Calculation of 1994 proforma income statement and balance sheet, champion road case

Case 22 Champion Road Machinery 271 Exhibit 4 ELIGIBILITY FOR INVESTMENT Eligibility of the Common Shares offered hereby for investment by purchasers to whom the following statutes apply is, in certain cases, govemed by criteria which such purchase required to establish as policies or guidelines pursuant to applicable statute (and, applicable, the regulations thereunder) and is subiect to the prudent investment standards general investment provisions provided therein: Insurance Companies Act (Canada) Trust and Loan Companies Act (Canada) Pension Benefits Standards Act (Canada) Loan and Trust Corporations Act (British Columbia) Insurance Act (Manitoba) The Trustee Act (Manitoba) Trustees Act (New Brunswick) Loan and Trust Corporations Act (Ontario) Pension Benefits Act (Ontario) Supplemental Pension Plans Act (Quebec) An Act Respecting Insurance (Quebec) An Act Respecting Trust Companies and Savings Companies (Quebec) In the opinion of Blake, Cassels & Graydon, counsel to the Company and Goodman and Cart, counsel to the Underwriters, the Common Shares offered hereby will, at the date of issue, be eligible investments without resort to the so-called "basket" provisions, but subject to certain investment provisions and restrictions pertaining generally to purchasers, for insurers under the Insurance Act (Ontario), the Insurance Act (Alberta) and the Employment Pensions Plans Act (Alberta). In the opinion of such counsel, the Common Shares if, as, and when listed on a pre- scribed stock exchange, will be qualified investments under the Income Tax Act (Canada) for trust governed by registered retirement savings plans, registered retirement income funds and deferred profit sharing plans. Source: Champion Road Machinery Company Prospectus. RBC Dominion Securities 270 Part 8 Dividend Policy Exhibit 3 BALANCE SHEETS For The Years Ending December 31 ($000) 1993 1992 Assets: Accounts Receivable Notes Receivable Inventory Prepaid Expenses $14,851 1,526 20,275 282 36,934 10,253 622 $9,640 2,132 18,145 256 30,173 9,725 128 Property, Plant and Equipment Other Assets TOTAL $40,026 $47,809 Liabilities: Bank Indebtedness Account Payable Income Tax Payable Current Portion of Long Term Debt $ 4,228 19,041 2,301 2.788 28,358 5,286 655 $ 6,032 12,395 315 3,409 22,151 6,327 898 Long-Term Debt Deferred Income Taxes Shareholders' Equity: Share Capital Retained Earnings 1,578 11.932 3,375 7.275 TOTAL $47,809 $40,026 Source: Champion Road Machinery Company Prospectus. ction of the new se, which would nding the compa- ing the quality of the product line. ufacturing begin when Champion's financi 266 Part & Dividend Policy wality of the product line. This final step would be accomplished by the introduction third quarter of 1994. The second phase, which whes 700 IV large grader which was planned for the h un Champions financial strength improved, would focus on growth through expandine nies that fit with the core business of manufa nys existing markets and by acauiring other companie equipment used for road construction and maintenance. le management of Chamnion were patient when looking for acquisitions and consequently purchase companies at very reasonable prices, Waiting for the night deal had helped the compare sed for any of its acquisitions. One stock and target requirement of a IS ner cent return on capital employe described Champion's capital allocation program as "very success . acquiring paintennen lookinghe right quisitions and, consequently, were able e company reach its Stock Exchange on additional financ- was outstanding as company would have the on processes, INITIAL PUBLIC OFFERING champion common stock dicted on the Tattorito Stock Exchange and the Montreal Stock Exch april 25, 1994, through an IPO. Management had decided that the company should secure additional mng for several reasons. Tirst management wanted to repay the Sil million in debt that was outstand April, 1994. Then, if a sufliciently attractive opportunity presented itself, the company would has Texibility to add debt. Second, because the company wanted to continue to update its production praca at would require about $3 million to fund capital expenditures planned for 1994. Third, future sales o would also require additional working capital. Prior to the IPO, there were 8.750,000 common shares outstanding, owned by 91 shareholders of company as of February 2. 1994. Almost 40 per cent of the shares were held by the directors and executive The three largest shareholders were William Walsh, Chairman; Robert Ferris, Secretary; and Arthur Chumba President and CEO, An additional 2.420.000 shares were issued at a price of $12 per share, at the time of the ry, resulting in a total of 11.170.000 common shares outstanding, Gross proceeds from the IPO warto mmon, but the company received $26.6 million after issue costs. As part of the agreement, the 91 h holders could not sell any stock for one vear after the IPO, but were able to sell 1,100,000 shares as part of the IPO. Consequently, a total of 3.520.000 shares were available to the public. The common stock issue was targeted at investors interested primarily in capital gains. The company had examined the dividend policy issue at the time of the IPO, but had determined that sufficient cash was not available to pay a cash dividend. A cash dividend did not seem to fit with the expectations of the new share- holders. Seventy per cent of the stock had been purchased by institutional investors and 30 per cent by retail investors. The institutional investors included many of the large Canadian-based money managers, such as the Caisse de dpt et placement du Qubec based in Montreal. There were approximately 1,500 retail investors, which included the more than 600 Champion employees. The Champion stock was considered to be eligible for most institutional investments, consequently, investment managers for large pools of invest- ments, such as pension funds, could purchase the stock for their portfolios. Exhibit 4 lists the acts under which Champion was eligible for investment. Ilistorically, eligibility rules required firms to pay dividends each year for a number of years (typically five to seven). More recently, most Canadian federal and provin cial legislation relating to financial institutions provided for prudent investor" standards. Rather than oper- ating under restrictions (such as earnings or dividend history) on individual stocks, the entire portfolio of stocks was judged as a group to determine whether a prudent investor would invest in such a basket of secu- rities. Some exceptions to the prudence test are also listed in Exhibit 4. It was one analyst's opinion that any acts that did not currently comply with the "prudence" standard would have adopted it by the time Champion had built up a dividend history. Since its initial listing on the Toronto Stock Exchange, the price of Champion's stock had been at its high- est point, $12.38, just four trading days after the IPO. This was also the period when trading volume was heaviest, as over 400,000 shares were traded in the stock's first seven trading days. Since then daily volume was generally below 20,000 shares per day. While the price hit a low of $9.25 on June 29, it rebounds! quickly to close at just under $12 on July 22 (see Exhibit 5). Case 22 Champlon Road Machinery 269 Exhibit 2 INCOME STATEMENTS For The Years Ending December 31 ($000) 1993 Net Sales Cost of Sales Gross Profit $125,419 97,427 1992 $101.590 80,321 21,269 1991 $111,392 87,016 24,376 27,992 Selling & Administrative Profit Sharing Plan Operating Income 17,608 1,301 9,083 18,865 17 2,387 17,838 516 6,022 Interest Expense Income Before Taxes 1,519 7,564 2,058 329 3.019 3,003 Income Tax Expense Current Deferred Net Income 942 3,134 (243) $_4.673 419 (297) $_207 $ 2,01 Source: Champion Road Machinery Company Prospectus. VIDEND CONSIDERATIONS case 22 Champion Road Machinery Hall re-visited the dividend is 201 ing well above ex 9:1994, when he was satisfied that the company had been per 11 above expections and that cash had also been well managed. In the six-monin e Champion had generated 12.3 million in cash.comnared with $43 million a ye gouvang enough cash that it could take advantage of any business Abat presented itsell. Even i Champion were to purchase the few companies l. Therefore, if a dividend were paid it would be paid out of resid- tunity that presente 2, 1994, Champion had confident that the company was x-month period ending July h $4.3 million a year earlier. Hall was its criteria, there would still be the few companies that were likely to meet ual" cash, Cash flows for future dividends exhile the company nad a target capital structure that inchided that one half debt and one-half cu he company had a target capital stru depend on economic conditions and Champion's debt policies. Saferred to add Get on it an acquisition opportunity warranted. This target capital structure con much smaller proportion of debt to total as ot debt) and Caterpillar (82 per cent debt). Shareholders' equity was $45 million as at July 4.1 total assets than other companies in the industry such as Finning (67 per Only three months earlier, Champion had concluded that a dividend did not fit with the company's goal farowth, Snarenolders, who appeared to be more concerned with canital pains, had not bought ac restock for income. Hall did not think that the nrofile of shareholders had changed dramatically si April Nevertheless, he was confident that if investors were convinced that the company was still following a strong and effective capital allocation policy and if. at the same time, there was excess cash, a dividend would be a welcomed source of income. If a dividend was declared the company had to be very certain that it could be sustained. Decreasing or eliminating a dividend without a valid reason might result in a fall in the stock price. He thought that the only acceptable reason for the elimination of a dividend would be the opportunity of a large acquisition with a price tag beyond the available cash and debt capacity of the company. The company wanted to issue equity financing only as a last resort, so as to not dilute the existing ownership Hall felt that the dividend policies of Champion's competitors would be important to shareholders. The July 1994 annualized dividend yield for the TSE 300 and the Toronto 35 was 2.34 per cent and 2.92 per cent, respectively. Over the last 40 years, the average dividend yield for the TSE 300 had been around 3.5 per cent. Caterpillar's regular cash dividend of $0.15 cach quarter translated into a dividend yield of only 0.60 per cent. Two Canadian-based heavy equipment dealers, Finning Tractor and Toromont Industries, had dividend yields of 1.12 per cent and 1.69 per cent, respectively. A final factor that Hall needed to consider was the tax implications of dividends for shareholders. Dividends and capital gains were taxed differently in the U.S. and Canada. In the United States, dividends were taxed as regular income and were subject to tax at the individual marginal tax rate, which peaked at 39.6 per cent, in 1994 for incomes over $250,000. Unlike capital gains, which were taxable at a maximum rate of 28 per cent, dividends generated an overall higher tax bill for high income investors. In contrast, Canadian tax law provided for a Dividend Tax Credit for dividends of Canadian companies and therefore, dividend income resulted in a lower tax bill than did an equivalent amount of capital gains. Exhibit 6 shows an example of these differences in tax treatment. DECISION If Hall decided to recommend a dividend, he would also need to make a recommendation on the size of a dividend. Armed with a pro forma income statement for the year ended December 31, 1994 (Exhibit 7.be sat down to consider his recommendation Case 22 Champion Road Machinery DIVIDEND AND CAPITAL GAIN INCOME TAX EFFECT Exhibit 6 272 CANADA $1,000 of Dividend Income: Gross-Up @ 125% Federal Tax @ 29% Federal Tax Credit @ 13.33% = $1,250 $363 $167 Federal Tax Payable = Provincial Tax Payable (approximately 50% of Federal Tax Payable) $196 $ 98 $1,000 of Capital Gain: Taxable Gain @ 75% = Federal Tax Payable @ 29% = Provincial Tax Payable (approximate) $750 $218 $109 UNITED STATES $1,000 of Dividend Income: Taxable @ 39.6% = $396 $1,000 of Capital Gain: Taxable @28% = $280 Case 22 Champion Road Machinery 271 Exhibit 4 ELIGIBILITY FOR INVESTMENT Eligibility of the Common Shares offered hereby for investment by purchasers to whom the following statutes apply is, in certain cases, govemed by criteria which such purchase required to establish as policies or guidelines pursuant to applicable statute (and, applicable, the regulations thereunder) and is subiect to the prudent investment standards general investment provisions provided therein: Insurance Companies Act (Canada) Trust and Loan Companies Act (Canada) Pension Benefits Standards Act (Canada) Loan and Trust Corporations Act (British Columbia) Insurance Act (Manitoba) The Trustee Act (Manitoba) Trustees Act (New Brunswick) Loan and Trust Corporations Act (Ontario) Pension Benefits Act (Ontario) Supplemental Pension Plans Act (Quebec) An Act Respecting Insurance (Quebec) An Act Respecting Trust Companies and Savings Companies (Quebec) In the opinion of Blake, Cassels & Graydon, counsel to the Company and Goodman and Cart, counsel to the Underwriters, the Common Shares offered hereby will, at the date of issue, be eligible investments without resort to the so-called "basket" provisions, but subject to certain investment provisions and restrictions pertaining generally to purchasers, for insurers under the Insurance Act (Ontario), the Insurance Act (Alberta) and the Employment Pensions Plans Act (Alberta). In the opinion of such counsel, the Common Shares if, as, and when listed on a pre- scribed stock exchange, will be qualified investments under the Income Tax Act (Canada) for trust governed by registered retirement savings plans, registered retirement income funds and deferred profit sharing plans. Source: Champion Road Machinery Company Prospectus. RBC Dominion Securities 270 Part 8 Dividend Policy Exhibit 3 BALANCE SHEETS For The Years Ending December 31 ($000) 1993 1992 Assets: Accounts Receivable Notes Receivable Inventory Prepaid Expenses $14,851 1,526 20,275 282 36,934 10,253 622 $9,640 2,132 18,145 256 30,173 9,725 128 Property, Plant and Equipment Other Assets TOTAL $40,026 $47,809 Liabilities: Bank Indebtedness Account Payable Income Tax Payable Current Portion of Long Term Debt $ 4,228 19,041 2,301 2.788 28,358 5,286 655 $ 6,032 12,395 315 3,409 22,151 6,327 898 Long-Term Debt Deferred Income Taxes Shareholders' Equity: Share Capital Retained Earnings 1,578 11.932 3,375 7.275 TOTAL $47,809 $40,026 Source: Champion Road Machinery Company Prospectus. ction of the new se, which would nding the compa- ing the quality of the product line. ufacturing begin when Champion's financi 266 Part & Dividend Policy wality of the product line. This final step would be accomplished by the introduction third quarter of 1994. The second phase, which whes 700 IV large grader which was planned for the h un Champions financial strength improved, would focus on growth through expandine nies that fit with the core business of manufa nys existing markets and by acauiring other companie equipment used for road construction and maintenance. le management of Chamnion were patient when looking for acquisitions and consequently purchase companies at very reasonable prices, Waiting for the night deal had helped the compare sed for any of its acquisitions. One stock and target requirement of a IS ner cent return on capital employe described Champion's capital allocation program as "very success . acquiring paintennen lookinghe right quisitions and, consequently, were able e company reach its Stock Exchange on additional financ- was outstanding as company would have the on processes, INITIAL PUBLIC OFFERING champion common stock dicted on the Tattorito Stock Exchange and the Montreal Stock Exch april 25, 1994, through an IPO. Management had decided that the company should secure additional mng for several reasons. Tirst management wanted to repay the Sil million in debt that was outstand April, 1994. Then, if a sufliciently attractive opportunity presented itself, the company would has Texibility to add debt. Second, because the company wanted to continue to update its production praca at would require about $3 million to fund capital expenditures planned for 1994. Third, future sales o would also require additional working capital. Prior to the IPO, there were 8.750,000 common shares outstanding, owned by 91 shareholders of company as of February 2. 1994. Almost 40 per cent of the shares were held by the directors and executive The three largest shareholders were William Walsh, Chairman; Robert Ferris, Secretary; and Arthur Chumba President and CEO, An additional 2.420.000 shares were issued at a price of $12 per share, at the time of the ry, resulting in a total of 11.170.000 common shares outstanding, Gross proceeds from the IPO warto mmon, but the company received $26.6 million after issue costs. As part of the agreement, the 91 h holders could not sell any stock for one vear after the IPO, but were able to sell 1,100,000 shares as part of the IPO. Consequently, a total of 3.520.000 shares were available to the public. The common stock issue was targeted at investors interested primarily in capital gains. The company had examined the dividend policy issue at the time of the IPO, but had determined that sufficient cash was not available to pay a cash dividend. A cash dividend did not seem to fit with the expectations of the new share- holders. Seventy per cent of the stock had been purchased by institutional investors and 30 per cent by retail investors. The institutional investors included many of the large Canadian-based money managers, such as the Caisse de dpt et placement du Qubec based in Montreal. There were approximately 1,500 retail investors, which included the more than 600 Champion employees. The Champion stock was considered to be eligible for most institutional investments, consequently, investment managers for large pools of invest- ments, such as pension funds, could purchase the stock for their portfolios. Exhibit 4 lists the acts under which Champion was eligible for investment. Ilistorically, eligibility rules required firms to pay dividends each year for a number of years (typically five to seven). More recently, most Canadian federal and provin cial legislation relating to financial institutions provided for prudent investor" standards. Rather than oper- ating under restrictions (such as earnings or dividend history) on individual stocks, the entire portfolio of stocks was judged as a group to determine whether a prudent investor would invest in such a basket of secu- rities. Some exceptions to the prudence test are also listed in Exhibit 4. It was one analyst's opinion that any acts that did not currently comply with the "prudence" standard would have adopted it by the time Champion had built up a dividend history. Since its initial listing on the Toronto Stock Exchange, the price of Champion's stock had been at its high- est point, $12.38, just four trading days after the IPO. This was also the period when trading volume was heaviest, as over 400,000 shares were traded in the stock's first seven trading days. Since then daily volume was generally below 20,000 shares per day. While the price hit a low of $9.25 on June 29, it rebounds! quickly to close at just under $12 on July 22 (see Exhibit 5). Case 22 Champlon Road Machinery 269 Exhibit 2 INCOME STATEMENTS For The Years Ending December 31 ($000) 1993 Net Sales Cost of Sales Gross Profit $125,419 97,427 1992 $101.590 80,321 21,269 1991 $111,392 87,016 24,376 27,992 Selling & Administrative Profit Sharing Plan Operating Income 17,608 1,301 9,083 18,865 17 2,387 17,838 516 6,022 Interest Expense Income Before Taxes 1,519 7,564 2,058 329 3.019 3,003 Income Tax Expense Current Deferred Net Income 942 3,134 (243) $_4.673 419 (297) $_207 $ 2,01 Source: Champion Road Machinery Company Prospectus. VIDEND CONSIDERATIONS case 22 Champion Road Machinery Hall re-visited the dividend is 201 ing well above ex 9:1994, when he was satisfied that the company had been per 11 above expections and that cash had also been well managed. In the six-monin e Champion had generated 12.3 million in cash.comnared with $43 million a ye gouvang enough cash that it could take advantage of any business Abat presented itsell. Even i Champion were to purchase the few companies l. Therefore, if a dividend were paid it would be paid out of resid- tunity that presente 2, 1994, Champion had confident that the company was x-month period ending July h $4.3 million a year earlier. Hall was its criteria, there would still be the few companies that were likely to meet ual" cash, Cash flows for future dividends exhile the company nad a target capital structure that inchided that one half debt and one-half cu he company had a target capital stru depend on economic conditions and Champion's debt policies. Saferred to add Get on it an acquisition opportunity warranted. This target capital structure con much smaller proportion of debt to total as ot debt) and Caterpillar (82 per cent debt). Shareholders' equity was $45 million as at July 4.1 total assets than other companies in the industry such as Finning (67 per Only three months earlier, Champion had concluded that a dividend did not fit with the company's goal farowth, Snarenolders, who appeared to be more concerned with canital pains, had not bought ac restock for income. Hall did not think that the nrofile of shareholders had changed dramatically si April Nevertheless, he was confident that if investors were convinced that the company was still following a strong and effective capital allocation policy and if. at the same time, there was excess cash, a dividend would be a welcomed source of income. If a dividend was declared the company had to be very certain that it could be sustained. Decreasing or eliminating a dividend without a valid reason might result in a fall in the stock price. He thought that the only acceptable reason for the elimination of a dividend would be the opportunity of a large acquisition with a price tag beyond the available cash and debt capacity of the company. The company wanted to issue equity financing only as a last resort, so as to not dilute the existing ownership Hall felt that the dividend policies of Champion's competitors would be important to shareholders. The July 1994 annualized dividend yield for the TSE 300 and the Toronto 35 was 2.34 per cent and 2.92 per cent, respectively. Over the last 40 years, the average dividend yield for the TSE 300 had been around 3.5 per cent. Caterpillar's regular cash dividend of $0.15 cach quarter translated into a dividend yield of only 0.60 per cent. Two Canadian-based heavy equipment dealers, Finning Tractor and Toromont Industries, had dividend yields of 1.12 per cent and 1.69 per cent, respectively. A final factor that Hall needed to consider was the tax implications of dividends for shareholders. Dividends and capital gains were taxed differently in the U.S. and Canada. In the United States, dividends were taxed as regular income and were subject to tax at the individual marginal tax rate, which peaked at 39.6 per cent, in 1994 for incomes over $250,000. Unlike capital gains, which were taxable at a maximum rate of 28 per cent, dividends generated an overall higher tax bill for high income investors. In contrast, Canadian tax law provided for a Dividend Tax Credit for dividends of Canadian companies and therefore, dividend income resulted in a lower tax bill than did an equivalent amount of capital gains. Exhibit 6 shows an example of these differences in tax treatment. DECISION If Hall decided to recommend a dividend, he would also need to make a recommendation on the size of a dividend. Armed with a pro forma income statement for the year ended December 31, 1994 (Exhibit 7.be sat down to consider his recommendation Case 22 Champion Road Machinery DIVIDEND AND CAPITAL GAIN INCOME TAX EFFECT Exhibit 6 272 CANADA $1,000 of Dividend Income: Gross-Up @ 125% Federal Tax @ 29% Federal Tax Credit @ 13.33% = $1,250 $363 $167 Federal Tax Payable = Provincial Tax Payable (approximately 50% of Federal Tax Payable) $196 $ 98 $1,000 of Capital Gain: Taxable Gain @ 75% = Federal Tax Payable @ 29% = Provincial Tax Payable (approximate) $750 $218 $109 UNITED STATES $1,000 of Dividend Income: Taxable @ 39.6% = $396 $1,000 of Capital Gain: Taxable @28% = $280