Capital Structure

You are a new associate at a well-known financial consulting firm. As part of the firms in-house training program you have just visited two client companies. Next week you will present your financial recommendations to best enhance shareholder value for each client. Recommend a financing plan for each firm and then explain why your plan is the best way to enhance shareholder value. Do not make suggestion like firing the CEO. I want purely financial recommendations.

A. Company A is a multi-divisional company in a mature industry. The company generates fairly large cash flows each year but has limited growth prospects. The long-time CEO is a very charismatic individual, but has a tendency to treat the company as his own rather than shareholders. One example of this is an acquisition he pushed the company to make that was later sold at a loss. A second example is a company plane that internal auditors complain is not used often enough to justify its cost. The CEO is 63 years old, but has not named a successor yet. He owns about 1% of the companys stock. The CEO has hired some very talented younger executives. Although this group of managers has been rewarded well with stock, they are a little frustrated that stock price has not risen very much over the past few years. As a group they own (or have in-the-money options on) about 4% of the companys shares. The company, largely because of the personal experiences of the CEO during the depression, has almost no debt. Despite having a large and growing cash and marketable securities account, the company has never distributed dividends. Employee wages are competitive within the industry, but the company gives generous benefits so total labor costs are slightly above average. Employee turnover is very low and morale is very high. Since many jobs in the company are technical in nature (e.g., machinists, etc.) low turnover is considered of high value. The board of directors, which includes two new directors, has asked your consulting firm for suggestions on how the company can create more value for shareholders.

B. Company B is a small, publicly-traded technology company. Company B is close to completing development of a new software/hardware product for schools that uses voice recognition to quickly translate a lecture into written notes that are projected onto a screen. The lecturer can then annotate the notes with a drawing pad linked to the computer projection system. The company needs about $12 million to complete development and begin production and marketing of this product. The company is profitable with one other product that generates about $500,000 in cash flow annually. For many reasons the company has been very secretive about its new product so its stock price is quite low, being based on the modest cash flows of its existing product. Company officials and outside consultants agree that it is too early to reveal the new products details given what they know of competing products. The company is reluctant to issue more stock at this low price because management is certain that the new product will be successful and stock price will rise dramatically once the product is introduced. They feel that selling stock now would be giving away the unrealized value of current shareholders, including themselves.

Current interest rates on bonds or notes for companies of this type are in the range of 8% to 10%, which would very likely exceed the companys debt service capabilities. Convertible debt would probably have a coupon rate of 3% to 5% depending on the conversion price. The higher the conversion price the higher the coupon rate. The companys tax rate is about 28%.