Page 1 FIN 610 Team Project Title: Financial Analysis Tasks Responding to the Controller Introduction: You are a financial analyst at the Stirm Windows Company. After the Monday morning staff meeting with the Controller, Sue Sims, she pulls you aside and asks you apply your analytical abilities to several high priority tasks with a team you assemble. When your team completes the 9 individual tasks given, each individual will need to assemble all the specific tasks together for a presentation to senior management which explains their contributions and individual recommendations. Review the steps below and proceed to complete each step. Review background materials that are included to help you perform each task - they are all connected and lead you to the final assignment outcome. Task 1 Weekly Management meeting in Accounting: Sue Sims (controller): I really need you to analyze Winco Construction Company and see if we should extend them credit for this project we are deciding upon. I want you to analyze their financial statements and review their financial ratios (liquidity, solvency, efficiency, profitability and market ratios). We really need to insure that this customer is worthy of credit and can pay for our services. Scenario Steps to Completion 1. You are to analyze various aspects of a customer firm and our firm; Stirm Windows Inc. and to perform various financial analysis tasks associated with the customer firm Winco Const. to ensure their financial strength is sufficient to justify several large orders received from the firm and an investment in the firm itself. Some basic statistics are needed to assess the firm's financial health, given the amount of business the two firms transact. Calculate the appropriate ratios which should include the Dupont ratio among others. Place the numbers into the following context of questions that Sue wants answered: Are these ratios sufficient enough for you to evaluate our customer? What do you conclude about the firm's financial health and any change from 2013 to 2014? Is this a firm we would feel comfortable extending significant credit to in the future? We are also looking to take a minority ownership position in Winco Const. and need a profitability analysis. Use the decomposed Dupont model to analyze the drivers (return on assets, profit margin, debt/leverage) of Winco's return on equity (ROE) for 2014 and 2014. What can you conclude about the drivers of Winco's ROE? Concept Check: Ratios are simply the relationship between two variables. Keep in mind where the numbers are coming from in the financial statements and think about how these variables relate to one another and what the result shows in general before we look at the specific company. Helpful Hint: When calculating financial ratios you need to place them in context of either; a competitor, previous year's results or to industry benchmarks. A single ratio merely shows a relationship between two variables. The financial statements are provided below: Page 2 Winco Construction Inc. 2014 Income Statement ($ in millions) Net sales Less: Cost of goods sold Less: Depreciation Earnings before interest and taxes Less: Interest paid Taxable Income Less: Taxes Net income $8,450 7,240 400 810 70 $ 740 259 $ 481 Winco Construction Inc.. 2013 and 2014 Balance Sheets ($ in millions) 2013 Cash $ 120 Accounts rec. 930 Inventory 1,480 Total $2,530 Net fixed Assets 3,150 Total assets $5,680 2014 $ 140 780 1,520 $2,440 Accounts payable Long-term debt Common stock Retained earnings 3,600 $6,040 Total liabilities & equ 2013 2014 $1,110 $1,120 840 1,210 3,200 3,000 530 710 $5,680 $6,040 Average Industry Ratios Day's sales in receivables Cash Coverage ratio Debt ratio Return on Equity Lower Quartile 60 2.0 1.00 13 Median 40 10.0 .90 14.0 Upper Quartile 30 18.0 0.80 15.0 Sue Sims, in your weekly meeting, explains a new strategy she has thought of to help offset the risk of a slump in business. She believes that having a cash buffer to working capital is very important in case of a downturn in business because it can lead to a competitive advantage when work picks up. Her presentation to you was as follows: Scenario Steps to Completion 2. Since the construction industry is notorious for having slumps in the course of business where operational cash flow is constrained, Ms. Sims has decided to put aside $15,000 a month from profits for the next five years as a safety net for recessionary periods. The money will be set aside in a separate account which pays 3.25% annual interest compounded monthly. The first $15,000 is placed in the account today. Activity: Compute how much this account will contain after 5 years. You know that the board of directors will have questions for Sue to answer and to place this in context of Sue's recommendations and potential impact to the company you should prepare answers for her based on your research and conversations with Sue. Here are some of the questions the board may ask: Isn't this money an opportunity cost to the company? Page 3 Would you recommend using company profits in this manner? Are there better options here to manage the volatility of sales? Explain and support your answers since Sue is counting on you to prepare her for this board meeting. Concept check: In every managerial decision concerning company assets we have to keep in mind the time value of money as well as unseen opportunity costs. Every action has an impact on the overall health of the business and the long-term as well as short-term cash flow needs. One option is always to do nothing. Helpful Hint: Compound interest is the interest earned on the interest you have received in the past. You cannot just multiply a dollar amount by the interest rate and then by the number of years it is invested or you will miss the compounding effect. Be careful with the number of time periods and the periodic interest rate involved with compounding. When you present your thoughts to Sue she thinks about your input and decides to invite in an investment banker to give her additional guidance. She invites you to the meeting and the investment banker presents several options. The first option is to issue bonds and the second option is to call in your outstanding bonds and obtain a loan from a bank instead. Scenario Steps to Completion 3. Option one is for Stirm to issue debt in the form of bonds to fund recessionary periods resulting in order and thus revenue shortfalls. If the company issues new bonds bearing a 6% coupon, payable semiannually and the bond matures in 8 years and has a $100,000 face value. Currently, the bond sells at par. Please compute the yield to maturity considering that there will be no change in the interest rates for the life of the bond. What happens if interest rates rise or fall during this 8 year period? Concept Check: Yield to maturity takes into account; the interest rate in relation to the price, the purchase price in relation to the par value, and the years remaining until the bond matures. Helpful Hint: The price of a bond has an inverse relationship to the interest rate. Scenario Steps to Completion 4. Another option for financing is to call in the outstanding bonds you have issued and obtain a loan with more favorable terms than the bonds you would issue. Presently, the company has a 6% coupon bond that matures in 11 years. The bond pays interest semiannually. What is the market price of a $1,000 face value bond if the current rate of interest is 12.9%? How much will it cost the company to call in 1,000 of these bonds? Is it worth pursuing this strategy if your interest rate on a loan is 13%? Concept Check: When you purchase a bond at par your present rate of interest is not changed from the rate of interest at issue of the bond. If the bond is selling at a discount that is because interest rates are Page 4 higher than when the bond was issued. If the bond is selling at a premium that is because interest rates are lower than when the bond was issued. Helpful Hint: The coupon rate of a bond never changes when calculating YTM; only market interest rates change. In your weekly meeting Sue asks you to prepare some numbers for the investor conference call right after the board meeting. You know one question potential investors will have is how much return they can expect from investing in your common stock. So you need to calculate the cost of your stock in relation to the price and expected return. Scenario Steps to Completion 5. The company's common stock is currently selling for $50 per share. The current dividend is $2.00 per share. If dividends are expected to grow at 6 percent per year, the average market return is expected to be 6% for the next several years, your stock is of average volatility for the market, and inflation is expected to be 3% which is equal to the return on government bonds then what is the firm's cost of capital for common stock and expected return for investors? Concept Check: Capital is acquired in the marketplace. For many of us it is in the form of loans; publicly traded companies have access to debt in the form of bonds and equity in the form of stocks. In any instance we are being judged as to how much of a risk is the capital at for not being recovered. Risks include (but are not limited to); inflation or the erosion of the value of my money; opportunity costs in the form of interest free government securities, compensation for the chance of not being paid back (default risk), compensation for the length of time the capital is at risk (maturity) and compensation for the ability to be able to turn the investment of capital into cash by trading it or converting the obligation (liquidity risk). Cost of Capital = Inflation Premium + Compensation for risk free rate of return + Specific Risk Premium compensations (Default risk, Liquidity Risk, Maturity Risk, Opportunity Risk,etc) Helpful Hint: We need to look at this from the market perspective of what is a fair rate of return for the investment compared to alternatives available. This is where we look at market returns versus individual returns and use the Capital Asset Pricing Model (CAPM). re = (Inflation + risk free rate) + beta (market return - risk free rate) This equation considers similar views of return as above but also factors in the required market return (r m) as well as the inflation adjusted risk free rate (rf) and a measure of the individual stock risk beta (b). So, when asking for a loan we need to think in terms of the lender and we need to communicate to them why their capital is at the lowest point of risk and that the return is adequate to cover that risk as well as be desirable compared to alternative investments. Another question that you conclude will be asked by the potential investors on the call will be about the capital structure of the company and the mix of debt and equity. You need to calculate the weighted average cost of capital (WACC). Scenario Steps to Completion 6. Calculate the company's weighted average cost of capital (WACC) under the following assumptions provided Page 5 by Sue. The company's long-term bonds currently offer a yield to maturity of 8 percent. The company's stock price is $50 per share (P0 = $50). The company recently paid a dividend of $2 per share (D0 = $2.00). The dividend is expected to grow at a constant rate of 6 percent a year (g = 6%). The company's target capital structure is 75 percent equity and 25 percent debt. The company's tax rate is 40 percent. How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC? Concept Check: 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 = (E/V) x re + (D/V) x Rd 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 of the projects we undertake to increase sales rises then our risk rises and the 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 or returns decrease 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. Meanwhile, a colleague of yours from IT needs help justifying the purchase of software for your department and asks for your help in justifying the investment. You agree to help because you know that this particular software will help you generate the information you need in your board presentation. Scenario Steps to Completion 7. The company can purchase new planning software for $3,600. The software (asset) has a two-year life, will produce a savings of $600 in the first year and $4,200 in the second year. The discount rate is 15%. Calculate the project's payback and discounted payback period assuming steady cash flows. Also calculate the project's NPV and IRR. Should the project be funded? Page 6 In light of the previous information provided, is the 15% discount rate justified. Explain your answer. Concept Check: Payback analysis is the first step in project evaluation. The calculation enables you to understand if you can simply cover the investment within a certain time period. When doing Discounted Payback analysis or NPV analysis, a discounting rate is used to reduce future cash flows to a present value. The discount rate can be determined in many ways; existing cost of capital, projected cost of capital, desired return rate, etc as long as you justify what you wish to use for discounting cash flows and are consistent in your application evaluation will be easier. Helpful Hint: IRR is discovered when you calculate an NPV where the result is zero (or as close to zero as you can get); this is an iterative process of adjusting the discount rate until you arrive at zero for an NPV. The best thing to do is first calculate NPV and see how far away from zero you are - you can then increase or decrease the discount rate until your NPV = zero. Sue has another vexing problem she has been encountering with regard to capital investments. She has competing investments and has looked at them from several different perspectives and would like your input. Scenario Steps to Completion 8. Two of the company's projects A and B have the same expected lives and initial cash outflows. However, one project's cash flows are larger in the early years, while the other project has larger cash flows in the later years. The two NPV profiles are given below: NP V A B r Which of the following statements is most correct? a. Project A has the smaller cash flows in the later years. b. Project A has the larger cash flows in the later years. c. We require information on the cost of capital in order to determine which project has larger early cash flows. d. The NPV profile graph is inconsistent with the statement made in the problem. e. None of the statements above is correct. Explain and support your position. Concept Check: NPV profile is the result of mapping the relationship between an investment's NPV and various discount rates. We begin at the r of zero on the Y axis. Helpful Hint: It may help to place some numbers on the lines beginning with known variables. Page 7 Scenario Steps to Completion 9. Sue has asked you to analyze the company's glass division which has a cost of capital equal to 10%. If the following projects are mutually exclusive, and you only have the information that is provided, which should you accept? Payback (years) IRR NPV (Millions) A 1 18% $40 B 5 20% $75 C 2 20% $35 E 5 12% $100 Justify your answer. What does the condition \"mutually exclusive\" mean? Why would the Division's cost of capital be different than the company's overall weighted cost of capital calculated in task 6? Concept Check: Every organization is faced with multiple opportunities and limited resources. Management must develop systems to logically and impartially examine these options and allocate capital and other resources for the best outcome overall so the organization can expand within the limits of their mission. Helpful Hint: Many financial models and rules are established to help managers determine best resource allocations. Just like any system, the variables or models can be manipulated to determine an outcome. There should be more than one way to analyze different opportunities and the variables used to measure efficiency need to be constantly monitored for relevancy and accuracy. 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: Is this a group project also? The final paper is not a group project it is an individual assignment. This is so you can get a grade separate from your group and you can explain the process used by your group, the lesson's learned and anything appropriate to communicate to upper management from each individuals perspective. 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. Page 8