Professional Documents
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Case Solutions
Case #
Input boxes in tan 1
Output boxes in yellow 2
Given data in blue 3
Calculations in red 4
Answers in green 5
6
7
8
9
10
ions
List of Mini-Cases Chapter
Sunset Boards 2
S&S Air 4
Pop Goes the Balloon 6
S&S's Bond 7
Valuing Refresh Ltd 8
Crystal Electronics 11
SDC's Cost of Capital 14
Spinning Wheels' Dividend Policy 17
Winter Woollies 18
S&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
Output area:
2007 2008
Operating cash flow R 57,396 R 65,374
Capital Spending
Ending net non-current assets R 134,000
- Beginning net non-current assets 105,000
+ Depreciation 26,900
Net capital spending R 55,900
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
Output area:
Dividends R 3,562,020
Add to RP R 8,311,380
Shareholder Equity
Ordinary 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
EFN R 7,404,620
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
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 Air’s 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:
Output area:
Output area:
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.
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 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
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
Input area:
WACC 20.83%
After 2010
Assumed capex after 2010 -5,000
Sustainable continuous cash flow after 2010 48,020
Growth model valuation of post-2010 cash flow at growth rate = inflation 487,739
2008 2009 2010 2010
PV of FCF 24,197 26,467 4,546 276,480
Total PV 331,689
Less debt -45,016
Plus cash 204
Plus investment in associate 2,006
Surrender value of key person policies 4,335
Value of equity R 293,218
Case #6 - Crystal Electronics
Input Area:
Equipment R20,000,000
Salvage value R3,000,000
R&D R750,000 sunk cost
Marketing study R200,000 sunk cost
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 analysis
New price R260
Quantity change 100 NOTE: Change in units per year
Output Area:
VC
New 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
NWC
Beg R0 R2,520,000 R3,100,000 R5,000,000 R4,250,000
End 2,520,000 3,100,000 5,000,000 4,250,000 0
NWC CF (R2,520,000) (R580,000) (R1,900,000) R750,000 R4,250,000
Salvage
BV of equipment R0
Taxes -870,000
Salvage CF R2,130,000
Net CF Time
0 (R20,000,000)
1 R3,646,000
2 R5,874,400
3 R8,774,000
4 R8,517,400
5 R12,983,000
VC
New 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
NWC
Beg R0 R2,660,000 R3,260,000 R5,200,000 R4,420,000
End 2,660,000 3,260,000 5,200,000 4,420,000 0
NWC CF (R2,660,000) (R600,000) (R1,940,000) R780,000 R4,420,000
Salvage
BV of equipment R0
Taxes -870,000
Salvage CF R2,130,000
Net CF Time
0 (R20,000,000)
1 R4,003,000
2 R6,422,400
3 R9,444,000
4 R9,150,900
5 R13,685,500
NPV R8,997,140.38
DNPV/DP R203,372.31
VC
New R6,028,600 R6,888,600 R8,608,600 R7,318,600 R6,458,600
Lost sales 1,020,000 1,020,000
R5,008,600 R5,868,600 R8,608,600 R7,318,600 R6,458,600
NWC
Beg R0 R2,525,000 R3,105,000 R5,005,000 R4,255,000
End 2,525,000 3,105,000 5,005,000 4,255,000 0
NWC CF (R2,525,000) (R580,000) (R1,900,000) R750,000 R4,255,000
Salvage
BV of equipment R0
Taxes -870,000
Salvage CF R2,130,000
Net CF Time
0 (R20,000,000)
1 R3,652,644
2 R5,886,044
3 R8,785,644
4 R8,529,044
5 R12,999,644
NPV R7,003,764.16
DNPV/DQ R403.47
Case #7 - SDC's Cost of Capital
Input Area:
Output Area:
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
capital.
b)
As the Outside shareholders
subsidiaries interest
are in similar lines of business and have similar risk
and growth prospects, we assume that their cost is the same as
ordinary shares.
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
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.
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:
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
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
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
Level production
Expected sales for next 8 months R 1,282,000
Average expected monthly sales R 160,250
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 (1) R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063
Materials (2) R 42,000 R 66,500 R 52,500 R 56,088 R 56,088 R 56,088 R 56,088 R 56,088
Expenses R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000
Office salaries R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000
Cash 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
(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)
Cash outflows for materials will only change in March under level production, since payment terms for purchases are 60 days.
R 40,000
R 20,000
R0
-R 20,000
-R 40,000
-R 60,000
-R 80,000
Jan Feb Mar Apr May Jun Jul Aug
Level Seasonal
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 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:
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 pub
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 t
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. Howev
the conversion feature the price will be R800. In essence, the company is receiving R143,
conversion feature.
2
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, bon
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 b
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 t
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 th
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.
5 The call provision allows the company to redeem the bonds at the company's discretion. I
company's shares appear to be poised to rise, the company can call the outstanding bond
be possible that the bondholders would benefit from converting the bonds at that point, bu
eliminate the potential future gains to the bondholders
R25 because it means the share price will have to
efit from the conversion, in this case 25 per cent. Even
d, the conversion price is important. First, the company
s discuss whether the company has plans to go public,
he company does go public, the bondholders will have an
rt. Second, even if the company does not go public, the
uity interest in the company. This equity interest can be
lse. The potential problem with private equity is that the
public company. This illiquidity lowers the value of the