Fundamentals of Corporate Finance 4th South African Edition Firer, Ross, Westerfield & Jordan

Case Solutions
Case #

Input boxes in tan Output boxes in yellow Given data in blue Calculations in red Answers in green

1 2 3 4 5 6 7 8 9 10

tions
List of Mini-Cases Sunset Boards S&S Air Pop Goes the Balloon S&S's Bond Valuing Refresh Ltd Crystal Electronics SDC's Cost of Capital Spinning Wheels' Dividend Policy Winter Woollies S&S's Convertible Bond Chapter 2 4 6 7 8 11 14 17 18 21

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

Input area:

Cost of goods sold Cash Depreciation Interest expense Selling & Administrative Accounts payable Fixed assets Sales Accounts receivable Bank overdraft Long-term debt Inventory New equity Tax rate Dividend percentage

2007 84,310 12,165 23,800 5,180 16,580 21,500 105,000 165,390 8,620 9,800 53,000 18,140 20% 30%

2008 106,450 18,380 26,900 5,930 21,640 24,350 134,000 201,600 11,182 10,700 61,000 24,894 10,000

Output area:

2007 Income Statement Sales R Cost of goods sold Selling & Administrative Depreciation PBIT R Interest PBT R Taxes NPAT R Dividends R Addition to retained profits R

165,390 84,310 16,580 23,800 40,700 5,180 35,520 7,104 28,416 8,525 19,891

2007 Income Statement Sales R Cost of goods sold Selling & Administrative Depreciation PBIT R Interest PBT R Taxes NPAT R Dividends R Addition to retained profits R

201,600 106,450 21,640 26,900 46,610 5,930 40,680 8,136 32,544 9,763 22,781

Owners equity Long-term debt Accounts payable Short-term debt Current liabilities Total equity and liabilities

Balance sheet as of Dec. 31, 2007 59,625 Net non-current assets 53,000 Inventory 21,500 Accounts receivable 9,800 Cash R 31,300 Current assets R 143,925 Total assets R

R 105,000 18,140 8,620 R 12,165 R 38,925 R 143,925

Owners equity Long-term debt Accounts payable Short-term debt Current liabilities Total equity and liabilities

Balance sheet as of Dec. 31, 2008 92,406 Net non-current assets 61,000 Inventory 24,350 Accounts receivable 10,700 Cash R 35,050 Current assets R 188,456 Total assets R

R 134,000 24,894 11,182 R 18,380 R 54,456 R 188,456

Operating cash flow

2007 57,396

2008 65,374

Capital Spending Ending net non-current assets R - Beginning net non-current assets + Depreciation Net capital spending R

134,000 105,000 26,900 55,900

Change in Net Working Capital Ending NWC -Beginning NWC Change in NWC

R R

19,406 7,625 11,781

Cash Flow from Assets Operating cash flow - Net capital spending -Change in NWC Cash flow from assets

65,374 55,900 11,781 (2,307)

Cash Flow to Lenders Interest paid -Net New Borrowing Cash flow to Lenders

R R

5,930 8,000 (2,070)

Cash Flow to Shareholders Dividends paid -Net new equity raised Cash flow to Shareholders

R R

9,763 10,000 (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 noncurrent 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.

The 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 COGS Other expenses Depreciation PBIT Interest PBT Taxes (40%) NPAT Dividends Add to RP

R R R R R R R R R R R

128,700,000 90,700,000 15,380,000 4,200,000 18,420,000 2,315,000 16,105,000 6,442,000 9,663,000 2,898,900 6,764,100 Assets Non-current assets R 1,000,000 41,570,000 42,570,000 25,950,000 Current Assets Inventory Accounts rec. Cash Total CA

Liabilities & Equity Shareholder Equity Ordinary shares R Retained profits R Total Equity R Long-term debt Current Liabilities Accounts Payable Short-term debt Total CL Total L&E Growth rate Minimum NCA purchase R

72,280,000

R R R R

4,720,000 4,210,000 2,340,000 11,270,000

R R R R

4,970,000 10,060,000 15,030,000 83,550,000 20% 30,000,000

Total Assets Tax rate

83,550,000 40%

Output area:

Current ratio Quick ratio Cash ratio Total asset turnover Inventory days Receivables days Total debt ratio Debt-equity ratio Equity multiplier Times interest earned Cash coverage ratio Profit margin Return on assets Return on equity Retention ratio Internal growth rate Sustainable growth rate

0.75 0.44 0.16 1.54 19.0 11.9 0.49 0.85 1.96 7.96 9.77 7.51% 11.57% 22.70% 0.70 8.81% 18.89%

Sales COGS Other expenses Depreciation PBIT Interest PBT Taxes (40%) NPAT Dividends Add to RP

R R R R R R R R R R R

154,440,000 108,840,000 18,456,000 5,040,000 22,104,000 2,315,000 19,789,000 7,915,600 11,873,400 3,562,020 8,311,380 Assets

Liabilities & Equity Shareholder Equity Ordinary shares Retained profits Total Equity Long-term debt Current Liabilities Accounts Payable Short-term debt Total CL Total L&E EFN

R R R R

1,000,000 49,881,380 50,881,380 25,950,000

Non-current assets Current Assets Inventory Accounts rec. Cash Total CA

86,736,000

R R R R

5,664,000 5,052,000 2,808,000 13,524,000

R R R R R

5,964,000 10,060,000 16,024,000 92,855,380 7,404,620 Total Assets R 100,260,000

EFN if minimum NCA purchase is New depreciation Reduction in NPAT Reduction in RP Liabilities & Equity Shareholder Equity Ordinary shares Retained profits Total Equity Long-term debt Current Liabilities Accounts Payable Short-term debt Total CL Total L&E EFN

R R R R

30,000,000 5,943,221 541,932 379,353 Assets Non-current assets R 102,280,000

R R R R

1,000,000 49,502,027 50,502,027 25,950,000

Current Assets Inventory Accounts rec. Cash Total CA

R R R R

5,664,000 5,052,000 2,808,000 13,524,000

R R R R R

5,964,000 10,060,000 16,024,000 92,476,027 23,327,973

Total Assets

115,804,000

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.

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

Case #3 - Pop Goes the Balloon

Input area:

Cost of bike Balloon payment Best offer after 4 years Lease period Interest rate

164,103 97,000 45,000 4 24%

Output area:

1 2

Risk: bike value may be less than balloon payment Total interest paid Present value Interest rate per month Number of lease payments Future value Monthly payment Total payments Capital repaid Interest paid

R (164,103.00) 2% 48 R 97,000.00 R 4,127.68 R R R 198,128.69 67,103.00 131,025.69 14% 38%

3 4 5

Depreciation rate to balloon value Depreciation rate to market value Inflation on bikes dropped below expected level

Case #4 -Financing S&S Airs Expansion Plans With A Bond Issue

Output area: 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.
1 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.
2 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.
3 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.
4 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 companys advantage, thus the bondholders 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.

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.
6

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.
7 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 companys actions.

Bond Issue

Case #5 - Refresh Ltd

Input area: Balance sheets R'000 Shareholders' equity Deferred taxation Long-term loan Capital employed Non-current assets Capitalised expenses Investment in associate Other investments 2007 111,427 4,232 38,574 154,233 120,919 2,006 2,712 2008 108,693 4,895 28,554 142,142 99,135 2,438 2,856 2,712 2009 110,697 5,268 14,226 130,191 77,551 1,625 3,706 2,712 2010 113,623 5,569 119,192 87,968 812 4,556 2,712

Inventory Accounts receivable Cash Current assets Accounts payable Provisions Tax owing Short-term borrowings Current liabilities Net current assets Net assets

34,485 43,656 204 78,345 37,887 1,847 3,573 6,442 49,749 28,596 154,233

39,182 48,895 241 88,318 41,958 2,445 2,866 6,048 53,317 35,001 142,142

42,770 52,953 332 96,055 45,067 2,644 3,747 51,458 44,597 130,191

47,502 57,984 465 105,951 49,169 2,544 4,608 26,486 82,807 23,144 119,192

Income statements Gross profit Depreciation Other expenses Abnormal items Profit before interest Interest Profit before tax Tax Net profit after tax Income from associate Dividends paid Transfer to non-distributable reserve Retained profit for the year

2007 76,151 -22,471 -28,675 6,116 31,121 -4,335 26,786 -7,234 19,552 787 -12,500 -787 7,052

2008 83,451 -24,784 -31,211 -2,644 24,812 -7,364 17,448 -7,032 10,416 850 -14,000 -850 -3,584

2009 89,018 -25,584 -33,699 29,735 -4,883 24,852 -8,698 16,154 850 -15,000 -850 1,154

2010 94,191 -34,584 -25,419 34,188 -4,071 30,117 -10,541 19,576 850 -17,500 -850 2,076

Inflation from 2010 onwards Corporate income tax rate Weighted average cost of capital Surrender value of key person policies

10% 35% 20.83% 4,335

Output area: 2008 -3,573 -7,032 663 2,866 -2577 -9,653 120,919 -24,784 -99,135 -3,000 2009 -2,866 -8,698 373 3,747 -1709 -9,153 99,135 -25,584 -77,551 -4,000 2010 -3,747 -10,541 301 4,608 -1425 -10,804 77,551 -34,584 -87,968 -45,001

Opening balance on tax owing Charge for the year Deferred tax Closing balance Tax effect of interest Cash taxes paid Opening non-current assets balance Depreciation Closing non-current assets balance Capital expenditure for the year

Gross profit Other expenses Abnormal items Cash taxes NOPAT Capital expenditure Inventory Receivables Payables Capitalised expenses Provisions I FCF = NOPAT - I WACC 20.83%

2008 83,451 -31,211 -2,644 -9,653 39,943 -3,000 -4,697 -5,239 4,071 -2,438 598 -10,705 29,238

2009 89,018 -33,699 0 -9,153 46,166 -4,000 -3,588 -4,058 3,109 813 199 -7,525 38,641

2010 94,191 -25,419 0 -10,804 57,968 -45,001 -4,732 -5,031 4,102 813 -100 -49,949 8,019

Assumed capex after 2010 Sustainable continuous cash flow after 2010 Growth model valuation of post-2010 cash flow at growth rate = inflation PV of FCF Total PV Less debt Plus cash Plus investment in associate Surrender value of key person policies Value of equity 2008 24,197 331,689 -45,016 204 2,006 4,335 293,218 2009 26,467

After 2010 -5,000 48,020 487,739 2010 2010 4,546 276,480

Case #6 - Crystal Electronics

Input Area:

Equipment Salvage value R&D Marketing study

R20,000,000 R3,000,000 R750,000 R200,000 Year 1 70,000 50.00% 80,000 15,000 R250 R86 R3,000,000 R240 R20 R68 29% 20% 12%

sunk cost sunk cost Year 2 80,000 30.00% 60,000 15,000 Year 3 100,000 20.00% Year 4 85,000 Year 5 75,000

Sales(units) Depreciation rate Sales of old PCB Lost sales Price VC FC Price of old PCB Price reduction of old PCB VC of old PCB Tax rate NWC percentage Required return Sensivity analysis New price Quantity change

R260 100 NOTE: Change in units per year

Output Area:

Sales New Lost sales Lost rev. Net sales VC New Lost sales

Year 1 R17,500,000 3,600,000 1,300,000 R12,600,000

Year 2 R20,000,000 3,600,000 900,000 R15,500,000

Year 3 R25,000,000

Year 4 R21,250,000

Year 5 R18,750,000

R25,000,000

R21,250,000

R18,750,000

R6,020,000 1,020,000 R5,000,000

R6,880,000 1,020,000 R5,860,000

R8,600,000 R8,600,000

R7,310,000 R7,310,000

R6,450,000 R6,450,000

Sales VC Fixed costs Dep PBT Tax NPAT +Dep OCF NWC Beg End NWC CF Net CF Salvage BV of equipment Taxes Salvage CF Net CF

R12,600,000 5,000,000 3,000,000 10,000,000 (R5,400,000) (1,566,000) (R3,834,000) 10,000,000 R6,166,000

R15,500,000 5,860,000 3,000,000 6,000,000 R640,000 185,600 R454,400 6,000,000 R6,454,400

R25,000,000 8,600,000 3,000,000 4,000,000 R9,400,000 2,726,000 R6,674,000 4,000,000 R10,674,000

R21,250,000 7,310,000 3,000,000 0 R10,940,000 3,172,600 R7,767,400 0 R7,767,400

R18,750,000 6,450,000 3,000,000 0 R9,300,000 2,697,000 R6,603,000 0 R6,603,000

R0 2,520,000 (R2,520,000) R3,646,000

R2,520,000 3,100,000 (R580,000) R5,874,400

R3,100,000 5,000,000 (R1,900,000) R8,774,000

R5,000,000 4,250,000 R750,000 R8,517,400

R4,250,000 0 R4,250,000 R10,853,000

R0 -870,000 R2,130,000 Time 0 1 2 3 4 5

(R20,000,000) R3,646,000 R5,874,400 R8,774,000 R8,517,400 R12,983,000 3.200 1.348 22.80% R6,963,417.30

Payback period PI IRR NPV

Sensitivity to change in price Sales New Lost sales Lost rev. Net sales VC New Lost sales Year 1 R18,200,000 3,600,000 1,300,000 R13,300,000 Year 2 R20,800,000 3,600,000 900,000 R16,300,000 Year 3 R26,000,000 Year 4 R22,100,000 Year 5 R19,500,000

R26,000,000

R22,100,000

R19,500,000

R6,020,000 1,020,000 R5,000,000

R6,880,000 1,020,000 R5,860,000

R8,600,000 R8,600,000

R7,310,000 R7,310,000

R6,450,000 R6,450,000

Sales VC Fixed costs Dep PBT Tax NPAT +Dep OCF NWC Beg End NWC CF Net CF Salvage BV of equipment Taxes Salvage CF Net CF

R13,300,000 5,000,000 3,000,000 10,000,000 (R4,700,000) (1,363,000) (R3,337,000) 10,000,000 R6,663,000

R16,300,000 5,860,000 3,000,000 6,000,000 R1,440,000 417,600 R1,022,400 6,000,000 R7,022,400

R26,000,000 8,600,000 3,000,000 4,000,000 R10,400,000 3,016,000 R7,384,000 4,000,000 R11,384,000

R22,100,000 7,310,000 3,000,000 0 R11,790,000 3,419,100 R8,370,900 0 R8,370,900

R19,500,000 6,450,000 3,000,000 0 R10,050,000 2,914,500 R7,135,500 0 R7,135,500

R0 2,660,000 (R2,660,000) R4,003,000

R2,660,000 3,260,000 (R600,000) R6,422,400

R3,260,000 5,200,000 (R1,940,000) R9,444,000

R5,200,000 4,420,000 R780,000 R9,150,900

R4,420,000 0 R4,420,000 R11,555,500

R0 -870,000 R2,130,000 Time 0 1 2 3 4 5

(R20,000,000) R4,003,000 R6,422,400 R9,444,000 R9,150,900 R13,685,500 R8,997,140.38 R203,372.31

NPV DNPV/DP Sensitivity to change in quantity Sales New Lost sales Lost rev. Net sales VC New Lost sales Year 1 R17,525,000 3,600,000 1,300,000 R12,625,000

Year 2 R20,025,000 3,600,000 900,000 R15,525,000

Year 3 R25,025,000

Year 4 R21,275,000

Year 5 R18,775,000

R25,025,000

R21,275,000

R18,775,000

R6,028,600 1,020,000 R5,008,600

R6,888,600 1,020,000 R5,868,600

R8,608,600 R8,608,600

R7,318,600 R7,318,600

R6,458,600 R6,458,600

Sales VC Fixed costs Dep PBT Tax NPAT +Dep OCF NWC Beg End NWC CF Net CF Salvage BV of equipment Taxes Salvage CF Net CF

R12,625,000 5,008,600 3,000,000 10,000,000 (R5,383,600) (1,561,244) (R3,822,356) 10,000,000 R6,177,644

R15,525,000 5,868,600 3,000,000 6,000,000 R656,400 190,356 R466,044 6,000,000 R6,466,044

R25,025,000 8,608,600 3,000,000 4,000,000 R9,416,400 2,730,756 R6,685,644 4,000,000 R10,685,644

R21,275,000 7,318,600 3,000,000 0 R10,956,400 3,177,356 R7,779,044 0 R7,779,044

R18,775,000 6,458,600 3,000,000 0 R9,316,400 2,701,756 R6,614,644 0 R6,614,644

R0 2,525,000 (R2,525,000) R3,652,644

R2,525,000 3,105,000 (R580,000) R5,886,044

R3,105,000 5,005,000 (R1,900,000) R8,785,644

R5,005,000 4,255,000 R750,000 R8,529,044

R4,255,000 0 R4,255,000 R10,869,644

R0 -870,000 R2,130,000 Time 0 1 2 3 4 5

(R20,000,000) R3,652,644 R5,886,044 R8,785,644 R8,529,044 R12,999,644 R7,003,764.16 R403.47

NPV DNPV/DQ

Case #7 - SDC's Cost of Capital

Input Area:

Risk-free rate Market risk premium Beta of SDC Number of shares in issue Share price Book value of ordinary shareholders' interest Book value of outside shareholders interest Coupon rate on new debt Coupon rate on existing debt Tax rate Book value of long-term debt Life of existing long-term debt

10% 6% 1.5 24,000,000 R5 R 80,000,000 R 10,000,000 15% 12% 29% R 60,000,000 10

Output Area:

Cost of equity After-tax cost of debt Market value of ordinary shareholders' equity

19.00% 10.65% R 120,000,000

Book value of ordinary shareholders' equity R 80,000,000 Market-to-boook value of ordinary shareholders' interest 1.5 Assuming same market-to-book value for outside shareholders' interest: Market value of outside shareholders interest R 15,000,000 Market value of total shareholders interest R 135,000,000 Market value of existing debt R 50,966,216 Market value debt-capital ratio 27.4% Market value equity-capital ratio 72.6% WACC 16.71%

NOTES a) Deferred taxation Deferred 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 b) Outside shareholders interest As the subsidiaries are in similar lines of business and have similar risk and growth prospects, we assume that their cost is the same as 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

Case #8 - Spinning Wheels Ltd

Case #8 - Spinning Wheels Ltd

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: Has the firm reached the end of its high growth period? Will continued investment in R&D be required? Does the establishment of a set of test equipment mean that new investment in this area may be winding down now? 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 profitability is on the increase, providing an increasing source of cash flow to fund both new investment as well as a cash dividend 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? 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. So what possible policies can be used? 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 60 days 90 days Discount for prompt payment Labour % of expected sales Materials % of expected sales Office salaries Expenses Depreciation (per month) Cost of loan Loan outstanding Life of loan (years) Computer Tax rate Tax payment due in February Tax payment due in August Cash balance end December Oct Sales

30% 60% 10% 2% 25% 35% R 30,000 R 22,000 R 5,000 16% R 300,000 6 R 15,000 30% R 20,000 R 23,000 R 5,000 Nov Dec Jan Feb Mar Apr May Jun Jul Aug 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 100,000

Output Area:

Seasonal production Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sales 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 Discounts: 2% of 30% of last month's sales R 1,140 R 900 R 720 R 840 R 900 R 1,200 R 1,440 R 972 Net 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 47,628 On 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 144,000 Late payers R 12,000 R 19,000 R 15,000 R 12,000 R 14,000 R 15,000 R 20,000 R 24,000 Cash 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 Materials Expenses Office salaries Cash out Net operating cash flow Tax due Computer Loan repayment Net cash flow for the month Opening cash balance Available cash Level production Expected sales for next 8 months Average expected monthly sales R 37,500 R 42,000 R 22,000 R 30,000 R 131,500 R 8,360 R 30,000 R 66,500 R 22,000 R 30,000 R 148,500 R 28,600 R 20,000 R 15,000 R 8,360 R 5,000 R 13,360 R 8,600 R 13,360 R 21,960 R 19,676 -R 18,896 R 21,960 R 3,064 -R 6,340 R 3,064 -R 3,276 -R 23,900 -R 3,276 -R 27,176 R 19,676 -R 20,376 -R 27,176 -R 47,552 R 48,060 -R 47,552 R 508 R 26,628 R 508 R 27,136 R 35,000 R 52,500 R 22,000 R 30,000 R 139,500 R 780 R 37,500 R 42,000 R 22,000 R 30,000 R 131,500 -R 6,340 R 50,000 R 49,000 R 22,000 R 30,000 R 151,000 -R 8,900 R 60,000 R 52,500 R 22,000 R 30,000 R 164,500 -R 700 R 40,500 R 70,000 R 22,000 R 30,000 R 162,500 R 48,060 R 30,000 R 84,000 R 22,000 R 30,000 R 166,000 R 49,628 R 23,000

R 1,282,000 R 160,250 Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug 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 55,860 R 72,000 R 12,000 R 139,860 R 40,063 R 42,000 R 22,000 R 30,000 R 134,063 R 5,798 R 900 R 44,100 R 114,000 R 19,000 R 177,100 R 40,063 R 66,500 R 22,000 R 30,000 R 158,563 R 18,538 R 20,000 R 15,000 R 5,798 R 5,000 R 10,798 -R 1,463 R 10,798 R 9,335 R 19,676 -R 23,959 R 9,335 -R 14,624 -R 22,990 -R 14,624 -R 37,614 -R 21,050 -R 37,614 -R 58,664 R 19,676 -R 4,026 -R 58,664 -R 62,690 R 62,410 -R 62,690 -R 280 R 44,478 -R 280 R 44,198 R 720 R 35,280 R 90,000 R 15,000 R 140,280 R 40,063 R 52,500 R 22,000 R 30,000 R 144,563 -R 4,283 R 840 R 41,160 R 72,000 R 12,000 R 125,160 R 40,063 R 56,088 R 22,000 R 30,000 R 148,150 -R 22,990 R 900 R 44,100 R 84,000 R 14,000 R 142,100 R 40,063 R 56,088 R 22,000 R 30,000 R 148,150 -R 6,050 R 1,200 R 58,800 R 90,000 R 15,000 R 163,800 R 40,063 R 56,088 R 22,000 R 30,000 R 148,150 R 15,650 R 1,440 R 70,560 R 120,000 R 20,000 R 210,560 R 40,063 R 56,088 R 22,000 R 30,000 R 148,150 R 62,410 R 972 R 47,628 R 144,000 R 24,000 R 215,628 R 40,063 R 56,088 R 22,000 R 30,000 R 148,150 R 67,478 R 23,000

Sales Discounts: 2% of 30% of last month's sales Net cash received after discount On time net payers Late payers Cash from receivables Labour (1) Materials (2) Expenses Office salaries Cash out Net operating cash flow Tax due Computer Loan repayment Net cash flow for the month Opening cash balance Available cash
(1)

R 100,000

(2)

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

Winter Woollies Manufacturing Cash Budget

R 60,000

R 40,000

R 20,000 Cash at month end

R0

-R 20,000

-R 40,000

-R 60,000

-R 80,000 Jan Feb Mar Apr

Level

May
Seasonal

Jun

Jul

Aug

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.

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

Input area:

Industry PE Company EPS Conversion price (stock) Maturity (years) Convertible bond coupon Conversion value of bond Plain vanilla coupon

R R

12.5 1.60 25.00 20 6% 800 10%

Output area:

1 Share price Intrinsic bond value Floor value Conversion ratio Conversion premium

R20.00 R656.82 R800.00 32.00 25.00%

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

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

Thandi's argument is wrong because it ignores the fact that if the company does well, bon will be allowed to participate in the company's success. If the share price rises to R40, bo are effectively allowed to purchase shares at the conversion price of R25 3

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

4 Reconciling the two arguments requires that we remember our central goal: to increase th of the existing shareholders. Thus, with 20-20 hindsight, we see that issuing convertible b turn out to be worse than issuing straight bonds and better than issuing common stock if company prospers. The reason is that the prosperity has to be shared with bondholders a convert. In contrast, if a company does poorly, issuing convertible bonds will turn out to be better t issuing straight bonds and worse than issuing ordinary shares. The reason is that the firm 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, wh is better for the company will only be known in the future and will depend on the performa company. The table below illustrates this point.
If the company does poorly Low share price and no conversion Cheap financing because coupon rate is lower (good outcome). Expensive financing because firm could have issued ordinary shares at high prices (bad outcome).

Convertible bonds issued instead of straight bonds Convertible bonds issued instead of ordinary shares

If the company prospers High share price and conversion Expensive financing becau bonds are converted, whic dilutes existing equity (bad outcome). Cheap financing because f issues shares at high prices when bonds are converted (good outcome).

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

R25 because it means the share price will have to nefit from the conversion, in this case 25 per cent. Even d, the conversion price is important. First, the company es discuss whether the company has plans to go public, he company does go public, the bondholders will have an ert. Second, even if the company does not go public, the quity interest in the company. This equity interest can be else. The potential problem with private equity is that the a public company. This illiquidity lowers the value of the

means that if the company offered bonds with the same hey would be able to sell them for 656,82. However, with 800. In essence, the company is receiving R143,18 for the

nores the fact that if the company does well, bondholders any's success. If the share price rises to R40, bondholders s at the conversion price of R25

he company is issuing debt with a lower coupon rate than . If the company does poorly, it will receive the benefit of a lower coupon rate

hat we remember our central goal: to increase the wealth 20-20 hindsight, we see that issuing convertible bonds will bonds and better than issuing common stock if the e prosperity has to be shared with bondholders after they

uing convertible bonds will turn out to be better than suing ordinary shares. The reason is that the firm will have ts on the convertible bonds

uth; we just need to combine them. Ultimately, which option wn in the future and will depend on the performance of the point.
If the company prospers High share price and conversion Expensive financing because bonds are converted, which dilutes existing equity (bad outcome). Cheap financing because firm issues shares at high prices when bonds are converted (good outcome).

e company does poorly share price and no ersion p financing because on rate is lower (good me).

nsive financing because could have issued ordinary s at high prices (bad me).

redeem the bonds at the company's discretion. If the o rise, the company can call the outstanding bonds. It ould benefit from converting the bonds at that point, but it to the bondholders