Environgrad Corporation

A Case Study
Team Based Project

CORPORATE FINANCE COURSE

Masters in Business Administration (MBA) Program August Semester

Asian Institute of Technology & Management (AITM) Affiliated to Asian Institute of Technology [AIT] Bangkok, Thailand Knowledge Village, Kumaltar Heights, Lalitpur

Team Members: Abhi K Shrestha Archana Sharma Raghavendra Mahto

ACKNOWLEDGEMENT
Coming together is a beginning. Keeping together is progress. Working together is success.

Foremost, Our deepest gratitude to our Corporate Finance course coordinator Prof Radheshaym Adhikari, for his constant guidance, support, motivation and untiring help during the course. He guided us through the obstacles, along the way, and has been so instrumental and continuous source of inspiration through out our project work. We would like to articulate sincere thanks to our colleagues, family members for their support, co-operation, inspiration, guidance, valuable hints during all stages of the preparation of this report. This project study may not have the inclusions thoroughly so we heartily welcome suggestions and comments for the improvement of the project. Finally, we again send our warm greets and obligations to all those who were involved in this project directly or indirectly. Abhi K Shrestha Archana Sharma Raghavendra Mahto Date: 8th December 2013

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1. Background of the Company

Evirongard Corporation was established in 1980 in the Chicago area of United States of America. It was solely focused on building equipments for air pollution scrubbing for eliminating airborne sulfur dioxide from smokestack emissions. This scrubber was an

innovation in the market and Envirogard owes a large measure of its success to the development of the technology it embodies. With the newer restrictions to be imposed by Environment Protection Agency (EPA) regarding emissions regulations, new type of scrubber is already in market, which is cheaper and effective against other pollutants. Considering this factor, Evirongard Co. needs to act fast and bring out its new product i.e. the Scrubber King, which should allow the company to regain tis competitive edge. The company wants to start the production as soon as possible and for the new venture it requires fresh new capital to cover not only the remodeling of existing plant but also to purchase new equipment and materials and to initiate the Scrub King marketing program. Approximately it will need $34 million and the board is given with the responsibility to come up with the decision of arranging funs through various means. The board has come up with three major ways to get the new capital and thus will be presented in the next section of the report. Prior to this Environgard has always obtained equity funds in the form of retained earnings. The only long-term borrowing was done in1997 for $16 million.

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2. The Three Alternative Methods

a. Stock The company can sell common stock to net $32 per share. The current price of the stock is $37 per share, floatation costs of $5 per share. The sale would be made through investment banks to the general public and not through rights offering.

b. Bonds The company can privately sell 25-year, 10 percent bonds to a group of life insurance companies. The bonds would have sinking fund calling for the retirement, by a lottery method, of 3 percent of the original amount of the bond use each year. Covenants under the bond agreement would also stipulate that dividends be paid only out of earnings subsequent to the bond issue; that is, the retained earrings of the company at present could not be used to pay dividends on the common stock. No floatation costs would be incurred.

c. Cumulative Preferred Stock The company can sell 6 percent cumulative preferred stock. The issue would not be callable and would not have a sinking fund. The price of the preferred would be $32 per share, the usual dividend would be $6.00 per share, and the stock would be sold to net Environgard $30 per share.

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Key Points

Inflation might increase in the near future as the value of the dollar falls against foreign currencies and the dollar price of the imports goes up, so by borrowing at the present, the company will be able to repay its loans with cheap dollars.

Sale of common stock is unappealing to the majority stockholders as their holdings are not sufficient to give them absolute control of the company, if additional shares are sold.

The danger of major strike is still present and the economy in general is in a tenuous position, with prediction that if huge budget deficits are not corrected soon, the falling dollar could precipitate a severe recession.

Company has applied for American Stock Exchange but was unable to fulfill requirements.

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Table 1: Year ended December 31,2006 (Millions of Dollars) Current Asset Fixed Asset Total Asset Current Liabilities (accruals & payable) Long-Term Debt (7.5%) Common Stock ($1 par, 10 milion shares outstanding ) Retained Earnings Total Liabilities & Net Worth $40 16 $10 $198 $264 $104 $160 $264

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Table 2: Year ended December 31, 2006 (Millions of Dollars) Sales Cost of Good Sold Gross Profit General & Administrative Expenses Lease Payment on Equipment Earnings Before Interest Interest Charges Earnings Before Tax Tax (48 percent, Marginal Tax Rate) Net Income Dividends Addition to Retained Earnings Notes: a. Includes depreciation charges of $16 million b. Five-year lease for equipment $6.8 $20.5 $25.2 $27.3 $1.2 $52.5 $9.9 2.4 $53.7 $254.0 188.0 $66.0

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Table 3: Selected Information Year Sales (Million $) Profit after tax (Million $) 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 $254 229 136 187 136 190 175 99 155 142 $27.3 20.6 (4.1) 17.8 5.9 13.1 16.9 (5.9) 14.2 12.8 Earnings Per Share Price of Stock

Dividends Per share $0.68 0.60 0.60 0.60 0.30 0.30 0.30 0.30

$2.73 2.06 (0.41) 1.78 0.59 1.31 1.69 (0.59) 1.42 1.28

$37 36 25 33 23 25 19 24 23 22

1) Assuming that the new funds earn the same rate of return currently being earned on the firms assets (earnings before interest and taxes/total assets), what would earnings per share be for 2007 Page 8 of 25

under each of the three financing method? Assume that the new outside funds are employed during the whole year of 2007, the sinking fund payment for 2007 is ignored, and retained earnings for 2007 are not employed until 2008. Under which methods of financing alternatives, EPS is highest and why? Info: New funds earn same rate of return on assets. Old rate of return: EBIT/(Total Assets) = 53.7/264 = 20.34%

Return from additional 34 million: 20.34% X 34 = $6.92 million Total return from old and new assets: 53.7 + 6.92 = $60.62 million Option A (Issuing common stock) Additional Shares: Fund to be raised/net price per share =34 million/32 = 1062500 units Total Shares: 10 million + 1,062,500 = 11,062,500 units

Earning per Share = Net income/number of shares = 30.74/11.0625 = 2.78 In millions Earning before Interest and Tax Interest Earning before Tax Tax(48%) Net Income Shares Earning per Share 60.62 1.2 59.12 28.38 30.74 11.0625 2.78

Option B (Issuing Bonds) Page 9 of 25

Additional Shares: 0 units Total Shares: 10 million units In millions Earning before Interest and Tax Interest (old) Interest (Bonds) Earning before Tax Tax (48%) Net Income Shares Earning per Share 60.62 1.2 3.4 55.72 26.7456 28.9744 10 2.89

Option C (Issuing preferred stock) Page 10 of 25

Dividend per preferred share: $6 Additional preferred shares: Fund to be raised/net price per share =34 million/30 = 11333333.33 units = 11333334 units Dividend expense for preferred share: 1133334 X 6 = $6800004 Total Shares: 10 million units In millions Earning before Interest and Tax Interest Earning before Tax Tax (48%) Preferred dividend Net Income Shares Earning per Share 60.62 1.2 59.12 28.3776 6.800004 23.94 10 2.39

Number of shares for the firm derived from options A, B and C varies as only in options A new shares are issued. In Option A (Issuing new common stock), 1,062,500 units of new stocks will be issued, summing the total number of shares to 11,062,500 units. In Option B and C (Issue of bonds, issue of preferred stock), new stocks are not issued, hence, the total number of stocks remains 10 million units. In option B and C, there is an interest payment policy and dividend payment policy respectively. Hence, there is an expense of $3.4 million and $6.8 million respectively. This variation in number of shares and expenses incurred has resulted EPS for Options A, B and C to be $2.78, $2.89 and $2.39 respectively.

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2) Calculate the debt ratio at year end 2007 under each alternative method of financing. Assume that 2007 current liabilities remain at their current level and additions to retained earnings for 2007 total $20.5 million. Compare Environgard Corporations figures with the industry averages as given in Table 4. Here it is assumed that all the retained earnings from previous years has been used to undertake the new project and hence the only retained earning remaining is $20.5 million. Concept used: Total Asset = Total Liability & Net worth Option A (Issuing common stock) Total debt = Current liabilities + long term debt = 40 + 16 = $56 million Debt Ratio = debt/asset = 56/318.5 = 17.58% In millions Current liabilities Long term debt (7.5%) Common stock ($1 par, 10 million shares) Common stock (net $32, 1062500 shares) Old retained earning (Involved in new project) Retained earning Total liabilities & net worth Total Asset Total debt: current liabilities + long term debt Debt Ratio: debt/asset 40 16 10 34 198 20.5 318.5 318.5 56 17.58%

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Option B (Issuing Bonds) Total debt = Current liabilities + long term debt + bond interest = 40 + 16 + 34 = $90 million Debt Ratio = debt/asset = 90/318.5 =28.26% In millions Current liabilities Long term debt (7.5%) Bond (10%) Common stock ($1 par, 10 million shares) Old retained earning (Involved in new project) Retained earning Total liabilities & net worth Total Asset Total debt: Current liabilities + long term debt + bond interest Debt Ratio: debt/asset 40 16 34 10 198 20.5 318.5 318.5 90

28.26%

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Option C (Issuing preferred stock) Total debt = Current liabilities + long term debt = 40 + 16 = $56 million = debt/asset = 56/318.5 = 17.58% In millions Current liabilities Long term debt (7.5%) Common stock ($1 par, 10 million shares) Preferred stock ( net $30, 1133334) Old retained earning (Involved in new project) Retained earning Total liabilities & net worth Total Asset Total debt: 40 + 16 Debt Ratio: debt/asset 40 16 10 34 198 20.5 318.5 318.5 56 17.58%

Debt Ratio

Previously Total Asset was $264 million. Previous Total Debt was $56 million Previous Debt Ratio was 56/264 = 21% After the $34 million of additional fund and new retained earning of 20.5 million Total Asset in 2007 is 264+34+20.5 = $318.5 It is assumed that retained earning at the beginning of 2007 is $0. In Option A, asset has been increased via issue of stocks worth $34 million and there is a retained earning for 2007 as $20.5 million resulting the total asset to result to $318.5. As the equity base has increased the assets, debt ratio has decreased to 17.58%.

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In Option B, asset has been increased via issue of bonds worth $34 million, and there is a retained earning for 2007 as $20.5 million resulting the total asset to result to $318.5. Bond has increased the debt from $56 million to $90 million. As the debt has increased along with the equity base, debt ratio has increased to 28.26%. In Option C, asset has been increased via issue of preferred stocks worth $34 million and there is a retained earning for 2007 as $20.5 million resulting the total asset to result to $318.5. As the equity base has increased the assets, debt ratio has decreased to 17.58%. Industry Debt/Total Assets = 35% All three options lead to debt ratio lesser than the industry average of 35%. This indicates that all the debt ratio arriving from all three options are safe and reasonable.

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3) Calculate the before tax times interest earned coverage for 2007 under each of the financing alternative. Then compare Environgard corporations coverage ratios with the industry average.

Times interest coverage

Option A (Issuing common stock) Interest of old long term debt at 7.5% of 16 million

= 0.075 X 16 million = $1.2 million

Times interest coverage: EBIT/Interest = 60.62/1.2 =50.52x In millions Earning before Interest and Tax Interest (old) Times Interest Coverage 60.62 1.2 50.52x

Option B (Issuing Bonds) Total interest = Old interest + Bond interest = 1.2 + 3.4 = $4.6 million Times interest coverage: EBIT/Interest = 60.62/4.6 = 13.18x In millions Earning before Interest and Tax Interest (old) Interest (Bonds) Times Interest Coverage 60.62 1.2 3.4 13.18x

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Option C (Issuing preferred stock) In millions Earning before Interest and Tax Interest Times Interest Coverage 60.62 1.2 50.52x

Industry Times Interest Coverage: 9x 2006 Times interest Coverage: (EBIT for 2006)/(Interest for 2006) = 53.7/1.2 = 44.75x Options A & C does not impose any interest and the EBIT has been increased due to the return from additional fund of $34 million. Hence, the times interest coverage has increased to 50.52x. However, in Option B due to bonds, additional interest of $3.4 million has been imposed. This has resulted to a decrease of times interest coverage to 13.18x. Debt ratio situations for all the three options are better than the industry average. Which means that Environgard has a better debt-paying situation than its industry.

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4) Calculate the fixed charge coverage under each of the three alternatives for the year 2007. Ignore the sinking fund payment in the debt alternative. Then compare your results with the industry average. Calculate the debt service coverage ratio (the fixed charge coverage ratio including the sinking fund payment) for the bond alternative. What effect will the sinking fund covenant have on Environgard Corporations ability to meet its other fixed charges? Do you think that the company will be able to meet fixed obligations? In the event that the company incurred a loss, do you think that the company can meet the fixed obligations? Option A (Issuing common stock) Fixed charge coverage = (EBIT + Lease Obligations)/(Interest charge + Lease Obligations) = (60.62 + 2.4)/(1.2 + 2.4) =17.51x Earning before Interest and Tax Interest Lease Obligations Fixed Charge Coverage 60.62 1.2 2.4 17.51x

Option B (Issuing Bonds) Fixed charge coverage = (EBIT + Lease Obligations)/(Interest charge + Lease Obligations) = (60.32 + 2.4)/(1.2+3.4+2.4) =8.96x Earning before Interest and Tax Interest (old) Interest (Bonds) Lease Obligations Fixed Charge Coverage 60.62 1.2 3.4 2.4 9.00x

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Option C (Issuing preferred stock) Fixed charge coverage = (EBIT + Lease Obligations)/(Interest charge + Lease Obligations) = (60.62 + 2.4)/(1.2+2.4) = 17.51x Earning before Interest and Tax Interest Lease Obligations Fixed Charge Coverage 60.62 1.2 2.4 17.51x

Industry Fixed charge coverage: 6x Sinking fund: 3% X 34 million = $1.02 million Option B (Issuing Bonds) Debt service coverage ratio =(EBIT + Lease obligations)/(Interest charge + lease obligation + sinking fund) = (60.62 + 2.4)/(1.2 + 3.4 + 2.4 + 1.02) =7.86x

Earning before Interest and Tax Interest (old) Interest (Bonds) Lease Obligations Sinking fund Debt Service Coverage

60.62 1.2 3.4 2.4 1.02 7.86x

Under all three options, fixed charge coverage is better that the industry average. Sinking fund covenant has reduced the companys debt service coverage adding one more payment obligation. Company may fall into a risk if the ratio is too low.

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5) Assume that after the new capital is raised, fixed operating charges are $24 million (not including depreciation of $20 million) and the ratio of variable cost to sales stays the same. How much would sales have to drop before the equity financing would be preferable to debt in terms of EPS? (Hint: Calculate the breakeven level of sales at which EPS will be equal under bond or stock financing.) Fixed operating charges: 24 + 20 = $44 million Variable cost in 2006: $181.9 million Cost of goods sold= $188 million (includes depreciation charges of $16 million) => $172 million General and administrative expenses: $9.9 million Sales in 2006: $254 million Contribution ratio 2006: 181.9/254 (This stays same) Breakeven point in sales = Fixed cost/contribution ratio = 44/(1- (181.9/254)) = $155 million

The sales would have to drop by $99 million for the equity financing to be preferable to debt financing.

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6) Based on the data developed in questions 2,3 and 4 discuss the pros and cons of each of the financing methods that Hellriegel is considering .

Option A Earning per Share Remarks to EPS Debt Ratio Remark Debt ratio Times interest coverage Remark interest coverage Fixed charge coverage Remarks Fixed charge coverage 2.78 Moderate 17.58% Moderate Risk 50.52x Risk Free 17.51x Low risk

Option B 2.89 Relatively High 28.26% Relatively Higher Risk 13.18x Low Risk 9.00x Moderate risk

Option C 2.39 Relatively low 17.58% Moderate Risk 50.52x Risk Free 17.51x Low risk

There is not much difference in EPS among all three options, however, Option B shows higher yield in EPS and Option C shows lowest yield in EPS. All three calculations explain the companys ability to pay its liabilities. Options A and C have the same debt ratio, times interest coverage and fixed charge coverage, all of which are at low risk overall. Only Option B has relatively higher ratios, which are moderate in reality and not much of a risk.

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7) Determine the PE ratio for 2006. If the goal is to maximize the price of firms stock , calculate the prices of common stock for 2007 under various financing arrangements for PE ratio of 18,16,15,14,13 and 10 times. Which alternative has the higher market price per share? PE ratio for 2006 Earning per share: $2.73 Price per stock: $37 P/E: 37/2.73 = 13.55 For 2007 PE ratio EPS (option A)= 2.77 Price 49.86 44.32 41.55 38.78 36.01 33.24 27.7 EPS (option B)= 2.89 Price 52.02 46.24 43.35 40.46 37.57 34.68 28.9 EPS (option C)= 2.39 Price 43.02 38.24 35.85 33.46 31.07 28.68 23.9

18 16 15 14 13 12 10

Option B of issuing bond and having a PE ratio of 18 has the highest market price per share.

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8) Calculate the profit after taxes to total assets and profit after taxes to net worth for 2007 under each of the alternatives. Then compare these ratios with the industry average under each of the alternatives. Profit after tax to total assets; Profit after tax to net worth Total assets are retrieved from tables in Q.2 Total Net Worth in Option A: Common stock ($1 par, 10 million shares) Common stock (net $32, 1062500 shares) Old retained earning (Involved in new project) Retained earning (2007) Total Total Net worth in Option B: Common stock ($1 par, 10 million shares) Old retained earning (Involved in new project) Retained earning (2007) Total Total Net worth in Option C: Common stock ($1 par, 10 million shares) Preferred stock Old retained earning (Involved in new project) Retained earning (2007) Total Option A (millions)

= $10 million = $34 million = $198 million = $20.5 million = 262.5 million

= $10 million = $198 million = $20.5 million = $228.5 million

= $10 million = $34 million = $198 million = $20.5 million = 262.5 million Option C (millions) 23.94 318.5 262.5 7.52% 9.12%

Option B (millions) 28.97 318.5 228.5 9.10% 12.68%

Profit after tax (X) Total Assets (Y) Net worth(Z) X:Y (ROA) X:Z (ROE)

30.74 318.5 262.5 9.65% 11.71%

Industry average of Profit after tax to total assets: 8% Industry average of Profit after tax to net worth: 12%

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Environgard would have its ROA & ROE almost the same at the industry ROA and ROE. When financed its by Option A, issuing stocks, it would have the highest ROA of 9.65% which is 1.65% above the industry ROA of 8%. This is because there is no expense for additional funds raised. Similarly, Option B, issuing bonds would yield, the next highest ROA of 9.10% which is 1.10% above the industry ROA. This is the result of 10% coupon rate on the bonds. Finally, the worst result on ROA came from Option C, issuing preferred stock, with an ROA of 7.52%, which is 0.48% below industry average. This is purely due to $6/share dividend allocated for preferred stocks. ROE yielding from Option A, B and C were 11.71%, 12.68% and 9.12% respectively. Among the three Options A and C were below industry average of 12% and Option B was higher. This is because issuing stocks and issuing preferred shares contribute to equity where as issuing bonds contribute towards adding liabilities.

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9) How does stock exchange membership affect the decision? If the company were to be a member of American Stock Exchange the large percentage of stock owned by the management and members of Arenberg family would have to be dispersed. The floating supply of stock would need to have a broad geographic distribution as well. Hence, if the company were to get a membership in American stock exchange in future, issue common stocks would be advisable.

10) Do you think 2:1 current ratio requirement appear too restrictive? And also do you think that covenant prohibiting the payment of dividends out of retained earnings appear to be overly burdensome? Companys current asset in 2006 is $104 million and current liability is $40 million. With additional bonds, sinking fund of $1.02 million and interest payment of $3.4 million would be added to its current liability. Hence, total current liability would add up to be $44.6 million. With this the current ratio would be 2.33. If the company gets into trouble, or have a cash flow problem then it may not be able to abide by the 2:1 current ratio requirement as it is already close to the restriction. Assuming that the injected fund brings the same return at the same rate, prohibiting the payment of dividends out of retained earnings does not appear to be burdensome. Fixed expense imposed by the issue of new bonds would be $3.4 million interest and $1.02 million sinking cost, summing up to $4.42 million. Which means the newly raised $34 million must give a return of at least 13% in order cover its own expense and have no problem in payment of dividend. With 13% as base and estimating to have a return of 20.34%, there is a safety margin of 54%. 11) Which method would you recommend to the board? Analysing the earning per share and finding Option B having highest EPS. Analysing debt ratio and Option B having the ratio below industry average. Analysing times-interest-coverage and Option B having more than industry average. Analysing fixed-charge-average and Option B having more than industry average. Analysing ROA and Option B having a fair ROA. Analysing ROE and only Option B having above industry average ROE. I would recommend Option B, issuing bonds, to the board.

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