C A S E 3 1

WONDER BARS

COST OF CAPITAL OR REQU IRED RETURN

All rational investors want to invest in securities (or projects) that are expected to yield a return greater than their cost of capital. For the chief financial officer (CFO) of a company, the procedure for determining where to invest is a threestep process. The first step is finding the expected return on the securities (or projects) in which the firm may be interested. The second step is the determination of the firm's cost of capital. The final step is selecting those securities (or projects) whose expected return is greater than the firm's cost of capital. In reality neither of the first two steps precedes the other as the CFO may calculate the firm's cost of capital on an annual, a semiannual, or even a quarterly basis, depending on changes in the capital markets. The calculated cost of capital may then be compared to the expected returns of the various securities and capital projects available.

HISTORY OF WONDER BARS

Wonder Bars (WB) was founded in 1896 by Earle Greymore as a manufacturer of quality chocolate candy. As with most food companies established in the United States in that period, WB started as a modest manufacturer of a single product that was sold locally. Later, if successful, those firms expanded their sales efforts to state, regional, national, and sometimes even to international areas.

Wonder Bars was one of the successful companies. Greymore's first product was a chocolate bar that sold for two cents. The bar, known as the Wonder Bar, soon became famous for its quality and fine taste. Greymore expanded production to meet the rising demand for the Wonder Bar, but growth never exceeded cash available to pay for the expansion. Two of the basic tenets on which Greymore founded and ran WB were to make a quality chocolate bar and not to go into debt. These tenets were considered almost sacrosanct, and Greymore believed they were the reasons for his success while many other food companies failed.

By 1936, when Greymore turned the reins of his company over to his son, John, WB had grown into a respected and well-known $2.5-million regional chocolate firm. It had survived the Great Depression, according to Earle Greymore, because the firm still produced a quality product and, above all, had no debt. John Greymore followed the principles laid down by his father, and in the next 30 years WB grew to a national firm with $125 million in sales. Although WB had purchased a confectionery candy firm, over 90 percent of the sales were from chocolate candy. Significantly only 5 percent of the firm's capital structure was in long-term debt, the debt needed to purchase the confectionery candy firm.

In 1967, when John's son Earl became president of WB, the family still owned all the stock of the firm and the board of directors was made up entirely of family members. However, in 1971 the company was forced into going public because of two circumstances. The first was the need to raise cash to pay estate taxes following the death of John Greymore. The second came from the increasing awareness that the firm needed to modernize its plants to compete with other food companies, which were slowly taking market share from WB with better quality candy products and higher profits from their automated, modern equipment.

By the early 1980s the firm had completed its modernization, improving the quality of its products and reducing operating expenses. However, the firm was totally dependent on the chocolate and confectionery business and its managers were beginning to realize that diversification into other lines of the food business might be necessary for WB to survive in the increasingly competitive business environment. In addition, some family members were beginning to question the financial practices of the firm and the effects those practices had on the stock price. They noticed that throughout the 1970s, many of the old-line family food businesses were purchased by larger, publicly held firms run by managers who were not majority shareholders of the firm. More importantly they noticed that the returns on the shares sold seemed much higher than the returns they were receiving from their stock.

During the early 1980s, WB did expand into the pasta business through the purchase of three family-owned firms and by 1989 had an 18 percent market share of the $1 billion U.S. pasta business. Salem financed the purchase of these businesses through two bond issues. Long-term debt, however, was never more than 20 percent of total assets.

Sam Wendover

Sam Wendover, the chief financial officer (CFO) of WB, was hired in 1988 with specific instructions to improve the return on the financial resources of the firm. Wendover's background included four years as the cash manager of a large corporation with sales in excess of $9 billion. He was a graduate of an MBA program that is nationally known for its emphasis on financial management.

CASE 31 WONDER BARS 199

Wendover saw the job as CFO of WB as an outstanding opportunity to affect the financial decision making of a firm in transition from family ownership to one that was becoming a multibillion dollar, publicly held firm.

This Monday morning, Wendover had just walked into his office at 7:40 to find a note stuck on his computer's video monitor to call Earl Greymore, the CEO of Wonder Bars. The posting of the note was unusual in that most intraoffice memos were sent via the electronic mail system, by then very few of WB's top executive managers ever used their computers for this or any other purpose. Greymore, however, was making a real effort to bring WB into the modern era, insisting that the computers be installed and that all managers below the level of the executive officers take in-house training on how to use them. He also had many of the top executives attend financial seminars sponsored by the Wharton School. Wendover had suggested the seminars to Greymore as a vehicle to help these executives understand some of the changes he thought were necessary to improve Wonder Bars' financial performance.

Wendover called Greymore, who asked him to come up to his office. In the next 30 minutes Wendover learned that WB was considering the purchase of Sonzoni Foods, a pasta producer with annual sales in excess of $100 million, for $85 million. Before a decision could be made, Greymore wanted the answers to three financial questions from Wendover. First, what was the expected return from this proposed purchase? Second, what was Wonder Bars' cost of capital? Finally, what was Wendover's recommendation on how the purchase could be financed?

Financial Information

Wendover reviewed the WB financial data. (See Exhibits 1 and 2.) The average outstanding balance of short-term, interest-bearing debt in 1994 was $76,132,000 and the weighted average interest rate was 8.2 percent. Domestic borrowing under lines of credit and commercial paper was used to fund seasonal working capital requirements and provide interim financing for business acquisitions. Maximum short-term borrowings at any month were $372,400,000.

WB had two long-term, AA+ rated bonds outstanding. The first was an 8.25 percent sinking fund debenture due in 12 years. This debenture is traded on the New York Stock Exchange and closed Friday at 91%. Of the original $150 million issue, $133 million is still outstanding. The second issue was for $100 million and had a coupon interest rate of 9.375 percent. The entire issue was sold in 1990 in a private placement to two life insurance companies, and the issue will mature in 2020. Wendover then called WB's investment banker and learned that the banker was highly confident that Wonder Bars could issue up to $100 million of new debt at the current return on WB's outstanding longterm debt.

Like many other family-controlled but publicly held businesses, WB has two classes of common stock: Common Stock and Class B stock. The Common Stock has one vote per share and the Class B stock (held or controlled by family members) has 10 votes per share. However, the Common Stock, voting separately as a class, is entitled to elect one-sixth of the board of directors. With respect to dividend rights, the common stock is entitled to cash dividends that are 10 percent higher than those declared and paid on the Class B Stock. There are a total of 75 million shares of common stock and 10 million of Class B Stock outstanding. The current price of both the common stock and Class B Stock is $35 and its beta is 0.95. The common stock and Class B Stock generally vote together without regard to class on matters submitted to stockholders.

The growth rate of net income, earnings per share, dividends, and common stock prices are given in Exhibit 3 and have averaged about 14 percent a year over the last five years. Some of this growth rate is the result of an aggressive repurchase of the firm's common stock. Over the past three years the firm has repurchased over 5 million common stock shares. Finally, Wendover looked up the capitalization ratio for other firms in the food industry. (See Exhibit 4.) As he expected, WB had a much lower debt ratio than almost all other companies in the industry group.

Sam Wendover wrote down the additional information that he thought he needed before starting to work. The current Treasury Bill rate was 5.0 percent and the return on the S&P 500 has averaged 12 percent over the past 10 years. Salem's current combined federal and state income tax rate is 40 percent. The beta for Sonzoni Food was 0.90, almost the same as Wonder Bars.

QUESTIONS

1. What is WB's capital structure?

2. What is WB's before-tax cost of long-term debt?

3. What is the firm's cost of equity?

4. Calculate the cost of capital for WB.

5. If Wonder Bar uses book value rather than market value to determine its capital structure, what is the impact of the cost of capital on its budgeting decisions?

6. Which is superior, using the book value or the market value of the firm's capital in the determination of the cost of capital? Why?

7. Wendover apparently believes that WB's cost of capital can be used as the hurdle rate for the required return to evaluate the acquisition of Sonzoni Foods. Under what conditions, if any, is this appropriate?

8. How can the firm raise $85 million for the acquisition without changing the present capital structure?

9. Assuming an expected net income in 1995 of $182 million, how would you suggest that the firm finance the acquisition?

CASE 31 WONDER BARS 201

EXHIBIT 1

Wonder Bars Income Statement ($ Millions)

Net sales $2,168.0 $1,863.8 $1,635.5

Operating income 263.8 246.1 216.2

Interest expense 27.7 22.4 8.1

Pretax income 236.1 223.7 208.1

Taxes 91.6 99.6

100.9

Income from continuing operations Discontinued operations 144.5 124.1 107.2

Income 16.0 24.1 25.6

Gain on disposal 53.4

Net income $213.9 $148.2 $132.8

1994 1993 1992

Earnings per share

Continuing operations

Discontinued operations $1.60

2.37 $1.38 I. 64 $1.15

1.42

EXHIBIT 2

Wonder Bars Balance Sheet Comparison ($ Millions)

1994 1993

Assets

Cash $70.1 $7.8

Accounts receivable 166.8 121.5

Inventory 308.8 263.2

Other current assets 73.4 329.5

Total current assets 619.1 722.0

Net property, plant equipment 736.0 564.5

Other assets 409.6 257.9

Total assets

Liabilities stockholders' equity $1,746.7 I 544.4

Accounts payable $128.8 $108.0

Short-term debt 54.9 29.7

Other current liabilities 161.7 119.1

Total current liabilities 345.4 256.8

Long-term debt 233.0 280.9

Other long-term liabilities 48.O 43.2

Deferred income taxes 132.4 131.1

Stockholders' equity 1 005.9 832.4

EXHIBIT 3

Wonder Bars 5-year Financial Summary

Year Net Income EPSa DPS Stock Price

1994

1993

1992

1991

1990

5-Year Growth rate $213.9

189.2

171.8

151.3

130.9

12.3% $1.60

I .44

1.28

1.15

1.02

12.0% $0.67

0.60

0.52

0.48

0.43

12.0% 36%

31%

25

221/4

13.0%

'Trimary earnings per share.

EXHIBIT 4

Ratio of Long-Term Debt to Total Assets: Industry Group Analysis

Dreyer's Grand 65%

Borden 42

Hudson Foods 42

Flowers Industries 33

IGA Average 32

Gerber Products 31

Campbell Soup 26

Kellogg Company 24

Wonder Bars 22

Hershey Foods 18

Smucker (J.M.) 3

please answer question 5,6,7,8,9

5.If Wonder Bar uses book value rather than market value to determine its capital structure, what is the impact of the cost of capital on its budgeting decisions?

6. Which is superior, using the book value or the market value of the firm's capital in the determination of the cost of capital? Why?

7. Wendover apparently believes that WB's cost of capital can be used as the hurdle rate for the required return to evaluate the acquisition of Sonzoni Foods. Under what conditions, if any, is this appropriate?

8. How can the firm raise $85 million for the acquisition without changing the present capital structure?

9. Assuming an expected net income in 1995 of $182 million, how would you suggest that the firm finance the acquisition?

Capital Weights Structure Bond 1 $133,000,000 Bond 2 $100,000,000 Total Bonds $233,000,000 2330/12389 = 18.8070% Stockholders $1,005,900,000 10059/12389 Equity (In =81.1929% the Balance sheet) Total Capital $1,238,900,000 100 Structure (Bonds + Equity) = Ans 2: Before tax long N=12 PV=(91 3/8 x 10 term debt of Bond units ) = 913.75 1 PMT=82.50 (1000 *8.25% ) FV=1000 100 * 10 units), Loss on redemption = ( 1000 913.75 ) / 12 = 7.1875 total cost per yr 82.50 7.1875 89.6875 Bond 11/yr (89.6875 *100 956.875) (Avg Price ) = 9.3729% (89.6875 *100 / 913.75) = 9.8153% Bond 2 l/yr ( same 9.375% as given) + + PMT=82.50 (1000 *8.25%) FV=1000 100 * 10units), Loss on redemption = ( 1000 913.75 ) / 12 = 7.1875 I, total cost per yr 82.50 7.1875 89.6875 Bond 11/yr (89.6875 *100 956.875) (Avg Price ) = 9.3729% (89.6875 *100 / 913.75) = 9.8153% Bond 2 l/yr (same 9.375% as given) Avg Rate = (9.81539.5951% +9.375)/2 Ans 3: Cost of Equity using the CAPM r = Rp + beta x (Rm - Rp) where, r is the expected return rate on a security; Rp is the rate of a "risk-free" investment, i.e. Treasury Bill - 5% Rm is the return rate of the appropriate asset class - 12% Beta = 0.95 r = 5 + 0.95 x ( 12-5) r = 11.65% Ans 4 : Weighted Average Cost of Capital (WACC) = kd (1-t) * Debt / Debt + Equity + ke * Equity Debt + Equity = 9.5961% *(1-0.4) * 18.8070% + 11.65% 81.1929% = 10.5418 % CASE 31 WONDER BARS COST OF CAPITAL OR REQUIRED RETURN All rational investors want to invest in securities for projects that are expected to yield a return greater than their cost of capital. For the chief financial attir CHO of a company the procedure for determining where to invest in the stup preces. The find top in finding the expected return on the securities for projects in which the firm may be interested. The second step is the determina tion of the firm's cost of capital. The final epis selecting those securities for projects) whose expected tumingale than the firm's cost of capital. In al ity neither of the first two step procede the other as the CFO may calculate the farm's cost of capital on an annuala semana, or even a quarterly hesis, depending on changes in the capital markets. The calculated contef capital mas then be compared to the expected return of the various securities and capital prets available HISTORY OF WONDER BARS Wonder llars (WIS) was founded in 1996 by Earl Greymore as a mandatum of quality chocolate candy As with most food companies established in the United States in that period, WI started as a modest manufacturer of a single product that was sold locally. Later, if successful those firms expanded the Sales efforts to state, regional, national, and sometimes evento international Wonder Bars was one of the centul companies. Grymore's fint product was chocolate bar that sold for two cents. The bur, known as the Wonder Barn became famous for its quality and fine taste. Greymon expanded production to meet the rising demand for the Wonder Bar, but growth never ended cash aval able to pay for the expron. Two of the best on which Greymon founded and ran WH were to make a quality chocolate bar and not to point debt. These TART VI CARTAL STRUCTURE temets were comide almost canct, and Greymore believed they were the reasons for his succes while many other food companies failed By 1936, when Greymore tumed the wins of his company over to his son John, We had grown into a respected and well-known s5-million cional chocolate firm. It had survived the Great Depression, according to Earle Greymore, because the firm still produced a quality product and above all, had no debt. John Greymore followed the principles laid down by his father and in the next 30 years I grew to a national form with $125 million in sales Although WB had purchased a confectionery candy firm, over 90 percent of the sales were from chocolate candy. Significantly only 5 percent of the firm's capital structure was in long-term debt, the debt needed to purchase the con fectionery candy firm. In 1967, when Johnson Ear became president of the family still owned all the stock of the firm and the board of directors was made an entirely offam ily member. However in 1971 the company was forced into going public because of two circumstances. The first was the need to maine cash to puy estat taxes following the death of John Greymore. The second came from the increas ing aware that the firm needed to modemine its plants to compete with other food companies, which were slowly taking market share from Ws with better quality candy products and higher profits from their automated, modem equipment By the early 1980s the firm had completed its modemination, improving the quality of its products and reducing operating expenses. However, the firm was totally dependent on the chocolate and confectionery business and is man agers were beginning to maine that diversification into the lines of the food business might be necessary for to survive in the increasingly competitive business environment. In addition, the family members www beginning to question the financial practices of the firm and the effects those practices had on the stock price. They noticed that throughout the 1990s, many of the old-line family food businesses were purchased by larger publicly held firms run by managers who were not majority shareholders of the fim. More importantly they noticed that the returns on the shares sold seemed much higher than the returns they were moving from their stock During the early 1980, did expand into the pasta business through the purchase of three family-owned firms and by 190 had ant percent market share of the S1 billion US pasta business Salem financed the purchase of these businesses through two bodies Long-term debt, however, we mode than 20 percent of totales Sum Wendover Sam Wendover, the chief Financial officer (CFO) of W, was hired in 1985 with specific instructions to improve the return on the financial resources of the firm, Wendover's background included four years as the cash manat olan.com poration with sales in excess of S9 billion. He was a graduate of an MBAO gram that is nationally known for its emphasis on financial management, CASE WONDERBARS 1 Wendover saw the job as CFO of WB an outstanding opportunity to affect the financial decision making of a firm in transition from family ownership to one Alut was becoming a multibilion dollar, publicly held firm. This Monday moming, Wendover had just walked into his office at 7:40 10 find a note stuck on his computer's video monitor to call Far Crymore, the CEO of Wonder llars. The posting of the note was unusual in that most intra office memos were sent via the electronic mail system, by the very few of WES top executive managers ever used their computers for this or any other pur pose. Greymore, however, was making a ruleffort to bring into the med em a insisting that the computers be installed and that all managers below the level of the executive officers take in-house training on how to use them. He ho had many of the top executives attend financial seminars powed by the Wharton School Wendover had the minars to Grove de to help these executives understand some of the changes he thought wete necessary to improve Wonder en financial performance Wendover called Greymore, who asked him to come up to his office. In the next 30 minutes Wendover lewened that I was considering the purchase of Sanon Foods, a pasta producer with annual sales in excess of 100 million for $85 million. Before a decision muld be made, Grey wanted the answers to the financial questions from WendoveFirst, what was the expected retum from this proposed purchase Second, what was Wonder Blancost of capital Finally, what was Wendover's recommendation on how the purchase could be financed Financial Information Wendover reviewed the financial data. (See Exhibits 1 and 2.) The average outstanding balance of short-term, interest-bearing debt in 1954 was 54.132.000 and the weighted average interest rate was 82 percent. Domestic borrowing under lines of credit and commercial paper wassed to fund sal working capital requirements and provide interim financing for business acquisitions Maximum short-term borrowing at any month were $372.400,000 WB had two long-term. AA+ rated bonds outstanding. The first was an 8.25 percent sinking fund debenture doe in 12 years. This debenture is traded on the New York Stock Exchange and closed Friday at 91of the original 5150 million issue, 5133 million is still outstanding. The seconde was for $100 million and had a coupon interest rate of 9.375 percent. The entire se was sold in 1990 in a private placement to two bife insurance companies and theme will mature in 2 Wendover then called WB's investment banker and leamed that the banker was highly confident that Wonderlans could be up to 100 million of new debt at the current return on outstanding long term debit Like many other family controlled but poblidy held businesses, WB has two classes of common stock Common Stock and stock. The Common Stock has e vote per share and the Class stock held or controlled by family mem bers) has 10 votes per share. However, the Common Stock voting separately as 200 TART VI CAPITAL STRUCTURE to dividend righes, the common stock is entitled to cash dividends that are 10 percent higher than those declared and paid on the Class Stock. There are a total of 75 million shares of common stock and 10 million of Claw Stock out standing. The current price of both the common stock and Stock is 535 and its beta is 0.95. The common stock and Class 3 Stock generally waite together without regard to cars on matters subented to stockholders The growth rate of net income, camings per share dividends and commen stock prices are given in Exhibit and have averaged about 14 percent a year over the last five years. Some of this growth rate is the result of an repurchase of the firm's common stock. Over the past three years the firm has purchased over 5 million common stock share. Finally, Wendoverlooked up the capitalisation ratio for other forms in the food industry. See Exhibet. As he expected. Wada much lower debt ratio than almost all other companies in the industry group Sam Wendover we down the additional information that he thought the needed before starting to work. The current Treasury Bill rate was 30 percent and the return on the S&P 500 has a waged 12 percent over the past 10 years Salem's current combined federal and state income tax rate is percent. The beta for Songoni Food was 0.90, almost the same as Wonder Bar QUESTIONS WA 5. Wonder Bar uses book value rather than market value to determine its capital structure, what is the impact of the cost of capital on its budgeting decisions? 6. Which is superior using the book value or the market value of the firm's cap ital in the determination of the cost of capital? Why? 7. Wendover apparently believes that we's cost of capital can be used the hurdle rate for the required notum to evaluate the acquisition of Son Foods. Under what condition, if any, is this appropriate? & How can the firm raise $5 million for the acquisition without changing the present capital structure Assuming an expected net income in 196 of 182 million, how would you suggest that the form finance the acquisition? CASE WOTE BARS 201 EXHIBIT 1 Wonder Pars Income Status Mil Nuts Digi SUMUS 2011 Diwand Com EXHIBIT 2 Wonder Burs Balance Sheet Comparin i Milica Awwable Inwy Chew Nuplate SL Anale Svet S Other Defin Sexy 10 SIM STE TART VI CARTAL STRUCTURE EXHIBIT Wonder Ros Ser Financial Sum Your ITI 04 0.43 - www 12 EXHIBIT 4 Ratio of Long-Term Dehto Tal Aucts Industry Group Analysis CA A Campbell Sp Wester Hewly SUM Capital Weights Structure Bond 1 $133,000,000 Bond 2 $100,000,000 Total Bonds $233,000,000 2330/12389 = 18.8070% Stockholders $1,005,900,000 10059/12389 Equity (In =81.1929% the Balance sheet) Total Capital $1,238,900,000 100 Structure (Bonds + Equity) = Ans 2: Before tax long N=12 PV=(91 3/8 x 10 term debt of Bond units ) = 913.75 1 PMT=82.50 (1000 *8.25% ) FV=1000 100 * 10 units), Loss on redemption = ( 1000 913.75 ) / 12 = 7.1875 total cost per yr 82.50 7.1875 89.6875 Bond 11/yr (89.6875 *100 956.875) (Avg Price ) = 9.3729% (89.6875 *100 / 913.75) = 9.8153% Bond 2 l/yr ( same 9.375% as given) + + PMT=82.50 (1000 *8.25%) FV=1000 100 * 10units), Loss on redemption = ( 1000 913.75 ) / 12 = 7.1875 I, total cost per yr 82.50 7.1875 89.6875 Bond 11/yr (89.6875 *100 956.875) (Avg Price ) = 9.3729% (89.6875 *100 / 913.75) = 9.8153% Bond 2 l/yr (same 9.375% as given) Avg Rate = (9.81539.5951% +9.375)/2 Ans 3: Cost of Equity using the CAPM r = Rp + beta x (Rm - Rp) where, r is the expected return rate on a security; Rp is the rate of a "risk-free" investment, i.e. Treasury Bill - 5% Rm is the return rate of the appropriate asset class - 12% Beta = 0.95 r = 5 + 0.95 x ( 12-5) r = 11.65% Ans 4 : Weighted Average Cost of Capital (WACC) = kd (1-t) * Debt / Debt + Equity + ke * Equity Debt + Equity = 9.5961% *(1-0.4) * 18.8070% + 11.65% 81.1929% = 10.5418 % CASE 31 WONDER BARS COST OF CAPITAL OR REQUIRED RETURN All rational investors want to invest in securities for projects that are expected to yield a return greater than their cost of capital. For the chief financial attir CHO of a company the procedure for determining where to invest in the stup preces. The find top in finding the expected return on the securities for projects in which the firm may be interested. The second step is the determina tion of the firm's cost of capital. The final epis selecting those securities for projects) whose expected tumingale than the firm's cost of capital. In al ity neither of the first two step procede the other as the CFO may calculate the farm's cost of capital on an annuala semana, or even a quarterly hesis, depending on changes in the capital markets. The calculated contef capital mas then be compared to the expected return of the various securities and capital prets available HISTORY OF WONDER BARS Wonder llars (WIS) was founded in 1996 by Earl Greymore as a mandatum of quality chocolate candy As with most food companies established in the United States in that period, WI started as a modest manufacturer of a single product that was sold locally. Later, if successful those firms expanded the Sales efforts to state, regional, national, and sometimes evento international Wonder Bars was one of the centul companies. Grymore's fint product was chocolate bar that sold for two cents. The bur, known as the Wonder Barn became famous for its quality and fine taste. Greymon expanded production to meet the rising demand for the Wonder Bar, but growth never ended cash aval able to pay for the expron. Two of the best on which Greymon founded and ran WH were to make a quality chocolate bar and not to point debt. These TART VI CARTAL STRUCTURE temets were comide almost canct, and Greymore believed they were the reasons for his succes while many other food companies failed By 1936, when Greymore tumed the wins of his company over to his son John, We had grown into a respected and well-known s5-million cional chocolate firm. It had survived the Great Depression, according to Earle Greymore, because the firm still produced a quality product and above all, had no debt. John Greymore followed the principles laid down by his father and in the next 30 years I grew to a national form with $125 million in sales Although WB had purchased a confectionery candy firm, over 90 percent of the sales were from chocolate candy. Significantly only 5 percent of the firm's capital structure was in long-term debt, the debt needed to purchase the con fectionery candy firm. In 1967, when Johnson Ear became president of the family still owned all the stock of the firm and the board of directors was made an entirely offam ily member. However in 1971 the company was forced into going public because of two circumstances. The first was the need to maine cash to puy estat taxes following the death of John Greymore. The second came from the increas ing aware that the firm needed to modemine its plants to compete with other food companies, which were slowly taking market share from Ws with better quality candy products and higher profits from their automated, modem equipment By the early 1980s the firm had completed its modemination, improving the quality of its products and reducing operating expenses. However, the firm was totally dependent on the chocolate and confectionery business and is man agers were beginning to maine that diversification into the lines of the food business might be necessary for to survive in the increasingly competitive business environment. In addition, the family members www beginning to question the financial practices of the firm and the effects those practices had on the stock price. They noticed that throughout the 1990s, many of the old-line family food businesses were purchased by larger publicly held firms run by managers who were not majority shareholders of the fim. More importantly they noticed that the returns on the shares sold seemed much higher than the returns they were moving from their stock During the early 1980, did expand into the pasta business through the purchase of three family-owned firms and by 190 had ant percent market share of the S1 billion US pasta business Salem financed the purchase of these businesses through two bodies Long-term debt, however, we mode than 20 percent of totales Sum Wendover Sam Wendover, the chief Financial officer (CFO) of W, was hired in 1985 with specific instructions to improve the return on the financial resources of the firm, Wendover's background included four years as the cash manat olan.com poration with sales in excess of S9 billion. He was a graduate of an MBAO gram that is nationally known for its emphasis on financial management, CASE WONDERBARS 1 Wendover saw the job as CFO of WB an outstanding opportunity to affect the financial decision making of a firm in transition from family ownership to one Alut was becoming a multibilion dollar, publicly held firm. This Monday moming, Wendover had just walked into his office at 7:40 10 find a note stuck on his computer's video monitor to call Far Crymore, the CEO of Wonder llars. The posting of the note was unusual in that most intra office memos were sent via the electronic mail system, by the very few of WES top executive managers ever used their computers for this or any other pur pose. Greymore, however, was making a ruleffort to bring into the med em a insisting that the computers be installed and that all managers below the level of the executive officers take in-house training on how to use them. He ho had many of the top executives attend financial seminars powed by the Wharton School Wendover had the minars to Grove de to help these executives understand some of the changes he thought wete necessary to improve Wonder en financial performance Wendover called Greymore, who asked him to come up to his office. In the next 30 minutes Wendover lewened that I was considering the purchase of Sanon Foods, a pasta producer with annual sales in excess of 100 million for $85 million. Before a decision muld be made, Grey wanted the answers to the financial questions from WendoveFirst, what was the expected retum from this proposed purchase Second, what was Wonder Blancost of capital Finally, what was Wendover's recommendation on how the purchase could be financed Financial Information Wendover reviewed the financial data. (See Exhibits 1 and 2.) The average outstanding balance of short-term, interest-bearing debt in 1954 was 54.132.000 and the weighted average interest rate was 82 percent. Domestic borrowing under lines of credit and commercial paper wassed to fund sal working capital requirements and provide interim financing for business acquisitions Maximum short-term borrowing at any month were $372.400,000 WB had two long-term. AA+ rated bonds outstanding. The first was an 8.25 percent sinking fund debenture doe in 12 years. This debenture is traded on the New York Stock Exchange and closed Friday at 91of the original 5150 million issue, 5133 million is still outstanding. The seconde was for $100 million and had a coupon interest rate of 9.375 percent. The entire se was sold in 1990 in a private placement to two bife insurance companies and theme will mature in 2 Wendover then called WB's investment banker and leamed that the banker was highly confident that Wonderlans could be up to 100 million of new debt at the current return on outstanding long term debit Like many other family controlled but poblidy held businesses, WB has two classes of common stock Common Stock and stock. The Common Stock has e vote per share and the Class stock held or controlled by family mem bers) has 10 votes per share. However, the Common Stock voting separately as 200 TART VI CAPITAL STRUCTURE to dividend righes, the common stock is entitled to cash dividends that are 10 percent higher than those declared and paid on the Class Stock. There are a total of 75 million shares of common stock and 10 million of Claw Stock out standing. The current price of both the common stock and Stock is 535 and its beta is 0.95. The common stock and Class 3 Stock generally waite together without regard to cars on matters subented to stockholders The growth rate of net income, camings per share dividends and commen stock prices are given in Exhibit and have averaged about 14 percent a year over the last five years. Some of this growth rate is the result of an repurchase of the firm's common stock. Over the past three years the firm has purchased over 5 million common stock share. Finally, Wendoverlooked up the capitalisation ratio for other forms in the food industry. See Exhibet. As he expected. Wada much lower debt ratio than almost all other companies in the industry group Sam Wendover we down the additional information that he thought the needed before starting to work. The current Treasury Bill rate was 30 percent and the return on the S&P 500 has a waged 12 percent over the past 10 years Salem's current combined federal and state income tax rate is percent. The beta for Songoni Food was 0.90, almost the same as Wonder Bar QUESTIONS WA 5. Wonder Bar uses book value rather than market value to determine its capital structure, what is the impact of the cost of capital on its budgeting decisions? 6. Which is superior using the book value or the market value of the firm's cap ital in the determination of the cost of capital? Why? 7. Wendover apparently believes that we's cost of capital can be used the hurdle rate for the required notum to evaluate the acquisition of Son Foods. Under what condition, if any, is this appropriate? & How can the firm raise $5 million for the acquisition without changing the present capital structure Assuming an expected net income in 196 of 182 million, how would you suggest that the form finance the acquisition? CASE WOTE BARS 201 EXHIBIT 1 Wonder Pars Income Status Mil Nuts Digi SUMUS 2011 Diwand Com EXHIBIT 2 Wonder Burs Balance Sheet Comparin i Milica Awwable Inwy Chew Nuplate SL Anale Svet S Other Defin Sexy 10 SIM STE TART VI CARTAL STRUCTURE EXHIBIT Wonder Ros Ser Financial Sum Your ITI 04 0.43 - www 12 EXHIBIT 4 Ratio of Long-Term Dehto Tal Aucts Industry Group Analysis CA A Campbell Sp Wester Hewly SUM