Heritage Corporation Case Problem

1. What combination of investments will maximize shareholder wealth?

2. What combination of investments will maximize shareholder wealth if no investments earning more than the weighted average cost of capital would be available after the initial investment decision?

3. Assume existing investment opportunities other than the acquisition can be postponed until the end of the 5-year rationing period, but no other investments with returns above the weighted average cost of capital will be available. Identify the investment choices and timing that will maximize shareholder wealth.

Repce or current equipmen Expansion of exsting products in Iroduction of new product into roduction of existing products into new Automation of existing plant & del sting products in existing markets of new product into new markets PORABUTY COS 1,000,000 of existing plant & delivery proces 500,000 500.000 500 000 500 000 SOS b. What personal At what level would you recommend for the coming year, given the investment Listing above? What is the end cutting off capital investment personal ethical dilemma here? What personal or corporate limiting factors might cause you to change your decision toward capital rationing of toward accepting all of the investments? If marketing is the only limiting factor and the investments all have an equal expected net present value, which investments would you recommend and in which order? CASE PROBLEM Heritage Corporation Harold Gray started Heritage Corporation companies that had grown more rapidly. as a one-man carpentry shop in Lansing, with high debt and high fixed costs, went Michigan, in 1892, and gradually ex- bankrupt. John credited the survival of panded to eighty employees by the time of Heritage to business skill, low fixed costs, his retirement in 1928. Gray maintained a and no debt. conservative growth pattern, rarely using John retired in 1954, turning the busi- debt and never turning to outside sources ness over to his son, Fred, who joined of equity. As a result, he handed a debt- other furniture companies in moving to free company to his son, John, on what North Carolina in 1958. This move had turned out to be the eve of the Great been under consideration since the early 1950s because labor costs in Lansing were Depression. The depression was an extremely diffi- high and the supply of prime Michigan cult time for the furniture business, al- hardwood was declining. In the following lough fine furniture was not hit as hard years, the firm benefited from the Baby the lower-priced lines. Many furniture Boom and a growing number of affluent 752 Part Five Financing Decisions and Required Return TABLE 22-3 Pro Forma Financial Statements for Heritage Corporation soles $432,731 30,499 $122.497 Current Fixed ones Tolosses 239.499 5241.25 Net operating income Interest expense Earnings before tox Income tax Net Income 27,683 .392 $19.29 Current liabilities Long term debt Deferred taxes Common stock Total liabilities & net worth $ 64,133 44 Bos 13,596 239.777 5,000 15,485 -Dividends + Depreciation Deferred to increase - Cosh low 11.453 Americans, Fred took advantage of this po- board of directors. The family memben sition to maintain a sound growth policy wanted to continue the tradition of main through the 1960s and 1970s. By the time taining little or no debt and funding of his retirement in 1980, Heritage had uity growth through retained earnings, become one of the major producers of but the family also wanted some dividend fine furniture. Furthermore, this position income. Specifically, they wanted a total had been obtained without selling outside dividend payment of $5 million a year. equity and with the addition of very little Based on the company's pro forma finan- debt. Because Heritage was privately cial statements (Table 22-3), it appeared owned, there was no clamor for dividends, that $31,453,000 would be available for in and Fred had been able to pour nearly vestment over the next year. The remain 90 percent of earnings back into the busi: ing problem was the choice of specific cap ness. The primary debt of the company ital investments. was in the form of industrial revenue bonds provided by communities as incen- PROPOSED CAPITAL tives for factory expansion. INVESTMENTS Fred's retirement marked the end of an era. There was no family member to take over the business, so the reins passed to Management was considering six capital Lynn Shelby, who had come up through investment proposals. (All dollar amounts the marketing side of the business. The in- and rates of return for these projects are after tax.) fluence of the family was hardly lost in this transition. The stock was held entirely by 1. Invest $6.4 million in an efficiency family members, who comprised the provement program at the Green plant. The effic The efficiency program was ex- ad to generate after tax cash 51,364.000 at the end of each Chapter 12 Capital Rating 753 ein lyar US. Over rities yielding 7.1 percent after tako buy 5-year US government securities yielding 9 percentar Due to uncertainty in the basis Her age generally used a 10-year planning for 10 years, a small specialty furniture Com for $13.6 million. The company. ad complement Heritage's existing roducts, and marketing could be horizon for evaluating new investments Siedled by Heritage's existing sales. However, exceptions were made in certain iration. Cash flow was expected he $2.58 million at the end of the cases, such as purchase of timber stands. It was impossible to evaluate these invest first year, and was expected to grow alment unless a longer life was considered. percent a year thereafter Heritage had a weighted average cost of Build a new mill at Bernwood. The capital of approximately 15 percent project would require 2 years for com Shelby knew that nothing could be pletion. Outlays of $5.2 million done about the board's capital rating be required immediately and another policy immediately, but uw modification $5.8 million would be required in 1 of this policy as an important objective year. Operation would begin in year Shelby decided to work under the sump Cash flows would then be $2.8 million tion that it would take 5 years to persuade at the end of each year for 10 years, the board to change its policy. Capitala with an estimated terminal value of tioning would be eliminated if the policy was changed, although the cost of capital $5 million, after tax. Invest $3 million in a new design and was not expected to change significantly development center. Operating costs for the center would then be $160,000 Case Questions at the end of each year. While im- 1. What combination of investments will proved designs were expected, there maximire shareholder wealth? was no identifiable cash flow benefit. 2. What combination of investments 5. Purchase tracts of young hardwood would maximize shareholder wealth if for $100 an acre. Maintenance costs no investments earning more than the would be $12 an acre payable at the wrichted average cost of capital would he available after the initial invest end of each year for 15 years. The hardwood could be harvested and Assume existing investment opportu- sold to produce cash flow of $3,100 an acre. Immediately after harvest, the 3 ment decision? and would have a value of $200 an acre. At least 200.000 acres of young hardwood were available in plots of almost every possible sire. Timberland Casily bought and sold at any state of maturity to provide the owners the le rate of return regardless of how nities other than the acquisition can b e postponed until the end of the 5year rationing period, but no other investments with returns above the weighted average cost of capital will be available. Identify the investment choices and timing that will maximize shareholder wealth - long it is held Repce or current equipmen Expansion of exsting products in Iroduction of new product into roduction of existing products into new Automation of existing plant & del sting products in existing markets of new product into new markets PORABUTY COS 1,000,000 of existing plant & delivery proces 500,000 500.000 500 000 500 000 SOS b. What personal At what level would you recommend for the coming year, given the investment Listing above? What is the end cutting off capital investment personal ethical dilemma here? What personal or corporate limiting factors might cause you to change your decision toward capital rationing of toward accepting all of the investments? If marketing is the only limiting factor and the investments all have an equal expected net present value, which investments would you recommend and in which order? CASE PROBLEM Heritage Corporation Harold Gray started Heritage Corporation companies that had grown more rapidly. as a one-man carpentry shop in Lansing, with high debt and high fixed costs, went Michigan, in 1892, and gradually ex- bankrupt. John credited the survival of panded to eighty employees by the time of Heritage to business skill, low fixed costs, his retirement in 1928. Gray maintained a and no debt. conservative growth pattern, rarely using John retired in 1954, turning the busi- debt and never turning to outside sources ness over to his son, Fred, who joined of equity. As a result, he handed a debt- other furniture companies in moving to free company to his son, John, on what North Carolina in 1958. This move had turned out to be the eve of the Great been under consideration since the early 1950s because labor costs in Lansing were Depression. The depression was an extremely diffi- high and the supply of prime Michigan cult time for the furniture business, al- hardwood was declining. In the following lough fine furniture was not hit as hard years, the firm benefited from the Baby the lower-priced lines. Many furniture Boom and a growing number of affluent 752 Part Five Financing Decisions and Required Return TABLE 22-3 Pro Forma Financial Statements for Heritage Corporation soles $432,731 30,499 $122.497 Current Fixed ones Tolosses 239.499 5241.25 Net operating income Interest expense Earnings before tox Income tax Net Income 27,683 .392 $19.29 Current liabilities Long term debt Deferred taxes Common stock Total liabilities & net worth $ 64,133 44 Bos 13,596 239.777 5,000 15,485 -Dividends + Depreciation Deferred to increase - Cosh low 11.453 Americans, Fred took advantage of this po- board of directors. The family memben sition to maintain a sound growth policy wanted to continue the tradition of main through the 1960s and 1970s. By the time taining little or no debt and funding of his retirement in 1980, Heritage had uity growth through retained earnings, become one of the major producers of but the family also wanted some dividend fine furniture. Furthermore, this position income. Specifically, they wanted a total had been obtained without selling outside dividend payment of $5 million a year. equity and with the addition of very little Based on the company's pro forma finan- debt. Because Heritage was privately cial statements (Table 22-3), it appeared owned, there was no clamor for dividends, that $31,453,000 would be available for in and Fred had been able to pour nearly vestment over the next year. The remain 90 percent of earnings back into the busi: ing problem was the choice of specific cap ness. The primary debt of the company ital investments. was in the form of industrial revenue bonds provided by communities as incen- PROPOSED CAPITAL tives for factory expansion. INVESTMENTS Fred's retirement marked the end of an era. There was no family member to take over the business, so the reins passed to Management was considering six capital Lynn Shelby, who had come up through investment proposals. (All dollar amounts the marketing side of the business. The in- and rates of return for these projects are after tax.) fluence of the family was hardly lost in this transition. The stock was held entirely by 1. Invest $6.4 million in an efficiency family members, who comprised the provement program at the Green plant. The effic The efficiency program was ex- ad to generate after tax cash 51,364.000 at the end of each Chapter 12 Capital Rating 753 ein lyar US. Over rities yielding 7.1 percent after tako buy 5-year US government securities yielding 9 percentar Due to uncertainty in the basis Her age generally used a 10-year planning for 10 years, a small specialty furniture Com for $13.6 million. The company. ad complement Heritage's existing roducts, and marketing could be horizon for evaluating new investments Siedled by Heritage's existing sales. However, exceptions were made in certain iration. Cash flow was expected he $2.58 million at the end of the cases, such as purchase of timber stands. It was impossible to evaluate these invest first year, and was expected to grow alment unless a longer life was considered. percent a year thereafter Heritage had a weighted average cost of Build a new mill at Bernwood. The capital of approximately 15 percent project would require 2 years for com Shelby knew that nothing could be pletion. Outlays of $5.2 million done about the board's capital rating be required immediately and another policy immediately, but uw modification $5.8 million would be required in 1 of this policy as an important objective year. Operation would begin in year Shelby decided to work under the sump Cash flows would then be $2.8 million tion that it would take 5 years to persuade at the end of each year for 10 years, the board to change its policy. Capitala with an estimated terminal value of tioning would be eliminated if the policy was changed, although the cost of capital $5 million, after tax. Invest $3 million in a new design and was not expected to change significantly development center. Operating costs for the center would then be $160,000 Case Questions at the end of each year. While im- 1. What combination of investments will proved designs were expected, there maximire shareholder wealth? was no identifiable cash flow benefit. 2. What combination of investments 5. Purchase tracts of young hardwood would maximize shareholder wealth if for $100 an acre. Maintenance costs no investments earning more than the would be $12 an acre payable at the wrichted average cost of capital would he available after the initial invest end of each year for 15 years. The hardwood could be harvested and Assume existing investment opportu- sold to produce cash flow of $3,100 an acre. Immediately after harvest, the 3 ment decision? and would have a value of $200 an acre. At least 200.000 acres of young hardwood were available in plots of almost every possible sire. Timberland Casily bought and sold at any state of maturity to provide the owners the le rate of return regardless of how nities other than the acquisition can b e postponed until the end of the 5year rationing period, but no other investments with returns above the weighted average cost of capital will be available. Identify the investment choices and timing that will maximize shareholder wealth - long it is held