CONFIDENTIAL WFF3193 UNIVERSITI UTARA MALAYSIA FINAL EXAMINATION SECOND SEMESTER SESSION 2008/2009 CODE/COURSE NAME: WFF3193/ SEMINAR IN FINANCE : 4MAY 2009 (MONDAY) : 12.30 ~3.00 PM (2 % HOURS) : DMS 1. This examination paper contains THREE (3) cases on ELEVEN (11) printed pages excluding the cover page. 2. Answer ALL questions in the answer booklet provided. | MATRIC NO. : (in words) } Ic NUMBER I } LECTURER : _ | GRouP: TABLE NO. : DO NOT OPEN THIS EXAMINATION PAPER UNTIL YOU ARE INSTRUCTED TO DO SO CONFIDENTIALWE 3193 Seminar in Finance Matric No. CASE 1 (30 MARKS) “A Switch in Time Saves Nine” Simon sat at his office desk pondering over what was discussed at his last meeting with the Treasurer, Angela Krampf, The working capital of their firm, Progressive Farm Equipment Incorporated, had increased at an alarming rate over the past couple of years making the directors and top managers very concemed. Despite the implementation of a just in time” inventory system and more efficient cash management methods, the ‘working capital continued to rise. This time, however, it was the accounts receivable that needed attention. Angela received a memo from the board asking her to review and rectify the credit management problem as soon as possible, One of the sentences in the ‘memo read "we simply cannot continue to carry our customers as long as we have been," ‘Angela had therefore called on her assistant, Simon Martinez, and briefed him of the situation. Progressive Farm Equipment Inc. had been in business since 1945, producing small and medium sized tractors, tillers, and other farm equipment. Its customer base included various local and regional hardware stores, farm equipment stores, and repair shops. Most of the clients were strapped for cash and were accustomed to fairly flexible credit terms. The firm had been hard pressed to offer terms of net 60 to its clients, primarily to counter competition from national suppliers and to maintain good customer relationships. Sales had steadily increased over the years but over the past year, higher interest rates and a weakening economy had caused a slump in the agricultural sector leading to a drop in sales of farm equipment. Moreover, the number of farmers filing for bankruptcy had been increasing at an alarming rate. ‘As Angela and Simon reviewed the accounting statements (see Tables 1 and 2) and the aging schedule of receivables, they realized that despite the fairly liberal credit terms of net 60, on average, 40% of the credit sales were being collected 10 days late. The company had not implemented a policy of charging interest or late fees for fear of losing customers. They also noticed that over the past year the number of bad debts had gone up from 1% of sales to its current level of 2% of sales. Angela told Simon that the directors expected to see a proposal that would be realistic and effective. "On the one hand, we have to be careful about not turning customers away”, said Angela. "But on the other hand, we simply cannot afford to continue the current policy of allowing customers to pay late. Some credit will have to be given, but collections have to be tightened up. I guess the time has come for us to switch or suffer.” ‘About six months earlier, Angela Krampf had recruited Simon Martinez, a certified financial manager, to assist her in managing the company’ s working capital. Initially, it was the management of cash and inventory that needed modification. After much debate and discussion, a more conservative policy of cash management was implemented, followed by a successful integration of a just-in-time inventory management system. TheWF 3193 Seminar in Finance Masri No: quarterly statements showed that the modifications had worked. Angela and Simon were aware that the company's collection policy was rather liberal. However, given the ‘economic conditions and sensitivity of the issue, they had refrained from suggesting any changes. As Simon pondered about what changes in the firm's collection policy he should recommend he realized that he would have to get some more data. He called up the folks in marketing and inquired about what effect a tighter collection policy would have. Upon being asked to be more specific, he told them that he was considering two alternatives: 1) 2/10net30, and 2) 220 net 60. He was told that under the first alternative, sales would probably decrease by about 10%. The sales people had built up a very good relations with their customers and were confident that, despite the tighter credit terms, they could retain most of the accounts provided there was some incentive for paying early. Moreover, they informed Simon that, most retailers could avail of commercial loans from banks at an average rate interest of 14% per year. If the second alternative were implemented, accounts receivable figure would be reduced without any loss of sales. Obviously, the sales people preferred the second approach. Simon estimated that under the new terms approximately 50% of sales would be collected within 10 days. Of the remaining 50% of sales, roughly 60% would be collected within the credit period and remaining 40% would be approximately 10 days late, as usual, Simon figured that he had better prepare pro forma statements showing the impact that these policies would have on the company's bottom line on the accounts receivable balance, before recommending any penalties and so on, Table 1 Progressive Farm Equipment Incorporated Latest Fiscal Year’s Income Statement (000s) Sales 495,000 Cost of Goods Sold 29,250 Gross Profit 15,750 Op. Expenses 7,200 Earnings Before Interest and Taxes 8,550 | Interest expenses (10% per year) 1,300 Earnings Before Taxes 7,250 Income taxes 3,420 Net Income 3,830WF 3193 Seminar in Finance Maric Table 2 Progressive Farm Equipment Incorporated Latest Fiscal Year’s Balance Sheet (‘000s) Cash 2,000 Accounts Payable 3,200 Accounts Receivable 7,890. Notes Payable 6,000 Inventory 6,000 Total Current Liabilities 9,200 Total Current Assets 13.890 Long-Term Debt 8,000 Fixed Assets 20,000 Stockholders’ Equity 18,690 Total Assets 35,890 Total Liabilities and equity 35,890 QUESTIONS: 1. What are the elements of a good credit policy? Evaluate Progressive Farm Equipment's credit policy. (8 marks) Why is the increase in accounts receivables of concem to the board of directors? ‘Are they justified in their demand for a tighter credit policy? Why? (@ marks) What is the amount of annual expense to the firm as a result of the delay in collections? What other risks do such delays entail? (3 marks) Calculate the cost of foregoing the 2% cash discount offered under the 2/10, net 30 and 2/10 net 60 terms respectively. Given that most retailers could take short-term loans from banks at the rate of 14% or less, evaluate the attractiveness of each policy. (4 marks) What are some other ways in which the company could speed up collections and reduce the receivables? (3 marks) ‘Why has this slow buildup in accounts receivable occurred? Could it have been avoided? How? Please explain. (3 marks)WF 3193 Seminar in Finance Maire No Develop the pro forma financial statements for the company under the two credit policy alternatives, i.e. 2/10, net 60; and 2/10 net 30 using the assumptions given. What would be the impact on the firm's return on sales, return on investment,and return on equity? (6 marks) Which policy should Simon recommend to the board? Why? (G marks)WF 3198 Seminar in Finance Matric No CASE 2 (35 MARKS) “Bigger Isn’t Always Better” ‘Andre Pires opened his automobile parts store, Quickfix Auto Parts, five years ago, in a mid-sized city located in the mid-western region of the United States. Having worked for an automobile dealership, first as a technician, and later as the parts department manager, for over 15 years, Andre had leamed the many nuances of the fiercely competitive automobile servicing business. He had developed many contacts with dealers and service technicians, which came in really handy when establishing his own retail store. Business had picked up significantly well over the years, and as a result, Andre had more than doubled his store size by the third year of operations. The industry and local forecasts for the next few years were very good and Andre was confident that his sales would keep growing at or above recent levels, However, Andre had used up most of his available funds in expanding the business and was well aware that future growth would have to be funded with extemal sources of funds, What was worrying Andre was the fact that over the past two years, the store’s net income figures had been negative, and his cash flow situation had gotten pretty weak (See Tables 1 and 2). He figured that he had better take a good look at his firm’s financial situation and improve it, if possible, before his suppliers found out. He knew fully well that being shut out by suppliers would be disastrous! Andre's knowledge of finance and accounting, not unlike many small businessmen’ s, was very limited. He had often entertained the thought of taking some financial management courses, but could never find the time. One day, at his weekly bridge session, he happened to mention his problem to Tom Andrews, his long time friend and bridge partner. Tom had often given him good advice in the past and Andre was desperate for a solution. “I'm no finance expert, Andre,” said Tom, “but you might want to contact the finance department business school and see if you can hire an MBA student as an intern. ‘These students can often be very insightful, you know.” ‘That's exactly what Andre did, Within a week he was able to recruit Juan Plexo, a second semester MBA student, who had an undergraduate degree in Accountancy and was interested in concentrating in Finance. When Juan started his intemship, Andre explained ‘exactly what his concerns were. "I'm going to have to raise funds for future growth, and given my recent profit situation, the prospects look pretty bleak. I can't seem to put my finger on the exact cause. The bank’s commercial loan committee is going to want some pretty convincing arguments as ta why they should grant me the loan. I need to put some concrete remedial measures in place, and was hoping that you can help sort things out, Juan," said Andre, "I think I may have bitten off more than i can currently chew."WF 3193 Sominar in Finance Maurie No, Table 1 r ‘Quickfix Autoparts Balance Sheets ‘ASSETS 2000 2004 ‘Cash and marketable Securities $155,000 | $309,099 $75,948 | $28,826 | $18,425 Accounts receivable 10,000 12,000 | 20,000 | 77,654 | 90,078 Inventory 250,000 270,000 | 500,000 ___520,000 | _ 560,000 Current assets $415,000 | $591,099 | $595,948 | $626,480 | $668,503 Land, buildings, plant, And equipment $250,000 | $250,000 $500,000 $500,000 | $500,000 Accumulated depreciation (25,000) | (50,000) | (100,000) | (150,000) | (200,000) Net fixed assets $225,000 | $200,000 | $400,000 | $350,000 $300,000 Total assets 8640,000_| $791,099 | $995,948 | $976,480 | $968,503 LIABILITIES AND EQUITIES Short-term bank loans T” ss0,000 | sias,o00 | s140,000 | $148,000 | $148,000 Accounts payable 10,000 10,506 19,998 15,995 | 14,795 Accruals, 5,000 5.100 7,331 9301 11,626 Current liabilities $65,000 | $160,606 | $167,329 | $173,296 | $176,421 ‘Long-term bank loans $63,366 | $98,000 | $196,000 | $190,000 | $183,000 Mortgage 175,000 | 173,000 | 271,000 | 268,000 | 264,000 Long-term debt $238,366 | $271,000 | $467,000 | $458,000 | $447,000 Total liabities $303,666 | $431,606 | $634,329 | $631,296 | $623,421 Common stock (100,00 shares) $320,000 | $320,000 | $320,000 | 320,000 | $320,000 Retained earnings 16,634 | 39,493 | 41,619 | _25,184 | _ 25,082 Total equity $336,634 | $359,497 | $361,619 | $345,184 | $345,082 Total liabilities and equity $640,000 | 791,099 | $995,948 | 3976480 | $968,503WF 3193 Seminar in Finance Matric No, Table 2 Quickfix Autoparts Income Statements 2000 2001 2004 Net sales ‘$600,000 | $655,000 $1,013,376 Cost of goods sold 480,000 | 537,100 | 655,200 | 742,560 | 861,370 Gross profit ‘$120,000 | $117,900 [$124,800 | $131,040 |” $152,006 Admin and selling exp $30,000 | $15,345 | $16,881 | $43,680 | $40,535 Depreciation 25,000 | 25,000 | 50,000 | 50,000 50,000 Miscellaneous expences 2,027 | 3,557 | 5,725 | 17,472 15,201 Total operating exp $57,027 | $43,902 | $72,606 | $111,152 | $105,736 EBIT $62,973 | $73,998 | $52,194 | $19,888 | $46,271 Interest on Short Term loans | $15,000 | $15,950 | $14,000 | $13,320 | $13,320 Interest on Long Term loans 8,000 | 7,840 } 15,680 | 15,200 14,640 Interest on mortgage 12,250 | 12,110 | 18,970 | 18,760 18,480 Total interest $35,250 | $35,900 | $48,650 | $47,280 | $46,440 Before-tax earnings $27,723 | $38,098 | $3,544 | ($27,392) (8169) Taxes 11,089 | 15,239 1,418 | (10,957) (68) Net income $16,634 | $22,859 | $2,126 | ($16,435) ($102) Dividends on stock 0 0 0 0 0 Addition to Retained earning $16,634 | $22,859 | $2,126 | ($16,435) (8102) EPS (100,000 shares) $0.17 | $0.23 | $0.02 | ($0.6) (80.00) QUESTIONS: 1. How does Quickfix'’s average compound growth rate in sale compare with its earnings growth rate over the past five years? (2 marks) 2. Which statements should Juan refer to and which ones should he construct so as to develop a fair assessment of the firm’s financial condition? Explain why? (G marks)IF 3193 Seminar in Finance What calculations should Juan do in order to get a good grasp of what is going on with Quickfix’s perfomance? (2 marks) Juan knows that he should compare Quickfix's condition with an appropriate benchmark. How should he go about obtaining the necessary comparison data? (2 marks) Besides comparison with the benchmark, what other types of analyses could Juan perform to comprehensively analyze the firm's condition? Perform the suggested analyses and comment on your findings. (12 marks) Comment on Quickfix's liquidity, asset utilization, long-term solvency, and profitability ratios. What arguments would have to be made to convince the bank that they should grant Quickfix the loan? (10 marks) If you were the commercial loan officer and were approached by Andre for a short-term loan of $25,000, what would your decision be? (1 marks) ‘What recommendation should Juan make for improvement, if any? (1 marks) What kind of problems do you think Juan would have to cope with when conducting a comprehensive financial statement analysis of Quickfix Auto Parts? (2 marks)WF 3193 Seminar in Finance Masre No CASE 3 (35 MARKS) “How Low Can It Go?” Dwayne sat at his desk wondering what he should do. Having opted for early retirement, six months ago, he knew that he needed to make some changes in the way his investment portfolio was structured. However, being primarily focused on science during his career, he had a fairly limited knowledge of stock selection and portfolio management. One thing was certain , though, Dwayne had an eagerness to learn and that’s exactly what he planned to do during his appointment with his broker, Jonathan Price, Dwayne Stevenson aged 58, had joined the Pharmacopia Company approximately thirthy years ago, as ¢ post-doctoral researcher in the field of immunology. His strong work ethic and knowledge of science enabled him to progress steadily along the research track of the ‘company. He won a number of awards and earned many promotions along the way. Five years ago, Dwayne eared the coveted title of “Research 5 Scientist” enjoyed by only 4 other individuals in the corporation. One of the main advantages of gaining the “Research 5” status was that he was given stock options as part of his remuneration package. At that time, shares of Pharmacopia (PCU) were trading at $30 per share. The company had annual sales in excess of $5 billion and the sales and earnings growth forecasts for the next few years were good. The company had applied for Food and Drug Administration (FDA) approval for two highly promising drugs and had a number of others in the pipeline. However, as luck would have it, about 3 years later, the firm suffered a few seatbacks. The FDA did not approve a couple of its applications and the Environmental Protection ‘Agency (EPA) was investigating Pharmacopia for possible dumping violations. Besides, the patents on two of its best selling drugs had expired and generic versions began to flood the market. Needless to say, the firm’s sales began to suffer and profits began to shrinks sending its stock price into a downward spiral. “Downsizing” and cost cutting were buzzwords that could be heard throughout the firm and on Wall Street. About a year later, Dwayne was offered the option to take early retirement, primarily because his project was one that had not gained FDA approval. The severance package offered by the company was too good to turn down so Dwayne opted for early retirement. Part of the retirement package included a significant amount of company stock, which was trading at $12 at the time. ‘As a result of having exercised stock options and his early retirement package, Dwayne had accumulated over 100,000 shares of PCU’s common stock. This caused his investment portfolio to not be well diversified and Dwayne knew that he needed to restructure it. With PCU’s stock price having declined to $8 per share in recent months, Dwayne wondered whether he should sell the stock or hold it until it reached a better price. Having had very little financial and investment training, Dwayne contacted his broker, Jonathan Price, for some advice. His main question to Jonathan was, “How low can it go?”WTF 3193 Seminar n Finance Matrie No: Jonathan told him to hold on to the stock because his calculations showed that it was significantly undervalued at $8 per share and should rise to about $28 per share in a few months, He felt that the company was having temporary regulatory problems and should bbe able to weather the storm quite well. He said that the current intrinsic value of the stock, in his opinion, was in the range of $10-$20. Not convinved, Dwayne asked him to explain how he arrived at that range, Jonathan replied that he used alternate forms of the dividend discount model, to which Dwayne responded, “Dividend what?” Jonathan realized that he would have to give Dwayne a primer on stock valuation and set up an appointment for the following week, In preparation for the appointment, Jonathan prepared Table 1 showing the sales, net income, earnings per share, and dividend per share data for the prior 10 year period. In addition, he estimated the firm’s beta and noted down the risk free rate, market risk premium, and the expected growth rate of the pharmaceutical industry (shown in Table 2). Jonathan knew that he would have to keep his explanations simple, yet convincing, and expected to be faced with many difficult questions. Table 1 Pharmacopia Company Key Financial Data for Prior 10- year Period (in $ millions except EPS, DPS) Year Sales ‘Net income EPS DPS 1995 3,000 150 1.50 0.60 1996 3,200 160 1.60 0.64 1997 4,000 200 2.00 0.80 1998 4,400 220 2.20 0.88 1999 4,800 240 2.40 0.96 2000 L 5,000 250 2.50 1.00 2001 5,200 260 2.60 1.04 2002 5,100 255 2.55 1.02 2003 4,900 245 2.45 0.98 2004 4,700 235 2.35 0.94 Table 2 Systematic Risk, Industry Growth Rate, Interest Rate Beta 30- year ‘Treasury Bond Yield Expected Market Risk Premium 9% Industry Average Growth Rate 10% 10WE 3193 Seminar in Finance ‘Marie No. QUESTIONS: L How should Jonathan describe the rationale of the dividend discount model (DMM) and demonstrate its use in calculating the justifiable price of common stock? (9 marks) Being a researcher, Dwayne asked Jonathan a key question, “How did you estimate the growth rates used in applying the model?” Using the data given in Tables 1 and 2, explain how Jonathan should respond. (4 marks) What is the rationale of the required rate of return that Jonathan used and how did he estimate it? (S marks) “What other variations of the DDM can one use and why?” asked Dwayne. What should Jonathan’s response be? (7 marks) “Why are you usings dividends and not earning per share, Jonathan?” asked Dwayne, What do you think Jonathan would have said? (5 marks) Dwayne wondered whether Pharmacopia’s preferred stock would be a better investment than its common stock, given that it was paying a dividend of $1.50 and trading at a price of $15. He asked Jonathan to explain to him the various features of preferred stock, how it differed from common stock and corporate ‘bonds, and the method that could be used for estimating its value. (5 marks) u