excel solutions to cases

Fundamentals of Corporate Finance4th South African Edition

Firer, Ross, Westerfield & Jordan

Case SolutionsCase #

Input boxes in tan 1

Output boxes in yellow 2

Given data in blue 3

Calculations in red 4

Answers in green 5678

910

Case SolutionsList of Mini-Cases Chapter

Sunset Boards 2

S&S Air 4

Pop Goes the Balloon 6

S&S's Bond 7

Valuing Refresh Ltd 8Crystal Electronics 11SDC's Cost of Capital 14Spinning Wheels' Dividend Policy 17

Winter Woollies 18S&S's Convertible Bond 21

Case #1 - Cash Flows and Financial Statements at Sunset Boards

Input area:

2007 2008

Cost of goods sold R 84,310 R 106,450

Cash 12,165 18,380

Depreciation 23,800 26,900

Interest expense 5,180 5,930

Selling & Administrative 16,580 21,640

Accounts payable 21,500 24,350

Fixed assets 105,000 134,000

Sales 165,390 201,600

Accounts receivable 8,620 11,182

Bank overdraft 9,800 10,700

Long-term debt 53,000 61,000

Inventory 18,140 24,894

New equity - 10,000

Tax rate 20%

Dividend percentage 30%

Output area:

2007 Income StatementSales R 165,390 Cost of goods sold 84,310 Selling & Administrative 16,580 Depreciation 23,800 PBIT R 40,700 Interest 5,180 PBT R 35,520 Taxes 7,104 NPAT R 28,416 Dividends R 8,525 Addition to retained profits R 19,891

2007 Income StatementSales R 201,600 Cost of goods sold 106,450 Selling & Administrative 21,640 Depreciation 26,900 PBIT R 46,610 Interest 5,930 PBT R 40,680 Taxes 8,136 NPAT R 32,544 Dividends R 9,763 Addition to retained profits R 22,781

Balance sheet as of Dec. 31, 2007Owners equity R 59,625 Net non-current assets R 105,000 Long-term debt 53,000

Inventory 18,140 Accounts payable 21,500 Accounts receivable 8,620 Short-term debt 9,800 Cash R 12,165 Current liabilities R 31,300 Current assets R 38,925 Total equity and liabilities R 143,925 Total assets R 143,925

Balance sheet as of Dec. 31, 2008Owners equity R 92,406 Net non-current assets R 134,000 Long-term debt 61,000

Inventory 24,894 Accounts payable 24,350 Accounts receivable 11,182 Short-term debt 10,700 Cash R 18,380 Current liabilities R 35,050 Current assets R 54,456 Total equity and liabilities R 188,456 Total assets R 188,456

2007 2008Operating cash flow R 57,396 R 65,374

Capital SpendingEnding net non-current assets R 134,000 - Beginning net non-current assets 105,000 + Depreciation 26,900 Net capital spending R 55,900

Change in Net Working CapitalEnding NWC R 19,406 -Beginning NWC 7,625 Change in NWC R 11,781

Cash Flow from AssetsOperating cash flow R 65,374 - Net capital spending 55,900 -Change in NWC 11,781 Cash flow from assets R (2,307)

Cash Flow to LendersInterest paid R 5,930 -Net New Borrowing 8,000 Cash flow to Lenders R (2,070)

Cash Flow to ShareholdersDividends paid R 9,763 -Net new equity raised 10,000 Cash flow to Shareholders R (237)

1

The firm had positive earnings in an accounting sense (NPAT > 0) and had positive cash flow from operations. The firm invested R11 781 in new net working capital and R55 900 in new net non-current assets. The firm had to raise R2 307 from its stakeholders to support this new investment. It accomplished this by raising R10 000 in the form of new equity and R8 000 in new long-term debt. After paying out R9 763 in dividends to shareholders and R5 930 in interest to lenders, R2 307 was left to meet the firm's cash flow needs for investment.

2The expansion plans may be a little risky. The company does have a positive cash flow, but a

large portion of the operating cash flow is already going to capital spending. The company has had to raise capital from lenders and shareholders for its current operations. So, the expansion plans may be too aggressive at this time. On the other hand,

companies do need capital to grow. Before investing or loaning the company money, you would want to know where the current capital spending is going, and why the company is

spending so much in this area already.

Case #2 - Ratios and Financial Planning at S&S Air

Input area:

Sales R 128,700,000 COGS R 90,700,000 Other expenses R 15,380,000 Depreciation R 4,200,000 PBIT R 18,420,000 Interest R 2,315,000 PBT R 16,105,000 Taxes (40%) R 6,442,000 NPAT R 9,663,000

Dividends R 2,898,900 Add to RP R 6,764,100

Liabilities & Equity AssetsShareholder Equity Non-current assets R 72,280,000 Ordinary shares R 1,000,000 Retained profits R 41,570,000 Current Assets Total Equity R 42,570,000 Inventory R 4,720,000

Accounts rec. R 4,210,000 Long-term debt R 25,950,000 Cash R 2,340,000

Total CA R 11,270,000 Current Liabilities Accounts Payable R 4,970,000 Short-term debt R 10,060,000 Total CL R 15,030,000 Total L&E R 83,550,000 Total Assets R 83,550,000

Growth rate 20% Tax rate 40%Minimum NCA purchase R 30,000,000

Output area:

Current ratio 0.75 Quick ratio 0.44 Cash ratio 0.16 Total asset turnover 1.54 Inventory days 19.0Receivables days 11.9Total debt ratio 0.49 Debt-equity ratio 0.85 Equity multiplier 1.96 Times interest earned 7.96 Cash coverage ratio 9.77 Profit margin 7.51%Return on assets 11.57%Return on equity 22.70%

Retention ratio 0.70 Internal growth rate 8.81%Sustainable growth rate 18.89%

Sales R 154,440,000 COGS R 108,840,000 Other expenses R 18,456,000 Depreciation R 5,040,000 PBIT R 22,104,000 Interest R 2,315,000 PBT R 19,789,000 Taxes (40%) R 7,915,600 NPAT R 11,873,400

Dividends R 3,562,020 Add to RP R 8,311,380

Liabilities & Equity Assets

Shareholder EquityOrdinary shares R 1,000,000 Non-current assets R 86,736,000 Retained profits R 49,881,380 Total Equity R 50,881,380 Current Assets

Inventory R 5,664,000 Long-term debt R 25,950,000 Accounts rec. R 5,052,000

Cash R 2,808,000 Current Liabilities Total CA R 13,524,000 Accounts Payable R 5,964,000 Short-term debt R 10,060,000 Total CL R 16,024,000

Total L&E R 92,855,380 Total Assets R 100,260,000

EFN R 7,404,620

EFN if minimum NCA purchase is R 30,000,000

New depreciation R 5,943,221 Reduction in NPAT R 541,932 Reduction in RP R 379,353

Liabilities & Equity Assets

Shareholder Equity Non-current assets R 102,280,000 Ordinary shares R 1,000,000 Retained profits R 49,502,027 Current Assets Total Equity R 50,502,027 Inventory R 5,664,000

Accounts rec. R 5,052,000 Long-term debt R 25,950,000 Cash R 2,808,000

Total CA R 13,524,000 Current Liabilities Accounts Payable R 5,964,000 Short-term debt R 10,060,000 Total CL R 16,024,000 Total L&E R 92,476,027 Total Assets R 115,804,000

EFN R 23,327,973

2 Boeing is probably not a good aspirant company. Even though both companies manufacture airplanes, S&S Air manufactures small airplanes, while Boeing manufactures large, commercial aircraft. These are two different markets. Additionally, Boeing is heavily involved in the defense industry, as well as Boeing Capital, which finances airplanes.

3

Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look may be needed in this area.

S&S is below the median industry ratios for the current and cash ratios. This implies the company has less liquidity than the industry in general. However, both ratios are above the lower quartile, so there are companies in the industry with lower liquidity ratios than S&S Air. The company may have more predictable cash flows, or more access to short-term borrowing. If you created an Inventory to Current liabilities ratio, S&S Air would have a ratio that is lower than the industry median. The current ratio is below the industry median, while the quick ratio is above the industry median. This implies that S&S Air has less inventory to current liabilities than the industry median. S&S Air has less inventory than the industry median, but more accounts receivable than the industry since the cash ratio is lower than the industry median.

The total asset turnover ratio and the inventory and receivables days are all better than the industry median; in fact, all three ratios are above the upper quartile. This may mean that S&S Air is more efficient than the industry.

The financial leverage ratios are all below the industry median, but above the lower quartile. S&S Air generally has less debt than comparable companies, but still within the normal range.

The profit margin for the company is about the same as the industry median, the ROA is slightly higher than the industry median, and the ROE is well above the industry median. S&S Air seems to be performing well in the profitability area.

Case #3 - Pop Goes the Balloon

Input area:

Cost of bike R 164,103

Balloon payment 97,000

Best offer after 4 years 45,000

Lease period 4

Interest rate 24%

Output area:

1 Risk: bike value may be less than balloon payment

2 Total interest paidPresent value R (164,103.00)Interest rate per month 2%Number of lease payments 48 Future value R 97,000.00 Monthly payment R 4,127.68

Total payments R 198,128.69 Capital repaid R 67,103.00 Interest paid R 131,025.69

3 Depreciation rate to balloon value 14%

4 Depreciation rate to market value 38%

5 Inflation on bikes dropped below expected level

Case #4 -Financing S&S Air’s Expansion Plans With A Bond Issue

Output area:

1

2

3

4

A rule of thumb with bond provisions is to determine who benefits by the provision. If the company benefits, the bond will have a higher coupon rate. If the bondholders benefit, the bond will have a lower coupon rate.

A bond with collateral will have a lower coupon rate. Bondholders have the claim on the collateral, even in bankruptcy. Collateral provides an asset that bondholders can claim, which lowers their risk in default. The downside of collateral is that the company generally cannot sell the asset used as collateral, and they will generally have to keep the asset in good working order.

The more senior the bond is, the lower the coupon rate. Senior bonds get full payment in bankruptcy proceedings before subordinated bonds receive any payment. A potential problem may arise in that the bond covenant may restrict the company from issuing any future bonds senior to the current bonds.

A sinking fund will reduce the coupon rate because it is a partial guarantee to bondholders. The problem with a sinking fund is that the company must make the interim payments into a sinking fund or face default. This means the company must be able to generate these cash flows.

A provision with a specific call date and prices would increase the coupon rate. The call provision would only be used when it is to the company’s advantage, thus the bondholder’s disadvantage. The downside is the higher coupon rate. The company benefits by being able to refinance at a lower rate if interest rates fall significantly, that is, enough to offset the call provision cost.

5

6

7

A deferred call would reduce the coupon rate relative to a call provision with a deferred call. The bond will still have a higher rate relative to a plain vanilla bond. The deferred call means that the company cannot call the bond for a specified period. This offers the bondholders protection for this period. The disadvantage of a deferred call is that the company cannot call the bond during the call protection period. Interest rate could potentially fall to the point where it would be beneficial for the company to call the bond, yet the company is unable to do so.

A make whole call provision should lower the coupon rate in comparison to a call provision with specific dates since the make whole call repays the bondholder the present value of the future cash flows. However, a make whole call provision should not affect the coupon rate in comparison to a plain vanilla bond. Since the bondholders are made whole, they should be indifferent between a plain vanilla bond and a make whole bond. If a bond with a make whole provision is called, bondholders receive the market value of the bond, which they can reinvest in another bond with similar characteristics. If we compare this to a bond with a specific call price, investors rarely receive the full market value of the future cash flows.

A positive covenant would reduce the coupon rate. The presence of positive covenants protects bondholders by forcing the company to undertake actions that benefit bondholders. Examples of positive covenants would be: the company must maintain audited financial statements; the company must maintain a minimum specified level of working capital or a minimum specified current ratio; the company must maintain any collateral in good working order. The negative side of positive covenants is that the company is restricted in its actions. The positive covenant may force the company into actions in the future that it would rather not undertake.

8

A negative covenant would reduce the coupon rate. The presence of negative covenants protects bondholders from actions by the company that would harm the bondholders. Remember, the goal of a corporation is to maximize shareholder wealth. This says nothing about bondholders. Examples of negative covenants would be: the company cannot increase dividends, or at least increase beyond a specified level; the company cannot issue new bonds senior to the current bond issue; the company cannot sell any collateral. The downside of negative covenants is the restriction of the company’s actions.

Case #4 -Financing S&S Air’s Expansion Plans With A Bond Issue

Case #5 - Refresh Ltd

Input area:

Balance sheets R'0002007 2008 2009 2010

Shareholders' equity 111,427 108,693 110,697 113,623Deferred taxation 4,232 4,895 5,268 5,569Long-term loan 38,574 28,554 14,226Capital employed 154,233 142,142 130,191 119,192

Non-current assets 120,919 99,135 77,551 87,968Capitalised expenses 2,438 1,625 812Investment in associate 2,006 2,856 3,706 4,556Other investments 2,712 2,712 2,712 2,712

Inventory 34,485 39,182 42,770 47,502Accounts receivable 43,656 48,895 52,953 57,984Cash 204 241 332 465Current assets 78,345 88,318 96,055 105,951

Accounts payable 37,887 41,958 45,067 49,169Provisions 1,847 2,445 2,644 2,544Tax owing 3,573 2,866 3,747 4,608Short-term borrowings 6,442 6,048 26,486Current liabilities 49,749 53,317 51,458 82,807Net current assets 28,596 35,001 44,597 23,144Net assets 154,233 142,142 130,191 119,192

Income statements 2007 2008 2009 2010Gross profit 76,151 83,451 89,018 94,191Depreciation -22,471 -24,784 -25,584 -34,584Other expenses -28,675 -31,211 -33,699 -25,419Abnormal items 6,116 -2,644Profit before interest 31,121 24,812 29,735 34,188Interest -4,335 -7,364 -4,883 -4,071Profit before tax 26,786 17,448 24,852 30,117Tax -7,234 -7,032 -8,698 -10,541Net profit after tax 19,552 10,416 16,154 19,576Income from associate 787 850 850 850Dividends paid -12,500 -14,000 -15,000 -17,500Transfer to non-distributable reserve -787 -850 -850 -850

Retained profit for the year 7,052 -3,584 1,154 2,076

Inflation from 2010 onwards 10%Corporate income tax rate 35%Weighted average cost of capital 20.83%Surrender value of key person policies 4,335

Output area:

2008 2009 2010Opening balance on tax owing -3,573 -2,866 -3,747

Charge for the year -7,032 -8,698 -10,541

Deferred tax 663 373 301

Closing balance 2,866 3,747 4,608

Tax effect of interest -2577 -1709 -1425Cash taxes paid -9,653 -9,153 -10,804

Opening non-current assets balance 120,919 99,135 77,551

Depreciation -24,784 -25,584 -34,584

Closing non-current assets balance -99,135 -77,551 -87,968

Capital expenditure for the year -3,000 -4,000 -45,001

2008 2009 2010Gross profit 83,451 89,018 94,191

Other expenses -31,211 -33,699 -25,419

Abnormal items -2,644 0 0

Cash taxes -9,653 -9,153 -10,804

NOPAT 39,943 46,166 57,968

Capital expenditure -3,000 -4,000 -45,001

Inventory -4,697 -3,588 -4,732Receivables -5,239 -4,058 -5,031Payables 4,071 3,109 4,102Capitalised expenses -2,438 813 813Provisions 598 199 -100I -10,705 -7,525 -49,949

FCF = NOPAT - I 29,238 38,641 8,019

WACC 20.83%After 2010

Assumed capex after 2010 -5,000Sustainable continuous cash flow after 2010 48,020Growth model valuation of post-2010 cash flow at growth rate = inflation 487,739

2008 2009 2010 2010PV of FCF 24,197 26,467 4,546 276,480Total PV 331,689Less debt -45,016Plus cash 204Plus investment in associate 2,006Surrender value of key person policies 4,335Value of equity R 293,218

Case #6 - Crystal Electronics

Input Area:

Equipment R20,000,000Salvage value R3,000,000R&D R750,000 sunk costMarketing study R200,000 sunk cost

Year 1 Year 2 Year 3 Year 4 Year 5Sales(units) 70,000 80,000 100,000 85,000 75,000Depreciation rate 50.00% 30.00% 20.00%Sales of old PCB 80,000 60,000 Lost sales 15,000 15,000

Price R250 VC R86 FC R3,000,000 Price of old PCB R240 Price reduction of old PCB R20 VC of old PCB R68 Tax rate 29%NWC percentage 20%Required return 12%

Sensivity analysisNew price R260 Quantity change 100 NOTE: Change in units per year

Output Area:

Sales Year 1 Year 2 Year 3 Year 4 Year 5New R17,500,000 R20,000,000 R25,000,000 R21,250,000 R18,750,000 Lost sales 3,600,000 3,600,000 Lost rev. 1,300,000 900,000 Net sales R12,600,000 R15,500,000 R25,000,000 R21,250,000 R18,750,000

VCNew R6,020,000 R6,880,000 R8,600,000 R7,310,000 R6,450,000 Lost sales 1,020,000 1,020,000

R5,000,000 R5,860,000 R8,600,000 R7,310,000 R6,450,000

Sales R12,600,000 R15,500,000 R25,000,000 R21,250,000 R18,750,000 VC 5,000,000 5,860,000 8,600,000 7,310,000 6,450,000 Fixed costs 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Dep 10,000,000 6,000,000 4,000,000 0 0 PBT (R5,400,000) R640,000 R9,400,000 R10,940,000 R9,300,000 Tax (1,566,000) 185,600 2,726,000 3,172,600 2,697,000 NPAT (R3,834,000) R454,400 R6,674,000 R7,767,400 R6,603,000 +Dep 10,000,000 6,000,000 4,000,000 0 0 OCF R6,166,000 R6,454,400 R10,674,000 R7,767,400 R6,603,000

NWCBeg R0 R2,520,000 R3,100,000 R5,000,000 R4,250,000End 2,520,000 3,100,000 5,000,000 4,250,000 0NWC CF (R2,520,000) (R580,000) (R1,900,000) R750,000 R4,250,000

Net CF R3,646,000 R5,874,400 R8,774,000 R8,517,400 R10,853,000

SalvageBV of equipment R0Taxes -870,000Salvage CF R2,130,000

Net CF Time0 (R20,000,000)1 R3,646,000 2 R5,874,400 3 R8,774,000 4 R8,517,400 5 R12,983,000

Payback period 3.200 PI 1.348 IRR 22.80%NPV R6,963,417.30

Sensitivity to change in price



R5,000,000 R5,860,000 R8,600,000 R7,310,000 R6,450,000

Sales R13,300,000 R16,300,000 R26,000,000 R22,100,000 R19,500,000 VC 5,000,000 5,860,000 8,600,000 7,310,000 6,450,000 Fixed costs 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Dep 10,000,000 6,000,000 4,000,000 0 0 PBT (R4,700,000) R1,440,000 R10,400,000 R11,790,000 R10,050,000 Tax (1,363,000) 417,600 3,016,000 3,419,100 2,914,500 NPAT (R3,337,000) R1,022,400 R7,384,000 R8,370,900 R7,135,500 +Dep 10,000,000 6,000,000 4,000,000 0 0 OCF R6,663,000 R7,022,400 R11,384,000 R8,370,900 R7,135,500


Net CF R4,003,000 R6,422,400 R9,444,000 R9,150,900 R11,555,500



NPV R8,997,140.38

R203,372.31

Sensitivity to change in quantity



R5,008,600 R5,868,600 R8,608,600 R7,318,600 R6,458,600

Sales R12,625,000 R15,525,000 R25,025,000 R21,275,000 R18,775,000 VC 5,008,600 5,868,600 8,608,600 7,318,600 6,458,600 Fixed costs 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000 Dep 10,000,000 6,000,000 4,000,000 0 0 PBT (R5,383,600) R656,400 R9,416,400 R10,956,400 R9,316,400 Tax (1,561,244) 190,356 2,730,756 3,177,356 2,701,756 NPAT (R3,822,356) R466,044 R6,685,644 R7,779,044 R6,614,644 +Dep 10,000,000 6,000,000 4,000,000 0 0 OCF R6,177,644 R6,466,044 R10,685,644 R7,779,044 R6,614,644


Net CF R3,652,644 R5,886,044 R8,785,644 R8,529,044 R10,869,644



NPV R7,003,764.16

R403.47

DNPV/DP

DNPV/DQ

Case #7 - SDC's Cost of Capital

Input Area:

Risk-free rate 10%Market risk premium 6%Beta of SDC 1.5Number of shares in issue 24,000,000Share price R 5Book value of ordinary shareholders' interest R 80,000,000Book value of outside shareholders interest R 10,000,000Coupon rate on new debt 15%Coupon rate on existing debt 12%Tax rate 29%Book value of long-term debt R 60,000,000Life of existing long-term debt 10

Output Area:

Cost of equity 19.00%After-tax cost of debt 10.65%Market value of ordinary shareholders' equity R 120,000,000

Book value of ordinary shareholders' equity R 80,000,000Market-to-boook value of ordinary shareholders' intere 1.5

Market value of outside shareholders interest R 15,000,000Market value of total shareholders interest R 135,000,000Market value of existing debt R 50,966,216Market value debt-capital ratio 27.4%Market value equity-capital ratio 72.6%

WACC 16.71%

NOTES

Assuming same market-to-book value for outside shareholders' interest:

a) Deferred taxationDeferred taxation has no cost, as it is an interest free loan from the Receiver of Revenue. Although, as in the case with depreciation, deferred taxation has an opportunity cost, it is treated like depreciation and is not included in the calculation of the weighted average cost of capital.

b) Outside shareholders interestAs the subsidiaries are in similar lines of business and have similar risk and growth prospects, we assume that their cost is the same as ordinary shares.

c) Bank overdraft

If there is any permanent portion, it should be included. However, an analysis of the balance sheet shows that the overdraft represents only a very small fraction of the current assets and a small decline in current assets would eliminate the need for the overdraft. The conclusion is therefore that no portion of the bank overdraft is permanent and is thus not included in the calculation of the cost of capital.

Case #8 - Spinning Wheels Ltd

Case #8 - Spinning Wheels Ltd

Has the firm reached the end of its high growth period?Will continued investment in R&D be required?

What if the firm's growth in fact slows down in the future.Conversely what if international expansion becomes a reality?

The bare facts of the case seem to indicate that a dividend could be considered, since:new investment in the test laboratory will reduce in the future, reducing the need to conserve cash

On the other hand what if:The contract is broken after 8 months?Interest rates rise rapidly, eating into operating profits?International markets open up rapidly, requiring an injection of cash into new machinery for the factory?

So what possible policies can be used?

The dividend decision is in fact a financing decision - should the firm retain the funds (thereby increasing its equity), or should it relinquish the funds to the shareholders. It all depends on the use the firm will make of the retained profits. In theory retain if positive NPV projects are available.

In practice there is a strong message from the market that firms should not cut dividends, even if they give reasons of the existence of positive NPV projects for making the cut. Although this seems illogical, it probably results from long years of experience by shareholders, who have learned to be highly suspicious of the information management offers to explain decisions made.

The payment of a dividend is akin to directors 'putting their money where their mouths are' in the sense that the payment of the dividend is a statement to shareholders that the prospects of the firm are sufficiently good to allow for the cash dividend to leave the company without seriously impairing its operating ability.

Spinning Wheels is no longer quite a start-up company, but they have been ploughing money heavily into R&D. Investors would presumably have been told that the firm did not anticipate paying a dividend, at least during its start-up and high growth phases. The questions therefore that might be posed are:

Does the establishment of a set of test equipment mean that new investment in this area may be winding down now?

profitability is on the increase, providing an increasing source of cash flow to fund both new investment as well as a cash dividend

An important consideration when establishing a dividend policy is the realisation that having declared a dividend, it is very difficult to go back to a zero dividend policy, or even to cut the dividend, without raising shareholder ire. Dividend stability is valued very highly by the investment community.

If the firm decides to pay dividends, it does need to consider the clientele effect. This concept suggests that there are different clienteles amongst the investment community, some preferring no dividends, some low dividends and some high dividends, relative to earnings. By changing dividend policy a firm may just land up exchanging one clientele for another.

Residual policy - leads to variable dividends and investor insecurity. Will firm's demand for new cash investment fluctuate up and down over the years? Probably not.

Fixed proportion of profits. Also leads to fluctuating dividends if profits are variable. Are profits likely to be variable? Yes if new product development is an important part of the firm's goals.

Fixed rand amount. Sets a base level of dividends and this can't be easily cut. However does lead to good information transfer to investors as prospects are usually good and sustainable when dividends are raised.

Scrip dividends. Saves cash but enables firm to transmit information on size of dividend to investors. However subject to the same issues discussed with cash dividends in terms of any dividend cuts.

On balance it seems that it is probably one year too early to consider the dividend. They should await the finalisation of the contract (in 8 months time). Then, if no international expansion appears, and the firm settles into a more mature mode, a dividend could be considered, starting at a low level for safety sake.

On the other hand, if management is contemplating an ongoing high level of R&D, the time to tell shareholders is now that the current no dividend policy will continue. It will be important however to ensure that they are given sufficient information about future plans to enable them to assess the likelihood of positive NPV projects in the years ahead. Otherwise the share price will suffer, making it difficult for the firm to raise new equity capital in the future.

All in all, the decision to commence paying a dividend is one that needs very careful consideration, since once the firm steps down that road, reversal of the decision has serious consequences. Most important of all is the need for management to be certain that they will be able to maintain a steady profit stream to support the dividends

Case #9 - Winter Woolies Manufacturing

Input Area:

Customers paying in:30 days 30%60 days 60%90 days 10%

Discount for prompt payment 2%Labour % of expected sales 25%Materials % of expected sales 35%Office salaries R 30,000Expenses R 22,000Depreciation (per month) R 5,000Cost of loan 16%Loan outstanding R 300,000Life of loan (years) 6 Computer R 15,000Tax rate 30%Tax payment due in February R 20,000Tax payment due in August R 23,000Cash balance end December R 5,000

Oct Nov Dec Jan Feb Mar Apr May Jun Jul AugSales R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000

Output Area:

Seasonal production Oct Nov Dec Jan Feb Mar Apr May Jun Jul AugSales R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000

R 1,140 R 900 R 720 R 840 R 900 R 1,200 R 1,440 R 972Net cash received after discount R 55,860 R 44,100 R 35,280 R 41,160 R 44,100 R 58,800 R 70,560 R 47,628On time net payers R 72,000 R 114,000 R 90,000 R 72,000 R 84,000 R 90,000 R 120,000 R 144,000Late payers R 12,000 R 19,000 R 15,000 R 12,000 R 14,000 R 15,000 R 20,000 R 24,000Cash from receivables R 139,860 R 177,100 R 140,280 R 125,160 R 142,100 R 163,800 R 210,560 R 215,628

Labour R 37,500 R 30,000 R 35,000 R 37,500 R 50,000 R 60,000 R 40,500 R 30,000Materials R 42,000 R 66,500 R 52,500 R 42,000 R 49,000 R 52,500 R 70,000 R 84,000Expenses R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000Office salaries R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000Cash out R 131,500 R 148,500 R 139,500 R 131,500 R 151,000 R 164,500 R 162,500 R 166,000

Net operating cash flow R 8,360 R 28,600 R 780 -R 6,340 -R 8,900 -R 700 R 48,060 R 49,628

Tax due R 20,000 R 23,000Computer R 15,000Loan repayment R 19,676 R 19,676Net cash flow for the month R 8,360 R 8,600 -R 18,896 -R 6,340 -R 23,900 -R 20,376 R 48,060 R 26,628Opening cash balance R 5,000 R 13,360 R 21,960 R 3,064 -R 3,276 -R 27,176 -R 47,552 R 508Available cash R 13,360 R 21,960 R 3,064 -R 3,276 -R 27,176 -R 47,552 R 508 R 27,136

Level productionExpected sales for next 8 months R 1,282,000Average expected monthly sales R 160,250

Oct Nov Dec Jan Feb Mar Apr May Jun Jul AugSales R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000

R 1,140 R 900 R 720 R 840 R 900 R 1,200 R 1,440 R 972Net cash received after discount R 55,860 R 44,100 R 35,280 R 41,160 R 44,100 R 58,800 R 70,560 R 47,628On time net payers R 72,000 R 114,000 R 90,000 R 72,000 R 84,000 R 90,000 R 120,000 R 144,000Late payers R 12,000 R 19,000 R 15,000 R 12,000 R 14,000 R 15,000 R 20,000 R 24,000Cash from receivables R 139,860 R 177,100 R 140,280 R 125,160 R 142,100 R 163,800 R 210,560 R 215,628

R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063

R 42,000 R 66,500 R 52,500 R 56,088 R 56,088 R 56,088 R 56,088 R 56,088Expenses R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000Office salaries R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000Cash out R 134,063 R 158,563 R 144,563 R 148,150 R 148,150 R 148,150 R 148,150 R 148,150

Net operating cash flow R 5,798 R 18,538 -R 4,283 -R 22,990 -R 6,050 R 15,650 R 62,410 R 67,478

Tax due R 20,000 R 23,000Computer R 15,000Loan repayment R 19,676 R 19,676Net cash flow for the month R 5,798 -R 1,463 -R 23,959 -R 22,990 -R 21,050 -R 4,026 R 62,410 R 44,478Opening cash balance R 5,000 R 10,798 R 9,335 -R 14,624 -R 37,614 -R 58,664 -R 62,690 -R 280Available cash R 10,798 R 9,335 -R 14,624 -R 37,614 -R 58,664 -R 62,690 -R 280 R 44,198

Cash outflows for materials will only change in March under level production, since payment terms for purchases are 60 days.

Discounts: 2% of 30% of last month's sales

Discounts: 2% of 30% of last month's sales

Labour (1)

Materials (2)

(1) Thhe costs of labour change with immediate effect in January where labour costs rise from R37 500 to R40 063. Later in the year level production labour costs drop below those of seasonal production. The model assumes level production in line with average expected sales

(2)

The net result, as we see from the graph, is that a higher overdraft level from March through July will be needed if the production process is changed from seasonal to level. What the firm needs to establish is whether the increased financing costs (note that level production will result in a build up of inventories) can be offset by any savings in labour costs as a result of not having to hire and fire workers with the season. These potential savings are not discussed in the case.

Jan Feb Mar Apr May Jun Jul Aug-R 80,000

-R 60,000

-R 40,000

-R 20,000

R 0

R 20,000

R 40,000

R 60,000

Winter Woollies Manufacturing Cash Budget

Level Seasonal

Cas

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Case #10 - S&S Air's Convertible Bond

Input area:

Industry PE 12.5 Company EPS R 1.60 Conversion price (stock) R 25.00 Maturity (years) 20 Convertible bond coupon 6%Conversion value of bond R 800 Plain vanilla coupon 10%

Output area:

1 Share price R20.00

Intrinsic bond value R656.82

Floor value R800.00

Conversion ratio 32.00

Conversion premium 25.00%

Chris is suggesting a conversion price of R25 because it means the share price will have to increase before the bondholders can benefit from the conversion, in this case 25 per cent. Even though the company is not publicly traded, the conversion price is important. First, the company may go public in the future. The case does discuss whether the company has plans to go public, and if so, how soon it might go public. If the company does go public, the bondholders will have an active market for the shares if they convert. Second, even if the company does not go public, the bondholders could potentially have an equity interest in the company. This equity interest can be sold to the original owners, or someone else. The potential problem with private equity is that the market is not as liquid as the market for a public company. This illiquidity lowers the value of the shares.

The floor value of the bond is R800. This means that if the company offered bonds with the same coupon rate and no conversion feature, they would be able to sell them for 656,82. However, with the conversion feature the price will be R800. In essence, the company is receiving R143,18 for the conversion feature.

2

3

4

5

Thandi's argument is wrong because it ignores the fact that if the company does well, bondholders will be allowed to participate in the company's success. If the share price rises to R40, bondholders are effectively allowed to purchase shares at the conversion price of R25

Mark's argument is incorrect because the company is issuing debt with a lower coupon rate than they would have been able to otherwise. If the company does poorly, it will receive the benefit of a

lower coupon rate

Reconciling the two arguments requires that we remember our central goal: to increase the wealth of the existing shareholders. Thus, with 20-20 hindsight, we see that issuing convertible bonds will turn out to be worse than issuing straight bonds and better than issuing common stock if the company prospers. The reason is that the prosperity has to be shared with bondholders after they convert.

In contrast, if a company does poorly, issuing convertible bonds will turn out to be better than issuing straight bonds and worse than issuing ordinary shares. The reason is that the firm will have benefited from the lower coupon payments on the convertible bonds

Both of the arguments have a grain of truth; we just need to combine them. Ultimately, which option is better for the company will only be known in the future and will depend on the performance of the company. The table below illustrates this point.

The call provision allows the company to redeem the bonds at the company's discretion. If the company's shares appear to be poised to rise, the company can call the outstanding bonds. It could be possible that the bondholders would benefit from converting the bonds at that point, but it would eliminate the potential future gains to the bondholders

If the company does poorly If the company prospersLow share price and no conversion

High share price and conversion

Convertible bonds issued instead of straight bonds

Cheap financing because coupon rate is lower (good outcome).

Expensive financing because bonds are converted, which dilutes existing equity (bad outcome).

Chris is suggesting a conversion price of R25 because it means the share price will have to increase before the bondholders can benefit from the conversion, in this case 25 per cent. Even though the company is not publicly traded, the conversion price is important. First, the company may go public in the future. The case does discuss whether the company has plans to go public, and if so, how soon it might go public. If the company does go public, the bondholders will have an active market for the shares if they convert. Second, even if the company does not go public, the bondholders could potentially have an equity interest in the company. This equity interest can be sold to the original owners, or someone else. The potential problem with private equity is that the market is not as liquid as the market for a public company. This illiquidity lowers the value of the

The floor value of the bond is R800. This means that if the company offered bonds with the same coupon rate and no conversion feature, they would be able to sell them for 656,82. However, with the conversion feature the price will be R800. In essence, the company is receiving R143,18 for the

Thandi's argument is wrong because it ignores the fact that if the company does well, bondholders will be allowed to participate in the company's success. If the share price rises to R40, bondholders are effectively allowed to purchase shares at the conversion price of R25

Mark's argument is incorrect because the company is issuing debt with a lower coupon rate than they would have been able to otherwise. If the company does poorly, it will receive the benefit of a

lower coupon rate

Reconciling the two arguments requires that we remember our central goal: to increase the wealth of the existing shareholders. Thus, with 20-20 hindsight, we see that issuing convertible bonds will turn out to be worse than issuing straight bonds and better than issuing common stock if the company prospers. The reason is that the prosperity has to be shared with bondholders after they

In contrast, if a company does poorly, issuing convertible bonds will turn out to be better than issuing straight bonds and worse than issuing ordinary shares. The reason is that the firm will have benefited from the lower coupon payments on the convertible bonds

Both of the arguments have a grain of truth; we just need to combine them. Ultimately, which option is better for the company will only be known in the future and will depend on the performance of the company. The table below illustrates this point.

The call provision allows the company to redeem the bonds at the company's discretion. If the company's shares appear to be poised to rise, the company can call the outstanding bonds. It could be possible that the bondholders would benefit from converting the bonds at that point, but it would eliminate the potential future gains to the bondholders

If the company does poorly If the company prospersLow share price and no conversion

High share price and conversion

Convertible bonds issued instead of straight bonds

Cheap financing because coupon rate is lower (good outcome).

Expensive financing because bonds are converted, which dilutes existing equity (bad outcome).

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