Friendly Case Outline

Due Date: April 22, 2021

Overview

Setting is early 1988

Friendly projecting a 20% increase in sales next year and even larger increase in earnings

Over 100 companies in industry 3 dominate; of these 3, 2 are publicly traded American

Greetings and Gibson while Hallmark is privately held

Total number of firms had declined about 15% per decade over last 30+ years

All firms had to deal effectively with fixed costs

Significant capital tied up in inventory

Managing distribution costs was critical to financial success

Business was seasonal but everyday sales had increased to 50% of total industry sales

Wendy Beaumont founded Friendly in 1978

Took company public in 1979 at $3/share

Manufactures full line of cards

o 30% of revenue was Christmas sales

o 25% of revenue was Valentine sales

o Balance of revenue was everyday sales and spring holiday sales

o Customers were generally cost-conscious

Company plant located in Reading, PA

o Operating at capacity

o Handled all design, printing and packaging

o Printing could be handled by outside printers if necessary

Business was capital intensive

Line of credit currently totaled $6.25 million and was priced at 250bp above prime (currently

prime was 8.5%)

Peak ($9.0 million) borrowing need was in December and January; low point was April (50% of

peak)

Banks urging Friendly to seek additional equity capital

Questions To Be Answered

Ms. Beaumont has posed the following 3 questions to her friend and consultant, Ms. McConville:

1. Should Friendly invest in equipment to enable the company to make rather than buy its

envelopes?

2. Should Friendly acquire Creative Designs, a small Midwestern manufacturer of studio cards?

3. Should Friendly go to market to raise additional equity to relieve the pressure on its financial

position?

Additional Information Needed For Case Questions

Envelope Machine (you will construct a DCF analysis and a set of projected financials)

Currently spending $1.5 million for 100 million envelopes

Equipment would cost $500,000

New equipment would produce envelopes equal to number bought in 1987

Economic life of 8 years

Additional employees would cost $91,000

Additional warehouse space needed

Working capital would increase by $200,000

Acquisition of Creative Designs (you will construct a DCF analysis and a set of projected financials)

Acquisition would result in decrease in cost of goods sold of 5% for CD

Other expenses would decrease 10%

Revenue projected to grow 6% annually after being flat in 1988

CD had unused lines of credit

Acquisition price 11x 1987 earnings

Friendly could issue stock at $9.50 per share; total of 198,000 shares

Issuance of Additional Common Stock (you will construct a set of projected financials)

Friendly stock traded on OTC market; volume very light

Beta very difficult to compute given light trading of stock

Currently trading at $9.50 per share

Ms. Beaumont owns 55% of stock; 20% owned by employees; 25% held by public

Investor group offered to acquire 200,000 shares at $8 per share

Very unlikely Friendly could do a secondary offering given market conditions

Key Constraints

Banks have imposed two restrictions on the company:

1. Loans to A/R <= 85%

2. Liabilities to equity <= 3.00

Wendy Beaumont has imposed an additional financial restriction on the company:

3. Interest-bearing debt to equity <= 2.00

Central (Not Sole) Focus of Case

Ms. Beaumont is trying to determine how to strengthen her balance sheet. She has two options:

1. Raise additional equity through a stock placement with some west coast investors

2. Acquire a company with a stronger balance sheet/more debt capacity.

Ms. Beaumont is also trying to determine the best course of action related to the following issue:

1. Should Friendly invest in equipment to enable the company to make rather than buy its

envelopes?

How To Address The Case Issues

Think of the case as having three distinct sections: a financing analysis, an investment analysis, and a

cost of capital analysis.

The financing analysis is similar to Upstate Canning in that you are projecting financial results for

Friendly, Creative, West Coast, and Envelope Machine. You are then combining these entity financial

statements to see what combination of actions produces the best result for Ms. Beaumont. The

following steps are needed to successfully complete the financing analysis:

1. Set up the provided Friendly projected income statements and balance sheets for 1988-1990

keeping in mind the three restrictions placed on the company by the bank and Ms. Beaumont.

2. Model the standalone Creative Designs projected financial statements, reflecting the issuance of

198,000 shares of Friendly at $9.50 per share as of December 31, 1987, and incorporating the

projected changes in Creative Designs performance after the acquisition by Friendly Cards.

3. Model the standalone financial statements resulting from the issuance of 200,000 shares of

Friendly Cards stock to West Coast investors at $8.00 per share, effective December 31, 1987.

4. Decide which alternative (FC+CD, FC+WC, or FC+CD+WC) is more attractive by constructing

combined financials for the three scenarios and test the pro formas against the three

restrictions put in place by the bank and Ms. Beaumont.

5. Model the standalone financial statements for the Envelope Machine as if the EM was

purchased on December 31, 1987. Combine the EM with your recommended financing option

from item 4, again testing the pro formas against the three restrictions.

6. You will have the following tabs containing financial statements for 1985 1991. 1985 1987

are actual results (if actual results are not applicable, fill the cells with grey); 1988 1990 are

projected results.

a. FC standalone

b. CD standalone

c. WC standalone

d. EM standalone

e. FC + CD

f. FC + WC

g. FC + CD + WC

h. Scenario e, f, or g + EM (your chosen financing solution + the envelope machine)

The cost of capital analysis starts differently than what we did in Star because we cant calculate beta

due to the lack of trading information for Friendlys stock. Instead, we will calculate a proxy beta using

industry information for two competitors. Once we have the proxy beta, we can then resume a familiar

process to calculate CAPM, WACC, and then the optimal WACC. The following steps are needed to

successfully complete the cost of capital analysis:

7. You need to determine your WACC to be able to discount cash flows. It is not practical to

compute Friendlys Beta given lack of solid data. You will need to use industry data provided in

case to work through the un-levering of the industry beta and re-levering process for Friendlys

beta. Note that there is an example calculation in the Marriott case.

8. Calculate Friendlys cost of debt using data provided in case. You should include the bank loan

(given it seems to be permanent in nature) as well as any long-term debt. The company cost of

debt is a weighted average of the rates paid on the bank loan and long-term debt.

9. Work through CAPM calculation and then determine the actual WACC. This is a pre-acquisition,

pre-offering, pre-envelope machine set of data for Friendly.

10. You should then calculate WACC for FC+CD, FC+WC, FC+CD+WC, and FC+CD+EM.

11. The hurdle rate for evaluating the Creative Designs acquisition will be Friendlys current standalone

WACC because Friendly will be the entity acquiring Creative Designs.

12. The hurdle rate for evaluating the envelope machine will be the resulting WACC for Friendly

after acquiring Creative Designs and/or completing the West Coast equity offering. This is

because Friendly cannot finance the envelope machine without taking action on either Creative,

the West Coast, or both. You should find that acquiring Creative Designs is the optimal result

based on your financing analysis, projected share price, and cost of capital results.

13. After you have determined the optimal combination of actions for Friendly, calculate a new

actual WACC (FC+CD+EM).

14. You will now have calculated the following WACCs:

a. FC

b. FC + CD

c. FC + WC

d. FC + CD + WC

e. FC+CD+EM

15. Similar to Star, youll need to construct a theoretical WACC table showing WACC at various

levels of leverage (10%, 20%, , 80%) and find the optimal level of leverage (optimal capital

structure)

16. Compare Friendlys WACC and capital structure after it completes your recommended actions to

the OCS. Quantify the amount of debt it should borrow or would need to repay to reach the OCS

from your capital structure of FC + scenario b, c, or d + EM.

The investment analysis is focused on two potential actions: buying the Envelope Machine and

buying Creative Designs. You will need to project cash flows for each proposed transaction and then

discount the cash flows using the appropriate cost of capital:

17. For the Envelope Machine, you should project 8 years of cash flows. This will look very similar to

the Star Appliance projects you recently evaluated. Once you have the nominal cash flows

projected, the discount factor can be applied to calculate the net present value. I expect you will

find the project has a very attractive internal rate of return and NPV. The discount rate used will

be the WACC for FC+CD since this is the entity that would acquire the Envelope Machine.

18. For Creative Designs, you should project 10 years of cash flow. You can use the projected

financial statements as a starting point for the cash flow projections. The projected financial

statements only forecast three years, so you will need to add seven years. Remember that we

always forecast cash flows on an unlevered basis so there will be no interest expense in the

Creative Designs results. You should find that the acquisition has an acceptable internal rate of

return and NPV. The discount rate used will be the WACC for FC since this is the entity that

would acquire Creative Designs.

19. Note that the West Coast offering does not require an investment analysis since this transaction

is only a potential financing solution.

The decision matrix is focused on the key factors that Ms. Beaumont will consider in making her

decision on how to move forward. You can summarize these factors on one page:

20. Construct a decision matrix for Ms. Beaumont. For her various options and current state (FC, FC

+ CD, FC + WC, FC + CD + WC, FC + CD + EM), assess the metrics that will impact her go forward

strategy:

a. WACC (as of 12/31/1987 only)

b. EPS (1985-1990)

c. % ownership (as of 12/31/1987; will remain static through projection period)

d. Stock price (1985 1990)

e. Covenant compliance (1985 1990)

f. Working capital (current assets current liabilities; 1985 1990)

You should have the following tabs in your Excel workbook. They break down into four sections; I

suggest ordering them as Decision Matrix, Financing Analysis, Cost of Capital Analysis, and Investment

Analysis. You should also have a COVER PAGE and TABLE OF CONTENTS.

FINANCING ANALYSIS (8 pages)

g. FC actual and projected financial statements (1985-1990; no cash flow statement

needed; show covenant compliance, earnings per share)

h. CD actual and projected financial statements (1985-1990; cash flow statement for

projected years; model as if acquired by FC on 12/31/1987)

i. WC projected financial statements (1988-1990; need balance sheet as of 12/31/1987;

cash flow statement for projected years)

j. EM projected financial statements (1988-1990; need balance sheet as of 12/31/1987);

cash flow statement for projected years)

k. FC + CD actual and projected financial statements (1985-1990; cash flow statement for

projected years; show covenant compliance, EPS)

l. FC + WC actual and projected financial statements (1985-1990; cash flow statement for

projected years; show covenant compliance, EPS)

m. FC + CD + WC actual and projected financial statements (1985-1990; cash flow

statement for projected years; show covenant compliance, EPS)

n. FC + CD + EM actual and projected financial statements (1985-1990; cash flow

statement for projected years; show covenant compliance, EPS)

COST OF CAPITAL ANALYSIS (2 pages)

o. Beta calculations (unlevered industry beta; levered beta for each financing scenario

FC, FC + CD, FC + WC, FC + CD + WC, FC + scenario e, f, or g from item 6 above + EM)

p. CAPM calculations (for each financing scenario)

q. WACC calculations (for each financing scenario)

r. Optimal capital structure (table and chart), including steps to take to get from capital

structure resulting from FC + CD + EM to optimal capital structure

INVESTMENT ANALYSIS (2 pages)

s. EM cash flow projections and NPV/IRR (use WACC from FC+CD)

t. CD cash flow projections and NPV/IRR (use WACC from FC standalone)

DECISION MATRIX (1 page)

u. Decision matrix (see item 20 above; you should include a brief narrative and/or graphic

that indicates your recommendation to Wendy Beaumont). Dont assume I can

determine your recommendation just based on the data table. You should endeavor to

highlight the rationale for your recommendation.