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Making Long Term FM Decisions - Integrative Case Title: Analyzing Long Term Financial Decision Making in the Firm (Learning Demonstration 3) Initial Steps to Completion: 1. Organize your team, choose a leader, and accept accountability for being the lead analyst for one or more parts of this list of tasks. 2. Complete your draft assigned task(s) and post in a common area for review by your team members. 3. Review, comment on, and suggest changes to draft completed tasks by the team. 4. Discuss and resolve differences and come to a consensus on the best responses. 5. Organize your analysis, conclusions, and recommendations Course Deliverable: Write a report responding to the tasks assigned to your team. Clearly organize your report and effectively communicate the team's analysis, conclusions and recommendations (if appropriate) associated with each task. Provide the details supporting your analysis as attachments. You should be completing tasks along the way - do not wait until the end of the course to complete your tasks. Introduction: As a special analytical group set up by ACME Iron by the firm's Controller, you have been tasked to respond to the following issues raised in a meeting with the CFO. You and your team must look over several prospective financial strategies to aid in the successful growth of ACME Iron. You are to work over an 10 week period on several projects, detail your work as you proceed on these projects, and assemble the report for the CFO to make to the board on the items listed while you work in a team environment. Management will be looking at the team over this period on how well they self-organize and analyze the research areas which will include: Capital investment analysis CAPM - Capital Asset Pricing Model determination for the company WACC - Weighted Average Cost of Capital computations EVA - Economic Value Analysis MVA - Market Value Added Capital structure of the company Dividend policy Stock repurchase and option pricing strategy Bankruptcy risk analysis Decision Tree Creation 1 Real option analysis of projects The CFO wants to test your team out on a simple project in the first task before you get into preparing items for his board presentation in subsequent tasks and projects. He wants to see how well you perform tasks as a team as well as how accurate and thoughtful you are in your work. Details are important to him as well as good organization/presentation and communication. Financial Statements for use on Tasks Here are the financial statements you are to use in this exercise: ACME Iron Balance Sheet Assets Current assets: 2014 Cash 2015 change 500,000 600,000 1,000,000 1,025,000 110,000,000 117,000,000 11,750,000 12,500,000 750,000 2,500,000 2,600,000 100,000 0 0 Total current assets 125,750,000 133,725,000 Fixed assets: 2014 2015 Property and equipment 165,000,000 175,000,000 0 0 Equity and other investments 55,000,000 65,000,000 10,000,000 Less accumulated depreciation 15,000,000 15,500,000 500,000 Total fixed assets 235,000,000 255,500,000 20,500,000 Other assets: 2014 2015 change Investments Inventories Accounts receivable Pre-paid expenses Other Leasehold improvements 100,000 25,000 7,000,000 - 7,975,000 change 10,000,000 - Goodwill 75,000,000 70,000,000 (5,000,000) Total other assets 75,000,000 70,000,000 (5,000,000) 435,750,000 459,225,000 Total assets 2 23,475,000 Liabilities and owner's equity Current liabilities: 2014 2015 change Accounts payable 40,500,000 42,400,000 1,900,000 Accrued wages 85,000,000 90,500,000 5,500,000 Accrued compensation 10,000,000 10,855,000 855,000 Income taxes payable 4,024,000 4,697,000 673,000 current portion of LT debt 5,500,000 10,350,000 0 0 Total current liabilities 145,024,000 158,802,000 Long-term liabilities: 2014 2015 Long term debt 125,000,000 130,000,000 5,000,000 Total long-term liabilities 125,000,000 130,000,000 5,000,000 Owner's equity: 2014 2015 Common stock 122,000,000 122,000,000 - Preferred stock 16,725,000 16,725,000 - Accumulated retained earnings 27,001,000 31,698,000 4,697,000 165,726,000 170,423,000 4,697,000 435,750,000 459,225,000 Other Total owner's equity Total liabilities and owner's equity 3 4,850,000 13,778,000 change change 23,475,000 Income Statement ACME Iron December 2015 Financial Statements in '000s of U.S. Dollars Revenue Gross Sales Less: Sales Returns and Allowances Net Sales 250,000 2,500 247,500 Cost of Goods Sold Beginning Inventory Add: Purchases Freight-in Direct Labor Indirect Expenses Inventory Available Less: Ending Inventory Cost of Goods Sold 7,500 4,500 75,000 15,000 102,000 102,000 Gross Profit (Loss) 145,500 Expenses Advertising Amortization Bad Debts Depreciation Dues and Subscriptions Employee Benefit Programs Insurance Interest Legal and Professional Fees Licenses and Fees Miscellaneous Office Expense Payroll Taxes Postage Rent Repairs and Maintenance Supplies Telephone Travel Utilities Vehicle Expenses Wages Total Expenses 7,500 5,000 500 18,750 2,500 10,350 100 10 100 5,625 3 5,000 2,000 120 1,750 50,000 450 25,000 134,758 Net Operating Income 10,742 Other Income Gain (Loss) on Sale of Assets Interest Income Total Other Income 1,000 1,000 Taxes 4,697 7,045 Net Income (Loss) 4 Task 1 Reach out to team members and assign roles. You all need to contribute. Rotating responsibilities is a suggested strategy in this team environment. Capital Asset Pricing Model (CAPM): Your team needs to investigate certain items to compute the required rate of return of your company. The expected market return for the coming year is 6%, you need to find the current rates for the 10 year Treasury bond to establish a risk-free rate. Please remember to cite your source of this data and justify your reasoning for using this source or data. Your team will also need to find a rationale for estimating beta since you do not have a long history on the stock market since you are recently listed. You realize that ACME Iron is capital intensive so the beta for the company will be influenced by this point. Since ACME Iron is an iron producer its beta should be in line with similar companies. Your team will need to analyze other companies or this industry to come up with a beta calculation for ACME Iron. Please document your investigation, sources and justify your choice of beta for Acme. Concept Check: The Capital Asset Pricing Model is a model that separates market risk from individual asset risk. We look at Market risk through the lens of inflationary impact on asset returns and the opportunity cost of the risk free rate. Market risk effects all assets so we utilize Beta as a measure of the volatility of price changes in the particular asset we are analyzing versus the market of that particular asset class. Helpful Hint: Discuss strategy of finding financial resources with your team. Sources should be current and dependable. Government resources are usually the best since they are free of charges and free of bias. Now that you all are comfortable working together as a team you will be given a series of tasks to help prepare the CFO for this quarter's board meeting and investor call. The objective here is to determine if your company has the correct capital structure for the strategic initiatives the CFO wants to pursue this coming year. In this first task of this series; (Task 2) we prepare for the board meeting by first establishing the required rate of return our investors will expect given the current market conditions and our risk profile. 5 Task 2 Capital Structure and Weighted Average Cost of Capital: We must now continue to build our models to help explain our financial strategy to the analysts, shareholders and (of course) senior management. In this task we are examining the current capital structure of ACME Iron and determining the WACC of the company. Assume that ACME's tax rate is 40%. To compute the WACC you must first find the after-tax cost of debt, the cost of equity and the proportions of debt and equity in the firm. You can assume that the cost of debt before tax is 8% for the firm. Please clearly show how you derive each of these values: After-tax cost of debt = Cost of equity = Proportions of debt and equity in the firm = How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC? Any insights into the capital structure of ACME Iron? Concept Check: Capital structure for a public company consists of both debt and equity. We must take into account the ability to write off interest payments in the calculation of our cost of debt which results in an after-tax cost of debt being used in our WACC calculation. The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is computing the effect of the capital structure on expected returns by investors. WACC= S/B+S x Rs + B/B+S x RB x (1 - tc ) Where S = value of equity B = value of debt Rs = cost of equity After tax cost of debt: RB x (1 - tc ) Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk we need to remember the following items: 1. Risk is deviation from expectations. 2. We need to set expectations for our investments in relation to risk and return. Higher risk = higher return. 6 3. Capital is obtained from the marketplace in two forms; equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed. 4. We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis). 5. If cost of capital rises then our risk rises and the projects we undertake to increase sales and return to our investors is reduced. 6. If debt rises then our obligation to make payments on interest increases and profits can decrease if sales do not increase rapidly enough. 7. If risk increases our beta will increase to show the increase in risk. This will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return we must use in discounting future cash flows. Task 3 To illustrate and further support our strategic financial planning systems we need to show the CFO and management team an example of the application of the previously constructed WACC. The CFO thinks that showing management how we can validate and choose projects based on expected returns developed from the WACC will help reduce risk of our investor's capital thus lowering the required rate of return we would have to provide to those investors. If we lower our expected return we can then do more projects and grow at a faster rate. He has asked your team to evaluate the following project: Capital investment: Acme is planning construction of a new loading ramp for its single iron mill. The initial cost of the investment is $1 million. Efficiencies from the new ramp are expected to reduce costs by $100,000 for the life of the plant which is currently estimated at another 30 years. When will this project break-even on a simple cash basis and a discounted cash basis. What is the NPV of the project if Acme has an after tax cost of debt of 8% and a cost equity of 12% (they are currently funded equally by debt and equity)? Concept Check: We need to adjust cash flows to account for things like inflation, our cost of capital and opportunity costs. Simply looking at cash flow not adjusted for some of these costs will lead to taking on projects which are not really adding to the value of the organization. Helpful Hint: The first step in conducting an NPV analysis is to include all the relevant cash flows. This includes savings from taxes and any expenses directly related to the venture. We reject any project with a negative NPV. 7 Task 4 An aspect of investment analysis that you and your team had thought about was the different outcomes that may happen when managing projects and how to adjust management's expectations for return in light of the real options or probabilities that alternative scenarios may develop depending on available information. You determine the best activity for your team to explain this to the CFO and management is to use a real example from a project you are currently evaluating. The most recent example was the company decision whether to invest $50 Million in developing and implementing a new enterprise system to help manage resources and meet customer demand in the face of considerable technological and market uncertainty. There can be a good and bad result for this investment. Good Result: A good result has a probability of .5 of occurring. Here the planned cost reductions have been realized and better integration of the supply chain is possible. These benefits are leveraged by strong market demand for the firm's product. There have also been feedback benefits, the enterprise system has significantly improved perceived quality and service from the customer's point of view. Annual benefits under this scenario equal $15 million in after tax cash flow per year over the life of the system which has been estimated as 10 years. Bad Result: The system proves to be more difficult to implement and improvements in management of the supply chain are less. In addition, the growth in market demand for the product is lower. Annual benefits under this scenario are $2 million in after tax cash flow per year for the 10 years. Real Options: For these capital investments you must analyze the nature of risk in this capital investment and decide on how to adjust for that risk. You have decided to utilize an NPV analysis of the project. Now you must define project risks and utilize the concepts in real options to adjust or plan for that risk. It will be best for you to provide an option tree graphic to show the options and then provide a table with the computations showing how you would compute the value of this project. Scenario #1: Use 10% cost of capital in computations and compute the good result and poor result NPVs. Calculate the real option NPV using the results computed. 8 Scenario #2: Use a risk adjusted cost of capital against the good scenario above which can adjust for risk variables such as; experience with the focus of the project, chance of change to estimated variables (revenue, costs, timing, etc) and/or the potential change in cost of capital in the future. Compute the new NPV using a variety of risk adjusted discount rates. Justify your computations in determining how you have adjusted discount rates for risk. Discuss the outcomes from your adjustments and how you would apply them in capital expenditure justification. Concept Check: Risk in finance is deviation from expectation. We use this concept in computing beta by mathematically computing the Security Market Line (SML) for assets and then computing the deviation of the individual assets against the market. The utilization of real option analysis in project evaluation is similar to these concepts and the concept of weighted average cost of capital. Helpful Hint: Risk adjustment in project management can be achieved in several manners. In the case of real options we first need to identify the different paths our investments can take and then the probability that each event may occur. Task 5 This leads the CFO to ask you team to look at how the market value of ACME is compared to the industry and research how you can show not only this value but come up with justification for the capital investments being made. Your team discusses this and has determined EVA (Economic Value Added) as well as MVA (Market Value Added) concepts need to be established for the corporation. Use the following table as a guide: Shares Outstanding Industry Average Competitor 1 ACME Iron Stock Price 25,000,000 $ 20,000,000 $ 15,000,000 $ 27.75 $ 35.00 $ 27.50 $ Market Capitalization 693,750,000 $ 700,000,000 $ 412,500,000 $ Debt & Equity (2015) WACC 675,000,000 695,455,000 300,423,000 13% 15% 12* EBIT $ $ $ Net Earnings 17,975,000 $ 15,000,000 18,255,000 $ 15,000,000 10,742,000 $ 7,045,000 *12% here is a plug number. This will be different than the number you calculated in Task 3. Compute the P/E ratio and market capitalization for everyone. Compute the MVA and EVA for all. Compare and contrast the ratios; what do the ratios convey to the investing public? How would you present these internally and externally? Make recommendations to management from your analysis. 9 Concept Check: Market value added focuses on the market price and relation to invested capital while economic value is based on operational profitability compared to invested capital. These measures help us evaluate our organization internally and externally to help identify gaps and opportunities. Helpful Hint: Ratios, by themselves, tell us very little; it is only when they are placed in context of the market, industry or competition that they truly can be powerful. Task 6 Leasing: You are to use your critical thinking skills, collaboration techniques, creative problem solving tools and communication skills under the following scenario: Your company (Acme Iron) is considering leasing a new computer, you and your team need to perform analysis to support the decision making process. The lease lasts for 9 years. The lease calls for 10 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $70,650 to buy and would be straight-line depreciated to a zero salvage over 9 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 8%. The corporate tax rate is 30%. a) What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in years 1-9? b) What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 0? c) What is the NPV of the lease relative to the purchase? d) What would the after-tax cash flow in year 9 be if the asset had a residual value of $500 (ignoring any possible risk differences)? e) Do you have a recommendation? Concept Check: Understanding which cash flows are relevant is key to determining best financing methods or project acceptance. It helps to detail all you assumptions within the model since questions may arise years after the initial construction of the model. Helpful Hint: Creating a time-line with corresponding cash flows is usually helpful. You should also do the NPV calculations showing your formula so if anyone wishes to change the variables they will know how to proceed. 10 Task 7 In your discussions with the CFO you have talked about the impact of a dividend on your company's market price and financial statements. He has asked that you and your team evaluate the impact of issuing a dividend. Use the income statement and balance sheet provided to make recommendation for the amount of dividend (if any). How are retained earnings impacted and what does this mean for the organization? Compute the Internal Growth Rate and Sustainable Growth Rate using current (2015) financial information and then a second scenario; if we issue a dividend payment of $3 million. Explain your thought process and rationale for a recommended dividend strategy. Concept Check: Dividends are distributions of profits to your investors who placed their capital at risk for you. Theoretically every company should eventually provide a dividend distribution to their investors. Helpful Hint: Dividends are voted on every quarter by the Board of Directors for a company; the amount of the dividend or if any is paid can be decided at that time. Task 8 Share repurchase proposal: Currently, the firm has available capital (cash and net income) of approximately $5,000,000. There is a large block of stock available at $25 a share. If the firm decides to spend this amount of excess cash on a share repurchase program, how many shares of stock will be outstanding after the stock repurchase is completed? What are the benefits of repurchasing shares? How will this affect the capital structure of the company? How can this be interpreted in the marketplace? Would a dividend be better? Please discuss the pros and cons of dividends and share buybacks. Make a recommendation to management. Concept Check: There are tax ramifications which tend to get very complex; for the sake of this exercise let us disregard tax implications and effects. 11 Helpful Hint: Think about the impact on the ratios that companies usually are measured by in the marketplace. Look at these policies through the eyes of current and potential investors as well as management of ACME. Task 9 Evaluation of potential acquisition: Martin & Sons has $4.2 million in net working capital. The firm has total assets with a book value of $48.6 million and a market value of $53.4 million. They currently carry no debt on their balance sheet, sales are expected to be $45 million next year, and their tax rate is similar to ACME at 40%. Through a mixture of synergistic savings and increased market share this acquisition should add $2 million in net profit per year for the next 10 years. Acme Iron is considering buying the company for $60 million in cash. The acquisition will be recorded using the purchase accounting method. What is the amount of goodwill that Acme will record on its balance sheet as a result of this acquisition? How do you recommend the firm finance this transaction? Is there a danger that ACME could damage their finances to the point that bankruptcy is a potential? Concept Check: 5-factor model of the Altman Z-score (a for private manufacturing firms): Z-score = 0.717T1 + 0.847T2 + 3.107T3 + 0.42T4 + 0.998T5 where, T1 = Working Capital / Total Assets T2 = Retained Earnings / Total Assets T3 = Earnings Before Interest and Taxes / Total Assets T4 = Equity / Total Liabilities T5 = Sales / Total Assets Zones of Discrimination: 1.23 or less - \"Distress\" Zone from 1.23 to 2.9 - \"Grey\" Zone 2.9 or more - \"Safe\" Zone Interpretation of Altman Z-Score 12 The Z-Scores are helpful in predicting corporate defaults as well as an easy-to-calculate measure of control for financial distress status of companies in academic studies. A Z-Score above 2.6 (2.9) indicates a company to be healthy. Besides, such a company is also not likely to enter bankruptcy. However, Z-Scores ranging from 1.1-2.6 (1.23-2.9) are taken to lie in the grey area. Course Deliverable: Review the scenarios 1 through 9. Assemble a report responding to the tasks you have been given by the Controller. Structure your report so it is clear which task you are addressing. Summarize the results of each task in the body of your report and refer to the detailed supporting calculations contained in your excel work sheet. Frequently Asked Questions: How long should my paper be in terms of pages? Since this is a comprehensive report to management it should be summarized with an executive summary, contain details on each scenario analysis with supporting calculations. Expectations would be 10-12 pages including cover page, executive summary and references. You should also include an Excel sheet with all detailed calculations with each problem clearly titled and references to any templates or material from other sources. Who is the audience for my paper? This is a report which will go to your immediate supervisor and senior management in your organization. Rubric: Learning Competency Highly Proficient 90 - 100 1 Communication: Learners demonstrate ability to communicate clearly both orally and in writing. 2 Critical Thinking: Learners demonstrate ability to apply logical, step-by-step decision-making processes to formulate clear, defensible ideas and to draw ethical conclusions. 3 Quantitative Reasoning: Learners demonstrate the ability to use mathematical operations and analytical concepts and operations to address problems and to inform decisionmaking. 13 Proficient 70 - 89 Low/No Proficiency 0 - 69 4 Financial Management Knowledge: Learners will demonstrate applied understanding of financial management concepts as used in the professions. 5 Integrated Thinking and Application: Apply knowledge of accounting and financial management in an integrated way to solve problems faced by individuals and organizations. 6 Data/Information Analysis: Learners gather and analyze data and information for information sharing, problem solving, decision making and other purposes. 14