Professional Documents
Culture Documents
On
Environgard Corporation
MBA(Finance)
21st Batch
Section A, Group 4
Submitted by:
Submitted to:
Sandhya Bogati
PROF. DR, RADHE SHYAM PRADHAN
Shreeya Aryal
Shreeyasi Paudel
Smriti Poudel
Sonam Dorje Lama
Suraj Thapa
Susmita Sharma
Utsav Acharya
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DECLERATION
We hereby declare that the report entitled “Environgard Corporation” submitted by group ‘4’ for
the partial fulfillment of the requirement for the degree of Master in Business Administration
(MBA-F). This project was carried out under the supervision of Prof. Dr. Radhe Shyam Pradhan.
We like to declare this project as our work.
Group 4
30th October 2021
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ACKNOWLEDGEMENTS
It's a great pleasure to present this report on case study for “Environgard Corporation”. To begin
with, we are very thankful to our group members for the start till the successful completion of
this case. We are thankful to Prof. Dr. Radhe Shyam Pradhan for providing his time and
guidance about the analysis of this case, and his support for critical reviews of case and the
report. We would also like to thank all the group members for their sincere effort and
cooperation throughout the completion of this case. Above all we would like to thank everyone
for the moral support. We are thankful to all group members for their time & passion during the
case analysis for the completion of the report on time.
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LIST OF ABBREVIATION
CR Current Ratio
DR Debt ratio
F Fixed Cost
V Variable Cost
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TABLE OF CONTENTS
Declaration--------------------------------------------------------------------------------------------- 02
Acknowledgement-------------------------------------------------------------------------------------03
List of Abbreviation ----------------------------------------------------------------------------------04
BACKGROUND---------------------------------------------------------------------------------------06
STATEMENT OF PROBLEMS--------------------------------------------------------------------08
OBJECTIVE OF STUDY----------------------------------------------------------------------------08
Issue 1-----------------------------------------------------------------------------------------------------09
Issue 2-----------------------------------------------------------------------------------------------------14
Issue 3-----------------------------------------------------------------------------------------------------18
Issue 4-----------------------------------------------------------------------------------------------------21
Issue 5-----------------------------------------------------------------------------------------------------25
Issue 6-----------------------------------------------------------------------------------------------------29
Issue 7------------------------------------------------------------------------------------------------------32
Issue 8------------------------------------------------------------------------------------------------------37
Issue 9------------------------------------------------------------------------------------------------------43
Issue 10----------------------------------------------------------------------------------------------------46
Issue 11----------------------------------------------------------------------------------------------------48
Issue 12----------------------------------------------------------------------------------------------------50
Conclusion------------------------------------------------------------------------------------------------53
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GENERAL BACKGROUND
Environgard Corporation was formed in 1980 in the Chicago. It has dominated the air pollution
scrubbing equipment market. SO2 Blaster, which is the product of Environgard Corporation, is
the scrubber which eliminated the airborne Sulphur dioxide from smokestack emissions.
With the development of technology, the rival firms are coming in strength which has become a
threat to the Environgard Corporation. With the technology, new and varieties of scrubber
developed which is cheaper and more effective for the other pollutants. With this new Scrubbers
plan emerging in the market, Environgard Corporation proceeded to develop a new model of
Scrub named as Scrub King, which is believed to regain the competitive edge.
The board agreed on the plan for Scrub King and ask to implement as soon as possible so that the
production would be early. Environgard Corporation need $50 million of new capital for new
equipment and remodeling of the existing equipment for the production of The Scrub King.
Previously, Environgard has always obtained equity funds in the form of retained earnings. Short
term debt in amounts had be used occasionally but no interest bearing short term debt is
outstanding till date. The Corporation took loan of $19.2 at 7% in 2008 and no other long term
fund have been borrowed since that date as to make the long term debt constant.
For the collection of $50 million, the firm came with the three alternative methods which are as
follows:
1) The company can sell common stock to net $39 per share, the current price of the stock is
$45 per share and the flotation cost is $6 which is included in the current price of the
share. The sale is to made through investment bankers to the general public. The
company is to apply for the American Stock Exchange in future.
2) The company can sell 25 years, 8 % bond to a group of life insurance company. The bond
would not have a sinking fund calling for retirement, by the lottery method, of 3% of the
original amount of the bond issue each year. The bond agreement require the current ratio
to be maintained 2:1 and the bond would not be callable for 10 years after which the call
premium would be as it is.
3) The company can sell cumulative preferred stock. The price of the stock would be $40
per share. The dividend would be $10 per share and the stock would be sold at net $35
per share. The issue would not be callable and would not have a sinking fund.
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Current assets $124.80
Balance sheet for the Environgard Corporation year ending December 31,2017
(million in $)
Income Statement of Environgard Corporation year ending Dec 31, 2017 (million in $)
Sales $304.8
Dividends $9.46
Notes: a. Includes depreciation charges of $19.2 million. b. Five-year lease for equipment.
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STATEMENT OF PROBLEM
After the discussion with investment banker, Williard Arenberg (chairman of the board
and the company’s major stockholder) and Gilbert Kushner (a long term director and
chairman of Environgard’s finance committee as well as president of Kusher &
Company) Marcia Hellriegel, (Vice president and controller of Environgard
Corporation) still could not figure out which method would be best for the
Environgard Corporation to raise the required fund of $50 million.
OBJECTIVE OF STUDY
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Issue 1
Assuming that the new funds earn the same rate of return currently being earned on the
firm's assets (earnings before interest and taxes/total assets), what would earnings per
share be for 2018 under each of the three financing methods? Assume that the new outside
funds are employed during the whole year of 2018, the sinking fund payment for 2018 is
ignored, and retained earnings for 2018 are not employed until 2019. Under which methods
of financing alternatives, EPS is highest and why?
The three financial methods to be followed for calculation on Earning per Share for 2018 are:
1) The company can sell common stock to net $39 per share, the current price of the stock is
$45 per share and the flotation cost is $6 which is included in the current price of the
share. The sale is to made through investment bankers to the general public. The
company is to apply for the American Stock Exchange in future.
2) The company can sell 25 years, 8 % bond to a group of life insurance company. The bond
would not have a sinking fund calling for retirement, by the lottery method, of 3% of the
original amount of the bond issue each year. The bond agreement require the current ratio
to be maintained 2:1 and the bond would not be callable for 10 years after which the call
premium would be as it is.
3) The company can sell cumulative preferred stock. The price of the stock would be $40
per share. The dividend would be $10 per share and the stock would be sold at net $35
per share. The issue would not be callable and would not have a sinking fund.
Assume that the new outside funds are employed during the whole year of 2018, the
sinking fund payment for 2018 is ignored, and retained earnings for 2018 are not
employed until 2019
Furthermore, assuming that the new funds earn the same rate of return currently being
earned on the firm’s assets i.e. earnings before interest and taxes/total assets which is
for year 2017. So,
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For the year ended December 31, 2017 (in million)
Particulars Amount
Earnings before Interest and Tax $64.44
Total assets $316.80
Interest Charge $1.34
Tax rate 40%
Calculation of Earnings per Share (EPS) under each of the three financial alternatives
for generating the required funds of $ 50 Million:
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Alternative 1(common stock): The Company selling the common stock to generate the
required funds
Market Price per Share (MPS) = $ 39 per share
The Number of new shares = Raised Capital/Market Price Per Share
= $50 million/$39 per share
= 1.28 million share
Therefore,
EPS = (EBIT−I) *(1−T)/Number of common shares outstanding
= (74.61-1.34) (1 – 0.4) / (12 + 1.28) {12 million at $1 par outstanding + new shares}
= $3.310 per share
Alternative 2(Bond): The Company privately sells 8% bond to a group of life insurance
companies.
The sinking fund of 3% ignored for 2018.
The New interest charge = 8% of $ 50Million = $ 4 Million
New interest charge = 1.34 + 4 = 5.34 million
Therefore, EPS = (EBIT−I) *(1−T)/Number of common shares outstanding
= (74.61-5.34) (1 – 0.4) / (12)
= $3.463 per share
Alternative 3(Preferred Stock): The Company to sell cumulative preferred stock
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Market price per preferred stock = $ 40 per preferred stock shares
Dividend per Share = $ 10 per share
Number of New Preferred stock = Raised Funds/MPS
= 50 million/40
= $1.25 million shares
Therefore,
Preference Dividend = 1.25 Million shares × 10 Per Share
= $ 12.5 Million
Now,
EPS = (EBIT−I) (1−T) − (Preference dividend)/Number of common shares outstanding
= (74.61-1.34) (1 – 0.4) – 12.5 / (12)
= $2.621 per share
EPS FOR 3 ALTERNATIVE FINANCING METHOD IN TABULAR FORM ($ million)
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EARNINGS PER SHARE ($)
4
3.5
2.5
2
3.31 3.463
1.5
2.621
1
0.5
0
Common stock Bond Preferred Stock
As per the question, the new funds earn the same rate of return currently being earned on the
firm’s assets. Taking this in consideration, we equated the return on EBIT for the year 2017 and
2018 to compute the EBIT for the year 2018. The total assets for the year 2018 was previous
Total assets for year 2017 i.e. $316.8 million added to $50 million to be generated which give the
amount of $366.8 million. From the help of EBIT for the year 2018 we calculated the EPS for
different alternative methods.
Here, calculating the Earning per share from different alternatives shows value in common stock
as $3.31, in bonds the EPS value is $3.463 and in preferred stock the value is $2.621. From the
calculation we can observed that Earning per Share is highest under Debt (Bond) that is ($3.463).
This is because interest is paid before the tax under debt financing method which reduces
Earning before Tax under this method in comparison with other two methods in common
stock issue and preferred stock issue. This leads to less tax payer under Debt method. So, EPS is
higher under Debt Financing method than other alternatives. Just considering the Earning per
share, the best alternative for the Environgard Corporation to raise $50 million fund is alterative
2 that is to sell 25 years, 8 percent bond to a group of life insurance companies assuming The
sinking funds which is 3% for 2018 is ignored, the new outside fund are employed during the
whole year of 2018 and retained earnings for 2018 are not employed until 2019.
Issue 2
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Calculate the debt ratio at year end 2018 under each alternative method of financing.
Assume that 2018 current liabilities remain at their current level and additions to
retained earnings for 2018 total $28.39 million. Compare Environgard Corporation’s
figures with the industry averages as given in Table 4.
Solution,
Here it is assumed that all the retained earnings from previous years has been used to
undertake the new project and hence the only retained earning remaining is $28.39 million.
We know,
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Debt Ratio = debt/asset
= 67.2/395.19
= 17.58%
Analytical table 2:
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After the $50 million of additional fund and new retained earnings of 28.39s million Total Asset
in 2018 is 316.8+50+28.39= $395.19
It is assumed that retained earning at the beginning of 2018 is $0.
In Option A, asset has been increased via issue of stocks worth $50 million and there is
retained earnings for 2018 as $28.39 million resulting the total asset to result to $395.19.
As the equity base has increased the assets, debt ratio has decreased to 17%.
In Option B, asset has been increased via issue of bonds worth $34 million, and there is
retained earnings for 2018 as $28.39 million resulting the total asset to result to $395.19.
Debt financing has increased the debt from $67.2 million to $117.2 million. As the debt has
increased along with the equity base, debt ratio has increased to 29.66%.
In Option C, asset has been increased via issue of preferred stocks worth $50 million and
there is retained earnings for 2018 as $28.39 million resulting the total asset to result to
$395.19. As the equity base has increased the assets, debt ratio has decreased to 17%.
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Debt ratio
40%
35%
30%
25%
20%
15%
10%
5%
0%
Common Stock Bond Preferred Stock
A lower debt ratio usually implies a more stable business with the potential of longevity
because a company with lower ratio also has lower overall debt. Each industry has its own
benchmark’s for debt, but 0.5 is reasonable ratio which means that the company has twice
as many assets as liabilities. In comparison to industry average debt ratio, the debt ratio of
Environgard Corporation in different alternatives are better.
The debt ratio of common stock and preferred stock is 0.17 which indicates that the
company has lower overall debt with less risk and in comparison to industry average i.e.
0.35 , it is better or very good. The debt ratio of bond is 0.2966 which is also less risky. So
from here we can conclude that common stock and preferred stock are the two best
alternatives in term of risk.
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Issue 3
Calculate the before tax times interest earned coverage for 2018 under each of the
financing alternatives. Then compare Environgard Corporation’s coverage ratios
with the industry average.
Solution:
The times interest earned ratio is an indicator of a corporation’s ability to meet the interest
payments on its debt. It is a measure of a company’s ability to honor its debt ability. The
larger the times interest earned ratio, the more likely that the corporation can make its
interest payments. It is referred to as the interest coverage ratio. It is calculated as either
EBIT or EBITDA divided by the total interest expense i.e.
$ 1.34
= 74.61/1.34
=55.68 times
=$1.34+$4
=$5.34
Times interest earned (Debt Financing) = EBIT/ Interest Expenses
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Interest
Expenses
= 74.61/5.34
=
= 13.97 Times
Analytical Table 3:
Financing Methods
Industry Average 9x 9x 9x
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Times interest earmed coverage rati o
Times Interest Earned Industry Average
55.68
55.68
13.97
9
9
Common Stock Bond P r efer r ed S t o c k
The times interest earned from three different alternatives are calculated. The times interest
earned
from common stock is 55.68 times, whereas the times interest earned from preferred stock is
also same as common stock i.e. 55.68 times. The times interest earned under common stock
financing and preferred stock are extremely high. This shows that Environgard has not been
using
debt financing than common and preferred average. The times interest earned of 13.97 A times
in
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case of bond financing is good and little high than the industry average. This shows that the
company has a good mix of debt and equity financing and it has earnings available for meeting
its
debt obligation. From here we can conclude that common stock and preferred stock are best
alternatives for financing.
Issue 4
Calculate the fixed charge coverage under each of the three alternatives for the year 20181.
Ignore the sinking fund payment in the debt alternative. Then compare your results with
the industry average. Calculate the debt service coverage ratio (the fixed charge coverage
ratio including the sinking fund payment) for the bond alternative 2. What effect will the
sinking fund covenant have on Environ Gard Corporation's ability to meet its other fixed
charges? Do you think that the company will be able to meet fixed obligations? In the event
that the company incurred a loss, do you think that the company can meet the fixed
obligations?
1) The company can sell common stock to net $39 per share.
2) The company can sell 25 years, 8 % bond to a group of life insurance company.
3) The company can sell cumulative preferred stock at $40 per share and $10 as dividend.
1
2
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Industrial Average = 6 times
Calculation of fixed coverage ratio of common stock, debt and preferred stock ($, million)
Particulars Common Stock Bond Preferred Stock
EBIT 74.61 74.61 74.61
Add: lease obligation 2.88 2.88 2.88
Required EBIT 77.49 77.49 77.49
Total Fixed Charge:
Interest 1.34 5.34 1.34
Lease obligation 2.88 2.88 2.88
Total fixed charged 4.22 8.22 4.22
Fixed charge =77.49/4.22 =77.49/8.22 =77.49/4.22
coverage = EBIT + =18.362 times =9.42 times =18.362 times
Lease
Obligation/Interest
expenses + Lease
Obligation
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Comparison of fixed Coverage ratio with industrial average
18
16
14
12 9.42
10
8 6 6 6
6
4
2
0
Common Stock Bond Preferred Stock
Fixed charge coverage ratio is the ratio that indicates a firm’s ability to satisfy fixed financing
expenses, such as interest and leases. From the above calculation we know that the industry
average is lower than all three alternatives of financing. Higher the coverage ratio higher will be
the firm’s ability to cover the fixed charge. So, under all the three alternatives company has the
ability to cover the fixed charges i.e. interest and lease payment. Among the 3 alterative the
common stock and preferred stock alternative have higher fixed charge coverage ratio i.e. 18.362
times and the bond alternative have 9.42 times. Comparing with the industrial average common
stock and preferred stock have very high fixed charge coverage and the bond have good fixed
Page | 23
charge coverage. If the decision has to be taken in considering with Fixed charge coverage
ratio, then the Common Stock and Preferred Stock are the best alternatives.
Debt service coverage ratio is also known as “debt coverage ratio” (DCR) is the ratio of cash
available for debt servicing to interest, principal and lease payments. The debt service coverage
ratio of environgard corporation being 7.972 times shows that the amount of cash flow is
available to meet annual interest and payments on debt including sinking fund payments. The
debt coverage ratio is the ratio of cash available for debt servicing to interest, principal and lease
payment. The higher debt service coverage ratio it is easier to obtain the loan. It refers to the
measurement of firm’s ability to produce enough amount cash to meet annual interest and
principal payment on debt including sinking fund payment.
If the environgard corporation incurred a loss than it will not able to meet the fixed obligation
because EBIT becomes negative it will cause coverage ratio and fixed charge coverage ratio to
be negative too. As a result, it makes coverage ratio and fixed charge coverage ratio low which
cannot meet the fixed obligations.
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Issue 5
Assume that after the new capital is raised, fixed operating charges are $28 million (not
including depreciation) and the ratio of variable cost to sales stays the same. How much
would sales have to drop before the equity financing would be preferable to debt in terms
of EPS?
According to the question, the ratio of variable cost to sales remains same in bond and stock
financing so,
Now we have,
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Interest on common stock alternative = $1.34
Number of shares under common stock alternative = 13.28 million
As per the question, EPS on bond alternative = EPS on common stock alternative
Or, EBIT – Interest on debt financing/ no of shares = EBIT – Interest on common stock
financing/no of shares
or, EBIT – 5.34/12 = EBIT – 1.34/13.28
or, EBIT = 54.8353/1.28
EBIT = 42.84 million
$42.84 million is the indifference point between bond financing and common stock financing.
The point is the intersection of the debt financing line and the common stock line in the graph.
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Let us assume that the break even sales for 2018 be B1. Then the variable cost will be
Variable cost = Variable cost of sales * Break even sales
V = 0.6771* B1
Calculating the breakeven level of sales
EBIT = B1-V-Total fixed operation charges
Or, 42.84 = B1 – (0.6771*B1) – 47.2
Or, B1 = 90.04/0.3329
B1 i.e., Break even sales = $278.84 million when EBIT = $42.84 million
We have,
EBIT = B1-V-Total fixed operation charges
Or, 74.61 = B1 – (0.6771*B1) – 47.2
Or, B1 = 121.81/0.3329
Page | 27
B1 i.e., Break even sales = $365.90 million when EBIT = $74.61 million
EPS DEBT
3.463
Common
Stock
3.310
3.121
From the graphical presentation, the indifference point between common stock and bond
financing is $42.84 million. As we know from the figure if the EBIT is greater than $42.84
million then firm should use Debt financing because the earning per share is higher in the debt
financing line, left to the indifference point, while comparing debt line and common stock line in
the corresponding EBIT. And if the EBIT of the firm is lower than the $42.84 million the firm
should stick with common stock financing, since the earning per share of common stock line is
higher than debt line in the corresponding EBIT.
At the present condition the company, debt financing best suits for the financing for future
expansion. But if the company wants to choose equity financing the company must decrease its
sales from $365.90 million to $278.84. $278.84 million being sales breakeven of the indifference
point, the company can choose from debt financing or equity financing. If the company
decreases sales by more than $278.84, than equity financing is more preferable to debt financing.
Since, the EPS would be higher below the indifference point of $42.84 million.
For the percentage decrease the company should decrease by 23.7%.
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($365.90-$278.84)/365.90=23.7%
Issue 6
Based on the data developed in Questions 2, 3, and 4, discuss the pros and cons of each of
the financing methods that Hellriegel is considering.
For the pros and cons for the common stock financial method, bond issue financial method and
preferred stock financial method, we take some of the observation and calculation from the
above discussed issue which is presented in tabulated form below.
COMMON STOCK
Pros of common stock
• The offering of common stock has the potential to raise large amounts of money.
• Environgard does not need to make obligatory interest payments to investors and instead can
make discretionary dividend payments when it has extra cash.
• Rather than adding more debt to a company's balance sheet Environgard company can take a
less expensive by issuing common stock.
• There is no maturity date on the security so Environgard will not have the burden of paying
back the capital like in case of bonds.
Page | 29
Cons of common stock
• There is loss of control of the management within the company as it provides voting rights to
the holders to elect the board of directors.
• The extensive research and IPO decision-making process can be quite costly to Environgard
owners. These costs are part of the risks that Environgard must assume during the stock offering
process.
• Dividends paid to common shareholders are not tax deductible.
BOND / DEBT
Pros of bonds
• Bonds offer safety of principal and periodic interest income, which is the product of the stated
interest rate or coupon rate and the principal or face value of the bond.
• The cost of bonds to Environgard is fixed as interest and principal The dividend payments to
shareholders are not tax deductible as dividends are distributed using after-tax profits will not
change with change in Environgard earnings.
• The ownership interest in the corporation will not be diluted by adding more bond holders. So,
it will not dilute earnings per share or control within the company.
• Interest payments are tax deductible and beneficial for Environgard as interest expenses paid
on bonds are subtracted from revenue to arrive at a lower taxable corporate income for the
company.
Cons of bonds
• The disadvantages of bonds include rising interest rates, market volatility and credit risk. Bond
prices rise when rates fall and fall when rates rise. Bond market volatility could affect the prices
of individual bonds, regardless of the issuers' underlying fundamentals.
• Environgard will have the legal obligations to pay the fixed charges or interest regardless of
available earnings or cash flow to the corporation.
• Bonds have a maturity date and the capital invested must be repaid to investors. So,
Environgard cannot utilize the fund for lifetime of the business as it has to repay at the time of
maturity.
Page | 30
• The issuance of bonds adds more risk to the Environgard Corporation as nonpayment of
interest and principal may result to bankrupt.
PREFERRED STOCK
Pros of preferred stock:
• Preferred stock payments are fixed and the company does not need to pay higher dividends in
case of higher earnings.
• If a corporation cannot pay its preferred shareholders, the company can pay later, when it has
the ability to pay. In the event of a corporate bankruptcy, preferred shareholders do not receive
dividends until the company's creditors are paid. So, preferred stock helps to reduce some of the
burdens during its hard times.
• It carries no voting rights, so Hellriegel will be able to keep full control over the company.
Page | 31
Issue 7
Determine the PE ratio for 2017. If the goal is to maximize the price of firm's stock,
calculate the prices of common stock for 2018 under various financing arrangements for
PE ratio of 18, 16, 15, 14, 13, 12, and 10 times. Which alternative has the higher market
price per share?
The price earnings ratio, also known as PE ratio, is a market prospect ratio that calculates the
market value of a stock relative to its earnings by comparing the market price per share by the
earning per share. In other word, the price earnings ratio shows what the market is willing to pay
for a stock based on its current earnings.
Mathematically,
Price earnings ratio = Market price per share / Earnings per share
= 45/ 3.155
= 14.26
As the Price earnings ratio is widely used to know the earning potentiality of the common
shareholders’ investment in the company on a per share basis. Higher the ratios better the
performance of the firm. However, 14.26 is less than the industry average i.e., 18 which shows
that the company is less attractive for the common stock investor.
Page | 32
Calculation of the price of common stock for 2018 under various financial arrangements
for PE ratio of 18, 16, 15, 14, 13, 12 and 10 times.
We have,
Price Earning Ratio = Market price per share / Earnings per share
i.e., PE ratio = MPS / EPS
Page | 33
COMMON STOCK
Common Stock
Common Stock
59.58
52.96
49.65
46.34
43.03
39.72
33.1
18 16 15 14 13 12 10
The figure shows the market price of the common stock. Here, when price earnings ratio is 18
times the market price of common stock is 59.58. Likewise, when the price earnings ratio is the
lowest i.e., 10 times then the market price of common stock is 33.1.
Page | 34
DEBT / BOND FINANCING
Bond fi nancing
Bond Financing
62.334
55.408
51.945
48.482
45.019
41.556
34.63
18 16 15 14 13 12 10
The figure shows the market price of the bond. Here, when price earnings ratio is 18 times the
market price of bond is 62.334. Likewise, when the price earnings ratio is the lowest i.e., 10
times then the market price of bond is 34.63.
Page | 35
PREFERRED STOCK
preferred Stock
Preferred Stock
47.178
41.936
39.315
36.694
34.073
31.452
26.21
18 16 15 14 13 12 10
The figure shows the market price of the preferred stock. Here, when price earnings ratio is 18
times the market price of common stock is 47.178. Likewise, when the price earnings ratio is the
lowest i.e., 10 times then the market price of common stock is 26.21.
Here, we can clearly see that financing alternatives 2 i.e. Debt/ Bond financing has higher market
price per share at higher PE ratio. (i.e. when the PE ratio is 18 times the market price per share is
62.334 which is the highest) In addition to this, financing in bond yields higher market price per
share at lower PE ratio.(i.e. when the PE ratio is 10 times then the market price per share is 34.63
which is also higher in comparison to other stocks) This is because if financing is made through
debt it will not increase the number of common stock outstanding. Net profit is divisible for
existing common shareholders. This will increase Earnings per share (EPS). And higher EPS
in a given PE ratio yields higher market price per share (MPS).
Page | 36
Issue 8
Calculate the profit after taxes to total assets and profit after taxes to net worth for 2018
under each of the alternatives. Then compare these ratios with the industry average under
each of the alternatives.
The return on total assets ratio indicates how well a company's investments generate value,
making it an important measure of productivity for a business. It is calculated by dividing the
company's earnings after taxes (EAT) by its total assets, and multiplying the result by 100%.
Profit after taxes to total assets = Net Profit after Tax / Total Assets
Profit after taxes to total assets = (EBIT – Interest) (1 – Tax) / Total Assets
Total Assets for 2018 = Current Liability + Long Term Debt + Common Stock + New Fund +
Retained Earnings
= $48 + $19.2 + $12 + $50 + $237.6
= $366.8 million
Profit after taxes to total assets = Net Profit after Tax / Total Assets
Profit after taxes to total assets = (EBIT – Interest) (1 – Tax) / Total Assets
Profit after taxes of total assets 2018 = 43.962 / 366.8 [NPAT from the calculation in Issue 1]
= 0.119 i.e., 11.9%
Using the common stock financing method, the company can generate 11.9% profit using $366.8
million assets.
Page | 37
Alternative 2 Bond Financing
Profit after taxes to total assets = Net Profit after Tax / Total Assets
Profit after taxes to total assets = (EBIT – Interest) (1 – Tax) / Total Assets
Profit after taxes of total assets 2018 = 41.562 / 366.8 [NPAT from the calculation in Issue 1]
= 0.113 i.e., 11.3%
Using the debt financing method, the company can generate 11.3% profit using $366.8 million
assets.
Profit after taxes to total assets = Net Profit after Tax / Total Assets
Profit after taxes to total assets = (EBIT – Interest) (1 – Tax) / Total Assets
Profit after taxes of total assets 2018 = 43.962 / 366.8 [NPAT from the calculation in Issue 1]
= 0.119 i.e., 11.9%
Using the preferred stock financing method, the company can generate 11.9% profit using
$366.8 million assets.
Page | 38
Analytical Table
Financing Profit after tax/ Total Industrial Remarks
Alternative Assets Average
Common Stock 11.9% 8% Good
Debt/Bond 11.3% 8% Good
Preferred Stock 11.9% 8% Good
11.90% 11.90%
12% 11.30%
10%
8% 8% 8%
8%
6%
4%
2%
0%
Common Stock Bond Preferred Stock
The above table shows profit after taxes to total assets. The profit after tax to total assets ratio
form three different alternative of financing is 11.9% from common stock, 11.3% from bond,
11.9% from preferred stock. The industry average for the ratio is 8%. On the basis of which we
can conclude that the two alternatives i.e., common stock and preferred stock are good or they
are more able to use the assets more effectively and get higher earnings. The bond alternative is
also good but it is not able to use the assets as effectively as two other alternatives. So, we can
say that the performance of common stock and preferred stock are more effective and good than
the debt financing.
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Calculation of profit after tax to net worth for 2018 under different financial alternatives.
Net profit after taxes to net worth is a ratio that measures the company’s profit after tax relative
to its net worth. The ratio is determined by a formula that divides net profit after taxes by
shareholder investment plus retained earnings.
Profit after taxes to net worth 2018 (ROE) = Net Profit after Tax (EAT)/ Net Worth
Profit after taxes to Net worth = (EBIT – Interest) (1 – Tax) / Net worth
Profit after taxes to Net worth = (EBIT – Interest) (1 – Tax) / Net worth
Profit after taxes net worth 2018= 43.962m /299.6m [EAT from calculation on issue 1]
=0.1467 i.e., 14.67%
ROE under preferred share financing explains the ability of firm to generate 14.67% profit
utilizing $299.6 million of equity.
Analytical Table
Financing Profit after tax/ Net Industrial Remarks
Alternative Worth Average
Common Stock 14.67% 12% OK
Debt/Bond 16.65% 12% Good
Preferred Stock 14.67% 12% OK
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Profit after taxes / Net Worth
18%
16.65%
16%
14.67% 14.67%
14%
12% 12% 12%
12%
10%
8%
6%
4%
2%
0%
Common Stock Bond Preferred Stock
The profit after tax to net worth ratio form three different alternative of financing is 14.67% from
common stock, 16.65% from bond, 14.67% from preferred stock. The industry average for the
ratio is 12%. The bond alternative of financing is good, it is able to use the assets as effectively,
the funding of the operation is done with a proportionate amount of debt and trade payables than
two other alternatives. The other alternative i.e., common stock and preferred stock has the
higher profit after tax to net worth, so it is good or it has used the assets more effectively and
getting higher earnings as well. The funding of the operation is utilized well with amount of debt
and trade payables.
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Issue 9
How does stock exchange membership affect the decision?
Organized and regulated financial market are the market where securities (bonds, notes, shares)
are bought and sold at prices governed by the forces of demand and supply. Stock exchange
market is the primary markets where corporations, governments, municipalities, and other
incorporated bodies can raise the capital by channeling savings of the investors into productive
ventures; and secondary markets where investors can sell their securities to other investors for
cash, thus reducing the risk of investment and maintaining liquidity in the system.
It performs various functions and offers useful services to investors and borrowing companies. It
is an investment intermediary and facilitates economic and industrial development of a country.
It provides a convenient and secured mechanism or platform for transactions in different
securities.
Generally, there are two types of stock exchange market. They are:
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Benefits:
Benefits of stock exchange:
1. Enhanced Profile
Companies listed on a stock exchange are much more recognizable and visible than their
privately held counterparts. The increased visibility that comes with being listed on an exchange
can help a company attract new clients and customers, and it draws press attention that might be
difficult and expensive for the company to draw on its own.
2. Increased Visibility
There may be no better PR move for a company than to go public, as the process generates free
publicity and excitement in the marketplace for the company. A successful IPO also results in a
flood of cash for a newly public company, and this cycle can be repeated down the road with
secondary offerings of additional stock. With this additional money, companies can further
expand their operations, or allow companies to offer more lucrative share option packages to
employees.
Companies not listed on stock exchanges typically rely on capital provided by venture capitalists
and private investors. In exchange for purchasing shares of a privately held company, investors
usually insist on having some degree of control of the company, including having members
appointed to the board. These demands can work counter to the intentions of the company itself;
outside investors often prioritize rapid returns on their investment rather than supporting a
company's long-term vision. Stock exchanges allow companies to maintain more autonomy and
control, because people who purchase the shares of a publicly traded company only have the
limited rights afforded to all shareholders.
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4. Reduction of the Cost of Other Capital
Going public reduces the costs of obtaining capital through bank loans. Banks view publicly
traded companies as less of a credit risk than their privately held counterparts, because publicly
traded companies have access to other capital and the auditing requirements for public
companies make their financial condition more transparent.
5. Liquidity
Stocks are termed as liquid assets i.e. an asset that can be easily converted to cash, which has
many buyers at any given point in time. The same is not the case for all assets, it is difficult to
find a buyer for some assets like property. It could take months to cash in on the investment
made in the property. However, in the case of stocks, it is much easier. The average daily volume
of transactions on NSE and BSE is high, which means that there are multiple buyers and sellers
for a single stock.
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Issue 10
Do you think 2:1 current ratio requirement appear too restrictive? And also, do you think
that covenant prohibiting the payment of dividends out of retained earnings appears to be
overly burdensome?
Current ratio is a financial ratio that measures whether a firm has enough resources to pay its
debts over the next 12 months. It compares a firm's current assets to its current liabilities. It is
expressed as follows:
Current ratio also indicates that how many assets is being used to pay the liabilities of the
company. If a company has its current ratio of 1:1, then it means that all the assets is being used
to pay its liabilities. This means that all of the assets are liquid enough to pay the debts of the
company.
In the case study of Environgard Corporation the company has to maintain the current ratio of
2:1. This means that the company should have the assets twice as much as its liabilities. This
restricts the company to have half of its assets stalled without any liquidity, as only half of the
assets is required to pay its liabilities. By the end of 2016, the company had the current assets of
value $124.80 million and current liabilities of value $48 million, resulting to the current ratio of
2.6:1, still exceeding the company requirements.
Since Environgard Corporation is a small firm, it is beneficial to have lesser current ratio,
somewhere between 1 and 2. So, the current ratio requirement of 2:1 seems to be too restrictive.
This forces the company to have half of its current assets unused to pay liabilities when needed.
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No, the covenant prohibiting the payment of dividends out of retained earnings doesn’t appear to
be overly burdensome. Actually, it is beneficial for the company if the dividends are not paid out
of retained earnings. Retained earnings are used for development, expansion and investment
process of the company.
If the dividends are paid out of retained earnings, there will be lesser amount to fund any kind of
investment for the company. In the context of Environgard Corporation the company has to find
ways to fund for its new expansion project of installing new modeling plant, which will cost
approximately $50 million to the company. The retained earnings by the end of 2017 is $28.39.
This means that the company has to look for external equity of $19.2 million only, which would
have increased if the dividends are paid out of the retained earnings. Looking at this perspective,
the covenant prohibiting the payment of dividends out of retained earnings appears to be less
burdensome, thus covering greater part for its investment on its new plant.
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Issue 11
From the analyzing the case issues from 1 to 10, it can be concluded that Bond financing is
the best option available for Environgard Corporation.
Being a company with large percentage of the stock ownership by family members and
limited geographic distribution of shares, Stock option won’t be fruitful as management
might be reluctant to reduce majority shareholding by raising funds through shares.
The Earning per Share of the bond financing indicates the highest profitability situation.
We can clear from the following table:
The EPS under Bond Financing is higher because the interest on debt is deducted before
taxes, while in preferred stock, dividends are deducted after taxes.
Industry Debt Ratio is 35%, however, Environgard’s Debt Ratio under the three alternate
financing methods are lower than the industry average. Environgard is relying on too less
debt and more on equity financing, which is costly. Environgard should option to debt
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financing is any fund required so as to be in par with the industry standards and take
advantages of tax savings from debts as they are tax deductible.
The times interest earned ratio for Environgard in the year 2018 is 55.68 times for the
common stock financing and preferred stock financing, whereas for bond financing the TIE
is 13.97 times, compared to the industry average of 9 times. Thus, bond financing should
be opted as it has earnings enough to meet interest obligations.
Higher Fixed Charge and Debt Charge Coverage Ratio shows that the firm has ability to
cover the fixed charges like interest and sinking funds. Thus, Environgard can use Bond
Financing. As the Market Price of Share under Debt financing is the highest, under various
price earnings ratio.
So, from overall analysis we could prefer Debt Financing and recommend to the board for
raising the capital of 50 million from bond financing and which could be best alternative
for the Environgard Corporation.
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Issue 12
Environgard is a company formed in 1980’s in Chicago had since then have dominated the
air pollution scrubbing equipment market as largest single product SO2. As it was ruling
the market its dominance became a threat as there was a development of a new type of
scrubber that is both cheaper and more effective against the air pollutants. Due to which
Environgard decided to expand and remodel their plant which required approximately $50
million. Not only the remodeling took place but a new equipment and materials were to be
brought to initiate the Scrub King marketing.
Marcia Hellriegal being the vice president and controller must recommend the method of
financing the $50 million.
Hence, According to Marcia Hellriegal, the company can sell the common stock net
$39per share. Since the current price of the stock is $45 per share floatation being $6 per
share. The sale was made through investment bankers to the general public as the sale of
the common stock is made through rights offering.
Again, As per Marcia, the company can privately sell 25 year, 8% bond to a group of life
insurance companies the bond shall have a sinking fund calling for the retirement by a
lottery method of 3% of the original amount of the bond issue each year.The bond
agreement is required to maintain current ratio of 2:1, and the bonds would not be callable
for a period of 10 years after which the usual call premium would not be invoked. And no
floatation cost is to be incurred.
The third and the last alternative, available to the company is to sell its cumulative
preferred stock. The issue would not be callable and would not have a sinking fund. The
price would be $40 per share and the usual dividend would be $10 per share and the stock
would be sold for $35 per share.
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Examining the entire instance of Environgard Corporation, we now take in the accompanying
lessons as:
The comparative benefits of bond are Corporate bonds are used by company to raise
funds for large-scale projects - such as business expansion, takeovers, new premises or
product development. They can be used to replace bank finance, or to provide long-
term working capital. Bonds can be a very flexible way of raising debt capital. It can
also offer a way of stabilizing your company's finances by having substantial debts on
a fixed-rate interest. This offers some protection against variable interest rates or
economic changes.
There are several advantages of issuing bonds or debt instead of stock when acquiring
assets. One advantage is that the interest on bonds and other debt is deductible on the
corporation's income tax return. Dividends on stock are not deductible on the income
tax return.
Another advantage of financing asset with bonds instead of stock is that the ownership
interest in the corporation will not be diluted by adding more owners. Bondholders
and other lenders are not owners of the assets or of the corporation. Therefore, all of
the gain in the value of the assets belongs to the stockholders. The bondholders will
receive only the agreed upon interest. This is related to the concept of leverage or
trading on equity. By issuing debt, the corporation gets to control a large asset by
using other people's money instead of its own. If the asset ends up being very
profitable, all of its earnings minus the interest will enhance the owners' financial
position.
This case study is designed to facilitate class discussion of corporate finance with real scenario,
based on a series of increasingly detailed questions and answers that reinforce conceptual
insights with numerical examples. Complete coverage of all areas of corporate finance includes
capital structure and financing needs along with project and company valuation, with specific
guidance on vital topics such as ratios and pro forma, dividends, debt maturity, asymmetric
information, and more. It provides comparative study of different alternatives of financing in a
project with higher level of profit and lower level of cost.
Explore the methods of valuation with free cashflow to firm and equity.
Navigating the intricate operations of corporate finance requires a deep and instinctual
understanding of the broad concepts and practical methods used every day. Interactive,
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discussion-based learning forces you to go beyond memorization and actually apply what ou
know, simultaneously developing your knowledge, skills, and instincts. Lessons in Corporate
Finance provide a unique opportunity to go beyond traditional textbook study and gain skills that
are useful in the field. It provides the knowledge, skills and techniques with the benefits of
choosing different alternatives while financing the project in the company.
CONCLUSION
Hence, From the overall case we came to the conclusion that Environment guard should adopt
for bond financing over common stock and preferred stock to raise the additional capital
requirement of $50 million which can be evaluated from the above case calculations as:
From the available alternatives EPS under Bond Financing is the highest.
Bonds interest are subject to tax deductible and Dividends are paid after the payment
of tax .
The TIE ratio under Bond financing is greater than industry average which indicates
bond financing is enough to meet the interest expenses.
Equity financing is much expensive compared to the other available alternatives.
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