"We've seen it happen again and again. The historic leader in a product area goes to sleep at the switch, and an upstart rival moves in on the strength of a technological development or a market change," stated Daryl Pierce, president of Environgard Corporation, to the hoard of directors. "We are continually being snipped at by smaller but faster-moving competitors. Thus, we must carry out the plant modernization immediately and begin production of our new Scrub King line." Environgard was formed in 1980 in the Chicago area, and it has dominated the air pollution scrubbing equipment market ever since with its largest single product, the SO2 Blaster, a highly effective scrubber for eliminating airborne sulfur dioxide from smokestack emissions. This scrubber was an innovation in the market, and Environgard owes a large measure of its success to the development of the technology embodied in the scrubber. A threat to Environgard's dominance of the scrubber market surfaced recently with the development of a new type of scrubber that is both cheaper to purchase and more effective against other pollutants. Several large power companies have shown a keen interest in the new system because of the more stringent Environmental Protection Agency (EPA) emission regulations that are due to take effect in the near future. Environgard observed this trend early, and it proceeded to develop and test its own improved model, the Scrub King, that should allow the company to regain its competitive edge. The board agreed with Pierce that Environgard must not hesitate and should begin plant remodeling immediately so they can start production as soon as possible. Environgard will need approximately $34 million of new capital to cover the remodeling of the existing plant, to purchase new equipment and materials, and to initiate the Scrub King marketing program. Historically, Environgard has always obtained equity funds in the form of retained earnings. Short-term debt in modest amounts had been used on occasion, but no interest-bearing short-term debt is currently outstanding. The company borrowed $16 million at 7.5 percent in 1998, and no additional long-term funds have been acquired since that date (see Tables I and 2). Thus, no effort has been made to keep the debt ratio constant. Table 1 Current asset Fixed asset Total asset Current liabilities (accruals and payables) Long-term debt (7.5 percent) Common stock ($1 par, 10 million shares outstanding) Retained earnings Total liabilities and net worth Year Ended December 31 2007 (Millions of Dollars) $ 104 160 $ 40 16 10 198 $264 $264 Sales Cost of goods sold1 Gross profit General and administrative expenses Lease payment on equipment2 Earnings before interest Interest Charges Earnings before tax Tax (40 percent, federal-plus-state marginal rate) Net income Dividends Addition to retained earning $ 254.0 188.0 $ 9.9 2.4 $ 66.0 $ 53.7 1.2 $ 52.5 21.0 $ 31.5 6.8 $ 24.7 Marcia Hellriegel, vice-president and controller, must recommend a method of financing the required $34 million to the board of directors. In discussions with the firm's investment bankers, Hellriegel has learned that the funds may be obtained by three alternative methods: 1. The company can sell common stock to net $32 per share. Since the current price of the stock is $37 per share, flotation costs of $5 per share are involved. The sale would be made through investment bankers to the general public; that is, the sale of common stock would not be through a rights offering. The possibility of a rights offering was considered, but Hellriegel agreed with the investment bankers that the firm's currently outstanding common stock is not distributed widely enough to ensure the success of such an offering. The stock is traded over-the-counter, but at some future time the company will apply for listing on the American Stock Exchange. 2. The company can privately sell 25-year, 10 percent bonds to a group of life insurance companies. The bonds would have a sinking fund calling for the retirement, by a lottery method, of 3 percent of the original amount of the bond issue each year. Covenants under the bond agreement would also stipulate that dividends be paid only out of earnings subsequent to the bond issue; that is, the retained earnings of the company at present could not be used to pay dividends on the common stock. The bond agreement would also require that the current ratio be maintained at a level of 2 to 1, and the bonds would not be callable for a period of ten years, after which the usual call premium would be invoked. No flotation costs would be incurred. 3. The third alternative available to the company is to sell 6 percent cumulative perpetual preferred stock. The issue would not be callable and would not have a sinking fund. The 1. Includes depreciation charges of $16 million. 2 Five-year lease for equipment. price of the preferred to the public would be $32 per share, the annual dividend would be $6.00 per share, and the stock would be sold to net Environgard $30 per share. In preliminary discussions with Willard Arenberg, chairman of the board and the company's major stockholder, Hellriegel learned that Arenberg favors the sale of bonds. Arenberg believes that inflation will increase in the near future as the value of the dollar falls against foreign currencies and the dollar price of imports goes up, so by borrowing now, the company will be able to repay its loans with "cheap" dollars. In addition, the chairman notes that the firm's price/earnings ratio at present is relatively low, making the sale of common stock unappealing. Finally, he notes that while his personal holdings are not sufficient to give him absolute control of the company, his shares, together with those of members of his family and the other directors, give management control of just over 50 percent of the outstanding stock. If additional shares were sold, management's absolute control would be endangered, and the company might be subjected to a takeover by one of the major conglomerates. Finally, Arenberg notes that the after-tax cost of the bonds is relatively low, and that the covenants should not prove onerous to the company. Hellriegel also discussed the financing alternatives' with Gilbert Kushner, a long-term director and chairman of Environgard's finance committee as well as president of Kushner & Company, an investment banking firm. Kushner disagrees with Arenberg and urges Hellriegel to give consideration to the common stock option. Kushner argues, first, that the company's sales have experienced some sharp downturns in the past and that similar downturns in the future would endanger the viability of the firm. As Table 3 shows, sales declined sharply on three occasions: in 2000, when the company faced a decrease in demand due to a postponement of strict EPA regulations; in 2003, when the company was involved in a long, drawn-out labor dispute; and in 2005, when a fire closed down many of the company's manufacturing facilities for a substantial part of the year. Kushner has pointed out to Hellriegel that the danger of a major strike is still present and that the economy in general is in a tenuous position, with some econ- omists predicting that if huge budget deficits are not corrected soon, the falling dollar could precipitate a severe recession. If interest rates should decrease even more as the Federal Reserve acts to stimulate the economy, now is not the time to issue debt. Table 3 Year 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 Selected Information (Millions of Dollars) Sales $254 229 136 187 136 190 175 99 155 142 Profit after Taxes $ 31.5 20.6 ( 4.1) 17.8 5.9 13.1 16.9 ( 5.9) 14.2 12.8 Dividends per Share 0.68 0.60 - 0.60 0.60 0.30 0.30 - 0.30 0.30 Earnings per Share $3.15 2.06 (0.41) 1.78 0.59 1.31 1.69 (0.59) 1.42 1.28 Price of Stock $37 36 25 33 23 25 19 24 23 22 Kushner also disagrees with Arenberg regarding the terms of the bond agreement. He observes that the dividend provision might require the company to forego paying cash dividends in any one year, and also that the combined cash drain on the firm resulting from the required payment of the interest plus the sinking fund would be very serious in the event of a severe drop in sales. He further notes that the interest rate on the bonds would be 10 percent and that the company could not call the bonds for 10 years. Kushner then points out one final factor to Hellriegel: the company's stock is currently traded over-the-counter, although the management group would like to obtain an American Stock Exchange listing. When the company made a tentative application for listing a year ago, it was denied on the grounds that: (1) a large percentage of the stock is owned by management and members of the Arenberg family, so the floating supply was not sufficient to meet American Stock Exchange requirements; and (2) the floating supply of stock does not have the broad geographic distribution required by the American Stock Exchange. Kushner emphasizes that if stock is sold through investment bankers, the distribution would be sufficiently broad, and the number of shares outstanding sufficiently large, to qualify Environ- gard Corporation for listing. Hellriegel herself wonders if the preferred stock alternative might not overcome Arenberg's objection to common stock and Kushner's objections to bonds, thus representing the best financing choice. QUESTIONS 1. Assuming that the new funds earn the same rate of return currently being earned on the firm's assets (earnings before interest and taxes/ total assets), what would earnings per share be for 2008 under each of the three financing methods? Assume that the new outside funds are employed during the whole year of 2008, the sinking fund payment for 2008 is ignored, and retained earnings for 2008 are not employed until 2009. 2. Calculate the debt ratio at year-end 2008 under each alternative method of financing. Assume that 2008 current liabilities remain at their current level and additions to retained earnings for 2008 total $24.7 million. Compare Environgard Corporation's figures with the industry averages as given in Table 4. Table 4 Industry Ratios Debt/total assets 35% Times-interest-earned 9X Fixed charge coverage 6X Profit after taxes/sales 6% Profit after tax/total assets 8% Profit after tax/net worth 12% Price/earnings 18X 3. Calculate the before-tax times-interest-earned coverage ratio for 2008 under each of the financing alternatives. Then compare Environgard Corporation's coverage ratios with the industry average. 4. Calculate the debt (or capital) service coverage ratio (the fixed charge coverage ratio including the sinking fund payment) for the bond, common stock, and preferred alternatives.3 What effect will the sinking fund covenant have on Environgard Corporation'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 after the new capital is raised, fixed operating charges are $24 million (not including depreciation of $16 million) and the ratio of variable cost to sales stays the same. How much would sales have to increase or drop before the common stock financing would be preferable to debt in terms of EPS? Ho much would sales have to increase or drop before preferred stock financing would be 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. Based on the data developed in Questions 1 through 6, discuss the pros and cons of each of the financing methods that Hellriegel is considering. How does stock exchange membership affect the decision? Which method would you recommend to the board? Fully justify your recommendation. 3 (END)