5762 10964 im financialmanagementandpolicy12e hornedhamija 9788131754467

8/18/2019 5762 10964 IM FinancialManagementandPolicy12e HorneDhamija 9788131754467

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NameCase 1 Fazio Pump Corporation.

CASE 2 National Food Corporation.

CASE 3 Capital Structure at Marriott.

CASE 4 Morley Industries, Inc.

CASE 5 Financial Ratios and Industries.

CASE 6 Caceres Semilla S A de C V.

CASE 7 Dougall and Gilligan Global Agency.

CASE 8 Rayovac Corporation.

Ch01_Goals and Functions Of Finance.

Ch02_ Regulatory Environment.

Ch03_Time Value of Money.

Ch04_Concepts in Valuation.

Ch05_Market Risk and Returns.Ch06_Multivariable and Factor Valuation.

Ch07_Option Valuation.

Ch08_Principles of Capital Investment.

Ch09_Risk and Real Options in Capital Budgeting.

Ch10_Creating Value through Required Returns.

Ch11_Theories of Capital Structure.

Ch12_Making Capital Structure Decisions.

Ch13_Dividends and Share Repurchase Theory and Practice.

Ch14_Financial Ratio Analysis.

Ch15_Financial Planning.

Ch16_Liquidity,Cash and Marketable Securities.

Ch17_Management of accounts Receivable.

Ch18_Management of Inventories.

Ch19_Liability Management and Short Medium Term Financing.

Ch20_Foundations for Longer-Term Financing.

Ch21_Lease Financing.

Ch22_Issuing Securities.Ch23_Fixed Income Financing.

Ch24_Hybrid Financing Through Equity.

Ch25_ Emerging Methods of Financing.

Ch26_Managing Financial Risk.

Ch27_ Mergers and the Market for Corporate Control.

Ch28_Corporate and Distress Restructuring.

(C) Pearson Education 2012

Financial Management and Policy, 12/e Horne/ Dhamija 9788131754467

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Ch29_International Financial Management.

Ch30_ Corporate Governance.



http://e/My%20doc/Project/2015%20and%20later/Van%20Horne%20Dhamija_Financial%20Management%20and%20Policy%2012e/Resources/Van%20Horne/Van%20Horne/Ch29_International%20Financial%20Management.dochttp://e/My%20doc/Project/2015%20and%20later/Van%20Horne%20Dhamija_Financial%20Management%20and%20Policy%2012e/Resources/Van%20Horne/Van%20Horne/Ch30_%20Corporate%20Governance.docxhttp://e/My%20doc/Project/2015%20and%20later/Van%20Horne%20Dhamija_Financial%20Management%20and%20Policy%2012e/Resources/Van%20Horne/Van%20Horne/Ch30_%20Corporate%20Governance.docxhttp://e/My%20doc/Project/2015%20and%20later/Van%20Horne%20Dhamija_Financial%20Management%20and%20Policy%2012e/Resources/Van%20Horne/Van%20Horne/Ch29_International%20Financial%20Management.doc


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CASE: FAZIO PUMP CORPORATION TEACHING NOTE

Purpose of Case

This case exposes the student to the important task of setting up cash flows for purposes ofanalyzing a capital-budgeting project. It embeds inflation assumptions and MACRS depreciation. The case

allows the instructor to discuss payback, internal-rate-of-return, and new-present value methods forevaluating the profitability of a project. Simulations from a spreadsheet afford insight into the risk of the project. It also allows exploration of inflation premiums in required rates of return.

Questions

1. How do you set up the cash flows in order to analyze them? (Assume the purchase of a new pumpis entirely incremental, with no consideration to the continuation of older pumps).

2. What is the payback period? Implications?

3. What is the net-present value of the project is the discount rate is 13 percent? Implications?

4. What is its internal rate of return? Reconcile with the results using NPV. “

5. If no allowance were made for inflation, what would be the cash-flows? Would the project beacceptable at a 13 percent required rate of return?

6. What happens when you change assumptions as to project savings, inflation and discount rate?Simulate.

Analysis of CaseWith 4 percent; inflation assumed –L in the savings after year I, the cash flows for the base case

are:Year 0 Year 1 Year 2 Year 3 Year 4

Cost 260,000

Savings 60,000 62,400 64,896 67,492

Depreciation 52,000 83,200 49,920 29,952

B.T. Profit 8,000 (20,800) 14,976 37,540

Taxes (38%) 3,040 (7,904) 5,691 14,265

Savings less taxes 56,960 70,304 59,205 53,227

Salvage value A.T.

Net cash flow −260,000 56,960 70,304 59,205 53,227

Year 5 Year 6 Year .7 Year 8

Cost

Savings 70,192 72,999 75,919 78,956

Depreciation 29,952 14,976

B.T. Profit 40,240 58,023 75,919 78,956

Taxes (38%) 15,291 22,049 28,849 30,003

Savings less taxes 54,900 50,950 47,070 48,953Salvage value A.T. 18,600

Net cash flow 54,900 50,950 (47,070) 67,553

In reviewing these cash flows, I go through the effect, of depreciation lowering the tax bite in the first6years, but all savings being subject to taxes in the last 2 years. I also review the tax treatment of salvagevalue. For year 2, the above assumes the tax loss can be used elsewhere in the company, or that there is a taxloss carryback Otherwise there is a carryforward situation and the net cash flows are changed so as to push



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CASE: NATIONAL FOOD CORPORATION TEACHING NOTE

Purpose of Case

The National Foods case provides a means for exposing students to the CAPM and its application to

required rates of return. Calculations are involved, and assumptions can be questioned by the instructor. Thecentral issue in the case is whether the company should use an overall required return or individual requiredreturns for each of its three divisions. Another important issue is whether the Restaurants Division should beentitled to a higher proportion of cheaper debt funds than the other two divisions. The case also exposes thestudent to the question of how you take account of mandated environmental projects in the returns yourequire for other projects.

Questions

1. Determine the weighted average cost- of capital for National Foods Corporation.

2. On the basis of the information in the case, determine weighted average costs of capital for each ofthe divisions before and after taking account of profit sustaining projects.

3. How should profit sustaining projects be treated? Is a “gross up” approach appropriate? Should thesame gross up factor be applied to all divisions?

4. Does the weighted average of the proxy company betas for the divisions approximate that for theoverall company? What weights should be used?

5. Should multiple hurdle rates be used by the company? As Laura Atkinson, what would yourecommend?’

Analysis of Case

The after-tax cost of debt funds is:

Rd = 8.00% (1 – .40) =4.80%

If the risk-free rate is taken to be five years, consistent with the average duration of projects, and the required

return on the market portfolio is 11 percent, the cost of equity capital using the CAPM is:Re = 5.4% + (11% – 5.4%) 1.05 = 11.28%

As taken up in Chapters 3, 4, and 8, there is controversy as to the maturity of Treasury security touse as the risk-free rate as well as controversy as to the employment of the CAPM in preference to othermodels. It may be appropriate to take up these issues at this juncture in the case. Using the CAPM, however,the weighted average cost of capital for the company is:

WACC = .40 (4.80%) + .60 (11.28%) = 8.69%

It is appropriate to use this rate for allocating capital if the company in. fact intends to finance at the marginwith 4 parts of debt for every 6 parts of equity and if the assumptions of the CAPM hold. Grossing up therequired return for profit sustaining projects, the required return for profit adding projects is:

Required Return = 8.69% (1.25) =10.86%This required return is substantially less than the 13 percent now used, which suggests the company isrejecting projects it should be accepting.

To determine required returns for three divisions, a proxy company approach is used based on theExhibit 4 information. It is useful to review whether the companies in the samples are representative of the

businesses of the divisions. Usually the arithmetic average is skewed by outliers, but in this case it makeslittle difference whether the median or the arithmetic average is employed. The average long-term liabilities-to capitalization ratios for the three industries, .42, .38, and .40, are very close to that which National Foodsintends to employ, .40. Therefore, it does not seem necessary to adjust the betas for leverage using theHamada beta adjustment formula in Chapter 8. Even if you wanted to adjust, there is not sufficientinformation. The total debt/equity ratios, for the proxy companies are not given, or are their tax rates.

The required rates of return on equity capital for the three divisions using the averages in Exhibit 4 are:

Rag. = 5.4% + (11% – 5.4%). 98 =10.89%



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If the debt ratios of 30 percent for the first two divisions and 50 percent for the last are used, the requiredreturns for the divisions would be:

Agricultural = .30(4.80%) + .70 (10.89%) = 9.06%

Bakery = .30 (4,80%) + .70 (9.99%) = 8.43%Restaurants = .50 (4.80%) + .50 (12.51%) = 8.65%

In order to allow for profit sustaining projects, these figures need to be grossed up by 1.25. The requiredreturns for profit adding projects would be

Agricultural = 1.25 (9.06%) = 11.33%

Bakery =1.25 (8.43%) = 10.54%

Restaurants =1.25 (8.65%) = 10.81%

The procedure is to adjust upward required returns for the fact that profit sustaining projects are presumed to provide no returns. Therefore, other projects, profit adding ones as defined in the case, must carry the freight.The procedure is an appropriate one, and occurs in many corporations. If the divisions are markedly differentin the proportions of profit sustaining projects, different gross-up factors should be employed. Otherwise,there will be in equities. While the lower WACC figure is used to judge a division’s performance, the highergrossed up figure is used as the hurdle rate for profit adding projects.

A check for internal consistency compares the sum of the beta parts with the whole, 1.05 for National Foods. Using various weighting devices, we have

Weight Beta ProductBy Sales:

Agricultural .193 .98 .189Bakery . .405 .82 .332Restaurants .402 1.27 .501

1.02

By Operating Profits:Agricultural .158 .98 .155Bakery .340 .82 .279Restaurant s .502 1.27 .638

1.07By Identifiable Assets:

Agricultural .148 .98 .145Bakery .362 .82 .297Restaurants .490 1.27 .623

1.07

The ideal weight are market value weights, and we use the above as surrogates. As they are close to thecompany’s overall beta, confidence can be placed in the proxy company approach. If the sum of the partswere significantly out of line with the whole, this would call into question the use of this approach. Eitherfaulty measurement or weighting would be involved, and one would want to investigate the cause.

The critical issue in this case is the wide difference in leverage between the Restaurants Divisionand the other two. Without this, Restaurants would have’ the highest required return. If 40 percent debt

proportions are used throughout, we have as required returns for the three divisions

Required GrossedReturn up 1. 25

Agricultural = .40 (4.80%) + :60 (10.89%) = 8.45% 10.56%

Bakery = .40 (4.80%) + .60 (9.99%) = 7.91% 9.89%Restaurants = .40 (4.80%) + .60 (12.51%) = 9.43% 11.78%



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that debt. If the tax shield were lost or reduced because of poor earnings caused by the Restaurants Division,this would raise the effective cost of debt for the overall company. Larger leverage for the division increasesthe variance of returns to stockholders of National Foods resulting in a higher beta and higher overallrequired return. Restaurants are risky, as attested to by the large number of failures. Finally, the debt costs ofthe Restaurants Division would be higher if it were a stand alone company.

These factors make the “true” cost of debt funds for the Restaurants Division higher than shown.While subjective, it may be appropriate to make some kind of adjustment. This can be done in the cost ofdebt funds for that division and/or in the weighting.

Decision in Case

The decision to use multiple required returns can be justified on the basis of better allocatingcapital. If 40 percent debt is used for all three divisions, there is almost a 2 percent difference in requiredreturns for the most risky division, Restaurants, from the least risky, Bakery. For all of the reasons inChapter 8, it makes sense to require different returns for different risks. The approach shown uses the proxycompanies only to determine equity costs. An alternative approach is to use the proxy company’s weightedaverage costs of capital for required returns. This approach is explained in the chapter.

In teaching this case, I also get into what gives rise to projects providing expected returns in excess of those

required by the financial markets. The focus is on industry attractiveness and competitive advantage.



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CASE: RESTRUCTURING THE CAPITAL STRUCTURE AT MARRIOTT

Purpose of CaseThe Marriott case provides a springboard for general discussion of corporate restructuring and the

creation destruction of value. The central issue is the transfer of wealth from bondholders to stockholders,and whether it is proper for a company to exploit bondholders in such a manner. This may lead into adiscussion of corporate objectives and whether the only stakeholder who matters is the stockholder. Theability of Host Marriott to service the debt also is a topic of interest. The case invariably ends up with aheated discussion of what bondholders and management, in behalf of stockholders, should do.

Questions1. What are the features of the restructuring plan and how creative is it?2. Why did the bond and stock prices react the way they did? What information is being conveyed?3. If you take the security price movements as representative, was there a net creation of value around

the time of the announcement? Assume the company has outstanding $2.3 billion in fixed-rate,long-term debt and 95.5 million shares of common stock.

4. What actions would you recommend that bondholders take? How should management, respond?

Analysis of CaseThe expropriation of bondholder wealth occurs because the creditworthiness of Host Marriott,where most of the debt will reside, is lower than the pre-restructured Marriott Corporation. This is seen inthe bond rating going from BBB to B. While the numbers are rough, the pre-restructured company hadapproximately $3.2 billion in debt to service with $800 million in operating cash flow before interest andtaxes. After the proposed restructuring, Host Marriott would have about $2.9 billion in debt and somewhatover $300 million in operating cash flow. Although very crude, this change in relationship tells the story of

bondholders being expropriated.Other sources of value creation/rearrangement include a possible information effect. If the

announcement conveys an impression of more aggressive management and value maximization, it couldhave a favorable impact on share price. Although the stock performed very well during 1993, the share priceimpact around, the time of the announcement would not suggest an effect other than wealth transfer. Thespin-off creates two separate public companies where only one existed before. There are new agency costs ofauditors and other monitoring devices, together with the ongoing costs of servicing two separate sets ofstockholders. It is possible certain synergy will be lost with splitting Marriott in two, but this probably willnot be significant.

As to net value creation or destruction, the maximum price effect for bonds occurred from Friday,October 2, 1992 to Wednesday, October 7. The announcement was on Monday, October 5. The price declinefor the first bond in Exhibit 3 was 28.5 percent, whereas for the second it was 23.6 percent. If we assumethat 25 percent approximates the actual price decline for al1 fixed-rate debt and that $2.3 billion isoutstanding, the value loss would be $575 million. Share price went from $17 −1/8 on October 2 to $19 −1/8on October 7, a gain of $2. With 95.5 million shares outstanding, this amounts to a total gain of $191million. If these crude calculations approximate the truth, we would have:

Debt holder loss $575 millionStockholder gain 191

−$384 millionIt would seem that there was either an over adjustment by debt holders or an under adjustment bystockholders. By October 30, bond prices and stock prices had increased. The bonds were down about 20

percent and the stock had risen to $20, a $2-7/8 gain over October 2. At October 30, we haveDebt holder loss $460 millionStockholder gain 275

−$185 millionIt makes sense for bondholders to challenge the legality of the restructuring plan. If somehow they

can keep the company from being split, the creditworthiness of their obligations will not lowered. Anotherstrategy is to insist that better security occur or that a higher interest rate occur in keeping with junk bonds.With significant recontracting, value could be restored to bondholders. Management, on the other hand, willwant to give assurances of servicing all debt and hope any furor blows over. After all, public bondholders in

other situations have been expropriated and, in final analysis, they were unable to prevent it. Having gone tomarket with a bond issue in April, 1992, Marriott's management has 1ittle credibility with bondholders.Another issue is the reputation effect. Is it necessary that the two companies have good relations



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management to propose the plan.

AftermathThe corporate bond investment community responded with a vengeance to the restructuring plan.

Investors were concerned not only with Marriott bonds, but with the precedent it would establish for otherexpropriations. A number of large institutional investors, including All state, CALPEFLS, IDS, Kemper,PPM, and TIAA banned together to bring a law suit through Wachtell, Lipton, Rosen & Katz. Eventuallythe suit involved a charge of securities fraud. In addition, there were a half dozen other law suits includingone later from preferred stockholders.

Pressure was brought against Merrill Lynch for selling the bonds of Marriott on the one hand, andthen engaging in a restructuring plan to expropriate their value. The threat of not buying securities throughMerrill was compelling. On November 17, 1992, Merrill resigned from the Marriott restructuring plan.However, they still kept Marriott as a client. At about the same time, Tom Piper, a long-time directorresigned from the Board in protest.

Recognizing the resolve of bondholders, management reluctantly entered into negotiations at theend of 1992. The bondholders wanted a higher interest rate. Other bargaining points revolved aroundMarriott International assuming some of the Host Marriott debt and around transfer payments from Host IVMarriott to Marriott International for services. Eventually Marriott settled with many of the bondholder

groups. Among other things, approximately $450 million of debt and assets were transferred from HostMarriott to IV Marriott International, the credit line from Marriott International to Host Marriott wasextended to the year 2007, the interest rate on the bonds offered in exchange was increased byapproximately 1 percent (but with a maturity extension of about four years), and there was to be a $70million issue of stock to retire bonds. There were other minor concessions as well.

In final analysis, Marriott caved in to do the deal. It is one of the few times that bondholder resolvehad a meaningful impact. With these changes, the bonds have risen in price. At the time of the settlement thetwo issues in Exhibit 3 traded above $100, near their prices before the restructuring announcement.However, interest rates declined over this time frame, so the opportunity loss is greater.



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CASE: MORLEY INDUSTRIES, INC.

Purpose of Case

This case requires a student to prepare a monthly cash budget for a seasonal business as well as a

year-end proforma income statement and balance sheet. On the basis of this information, one is able to planthe financing of the firm. Also, it is useful to explore the flow of funds through receivables and inventorieswhen demand for the product is seasonal but production is level.

Questions

1. Prepare a cash budget along with estimates of total bank credit required at the end of each month forthe year 2000. Note: to calculate collections and payments for purchases, assume each month has 30days and that sales and purchases per day are the same for each day of the month.

2. Prepare a pro-forma income statement for the year 2000 and a pro-forma balance sheet at December31, 2000.

3. Is this a sound credit situation? What would you recommend?

Analysis of CaseIn sizing up the company, it is useful to explore in general the implications of seasonal demand for

the product and level production. There will be a build-up in inventories that is greater than that whichwould occur, with seasonal production. As a result, the peak need for credit will be greater. The companywill be less flexible, and may find itself with excess inventories at the end of the season. In the case ofMorley, the inventory risk of obsolescence is only moderate. The product is not faddish and not subject to

physical deterioration if stored properly. The main problem of inventory carryover is the cost of storageand of financing. At this juncture I find it useful to discuss why a bank requires a period of “clean-up” for aseasonal credit facility, where the loan is paid off for one or two months. The reason is that a clean upindicates that the credit facility is used to finance seasonal funds needs and not more permanent needs.

A source and use of funds statement spanning the 1997 −1999 period reveals:

Sources UsesProfits $3,783 Dividends $2,160Depreciation 4,692 Additions to PP&E 13,464Bank loan 4,478 Accounts receivable 1,146Accounts payable 199 Inventories 2,648Accruals 30 Other assets 304

Mortgage payments 1,500Decrease − cash 8,040

$21,222 $21,222

The permanent nature of the funds requirements is evident, as the company financed its plantinvestment out of cash, which probably was built up in anticipation of the expenditure, as well as withthe bank line of credit. The bank seemed unaware that this was happening, despite the clean-up period,where Morley was out of bank debt, shortening to 1 −½ months.

Going over the cash, budget assumptions, receipts are comprised solely of collections. With a40-day average collection period, and the assumptions ‘of even daily sales across the month and 30-daymonths, this means that 2/3rds of the sales during a month is collected in following month and -l/3 rd iscollected two months latter December, 1999 sales were $3,218 (in thousands), so $2,145 would be expectedto be collected in January 2000, and $1,073 in February.

As to disbursements, the payment for purchases has a 33-day average lag. This means that 90 percent of purchases in a month is paid for in cash in the subsequent month, while 10 per cent is paid forin the second month following the month of purchase. Labor & overhead is $1,480 each month in




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January, as well as in July through December, and is $l,512 each month in February through June .General & administrative expenses are level throughout the year, and are $10,632/12 = $886 per monthEquipment expenditures of $640 each month from March through July are expected. Advertising &

promotion expenditures are scheduled as follows: $50 in January and February; $30,000 each monthfrom March through August; and $65,000 each month from September through December. The total tax

payment for the year is $3,997 in expected before-tax profit times 35 percent = $1,399. Taking one

quarter of this means that $349 would be payable in March, and $350 in June, September and December.Mortgage principal payments of $375 are required in June and in December. Mortgage interest is$10,500 (LTD plus the current portion of LTD) times .05 = $525 in June and $10,125 times .05 = $506in December. Common stock dividends of $300 are scheduled to be paid in March, June, September andDecember.

These are the assumptions involved in preparing a cash budget. Two things should be mentioned.Interest payments on bank borrowings are ignored. These are assumed to be embraced in the G&Aestimates. Whi1e they could be figured separately, for ease of computation they are not. Also ignored isinterest income on cash equivalents in the flush months of late Summer and early Autumn. This too isassumed to be embraced in the G&A estimates.

With these assumptions, we are able to produce the cash budget shown in the exhibit whichfollows. I find it useful to trace through the seasonal funds needs month by month, exploring the cash

shortfall and cash throw-off. Expected year 2000 compares with actual 1999 in the following ways:2000-Expected 1999 Actual

Peak borrowings $6,580 (Mar.) $8,100 (Mar)Trough 0 0Clean up 5 months 2 monthsYear-end borrowings $5,380 $4,418Cash peak $3,761(Aug) n.a.

The implication is that things are improving as far as the seasonal credit facility goes. With capitalexpenditures only modestly in excess of depreciation, the dependence on the line of credit is lessened.Peak borrowings are less, $8,100 versus $6,580, and the period of clean up is longer, 5 months versus 2months.

The pro-forma income statement for the year 2000 and the pro-forma balance sheet for December31, 2000 are shown in the two exhibits which follow the cash budget. The income statement is relativelystraight forward. The balance sheet involves one assumption that may cause students difficulty. For ease of

preparation, it is assumed that the depreciation burden is allocated entirely to inventory. In practice therewill be allocation to certain G&A facilities, but indirectly, though not directly, this too could be allocated toinventory.

Comparing the pro-forma balance sheet with the 1999 actual, the major uses of funds are:receivables up $451; inventories up $560; net PP&E up $600; and the mortgage payable down $750. Themajor sources of funds are retained earnings, up $1,401 and the bank loan up $902. While peak borrowingsare expected to be less in 2000 than they were in 1999, year-end borrowings are expected to be higher dueto significantly higher sales.

Decision in case

The company is coming back to a true seasonal credit after the use of the line of credit to fundcapital expenditures. The year 2000 is a digestion period. One can simulate the cash budget for such thingsas lower sales, a cost-price squeeze, a 50-day collection period etc. Under most scenarios, there is a cleanup. For example, if sales and purchases were down 10 percent, but labor & overhead and general &administrative were down only 5 percent (a cost/price squeeze), peak borrowings of $7,311 would occur atthe December year-end, and there would be a two month clean-up in July and August. This is a more-than-reasonable bank credit, and competition among banks would assure the accommodation of the company atsome institution should the company’s present bank decline to renew its line. The company has beenconsistently profitable, and it has a reasonably conservative balance sheet. Business risk is present; it is,




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after all, a cyclical industry. However, inventory risk is only moderate. For these reasons, most bankerswould be eager to do business with Morley Industries.

MORLEY INDUSTRIES

Original Cash Budget

Receipts: Jan Feb Mar Apr MaySales Collections 3,720 5,250 7,410 7,650 8,5502 months prior 561 1,073 1,240 1,750 2,4701 month prior 2,145 2,480 3,500 4,940 5,100Total receipts 2,706 3,553 4,740 6,690 7,570Disbursements:PurchasesPayment, 2 months priorPayment, 1 month priorLabor and overhead

General & administrative

1,503143

1,3261,480

866

1,583147

1,3531,512

866

1,583150

1,4251,512

866

1,583158

1,4251,512

866

1,583158

1,4251,512

866Equipment expendituresAdvertising & promotionTax payments

50 50640

30349

64030

64030

Mortgage principalMortgage interestDividends 300Total disbursements 3,885 3948 5,292 4651 4,651

Inflow or (outflow)Beginning cash without (1,179) (395) (552) 2,039 2,919Beginning cash without additionalfinancing.

1,524 345 (50) (602) 1,437

Ending cash without additionalfinancing

345 (50) (602) 1,437 4,356

Ending credit required for$1500 cash

5,633 6,028 6,580 4,541 1,622

Ending cash with additionalfinancing

1,500 1,500 1,500 1,500 1,500




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MORLEY INDUSTRIES

Original Cash Budget (con’t)

Jun Jul Aug Sep Oct Nov Dec4,830 4,020 3,360 1,920 1,800 1,890 3,6002,550 2,850 1,610 1,340 1,120 640 6005,700 3,220 2,680 2,240 1,280 1,200 1,2608,250 6,070 4,290 3,580 2,400 1,840 1,8601,583 1,503 907 1,503 1,503 1503 1503

158 158 158 150 91 150 1501,425 1,425 1,353 816 1,353 1,353 1,3531,512 1,480 1,480 1,480 1,480 1,480 1480

886 886 886 886 886 886 886640 640

30 30 30 65 65 65 65350 350 350375 375

525 506300 _________ __________ 300 _________ _________ 3006,201 4,469 3,907 4,048 3,874 3,934 5,4652,049 1,451 383 (468) (1,474) (2,094) (3,605)4,356 6,405 7,856 8,239 7,772 6,297 4,2036,405 7,856 8,239 7,772 6,297 4,203 598

0 0 0 0 0 1,775 5,3801,927 3,378 3,761 3,294 1,819 1,500 1,500




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Morley Industries

PROFORMA INCOME STATEMENT - 2000

Sales $54,000Costs of goods sold 37,800

Gross Profit $16,200General and administrative expenses 10,632Advertising & Promotion Expenses 540Mortgage interest expense 1,031Profit before taxes $3,997

Taxes (35%) 1,399Profit after taxes $2,598Dividends $1,200

Change in retained earnings $1,398

Morley IndustriesPROFORMA BALANCE SHEET DECEMBER 31, 2000

Cash (CB) $1,500 Bank Loan (CB) $5,38Receivables* 4,230 Accounts Payable ‡ 1,65Inventories** 7,840 Accruals (NC) 86

Current Assets $13,570 Mortgage, current 75Current Liabilities $8,65

Net PP&E.*** 27,579 Mortgage 9,00Common Stock (NC) 6,00

Other Assets (NC) 1,110 Retained Earnings ‡‡ 18,60$42,259 $42,25

*Nov. sales (1,890) + Dec. sales (3,600) − Dec. Collections of Nov. sales (1,260) = 4,230

** Start + Additions – CofGS

2,600 Depreciation

17,840 Materials7, 280 37,800 7,84017,920 Labor and Overhead

38,360

ì üï ïï ïï ïï ïï ïï ï+ - =í ýï ïï ïï ïï ïï ïï ï î þ

***26,979 + 3,200 Additional Equipment − 2,600 Depreciation‡ Nov. purchases (1,503) + Dec. purchases (1,503) − Dec. payment for Nov. purchases (150) =

1,653.‡‡ 17,211 + 1,398 (Proforma Income Statement) = 18,609




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CASE: FINANCIAL RATIOS AND INDUSTRIES

Purpose of Case

The purpose of this cases is to demonstrate that financial ratios often take on industry characteristics. It also provides a fun format for students in taking up a rather dry topic

Questions1. Which industries are likely to have the greatest proportions of property, plant &

equipment? Receivables? Inventories? Accounts payable and accruals? Long-term debtand leases? The least proportions of these items?

2. Which industries are likely to have the fastest turnovers of assets, receivables andinventories? The slowest turnovers?

3. Which industries are likely to have the highest net profit margin? Highest dividend payout? The-lowest net profit margin and dividend payout?

4. Match the financial ratios with the industry.

Analysis of Case

Before identifying the industries, I ask students which industries are likely to be outliers, orextremes, with respect to balance-sheet proportions and various financial ratios. In general, we might expectthe following:

Proportions: Greatest Least

PP&E Airline, utility, oil company, laundrydetergents & food retailer.

Employment service, advertising, bank & electronic wholesaler.

Receivables Advertising, employment service, bank, electronic wholesaler & hotelsupply.

Airline, utility & food retailer.

Inventories Food retailer, hotel supply &electronics wholesaler.

Airline, utility, bank,employment service, news &info. publisher, advertising, &computer software.

Accounts payable&accruals

Advertising, bank, employmentservice, hotel supply & electronicwholesaler.

Airline, utility, oil company,news & info. publisher, &computer software.

LTD & leases Airline, utility & aluminum producer.

Employment service, bank,computer software &

pharmaceuticals.

Turnovers: Fastest Slowest

Asset Employment service, food retailer& electronic wholesaler.

Utility & bank.

Receivables Food retailer, airline & utility. Employment service, bank & hotelsupply.

Inventories Airline, food retailer, oilcompany & computer software.

Hotel supply & pharmaceuticals.




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Decision in Case

The key to industry and the lettered columns is:

Letter Industry CompanyA Tools & process/

environmental controlsDanaher Corporation

B Electric & gas utility Wisconsin Energy Corp.C Employment services Manpower, Inc.D Laundry detergents Clorox CompanyE News & info. publishing Dow Jones & CoF Commercial banking Banc One CorporationG Advertising Interpublic Group, Inc.H Aluminum/packaging Reynolds Metals Co.I Computer software, Microsoft CorporationJ Food retailing Hannaford Bros. Co.K Wholesaler of electronic & computer

productsArrow Electronics ,Inc.

L Airline South west Airlines Co.M Hotel supply business Guest Supply, Inc.

N Pharmaceuticals Merck & Co., Inc.O Integrated oil production Chevron Corporation

The most difficult to identify are A., tools and environmental / process controls, D. , laundry detergents, andH. , aluminum / packaging. These companies, all manufacturers, are in the middle. The other companies areoutliers along one or more dimensions and can be more easily identified.

Percentages: Highest Lowest

Net margin Pharmaceuticals, computersoftware, bank & utility.

Employment service, electronicwholesaler, food retailer & hotel

supply.Dividend

payoutUtility, bank, pharmaceuticals, oilcompany, laundry detergents &aluminium .

Computer software, electronicwholesaler & airline.




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CASE: CACERES SEMILLA S.A. de C.V.

Purpose of Case

The focus of this case is upon funds flows through assets in a seasonal business and upon the best method of financing.

The student is required to complete the pro-forma balance sheet as to the expected cash position and the bank loan necessary,going forward month by month. A critical issue is the deteriorating trend in inventory turnover, and the large amounts of moneylikely to be tied up in this asset. Also, there are questions of growing in a sustainable way and the diversion of funds away fromthe business.

Questions

1. Analyze the company's past financial condition and performance.

2. Complete the pro-forma balance sheet. What are the projected funds flows though receivables and inventories? through payables and accruals? What is the pattern of projected borrowing requirements?

3. As to financing, what should the company seek? As the banker, would you accommodate the company's projected borrowing requirements? What, if anything, causes you concern?

Analysis of CaseA source and use of funds statement for the 1996-1999 period reveals the following (in thousands of pesos):

Sources Uses

Profits 1,830 Dividends 120Depreciation 1 ,014 Gross Addn. PP&E 1,740Accounts payable 714 Receivables 732Accruals 462 Inventories 1,770Bank loan 900 other assets 348

Cash - decrease 510 Long-term debt 720

5,430 5,430The major uses are inventories, capital expenditures in excess of depreciation, receivables and the pay down of debt. The majorsources are retained earnings, payables and accruals, and the bank loan. The inventory problem is particularly noteworthy at this

juncture of the case discussion.

The past financial ratios are shown in the first exhibit of this teaching note. The current and quick ratios decline overtime, what with the increase in accounts payable and in the bank loan. The average collection period increased in fiscal year 1999,indicating more funds being tied up in inventories. Particularly disturbing is the slowdown in inventory turns, from 5.9 x to 4.9 xto 4.2x. It is worth pointing out that the worsening turnover of receivables and inventories has caused most of the growth incurrent assets, as opposed to them being sales propelled. The debt/equity ratio declined from FY1996 to FY1998, and thenincreased with the jump in payables, accruals, and in the bank loan. The average payable period increased in FY1999, which mayhave repercussions for producer relations. As to trends in gross and net profit margin, both ratios fluctuated over time. The jumpin G&A to sales from FY1996 should be a matter of concern.

There are a number of business risks. Agricultural cycles are cyclical. There are considerable price fluctuations in bothcorn and alfalfa. With seasonality, there is inventory risk. The product is subject to spoilage if held over to the next sellingseason. The quality of the seed is always an issue, particularly if the company has to purchase seed in the spot market to meetdemand. The industry itself is competitive, though-Caceres enjoys. Good market share, 19%, in the Province of Santa Fe.

Past financing has consisted of the bank loan and an insurance company long-term loan to rebuild the Esperanza plant in1993. The latter loan is fixed rate, at 13%, with principal payments of P60,000 required semi annually. The bank loan is under aline of credit at the reference rate, presumably for the purpose-of funding seasonal-funds needs. However, the company isfinancing underlying build-ups in receivables and inventories with this facility. The 4.8 million peso line was exceeded the

previous August. The need is being driven by slower turnovers of these two current assets, as well as by capital expenditures inexcess of depreciation.

Assumptions behind the pro formats are questionable. Sales growth of 22.7 percent is projected, which is very largegiven what has happened over the past 4 years. Also, the 30-day average collection period and 60-day average payable periodassumptions seem a bit optimistic. Given the pro-formas produced, however, the following patterns are evident :



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Peak Trough

InventoriesReceivables

June

Sep. (Jan, lesser peak)

January

April, May

Payables

Accruals

April

Sep. (Jan, lesser peak)

October

April

The built-in methods of financing partially support the seasonal patterns in inventories and receivables. Payables partiallysupports the bulge in inventories early in the fiscal year, and the second receivable bulge in January, while accruals supports thereceivable bulges in September and in January.

The completed performs of Exhibits 3 and 4 of the case constitute the last two pages of this teaching note. The borrowings that are projected reflect a peak of 5,572 pesos in August, with high borrowing in June through October as well. Thetrough is 510 pesos in March, with no clean-up, and year-end borrowings of 1,906 pesos are projected. The peak requirements arein excess of the 4.8 million peso line, there is no clean up, and year-end borrowings are some 1 million pesos higher than at the

previous year-end. While the company is projected to be profitable, it clearly will use the bank line to finance underlying, asopposed to seasonal, funds needs. Inventories are projected to increase by 1,284 pesos from one year-end to the next. This hugeincrease represents 38 percent, versus only a 23 percent increase in sales being projected. No explanation is given by management

as to this increase.As to character, the company has built a tradition of over 110 years in business, is consistently profitable, has a high

quality product and is family run so control is not an issue. Negatives include inventory management, the bank overdraft in July,1998, the overage on the line in August, with no consultation with the bank, the diversion of 105,000 pesos to Joaquin Estabanwithout notification of the bank, the doubling of the dividend, the leaning on growers with a 60-day payment lag, and, perhaps,Juan Pablo's fascination with mules!

Decisions

The focus of management needs to be on-inventory. It needs to get a handle on the situation. The banker needs to forcemanagement focus on this. If inventories were to grow only with sales, year-end projected borrowings would be some half-million

pesos less. Inventory management is the key to financial health. Apart from this, it may be desirable to slow the growth of thecompany to low-double digit, as opposed to 23 percent. This would allow the company to concentrate on its more profitable

business. The banker should consider constraining, through-protective covenants, the following: dividends, future capitalexpenditures in relation to depreciation, and further investments in the steer manure or any other outside businesses. If some ofthese problems can be addressed, the company is a bankable credit. If not, the company will be financially strained.

Caceres Financial Ratios

1996 1997 1998 1999

Current ratio 1.5 1.4 1.4 1.3Quick ratio 0.8 0.7 0.6 0.5Ave. collection period 27.8 30.9 30.7 37.4Inventory turns − 5.9 4.9 4.2Debt/equity 1.4 1.2 1.0 1.2Ave. payable period* − 53.9 53.7 60.7

Gross profit margin 38.7% 38.1% 41.2 % 40.6%

Net profit margin 3.9 3.3 3.1 3.5P & Store/sales 11.0 11.1 12.2 11.9S & delivery/sales 12.5 12.4 13.6 12.7G & A/sales 7.5 8.1 9.1 8.9



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Exhibit 3

Caceres Semilla S.A. de C.V.

Pro forma Income Statements FY 2000

Mar. April May June July

Net salesCost of goods soldGross profit

1,6801,008672

1,260756504

1,260756504

1,6801,008672

1,6801,00867

Depreciation 31 31 31 32 32Procession & storing exp. 150 150 204 204 288Selling & delivery exp. 216 162 162 216 216General & admin. exp. 151 158 185 199 200

Profits before taxes 124 3 (78) 21 (64)Income taxes 96 110

Profits after taxes 28 3 (78) (89) (64)Dividends 120

Exhibit 4

Pro forma Balance Sheets for FY 2000

Mar. April May June JulyCash 200 200 200 200 200Account receivable 1,626 1,206 1,206 1,626 1,626Inventories 5,877 6,888 7,434 7,728 7,557

Total Current Assets 7,703 8,294 8,840 9,554 9,383

Net fixed assets 4,385 4,366 4,479 4,459 4,439Other Assets 654 654 654 660 660

Total Assets 12,742 13,314 13,973 14,673 14,482

Accounts payable 4,713 4,794 2,619 2,154 1,689Accruals 1,059 954 1,059 1,164 1,326Current portion, LTD 120 120 120 120 120Bank loan 510 1,103 3,910 5,239 5,415

Total Currents Liabilities 6,402 6,971 7,708 8,667 8,550

Long-term debt 1,440 1,440 1,440 1,380 1,380Common stock 192 192 192 192 192Paid-in-capital 534 534 534 534 534Retained earnings 4,174 4,177 4,099 3,890 3,826

Total Liabs. & Equity 12,742 13,314 13,973 14,673 14,482



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CASE: DOUGALL & GILLIGAN GLOBAL AGENCY

Purpose of Case

Dougall & Gilligan (D&G) is a case involving long - term financing. The company used a numberof types of such financing in past, which affords a discussion of the features of bank lines, private-

placement term loans, convertible debentures and equity financing. The four new financing alternativesinvolve analyses and a decision. The case can be used as a comprehensive introductory case on long-termfinancing or as a more detailed subsequent case on this subject matter.

Questions

1. What are the company’s financial condition and performance, its funds requirements, andits business risk?

2. Do the existing means of financing unduly restrict the company?

3. Analyze the financing alternatives as to which best fits D&G’s situation.

4. As CFO, what means of financing would you recommend?

Analysis of CaseThe financial ratios of consequence are the following:

1991 1992 1993 1994

Current ratio 1.1 1.1 1.1 1.1

Ave. collection period 51.4 45.7 38.5 42.2

Debt/equity ratio 7 0 6.2 7.4 6.9

Interest-bearing debt to capitalization .6 .6 .6 .6

Net profit margin 4.7% 5.3% 5.7% 5.6%

Salaries & ben./sales 54.4 52.5 53.5 52.7

Office & general/sales 33.8 34.5 33.5 34.8

The unusual aspect of an advertising agency is that it is a conduit for funds flows. It has a large amount ofreceivables, which represent billings to its clients. At the same time it has a large amount of payables, owedmostly to the media. The receivable versus payable lag is very important-, as small changes can have alarge effect on the company’s funds requirements. The average commission is but 13 percent, so it isnecessary to multiply the average collection period found in the usual manner by 13 percent. The favorabletrends are a moderate improvement in the average collection period and in the net profit margin, whencompared with 1991 as the base year. The company is marked by a relatively high degree of leverage. Theindustry also uses extensive debt, but the average debt/equity ratio in 1994 was only 4.5x. However, D&Ghas a higher profit margin.

As to business risk, the company is in a cyclical industry with rapidly changing trends. There is the

danger of creative obsolescence, and there is considerable client turnover. Interactive communications andthe Internet threaten older forms of advertising. There is pressure on margins, and the industry is verycompetitive. All in all, there is a good deal of business risk.

The means of financing in. the past allow discussion of the features of: 1) the bank lines of credit(interest rate and nature); 2) the term loans by institutional investors (range of interest rates, maturities,restrictive covenants on acquisitions and further debt, the credit rating of BBB, and flexibility of the

borrowing arrangement); 3) the convertible subordinated debentures (interest rate, conversion price,conversion premium, the nature of delayed equity financing and forcing conversion, the call pricetranslating into a share price of $124.75, which with a cushion means forcing conversion only if $143 orabove, and with a share price of $64, the issue overhangs the markets which clouds future equity-linkedfinancing); and 4) equity issue in 1992 (price of $71.50, rights offering with a very small ratio of 1 for 25,and a-beta of 1.3 versus 1.1 for the industry reflecting higher leverage).




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The immediate financing needs are assumed to be $300 million. The question is what is the bestfinancing alternative. I have students briefly review the features of the four alternatives: further bank

borrowings; additional term loans; 20-year debentures; and equity,. The bank loan is only a partial answer,as it will not cover the full financing needs. If the company were to sell equity, it wi11 need to beunderpriced from the current share price of $64. If one assumes a price of $58, this translates into 5,172,414new shares of stock, compared with 26,860,000 now outstanding. Even though the share price has declined,

the present price/earnings ratio ($2.77 eps) is 23x, which compares favorably with other major companies inthe industry.

An EBIT/ EPS analysis (described in Chapter 10) suggests an indifference point between thedebentures (10.75%) or term loan (10.50%) and common stock issuance of $238 million in EBIT. Thisassumes existing 1994 interest of $36.3 million, new interest, the interest reset described in the case, and5,172,414 new shares for the common-stock alternative. The present level of EBIT is $167.3 million, so thecompany is below the indifference point where debt dominates with respect to earnings per share: At 15

percent growth in EBIT it will take about 2-1/2 years to reach the indifference point. This analysis favors acommon-stock offering.

The immediate effect on the debt ratios is as follows:

1994 actual Pro forma

Total liabilities $1,879 $2,179Interest-bearing debt $440 273 $740

Shareholders’ equity 713 273

Capitalization $440 273 1,013

Debt/equity ratio 6.9 8.0

Interest-bearing debt to capitalization 0.62 0.73

The immediate effect on the coverage ratio of times interest earned if debentures are used is:

EBIT $167.3 $167.3

Interest 36.3 68.9

Times interest earned 4.6x 2.4x

This represents a sharp reduction, but debt service still is possible as long as long as earnings hold up.

The combination of effects on the debt ratio and on the coverage ratio will likely result in a down gradeof credit rating from BBB to BB. Very few companies are rated investment grade with a times interestearned of less than 3.0. Once a company is downgraded into the speculative grade category, it is difficult toregain an investment grade. This will affect the company’s interest costs and availability of credit,

particularly in any “flight to quality”.

Financial flexibility has to do with a decision now impacting future financing. It is hard to tell if thecompany will have future external financing needs. The more likely this becomes, the stronger the, case forkeeping the “top open” for debt financing in the future and building your equity base now. Another aspect

of flexibility concern s not being able to repay the term loan.The timing of debt and equity issues needs to be factored in. Interest rates appear to be heading further

up, after rising in 1994. This proved not to be the case in 1995, when they declined, but the generalexpectation at the time of the case was that interest rates would rise further. The stock market gives thecompany a P/E ratio of 23, which is better than other large companies in the industry. The president, DrewWaitley, wants to postpone any stock offering. He believes the “company is on a roll” and that if stock is to

be used in financing it can be done on much more favorable terms in the future. This argument can beviewed in the context of the option value of equity in a levered situation (see Chapter 9)




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Decision in Case

Most of the analyses above, as well as the underlying business risk in the case, argue for common-stockfinancing and building the equity base. If one goes with one of the two methods of long-term debt, it must

be predicated upon confidence in your growth forecast after fully considering business risk. Moreover, youmust be willing to give up an investment-grade credit rating. Postponing a decision by further reliance on

bank lines of credit is only possible for a short while, given the ultimate $300 million in external financingrequired. I have found that most students decide upon the common - stock alternative but some do not wantto sell stock and suffer dilution, being inclined to bear the risk.




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CASE: RAYOVAC CORPORATION

Purpose of Case

The Rayovac case deals with exit strategy from a previous leveraged buyout and the timing of such. It,allows exploration into: leveraged buyouts in general, the hallmarks of a good candidate, the sources of

value, and management execution once a buyout has occurred. Finally, one can investigate the question ofwhether an IPO is the best exit strategy.

Questions

1. Was Rayovac a good LBO candidate in September, 1996? What were the positives? the negatives?

2. Was the valuation appropriate from the standpoint of the LBO firm? Was the structure of the dealtypical?

3. What did-management do? Did they create value?

4. Is it appropriate to consider an exit strategy only one year after the LBO? Would you exit at this timeand, if so, what would be the vehicle?

Analysis of Case

With respect to the first question of whether, ex ante, Rayovac was a good LBO candidate, the positivesare impressive. It is a long standing company with a well known brand name, even though it has only a 10

percent overall market share. It has market dominance in several niches: hearing aid, lithium, wafer,lantern, heavy duty, and rechargeable. While a mature industry, the market is growing at about 5 percent,as new electronic devices require specialized batteries and miniaturization. Rayovac’s manufacturingfacilities are modern and efficient, so cash flow can be dedicated to debt service-There are reasonable

barriers to entry; the manufacturing process is complicated and capital intensive. With respect toadvertising, Michael Jordan is a real plus. Finally, David Jones is a dynamic CEO with a proven trackrecord.

A major negative is that Rayovac is very much a number 3 player behind Duracell and Eveready.Rayovac must compete on the basis of price, with approximately a 10 percent discount from the twomarket leaders. The product mix is weighted in the direction of heavy duty, which is declining in volumeas customers prefer alkaline. The need to advertise means that part of the discretionary cash flow must beused for this purpose. A significant existing debt burden, $81.3 million, limits flexibility in financing.Finally, the business deteriorated to some extent during the time the previous owner was trying to sell it.On balance, the positives seem to outweigh the negatives so it is not surprising that on the basis ofqualitative considerations Thomas H. Lee (THL) considered the situation.

The next issue is valuation. The price at September, 1996 was $326.5 million to retire Rayovaccommon stock, which would be used to pay of existing debt and to cover fees, etc. This is far less than the$500 million Merrill Lynch initially suggested in their role of advisor to the seller. It is 7.5 times trailingEBITDA (earnings before interest, taxes, depreciation and amortization). This compares favorably to thecompanies in Exhibit V of the case. Gillette paid 15.1 times EBITDA for Duracell. The enterprise value(interest bearing debt + preferred stock + market capitalization of common stock - cash when significant)to sales ratio is only 0.8x.This is much less than the 3.5x for Duracell , and less than the other companiesshown in Exhibit V, which range from 1.2x to 3.1x. On a relative basis, the price paid seemed favorablefrom the standpoint of the LBO firm, THL. In retrospect, it bought cheaply and that was a major source ofvalue.

The structure of the LBO was (in millions):

Revolv ing credit facility $26Term loan 105Bridge loan 100THL investment 72Pyle continuing equity 18Foreign debt and capital leases 5.5

$326.5




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At the end of the day, Mr. Pyle, the seller, had 9.9 percent of the "Newco" stock, existing management, 9.9 percent , and THL and David Jones, 80.2 percent . Mr. Pyle insisted upon the bridge loan as opposed to the promise by THL to raise the debt capital. The structure consisted of debt and common equity, there beingno mezzanine layer of financing.

The new management team created value by their actions. Efficiency gains .occurred through rationalizingmanufacturing, getting better plant utilization, and increasing productivity through better training, newinformation systems, and new equipment . Plants were reduced from 8 to 4, purchasing and other thingswere centralized and a number of other actions occurred. Jones changed the corporate culture towardsdecision making at lower levels, accountability, better communication, and the encouragement of risktaking. For fiscal-year 1997, costs were reduced by $6.3 million, and $8.6 million in savings going forwardappeared to be possible. The product mix changed slightly towards somewhat more alkaline , and lessheavy duty and rechargeable. Hearing aid and other products were up some in the mix.

The following occurs a cross the two fiscal years:

FY 1997 FY 1998Gross profit margin 43.5% 45.8%Operating income to-sales 7.2 8.0SG&A-to-sales 35.0 36.4Sales +2.2%EBITDA +8.5%While certainly not striking, solid improvement is evidenced in these figures. The exception is SG&A, buthere some of the increase is due to a reclassification of expenses.

To exit one year after an LBO is unusual; the typical horizon is 4 years or more. However, a lot of progresshas occurred and the "low hanging fruit" has been picked. Now it is a matter of grinding it out. The stockmarket is booming and consumer product stocks are relatively hot. Probably most importantly, THL wantsto liquefy part of their investment and reduce its exposure to Rayovac in its portfolio.

I like to explore next how attractive the company is for an IPO. This considers the things previouslydiscussed. As to valuation, the goal of the company is to increase sales by 10 percent and EBITDA by 20

percent. If this were to occur, sales for FY1998 would be $476 million, EBITDA would be $55 million,and EBIT would be $41.4 million, if it too increased by 20 percent. With $24.9 million in interest and

other expenses (the same as in FY1997) and a tax rate of 35 percent, profit after taxes for FY1998 would be $10.7 million. The following valuation ranges then might be in order (in millions):

Sales multiple: Enterprise value Equity value = enterprise value -debt of $2071.0x $476 $2691.4 666 4591. 8 857 6502 .2 1,047 840

EBITDA multiple:7.5x $413 $2068.5 468 2619.5 523 316

10:5 578 371

11.5 633 42612.5 688 481P/E multiple:

16x $17118 19320 21422 23524 25726 27828 30030 321




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The medians for the companies in Exhibit IV of the case are 2.3x for sales multiple, 11.8x for EBITDAmultiple, and 23x for P/E multiple. It is useful to go over the companies as comparables. Most studentscome up with an equity valuation of $300 million to $400 million in the "hot" market that existed at thetime.

Decisions in Case

The first decision is whether to exit now or to wait until further results are demonstrated. Much can besaid for seizing the opportunity now, as the window is open and there is the risk that something may gowrong with future operations. Although the exit is early, it is not pre-mature.and would be built upon asolid foundation.

The vehicles for exit reduce to two - an IPO or the sale to a strategic buyer. A leveraged build -up is anon-starter, not only because of THL's reluctance but because no battery business of reasonable size isavailable. After Duracell, Eveready, and Rayovac, no other manufacturer has even a 2 percent marketshare. As to a strategic buyer, Duracell and Eveready would not be feasible for anti -trust reasons. The

buyer would have to be from outside the battery industry, so significant economies would not be possible.

This leaves an initial public offering as the most feasible exit. The window is open and, at the time ofthe case, the market is likely to be receptive to a consumer products company.

AftermathOn November 21, 1991, Rayovac had an IPO of 6.7 million shares, with a Green shoe option for

another 1.0 million, at $14 per share. The offering, led by Merrill Lynch, Bear Stearns, DLJ, and SmithBarney, went well and the shares closed at $16.50 the first day. With 27.4 million shares outstanding, theequity value (market capitalization) was $452 million at the end of the day ($385 million at $14 share

price). After underwriting fees, the company realized $87.9 million in net proceeds. These proceeds wereused to reduce debt. In FY1998, the company continued to deliver, and earnings per share grew 64 percent.It increased its market share in alkaline batteries from 8 to 16 percent and in hearing-aid batteries from 46to 60 percent.

On June 3, 1998, THL and some members of management completed a secondary stock offering of6.4 million shares at $21 per share- Afterwards, THL's ownership was reduced to approximately 40 percentand management from 9.6 percent to 5.8 percent.




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Chapter-1

GOALS AND FUNCTIONS OF FINANCE

Case : Vision and objectives of Indian Oil Corporation Limited

Hints:1. Stakeholders of IOCL – customers, dealers, suppliers, employees, community, defence

services. No mention has been made of shareholders and government as stakeholders.2. Stockholders’ wealth maximization as legitimate objective –

• No – as there are other stakeholders as well.• Yes – stockholders bear the risk and are the last one to receive any thing.

Maximizing their wealth would mean that all other stakeholders have beentaken care of.

3. Financial objectives of IOCL –• Instead of maximizing return and dividends – adequate return and reasonable

dividend.• Focus on cost reduction and economy in expenditure.• Silent about the management of working capital and capital structure.

Solutions

1-1. Maximizing wealth takes into account all factors which influence the market price ofthe stock. Maximizing earnings is not "all inclusive" because it does not take account ofthe timing of earnings, of the business arid financial risk of the firm, and of dividend

policy. While shareholder wealth and corporate profitability tend to be closelycorrelated over time, the two can deviate for the reasons cited. As shareholder wealth is

more inclusive, we should use it.

1-2. If capital is allocated on a risk-adjusted return basis, it will flow to the most productiveinvestment opportunities. In this way, the economic growth of society will bemaximized as the most efficient investment projects are undertaken. As shareholderwealth is determined by the risk-return nature of the company, only a wealthmaximization objective will result in savings in our society being efficiently allocatedto productive investment opportunities.

1-3. The first project is expected to provide $350,000 in annual profits over 8 years or $2.8million in total. The second project is expected to have the following after-tax profits:

Year Profit1 02 03 $40,0004 80,0005 120,0006 160,0007 200,0008 240,0009 280,000

10 320,00011 320,000



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12 320,00013 320,000

14 320,00015 320,000Total $3,040,000

While the second project is expected to provide greater total profits, these profits arereceived further in the future than are the profits for the first project. Also, there may bemore uncertainty associated with the second project. Because of these factors, most

people prefer the first proposal.

1-4. The major functions of the financial manager are the investment decision, the financingdecision, and the dividend decision. The subsets under each are given in the chapter.These decisions share the common thread that they affect the value of the company'sstock. Together they determine the stock's value.

1-5. If managers have sizable stock positions in the company, they will have a greaterunderstanding for the valuation of the company. Moreover, they may have a greaterincentive to maximize shareholder wealth than they would in the absence of stockholdings. However, to the extent persons have not only their human capital but alsomost of their financial capital tied up in the company, they may be more risk aversethan is desirable. If the company deteriorates because a risky decision proves bad, theystand to lose not only their jobs but have a drop in the value of their assets. Excessiverisk aversion can work to the detriment of maximizing shareholder wealth as canexcessive risk seeking if the manager is particularly risk prone.

1-6. Regulations imposed by the government constitute constraints against whichshareholder wealth can still be maximized. It is important that wealth maximizationremain the principal goal of firms if economic efficiency is to be achieved in societyand people are to have increasing real standards of living. The benefits of regulations tosociety must be evaluated relative to the costs imposed on economic efficiency. Where

benefits are small relative to the costs, businesses need to make this known through the political process so that the regulations can be modified. Presently there is considerableattention being given to deregulation. Many things have been done to make regulationsless onerous and to allow competitive markets to work more effectively.

1-7. As in other things, there is a competitive market for good managers. A company must pay them their opportunity cost, and indeed this is in the interest of stockholders. To the

extent managers are paid in excess of their economic contribution, the returns availableto investors will be less. However, stockholders can sell their stock and investelsewhere. Therefore, there is a balancing force that works in the direction ofequilibrating managers' pay across business firms for a given level of economiccontribution.

1-8. In competitive and efficient markets, greater rewards can be obtained only with greaterrisk. The financial manager is constantly involved in decisions involving a tradeoff

between the two. For the company, it is important that it do well what it knows best. Ifit gets into a new area in which it has no expertise, there is little reason to believe thatthe rewards will be commensurate with the risk that is involved. The risk-rewardtradeoff will become increasingly apparent to the reader as this book unfolds.



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Chapter 2 : Solutions

Problem 1:

Taxable Income = INR 1,580,300

Income Tax Rate TaxUpto 160,000 0 0160,001-500,000 10% 34,000500001 – 800,000 20% 60,000More than 800,000 30% 234,090Total 328,090Add: Education Cess 3% of Tax 9,843

337,933

Problem 2

Depreciation 25% of INR 4 million = 1 millionTax Saves 30% of 1 million = 300,000Plus surcharge @ 7.5% = 22,500Plus education cess = 9,675Total Saving (tax shield) 332,175

If depreciation rate is 40% the tax shield will increase to INR 531,480.




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Chapter-3

Time Value and Money

3.1. a) (1) $133.10 (2) $800 (3) $100

b) (1) $134.49 (2) $1,455.19

c) The more times a year interest is paid, the greater the terminal value. It is particularlyimportant when the interest rate is high, as evidenced by the difference in solutions betweena) (2) and b) (2)

d) (1)$259.37 (2) $265.33 (3) $268.51 (4) $271.83

3.2. a) (1) $100 x .75131 = $75.13

(2)$100 $100

$12.503 8

= =

[2]

(3) $100

(2) $100 x .80000 = $80.00

500 x .64000 = 320.00

1,000 x .51200 = 512.00

$912.00

d) (1) $1,000 x.96154 = $961.54

500 x.92456 = 462.28

100 x.88900 = 88.90

$1,512.72

(2) $1,000 x .80000 = $800.00

500 x .64000 = 320.00

100 x .51200 = 51.20

$1,171.20

b) (1) $500 x 2.7751 = $1,387.55

(2) $500 x 1.9520 = $976.00

c) (1) $100 x .96154 = $96.15

500 x .92456 = 462.28

1,000 x .88900 = 889.00

$1,447.43



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3.3. a) 7.18 percent

b) 23.38 percent

c) 40.62 percent

d) IRR = $60/$1,000 = 6 percent (a perpetuity).

3.4

3.5. a) Annuity of $10,000 per year for 15 years at 5 percent. The discount factor in Table B at the endof the book is 10.3796.

Purchase price = $10,000 x 10.3796 = $103,796.

b) Discount factor for 10 percent for 15 years is 7.6061.

Purchase price = $10,000 x 7.6061 = $76,061.

As the insurance company is able to earn more on the amount put up, it requires a lower purchase price.

c) Annual annuity payment for 5 percent = $30,000/10.3796 = $2,890.28.

Annual annuity payment for 10 percent = $30,000/7.6061 = $3,944.20.

The higher the interest rate embodied in the yield calculations, the higher the annual payments.

3.6. $50,000/$25,000 = 2.0 or a doubling in 6 years. The reciprocal of this is .50. Looking in Table A atthe back of the book, the discount factor for 12 percent is. 50663 and that for 13 percent is .48032.Interpolating, we have

( )( ).50663 .50000

12% 12.25%.50663 .48032

-+ =

-

as the interest rate implied in the contract in going from the end of year 6 to the end of year 12.

3.7. a) $10,000 = 2.9137x

$10,000$3,432

2.9137 x = =



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b) End of Year Installment Principal at Year End Annual Interest Principal Payment

0 - $10,000 - -

1 $3,432 7,968 $1,400 $2,032

2 3,432 5,652 1,116 2,316

3 3,432 3,011 791 2,641

4 3,432 0 421 3.011

3.8

Month Payment Interest Principal Repayment Remaining Balance

0 0 0 0 $8,000.00

1 $265.71 $80.00 $185.71 7,814.29

2 265.71 78.14 187.57 7,626.72

3 265.71 76.27 189.44 7,437.28

4 265.71 74.37 191.34 7,245 .94

5 265.71 72.46 193.25 7,052.69

6 265.71 70.53 195.18 6,857.51

7 265.71 68.58 197.13 6,660.37

8 265.71 66.60 199.11 6,461.27

9 265.71 64.61 201.10 6,260.17

10 265.71 62.60 203.11 6,057.06

11 265.71 60.57 205.14 5,851.92

12 265.71 58.52 207.19 5,644.73

13 265.71 56.45 209.26 5,435.47

14 265.71 54.35 211. 36 5,224.11

15 265.71 52.24 213.47 5,010.65

16 265.71 50.11 215.60 4,795.04

17 265.71 47.95 217.76 4,577.28

18 265.71 45.77 219.94 4,357.35

19 265.71 43.57 222.14 4,135.21

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