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Fundamentals of Corporate Finance

4th South African Edition


Firer, Ross, Westerfield & Jordan

Case Solutions
Case #
Input boxes in tan 1
Output boxes in yellow 2
Given data in blue 3
Calculations in red 4
Answers in green 5
6
7
8
9
10
ions
List of Mini-Cases Chapter
Sunset Boards 2
S&S Air 4
Pop Goes the Balloon 6
S&S's Bond 7
Valuing Refresh Ltd 8
Crystal Electronics 11
SDC's Cost of Capital 14
Spinning Wheels' Dividend Policy 17
Winter Woollies 18
S&S's Convertible Bond 21
Case #1 - Cash Flows and Financial Statements at Sunset Boards

Input area:

2007 2008
Cost of goods sold R 84,310 R 106,450
Cash 12,165 18,380
Depreciation 23,800 26,900
Interest expense 5,180 5,930
Selling & Administrative 16,580 21,640
Accounts payable 21,500 24,350
Fixed assets 105,000 134,000
Sales 165,390 201,600
Accounts receivable 8,620 11,182
Bank overdraft 9,800 10,700
Long-term debt 53,000 61,000
Inventory 18,140 24,894
New equity - 10,000

Tax rate 20%


Dividend percentage 30%

Output area:

2007 Income Statement


Sales R 165,390
Cost of goods sold 84,310
Selling & Administrative 16,580
Depreciation 23,800
PBIT R 40,700
Interest 5,180
PBT R 35,520
Taxes 7,104
NPAT R 28,416
Dividends R 8,525
Addition to retained profits R 19,891

2007 Income Statement


Sales R 201,600
Cost of goods sold 106,450
Selling & Administrative 21,640
Depreciation 26,900
PBIT R 46,610
Interest 5,930
PBT R 40,680
Taxes 8,136
NPAT R 32,544
Dividends R 9,763
Addition to retained profits R 22,781
Balance sheet as of Dec. 31, 2007
Owners equity R 59,625 Net non-current assets R 105,000
Long-term debt 53,000
Inventory 18,140
Accounts payable 21,500 Accounts receivable 8,620
Short-term debt 9,800 Cash R 12,165
Current liabilities R 31,300 Current assets R 38,925
Total equity and liabilities R 143,925 Total assets R 143,925

Balance sheet as of Dec. 31, 2008


Owners equity R 92,406 Net non-current assets R 134,000
Long-term debt 61,000
Inventory 24,894
Accounts payable 24,350 Accounts receivable 11,182
Short-term debt 10,700 Cash R 18,380
Current liabilities R 35,050 Current assets R 54,456
Total equity and liabilities R 188,456 Total assets R 188,456

2007 2008
Operating cash flow R 57,396 R 65,374

Capital Spending
Ending net non-current assets R 134,000
- Beginning net non-current assets 105,000
+ Depreciation 26,900
Net capital spending R 55,900

Change in Net Working Capital


Ending NWC R 19,406
-Beginning NWC 7,625
Change in NWC R 11,781

Cash Flow from Assets


Operating cash flow R 65,374
- Net capital spending 55,900
-Change in NWC 11,781
Cash flow from assets R (2,307)

Cash Flow to Lenders


Interest paid R 5,930
-Net New Borrowing 8,000
Cash flow to Lenders R (2,070)

Cash Flow to Shareholders


Dividends paid R 9,763
-Net new equity raised 10,000
Cash flow to Shareholders R (237)

The firm had positive earnings in an accounting


sense (NPAT > 0) and had positive cash flow from
operations. The firm invested R11 781 in new net
working capital and R55 900 in new net non-current
assets. The firm had to raise R2 307 from its
stakeholders to support this new investment. It
accomplished this by raising R10 000 in the form of
new equity and R8 000 in new long-term debt. After
paying out R9 763 in dividends to shareholders and
R5 930 in interest to lenders, R2 307 was left to
meet the firm's cash flow needs for investment.
2
The expansion plans may be a little risky. The
company does have a positive cash flow, but a
large portion of the operating cash flow is already
going to capital spending. The company has had to
raise capital from lenders and shareholders for its
current operations. So, the expansion plans may
be too aggressive at this time. On the other hand,
companies do need capital to grow. Before
investing or loaning the company money, you
would want to know where the current capital
spending is going, and why the company is
spending so much in this area already.
Case #2 - Ratios and Financial Planning at S&S Air

Input area:

Sales R 128,700,000
COGS R 90,700,000
Other expenses R 15,380,000
Depreciation R 4,200,000
PBIT R 18,420,000
Interest R 2,315,000
PBT R 16,105,000
Taxes (40%) R 6,442,000
NPAT R 9,663,000

Dividends R 2,898,900
Add to RP R 6,764,100

Liabilities & Equity Assets


Shareholder Equity Non-current assets R 72,280,000
Ordinary shares R 1,000,000
Retained profits R 41,570,000 Current Assets
Total Equity R 42,570,000 Inventory R 4,720,000
Accounts rec. R 4,210,000
Long-term debt R 25,950,000 Cash R 2,340,000
Total CA R 11,270,000
Current Liabilities
Accounts Payable R 4,970,000
Short-term debt R 10,060,000
Total CL R 15,030,000
Total L&E R 83,550,000 Total Assets R 83,550,000

Growth rate 20% Tax rate 40%


Minimum NCA purchase R 30,000,000

Output area:

Current ratio 0.75


Quick ratio 0.44
Cash ratio 0.16
Total asset turnover 1.54
Inventory days 19.0
Receivables days 11.9
Total debt ratio 0.49
Debt-equity ratio 0.85
Equity multiplier 1.96
Times interest earned 7.96
Cash coverage ratio 9.77
Profit margin 7.51%
Return on assets 11.57%
Return on equity 22.70%

Retention ratio 0.70


Internal growth rate 8.81%
Sustainable growth rate 18.89%
Sales R 154,440,000
COGS R 108,840,000
Other expenses R 18,456,000
Depreciation R 5,040,000
PBIT R 22,104,000
Interest R 2,315,000
PBT R 19,789,000
Taxes (40%) R 7,915,600
NPAT R 11,873,400

Dividends R 3,562,020
Add to RP R 8,311,380

Liabilities & Equity Assets

Shareholder Equity
Ordinary shares R 1,000,000 Non-current assets R 86,736,000
Retained profits R 49,881,380
Total Equity R 50,881,380 Current Assets
Inventory R 5,664,000
Long-term debt R 25,950,000 Accounts rec. R 5,052,000
Cash R 2,808,000
Current Liabilities Total CA R 13,524,000
Accounts Payable R 5,964,000
Short-term debt R 10,060,000
Total CL R 16,024,000

Total L&E R 92,855,380 Total Assets R 100,260,000

EFN R 7,404,620

EFN if minimum NCA purchase is R 30,000,000

New depreciation R 5,943,221


Reduction in NPAT R 541,932
Reduction in RP R 379,353

Liabilities & Equity Assets

Shareholder Equity Non-current assets R 102,280,000


Ordinary shares R 1,000,000
Retained profits R 49,502,027 Current Assets
Total Equity R 50,502,027 Inventory R 5,664,000
Accounts rec. R 5,052,000
Long-term debt R 25,950,000 Cash R 2,808,000
Total CA R 13,524,000
Current Liabilities
Accounts Payable R 5,964,000
Short-term debt R 10,060,000
Total CL R 16,024,000
Total L&E R 92,476,027 Total Assets R 115,804,000

EFN R 23,327,973

2 Boeing is probably not a good aspirant company. Even though both companies manufacture airplanes, S&S Air manufactures small
airplanes, while Boeing manufactures large, commercial aircraft. These are two different markets. Additionally, Boeing is heavily
involved in the defense industry, as well as Boeing Capital, which finances airplanes.
3
S&S is below the median industry ratios for the current and cash ratios. This implies the company has less liquidity than the industry in
general. However, both ratios are above the lower quartile, so there are companies in the industry with lower liquidity ratios than S&S
Air. The company may have more predictable cash flows, or more access to short-term borrowing. If you created an Inventory to
Current liabilities ratio, S&S Air would have a ratio that is lower than the industry median. The current ratio is below the industry
median, while the quick ratio is above the industry median. This implies that S&S Air has less inventory to current liabilities than the
industry median. S&S Air has less inventory than the industry median, but more accounts receivable than the industry since the cash
ratio is lower than the industry median.

The total asset turnover ratio and the inventory and receivables days are all better than the industry median; in fact, all three ratios are
above the upper quartile. This may mean that S&S Air is more efficient than the industry.
The financial leverage ratios are all below the industry median, but above the lower quartile. S&S Air generally has less debt than
comparable companies, but still within the normal range.
The profit margin for the company is about the same as the industry median, the ROA is slightly higher than the industry median, and
the ROE is well above the industry median. S&S Air seems to be performing well in the profitability area.
Overall, S&S Air’s performance seems good, although the liquidity ratios indicate that a closer look may be needed in this area.
Case #3 - Pop Goes the Balloon

Input area:

Cost of bike R 164,103


Balloon payment 97,000
Best offer after 4 years 45,000
Lease period 4
Interest rate 24%

Output area:

1 Risk: bike value may be less than balloon payment

2 Total interest paid


Present value R (164,103.00)
Interest rate per month 2%
Number of lease payments 48
Future value R 97,000.00
Monthly payment R 4,127.68

Total payments R 198,128.69


Capital repaid R 67,103.00
Interest paid R 131,025.69

3 Depreciation rate to balloon value 14%

4 Depreciation rate to market value 38%

5 Inflation on bikes dropped below expected level


Case #4 -Financing S&S Air’s Expansion Plans With A Bond Issue

Output area:

A rule of thumb with bond provisions is to determine who


benefits by the provision. If the company benefits, the
bond will have a higher coupon rate. If the bondholders
benefit, the bond will have a lower coupon rate.

1
A bond with collateral will have a lower coupon rate.
Bondholders have the claim on the collateral, even in
bankruptcy. Collateral provides an asset that bondholders
can claim, which lowers their risk in default. The downside
of collateral is that the company generally cannot sell the
asset used as collateral, and they will generally have to
keep the asset in good working order.

2 The more senior the bond is, the lower the coupon rate.
Senior bonds get full payment in bankruptcy proceedings
before subordinated bonds receive any payment. A
potential problem may arise in that the bond covenant may
restrict the company from issuing any future bonds senior
to the current bonds.

3 A sinking fund will reduce the coupon rate because it is a


partial guarantee to bondholders. The problem with a
sinking fund is that the company must make the interim
payments into a sinking fund or face default. This means
the company must be able to generate these cash flows.

4
A provision with a specific call date and prices would
increase the coupon rate. The call provision would only be
used when it is to the company’s advantage, thus the
bondholder’s disadvantage. The downside is the higher
coupon rate. The company benefits by being able to
refinance at a lower rate if interest rates fall significantly,
that is, enough to offset the call provision cost.
5

A deferred call would reduce the coupon rate relative to a


call provision with a deferred call. The bond will still have a
higher rate relative to a plain vanilla bond. The deferred
call means that the company cannot call the bond for a
specified period. This offers the bondholders protection for
this period. The disadvantage of a deferred call is that the
company cannot call the bond during the call protection
period. Interest rate could potentially fall to the point where
it would be beneficial for the company to call the bond, yet
the company is unable to do so.

A make whole call provision should lower the coupon rate


in comparison to a call provision with specific dates since
the make whole call repays the bondholder the present
value of the future cash flows. However, a make whole call
provision should not affect the coupon rate in comparison
to a plain vanilla bond. Since the bondholders are made
whole, they should be indifferent between a plain vanilla
bond and a make whole bond. If a bond with a make
whole provision is called, bondholders receive the market
value of the bond, which they can reinvest in another bond
with similar characteristics. If we compare this to a bond
with a specific call price, investors rarely receive the full
market value of the future cash flows.

7
A positive covenant would reduce the coupon rate. The
presence of positive covenants protects bondholders by
forcing the company to undertake actions that benefit
bondholders. Examples of positive covenants would be:
the company must maintain audited financial statements;
the company must maintain a minimum specified level of
working capital or a minimum specified current ratio; the
company must maintain any collateral in good working
order. The negative side of positive covenants is that the
company is restricted in its actions. The positive covenant
may force the company into actions in the future that it
would rather not undertake.
8

A negative covenant would reduce the coupon rate. The


presence of negative covenants protects bondholders from
actions by the company that would harm the bondholders.
Remember, the goal of a corporation is to maximize
shareholder wealth. This says nothing about bondholders.
Examples of negative covenants would be: the company
cannot increase dividends, or at least increase beyond a
specified level; the company cannot issue new bonds
senior to the current bond issue; the company cannot sell
any collateral. The downside of negative covenants is the
restriction of the company’s actions.
ond Issue
Case #5 - Refresh Ltd

Input area:

Balance sheets R'000


2007 2008 2009 2010
Shareholders' equity 111,427 108,693 110,697 113,623
Deferred taxation 4,232 4,895 5,268 5,569
Long-term loan 38,574 28,554 14,226
Capital employed 154,233 142,142 130,191 119,192

Non-current assets 120,919 99,135 77,551 87,968


Capitalised expenses 2,438 1,625 812
Investment in associate 2,006 2,856 3,706 4,556
Other investments 2,712 2,712 2,712 2,712

Inventory 34,485 39,182 42,770 47,502


Accounts receivable 43,656 48,895 52,953 57,984
Cash 204 241 332 465
Current assets 78,345 88,318 96,055 105,951

Accounts payable 37,887 41,958 45,067 49,169


Provisions 1,847 2,445 2,644 2,544
Tax owing 3,573 2,866 3,747 4,608
Short-term borrowings 6,442 6,048 26,486
Current liabilities 49,749 53,317 51,458 82,807
Net current assets 28,596 35,001 44,597 23,144
Net assets 154,233 142,142 130,191 119,192

Income statements 2007 2008 2009 2010


Gross profit 76,151 83,451 89,018 94,191
Depreciation -22,471 -24,784 -25,584 -34,584
Other expenses -28,675 -31,211 -33,699 -25,419
Abnormal items 6,116 -2,644
Profit before interest 31,121 24,812 29,735 34,188
Interest -4,335 -7,364 -4,883 -4,071
Profit before tax 26,786 17,448 24,852 30,117
Tax -7,234 -7,032 -8,698 -10,541
Net profit after tax 19,552 10,416 16,154 19,576
Income from associate 787 850 850 850
Dividends paid -12,500 -14,000 -15,000 -17,500
Transfer to non-distributable reserve -787 -850 -850 -850
Retained profit for the year 7,052 -3,584 1,154 2,076

Inflation from 2010 onwards 10%


Corporate income tax rate 35%
Weighted average cost of capital 20.83%
Surrender value of key person policies 4,335
Output area:

2008 2009 2010


Opening balance on tax owing -3,573 -2,866 -3,747
Charge for the year -7,032 -8,698 -10,541
Deferred tax 663 373 301
Closing balance 2,866 3,747 4,608
Tax effect of interest -2577 -1709 -1425
Cash taxes paid -9,653 -9,153 -10,804

Opening non-current assets balance 120,919 99,135 77,551


Depreciation -24,784 -25,584 -34,584
Closing non-current assets balance -99,135 -77,551 -87,968
Capital expenditure for the year -3,000 -4,000 -45,001

2008 2009 2010


Gross profit 83,451 89,018 94,191
Other expenses -31,211 -33,699 -25,419
Abnormal items -2,644 0 0
Cash taxes -9,653 -9,153 -10,804
NOPAT 39,943 46,166 57,968

Capital expenditure -3,000 -4,000 -45,001


Inventory -4,697 -3,588 -4,732
Receivables -5,239 -4,058 -5,031
Payables 4,071 3,109 4,102
Capitalised expenses -2,438 813 813
Provisions 598 199 -100
I -10,705 -7,525 -49,949

FCF = NOPAT - I 29,238 38,641 8,019

WACC 20.83%
After 2010
Assumed capex after 2010 -5,000
Sustainable continuous cash flow after 2010 48,020
Growth model valuation of post-2010 cash flow at growth rate = inflation 487,739
2008 2009 2010 2010
PV of FCF 24,197 26,467 4,546 276,480
Total PV 331,689
Less debt -45,016
Plus cash 204
Plus investment in associate 2,006
Surrender value of key person policies 4,335
Value of equity R 293,218
Case #6 - Crystal Electronics

Input Area:

Equipment R20,000,000
Salvage value R3,000,000
R&D R750,000 sunk cost
Marketing study R200,000 sunk cost

Year 1 Year 2 Year 3 Year 4 Year 5


Sales(units) 70,000 80,000 100,000 85,000 75,000
Depreciation rate 50.00% 30.00% 20.00%
Sales of old PCB 80,000 60,000
Lost sales 15,000 15,000

Price R250
VC R86
FC R3,000,000
Price of old PCB R240
Price reduction
of old PCB R20
VC of old PCB R68
Tax rate 29%
NWC percentage 20%
Required return 12%

Sensivity analysis
New price R260
Quantity change 100 NOTE: Change in units per year

Output Area:

Sales Year 1 Year 2 Year 3 Year 4 Year 5


New R17,500,000 R20,000,000 R25,000,000 R21,250,000 R18,750,000
Lost sales 3,600,000 3,600,000
Lost rev. 1,300,000 900,000
Net sales R12,600,000 R15,500,000 R25,000,000 R21,250,000 R18,750,000

VC
New R6,020,000 R6,880,000 R8,600,000 R7,310,000 R6,450,000
Lost sales 1,020,000 1,020,000
R5,000,000 R5,860,000 R8,600,000 R7,310,000 R6,450,000

Sales R12,600,000 R15,500,000 R25,000,000 R21,250,000 R18,750,000


VC 5,000,000 5,860,000 8,600,000 7,310,000 6,450,000
Fixed costs 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000
Dep 10,000,000 6,000,000 4,000,000 0 0
PBT (R5,400,000) R640,000 R9,400,000 R10,940,000 R9,300,000
Tax (1,566,000) 185,600 2,726,000 3,172,600 2,697,000
NPAT (R3,834,000) R454,400 R6,674,000 R7,767,400 R6,603,000
+Dep 10,000,000 6,000,000 4,000,000 0 0
OCF R6,166,000 R6,454,400 R10,674,000 R7,767,400 R6,603,000

NWC
Beg R0 R2,520,000 R3,100,000 R5,000,000 R4,250,000
End 2,520,000 3,100,000 5,000,000 4,250,000 0
NWC CF (R2,520,000) (R580,000) (R1,900,000) R750,000 R4,250,000

Net CF R3,646,000 R5,874,400 R8,774,000 R8,517,400 R10,853,000

Salvage
BV of equipment R0
Taxes -870,000
Salvage CF R2,130,000

Net CF Time
0 (R20,000,000)
1 R3,646,000
2 R5,874,400
3 R8,774,000
4 R8,517,400
5 R12,983,000

Payback period 3.200


PI 1.348
IRR 22.80%
NPV R6,963,417.30
Sensitivity to change in price

Sales Year 1 Year 2 Year 3 Year 4 Year 5


New R18,200,000 R20,800,000 R26,000,000 R22,100,000 R19,500,000
Lost sales 3,600,000 3,600,000
Lost rev. 1,300,000 900,000
Net sales R13,300,000 R16,300,000 R26,000,000 R22,100,000 R19,500,000

VC
New R6,020,000 R6,880,000 R8,600,000 R7,310,000 R6,450,000
Lost sales 1,020,000 1,020,000
R5,000,000 R5,860,000 R8,600,000 R7,310,000 R6,450,000

Sales R13,300,000 R16,300,000 R26,000,000 R22,100,000 R19,500,000


VC 5,000,000 5,860,000 8,600,000 7,310,000 6,450,000
Fixed costs 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000
Dep 10,000,000 6,000,000 4,000,000 0 0
PBT (R4,700,000) R1,440,000 R10,400,000 R11,790,000 R10,050,000
Tax (1,363,000) 417,600 3,016,000 3,419,100 2,914,500
NPAT (R3,337,000) R1,022,400 R7,384,000 R8,370,900 R7,135,500
+Dep 10,000,000 6,000,000 4,000,000 0 0
OCF R6,663,000 R7,022,400 R11,384,000 R8,370,900 R7,135,500

NWC
Beg R0 R2,660,000 R3,260,000 R5,200,000 R4,420,000
End 2,660,000 3,260,000 5,200,000 4,420,000 0
NWC CF (R2,660,000) (R600,000) (R1,940,000) R780,000 R4,420,000

Net CF R4,003,000 R6,422,400 R9,444,000 R9,150,900 R11,555,500

Salvage
BV of equipment R0
Taxes -870,000
Salvage CF R2,130,000

Net CF Time
0 (R20,000,000)
1 R4,003,000
2 R6,422,400
3 R9,444,000
4 R9,150,900
5 R13,685,500

NPV R8,997,140.38

DNPV/DP R203,372.31

Sensitivity to change in quantity

Sales Year 1 Year 2 Year 3 Year 4 Year 5


New R17,525,000 R20,025,000 R25,025,000 R21,275,000 R18,775,000
Lost sales 3,600,000 3,600,000
Lost rev. 1,300,000 900,000
Net sales R12,625,000 R15,525,000 R25,025,000 R21,275,000 R18,775,000

VC
New R6,028,600 R6,888,600 R8,608,600 R7,318,600 R6,458,600
Lost sales 1,020,000 1,020,000
R5,008,600 R5,868,600 R8,608,600 R7,318,600 R6,458,600

Sales R12,625,000 R15,525,000 R25,025,000 R21,275,000 R18,775,000


VC 5,008,600 5,868,600 8,608,600 7,318,600 6,458,600
Fixed costs 3,000,000 3,000,000 3,000,000 3,000,000 3,000,000
Dep 10,000,000 6,000,000 4,000,000 0 0
PBT (R5,383,600) R656,400 R9,416,400 R10,956,400 R9,316,400
Tax (1,561,244) 190,356 2,730,756 3,177,356 2,701,756
NPAT (R3,822,356) R466,044 R6,685,644 R7,779,044 R6,614,644
+Dep 10,000,000 6,000,000 4,000,000 0 0
OCF R6,177,644 R6,466,044 R10,685,644 R7,779,044 R6,614,644

NWC
Beg R0 R2,525,000 R3,105,000 R5,005,000 R4,255,000
End 2,525,000 3,105,000 5,005,000 4,255,000 0
NWC CF (R2,525,000) (R580,000) (R1,900,000) R750,000 R4,255,000

Net CF R3,652,644 R5,886,044 R8,785,644 R8,529,044 R10,869,644

Salvage
BV of equipment R0
Taxes -870,000
Salvage CF R2,130,000

Net CF Time
0 (R20,000,000)
1 R3,652,644
2 R5,886,044
3 R8,785,644
4 R8,529,044
5 R12,999,644

NPV R7,003,764.16

DNPV/DQ R403.47
Case #7 - SDC's Cost of Capital

Input Area:

Risk-free rate 10%


Market risk premium 6%
Beta of SDC 1.5
Number of shares in issue 24,000,000
Share price R5
Book value of ordinary shareholders' interest R 80,000,000
Book value of outside shareholders interest R 10,000,000
Coupon rate on new debt 15%
Coupon rate on existing debt 12%
Tax rate 29%
Book value of long-term debt R 60,000,000
Life of existing long-term debt 10

Output Area:

Cost of equity 19.00%


After-tax cost of debt 10.65%
Market value of ordinary shareholders' equity R 120,000,000

Book value of ordinary shareholders' equity R 80,000,000


Market-to-boook value of ordinary shareholders' intere 1.5
Assuming same market-to-book value for outside
shareholders' interest:
Market value of outside shareholders interest R 15,000,000
Market value of total shareholders interest R 135,000,000
Market value of existing debt R 50,966,216
Market value debt-capital ratio 27.4%
Market value equity-capital ratio 72.6%

WACC 16.71%

NOTES
a) Deferred taxation
Deferred taxation has no cost, as it is an interest free loan from the
Receiver of Revenue. Although, as in the case with depreciation,
deferred taxation has an opportunity cost, it is treated like depreciation
and is not included in the calculation of the weighted average cost of
capital.

b) subsidiaries
As the Outside shareholders interest
are in similar lines of business and have similar risk
and growth prospects, we assume that their cost is the same as
ordinary shares.

c) Bank overdraft

If there is any permanent portion, it should be included. However, an


analysis of the balance sheet shows that the overdraft represents only
a very small fraction of the current assets and a small decline in current
assets would eliminate the need for the overdraft. The conclusion is
therefore that no portion of the bank overdraft is permanent and is thus
not included in the calculation of the cost of capital.
Case #8 - Spinning Wheels Ltd
Case #8 - Spinning Wheels Ltd

The dividend decision is in fact a financing decision - should the firm retain the funds (thereby increasing its
equity), or should it relinquish the funds to the shareholders. It all depends on the use the firm will make of
the retained profits. In theory retain if positive NPV projects are available.

In practice there is a strong message from the market that firms should not cut dividends, even if they give
reasons of the existence of positive NPV projects for making the cut. Although this seems illogical, it
probably results from long years of experience by shareholders, who have learned to be highly suspicious of
the information management offers to explain decisions made.

The payment of a dividend is akin to directors 'putting their money where their mouths are' in the sense that
the payment of the dividend is a statement to shareholders that the prospects of the firm are sufficiently
good to allow for the cash dividend to leave the company without seriously impairing its operating ability.

Spinning Wheels is no longer quite a start-up company, but they have been ploughing money heavily into
R&D. Investors would presumably have been told that the firm did not anticipate paying a dividend, at least
during its start-up and high growth phases. The questions therefore that might be posed are:
Has the firm reached the end of its high growth period?
Will continued investment in R&D be required?
Does the establishment of a set of test equipment mean that new investment in this area may be winding
down now?
What if the firm's growth in fact slows down in the future.
Conversely what if international expansion becomes a reality?

The bare facts of the case seem to indicate that a dividend could be considered, since:
new investment in the test laboratory will reduce in the future, reducing the need to conserve cash
profitability is on the increase, providing an increasing source of cash flow to fund both new investment as
well as a cash dividend

On the other hand what if:


The contract is broken after 8 months?
Interest rates rise rapidly, eating into operating profits?
International markets open up rapidly, requiring an injection of cash into new machinery for the factory?

An important consideration when establishing a dividend policy is the realisation that having declared a
dividend, it is very difficult to go back to a zero dividend policy, or even to cut the dividend, without raising
shareholder ire. Dividend stability is valued very highly by the investment community.
If the firm decides to pay dividends, it does need to consider the clientele effect. This concept suggests that
there are different clienteles amongst the investment community, some preferring no dividends, some low
dividends and some high dividends, relative to earnings. By changing dividend policy a firm may just land up
exchanging one clientele for another.

So what possible policies can be used?


Residual policy - leads to variable dividends and investor insecurity. Will firm's demand for new cash
investment fluctuate up and down over the years? Probably not.
Fixed proportion of profits. Also leads to fluctuating dividends if profits are variable. Are profits likely to be
variable? Yes if new product development is an important part of the firm's goals.
Fixed rand amount. Sets a base level of dividends and this can't be easily cut. However does lead to good
information transfer to investors as prospects are usually good and sustainable when dividends are raised.
Scrip dividends. Saves cash but enables firm to transmit information on size of dividend to investors.
However subject to the same issues discussed with cash dividends in terms of any dividend cuts.

On balance it seems that it is probably one year too early to consider the dividend. They should await the
finalisation of the contract (in 8 months time). Then, if no international expansion appears, and the firm
settles into a more mature mode, a dividend could be considered, starting at a low level for safety sake.

On the other hand, if management is contemplating an ongoing high level of R&D, the time to tell
shareholders is now that the current no dividend policy will continue. It will be important however to ensure
that they are given sufficient information about future plans to enable them to assess the likelihood of
positive NPV projects in the years ahead. Otherwise the share price will suffer, making it difficult for the firm
to raise new equity capital in the future.

All in all, the decision to commence paying a dividend is one that needs very careful consideration, since
once the firm steps down that road, reversal of the decision has serious consequences. Most important of all
is the need for management to be certain that they will be able to maintain a steady profit stream to support
the dividends
Case #9 - Winter Woolies Manufacturing

Input Area:

Customers paying in:


30 days 30%
60 days 60%
90 days 10%
Discount for prompt payment 2%
Labour % of expected sales 25%
Materials % of expected sales 35%
Office salaries R 30,000
Expenses R 22,000
Depreciation (per month) R 5,000
Cost of loan 16%
Loan outstanding R 300,000
Life of loan (years) 6
Computer R 15,000
Tax rate 30%
Tax payment due in February R 20,000
Tax payment due in August R 23,000
Cash balance end December R 5,000

Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Sales R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000

Output Area:

Seasonal production Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Sales R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000
Discounts: 2% of 30% of last month's
sales R 1,140 R 900 R 720 R 840 R 900 R 1,200 R 1,440 R 972
Net cash received after discount R 55,860 R 44,100 R 35,280 R 41,160 R 44,100 R 58,800 R 70,560 R 47,628
On time net payers R 72,000 R 114,000 R 90,000 R 72,000 R 84,000 R 90,000 R 120,000 R 144,000
Late payers R 12,000 R 19,000 R 15,000 R 12,000 R 14,000 R 15,000 R 20,000 R 24,000
Cash from receivables R 139,860 R 177,100 R 140,280 R 125,160 R 142,100 R 163,800 R 210,560 R 215,628

Labour R 37,500 R 30,000 R 35,000 R 37,500 R 50,000 R 60,000 R 40,500 R 30,000


Materials R 42,000 R 66,500 R 52,500 R 42,000 R 49,000 R 52,500 R 70,000 R 84,000
Expenses R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000
Office salaries R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000
Cash out R 131,500 R 148,500 R 139,500 R 131,500 R 151,000 R 164,500 R 162,500 R 166,000

Net operating cash flow R 8,360 R 28,600 R 780 -R 6,340 -R 8,900 -R 700 R 48,060 R 49,628

Tax due R 20,000 R 23,000


Computer R 15,000
Loan repayment R 19,676 R 19,676
Net cash flow for the month R 8,360 R 8,600 -R 18,896 -R 6,340 -R 23,900 -R 20,376 R 48,060 R 26,628
Opening cash balance R 5,000 R 13,360 R 21,960 R 3,064 -R 3,276 -R 27,176 -R 47,552 R 508
Available cash R 13,360 R 21,960 R 3,064 -R 3,276 -R 27,176 -R 47,552 R 508 R 27,136

Level production
Expected sales for next 8 months R 1,282,000
Average expected monthly sales R 160,250

Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug
Sales R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000
Discounts: 2% of 30% of last month's
sales R 1,140 R 900 R 720 R 840 R 900 R 1,200 R 1,440 R 972
Net cash received after discount R 55,860 R 44,100 R 35,280 R 41,160 R 44,100 R 58,800 R 70,560 R 47,628
On time net payers R 72,000 R 114,000 R 90,000 R 72,000 R 84,000 R 90,000 R 120,000 R 144,000
Late payers R 12,000 R 19,000 R 15,000 R 12,000 R 14,000 R 15,000 R 20,000 R 24,000
Cash from receivables R 139,860 R 177,100 R 140,280 R 125,160 R 142,100 R 163,800 R 210,560 R 215,628

Labour (1) R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063 R 40,063
Materials (2) R 42,000 R 66,500 R 52,500 R 56,088 R 56,088 R 56,088 R 56,088 R 56,088
Expenses R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000 R 22,000
Office salaries R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000 R 30,000
Cash out R 134,063 R 158,563 R 144,563 R 148,150 R 148,150 R 148,150 R 148,150 R 148,150

Net operating cash flow R 5,798 R 18,538 -R 4,283 -R 22,990 -R 6,050 R 15,650 R 62,410 R 67,478

Tax due R 20,000 R 23,000


Computer R 15,000
Loan repayment R 19,676 R 19,676
Net cash flow for the month R 5,798 -R 1,463 -R 23,959 -R 22,990 -R 21,050 -R 4,026 R 62,410 R 44,478
Opening cash balance R 5,000 R 10,798 R 9,335 -R 14,624 -R 37,614 -R 58,664 -R 62,690 -R 280
Available cash R 10,798 R 9,335 -R 14,624 -R 37,614 -R 58,664 -R 62,690 -R 280 R 44,198

(1)
Thhe costs of labour change with immediate effect in January where labour costs rise from R37 500 to R40 063. Later in the year level production labour costs drop below those of
seasonal production. The model assumes level production in line with average expected sales
(2)
Cash outflows for materials will only change in March under level production, since payment terms for purchases are 60 days.

Winter Woollies Manufacturing Cash Budget


R 60,000

R 40,000

R 20,000
Cash at month end

R0

-R 20,000

-R 40,000

-R 60,000

-R 80,000
Jan Feb Mar Apr May Jun Jul Aug
Level Seasonal

The net result, as we see from the graph, is that a higher overdraft level from March through July will be needed if the production process is changed from seasonal to level. What the firm needs to establish is whether
the increased financing costs (note that level production will result in a build up of inventories) can be offset by any savings in labour costs as a result of not having to hire and fire workers with the season. These
potential savings are not discussed in the case.
Case #10 - S&S Air's Convertible Bond

Input area:

Industry PE 12.5
Company EPS R 1.60
Conversion price (stock) R 25.00
Maturity (years) 20
Convertible bond coupon 6%
Conversion value of bond R 800
Plain vanilla coupon 10%

Output area:

1 Share price R20.00

Intrinsic bond value R656.82

Floor value R800.00

Conversion ratio 32.00

Conversion premium 25.00%

Chris is suggesting a conversion price of R25 because it means the share price will have
increase before the bondholders can benefit from the conversion, in this case 25 per cent
though the company is not publicly traded, the conversion price is important. First, the com
may go public in the future. The case does discuss whether the company has plans to go
and if so, how soon it might go public. If the company does go public, the bondholders wil
active market for the shares if they convert. Second, even if the company does not go pub
bondholders could potentially have an equity interest in the company. This equity interest
sold to the original owners, or someone else. The potential problem with private equity is t
market is not as liquid as the market for a public company. This illiquidity lowers the value
shares.

The floor value of the bond is R800. This means that if the company offered bonds with th
coupon rate and no conversion feature, they would be able to sell them for 656,82. Howev
the conversion feature the price will be R800. In essence, the company is receiving R143,
conversion feature.
2
Thandi's argument is wrong because it ignores the fact that if the company does well, bon
will be allowed to participate in the company's success. If the share price rises to R40, bo
are effectively allowed to purchase shares at the conversion price of R25

3 Mark's argument is incorrect because the company is issuing debt with a lower coupon
they would have been able to otherwise. If the company does poorly, it will receive the b
lower coupon rate

4 Reconciling the two arguments requires that we remember our central goal: to increase th
of the existing shareholders. Thus, with 20-20 hindsight, we see that issuing convertible b
turn out to be worse than issuing straight bonds and better than issuing common stock if t
company prospers. The reason is that the prosperity has to be shared with bondholders a
convert.
In contrast, if a company does poorly, issuing convertible bonds will turn out to be better th
straight bonds and worse than issuing ordinary shares. The reason is that the firm will hav
benefited from the lower coupon payments on the convertible bonds
Both of the arguments have a grain of truth; we just need to combine them. Ultimately, wh
is better for the company will only be known in the future and will depend on the performa
company. The table below illustrates this point.

If the company does poorly If the comp


Low share price and no High share
conversion conversion
Convertible bonds Cheap financing because Expensive f
issued instead of coupon rate is lower (good bonds are co
straight bonds outcome). dilutes exist
outcome).

5 The call provision allows the company to redeem the bonds at the company's discretion. I
company's shares appear to be poised to rise, the company can call the outstanding bond
be possible that the bondholders would benefit from converting the bonds at that point, bu
eliminate the potential future gains to the bondholders
R25 because it means the share price will have to
efit from the conversion, in this case 25 per cent. Even
d, the conversion price is important. First, the company
s discuss whether the company has plans to go public,
he company does go public, the bondholders will have an
rt. Second, even if the company does not go public, the
uity interest in the company. This equity interest can be
lse. The potential problem with private equity is that the
public company. This illiquidity lowers the value of the

means that if the company offered bonds with the same


hey would be able to sell them for 656,82. However, with
800. In essence, the company is receiving R143,18 for the
nores the fact that if the company does well, bondholders
any's success. If the share price rises to R40, bondholders
s at the conversion price of R25

he company is issuing debt with a lower coupon rate than


. If the company does poorly, it will receive the benefit of a
lower coupon rate

hat we remember our central goal: to increase the wealth


0-20 hindsight, we see that issuing convertible bonds will
bonds and better than issuing common stock if the
e prosperity has to be shared with bondholders after they

uing convertible bonds will turn out to be better than issuing


dinary shares. The reason is that the firm will have
ts on the convertible bonds
th; we just need to combine them. Ultimately, which option
wn in the future and will depend on the performance of the
point.

If the company does poorly If the company prospers


Low share price and no High share price and
conversion conversion
Cheap financing because Expensive financing because
coupon rate is lower (good bonds are converted, which
outcome). dilutes existing equity (bad
outcome).

redeem the bonds at the company's discretion. If the


rise, the company can call the outstanding bonds. It could
enefit from converting the bonds at that point, but it would
bondholders