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SAMPLE FINAL EXAM






INSTRUCTIONS

1. Write or print your name ONLY on the back of the last page of the exam booklet.

2. Please write on one side only of pages in exam booklet.

3. You may leave the room at any time, for a break, but you are not to discuss the exam with
anyone.

4. You are allowed to have one 8.5 x 11 inch pages of notes written on the front and back.

5. Please provide an audit trail for your answers.

6. Partial credit will be granted where appropriate.

7. Good luck!



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Video Now, Inc.

Video Now, Inc is a rapidly growing retail chain of video rental stores in the metropolitan
New York City area. Founded in 1991 by native New Yorker, Stuart Pidasso, Video Now had
expanded from a single store in lower Manhattan to a chain of 150 stores spanning the five
boroughs of New York. By providing a more extensive list of foreign and independent films and
by maintaining a reputation for superior customer service, Video Now was able to compete
directly with the industry leaders. Unlike national chains like Blockbuster Video, however,
Video Now had no desire to expand the business beyond the metropolitan New York area.

As Pidasso and other members of the board of directors conducted their annual review of
the business in J anuary of 2002, they were concerned with three issues. First, Video Now’s
recent growth had dramatically altered its capital structure. While Video Now had once been a
debt-free, cash-rich company, it now carried enough debt that the company’s debt rating had
fallen from AAA to AA. Although the board viewed the costs of financial distress as negligible
at the current debt level (due to the ease of liquidation of inventory and real estate), Pidasso and
the other board members had a strong preference for maintaining a AAA debt rating. Second,
the company’s recent growth had reduced the company’s cash balance well below its target level
of $10 million. Third, the recent entry of internet-based competitors into the home video market
had eroded some of Video Now’s revenue. These internet-based competitors offered home
delivery of videos by allowing customers to choose from available movies on a webpage, then
specify a time for delivery.

Restructuring Alternatives

To address these issues, the board was considering two independent, but not mutually
exclusive alternatives. Under the first alternative, Video Now would acquire the equity of
Kramer.com, one of VideoNow’s main internet-based competitors. Under the second
alternative, Video Now would issue new shares to the public and use the proceeds to alter its
financial structure. Currently, VideoNow’s shares are priced at $26 per share in the market.

Over the past two months, Pidasso had carefully amassed a large amount of data that he
considered relevant to the restructuring alternatives. These data include VideoNow’s current
balance sheet (Exhibit 1), its income statement for the most recent fiscal year (Exhibit 2), data on
current yields on debt securities (Exhibit 3), historical rates of return on various financial
instruments (Exhibit 4), and financial data for other local video chains and internet-based
competitors (Exhibit 5). His plan was to conduct a thorough analysis of each alternative
independently. That is, each alternative would be evaluated as if the other alternative was not
being pursued.

Acquisition of Kramer.com

Of the two internet-based competitors operating in the New York City area, Pidasso felt
that Kramer.com was a superior acquisition candidate since, like VideoNow, it focused its
strategy on customer service. To date, this strategy had been quite effective, as evidenced by
Kramer.com’s large share of the internet-based market.


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By acquiring Kramer.com, VideoNow would gain entry into the growing market for
home video delivery. Internet-based competitors such as Kramer.com had already substantially
eroded the sales of local video chains. Exhibits 6 and 7 contain balance sheet and income
statement data for Kramer.com. Based on Pidasso’s projections, Kramer.com’s sales could be
expected to grow at an annual rate of 15% for the next two years (2002-2003), then at 10% for
the following two years (2004-2005). Beyond that point, Pidasso expected the company’s cash
flows (not sales) to grow at a constant rate of 4% per year for the forseeable future.

In addition, Pidasso envisioned several other benefits to the acquisition. First, by
combining corporate headquarters, several administrative positions within Kramer.com could be
eliminated. Pidasso estimated that these staff cuts would permanently reduce Kramer’s selling
and administrative expenses as a percent of sales by 4%. Second, by combining the inventory of
VideoNow and Kramer.com, Pidasso estimated that Kramer.com’s net working capital could be
reduced to 20% of its sales and remain at that percentage of sales in the future. Third, Pidasso
expected to alter Kramer.com’s financial structure so that only 10% of the company’s total
capital would come from debt sources. By Pidasso’s estimates, this would raise Kramer’s debt
rating from its current level of A to AAA, thereby reducing Kramer’s borrowing costs. (Of
course, any debt issued by VideoNow to finance the acquisition would be rated AA as per their
current bond rating.) Pidasso expects that Kramer.com’s cost of goods sold as a percent of sales
will remain constant even if the company is acquired.

Exhibit 8 contains projections of capital expenditures and depreciation for Kramer.com
over the next four years. If VideoNow pursues the acquisition of Kramer.com, Pidasso expects
that the transaction will be structured so that VideoNow purchases the equity of Kramer.com and
assumes responsibility for the company’s outstanding debt.

The Equity Issue

Pidasso believes that in order to achieve a AAA debt rating, VideoNow must reduce its
debt level. In order to determine the appropriate debt level, he has collected data on the debt
structure of other retail video outlets. These data are given in Exhibit 5. In addition, Pidasso
believes that it is essential for the company to maintain a minimum cash balance of $10 million.

In order to reduce debt and increase the company’s cash balance, Pidasso is considering a
public issue of shares. The proceeds of the stock issue would be used to repurchase some of
VideoNow’s existing long-term debt and to increase the company’s cash balance to the the target
level. Pidasso plans to assume that the debt level following the equity issue will remain constant
for the forseeable future.

After assessing how much equity to issue, Pidasso intends to evaluate the effects of the
stock issue and corresponding recapitalization on the market value of VideoNow and on its share
price. In making this assessment, Pidasso plans to assume that the company’s current market
value is based on the assumption that the current debt level will remain constant into the future.




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Questions

1. (50 points) Should VideoNow pursue the acquisition of Kramer.com. If so, what price
per share should they offer? In answering this question, assume that the proposed equity
issue does not take place.

2. (50 points) How much equity should VideoNow issue in order to achieve a debt rating of
AAA and a cash balance of $10 million? At what price should the equity issue take
place? How many shares will be issued? What will be the market value of VideoNow’s
common stock following the equity issue? What will be VideoNow’s stock price
following the equity issue? Should VideoNow pursue this recapitalization?



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Exhibit 1

VideoNow, Inc.
Income Statements
(in $ thousands)



2001

Sales 96142
Cost of Goods Sold (76,914)
Selling and Administrative Expense (4,807)
Operating Income 14,421
Depreciation (6,428)
Earnings before Interest and Taxes 7,993
Interest Expense (3,322)
Net Income before Taxes 4,672
Taxes (1,869)
Net Income 2,803

Shares outstanding 1200
Earnings per share 2.34


The company’s marginal tax rate is 40%.


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Exhibit 2

VideoNow, Inc.
Balance Sheet as of December 31, 2001
(in $ thousands)



Assets Liabilities and Owners Equity

Cash $ 3,114 Accounts Payable $ 14,173
Accounts Receivable 35,610
Inventory 60,528
Current Assets 99,252 Current Liabilities 14,173

Gross Property, Plant & Long-term debt 51,500
Equipment 86,040 Common Stock ($1.00 par) 1,200
Accumulated Depreciation (12,856) Paid in Surplus 2,400
Net Property, Plant & Retained Earnings 103,163
Equipment 73,184
Total Liabilities
Total Assets $ 172,436 & Owners Equity $ 172,436




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Exhibit 3

Current Financial Market Data



Yield-to-Maturity
Type of Bond Maturity as of J anuary 2002

U.S. Treasury March 2002 5.23%

U.S. Treasury J anuary 2012 5.16%

U.S. Treasury J anuary 2022 5.40%

AAA-Rated Corporate 15-year 6.24%

AA-Rated Corporate 15-year 6.45%

A-Rated Corporate 15-year 6.98%

BBB-Rated Corporate 15-year 7.24%

BB-Rated Corporate 15-year 7.61%
_____________________________________________________________________________________



Exhibit 4

Historical Financial Market Data

Arithmetic
Average Annual Return
1

Security 1926-1999

Common Stocks 13.3%

U.S. Treasury Bills 3.8%

U.S. Treasury Intermediate-term Bonds 5.4%

U.S. Treasury Long-term Bonds 5.5%

Long-term Corporate Bonds 5.9%

U.S. Inflation Rate 3.2%

1
Source: Ibbotson Associates.


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Exhibit 5

Video Industry Comparison
for the year 2001



Book Book Value of Coupon
Value Shares Long-term Interest
Sales of EBIT Outstanding Stock Debt Rate Bond
(in thousands) Assets (in thousands) (in thousands) Price (in thousands) on Debt Rating Beta
Retail Chains

Corner Video. 191,100 159,250 11,499 3,250 24.50 34,125 6.24% AAA 1.51

Moo-vies 357,630 298,025 20,162 2,800 32.75 137,550 6.98% A 2.28

King Video 123,480 102,900 7,301 4,200 12.25 34,300 6.45% AA 1.68


Internet Competitors

ON-line Video 92,400 77,000 1,723 4,000 14 14,000 7.24% BBB 1.73

Kramer.com 41,850 34,875 5,965 1,250 23.25 9,688 6.98% A 1.80




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Exhibit 6

Kramer.com
Income Statement
(in $ thousands)



2001

Sales 41,850
Cost of Goods Sold (31,388)
Selling and Administrative Expense (3,348)
Operating Income 7,115
Depreciation (1,150)
Earnings before Interest and Taxes 5,965
Interest Expense (676)
Net Income before Taxes 5,288
Taxes (2,115)
Net Income 3,173

Earnings per share 2.54


The company’s marginal tax rate is 40%.


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Exhibit 7

Kramer.com
Balance Sheet as of December 31, 2001
(in $ thousands)



Assets Liabilities and Owners Equity

Cash $ 2,378 Accounts Payable $ 7,087
Accounts Receivable 7,122
Inventory 12,106
Current Assets 21,606 Current Liabilities 7,087

Gross Property, Plant & Long-term debt 9,688
Equipment 17,208 Common Stock ($1.00 par) 1,250
Accumulated Depreciation (3,939) Paid in Surplus 2,500
Net Property, Plant & Retained Earnings 14,351
Equipment 13,269
Total Liabilities
Total Assets $ 34,875 & Owners Equity $ 34,875




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Exhibit 8

Kramer.com
Projected Capital Expenditures and Depreciation, 2002-2005
(in $ thousands)


2002 2003 2004 2005

Capital Expenditures 1,000 1,050 1,100 1,150

Depreciation 1,400 1,600 1,800 2,000
_____________________________________________________________________________________




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Question #1 (50 points)

Should VideoNow pursue the acquisition of Kramer.com. If so, what price per share should they
offer? In answering this question, assume that the proposed equity issue does not take place.



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Question #2 (50 points)

How much equity should VideoNow issue in order to achieve a debt rating of AAA and a cash
balance of $10 million? At what price should the equity issue take place? How many shares will
be issued? What will be the market value of VideoNow’s common stock following the equity
issue? What will be VideoNow’s stock price following the equity issue? Should VideoNow
pursue this recapitalization?