Making Long Term FM Decisions - Integrative Case

Introduction: As a special analytical group set up by ACME Iron by the firms Controller, you have been tasked to respond to the following issues raised in a meeting with the CFO.

You must look over several prospective financial strategies to aid in the successful growth of ACME Iron: 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; Real option analysis of projects

The CFO wants to test you 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 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

ACME Iron		Balance Sheet
Assets
Current assets:	2014	2015	change
Cash	500,000	600,000	100,000
Investments	1,000,000	1,025,000	25,000
Inventories	110,000,000	117,000,000	7,000,000
Accounts receivable	11,750,000	12,500,000	750,000
Pre-paid expenses	2,500,000	2,600,000	100,000
Other	0	0	-
Total current assets	125,750,000	133,725,000	7,975,000
Fixed assets:	2014	2015	change
Property and equipment	165,000,000	175,000,000	10,000,000
Leasehold improvements	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
Goodwill	75,000,000	70,000,000	(5,000,000)
Total other assets	75,000,000	70,000,000	(5,000,000)
Total assets	435,750,000	459,225,000	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	4,850,000
Other	0	0	-
Total current liabilities	145,024,000	158,802,000	13,778,000
Long-term liabilities:	2014	2015	change
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	change
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
Total owner's equity	165,726,000	170,423,000	4,697,000
Total liabilities and owner's equity	435,750,000	459,225,000	23,475,000

Income Statement

ACME Iron

December 2015

Financial Statements in '000s of U.S. Dollars

REVENUE
Gross Sales	250,000
Less: Sales Returns & Allowances	2,500
Net Sales		247,500
COST OF GOODS SOLD
Beginning Inventory	7,500
Add: Purchases	4,500
Freight-in	-
Direct Labor	75,000
Indirect Expenses	15,000
Inventory Available	102,000
Less: Ending Inventory
Cost of Goods Sold		102,000
Gross Profit (Loss)		145,500
EXPENSES
Advertising	7,500
Amortization	-
Bad Debts	5,000
Depreciation	500
Dues and Subscriptions	-
Employee Benefit Programs	18,750
Insurance	2,500
Interest	10,350
Legal & Professional Fees	100
Licenses & Fees	-
Miscellaneous	10
Office Expenses	100
Payroll Taxes	5,625
Postage	3
Rent	-
Repairs & Maintenance	5,000
Supplies	2,000
Telephone	120
Travel	1,750
Utilities	50,000
Vehicle Expenses	450
Wages	25,000
Total Expenses		134,758
Net Operating Income		10,742
OTHER INCOME
Gain (Loss) on Sale of Assets	-
Interest Income	1,000
Total Other Income		1,000
TAXES		4,697
Net Income (Loss)		7,045

Task 1

Capital Asset Pricing Model (CAPM):

You need 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.

You 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. You 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.

Task 2

In this task we are examining the current capital structure of ACME Iron and determining the WACC of the company. Assume that ACMEs 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?

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.

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

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)?

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.

Task 4

An aspect of investment analysis that you had thought about was the different outcomes that may happen when managing projects and how to adjust managements 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 you 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 has 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.
• 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.

Task 5

This leads the CFO to ask you 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.

You should determine EVA (Economic Value Added) as well as MVA (Market Value Added) concepts needed to be established for the corporation.

Use the following table as a guide:

	Shares Outstanding	Stock Price	Market Capitalization	Debt & Equity	WACC	EBIT	Net Earnings
Industry Average	25,000,000	$27.75	$693,750,000	$675,000,000	13%	$17,975,000	$15,000,000
Competitor 1	20,000,000	$35.00	$700,000,000	$695,455,000	15%	$18,255,000	$15,000,000
ACME Iron	15,000,000	$27.50	$412,500,000	$300,423,000	12*	$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.

Task 6

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%.

• What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in years 1-9?
• What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 0?
• What is the NPV of the lease relative to the purchase?
• 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)?
• Do you have a recommendation?

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.

Task 7

In your discussions with the CFO you have talked about the impact of a dividend on your companys market price and financial statements. He has asked that you to evaluate the impact of issuing a dividend.

Use the income statement and balance sheet provided to make recommendations 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 if we issue a dividend payment of $3 million ($0.20 per share times 15 million shares).

Explain your thought process and rationale for a recommended dividend strategy.

Task 8

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.

Task 9

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

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.