see questions 3&4 last page of the case. Can we work on # 4 please?

The Rondo Company For MBAF 602--Financial Decision Making The Rondo Company is a medium size manufacturing company that manufactured copper, steel, and iron pipe. The company was founded by Bill Rondo, the current president and board chairman. Mr. Rondo owned 60% of the company's 800,000 shares of outstanding stock. The stock is actively traded on the NASDAQ exchange at the current price of $60. The company had two interesting opportunities. The first opportunity was a special contract with a long-time customer. The customer wanted to enter into a five-year agreement to have Rondo produce a new type of pipe. Sales each year would be $6,000,000 with EBIT of 1,600,000. In order to take advantage of the project, Rondo would have to invest $5,000,000 in special purpose equipment. It is unlikely that the contract would be renewed and also unlikely that the new equipment could be adapted to other production. Since the equipment was special purpose, the expected salvage value was zero. The second opportunity was the possibility of acquiring a company that made PVC pipe. This company, Poly Pipe Incorporated (Poly) was smaller than Rondo. It had been started by several previous Rondo managers to take advantage of the new poly vinyl chloride pipe making technology. Although both companies were in the pipe business, their customer base did not overlap significantly. Metal pipe and PVC pipe are used in different applications. Poly was traded on the NASDAQ pink sheets. The market was not active. Seventy percent of the stock was still owned by the three founders. The remainder of the stock was owned by several hundred stockholders; its ownership was not concentrated. In addition to these opportunities, Rondo continued its modest growth. While the company's growth rate had varied, the average for the last 10 years has been 8%; the company expects this rate to continue. They were operating near their capacity; as a practical matter growth will require incremental additions to production equipment. MBAF 602 1 of 7 Rondo, Inc. Balance Sheet December 31 Cash Accounts Receivable Inventory Total Current Assets 2005 1,175,200 7,200,000 3,300,000 11,675,200 2006 1,536,000 7,500,000 3,700,000 12,736,000 2007 1,800,000 7,800,000 4,200,000 13,800,000 Equipment Property and Plant Total Assets 15,200,000 12,800,000 39,675,200 14,700,000 12,300,000 39,736,000 14,000,000 11,800,000 39,600,000 1,200,000 2,000,000 2,700,000 5,900,000 1,800,000 2,000,000 2,800,000 6,600,000 2,000,000 2,000,000 3,000,000 7,000,000 Bank Loan 8% Mortgage Bond 10% Total Liabilities 8,000,000 4,000,000 17,900,000 6,000,000 4,000,000 16,600,000 4,000,000 4,000,000 15,000,000 Common Stock Retained Earnings Total Liabilities & Equity 7,670,000 14,105,200 39,675,200 7,670,000 15,466,000 39,736,000 7,670,000 16,930,000 39,600,000 Accounts Payable Current Portion of Bank Loan Accruals Total Current Liabilities The Current Portion of Bank Loan refers to $2,000,000 of the loan that is due in the current year. Accruals are normal accounting accruals and remain relatively stable from year to year. The Bank Loan is from the First National Bank. It is a term loan with two years remaining. The interest is at 8% compounded annually. Principle payments of $2,000,000 are due on December 31 this year, the next year, and the year after that. The Mortgage Bond is with the ABC Insurance Company. The company negotiated the bond three years ago. It is secured by the plant and pays interest at 10%, payable semiannually. Beginning in two years, the bond requires a principle payment of 266,000 per year for 15 years. The bond will be completely paid off in at its maturity, 20 years from the initiation date. Rondo, Inc. Income Statement For the Year Ending December 31 Sales Cost of Goods Sold Gross Profit SelliQg General & Admin Expenses Depreciation Earnings Before Interest & Taxes Interest Earnings Before Tax Income Tax at 40% Net Income Earnings Per Share Dividends Paid Increase in Retained Earnings 2005 33,000,000 23,100,000 9,900,000 3,648,000 1,200,000 5,052,000 1,360,000 3,692,000 1,476,800 2,215,200 2.77 1,107,600 1,107,600 2006 37,000,000 25,900,000 11,100,000 4,164,000 1,200,000 5,736,000 1,200,000 4,536,000 1,814,400 2,721,600 3.40 1,360,800 1,360,800 2007 40,000,000 28,000,000 12,000,000 4,680,000 1,400,000 5,920,000 1,040,000 4,880,000 1,952,000 2,928,000 3.66 1,464,000 1,464,000 Combined Federal and state income taxes give a tax rate of 40%. The Board of Director's policy is to maintain a 40-50% dividend payout ratio. Analysis of Rondo provided additional information. The Company's Beta is .90 The Board of Directors had established several policies. While the Board preferred that these policies were followed, they would modify the policies if it made sense for the company. The dividend payout ratio would be between 40% and 50%. The debt to total assets ratio would not be higher than 50%. The Board's intention was to maintain total debt, including current liabilities, at 50% of assets or lower. Company growth would continue in the 5% to 10% range. Growth would be measured in the increase in Earnings Per Share. The company should maintain flexibility in financial transactions. No high risk transactions should be used, nor should the company tie its hands with financial arrangements. In addition, Mr. Rondo wanted to maintain his family ownership a minimum of 30%. He did not want to be required to purchase any additional stock. Since the Rondo family counted on the dividend payments, he was adamant about continuing the dividend payments near their current per share rate. Preliminary financial review yielded additional information about the company. Average Collection Period Days to Sell Inventory Current Ratio Cash as a Percent of Sales Total Debt to Total Assets Gross Profit Margin Profit Margin Return on Assets NI/Assets Rondo Poly Pipe Incorporated Purchase Industry Average 1.85 45 Days 50Days 3% 0.5 35% 10% 9% Poly was a small company that manufactured PVC pipe. They have been in business for 10 years. Growth had been consistent at 12% per year for the last five years. Poly's products did not compete directly with Rondo's. The company's owners controlled poly shares. Management owned 80% of the stock. The employees held the remainder. The company did have a repurchase agreement for the 20% owned by employees. A price was set at the beginning of the year using an independent appraiser. The current price was $30. The manager's shares were originally purchased for costs between $2 and $3. Poly's managers wanted to sell the company. If the sale was to be a cash sale they required a premium of 50% above the current "market" price. They would be willing to sell by exchanging shares with an appropriate company. Poly Pipe Incorporated Balance Sheet For the Year Ending December 31 Cash Accounts Receivable Inventory Total Current Assets Equipment Property and Plant Total Assets 1,800,000 4,200,000 6,500,000 12,500,000 7,500,000 4,000,000 24,000,000 Accounts Payable Accruals Total Current Liabilities 3,500,000 1,500,000 5,000,000 Bank Loan 10% Total Liabilities 4,000,000 9,000,000 Common Stock Retained Earnings Total Liabilities and Equity 2,000,000 13,000,000 24,000,000 Poly Pipe Incorporated Income Statement For the Year Ending December 31 Sales Cost of Goods Sold Gross Profit Selling General & Administrative Expense Depreciation Earnings Before Interest and Taxes Interest Earnings Before Tax Income Tax at 40% Net Income Earnings Per Share Dividends Paid Market Price of One Share of Stock 25,000,000 17,500,000 7,500,000 1,783,334 1'150,000 4,566,666 400,000 4,166,666 1,666,666 2,500,000 2.50 0 30 Sources of Funds The company has investigated several sources of funding for the new project and for future needs. The following information is available for each source of funds. Terms are those required by the provider of funds. While some conditions may be negotiable, most are cast in stone. Common Stock New common stock could be issued at the current market price of $60 per share. Underwriting costs and other associated costs of this issue would be about $12 per share. Mortgage Bond The ABC Insurance Company, the company that provided the original mortgage bond, is willing to refund it. The current bond would be replaced with a new one. Conditions of the new bond would be: 1. The interest rate would be 12% 2. A total of up to $6,000,000 above the current loan would be available. 3. If Rondo purchases Poly, a maximum of $10,000,000 above the current loan would be available. 4. The loan would be secured by all assets of Rondo, including any assets acquired in the future. 5. Ten percent of the original loan would be repaid each year. The loan's term would be 10 years. Convertible Bond The XYZ Insurance Company is willing to issue a convertible bond. They want to be able to share in Rondo's success but also retain the ability to remain a creditor if the Company is not successful. Conditions of the bond would be: 1. 2. 3. 4. Up to $8,000,000 would be available The interest would be 11.5% Each $1,000 bond would be convertible into 12.5 shares of Rondo common stock Cash dividends would be restricted. Cash dividends could not be paid unless net income was 20% of the value of bonds outstanding. 5. The bond will be for 20 years. Preferred Stock The MNO Insurance Company was willing to offer up to $6,000,000 (up to $10,000,000 if Poly is acquired) in a preferred stock arrangement. In addition to the preferred stock, MNO wanted warrants to sweeten the deal. Conditions of the preferred stock would be: 1. The preferred stock would be $100 par value and carry a 12.5% dividend. The dividend would be paid quarterly. 2. The preferred stock would be cumulative. 3. If four consecutive dividends were missed, the preferred stockholders would elect 50% of the board of directors. 4. Each share of preferred stock would contain warrants that allowed the purchase of up to 10 shares of common stock within six years at $75 per share. 5. The preferred stock could be called after 15 years at $105 per share. Bank Loan The current bank loan could be extended and an additional $4,000,000 would be available. This would be a four-year loan with payments of $2,000,000 per year plus interest. Conditions would be: 1. The loan would be renegotiated with up to $8,000,000 available. 2. Payments would be $2,000,000 per year for 4 years. 3. The bank would not be able to loan additional funds to Rondo until the loan was paid down below $4,000,000. 4. The interest rate would be 11.5%. Foreign Denominated Loan A local branch of a Swiss bank is willing to lend Rondo up to 8,000,000 Swiss francs or up to 14,000,000 Swiss francs if they complete the purchase of Poly. Conditions of the loan would be: 1. 2. 3. 4. 5. The loan would be in the form of bonds with a stated interest rate of 9%. Beginning the fifth year, 10% of the bonds original value would be repaid each year. The entire issue would be repaid in 15 years. All payments will be made in Swiss francs. Expected exchange rates for the Swiss franc (quoted in Swiss francs per dollar) Year 0 1 2 3 4 5 6 7 Years 8-15 Average Rate 1.33333 1.33333 1.29000 1.25000 1.21212 1.17567 1.14286 1.10343 The frank will appreciate 1% per year As the new CFO, your assignment is to evaluate Rondo and the opportunities available to Rondo. How is Rondo doing at this point in time? What are Rondo's financing needs for the next 6 years? Include the new project in your calculations but don't include the purchase of Poly. Is the new project a good deal? Why or why not? Are funds available internally? Are there any Board of Directors policies that you would suggest be changed? Why? Evaluate the Swiss Frank loan? Which financing source should be used to finance the new project and the company's continuing growth? Justify your answer. Should Rondo purchase Poly? What should the offer be