and by January 1,2008, the stock had reached a price of $61.75. Since no
specific events involving the company had taken place, it appeared that the stock
market had a favorable impression of the firmo

Required What was the percent underwriting speed?

. Subsequent to the issue, by what amount would eamings per share
be diluted? \J \ - U'
What are the net proceeds to tbe corporation from the issue?
What rate of retum would the corporation need to eam on the net
roceeds to avoid dilution? Note: because of the relatively high PIE
of 25, the answer is les s than 5 percent. However, the PIE does not
figure directly into the calculation.
5. Using the original earnings per share of $1.50, what would the PIE
ratio be based on the stock price of$61.75 on January 1, 2008?
6. Should Mr. Glazer be happy about the pricing of the stock by the
investment banker and the movement of the stock price after tbe
public offering?
 CASE

23
Leland Industries

Leland Industries is the nation's fifth companies and pension funds, but Al
largest producer of bakery and snack believed this was an appropriate time to
goods, with operations primarily located approach the public markets based on the
in the southeastem United States. Over company's recent strong performance.
the last 10 years, Leland had be en one of He called his investrnent banker and
the most efficient bakeries in the nation, was told that the rating that the firm
with a l O-year average sales growth of received from Standard and Poor's and
9.8 percent an "an average retum- on Moody's would be a key variable in
equi of 16.8 percent. Management goals determining the interest rate that would be
for the company include 10 percent paid on the debt issue. Leland industries
eamings growth per year, and an average intended to issue $20 million of new debt.
return of 16.8 percent on equity over time. A comparison of Leland Industries to
Late in the year 2008, Leland reached other bakeries is shown in Figure 1. The
an agreement with a major food chain to other five fmns all had issued debt publicly
provide private label bakery service in according to Ben Gilbert, who was Leland
addition to its own products that are sold Industries' major contact at the investrnent
to Krogers, Albertson's, and many other banking firm of Gilbert, Rollins and Ross.
grocery stores. The new private label As an altemative to a straight bond
program had significant start-up costs, issue, Ben Gilbert suggested that the firm
including new packaging techniques and consider issuing floating rate or even zero-
the addition of 250 sales routes. coupon rate bonds. He said the principal
Al Oliver, the vice president of finance, advantage to the floating rate bonds was
believed in maintaining a balanced capital that they could be issued at 1y. percent
structure, and since a 1 million share stock below the going market rate for straight
issue totaling $25 million in value had debt issues. Al Oliver was pleasantly
been offered earlier in the year, he thought surprised to hear this, and asked his
this was a good time to go to the debt investrnent banker what the catch was. Al
market. Previously, the firm's debt issues had heard too many times that "there is no
had been privately placed with insurance such thing as a free lunch." His investment
 CASE

23
Leland Industries

Leland Industries is the nation's fifth companies and pension funds, but Al
largest producer of bakery and snack believed this was an appropriate time to
goods, with operations primarily located approach the public markets based on the
in the southeastem United States. Over company's recent strong performance.
the last 10 years, Leland had been one of He called his investrnent banker and
the most efficient bakeries in the nation, was told that the rating that the firm
with a l O-year average sales growth of received from Standard and Poor' s and
9.8 percent an "an average retum on Moody's would be a key variable in
equi of 16.8 percent. Management goals determining the interest rate that would be
for the company include 10 percent paid on the debt issue. Leland industries
eamings growth per year, and an average intended to issue $20 million of new debt.
retum of 16.8 percent on equity over time. A comparison of Leland Industries to
Late in the year 2008, Leland reached other bakeries is shown in Figure l. The
an agreement with a major food chain to other five firms all had issued debt publicly
provide private label bakery service in according to Ben Gilbert, who was Leland
addition to its own products that are soId Industries' major contact at the investrnent
to Krogers, Albertson's, and many other banking firm of Gilbert, Rollins and Ross.
grocery stores. The new private label As an altemative to a straight bond
program had significant start-up costs, issue, Ben Gilbert suggested that the firm
including new packaging techniques and consider issuing floating rate or even zero-
the addition of 250 sales routes. coupon rate bonds. He said the principal
Al Oliver, the vice president of finance, advantage to the floating rate bonds was
believed in maintaining a balanced capital that they could be issued at 1Y4 percent
structure, and since a 1 million share stock below the going market rate for straight
issue totaling $25 million in value had debt issues. Al Oliver was pleasantly
been offered earlier in the year, he thought surprised to hear this, and asked his
this was a good time to go to the debt investrnent banker what the catch was. Al
market. Previously, the firm's debt issues had heard too many times that "there is no
had been privately placed with insurance such thing as a free lunch." His investment
90 Case 23

banker explained that with a floating rate bond the problem of interest rate changes
was shifted from the borrower to the lender. To quote Ben Gilbert:

Normally the risk of changes in yield to maturity is a burden or opportunity that

bondholders must considero If yields go up, bond prices of existing bonds go down and
the opposite is true if rates decline. There is a risk and many investors do not like this
risk. With a floating rate bond the interest rate that the investor directly receives changes
with market conditions and therefore the bond tends to trade at its initial par value. For
example, if a bond were issued at 9 percent interest for 20 years and market rates went
to 13 percent, a floating rate bond would adjust its payment up .10 13 percent, and the
market value would remain at $1,000. On a straight bond issue the interest rate would
remain at 9 percent and because it is 4percent below the market, the bond price would
drop to the $700 range.

Al Oliver quickly perceived that with a floating rate bond he could pay
1lj.percent lower interest than with a fixed rate bond, but that in future years he
could not predict what his interest rates would be. He was pretty turned off by the
whole idea until his investment banker suggested that the futures and options
experts at Gilbert, Rollins and Ross could hedge this risk at a probable aftertax
cost of about $120,000 Qer year. While he was making this point, Ben Gilbert
gave Al Oliver a copy orFoundations of: inancial Management by Block and
Hirt and suggested that he review the material on hedging at the end of Chapter
8. Al Oliver knew that he must make a decision about the benefits and costs of
floating rate bonds.
Before the discussion was over, Al Oliver was presented with one last option.
It was possible the firm might wish to issue zero-coupon rate bonds. Because no
interest was paid on an annual basis and the only gain to the investor carne in the
form of capital appreciation, Al Oliver initially liked the idea. However, he
remembered the no free lunch argument and asked Ben Gilbert what drawbacks
there might be to this type of issue. Ben responded:

Well, Al, since you are not paying annual interest or retiring any part of the issue
during its life, there can be greater risk, which may mean there is a lower rating on the
issue. You, of course, know what that means in terms of a higher required yield on the
bond issue.

Al Oliver thought he would need to put some numbers to zero-coupon bonds

as well as many of the other items that Ben Gilbert brought up. He called his
young assistant in for some help.
Leland Industries 91
/
Figure 1 Bond ratings of comparative firms
International Bakeries
Debt to total assets 30% Bond price $1,100
Times interest earned 7.1X Annual interest 10.35%
Fixed charge coverage 5.0X Maturity 25 years
Current ratio 3.1X Par value $1,000
Return on stockholders' equity 22% (principal payment)
Rating AA1

Gates Bakeries
Debt to total assets 42% Bond price $920
Times interest earned 5.5X Annual interest 9.45%
Fixed charge coverage 4.2X Maturity 20 years
Current ratio 2.3X Par value $1,000
Return on stockholders' equity 17.1% (principal payment)
Rating A1

Savanah Products
Debt to total assets 65% Bond price $1,150
Times interest earned 2.0X Annual interest 15.75%
Fixed charge coverage 1.7X Maturity 15 years
Current ratio 1.2X Par value $1,000
Return on stockholders' equity 7% (principal payment)
Rating B3

Dyer Pastries
Debt to total assets 35% Bond price $1,060
Times interest earned 6.0X Annual interest 10.30%
Fixed charge coverage 3.6X Maturity 20 years
Current ratio 2.8X Par value $1,000
Return on stockholders' equity 19% (principal payment)
Rating AA3

Nolan Bread
Debt to total assets 47% Bond price $950
Times interest earned 4.9X Annual interest 10.30%
Fixed charge coverage 3.8X Maturity 25 years
Current ratio 2.1X Par value $1,000
Return on stockholders' equity 15% (principal payment)
Rating A2
92 Case 23

-1
. Leland Industries*

Debt to total assets 44%

Times interest earned 5.7X
Fixed charge coverage 3.7X
Current ratio 2.0X
Return on stockholders' equity 16.8%
Rating: To be determined
* The first three ratios for Leland industries assume the impact of the new bond issue. Of course, these are
approximations.
The bond rating agencies require such information.

Required 1. Based on the data in Figure 1, which rating do you think is most
likely for Leland Industries?
2. Compute the approximate yield to maturity for the bonds of
Intemational Bakeries, Gates Bakeries, and Savanah Products.
3. What is the percentage aftertax cost of debt for the bond issues
listed in question 2? Refer to Chapter 11 for the aftertax ost of debt
formula. Assume a tax rate of 35 percent for the three firms.
4. If the bonds of Leland Industries carried a requirement that
5 percent of the bonds outstanding be retired each year, what would
be the total amount of bonds outstanding after the third year? Based
on an assumed 10 percent annual interest rate for Leland, which is
consistent with the comparable companies, and a tax rate of 35
percent, what would be the aftertax dollar cost of interest payments
e on this sum?
5. From a strictly dollars and cents viewpoint, does the floating rate
bond with the hedging approach appear to be viable? Base your
analysis on the new $20 million of debt outstanding, the
1Y4percent interest savings, and after-tax dollars.
6. Assume the zero-coupon rate bond s would be issued at 11 percent
for 20 years, what will be the initial price of a $1,000 bond? Use
Appendix B to find the present value (price of the bond).
How many bonds must be issued to raise $20 million? What is the
danger in issuing the zero-coupon rate bond s?

I I , I
 CASE

24
Warner Motor Oil Company

Gina Thomas was con cerned about the issues?" Gina had a quick and direct
effect that high interest expenses were answer. "No, and the reason is that the old
having on the bottom line reported profits issues have a call provision associated
of Warner Motor Oil Co. Since joining with them." A call provision allows the
the company three years ago as vice firm to call in bonds at slightly over par
president of finance, she noticed that (usually 8 to 10 percent above par)
operating profits appeared to be regardless of what the market price is.
improving each year, but that eamings
after interest and taxes were declining The Pro po sed Refunding Decision
because of high interest charges.
Because interest rates had finally Gina thought if she could present
started declining after a steady increase, a specific example to Al he would have a
she thought it was time to consider the better feel for the bond refunding process.
possibility of refunding a bond issue. As She proposed to call in an 11.50 percent
she explained to her boss, Al Rosen, $30,000,000 issue that was scheduled to
refunding meant calling in a bond that had mature in the year 2025. The bonds had
been issued at a high interest rate and been issued in 2005 and since it was now
replacing it with a new bond that was 2010, the bonds had 15 years remaining to
similar in most respects, but carried a maturity. It was Gina's intent to replace the
lower interest rateo Bond refunding was bonds with a new $30,000,000 issue that
only feasible in a period of declining would have the same maturity date 15 years
interest rates. Al Rosen, who had been the into the future as that of the original 2005
CEO of the company for the last seven issue. Based on advice fro~ the firm's
years understood the general concept, but investment banking firm, Walston and
he still had some questions. Sons, the bonds could be issued at arate of
He said to Gina, "If interest rates are 10 percent. Joe Walston, a senior partner
going down, bond prices are certain to be in the investment banking fmn, further
going up. Won't that make it quite indicated that the underwriting cost on
expensive to buy outstanding issues so the new issue would be 2.8 percent ofthe
that we can replace them with new $30,000,000 amount involved.
94 Case 24

Before she could do her analysis, Gina needed to accumulate information on

the old 11.50 percent bond issue that she was proposing to refundo The original
bond indenture indicated that the bonds had an 8 percent call premium, and that
the bonds could be called anytime after five years. Gina explained to Al Rosen
that the bondholders were protected from having their bonds called in for the first
five years after issue, but that the bonds were fair game after that. Furthermore,
from the sixth through the 13th year, the call premium went down by 1 percent
per year. By the 14th year after issue, there was no call premium and the
corporation could merely call in the bonds at par. Since in this case five years had
passed, the call premium would be exactly eight percent.
Gina knew that the underwriting cost on the old issue was important to the
calculations related to the refunding decision. She checked with the chief
accountant and found out they had initially been $400,000.
The firm was currently paying taxes at arate of 30 percent and would use
a discount rate of 7 percent for bond refunding decisions.

Required l. Before you do the bond refunding analysis, determine what the
current price of the old bonds would be for the previously issued
bonds in the marketplace. Do the example based on a $1,000 bond
using semiannual analysis. As specified in the case, the bonds have
15 years remaining. The interest rate at the time of issue was
11.50 percent, but is now 10 percent.
2. As a result of paying the 8 percent call premium over par instead of
the market price determined in question 1, how much will the firm
save on each old $1,000 bond in reacquiring it?
13. Using the four steps outlined in Chapter 16 of the text for a bond
refunding decision, determine whether the potential refunding has a
positive net present value. (Round all values to the nearest dollar).
Assuming you did your calculations correctly in question 3, you
should have gotten a positive net present value. If not, you will want
to rerun your numbers. Now assume Gina goes to Al Rosen with these
numbers and suggests they do the refunding because there is a
positive net present value. What is an additional important
consideration that Gina and Al must consider before they go ahead
with the refunding and all the associated costs?
5. Assume that before Wamer Motor Oil Company can get the
refunding completed, interest rates on new 15 year bonds goes up to
10.4 percent. Assume all other numbers previously given are the
same, should the refunding be undertaken?