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Delicious, Inc.

In early January 1978, John Hescott, treasurer of Delicious, Inc., was ready to analyze
three proposals for financing a $3 million capital improvement program. The firms
board was going to meet in a few days, and at that time he would have to recommend
which of the three proposals should be selected.
BACKGROUND
Delicious, Inc., was founded by Harold Steinberg in 1922 to manufacture and sell candy
and related products. The firm was immediately profitable, and sales and profits
increased each year through 1929. The Great Depression hit the firm quite hard, and three
consecutive annual losses were experienced. The firm survived only by stringent costcutting efforts and the support of its commercial bank. At that time the firm had a sizable
loan with its commercial bank, which agreed to postpone interest and principal payments
for four years. This experience convinced Mr. Steinberg of the importance of sound
marketing and financial policies. In his judgment, sound policies meant no debt and slow
sales growth. Over the years, many of the firms managers proposed faster growth and/or
the 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 maintain
flexibility in setting policy and maintain control. By 1978, 892,000 common shares were
outstanding. Members of the Steinberg family owned 60 percent of these shares, and
former 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 have
the 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 a
situation, 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 was
unfair, for the following reasons. First, employees who took advantage of the firms stock
option plan could have selected an alternative profit-sharing scheme. Second, although
the policy was that a seller might have to wait one year, this never happened since the
firm 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. Since
that time there had never been a dividend cut; on the contrary, small increases in the
dividend rate were frequent. Mr. Steinberg thought that the dividend returns the
shareholders 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. On
these shares they will now earn a return of 165 percent!
When the founder died in late 1968, his son Richard assumed the presidency. Although
the new president also believed in conservative policies, he had long felt that his father
had been a bit too conservative. Moreover, he had always disagreed with his fathers
policy of keeping the company private. These disagreements were not secret, and it was
also known that the elder Steinberg had begun to yield on the issue of taking the company

public. He had still believed that it was best to keep the company private, but he had
realized that, since so many shares were outstanding, a problem could develop if many
stockholders decided to sell at the same time. If they were to do so, the firm might have
to borrow a substantial sum to repurchase the shares; from the founders 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 of
directors to accept a goal of going public and to change its policy on the use of debt. He
wanted 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 a
moderate amount of debt. He was able to do this by demonstrating that financing
expansion 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 best
accomplished by introducing two new product lines (that is, different types of candy). He
had originally planned to introduce both at the same time and to finance the entire
expansion program with debt. However, discussions with members of the board
convinced him that the board would never approve such a program. While there was a
consensus to accelerate growth somewhat and to use some debt, there was strong
sentiment that the marketing and financial policies that proved so successful should not
be changed too much. Consequently, the president proposed a three-phase program. The
first new product line (hard rock candy) would require $5 million. It would take about
five years, until 1975, for this new product to be fully integrated into the firms existing
operations.
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 1
could 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) would
require about $2 million.
Although phases 2 and 3 were related, the first phase was unrelated to the others. In other
words, by accepting the first phase the firm was not committing itself to the remainder of
the program. Thus the board voted to accept phase 1 and finance it with a debt. A $5
million, five-year term loan was obtained from its commercial bank. Interest and
principal payments were required semiannually, commencing six months from the date
on which the loan agreement was signed.
Phase 1 proceeded smoothly. Sales and profit targets were achieved. Loan payments were
easily met, and dividends were increased to an all-time high of $2 per share in 1975. In

early 1976, the board decided to proceed with phases 2 and 3 even though the costs were
higher than those originally estimated. (In 1976 it was estimated that phase 2 would
require $7 million and that phase 3 would require almost $3 million.) Despite the success
with phase 1, the board balked at financing the second phase entirely with debt. After
considerable 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 obtained
from the firms 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 for
financial statements for 1976 and 1977.) A $2 million, 12-percent preferred stock issue
was privately placed with a pension fund. The firm had the option of calling $500,000 on
the issue each year at par, commencing December 31, 1979. Mr. Steinberg wanted the
call privilege to take effect starting December 31, 1977, but he could not obtain this
feature without increasing the dividend rate. Both parties had the option of converting the
issue to a debenture, which would be subordinated to bank debt on January 1, 1987. If
exercised, the loan would be repaid in five equal annual installments, and the interest rate
would 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 and
then expand the line three years later (phase 3). In mid-1977, however, it became
apparent 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 $3
million 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 $3
million note. Mr. Hescott, the firms treasurer, was responsible for identifying options
and recommending which should be chosen.
FINANCING OPTIONS
Mr. Hescotts first step was to meet with the firms commercial banker. He was told that,
at a recent meeting, the banks 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 at
10 percent. Principal payments of $1 million would also be required at the end of each
of the three years.
Since prepaying the existing term loan would involve no penalty, Mr. Hescott recognized
that 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 that
their banks could provide, these officers always made clear that the firm would have to
do all its banking business with a new bank or at least establish a substantial deposit
relationship. Although switching banks might be attractive in terms of cost, Mr. Hescott
realized that this option was not feasible. This firm had done business with the same
commercial bank since 1922, and this was the bank that had stood by the firm during the
difficult Depression years. In short, the bond would not consider switching banks.

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 an
insurance 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 convert
to a five-year term loan commencing on January 1, 1987, would also apply to these
shares.
The third offer was from an investment company that had many wealthy clients. It was
willing 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 rights
through December 31, 1979. On January 1, 1980, each class B share would be converted
into a regular share, and hence at that time there would be only one class of common
stock.
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 firms commercial bank, the new issue of
preferred stock, and the class B shares. He would also recommend which of the three he
thought was best. To perform the analysis, he obtained a copy of the notes he had taken at
a seminar on financial management that he attended during 1974 (Exhibit 4). It sure
looked easy in that classroom, he thought, as he read over the notes.

EXHIBIT 1
Delicious, Inc.
Income Statements*
Years Ended 12/31
(000 omitted)
1977

1976

Net Sales
Cost of goods sold

$ 79,388
51,476

$ 77,115
50,986

Gross profit
Selling, general and administrative expenses

$ 27,912
20,897

$ 26,129
20,049

Operating income
Interest on term debt

$ 7,015
550

$ 6,080
140

Profit before taxes


Taxes @ 48%

$ 6,465
3,103

$ 5,940
2,851

Net Income
Preferred dividends

$ 3,362
240

$ 3,089
64

Earnings for common


No. of common shares outstanding
Earnings per share
Dividends per share

$ 3,122
892
$ 3.50
$ 2.00

$ 3,025
892
$ 3.39
$ 2.00

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

EXHIBIT 2
Delicious, Inc.
Balance Sheets At 12/31
(000 omitted)
1977
Cash and marketable securities
Accounts receivable, net
Inventories
Other current

Total current
Property, plant, and equipment, net
Other assets

$ 14,156
18,444
371

$ 13,791
15,219
462

$ 32,971

$ 29,472

Total

743
5,640
7,477
296

1976
$

566
5,542
7,322
361

Exhibit 2 (continued)

1977

1976

Notes payable
Accounts payable and accruals
Current portion of term debt
Other current

$ 3,000
7,853
1,000
91

Total current
Term debt
Preferred stock
Common stock and surplus
Retained earnings

$ 11,944
3,000
2,000
7,655
8,372

$ 8,686
4,000
2,000
7,655
7,131

$ 32,971

$ 29,472

Total

7,599
1,000
87

EXHIBIT 3
Delicious, Inc.
Projected Sources and Uses of Funds*
Years Ended 12/31
(000 omitted)
1978
Sources
Net income after taxes
Depreciation
Funds flow
Accounts payable and
accruals
Total Sources
Uses
Working Capital
Fixed asset expenditures
Debt payments
Preferred sinking fund
Preferred dividends
Common dividends
Total Uses
Sources less Uses
Cumulative

1979

1980

1981

1982

$ 4,019
300

$ 4,316
300

$ 4,414
325

$ 4,622
325

$ 4,842
325

$ 4,319

$ 4,616

$ 4,739

$ 4,947

$ 5,167

150

140

140

135

130

$ 4,469

$ 4,756

$ 4,879

$ 5,082

$ 5,297

$ 600
150
1,000

240
1,784

$ 600
150
1,000
500
240
1,784

$ 480
200
1,000
500
180
1,784

$ 470
200
1,000
500
120
1,784

$ 460
200

500
60
1,784

$ 3,774
$ 695
$ 695

$ 4,274
$ 482
$ 1,177

$ 4,144
$ 735
$ 1,912

$ 4,074
$ 1,008
$ 2,920

$ 3,004
$ 2,293
$ 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, the
estimates assume no increases in common dividend rate.

EXHIBIT 4
Memorandum
TO:
File
FROM: John Hescott
RE:
Notes on Long-Term Financing Session
The session on long-term financing was very interesting. The instructor assigned the
following 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 class
he referred to several articles, especially one by Modigliani and Miller.
Once a firm has determined its external permanent financial requirements, it must decide
how 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 security
type; for example, debt could be made convertible into common stock in order to make
the security more attractive to investors.
Various factors must be considered in making a long-term financing decision. During the
class we discussed the following factors:
1. Analysis of suppliers of capital
2. Control
3. Flexibility
4. Income
5. Risk
6. Value

1. ANALYSIS OF SUPPLIERS OF CAPITAL

Individuals, financial institutions, and other organizations purchase securities. The firm
must analyze the needs of various types of investors as well as their ability and
willingness to purchase certain types of securities in a manner similar to how it analyzes
the 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 is
designed 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, they
must rely on an outsider, such as an investment banker, for assistance. The responsibility
for 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 the
major participants in these markets.

2. CONTROL

Control is concerned with the effect that the financing choice could have on the
management 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 a
change in management. The importance of this factor depends on the number of new
shares being considered relative to the existing number outstanding and the degree of
ownership concentration. One normally thinks of loss of ownership control in the context
of 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 on
future financial decisions. If we raise debt now, will we have to raise equity next time? A
firm must always be in a position to raise funds, whether the source be external or
internal. The more options open to it, the more likely it is that it will be able to raise
funds. Flexibility is important for all firms, but it is especially critical for firms that are
frequently 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 $1
million in EBIT (earnings before interest and taxes) for the year ended 19x as shown in
the income statement in Exhibit 4-A.
Firm A has decided to undertake an expansion project, which is expected to increase
EBIT by $200,000, to $1.2 million. It needs $500,000 of external capital to finance the
expansion, and it is considering the following three possibilities.
1. Long-term debt, with an interest rate of 10 percent. Principal payments of $50,000 per
year would be required, commencing at the end of the first year.

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 stock
agreement that, under certain conditions, preferred shares have voting rights. The most common
condition is that voting rights are obtained if preferred dividends are not paid for a specified period.

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 in
calculating EPS for the debt options. While the level of sinking fund payments is
certainly relevant for making the decision, these payments are not expenses and hence do
not affect the calculation of EPS.

EXHIBIT 4-A
A Company
Income Statement

Years Ended 19x


(000 omitted)
Net Sales
Cost of goods sold
Gross profit
Operating expenses
Earnings before interest and taxes
Interest expense
Earnings before taxes
Income taxes @ 50%
Earnings after taxes
Less preferred dividends
Earnings available to common stock
No. of common shares outstanding
Earnings per share

$ 10,000
7,000
$ 3,000
2,000
$ 1,000
100
$ 900
450
$ 450
200
$ 250
250
$ 1.00

EXHIBIT 4-B
A Company
EBIT-EPS Analysis

Years Ended 19x


(000 omitted)
Debt

Preferred

Common

EBIT
Existing interest
New Interest

$ 1,200
100
50

$ 1,200
100
0

$ 1,200
100
0

Earnings before taxes


Income taxes @ 50%

$ 1,050
525

$ 1,100
550

$ 1,100
550

Earnings after taxes


Existing preferred dividends
New preferred dividends

$ 525
200

$ 550
200
45

$ 550
200

Earnings available to common stock


No. of common shares outstanding
Earnings per share

$ 325
250
$ 1.30

$ 305
250
$ 1.22

$ 350
300
$ 1.17

Why is there a difference among the three choices? Will debt always produce the highest
level of EPS? Will common stock always produce the lowest level of EPS? To answer
these questions, the instructor began by noting that debt and preferred stock are fixed cost
securities. The after-tax dollar cost of debt in the example is $25,000 (interest of $50,000
times 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 the
other hand, if earnings are high, the fixed dollar cost will be a small proportion of these
earnings. Preferred stock is also a fixed cost security. While preferred dividends are not
expenses, 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 of
the 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 of
debt is less than that for preferred stock, the debt option will produce a higher level of
EPS than preferred stock at any level of debt.2
Common stock creates a fixed-percentage dilution. That is, the new shareholders are
entitled to a fixed percentage of the total earnings available to common stock. In the
preceding example, the fixed-percentage dilution is 16 percent [number of new
common shares (50,000) divided by the total number of common shares that will be
outstanding (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 by
interest.

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Consequently, whether preferred stock and/or debt will produce a higher level of EPS
than common stock depends on the level of EBIT. Moreover, there is a level of EBIT at
which EPS will be the same for the debt and common stock options and another level of
EBIT 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 to
rely on algebra. We first restate the EBIT-EPS analysis in equation form:
(EBIT i) (1 T) P
EPS =
n
where EBIT
i
T
P

= earnings before interest and taxes


= total dollars of interest (existing interest plus new interest)
= tax rate
= total dollars of preferred dividends (existing preferred dividends plus new
preferred dividends
n = 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 righthand side of this equation for a fixed cost security option and solving for EBIT will give
the indifference point, that is, the level of EBIT at which EPS will be the same for both
alternatives. To illustrate:
Debt

Common

(EBIT 150) (1 0.5) 200

(EBIT 100) (1 0.5) 200


=

250

300
EBIT = $800,000
Debt

Common

EBIT
Interest

$ 800
150

$ 800
100

Earnings before taxes


Income taxes @ 50%

$ 650
325

$ 700
350

Earnings after taxes


Preferred dividends

$ 325
200

$ 350
200

Earnings available to common stock


No. of common shares outstanding
Earnings per share

$ 125
250
$ 0.50

$ 150
300
$ 0.50

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At any EBIT level above $800,000, EPS would be higher under the debt option; at any
EBIT 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

Common

EBIT
Interest

$ 1,040
100

$ 1,040
100

Earnings before taxes


Income taxes @ 50%

940
470

$ 940
470

Earnings after taxes


Preferred dividends

$ 470
245

$ 470
200

Earnings available to common stock


No. of common shares outstanding
Earnings per share

$ 225
250
$ 0.90

$ 270
300
$ 0.90

Finally, there is no indifference point between debt and preferred stock because the fixed
after-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 refers
only 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 on
several factors and not just on the choices effect on EPS.

5. RISK

This factor is concerned with the ability to service debt (or preferred stock). Many
approaches are used to evaluate debt capacity. For example, a popular measure is the
earnings coverage standard, which is defined as follows:
EBIT
Earnings coverage =
i+

where EBIT
i
SF
T

SF
1T

= earnings before interest and taxes


= dollars of interest
= sinking fund payments
= tax rate

Since a sinking fund payment is not an expense, it is not tax deductible. Hence, we divide
the 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 firms earnings with the size of its debt
service. Generally, a ration of 2 or 3 or even more is desired to provide for an adequate
margin of safety. As Donaldson pointed out in his classic article, earnings and cash flow
are not the same thing. Since debt payments are made with cash, he recommended
comparing the size of the debt service with the size of the firms cash flow. He suggested
that the firm should estimate what its cash flows would be under unfavorable conditions
in judging how much debt it can service.
The instructor pointed out that Donaldsons approach was basically an application of pro
forma analysis. He concluded by noting that measuring debt capacity is a most important
task. A firm has many goals, a primary one being to maximize the market value of the
firms common stock. However, it is obvious that a managers top priority must be to
assure the firms survival.

6. VALUE

As noted, a primary goal of management should be to maximize the market price of the
firms common shares. Thus, in making a financial decision, the manager must evaluate
what impact the choice will have on the market value of the firms common shares. As
we saw, different financing alternatives will produce different levels of EPS. The choice
might also have an effect on the multiple (that is, price-earnings ratio) that investors are
willing to pay for a firms earning. Investors dont like risk. Since debt creates financial
risk, investors might penalize the firms price-earnings ratio, and thus it is possible for the
price of the firms common shares to decline by using debt even if debt produces a higher
level of EPS. On the other hand, if the firm is using moderate amounts of debt, the choice
of debt might not reduce the price-earnings ratio and could possibly increase it. The
reason 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 the
growth 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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