The Case of Adam Co

Adam is thinking of starting his own business. He believes that his business would be a big success. He loves managing his own business, but he is afraid that he might face some limitations with funding. Therefore, he is thinking of forming a corporation (Adam Plc) and getting it listed on the stock market. Adam believes that he does not need the help of an investment banker to go ahead with the share issuance and marketing. After consultation with his friend, Abdulrahman, who is an MBA graduate, Adam decided to form a Limited liability partnership as he got convinced that this might be a better option.

In a meeting few days later, Adam was discussing the mission of the company with the rest of his partners, some of them suggested that shareholders should always be the focal point of managing any corporation. One of the partners suggested following the Johnson and Johnson mission with doing some paraphrasing.

The mission of Johnson and Johnson is

Our final responsibility is to our stockholders. When we operate according to these principles, the stockholders should realize a fair return.

One partner though was more in favour of the mission of Sainsbury which states:

Our values help us strengthen relationships with all our stakeholders, build trust, reduce operating costs, mitigate risks and attract and retain talent in a crowded marketplace.

After a lengthy discussion, the partners agreed on adopting a paraphrased version of the mission of Johnson and Johnson.

Adams business is related to exporting some textile materials from China and sell in Oman. He got price offers from some companies in China. One of them Ying Shue was able to give the lowest price. Adam questioned the quality of these materials, so he asked for a sample, he was so happy with the quality of the sample sent. When trying to investigate further, how the company is making profits with these low prices, the firm clarified that the reason behind the low prices is the use of orphan children and widows who usually accept lower wages. Being satisfied with the quality of the sample, Adam, after consulting with his partners agreed on exporting from Ying Shue company.

To finance the company, Adam plc relied on a mixture of equity and debt financing. The earnings of the firm for the past few years were as follows:

Year	2016	2017	2018	2019
Earnings	-200,000	1000,000	2000,000	10,000,000

Having made profits for the past 3 years, and since the profits for this year were much higher than the previous years, Adam is thinking that the firm needs to start paying dividends to its shareholders who are mainly family and friends. He believes that this would give a good image of the firm and indicates good performance. Another partner, Saeed, disagreed with Adam, he believes that firms should not pay dividends unless all projects with positive NPV are taken, and since the firm is still growing, this is not the case. Another partner, Mohammed, disagreed with Saeed, and supported Adam, he believes that the value of the firm is irrelevant to whether it distributes dividends or not! The firm can distribute dividends and issue shares to the public to finance its investments. Eventually, it was decided that the firm will pay OMR 0.25 as a dividend per share.

The firm is thinking of expanding into another line of business. It is considering between 3 options as follows. Knowing that the cost of capital of a competitor company is 10%.

	CF0	CF1	CF2	CF3	CF4
Project A	-10,000	1,000	3,000	4,500	6500
Project B	-12,000	7,000	7000	0	0
Project C	-8,000	2000	3000	3000	2000

Adam Co is considering a cutoff of 3 years period if the payback method is utilized.

Adam Co believes that the cost of capital that it is using to discount projects might not reflect the true risk that the firm is facing. It is thinking that it needs to calculate its own cost of capital to use it as a discount rate in investment appraisal.

The following is an extract from the financial position of the firm at 31 December 2019

Equity	OMR 000
Ordinary shares (nominal value 0.5 OMR)	4,000
Reserves	18,000
Long term liabilities
4% preference shares (nominal value OMR 1)	3,000
7% Bonds (redeemable after 6 years)	3,000
Long term bank loan	1,000

Knowing that the P/E of a competitor firm that is listed on the Muscat Securities Market is OMR 10. The last dividends paid by Adam Co were OMR 0.25 per share. The retained earnings are expected to generate a rate of returns equal to 12%.

The preference shares have an ex div market value of OMR 1.5 per share. The 7% bonds have an ex interest market value of OMR 10450 per bond. The bank loan has a variable interest rate that has averaged 4% per year in recent years. The profits are taxed at an annual rate of 20% per year.

The firm is thinking of taking over a competitor. The following information is provided about the target company:

Non-current assets	OMR 900,000
Net current assets	OMR 90,000
	OMR 990,000
Represented by:
OMR 1 ordinary shares	OMR 300,000
Reserves	OMR 490,000
6% loan notes	OMR 200,000
	OMR 990,000

You ascertain that:

1. There is a redemption penalty on the loans of OMR 5,000.
2. The non-current assets consist of land and buildings at OMR 600,000 and machinery at OMR 200,000. There is not a ready market for the machinery, so its net realizable value is OMR 90,000. The land and buildings have a market value of OMR 800,000.
3. Some of the customers will not pay and they will default on what they owe to the company. This is expected to be OMR 6000

To be able to buy the target that the firm wants to take over, the firm is on need of finance. To raise the needed funds, Adam is thinking of issuing shares to the public and get the firm listed on the exchange. Saeed, is thinking of getting the finance through increasing the debt level for the firm. He is totally against issuing new shares and getting the company listed. He believes that the firm should rely on retained earnings and debt but no public issuance of shares should be conducted. Mohammed is thinking of conducting a better working capital management to secure the funding needed.

Adam Co is thinking of opening a branch in Turkey, Adam believes that this would be a good step to the company and will increase the firms profits.

Required:

1-Do you agree with Adam to start his business in the form of a corporation? Discuss how Abdulrahman could have convinced Adam to change his decision and move to a partnership rather than a PLC. (5 marks)

2-Do you agree with the mission chosen for Adam Co? Analyze whether the firm responsibility should be solely towards its own shareholders? (5 marks)

3-Clarify what is meant by corporate social responsibility (CSR) and assess whether you believe that Adam Plc is committed to/violating CSR (7 marks).

4-Making use of the different dividend theories that you covered, link the opinions of Adam, Saeed, and Mohammed to the theories that are the base of these opinions (10 marks).

5-As an IBM graduate, you were consulted on the dividend policy that the firm should adopt. Explain what would be the dividend policy that you would recommend (5 marks).

6- As an IBM graduate, advice the firm which project it should undertake (make use of NPV and payback period). Justify your decision (with the help of calculations) and critically discuss the limitations of each method used. (All calculations need to be displayed clearly in the appendix). (25 marks)

7-Making use of the information provided, calculate: (25 marks)

7-1-the cost of equity

7-2-the cost of preferred shares

7-3-the cost of debt

7-4-the cost of loan

7-5-the WACC

7-6-Critically discuss the limitations of the WACC you calculated.

8-Calaculte, using the adjusted net asset value method, the price that the firm should pay for the target company (5 marks).

9- Comment on the capital structure of the firm. Given the current capital structure:

9-1-Do you agree that the firm should not issue shares to the public and only rely on debt? What theory of capital structure is the base of this argument? Explain your answer (4 marks).

9-2-Critically assess how would issuing more debt affect the WACC? (3 marks).

10-Assess the risk that Adam Co might face if the firm decided to make an investment in Turkey. (6 marks).