There were no family members to take over the business, so the reins passed to Lynn Shelby, who had come up through the marketing side of the business The influence of the family was hardly lost in the transition The stock was held entirely by family members, who comprised the bored of directors The family members wanted to continue the tradition of maintaining little or no debt and funding equity growth through retained earnings, but the family also wanted some dividend income Specifically they wanted a total dividend payment of $5 million a year Based on the companies pro forma financial statements, it appeared that $31,453,000 would be available for investment in the next year The remaining problem was the choice of specific capital investments Pro Forma Financial Statements for Heritage Corporation Sales $432,731 Current Assets $122,437 Net Operating Income 30,499 Fixed Assets 239,439 Invested Expense 2,816 Total Assets 361,876 Earnings before tax 27,683 Income Tax 8,392 Current Liabilities $64,138 Net Income $19,219 Long Term Debt 44,865 Differed Taxes 13,596 Dividends 5,000 Common Stock 239,277 Depreciation 15,485 Total Liabilities and Net worth 361,876 Deferred Tax Increase 1,677 Cash Flow 31,453 Proposed Capital Investment Management was considering six capital investment proposals (all dollar amounts and rates of return for these projects are after tax) Invest $6 4 million in efficiency improvement program at the Greenhill plant The efficiency program was expected to generate after cash tax flows of $1,364,000 at the end of each year for 10 years Buy a small, specialty furniture company for $23 6 million The company would compliment Heritage's existing products, and marketing can be handled by Heritage's existing sales organization Cash flow was expected to be $2 58 million at the end of the first year, and was expected to grow at 3 a year thereafter Build a new mill at Bernwood The project would require two years for completion Outlays of $5 2 million would be required immediately and another $5 8 million would be required in one year Operation would begin in year three Cash flows would then be $2 8 million at the end of each year for ten years, with an estimated terminal value of $5 million after tax Invest $3 million in a new design and development center Operating costs for the center would then be $460,000 at the end of each year While improved designs were expected, there was no identifiable cash flow benefit Purchase tracks of young hardwood for $400 an acre Maintenance costs would be $12 an acre, payable at the end of each year, for 15 years the hardwood could be harvested and sold to produce cash flow of $3,100 an acre Immediately after harvest, the land would have a value of $200 an acre Atleast 200,000 acres of young hardwood were available , in plots of almost every possible size Timberland is easily bought and sold at any state of maturity to provide the owners the same rate of return regardless of how long it is held Invest in 1 year U S government securities yielding 7 1 percent after tax, or buy 5 year U S government securities yielding 8 9 percent after tax Due to uncertainty in the business, Heritage generally used a 10 year planning horizon for evaluating new investments However, exceptions were made in certain cases, such as purchase of timber stands It was impossible to evaluate these investments unless a longer life was considered Heritage had a weighted average cost of capital of approximately 13 percent Shelby knew that nothing could be done about the boards capital rationing policy immediately, but saw modification of this policy as an important objective Shelby decided to work under the assumption that it would take 5 years to persuade the board to change its policies Capital rationing would be eliminated if the policy was changed, although the cost of capital was not expected to change significantly Case Questions What combination of investments will maximize shareholder wealth What combination of investments would maximize shareholder wealth if no investments earning more than the weighted average cost of capital would be available after the initial investment decision Assume existing investment opportunities other than acquisition can be postponed until the end of the 5 year rationing period, but no other investments with returns above the weighted average cost of capital would be available Identify the investment choices and timing that will maximize shareholder wealth

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There were no family members to take over the business, so the reins passed to Lynn Shelby, who had come up through the marketing side

There were no family members to take over the business, so the reins passed to Lynn Shelby, who had come up through the marketing side of the business. The influence of the family was hardly lost in the transition. The stock was held entirely by family members, who comprised the bored of directors. The family members wanted to continue the tradition of maintaining little or no debt and funding equity growth through retained earnings, but the family also wanted some dividend income. Specifically they wanted a total dividend payment of $5 million a year. Based on the companies pro forma financial statements, it appeared that $31,453,000 would be available for investment in the next year. The remaining problem was the choice of specific capital investments.

Pro Forma Financial Statements for Heritage Corporation.

Sales $432,731. Current Assets $122,437

Net Operating Income 30,499. Fixed Assets 239,439

Invested Expense 2,816. Total Assets 361,876

Earnings before tax 27,683

Income Tax 8,392. Current Liabilities $64,138

Net Income $19,219. Long Term Debt 44,865

Differed Taxes. 13,596

-Dividends 5,000 Common Stock 239,277

+Depreciation 15,485. Total Liabilities and Net-worth 361,876

+Deferred Tax Increase. 1,677

=Cash Flow 31,453

Proposed Capital Investment

Management was considering six capital investment proposals. (all dollar amounts and rates of return for these projects are after tax)

Invest $6.4 million in efficiency improvement program at the Greenhill plant. The efficiency program was expected to generate after cash tax flows of $1,364,000 at the end of each year for 10 years.
Buy a small, specialty furniture company for $23.6 million. The company would compliment Heritage's existing products, and marketing can be handled by Heritage's existing sales organization. Cash flow was expected to be $2.58 million at the end of the first year, and was expected to grow at 3% a year thereafter.
Build a new mill at Bernwood. The project would require two years for completion. Outlays of $5.2 million would be required immediately and another $5.8 million would be required in one year. Operation would begin in year three. Cash flows would then be $2.8 million at the end of each year for ten years, with an estimated terminal value of $5 million after tax.
Invest $3 million in a new design and development center. Operating costs for the center would then be $460,000 at the end of each year. While improved designs were expected, there was no identifiable cash flow benefit.
Purchase tracks of young hardwood for $400 an acre. Maintenance costs would be $12 an acre, payable at the end of each year, for 15 years. the hardwood could be harvested and sold to produce cash flow of $3,100 an acre. Immediately after harvest, the land would have a value of $200 an acre. Atleast 200,000 acres of young hardwood were available , in plots of almost every possible size. Timberland is easily bought and sold at any state of maturity to provide the owners the same rate of return regardless of how long it is held.
Invest in 1-year U.S. government securities yielding 7.1 percent after tax, or buy 5-year U.S. government securities yielding 8.9 percent after tax.

Due to uncertainty in the business, Heritage generally used a 10-year planning horizon for evaluating new investments. However, exceptions were made in certain cases, such as purchase of timber stands. It was impossible to evaluate these investments unless a longer life was considered. Heritage had a weighted average cost of capital of approximately 13 percent.

Shelby knew that nothing could be done about the boards capital rationing policy immediately, but saw modification of this policy as an important objective. Shelby decided to work under the assumption that it would take 5 years to persuade the board to change its policies. Capital rationing would be eliminated if the policy was changed, although the cost of capital was not expected to change significantly.

Case Questions

What combination of investments will maximize shareholder wealth?
What combination of investments would maximize shareholder wealth if no investments earning more than the weighted average cost of capital would be available after the initial investment decision?
Assume existing investment opportunities other than acquisition can be postponed until the end of the 5-year rationing period, but no other investments with returns above the weighted average cost of capital would be available. Identify the investment choices and timing that will maximize shareholder wealth.