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Cash Flow Analysis
Signal Cable Company
When Jay Smith took the job of Assistant to the President, two years ago, things were going rather well at the Signal Cable Company. The company was on an expansionary path and had branched off into the fiber optics business. The prospects looked good and the economy was strong. The threat of competition was not too severe. Due to the expectation of increased demand for fiber optic communications, the company had established two additional manufacturing facilities, and significantly increased its inventory. Signal Cable had enjoyed quite a run up in profits over the past few years. However, when the accounting statements were prepared for the current year, the results showed a lower net profit margin. More importantly, there was a severe drop in the cash balance of the company and the stock price had recently fallen from $7 to $5.50 per share. Jay knew that the shareholders would be very concerned and possibly irate. He was also sure that his boss, Joe Mathis, would have to
Case 1 Signal Cable Company
come up with some feasible answers and suggestions as to how the liquidity problems could be alleviated. This concern was primarily important since the firm had been expecting to raise some short-term capital in the immediate future. Jay's expectations were fulfilled when Joe called him up and asked him to prepare a report explaining the financial condition of the firm. Table 1 and 2 present the Income Statement and Balance Sheet for the recent two years. Table 1
2004 Net Sales Cost of Goods sold Depreciation Selling & Administrative Expenses Earnings Before Interest and Taxes Interest Paid Taxable Income Taxes (40%) Net Income Dividends Addition to Retained Earnings 2,050,000 1,537,500 79,000 40,000 393,500 155,000 238,500 95,400 143,100 42,930 100,170 2003 1,678,894 1,343,115 51,000 32,945 251,833.8 44,000 207,833.8 83,133.52 124,700.3 37,410.08 87,290.2
Signal Cable Company
2004 ASSETS Cash Accounts Receivable Inventories Total Current Assets NWC Gross Fixed Assets Accumulated Depreciation Net Fixed Assets 5,000 540,000 1,300,450 1,845,450 950,450 1,300,000 232,000 1,068,000 40,000 200,000 650,000 890,000 535,000 510,000 153,000 357,000 2003
LIABILITIES & EQUITY Accounts Payable Notes Payable Total Current Liabilities Long-term Debt Common-stock and Paid in Surplus (200,000 shares outstanding) Retained Earnings Total 145,000 750,000 895,000 1,226,280 55,000 300,000 355,000 200,000
600,000 192,170 2,913,450
600,000 92,000 1,247,000
Signal Cable Company
1. Why has the stock price fallen despite the fact that the net income has increased? 2. How liquid would you say that this company is? Calculate the absolute liquidity of the firm. How does it compare with the previous year's liquidity position? 3. How does the market value of the stock compare with its book value? Is the book value accurately reflecting the true condition of the company? 4. The board of directors is not clear as to why the cash balance has dropped so much in spite of the increase in sales and the gross profit margin. What should Jay tell the board? 5. Measure the free cash flow of the firm. What does it indicate? 6. Calculate the net working capital of the company for each of the two years. What can you conclude about the firm's net working capital? 7. Should the shareholders be concerned about the drop in cash flow or should they be happy that the earnings per share have increased? Explain your answer.
Financial Ratio Analysis
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 learned 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 external sources of funds. What was worrying
not unlike many small businessmen's. Tom had often given him good advice in the past and Andre was desperate for a solution. the store's net income figures had been negative. a second semester MBA student. his long time friend and bridge partner.6 Case 2 Bigger Isn 't Always Better! Andre was the fact that over the past two years. When Juan started his internship. but could never find the time. who had an undergraduate degree in Accountancy and was interested in concentrating in Finance. and given my recent profit situation." said Tom. The bank's commercial loan committee is going to want some pretty convincing arguments as to why they should grant me the loan. at his weekly bridge session. "I'm no finance expert." said Andre." That's exactly what Andre did. and his cash flow situation had gotten pretty weak (See Tables 1 and 2). you know. I need to put some concrete remedial measures in place. he happened to mention his problem to Tom Andrews. Andre. was very limited. These students can often be very insightful. "I'm going to have to raise funds for future growth. "I think I may have bitten off more than I can currently chew. He knew fully well that being shut out by suppliers would be disastrous! Andre's knowledge of finance and accounting. He figured that he had better take a good look at his firm's financial situation and improve it. Andre explained exactly what his concerns were. and was hoping that you can help sort things out. if possible." . the prospects look pretty bleak. He had often entertained the thought of taking some financial management courses. One day. Juan. before his suppliers found out. Within a week he was able to recruit Juan Plexo. "but you might want to contact the finance department at our local university's business school and see if you can hire an MBA student as an intern. I can't seem to put my finger on the exact cause.
000 2000 2001 2002 2003 2004 $155.000 271.000 i $791.000 39.619 $361.000 (25.000 500.296 $148.366 $145.329 $148.000) $300.000 19.626 $176.4211 $320.184 $345.000 173.099 $995.619 $320.948 $976.000 16.000 $458.000 $500.000 264.366 $303.000 25.948 20.296 $190.421 $183.000 shares) Retained earnings Total equity Total liabilities | and equity $320.000 $238. buildings plant.948 $28.503 LIABILITIES AND EQUITIES 1 Short-term bank loans Accounts payable Accruals Current liabilities Long-term bank loans Mortgage Long-term debt Total liabilities $50.000 41.000 $631.000 $500.184 $640.634 $320.000 16.998 7.480 $968.000 270.000 $63.506 5.000 25.000 (150.000 $623.795 11.000 250.493 $320.329 $196.000 $791.000 15.000 (200.000 $634.331 $167.000 $309.301 $173.000 (50.425 90.Case 2 Bigger Isn't Always Better! 7 Table 1 Quickfix Autoparts Balance Sheets ASSETS Cash and marketable securities [Accounts receivable Inventory Current assets Land.099 $995.366 175.503 Total assets $640.000 $626.493 $359.000 $431.826 77.000 10.000 $250.000) $350.653 520.100 $160.082 $345.000 $65.503 .948 $976. and equipment Accumulated depreciation Net fixed assets $250.000 $467.000 268.000) $400.099 12.078 560.000 5.480 $968.000 $591.000 (100.606 $98.480 $18.000 10.000) $200.000) $225.995 9.000 $415.000 10.082 Common stock (100.634 $336.000 $447.000 $500.000 $271.099 $75.000 $595.606 $140.000 $668.
100 $117.950 7.000 12.02 ($0.370 $152.006 $40.280 ($27.152 $19.089 $16.250 $27.23 $2.973 $15.435) 0 2004 $1.544 1.239 $22.000 3.957) ($16.480 $46.000 480.271 $13.250 $35.640 18.859 0 2002 $780.000 $120.320 14.900 $38.200 $124.200 18.000 537.027 $57.000 5.000 shares) $16.000 $30.888 $13.723 11.606 $52.000 655.098 15.000 15.998 $15.881 50.557 $43.040 $43.970 $48.902 $73.027 $62.736' $46.345 25.800 $16.000 2.392) (10.680 50.000 25.634 0 2001 $655.376 861.000 8.680 18.00) $600.440 ($169) (68) ($102) 0 .194 $14.2011 $105.16) ($102) ($0.560 $131.013.634 $0.000 15.435) $0.126 0 2003 $873.320 15.126 ($16.000 17.535 50.859 $0.900 $15.8 Case 2 Bigger Isn't Always Better! Table 2 Quickfix Autoparts Income Statements 2000 Net sales Cost of goods sold Gross profit Admin and selling exp Depreciation Miscellaneous expenses Total operating exp EBIT Interest on ST loans Interest on LT loans Interest on mortgage Total interest Before-tax earnings Taxes Net income Dividends on stock Addition to retained earnings EPS (100.110 $35.760 $47.650 $3.840 12.418 $2.17 $22.472 $111.600 742.725 $72.
asset utilization. long-term solvency. What arguments would have to be made to convince the bank that they should grant Quickfix the loan? 7. if any? 9. 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. How should he go about obtaining the necessary comparison data? 5. What kinds of problems do you think Juan would have to cope with when conducting a comprehensive financial statement analysis of Quickfix Auto Parts? What are the limitations of financial statement analysis in general? . What recommendations should Juan make for improvement. How does Quickfix's average compound growth rate in sales compare with its earnings growth rate over the past five years? 2.000. If you were the commercial loan officer and were approached by Andre for a short-term loan of $25. Juan knows that he should compare Quickfix's condition with an appropriate benchmark. and profitability ratios. What calculations should Juan do in order to get a good grasp of what is going on with Quickfix's performance? 4.Case 2 Bigger Isn 't Always Better! 9 Questions: 1. 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? 3. Comment on Quickfix's liquidity. what would your decision be? Why? 8. 6.
the President and Chief Executive Officer of Plastichem Inc.. Foremen and supervisors were offered stock option incentives. had been instrumental in significantly increasing the company's size during his first five years in office. He spearheaded some successful marketing campaigns and revamped the production facilities by adopting the latest technology in injection molding. a medium-sized plastic molding company.. and bonuses were tied to earnings per share (EPS) growth. Plastichem Inc. Jack Brown.3 DuPont Analysis Playing the Numbers Game! "Numbers! I need to see numbers!" exclaimed Andrew in response to comments made by the assistant vice-president of Finance. Michigan. Andrew Sullivan. was founded in 1990 and was located in Midland. He also implemented various cost-cutting measures and introduced performance plans to boost efficiency. The company supplied molded plastic products to various processing industries as well as end-users. It enjoyed a fairly diversified base of customers ranging .
a motivated leader. which traded in the over-the-counter market. Plastichem's stock. Is Jay right? Of what use is such an analysis? Please prepare common size balance sheets and income statements for Plastichem and DCM Molding and discuss your findings. the firm's revenues and profits had almost quadrupled. Jack Brown. leverage." Questions: 1. His track record of turning companies around was very good. was not about to give up easily.4 . Despite the fierce competition. a recently hired intern. The plastics business offered potential for high profit margins and as a result it attracted many competitors. prepare a detailed comparison report indicating the strengths and weaknesses of each company. After an initial period of sluggish growth. a "Strong Buy" rating while downgrading Plastichem's rating to a "Hold. Recently. activity. the assistant VP of Finance. . He.Case 3 Playing the Numbers Game! 11 from automobile and home products manufacturers to the federal government. Using the income statement and balance sheet data shown in Tables 1 . however. had tripled in value over the past five years making the shareholders very happy. the stock price had dipped sharply. brought this matter to Andrew's attention informing him that the analysts had given their closest rival. Jack Brown realizes that the first thing he must do is compare the liquidity. Andrew. has suggested to Jack that he should include an analysis of common size statements in the report. therefore. DCM Molding. he would be able to make some strategic moves to alleviate the problems. raising concerns among security analysts. He knew that if he could identify the main problem areas. Most of the increase had been achieved under the leadership of Andrew Sullivan. Andrew had learned over the years that in order to be successful it was very important to "play the numbers game. Jay Singh. and profitability ratios of the two companies." This recent development had outraged shareholders and the Personal Relations department had been overwhelmed with calls from anxious owners wanting to know what was going on. 2. demanded that he be given a detailed report of the firm's financial condition in comparison to that of DCM Molding. however.
After collecting. What are some of the limitations regarding the various analyses that have been suggested above? What additional data would Jay and Jack need to improve their findings? Are there any other calculations and comparisons that would be helpful? Please explain. Jay has also recommended that a DuPont analysis be done. what conclusions and recommendations would Jack be justified in making in his report to Andrew? 6. and analyzing the data. compiling.12 Case 3 Playing the Numbers Game! 3. How can such an analysis be performed and what information does it indicate about the relative performance of the two companies? 4. how acute is the problem facing Plastichem. 5.? What strategic moves do you think Andrew could make to alleviate the problems? 7. Inc. In your opinion. How accurate are the analysts in their recommendations of the two firms? .
6 56.3 10.3 287.3 222.6 0.2 221.2 182.3 0.8 0. Gross kccumulated depreciation & Depletion Property.0 50.6 96.1 80.9 87.7 185.7 57.7 3.4 172.0 215.5 -14.7 0.0 0.0 0.7 Mil 7.0 30.9 3.7 19.1 20.0 0.1 5.6 33.3 0.4 34.9 340.7І 99.6 24.9 67.6 Mil 6.9 340. Plant & Equipment.7 38.0 7.0 0.2 98.0 247.0 0.3 6.2 222.5 3.8 343.5 64.1 7.4 265.7 87.7 47. Net Intangibles Other Non-Current Assets Total Non-Current Assets Total Assets LIABILITIES AND EQUITIES Current Liabilities Accounts payable Short Term Debt Other Current Liabilities Total Current Liabilities Non-Current Liabilities Long-term debt Deferred Income Taxes Other Non-Current Liabilities Minority Interest Total Non-Current Liabilities Total Liabilities Shareholder's Equity Preferred Stock Equity Common Stock Equity iTotal equity Total liabilities and Stock Equity Total Common Shares outstanding Preferred Shares [Treasury Shares 20.2 3.5 30.0 0.0 0.2 121.0 56.6 35. Plant & Equipment.2 Mil 7.0 0 0.3 60.0 0.4 2003 2002 2001 94.3 282.3 280.5 35.5 6.2 224.4 4.1 27.7 265.7 63.0| .0 2.9 26.8 4.0 0.1 23.0 0.0 8.0 -14.3 28.3 31.0 0.0 0.6 Mil 0.7 59.0 0 0.4 32.2І 99.9 27.7 9.8 3.4 55.2 46.9 12.0 218.8 343.5 7.0 42.6 20.8 59.0 62.8 5.2 42.5 0.9 12.0 58.8 252.Case 3 Playing the Numbers Game! 13 Table 1 Plastichem Incorporated Annual Balance Sheets (Values in millions) 2004 ASSETS Current Assets Cash and marketable securities Accounts receivable Inventory Other Current assets Total Current Assets Non-Current Assets Property.1 25.0 58.0 0.
0 21.2 0.9 1.7 18.5 3.6 15.4 0.8 0.0 0.1 7.8 31.3 3.3 17.2 20.0 0.0 35.4 35.3 mil 0.0 o.1 mil 0.9 1.3 mil 0.1 11.0 2.0 7.5 87.0 39.1 64.1 4.7 7.0 18.1 19.1 90.3 90. Net Intangibles pther Non-Current Assets [Total Non-Current Assets Total Assets LIABILITIES AND EQUITIES Current Liabilities kccounts payable Short Term Debt pther current Liabilities [Total Current liabilities Non-Current liabilities Long-term debt Deferred Income Taxes pther Non-Current Liabilities Minority Interest [Total Non-Current Liabilities Total Liabilities Shareholder's Equity Preferred Stock Equity Common Stock Equity [Total equity [Total liabilities and Stock Equity [Total Common Shares outstanding Preferred Shares [Treasury Shares 25.1 20.3 13.7 5.0 0.8 0.6 15.3 2.9 12.9 0.0 0.0І 36.2 2.0 4.6 35.0 6.7 27.4 1.7 15.3 13.9 16.0 32.1 5.4 52.9 11.9 0.0 3.4 1.14 Case 3 Playing the Numbers Game! Table 2 DCM Molding Annual Balance Sheets (Values in millions) 2004 [ASSETS [Current Assets Cash and marketable securities Accounts receivable Inventory Other Current assets Total Current Assets Non-Current Assets Property.0 21.9 6.1 16.0 9.9 5.7 6.1 25.5 27.1 36.7 32.0 28.o| .7 4.4 24.6 57.1 28.7 0.1 2.2 1.0 0. Gross Accumulated depreciation & Depletion Property.1 30.8 7.0 41.9 7.0 0.5 20.3 mil 0.5 36.0 4.8 0.8 1.0 3. Plant & Equipment.4 87.7 1.3 0.2 57.0 5. Plant & Equipment.5 2003 2002 2001 42.1 3.9 64.0 0.3 30.8 7.1 41.0 22.7 2.9 2.0 20.0 28.4 0.0 28.4 1.0 0.9 49.1 0.
0 15. General & Admin.8 0.1 3.0 0.1 45.8 18.0 16.7 8.3 7.9 15.3 84.0 2.4 47.0 -5.6 0.8 39.7 0.0 -5.Operations Net Income from Discont.8 0.6 0.5 55.4 0.0 8.0 0.0 0.0 7.0 -71.2 26.0 2. Income from Tax Loss Carryforward Other Gains [Total Net Income 297.0 0.of Acct.0 7.1 2.7 2003 294.0 2.3 17.0 17.6 0. Interest Expense Minority Interest Pre-Tax Income Income Taxes Special Income/Charges Net Income from Cont.5 54.0 8.4 160.6 39.7 30.4 18.3 0.2 74.0 184.1 45.8 -71.2 38.1 12.6 0.0 7.0 2002 252.6 2001 129.0 0. Eff.1 -15.3 14.7 0.8 0.5 16.8 5.4 5.0 0.5 109.3 0.7 -5. Net Total Income Avail for Interest Exp.0 0.Case 3 Playing the Numbers Game! 15 Table 3 Plastichem Incorporated Annual Income Statements (Value in Millions) 2004 Sales Cost of Sales Gross Operating profit Selling.3 6.0 0.0 0.2 0.0 0.0 0.3 .3 0.0 19.6 22.1 -65.4 20. Chg.1 -0.0 92.0 0.7 0.4 35. Opers.0 222.7 12.9 0.0 7.3 30.0 0.3 0. Net Income from Total Operations Normalized Income Extraordinary Income Income from Cum. Expenses EBITDA Depreciation & Amortization EBIT Other Income.0 -71.
0 4.0 9.2 37.6 0.2 .3 0.0 0.0 7.0 0.5 0.2 27.3 0.0 3.0 0.0 7. Eff of Acct.7 12.9 2.0 7.0 6.0 6.2 0.3 -0.0 2.0 0.1 9.3 0.2 0.6 0.2 16.7 55.6 41.9 0.9 4.6 1.6 6. General & Admin.3 2003 106.0 14.6 4. Expenses EBITDA Depreciation & Amortization EBIT Other Income.0 0.1 4.6 6.0 0.7 9.4 2.8 0.3 19.6 2002 85.5 19.7 5.0 0.0 3.Operations Net Income from Discont.7 14.0 2.2 16.0 0. Interest Expense Minority Interest Pre-Tax Income Income Taxes Special Income/Charges Net Income from Cont.4 3.3 7. Income from Tax Loss Carryforward Other Gains |Total Net Income 123. Opers.6 0.0 6.16 Case 3 Playing the Numbers Game! Table 4 DCM Molding Annual Income Statements (Value in Millions) 2004 Sales Cost of Sales Gross Operating profit Selling.9 17.7 -0.6 4.0 3.0 0.7 0.5 30.6 82. Chg.6 0.2 2.7 1. Net Income from Total Operations Normalized Income Extraordinary Income Income from Cum.8 3.0 12.0 4.0 11.0 21.8 13.2 0.0 2.3 4.0 0.0 0.0 7.7 69.5 0.0 0.0 0.2 0.0 0.1 4.0 10.0 0. Net Total Income Avail for Interest Exp.9 2001 43.
a former college gymnastics coach. "I know I shouldn't complain. upon the suggestions of their close friends who simply loved the way their oatmeal tasted. insists that he never "intended to start a business. The industry growth forecast had been estimated at 30% per year and Mason was confident that his firm would be able to at least achieve if not beat that rate of sales growth. but we better have the capacity to fill the orders or we'll be hurting ourselves. Oats 'R' Us.4 Financial Forecasting Growing Pains "We are growing too fast. After considerable help from local retailers and a sponsorship by a major bread company their firm. Mason. ." Vicky and Mason Coleman started their oatmeal snacks company in 1998. was established in 1998 and reached sales of over $4 million by 2004. Mason was confident that sales would increase significantly over the next few years." but the thought of being able to support his college team played a significant role in motivating him to go for it." said Mason. Given the current trend of eating healthy snacks and keeping fit.
He immediately asked the accounting department to give him the last three years' financial statements (see Tables 1 and 2) and got right to work! Questions: 1. If Oats 'R' Us is operating its fixed assets at full capacity. I need to know how much additional funding we are going to need for the next year. After conducting an interview with the production manager." Mason immediately called the treasurer. Oats 'R' Us has a flexible credit line with the Midway Bank. How much additional financing will it need to support revenue growth rates ranging from 25% to 40% per year? 5. "I think we've been playing it by ear for too long. I would really appreciate if you can have the forecast on my desk by early next week." said Vicky. If Mason decides to keep the debt-equity ratio constant. Initially Jim assumes that the firm is operating at full capacity. 4. "Jim. "The growth rate of revenues should be between 25% and 40%." Jim knew that his fishing plans for the weekend had better be put aside since it was going to be a long and busy weekend for him." said Mason. Jim Moroney. what growth rate can it support without the need for any additional external financing? 3. how do you think they should proceed? Which approaches or models can they use? What are the assumptions necessary for utilizing each model? 2. Since this is the first time Jim and Mason will be conducting a financial forecast for Oats 'R' Us. up to what rate of growth in revenue can the firm support? What assumptions are necessary when calculating this rate of growth? Are these assumptions realistic in the case of Oats 'R' Us? Please explain.18 Case 4 Growing Pains "We must plan for the future. Jim realizes that Oats 'R' Us is operating its plant at 90% .
Table 1 . 8. 7.Case 4 Growing Pains 19 capacity. What are some actions that Mason can take in order to alleviate some of the need for external financing? Analyze the feasibility and implications of each suggested action. How critical is the financial condition of Oats 'R' Us? Is Vicky justified in being concerned about the need for financial planning? Explain why. what will the firm's pro-forma income statement and balance sheet look like under the scenario of 40% growth in revenue for 2005 (ignore feedback effects). Given that Mason prefers not to deviate from the firm's 2004 debt-equity ratio. how much additional financing will it need to support growth rates ranging from 25% to 40%? 6.
20 Case 4 Growing Pains Table 2 .
"Why don't you prepare a detailed financial performance analysis of the firm for the most recent three years.5 Financial Analysis and Forecasting There's More to Us Than Meets the Eye! "Scott. I'd like you to prepare a 12-month pro-forma forecast using a scenario analysis. Use our current average compound growth rate in sales as the base estimate and vary that up and down by 10% for the best case and worst case scenarios respectively." said Tom. and I'm depending on you to come up with a realistic and honest appraisal of our company's position. "After that. complete with industry comparisons and a DuPont Analysis? It will help me make the case to the rating agencies that they need to raise our rating. This will help us figure . to his assistant Scott Beasley. "I'm sure that 'there's more to us than meets the eye!'" he quipped. the board of directors' meeting is scheduled two weeks from today. "But those darn analysts are still punishing us for Roger's accounting jugglery!" he said with a frown.
ethical person and he enjoyed working for him. Scott initially hesitated. But lenders were reluctant to lower the interest rates due to their suspicions about the firm's past reporting practices. But Tom made him an offer that he found very hard to refuse. Roger was fired because the firm had come under Federal investigation for non-compliance of the Sarbanes-Oxley Act (2002). Scott Beasley. Tom realized that there was no formal policy of conducting long-term planning and forecasting in place. Moreover. Scott had been working for Eastern for over 10 years. When the opportunity came up. the stock had plummeted to its all-time low despite reasonably strong sales and income growth. Scott knew that Tom was an honest. Moreover. the stock market analysts had been unforgiving in that the stock price was still hovering around its all time low of $12. away from their prior employer." he added looking rather stressed. Tom Anderson.22 Case 5 There's More to Us Than Meets the Eye! out how much additional funds we are going to have to acquire over the next year. so we should be able to support some growth without additional plant and equipment. was hired last year to replace Roger Holland. The significant growth rate that the firm had been experiencing had necessitated the infusion of more capital. Under Roger's watch. . The remuneration package included a very attractive stock option plan as well as a signing bonus. Eastern Paper. Tom implemented various measures to bring the firm in compliance with the 2002 Act. Being an old veteran. Tom was fully aware that haphazard growth could be a recipe for disaster. Tom had a hunch that the company could save a bundle in interest costs if the markets were convinced that the firm's accounting and reporting practices were clearly within the SarbanesOxley guidelines. The firm's sales had been increasing steadily due to its excellent commitment to quality. when he took over from Roger. One of the first things that Tom did upon joining Premier was to lure his assistant. He was enjoying a fairly comfortable lifestyle and the city had a lot to offer. He was determined to set things straight and he knew that the market would take note. Most of what Roger did was based on his gut feelings regarding the economy. He knew that an upward hike in the firm's credit rating would help expedite the process. The Production folks tell me that we are currently operating at 90% of capacity. the new CFO of The Premier Paper Co. However.
"We'll show those dumb analysts just how wrong they are!" Scott had the folks in accounting send him the firm's financial statements for the past three years along with the aggregate financial statements for the select group of 6 firms that were their main competitors. Will Premier Paper have to raise external capital over the next 12 months? If so how much? If not. explain how you would attempt to convince the rating agencies that the firm's debt rating should be raised. its beta estimate. turnover. Scott was fully aware that the firm's stock price and capital cost structure depended on his analysis and he was determined to present a comprehensive and convincing appraisal of the firm's performance to the board.Case 5 There's More to Us Than Meets the Eye! 23 "I'll get on it right away. leverage." promised Scott. and other market information. he collected data regarding the firm's sales history. 4. Using a cash flow statement for the most recent year. . Using common size statements help Scott present an appraisal of the company's performance and financial condition vis-a-vis its key competitors. why not? 7. 3. and profitability using ratio analysis. explain how Scott would sum up the company's cash position. What would Scott find out after performing a DuPont Analysis on the company's key profitability ratios? 5. 8. Is Tom correct in saying "there is more to us than meets the eye"? Explain. Questions: 1. Analyze the firm's liquidity. In addition. Tom. 2. How much additional sales can the company support without having to add fixed assets? 6. If you are Tom.
24 Case 5 There's More to Us Than Meets the Eye! Table 1 .
00 28.00 518.564.00 3.000.568.00 10.000.00 10.000.00 10.129.000.000.00 20.00 2.019.00 1.00 14.000.000.00 23.525.000.000.000.000.00 638.000.320.629.00 15.000.Case 5 There's More to Us Than Meets the Eye! 25 Table 2 The Premier Papei Co.000. Prior 3-year Balance Sheets 2003 Cash Marketable Securities Accounts Receivables Inventories Current Assets Net Fixed Assets Total Assets 396.875.000.225.000.00 460.000.00 495.00 12.000.000.070.250.806.00 540.996.000.000.931.500.00 6.000.000.00 10.550.000.00 17.00 1.00 13.00 4.140.576.00 567.00 2.00 150.000.00 6.758.980.000.00 Accounts Payables Accruals Notes Payables Current Liabilities Long Term Debt Total Liabilities Preferred Stock Common Stock Retained Earnings Total Common Equity Total Liabilities and Owner's Equity 425.140.860.00 20.985.000.000.980.00 1.741.00 478.850.000.013.00 13.564.00 2004 428.000.00 8.00 3.000.443.00 28.00 7.00 5.714.939.00 2.000.950.00 8.00 180.00 .000.387.00 1.020.686.000.00 9.000.00 3.000.372.00 6.000.000.00 1.020.936.00 694.000.00 175.00 6.860.241.00 2.000.500.806.000.950.450.019.000.000.000.000.00 23.225.000.250.00 2005 587.00 5.
000 27.690.26 Case5 There's More to Us Than Meets the Eye! Table 3 Aggregate Income Statement for Paper • Industry .000.000 53.Select 6 for year ended December 31st. 2005 Sales Revenues Cash Operating Costs Depreciation Total Operating Costs Operating Income (EBIT) Interest Expenses Taxable Income Taxes Preferred Dividends Net Income 590.040.270.022.000 .000 18.000 46.408.000 31.020.000 536^10.000 590.000 505.000 7.670.
000.00 3.000.885.000.200.00 226.000.000.000.796.000.00 32.942.486.057.510.898. 2005 Cash Marketable Securities Accounts Receivables Inventories Current Assets Net Fixed Assets Total Assets Accounts Payables Accruals Notes Payables Current Liabilities Long Term Debt Total Liabilities Preferred Stock Common Stock Retained Earnings Total Common Equity Total Liabilities and Owner's Equity 6.00 .00 131.000.306.513.867.600.00 11.00 100.800.200.000.200.00 1.00 226.000.Select 6 as at December 31st.046.752.400.800.000.073.00 131.085.00 55.00 72.00 45.00 30.00 82.000.Case 5 There's More to Us Than Meets the Eye! 27 Table 4 Aggregate Balance Sheet for Paper Industry .00 10.554.000.00 94.00 5.
000 21.825.345.246.000 16.000 .000 28.235.000 18.255.250.000 12.000 14.000 13.000 37.275.234.340.450.28 Case 5 There's More to Us Than Meets the Eye! Table 5 Historical Sales for The Premier Paper Company Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Revenues 8.670.000 24.000 54.
68 billion in fiscal 2000.6 Time Value of Money Lottery Winnings . and generated $586 million in net revenue for the state School Aid Fund. In Michigan alone. Michigan Lottery reported annual sales of $1. The numbers are quite impressive. Retailers received annual commissions of $121 million. .Looks Can Be Deceptive! State-sponsored lotteries are extremely popular and highly successful methods by which state governments in many countries raise much needed funds for financing public expenses. while Michigan Lottery players collected prizes worth $919 million. especially education. supporting public education (K-12) programs throughout the state. Table I presents sales and funding figures accounted for by the Michigan Lottery since its inception in 1972. during the year 2003.
2 percent).30 Case 6 Lottery Winnings-Looks Can Be Deceptive! Table 1 Totals: 1972 Start-up through FY 2003* Total Lottery Ticket Sales Net Revenue to Aid Education Retailer Commissions Prizes to Players *http://www.5 million. Michigan. each worth an annuitized value of $181. In effect. New Jersey and Virginia. Regardless of which option the winner selects. Illinois. and the winner is required to satisfy any further tax liability for the year in which the prize award is claimed. the Lottery pays the winner the present cash value of the announced jackpot in one lump-sum payment. the member lotteries are able to offer players jackpots that start at $5 million. By teaming up together. Jackpots can grow as high as $200 million or more. In fact.62 billion $2. Michigan. Michigan. and Joe and Sue Kainz of Lake County. the Lottery takes all of the money that would have been invested to fund the 26-year annuity and turns it all over to the winner.000. The Big Game holds the record for the largest lottery jackpot ever in the United States: $363 million! This jackpot rolled 18 times since last being hit! Two winning tickets — one sold in Michigan. . The Michigan Lottery can pay Big Game jackpot winnings in one of two ways: as an annuity or in one lump-sum/cash-option payment for the present cash value of the jackpot share.gov/lottery $30. on any prize over $5. retaining absolutely none of the prize.04 billion $15. The winners were Larry and Nancy Ross of Shelby Township. When a winner selects the cash option. These amounts are estimates only. the jackpot is paid out in equal installments over 26 years. Illinois. The jackpots grow until someone wins. Seven states participate in The Big Game: Georgia.55 billion The Big Game is a multi-state lottery game with BIG Jackpots. and one sold in Illinois ~ matched all six numbers in this Big Game drawing. Massachusetts. the Michigan Lottery is required by law to withhold estimated income taxes for federal (28 percent) and state (4. Maryland.10 billion $11. When a winner selects annuity payments. which is typically about 50% of the published value.
If you decide to select the annuity option. which option would you select? Why? 2. If Michigan Lottery would like to give the annuity option an equal chance of being selected. how much money would you receive each year after taxes? 3. 4. Why do most winners select the cash option plan when given a choice? 6.Case 6 Lottery Winnings-Looks Can Be Deceptive! 31 Questions: 1. If the only option available was an annuity payment plan. what could Larry do to maximize the value of his winnings assuming that the risk-free rate of interest is 5%. If you were one of the winners. 5. Is the State of Michigan justified in advertising the prize amount as $363 million? Explain. how would it have to structure its payments? .
" said Ryan as he stared at the papers on his desk. I would not be in such a predicament today. graduated five years ago with a degree in food marketing and is currently employed as a middle-level manager for a fairly successful grocery chain.7 Retirement Planning It's Better Late Than Never! "Boy.000 per year) and the company matches every dollar that the employee contributes. whereby employees are allowed to contribute up to 11% of their gross annual salary (up to a maximum of $12. Ryan has not yet taken advantage of the retirement savings program. Unfortunately. and consume most of his income." Ryan Daniels. . If only I had taken the advice of my finance instructor.000 has increased at an average rate of 5 percent per year and is projected to increase at least at that rate for the foreseeable future. His current annual salary of $70. aged 27. like many other young people who start out in their first "real" job. He opted instead to buy a fancy car. The firm has had a voluntary retirement savings program in place. rent an expensive apartment. this is all so confusing.
the differences in timelines. His fiancee. What was Ryan's starting salary? How much could he have contributed to the voluntary savings plan in his first year of employment? 2. "It's better late than NEVER!" Questions: 1. But. should cost about $15. every year for the past five years. had a lot to do with giving him this reality check. he knows that an automatic payroll deduction is probably the best way to go since he is not a very disciplined investor. He estimates that the wedding.000 in today's dollars.Case 7 // 's Better Late Than Never! 33 However. and would need 20% for a down payment. Ryan is really not sure how much money he should put away each month. If only he had started planning and saving five years ago. Moreover. 100% in common stocks). assuming a nominal rate of return of 7%? How much more would his investment value have been worth had he opted for a higher risk alternative (i. of course. there were various other large expenses that would be forthcoming and that it would be wise for him to design a comprehensive savings plan. Ryan is aware that his cost estimates are in current terms and would need to be adjusted for inflation. which will take place in twelve months.P. Amber reminded Ryan that besides retirement.000 house (in today's terms) after 5 years.R. how much money would he currently have accumulated in his retirement account. Ryan figures that the two largest expenses down the road would be those related to the wedding and down payment on a house. Had Ryan taken advantage of the company's voluntary retirement plan up to the maximum. his financial situation would have been so much better. and the salary increases that would be forthcoming. given the inflation effects. Ryan has finally come to the realization that he had better start putting away some money for the future. which was expected to yield an average compound rate of return of 12% (A. Furthermore. with wedding plans on the horizon. Amber. as the saying goes.e. he plans to move into a $250.)? . keeping in mind the various cost estimates and timelines involved. All this number crunching seems overwhelming and the objectives seem insurmountable.
If Ryan starts his retirement savings plan from January of next year by contributing the maximum allowable amount into the firm's voluntary retirement savings program. assuming that his investment fund is expected to yield a rate of return of 7% per year? 5. How much would Ryan have to save each month.R. how much money will he have accumulated for retirement. how much can he withdraw each month (beginning one month after his retirement) in equal dollar amounts. Assume his savings earn a rate of 7% per year (A. 4. assuming he retires at age 65? Assume that the rate of return on the account is 7% per year.P. starting from the end of the next month. .).. 7. how much additional money will he have to save each month? Assume an investment rate of return of 7% per year. If Ryan starts saving immediately for the 20% down payment on his house. if he figures he will live up to the age of 85 years? Assume that his investment fund yields a nominal rate of return of 7% per year. If Ryan wants to have a million dollars (in terms of today's dollars) when he retires at age 65. If Ryan saves up the million dollars (in terms of today's dollars) by the time of his retirement at age 65. in order to accumulate enough money for his wedding expenses. how much should he save in equal monthly deposits from the end of the next month? Ignore the cost of the wedding and the down payment on the house. 6.Case 7 // 's Better Late Than Never! 3. compounded monthly and that the maximum allowable contribution does not change.
Ryan estimates that the maximum he will be able to save for retirement is $300 per month. If the account provides a nominal annual return of 7%. for the first five years. What is the lesson to be learned from this case? Explain. how much money will Ryan be able to withdraw per month during his retirement phase? 9. After that he is confident that he will be able to increase the monthly saving to $500 per month until retirement.Case 7 // *s Better Late Than Never! 35 8. . After preparing a detailed budget.
8 Loan Amortization Paying Off That Dream House When Evelyn and Paul Peters were "house hunting" five years ago. Evelyn and Paul have seen 15-year fixed rates (with no closing . The fixed rate on a 30-year mortgage was 8. mortgage rates have come down significantly and the "refinancing" frenzy is under way. they finally reached a consensus and decided to buy a $200. due to a worsening of economic conditions. To avoid prepaid mortgage insurance (PMI) the couple had to borrow from family members and come up with the 20% down payment and the additional required closing costs. Currently. they decided to opt for lower monthly payments by taking on a 30-year mortgage. Since Evelyn and Paul had already accumulated significant credit card debt and were still paying off their college loans. After walking through many homes. the mortgage rates were pretty high.75% while the 15-year fixed rate was at 8%.000 two-story house in an up and coming suburban neighborhood in the Midwest. despite its higher interest rate.
Case 8 Paying Off That Dream House 37 costs) advertised at 5% and 30-year rates at 5.75% mortgage? 5. What is Evelyn and Paul's monthly mortgage payment prior to the refinancing? 2. Under the original 15-year. . the couple called their mortgage officer at the Uptown Bank and locked in the 5%. 8%).75%. Evelyn and Paul realize that refinancing is quite a hassle due to all the paperwork involved but with rates being down to 30-year lows. This time. and had missed the boat. 15-year rate. Should Evelyn and Paul cash out the excess equity that they have built up? Assume money market rates are 4%. If the house is currently worth $245. Nothing was going to stop them from reducing the costs of paying off their dream house this time! Questions: 1. how much excess equity can the Peters cash out? 7. how much money has the couple paid towards the mortgage? What proportion of this has been applied towards interest? 3. rates were down to similar levels but they had procrastinated. 6.75% mortgage? Assume the Peters' tax rate is 30%. About 2 years ago.000 and most lenders are willing to lend up to 90% of home value. however. Had the couple opted for the original 15-year mortgage proposal (15 year. how much total interest would have been paid over the life of the loan? How does this compare with the total interest that would be paid on the 30-year. 8. how much higher would their monthly payment have been? 4. 8% mortgage option. If the Peters had chosen the original 15-year. 8% mortgage proposal. 8. they don't want to let this opportunity pass them by. During the first 5 years of owning their dream home. how much tax shelter would they have lost (over the last five years) as compared to the 30-year.
what would their current loan balance amount to? Using the assumption in question 8. how many total years would it take for the Peters to pay off the existing loan? Demonstrate your answer with an amortization schedule. Should Evelyn and Paul go ahead and close the 5%. 15 year mortgage? Explain your answer with suitable calculations. .Case 8 Paying Off That Dream House If the Peters had increased each payment by one twelfth (since the beginning of the loan).
came across the advertisement in a local newspaper and it certainly caught their attention." he always said when asked whether it made sense to borrow at low rates of interest." he advised. The Halls had "tied the knot" about three years ago and were enjoying a fairly comfortable lifestyle. "A debtor is a slave to the lender. and saving for retirement. . Dan's financial consulting business had blossomed over the past few years because of such slogans and because Dan strongly believed in and preached the benefits of financial freedom. "The only way to financial independence is to be debt-free. Marty & Laura Hall. who lived in the same town where Dan ran his consulting business. budgeting.9 Time Value of Money Wake Up and Smell the Coffee! "Wake Up And Smell The Coffee!" was the latest slogan that Dan Roth had used in his advertising campaign to make people aware of their need for financial planning.
They loved to take annual vacation trips and host parties so as to keep up with their social circle. Both of them had racked up quite a bit of credit card debt and college loans over the years. while Laura worked as an elementary school teacher in the public school system. expenses.40 Case 9 Wake Up And Smell the Coffee! Marty was a middle-level manager at an industrial chemical company. Their thoughts immediately turned to the future and it was only then that it hit them. Table 1 presents a summary of the information that the Halls reported. debts. . So they took an appointment to see Dan and at the first meeting they were asked to present information about their ages. and desired goals. And then the other day. they knew that they had better get some advice. current earnings. With very little money saved up and no financial plan. but were making all the required minimum payments on time. savings. Laura announced that she was pregnant with their first child.
25% per annum Minimum monthly payment required on credit card debt.99% per annum $12. 3% of balance owed Car Loans owed (24 payments remaining) Monthly rent Income Tax Rate $5.000 $0 30 30 $10..000 @5.000 @5. Marty's age Laura's age Credit Card Balance owed College Loans owed (24 months remaining) $50.000 @ 15..Case 9 Wake Up And Smell the Coffee! 41 Table 1 Financial Information reported by Laura and Marty Hall Marty's Salary Laura's Salary Savings Account Balance.99% per annum $1200 28% .000 $25.
000." said Dan." said Dan "We'll come up with some suggestions. Laura told Dan that they were expecting their first child by the end of the year and were interested in starting a savings plan for their child's college education." they said. let's get to work. "You will need to come up with a down payment and closing costs." said Dan. "Do you guys own your own home?" "No. "We want to be able to tour the world while we still can!" "My thoughts exactly. "Unfortunately. not a day beyond 65. we realized that we had better wake up and start planning for the future. "we are renting a two-bedroom apartment but would like to move into an affordable house as soon as possible. Tell me. we have been living it up and living off borrowed money. "All right. Do you think that's a good idea?" "Well." they said. said Dan "With college costs increasing by about 4% per year and current annual costs of a college education averaging $20. it's never too early to start saving for your child's education. Based on the information provided in Table 1. it's never too late.42 Case 9 Wake Up And Smell the Coffee! When asked about their goals and objectives." they both said without hesitation.000" they responded. "A two-story. " said Dan. "It's time to smell the coffee!" Questions: 1. how much money will they have left over for all other expenses? . What kind of house did you guys have in mind?" he queried. 3 bedroom house that is currently listed at $140. if the Halls continue making minimum payments on their outstanding debts. how long do you guys plan on working?" "Until we turn 65. "Excellent idea". What about a retirement nest egg? Have either of you put any money aside in some kind of pension plan?" Marty and Laura looked sheepishly at each other. "And thanks to your advertisement. it depends." "Once again.
how much money should they set aside each month so as to have enough money accumulated in their retirement nest egg? Assume that annual inflation rate is 4% per year for the whole term.000 house. How much money will Laura and Marty have to deposit each month (beginning one month after the child is born and ending on his or her 18th birthday) in order to have enough saved up for their child's college education. If the interest rate on a 30-year mortgage is at 5% per year when the Halls purchase their $140. how much will their mortgage payment be? Ignore insurance and taxes. 6. and that their child will enter college when he or she turns 18 and will complete the degree in 4 years. If the Halls want to have as much of an after-tax income when they retire as they currently have.Case 9 Wake Up And Smell the Coffee! 43 2. 3.000 house within 12 months? Assume that the closing costs amount to 2% of the loan and that the down payment is 10% of the price. college expenses increase at the rate of 4% per year. 30-year mortgage. 4. Construct an amortization schedule for the 5%. 5. the investment return is 8% per year before and after retirement. and assuming they live until they are 80 years old. and that their tax rate is 28% throughout their life. Assume that the yield on investments is 8% per year. . How much money will the Halls have to set aside each month so as to have enough saved up for a down payment on the $140.
how long will it take them to pay it off and how much total interest will they have paid? If you were Dan.Case 9 Wake Up And Smell the Coffee! 7. If the Halls continue paying the minimum 3% on their credit card debt each month. what would you advise them to do? .
had achieved most of its success due to its excellent client relations and focus on client support. the branch manager at the Cincinnati office.10 Bond Analysis and Valuation Corporate Bonds-They Are More Complex Than You Think Jill Dougherty was hired as an investment analyst by A. which included an MBA from a top ranking university and a CFA designation. The firm ranked among the very best in terms of the number of successful equity underwriting deals undertaken. Ohio office based on her sound academic credentials. Recently. a large utility company had hired it as the leading investment banker for a major corporate bond issue. John Sullivan. Smith Inc. . a prestigious investment services firm.. with branches in 30 major metropolitan areas.M. Since most of its retail customers were more familiar with stock investments. A. At the time of her recruitment she was told that one of her responsibilities would be to conduct educational seminars for current and prospective clients. Smith Inc.M. for the Cincinnati.
000 $1. "About 60% of our investors are in the 55+ age group. ratings. She realized that apart from a good knowledge about the current level and stability of interest rates and inflation. Your job is to convince them of the relative safety and income potential of corporate bonds" said John.3 $1092. sinking fund provision.46 Case 10 Corporate Bonds-They are More Complex Than You Think asked Jill to prepare and present a seminar outlining the various implications of fixed income investments. She decided to refer back to her Finance textbook and dig out some definitions and examples that she could use in her PowerPoint presentation. She downloaded current data for outstanding bonds of various maturities. were not well understood by most of the clients she interviewed.0 $1206.000 5% 0% 10% 11% Quoted 'fears until Sinking Call Price maturity Fund Period $703.1 $208. "However. In preparation for the seminar. so we should not have much trouble convincing them of the benefits of investing in bonds" remarked John.4 20 20 20 30 Yes Yes Yes No 3 Years NA 5 Years 5 Years | Rating AAA AAA AA AA .000 $1. interest rate risk. debentures. bond ratings.000 $1. Jill called up a few of her best clients and queried them regarding their awareness of the risk and return potential associated with corporate bond investments. Table 1 Corporate Bond Information Issuer ABC Energy ABC Energy TransPower Telco Utilities Coupon Face Value Rate $1. Bond features like callability. they may need clarifications regarding various terms and concepts associated with fixed income investing. Most of them seemed awfully interested in knowing more about the opportunities offered by bond investing and Jill knew that she would have a good turnout at the seminar. etc. and coupon rates (see Table 1) and started preparing her slides. convertibility. Jill. most customers were not very familiar about the finer aspects of bond investing.
She asks whether the discount bonds are a bargain. How should Jill go about explaining the riskiness of each bond? Rank the bonds in terms of their relative riskiness. How should Jill respond? 4. what will my realized return be on each bond investment?" How should Jill respond? . 8. Jill knows that the call period and its implications will be of particular concern to the audience. "If I buy 10 of each of these bonds. 7. What is the difference between the "nominal" and effective yields to maturity for each bond listed in Table 1? Which one should the investor use when deciding between corporate bonds and other securities of similar risk? Please explain. reinvest any coupons received at the rate of 5% per year and hold them until they mature. During the presentation one of the clients is puzzled why some bonds sell for less than their face value while others sell for a premium. What does the term "yield to maturity" mean and how is it to be calculated? 5. 6. How should she go about explaining the effects of the call provision on bond risk and return potential. How should Jill go about explaining the relationship between coupon rates and bond prices? Why do the coupon rates for the various bonds vary so much? 2. How are the ratings of these bonds determined? What happens when the bond ratings get adjusted downwards? 3.Case 10 Corporate Bonds-They are More Complex Than You Think 47 Questions: 1. One of Jill's best clients poses the following question.
aged 58. he knew that he needed to make some changes in the way his investment portfolio was structured. Jonathan Price. Five years ago. as a post-doctoral researcher in the field of immunology. Having opted for early retirement. being primarily focused on science during his career. Dwayne had an eagerness to learn and that's exactly what he planned to do during his appointment with his broker. had joined the Pharmacopia Company approximately thirty years ago. One of the main . 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. However. Dwayne earned the coveted title of "Research 5 Scientist" enjoyed by only 4 other individuals in the corporation. though.11 Application of Stock Valuation Methods How Low Can It Go? Dwayne sat at his desk wondering what he should do. six months ago. One thing was certain. Dwayne Stevenson. he had a fairly limited knowledge of stock selection and portfolio management.
"Downsizing" and cost cutting were buzzwords that could be heard throughout the firm and on Wall Street. primarily because his project was one that had not gained FDA approval. Dwayne was offered the option to take early retirement. shares of Pharmacopia (PCU) were trading at $30 per share. He said that the current intrinsic value of the stock.$20. about 3 years later. Having had very little financial and investment training. the firm suffered a few setbacks. Dwayne contacted his broker. for some advice. 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. the patents on two of its best selling drugs had expired and generic versions began to flood the market. The severance package offered by the company was too good to turn down so Dwayne opted for early retirement. The company had annual sales in excess of $5 billion and the sales and earnings growth forecasts for the next few years were good. As a result of having exercised stock options and his earlyretirement package. "How low can it go?" 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. The FDA did not approve a couple of its applications and the Environmental Protection Agency (EPA) was investigating Pharmacopia for possible dumping violations. Dwayne wondered whether he should sell the stock or hold it until it reached a better price. which was trading at $12 at the time.Case 11 How Low Can It Go? 49 advantages of gaining the "Research 5" status was that he was given stock options as part of his remuneration package. Jonathan . in his opinion. Besides. Needless to say. About a year later. was in the range of $10 . He felt that the company was having temporary regulatory problems and should be able to weather the storm quite well. Dwayne had accumulated over 100. Jonathan Price. This caused his investment portfolio to not be well diversified and Dwayne knew that he needed to restructure it. Part of the retirement package included a significant amount of company stock. the firm's sales began to suffer and profits began to shrink sending its stock price into a downward spiral. Dwayne asked him to explain how he arrived at that range. as luck would have it. However. With PCU's stock price having declined to $8 per share in recent months.000 shares of PCU's common stock. At that time. Not convinced. His main question to Jonathan was.
6 0.60 2.200 4.50 Case 11 How Low Can It Go ? replied that he used alternate forms of the dividend discount model.200 5. net income. In preparation for the appointment.35 DPS 0. DPS) Year 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Sales 3.50 2. and dividend per share data for the prior 10-year period. he estimated the firm's beta and noted down the risk-free rate.94 .100 4.700 Net Income 150 160 200 220 240 250 260 255 245 235 EPS 1. earnings per share.000 4.60 2. to which Dwayne responded. yet convincing.000 5. In addition.000 3.96 1. Jonathan knew that he would have to keep his explanations simple. market risk premium.900 4.88 0.00 2.04 1.20 2.40 2.50 1. Table 1 Pharmacopia Company Key Financial Data for Prior 10-year Period (in $ millions except EPS.400 4.02 0. and expected to be faced with many difficult questions.98 0.800 5. and the expected growth rate of the pharmaceutical industry (shown in Table 2).45 2.80 0.00 1. "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.64 0.55 2. Jonathan prepared Table 1 showing the sales.
Being a researcher. Interest Rates Beta 30-year Treasury Bond Yield Expected Market Risk Premium Industry Average Growth rate 1. Industry Growth Rate. Dwayne asked Jonathan a key question. What do you think Jonathan would have said? . "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. "Why are you using dividends and not earnings per share. How should Jonathan describe the rationale of the dividend discount model (DDM) and demonstrate its use in calculating the justifiable price of common stock? 2.1 5. "What other variations of the DDM can one use and why?" asked Dwayne.Case 11 How Low Can It Go? Table 2 51 Systematic Risk. What is the rationale of the required rate of return that Jonathan used and how did he estimate it? 4. Jonathan?" asked Dwayne. 3. What should Jonathan's response be? 5.1 % 9% 10% Questions: 1.
52 6. He asked Jonathan to explain to him the various features of preferred stock.50 and trading at a price of $15. given that it was paying a dividend of $1. Case 11 How Low Can It Go ? Dwayne wondered whether Pharmacopia's preferred stock would be a better investment than its common stock. and the method that could be used for estimating its value. . how it differed from common stock and corporate bonds.
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