***THESE ARE THE 7 QUESTIONS AT THE END OF THE ARTICLE, WHICH IS ATTACHED TO THIS REQUEST***

1. Assuming that the new funds earn the same rate of return before interest and taxes as is currently earned on the firm's assets (earnings before interest and taxes/total assets), what would earnings per share be under each alternative? Assume that the new outside funds are employed during the whole year 2008, but that 2008 additions to retained earnings are not employed until 2009. Interpret your measures of earnings per share of three alternatives.

2. Calculate the debt ratio at year-end 2008 with each of the alternatives using the template provided. Assume current liabilities increase as a percentage of sales, the dividend payout ratio remains constant, and predicted sales for 2008 are $41.6 million. Note that the assumed increase in retained earnings derived from sales in 2008 differs from the amount of earnings calculated in Question 1.

3. Calculate the before-tax times-interest-earned ratio for the year 2008 for each alternative.

4. Calculate the debt service-coverage ratio for the bond, common stock, and preferred stock alternatives.2 What effect does inclusion of the "sinking fund" component of the amortization payment have on Visual Imagery's ability to meet its other fixed charges this and later years? (Note: In lieu of the sinking fund payment for the debt alternative, you should consider using common dividends for the common stock alternative and preferred dividends for the preferred stock alternative.)

5. Assume that: (a) annual fixed costs will rise to $6 million after the new capital is acquired; and (b) the ratio of variable costs to sales is 74 percent. How much must sales increase before bond financing becomes preferable to common stock in terms of EPS? How much must sales increase before preferred stock financing becomes preferable to common stock in terms of EPS? (Hint: calculate the level of sales, called break-even sales, at which EPS will be equal under the two alternatives.) What do the measures of break-even sales tell about financing choices?

6. What other factors should you consider in choosing the best financing method?

7. Discuss the pros and cons of the financing methods that Dahlgren is reviewing. Incorporate comparisons of Visual Imagery's financial position with the industry averages in your analysis, as well as your analyses from Questions 1 through 6. Which financing method should Dahlgren recommend to the board? Fully justify your recommendation.

CASE: Stocks versus Bonds Visual Imagery, Inc. In the late-1970s, the American Business Machines Corporation (ABM) developed a process for transferring holographic images to a two-dimensional plane without losing the essence of the third dimension. When viewed from a fairly narrow angle directly in front of the two-dimensional plane, the object depicted in the picture appears to be floating in space as a true three dimensional body. Commercial application of this technology was not in the mainstream of ABM's lines of business, but management considered it worth pursuing because of its potential applications. ABM spent approximately $12 million developing the technology and, in the spring of 1999, employed a Boston marketing research firm to assess the market potential for the product. To the horror and amazement of ABM, the marketing experts' conclusion was that the market segment that would be interested in such a product was virtually nonexistent. Three-dimensional photography has been around the marketplace for over 30 years, hearkening back to the days of "3-D" movies and comic books that required the viewer to wear special glasses, and most people consider it to be nothing more than a gimmick. The general response of the marketing research firm was to question the overall fiscal viability of such an undertaking. Taken aback by this unanticipated conclusion, management decided to drop the project before full-scale production began and any more costs were incurred. Eleanor Dale, the project director for this research, had more faith in the product than in the marketing research team and its conclusions. She pointed out that the survey used as a basis for their conclusions was conducted by telephone, but the emotional essence of holography is a purely visual phenomenon. Hence, it is impossible to capture the consumer's true feelings about the product without using a test instrument keyed to visual responses. She remained convinced that true three-dimensional (3-D) holographically produced photographs would one day he viewed as more than just a novelty and would he recognized as a legitimate medium for unique expression on a par with painting or regular photography. A Baltimore-based investment banking firm agreed with Dale and helped to form a syndicate of investors who put up $10 million to purchase all of ABM's rights to the holographic photography process and to establish a manufacturing facility for Visual Imagery, Inc., the new company formed to exploit the process. Table 1 Selected Information (Thousands of Dollars) Year 2007 2006 Sales $39,230 35,860 Profit After Tax $3,588 3,064 EPS $0.36 0.31 Stock Price $10.60 7.13 2005 33,210 2,558 0.26 5.20 2004 27,930 2,109 0.21 4.41 2003 21,750 1,398 0.14 3.05 2002 15,507 989 0.10 1.80 2001 12,600 798 0.08 1.50 1 Operations started in February 2001 out of a leased warehouse near Eleanor Dale's home, but it was soon obvious that much more space was needed. Holographic art may in the past have been considered to be a passing fad that struck people's fancy, as charged by Dale's detractors, but during the remainder of 2001 sales totaled $12.6 million, with a profit after tax of $798,000 (see Table 1). Furthermore, Dale's faith in the continuing viability of the concept proved to be well founded, as sales grew rapidly until 2007, when they were $39.23 million with profits of $3,588,000 (see Table 2). The price of the company's stock, which was traded over-the counter from 2001 through 2003, is currently listed at $10.60 per share, and it earned $0.36 per share in 2007. Table 2 Year Ended December 31, 2007 (Thousands of Dollars) Sales $39,230 a Cost of goods sold Gross Profit 28,970 $10,260 General and administrative expenses Earnings before interest 2,480 $ 7,780 Interest charges 1,800 Earnings before taxes $ 5,980 Taxes (40 percent effective rate) Net income Dividends Addition to retained earnings Note: a 2,392 $ 3,588 $ 897 $ 2,691 Includes depreciation of $3.96 million Not only did a strong market exist for the original line of three dimensional artwork, but quite often people would call or come by the factory to share their ideas for displaying the images or to explain their own personal vision of what would look good in the new medium. Dale thrived in this highly creative atmosphere, and it stimulated her to think of even more exotic new applications. This left very little time for her to enjoy her great success, but that actually enhanced the pleasure she obtained from it. The concept was so new and exciting that even people who understood the theory and actually worked with holography were mesmerized by the depth of field in this form of 3-D photography, and therein lay the seeds of a new product idea--the "Window to the Infinite." Until now the largest images that had been produced were fairly small, not more than 12 by 15 inches. Dale envisioned expanding this to 36 by 48 inches or more by using a newly developed concave lens surface to achieve a broader angle in which the image can be seen. The first large-size prototypes were stunning-when hung on a wall they actually looked like a window to the infinite horizon. The visual impact was overwhelming. Depending on what objects were chosen to appear in the composition, the viewer's attention was drawn to the emerging scene as if it were real and required a physical response. For example, one of the first large 3-D pictures showed a locomotive hurtling toward the viewer. This was placed at the end of a long darkened corridor and was lighted to appear as if the train were just entering a tunnel--one in which the viewer is caught. When persons who had never seen it before 2 were led into the corridor and suddenly confronted by the scene, virtually everyone exhibited a tendency to jump out of the way. Even after the brain realized it was only a picture, the realism was striking and somewhat disconcerting. To begin full-scale production of this latest addition to their product line, Visual Imagery needed approximately $10 million for the necessary asset expansion. Previously Visual Imagery had met its financial requirements through the use of retained earnings and long-term debt. Because of capital restrictions on lending to a single customer, though, Visual Imagery's primary bank, First Baltimore National, has advised the company that its present $15 million line of credit cannot be increased. Thus, it was necessary to explore other sources of capital. After researching the various possibilities, Douglas Dahigren, the financial vice-president, has decided that there are three viable alternatives available to the company: (1) sale of a longterm debt issue that would be purchased by a large Maryland-based life insurance company; (2) sale of common stock; or (3) sale of preferred stock. The terms under which these sources would be made available are as follows: 1. Common stock can he sold to net Visual Imagery $9.60 per share after underwriting costs of $1.00 per share. 2. The company can sell preferred stock with a par value of $100 that would pay an $11 annual dividend. Preferred stock would be sold to the public at par and would incur brokerage costs of $4 per share.1 3. Visual Imagery can sell $10 million of notes to the Maryland Security Life Insurance Company. The notes would be fully amortized over the next 20 years and would bear an interest rate of 11 percent. Key provisions of this loan agreement require that the company: (1) maintain a current ratio of 2.5 to 1.0; (2) pay cash dividends only out of cash generated after the loan agreement is signed; and (3) engage in no additional long-term debt financing without the agreement of the Maryland Security Life Insurance Company. The notes would be callable, but only at a 17 percent call premium on the unamortized balance. When the senior officers met to discuss these three alternatives, Valerie Hendrix, the executive vice-president, spoke in favor of the common stock financing, pointing out that, relative to other firms in the industry, the company's capital structure is already overloaded with debt (see Tables 3 and 4). Eleanor Dale, however, disagreed, observing that the company's sales and profit projections suggest that earnings will continue to increase at a substantial rate over the next several years. Indeed, if certain new developments now in the research and development stage bear fruit, the actual rate of growth would be dramatic. Based on new product development, Dale projected that earnings would be as high as $0.64 per share by 2009. Assuming the price/earnings ratio stayed at its current level, this would mean that the stock should be selling at $19.20 per share in one year. Dale opposed the selling of stock for $10.60 per share that would soon be worth $19.20 per share. Megan Vickers, the sales manager, informed Dale that a major competitor, Codak, was rumored to be planning to start production of a similar holographic photography product and to promote it heavily with an aggressive sales team and advertising program. If this is true, Visual Imagery's sales and profit margins could suffer drastically until other markets were developed and prices were stabilized. Stewart Lomax, vice-president of production, backed Hendrix's position and also indicated that the cost of start-up production for the new "Window to the Infinite" product line could be 1 The preferred stock would not be callable for five years, after which it could be called at $111 per share. 3 higher than anticipated, thus temporarily causing profits to drop below projected levels. Because there are so many uncertainties surrounding this revolutionary new product, both Lomax and Vickers recommended the common stock alternative. Table 3 Year Ended December 31, 2007 (Thousands of Dollars) Current assets Fixed assets Total assets Current liabilities (accruals and accounts payable) Long-term debt (9 percent) Common stock ($1.80 par) Retained earnings Total liabilities and net worth Table 4 $19,000 33,000 $52,000 $ 9,000 20,000 18,000 5,000 $52,000 Industry Ratios Debt/total assets Times-interest-earned Times fixed charges covered Profit after taxes/sales Profit after tax/total assets Profit after taxet worth Price/earnings 50% 8X 6X 9% 9% 14% 40X Dahlgren suggested that a compromise in the form of an issue of preferred stock might be the optimum decision. Vickers, Lomax, and Dale all thought this was worth looking into, but after the meeting, Dahlgren himself questioned the cost of such a proposal. His primary concern was that the after-tax cost of preferred stock would be substantially higher than the after-tax cost of debt, and the company would still be locked into coverage of a fixed payment. QUESTIONS 1. Assuming that the new funds earn the same rate of return before interest and taxes as is currently earned on the firm's assets (earnings before interest and taxes/total assets), what would earnings per share be under each alternative? Assume that the new outside funds are employed during the whole year 2008, but that 2008 additions to retained earnings are not employed until 2009. Interpret your measures of earnings per share of three alternatives. 2. Calculate the debt ratio at year-end 2008 with each of the alternatives using the template provided. Assume current liabilities increase as a percentage of sales, the dividend payout ratio remains constant, and predicted sales for 2008 are $41.6 million. Note that the assumed 4 increase in retained earnings derived from sales in 2008 differs from the amount of earnings calculated in Question 1. 3. Calculate the before-tax times-interest-earned ratio for the year 2008 for each alternative. 4. Calculate the debt service-coverage ratio for the bond, common stock, and preferred stock alternatives.2 What effect does inclusion of the "sinking fund" component of the amortization payment have on Visual Imagery's ability to meet its other fixed charges this and later years? (Note: In lieu of the sinking fund payment for the debt alternative, you should consider using common dividends for the common stock alternative and preferred dividends for the preferred stock alternative.) 5. Assume that: (a) annual fixed costs will rise to $6 million after the new capital is acquired; and (b) the ratio of variable costs to sales is 74 percent. How much must sales increase before bond financing becomes preferable to common stock in terms of EPS? How much must sales increase before preferred stock financing becomes preferable to common stock in terms of EPS? (Hint: calculate the level of sales, called break-even sales, at which EPS will be equal under the two alternatives.) What do your measures of break-even sales tell about financing choices? 6. What other factors should you consider in choosing the best financing method? 7. Discuss the pros and cons of the financing methods that Dahlgren is reviewing. Incorporate comparisons of Visual Imagery's financial position with the industry averages in your analysis, as well as your analyses from Questions 1 through 6. Which financing method should Dahlgren recommend to the board? Fully justify your recommendation. (END) 2 5