delicious inc

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Delicious, Inc.

In early January 1978, John Hescott, treasurer of Delicious, Inc., was ready to analyzethree proposals for financing a $3 million capital improvement program. The firm’s

board was going to meet in a few days, and at that time he would have to recommendwhich of the three proposals should be selected.

BACKGROUND

Delicious, Inc., was founded by Harold Steinberg in 1922 to manufacture and sell candyand related products. The firm was immediately profitable, and sales and profitsincreased each year through 1929. The Great Depression hit the firm quite hard, and threeconsecutive annual losses were experienced. The firm survived only by stringent cost-cutting efforts and the support of its commercial bank. At that time the firm had a sizableloan with its commercial bank, which agreed to postpone interest and principal payments

for four years. This experience convinced Mr. Steinberg of the importance of soundmarketing and financial policies. In his judgment, sound policies meant no debt and slowsales growth. Over the years, many of the firm’s managers proposed faster growth and/orthe use of debt, but Mr. Steinberg would not seriously consider any of these proposals.

Mr. Steinberg also believed in keeping the company private, in order to maintainflexibility in setting policy and maintain control. By 1978, 892,000 common shares wereoutstanding. Members of the Steinberg family owned 60 percent of these shares, andformer and current employees owned the remainder. If a shareholder wished to sell shares,he or she would have to sell them back to the firm at book value. If the firm did not havethe funds, then the person would have to wait up to one year to receive the funds. The

only exception was if the shares were being sold for estate tax purposes. In such asituation, Mr. Steinberg would see to it that the shares were repurchased immediately.Although several people criticized this policy, Mr. Steinberg did not believe that it wasunfair, for the following reasons. First, employees who took advantage of the firm’s stockoption plan could have selected an alternative profit-sharing scheme. Second, althoughthe policy was that a seller might have to wait one year, this never happened since thefirm maintained a high level of liquidity. Third, the firm paid healthy dividends.Dividends had been paid in every year since 1940, when they were first instituted. Sincethat time there had never been a dividend cut; on the contrary, small increases in thedividend rate were frequent. Mr. Steinberg thought that the dividend returns theshareholders were earning were fantastic. When dividends per share were increased from

$1.60 to $1.65 in 1967, he said, “Many people purchased their shares for $1 per share. Onthese shares they will now earn a return of 165 percent!”

When the founder died in late 1968, his son Richard assumed the presidency. Althoughthe new president also believed in conservative policies, he had long felt that his fatherhad been a bit too conservative. Moreover, he had always disagreed with his father’s policy of keeping the company private. These disagreements were not secret, and it wasalso known that the elder Steinberg had begun to yield on the issue of taking the company


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public. He had still believed that it was best to keep the company private, but he hadrealized that, since so many shares were outstanding, a problem could develop if manystockholders decided to sell at the same time. If they were to do so, the firm might haveto borrow a substantial sum to repurchase the shares; from the founder’s point of view,this was less desirable than taking the company public.

Richard Steinberg spent his first two years as president trying to convince the board ofdirectors to accept a goal of going public and to change its policy on the use of debt. Hewanted to use debt to accelerate the rate of expansion so that the firm would be well positioned to become a public company. Convincing the board to accept the idea of going public was not difficult, since, as noted above, it was well known that the founder had been beginning to yield on this matter. Selling the idea of using debt was more difficult.After many discussions, Richard Steinberg succeeded in obtaining agreement to use amoderate amount of debt. He was able to do this by demonstrating that financingexpansion with a moderate level of debt was not too risky, and that it would probably permit greater growth in dividends per share because there would be less of a need for

raising funds by issuing new common shares.

To position the company to go public, the new president believed that it would be beneficial to increase both sales and profits. He also believed that this could be bestaccomplished by introducing two new product lines (that is, different types of candy). Hehad originally planned to introduce both at the same time and to finance the entireexpansion program with debt. However, discussions with members of the boardconvinced him that the board would never approve such a program. While there was aconsensus to accelerate growth somewhat and to use some debt, there was strongsentiment that the marketing and financial policies that proved so successful should not be changed too much. Consequently, the president proposed a three-phase program. Thefirst new product line (hard rock candy) would require $5 million. It would take aboutfive years, until 1975, for this new product to be fully integrated into the firm’s existingoperations.

The second phase was a different product line (licorice), which was larger than the product line of phase 1. This phase would begin in 1976 (after the success of phase 1could be evaluated) and require about $6 million. Three years after the beginning of phase 2 the product line would have to be expanded. This expansion (phase 3) wouldrequire about $2 million.

Although phases 2 and 3 were related, the first phase was unrelated to the others. In otherwords, by accepting the first phase the firm was not committing itself to the remainder ofthe program. Thus the board voted to accept phase 1 and finance it with a debt. A $5million, five-year term loan was obtained from its commercial bank. Interest and principal payments were required semiannually, commencing six months from the dateon which the loan agreement was signed.

Phase 1 proceeded smoothly. Sales and profit targets were achieved. Loan payments wereeasily met, and dividends were increased to an all-time high of $2 per share in 1975. In


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early 1976, the board decided to proceed with phases 2 and 3 even though the costs werehigher than those originally estimated. (In 1976 it was estimated that phase 2 wouldrequire $7 million and that phase 3 would require almost $3 million.) Despite the successwith phase 1, the board balked at financing the second phase entirely with debt. Afterconsiderable debate, it was decided to finance $5 million with debt and $2 million with

preferred stock. In the autumn of 1976, a $5 million five-year term loan was obtainedfrom the firm’s commercial bank. The interest rate was 11 percent, and annual principal payments of $1 million were to begin December 31, 1977. (See Exhibits 1 and 2 forfinancial statements for 1976 and 1977.) A $2 million, 12-percent preferred stock issuewas privately placed with a pension fund. The firm had the option of calling $500,000 onthe issue each year at par, commencing December 31, 1979. Mr. Steinberg wanted thecall privilege to take effect starting December 31, 1977, but he could not obtain thisfeature without increasing the dividend rate. Both parties had the option of converting theissue to a debenture, which would be subordinated to bank debt on January 1, 1987. Ifexercised, the loan would be repaid in five equal annual installments, and the interest ratewould be 200 basis points above the interest rate on single A industrial bonds at January

1, 1987.

As noted, phase 2 was a new product line. The plan was to introduce most of the line andthen expand the line three years later (phase 3). In mid-1977, however, it becameapparent that the firm could not compete effectively with a partial product line; thus phase 3 had to begin as soon as possible. In early September, the firm purchased $3million worth of capital equipment and obtained a short-term loan from its commercial bank. It was understood that more permanent financing would be arranged to retire the $3million note. Mr. Hescott, the firm’s treasurer, was responsible for identifying optionsand recommending which should be chosen.

FINANCING OPTIONS

Mr. Hescott’s first step was to meet with the firm’s commercial banker. He was told that,at a recent meeting, the bank’s board decided that its loan portfolio was too long; thus,during the next year, efforts would be made to shorten the average maturity.Consequently, the loan officer said that the best he could do was offer a three-year loan at10½ percent. Principal payments of $1 million would also be required at the end of eachof the three years.

Since prepaying the existing term loan would involve no penalty, Mr. Hescott recognizedthat one possibility was to obtain a $7 million term loan from another commercial bank.On many occasions at various social and community activities, he had been approached by the officers of other banks. While most of these discussion focused on the services thattheir banks could provide, these officers always made clear that the firm would have todo all its banking business with a new bank or at least establish a substantial depositrelationship. Although switching banks might be attractive in terms of cost, Mr. Hescottrealized that this option was not feasible. This firm had done business with the samecommercial bank since 1922, and this was the bank that had stood by the firm during thedifficult Depression years. In short, the bond would not consider switching banks.


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Mr. Hescott had numerous discussions with investment bankers and financial institutions.He received three offers, but one of these he immediately dismissed. It was from aninsurance company, which was willing to lend $3 million but wanted warrants to purchase common stock. The treasure thought that the number of new shares they wanted

the right to purchase was too high, and that the proposed exercise price was too low.

The second offer was from the pension fund that owned the $2 million of preferred stocks.This financial institution was willing to purchase an additional $3 million of 12-percent preferred stock. Each year, $500,000 of the new preferred stock could be called at par,commencing one year after the existing preferred stock was retired. The option to convertto a five-year term loan commencing on January 1, 1987, would also apply to theseshares.

The third offer was from an investment company that had many wealthy clients. It waswilling to underwrite class B shares in 10,000 share lots. Each of the 30 lots would be

sold for $100,000. The class B shares would have no voting rights or dividend rightsthrough December 31, 1979. On January 1, 1980, each class B share would be convertedinto a regular share, and hence at that time there would be only one class of commonstock.

At the board meeting that would be held in a few days, Mr. Hescott planned to present as possibilities the three-year term loan from the firm’s commercial bank, the new issue of preferred stock, and the class B shares. He would also recommend which of the three hethought was best. To perform the analysis, he obtained a copy of the notes he had taken ata seminar on financial management that he attended during 1974 (Exhibit 4). “It surelooked easy in that classroom,” he thought, as he read over the notes.


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EXHIBIT 1

Delicious, Inc.

Income Statements*Years Ended 12/31

(000 omitted)

1977 1976

Net Sales $ 79,388 $ 77,115Cost of goods sold 51,476 50,986

Gross profit $ 27,912 $ 26,129Selling, general and administrative expenses 20,897 20,049

Operating income $ 7,015 $ 6,080Interest on term debt 550 140

Profit before taxes $ 6,465 $ 5,940

Taxes @ 48% 3,103 2,851

Net Income $ 3,362 $ 3,089Preferred dividends 240 64

Earnings for common $ 3,122 $ 3,025 No. of common shares outstanding 892 892Earnings per share $ 3.50 $ 3.39Dividends per share $ 2.00 $ 2.00

* These statements have been restated to simplify the analysis. Interest expense on short-term debt isincluded in selling, general and administrative expenses. Interest income on marketable securities is treatedas a deduction form selling, general and administrative expense.

EXHIBIT 2

Delicious, Inc.

Balance Sheets – At 12/31(000 omitted)

1977 1976

Cash and marketable securities $ 743 $ 566Accounts receivable, net 5,640 5,542Inventories 7,477 7,322Other current 296 361

Total current $ 14,156 $ 13,791Property, plant, and equipment, net 18,444 15,219Other assets 371 462

Total $ 32,971 $ 29,472


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Exhibit 2 (continued) 1977 1976

Notes payable $ 3,000 $ ― Accounts payable and accruals 7,853 7,599Current portion of term debt 1,000 1,000Other current 91 87

Total current $ 11,944 $ 8,686Term debt 3,000 4,000Preferred stock 2,000 2,000Common stock and surplus 7,655 7,655Retained earnings 8,372 7,131

Total $ 32,971 $ 29,472

EXHIBIT 3

Delicious, Inc.

Projected Sources and Uses of Funds*Years Ended 12/31

(000 omitted)

1978 1979 1980 1981 1982

Sources

Net income after taxes $ 4,019 $ 4,316 $ 4,414 $ 4,622 $ 4,842 Depreciation 300 300 325 325 325

Funds flow $ 4,319 $ 4,616 $ 4,739 $ 4,947 $ 5,167

Accounts payable andaccruals 150 140 140 135 130

Total Sources $ 4,469 $ 4,756 $ 4,879 $ 5,082 $ 5,297

Uses

Working Capital $ 600 $ 600 $ 480 $ 470 $ 460 Fixed asset expenditures 150 150 200 200 200 Debt payments 1,000 1,000 1,000 1,000 ― Preferred sinking fund ― 500 500 500 500 Preferred dividends 240 240 180 120 60 Common dividends 1,784 1,784 1,784 1,784 1,784

Total Uses $ 3,774 $ 4,274 $ 4,144 $ 4,074 $ 3,004Sources less Uses $ 695 $ 482 $ 735 $ 1,008 $ 2,293Cumulative $ 695 $ 1,177 $ 1,912 $ 2,920 $ 5,213

* Flow-of-funds estimates include the increase in funds because of the $3 million capital expenditures program but not the financial burden created by the new financing. In other words, new interest charges,new dividend requirements, or new sinking fund payments that will be required are not included. Also, theestimates assume no increases in common dividend rate.


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EXHIBIT 4

Memorandum

TO: File

FROM: John HescottRE: Notes on Long-Term Financing Session

The session on long-term financing was very interesting. The instructor assigned thefollowing Harvard Business Review articles:

1. “Framework For Financial Decisions,” by William Sihler, March-April 1971.2. “New Framework For Corporate Debt Capacity,” by Gordon Donaldson, March-April

1962.

In assigning these articles, the instructor noted that, although many other articles were

important, they were really beyond the scope of an introductory session. During the classhe referred to several articles, especially one by Modigliani and Miller.

Once a firm has determined its external permanent financial requirements, it must decidehow to raise these funds. There are three basic security types from which to choose: debt, preferred stock, and common stock. Sometimes a feature is added to the basic securitytype; for example, debt could be made convertible into common stock in order to makethe security more attractive to investors.

Various factors must be considered in making a long-term financing decision. During theclass we discussed the following factors:

1. Analysis of suppliers of capital2. Control3. Flexibility4. Income5. Risk6. Value

1. ANALYSIS OF SUPPLIERS OF CAPITAL

Individuals, financial institutions, and other organizations purchase securities. The firmmust analyze the needs of various types of investors as well as their ability andwillingness to purchase certain types of securities in a manner similar to how it analyzesthe market for its products. A firm does not design a product and then analyze the market.Market research is conducted first, and then the product and marketing campaign isdesigned to capture the identified market. The same principle applies to selling securities.Since many firms do not have the expertise required to perform this market research, theymust rely on an outsider, such as an investment banker, for assistance. The responsibilityfor overseeing this activity rests with the financial manager. Consequently, it is essential


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that he or she understand the nature of financial markets and the characteristics of themajor participants in these markets.

2. CONTROL

Control is concerned with the effect that the financing choice could have on themanagement of the firm. The common shareholders elect the board of directors of a firm,each share having one vote. 1 When common stock is issued, there are new votes;consequently, it is possible for the composition of the board to change, leading to achange in management. The importance of this factor depends on the number of newshares being considered relative to the existing number outstanding and the degree ofownership concentration. One normally thinks of loss of ownership control in the contextof new common equity. A firm relinquishes a certain degree of control, however,whenever it raises external funds. If, for example, a covenant on a loan agreement is broken, the degree of control that a lender can exercise will become painfully clear.

3. FLEXIBILITY

This factor is concerned with the effect that the current financing choice will have onfuture financial decisions. If we raise debt now, will we have to raise equity next time? Afirm must always be in a position to raise funds, whether the source be external orinternal. The more options open to it, the more likely it is that it will be able to raisefunds. Flexibility is important for all firms, but it is especially critical for firms that arefrequently in need of external capital.

4. INCOME

The income factor is concerned with the effect that the financing choice has on earnings per share. The instructor relied on the following example. Assume that Firm A had $1million in EBIT (earnings before interest and taxes) for the year ended 19x as shown inthe income statement in Exhibit 4-A.

Firm A has decided to undertake an expansion project, which is expected to increaseEBIT by $200,000, to $1.2 million. It needs $500,000 of external capital to finance theexpansion, and it is considering the following three possibilities.

1. Long-term debt, with an interest rate of 10 percent. Principal payments of $50,000 peryear would be required, commencing at the end of the first year.

1 In some firms there is more than one class of common stock, with one or more not having voting rights.Also, preferred shareholders sometimes have voting rights and/or a stipulation in the preferred stockagreement that, under certain conditions, preferred shares have voting rights. The most commoncondition is that voting rights are obtained if preferred dividends are not paid for a specified period.


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2. Preferred stock, with a dividend rate of 9 percent.

3. 50,000 shares of common stock to net the firm $ 10 per share.

If EBIT increases to $1.2 million, earnings per share (EPS) will be $1.30, $1.22, or $1.17

depending on the financing option selected. (See Exhibit 4-B.)

The instructor noted that many people incorrectly deduct sinking fund payments incalculating EPS for the debt options. While the level of sinking fund payments iscertainly relevant for making the decision, these payments are not expenses and hence donot affect the calculation of EPS.

EXHIBIT 4-A

A Company

Income Statement

Years Ended 19x(000 omitted)

Net Sales $ 10,000Cost of goods sold 7,000

Gross profit $ 3,000Operating expenses 2,000

Earnings before interest and taxes $ 1,000Interest expense 100

Earnings before taxes $ 900Income taxes @ 50% 450

Earnings after taxes $ 450Less preferred dividends 200

Earnings available to common stock $ 250 No. of common shares outstanding 250Earnings per share $ 1.00


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EXHIBIT 4-B

A Company

EBIT-EPS Analysis Years Ended 19x

(000 omitted)

Debt Preferred Common

EBIT $ 1,200 $ 1,200 $ 1,200Existing interest 100 100 100 New Interest 50 0 0

Earnings before taxes $ 1,050 $ 1,100 $ 1,100Income taxes @ 50% 525 550 550

Earnings after taxes $ 525 $ 550 $ 550Existing preferred dividends 200 200 200

New preferred dividends―

45―

Earnings available to common stock $ 325 $ 305 $ 350 No. of common shares outstanding 250 250 300Earnings per share $ 1.30 $ 1.22 $ 1.17

Why is there a difference among the three choices? Will debt always produce the highestlevel of EPS? Will common stock always produce the lowest level of EPS? To answerthese questions, the instructor began by noting that debt and preferred stock are fixed costsecurities. The after-tax dollar cost of debt in the example is $25,000 (interest of $50,000times 1 minus the 50-percent tax rate). This is the cost regardless of the level of earnings.If earnings are low, the fixed dollar cost will be a high proportion of the earnings. On theother hand, if earnings are high, the fixed dollar cost will be a small proportion of theseearnings. Preferred stock is also a fixed cost security. While preferred dividends are notexpenses, they must be paid before common shareholders are entitled to any earnings.Thus they reduce the amount of earnings available to common stock, and the amount ofthe reduction is a fixed dollar amount. In the preceding example, the fixed dollar cost is$45,000. (Unlike interest payments, preferred dividends do not create a tax shield because they are not expenses.) Since, in this example, the fixed after-tax dollar cost ofdebt is less than that for preferred stock, the debt option will produce a higher level ofEPS than preferred stock at any level of debt.

2

Common stock creates a fixed-percentage dilution. That is, the new shareholders areentitled to a fixed percentage of the total earnings available to common stock. In the preceding example, the fixed-percentage dilution is 16⅔ percent [number of newcommon shares (50,000) divided by the total number of common shares that will beoutstanding (300,000)]. Since the percentage is constant, the dollar amount will vary.

2 This statement assumed that the firm will be in a position to take advantage of the tax shield created byinterest.


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Consequently, whether preferred stock and/or debt will produce a higher level of EPSthan common stock depends on the level of EBIT. Moreover, there is a level of EBIT atwhich EPS will be the same for the debt and common stock options and another level ofEBIT at which EPS will be the same for the preferred stock and common stock options.These EBIT levels are called indifference points.

There are various ways to determine these indifference points. The most common is torely on algebra. We first restate the EBIT-EPS analysis in equation form:

(EBIT – i) (1 – T ) – P EPS =

n

where EBIT = earnings before interest and taxesi = total dollars of interest (existing interest plus new interest)T = tax rate

P = total dollars of preferred dividends (existing preferred dividends plus new preferred dividendsn = number of common shares outstanding

EPS = earnings per share

Setting the right-hand side of this equation for a common stock option equal to the right-hand side of this equation for a fixed cost security option and solving for EBIT will givethe indifference point, that is, the level of EBIT at which EPS will be the same for bothalternatives. To illustrate:

Debt Common

(EBIT – 150) (1 – 0.5) – 200 (EBIT – 100) (1 – 0.5) – 200=

250 300

EBIT = $800,000

Debt Common

EBIT $ 800 $ 800Interest 150 100

Earnings before taxes $ 650 $ 700

Income taxes @ 50% 325 350Earnings after taxes $ 325 $ 350Preferred dividends 200 200

Earnings available to common stock $ 125 $ 150 No. of common shares outstanding 250 300Earnings per share $ 0.50 $ 0.50


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At any EBIT level above $800,000, EPS would be higher under the debt option; at anyEBIT level below $800,000, EPS would be higher under the common stock option.

The indifference point between the preferred and common stock option is $1.04 million.

Preferred CommonEBIT $ 1,040 $ 1,040Interest 100 100

Earnings before taxes $ 940 $ 940Income taxes @ 50% 470 470

Earnings after taxes $ 470 $ 470Preferred dividends 245 200

Earnings available to common stock $ 225 $ 270 No. of common shares outstanding 250 300Earnings per share $ 0.90 $ 0.90

Finally, there is no indifference point between debt and preferred stock because the fixedafter-tax dollar cost is different for each option al all levels of EBIT.

The instructor cautioned us against being misled by the term indifference point . It refersonly to the level of EBIT at which EPS is the same for two (or possibly several) financing possibilities. It does not represent the EBIT level at which the manager will be indifferent between the two financing choices. In other words, the financing choice is based onseveral factors and not just on the choice’s effect on EPS.

5. RISK

This factor is concerned with the ability to service debt (or preferred stock). Manyapproaches are used to evaluate debt capacity. For example, a popular measure is theearnings coverage standard, which is defined as follows:

EBITEarnings coverage =

i +T 1

SF

where EBIT = earnings before interest and taxesi = dollars of interest

SF = sinking fund paymentsT = tax rate

Since a sinking fund payment is not an expense, it is not tax deductible. Hence, we dividethe amount of the sinking fund by 1 minus the tax rate to convert it to a before-tax


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amount. This ratio compares the size of the firm’s earnings with the size of its debtservice. Generally, a ration of 2 or 3 or even more is desired to provide for an adequatemargin of safety. As Donaldson pointed out in his classic article, earnings and cash floware not the same thing. Since debt payments are made with cash, he recommendedcomparing the size of the debt service with the size of the firm’s cash flow. He suggested

that the firm should estimate what its cash flows would be under unfavorable conditionsin judging how much debt it can service.

The instructor pointed out that Donaldson’s approach was basically an application of proforma analysis. He concluded by noting that measuring debt capacity is a most importanttask. A firm has many goals, a primary one being to maximize the market value of thefirm’s common stock. However, it is obvious that a manager’s top priority must be toassure the firm’s survival.

6. VALUE

As noted, a primary goal of management should be to maximize the market price of thefirm’s common shares. Thus, in making a financial decision, the manager must evaluatewhat impact the choice will have on the market value of the firm’s common shares. Aswe saw, different financing alternatives will produce different levels of EPS. The choicemight also have an effect on the multiple (that is, price-earnings ratio) that investors arewilling to pay for a firm’s earning. Investors don’t like risk. Since debt creates financialrisk, investors might penalize the firm’s price-earnings ratio, and thus it is possible for the price of the firm’s common shares to decline by using debt even if debt produces a higherlevel of EPS. On the other hand, if the firm is using moderate amounts of debt, the choiceof debt might not reduce the price-earnings ratio and could possibly increase it. Thereason is that the use of debt or preferred stock magnifies the rate of change of EPS. Thus,if EBIT is growing, EPS will grow at a greater rate by using fixed cost securities. If thegrowth effect outweighs the risk effect, the price-earnings ratio might increase.

Obviously, it is extremely difficult to evaluate the impact on the price-earnings ratio. Nonetheless, it is an important consideration that cannot be ignored.

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