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Fundamentals of Corporate Finance

4th South African Edition


Firer, Ross, Westerfield & Jordan

Case Solutions
Case #

Input boxes in tan


Output boxes in yellow
Given data in blue
Calculations in red
Answers in green

1
2
3
4
5
6
7
8
9
10

ions
List of Mini-Cases

Chapter

Sunset Boards

S&S Air

Pop Goes the Balloon

S&S's Bond

Valuing Refresh Ltd


Crystal Electronics
SDC's Cost of Capital
Spinning Wheels' Dividend Policy
Winter Woollies
S&S's Convertible Bond

8
11
14
17
18
21

Case #1 - Cash Flows and Financial Statements at Sunset Boards


Input area:

Cost of goods sold


Cash
Depreciation
Interest expense
Selling & Administrative
Accounts payable
Fixed assets
Sales
Accounts receivable
Bank overdraft
Long-term debt
Inventory
New equity

Tax rate
Dividend percentage

2007
84,310
12,165
23,800
5,180
16,580
21,500
105,000
165,390
8,620
9,800
53,000
18,140
20%
30%

Output area:

2007 Income Statement


Sales
R
Cost of goods sold
Selling & Administrative
Depreciation
PBIT
R
Interest
PBT
R
Taxes
NPAT
R
Dividends
R
Addition to retained profits
R

165,390
84,310
16,580
23,800
40,700
5,180
35,520
7,104
28,416
8,525
19,891

2007 Income Statement


Sales
R
Cost of goods sold
Selling & Administrative
Depreciation
PBIT
R
Interest
PBT
R
Taxes
NPAT
R
Dividends
R
Addition to retained profits
R

201,600
106,450
21,640
26,900
46,610
5,930
40,680
8,136
32,544
9,763
22,781

2008
106,450
18,380
26,900
5,930
21,640
24,350
134,000
201,600
11,182
10,700
61,000
24,894
10,000

Owners equity
Long-term debt
Accounts payable
Short-term debt
Current liabilities
Total equity and liabilities

Balance sheet as of Dec. 31, 2007


59,625
Net non-current assets
53,000
Inventory
21,500
Accounts receivable
9,800
Cash
R
31,300
Current assets
R
143,925
Total assets
R

Accounts payable
Short-term debt
Current liabilities
Total equity and liabilities

Balance sheet as of Dec. 31, 2008


92,406
Net non-current assets
61,000
Inventory
24,350
Accounts receivable
10,700
Cash
R
35,050
Current assets
R
188,456
Total assets

Operating cash flow

Owners equity
Long-term debt

Capital Spending
Ending net non-current assets
- Beginning net non-current assets
+ Depreciation
Net capital spending

Change in Net Working Capital


Ending NWC
-Beginning NWC
Change in NWC

Cash Flow from Assets


Operating cash flow
- Net capital spending
-Change in NWC
Cash flow from assets

Cash Flow to Lenders


Interest paid
-Net New Borrowing
Cash flow to Lenders

Cash Flow to Shareholders


Dividends paid
-Net new equity raised
Cash flow to Shareholders

R
R

R
R

R
R

2007
57,396

134,000
105,000
26,900
55,900

19,406
7,625
11,781

65,374
55,900
11,781
(2,307)

5,930
8,000
(2,070)

9,763
10,000
(237)

1
The firm had positive earnings in an accounting
sense (NPAT > 0) and had positive cash flow from
operations. The firm invested R11 781 in new net
working capital and R55 900 in new net non-current
assets. The firm had to raise R2 307 from its
stakeholders to support this new investment. It
accomplished this by raising R10 000 in the form of
new equity and R8 000 in new long-term debt. After
paying out R9 763 in dividends to shareholders and
R5 930 in interest to lenders, R2 307 was left to
meet the firm's cash flow needs for investment.

2008
65,374

R 105,000
18,140
8,620
R 12,165
R 38,925
R 143,925

R 134,000
24,894
11,182
R 18,380
R 54,456
R 188,456

2
The expansion plans may be a little risky. The
company does have a positive cash flow, but a
large portion of the operating cash flow is already
going to capital spending. The company has had to
raise capital from lenders and shareholders for its
current operations. So, the expansion plans may
be too aggressive at this time. On the other hand,
companies do need capital to grow. Before
investing or loaning the company money, you would
want to know where the current capital spending is
going, and why the company is spending so much
in this area already.

Case #2 - Ratios and Financial Planning at S&S Air


Input area:

Sales
COGS
Other expenses
Depreciation
PBIT
Interest
PBT
Taxes (40%)
NPAT

R
R
R
R
R
R
R
R
R

128,700,000
90,700,000
15,380,000
4,200,000
18,420,000
2,315,000
16,105,000
6,442,000
9,663,000

Dividends
Add to RP

R
R

2,898,900
6,764,100

Liabilities & Equity


Shareholder Equity
Ordinary shares
R
Retained profits
R
Total Equity
R

Assets
Non-current assets R
1,000,000
41,570,000
42,570,000

Long-term debt

25,950,000

Current Liabilities
Accounts Payable
Short-term debt
Total CL
Total L&E

R
R
R
R

4,970,000
10,060,000
15,030,000
83,550,000

Growth rate
Minimum NCA purchase

20%
30,000,000

Output area:

Current ratio
Quick ratio
Cash ratio
Total asset turnover
Inventory days
Receivables days
Total debt ratio
Debt-equity ratio
Equity multiplier
Times interest earned
Cash coverage ratio
Profit margin
Return on assets
Return on equity

0.75
0.44
0.16
1.54
19.0
11.9
0.49
0.85
1.96
7.96
9.77
7.51%
11.57%
22.70%

Retention ratio
Internal growth rate
Sustainable growth rate

0.70
8.81%
18.89%

72,280,000

Current Assets
Inventory
Accounts rec.
Cash
Total CA

R
R
R
R

4,720,000
4,210,000
2,340,000
11,270,000

Total Assets

83,550,000

Tax rate

40%

Sales
COGS
Other expenses
Depreciation
PBIT
Interest
PBT
Taxes (40%)
NPAT

R
R
R
R
R
R
R
R
R

154,440,000
108,840,000
18,456,000
5,040,000
22,104,000
2,315,000
19,789,000
7,915,600
11,873,400

Dividends
Add to RP

R
R

3,562,020
8,311,380

Liabilities & Equity

Assets

Shareholder Equity
Ordinary shares
Retained profits
Total Equity

R
R
R

1,000,000
49,881,380
50,881,380

Long-term debt

25,950,000

Current Liabilities
Accounts Payable
Short-term debt
Total CL

R
R
R

5,964,000
10,060,000
16,024,000

Total L&E

92,855,380

EFN

7,404,620

EFN if minimum NCA purchase is

30,000,000

New depreciation
Reduction in NPAT
Reduction in RP

R
R
R

5,943,221
541,932
379,353

Non-current assets

86,736,000

Current Assets
Inventory
Accounts rec.
Cash
Total CA

R
R
R
R

5,664,000
5,052,000
2,808,000
13,524,000

Total Assets

100,260,000

Liabilities & Equity

Assets

Shareholder Equity
Ordinary shares
Retained profits
Total Equity

R
R
R

1,000,000
49,502,027
50,502,027

Long-term debt

25,950,000

Current Liabilities
Accounts Payable
Short-term debt
Total CL
Total L&E

R
R
R
R

5,964,000
10,060,000
16,024,000
92,476,027

EFN

23,327,973

Non-current assets

102,280,000

Current Assets
Inventory
Accounts rec.
Cash
Total CA

R
R
R
R

5,664,000
5,052,000
2,808,000
13,524,000

Total Assets

115,804,000

2 Boeing is probably not a good aspirant company. Even though both companies manufacture airplanes, S&S Air manufactures small

airplanes, while Boeing manufactures large, commercial aircraft. These are two different markets. Additionally, Boeing is heavily
involved in the defense industry, as well as Boeing Capital, which finances airplanes.

S&S is below the median industry ratios for the current and cash ratios. This implies the company has less liquidity than the industry in
general. However, both ratios are above the lower quartile, so there are companies in the industry with lower liquidity ratios than S&S
Air. The company may have more predictable cash flows, or more access to short-term borrowing. If you created an Inventory to
Current liabilities ratio, S&S Air would have a ratio that is lower than the industry median. The current ratio is below the industry
median, while the quick ratio is above the industry median. This implies that S&S Air has less inventory to current liabilities than the
industry median. S&S Air has less inventory than the industry median, but more accounts receivable than the industry since the cash
ratio is lower than the industry median.
The total asset turnover ratio and the inventory and receivables days are all better than the industry median; in fact, all three ratios are
above the upper quartile. This may mean that S&S Air is more efficient than the industry.
The financial leverage ratios are all below the industry median, but above the lower quartile. S&S Air generally has less debt than
comparable companies, but still within the normal range.
The profit margin for the company is about the same as the industry median, the ROA is slightly higher than the industry median, and
the ROE is well above the industry median. S&S Air seems to be performing well in the profitability area.
Overall, S&S Airs performance seems good, although the liquidity ratios indicate that a closer look may be needed in this area.

Case #3 - Pop Goes the Balloon


Input area:

Cost of bike
Balloon payment
Best offer after 4 years
Lease period
Interest rate

164,103
97,000
45,000
4
24%

Output area:

1 Risk: bike value may be less than balloon payment


2 Total interest paid

Present value
Interest rate per month
Number of lease payments
Future value
Monthly payment

R (164,103.00)
2%
48
R
97,000.00
R
4,127.68

Total payments
Capital repaid
Interest paid

R
R
R

198,128.69
67,103.00
131,025.69

3 Depreciation rate to balloon value

14%

4 Depreciation rate to market value

38%

5 Inflation on bikes dropped below expected level

Case #4 -Financing S&S Airs Expansion Plans With A Bond Issue


Output area:
A rule of thumb with bond provisions is to determine who
benefits by the provision. If the company benefits, the bond
will have a higher coupon rate. If the bondholders benefit,
the bond will have a lower coupon rate.
1

A bond with collateral will have a lower coupon rate.


Bondholders have the claim on the collateral, even in
bankruptcy. Collateral provides an asset that bondholders
can claim, which lowers their risk in default. The downside
of collateral is that the company generally cannot sell the
asset used as collateral, and they will generally have to
keep the asset in good working order.

2 The more senior the bond is, the lower the coupon rate.

Senior bonds get full payment in bankruptcy proceedings


before subordinated bonds receive any payment. A
potential problem may arise in that the bond covenant may
restrict the company from issuing any future bonds senior
to the current bonds.
3 A sinking fund will reduce the coupon rate because it is a

partial guarantee to bondholders. The problem with a


sinking fund is that the company must make the interim
payments into a sinking fund or face default. This means
the company must be able to generate these cash flows.
4

A provision with a specific call date and prices would


increase the coupon rate. The call provision would only be
used when it is to the companys advantage, thus the
bondholders disadvantage. The downside is the higher
coupon rate. The company benefits by being able to
refinance at a lower rate if interest rates fall significantly,
that is, enough to offset the call provision cost.

A deferred call would reduce the coupon rate relative to a


call provision with a deferred call. The bond will still have a
higher rate relative to a plain vanilla bond. The deferred
call means that the company cannot call the bond for a
specified period. This offers the bondholders protection for
this period. The disadvantage of a deferred call is that the
company cannot call the bond during the call protection
period. Interest rate could potentially fall to the point where
it would be beneficial for the company to call the bond, yet
the company is unable to do so.
6

A make whole call provision should lower the coupon rate


in comparison to a call provision with specific dates since
the make whole call repays the bondholder the present
value of the future cash flows. However, a make whole call
provision should not affect the coupon rate in comparison
to a plain vanilla bond. Since the bondholders are made
whole, they should be indifferent between a plain vanilla
bond and a make whole bond. If a bond with a make whole
provision is called, bondholders receive the market value
of the bond, which they can reinvest in another bond with
similar characteristics. If we compare this to a bond with a
specific call price, investors rarely receive the full market
value of the future cash flows.
7

A positive covenant would reduce the coupon rate. The


presence of positive covenants protects bondholders by
forcing the company to undertake actions that benefit
bondholders. Examples of positive covenants would be:
the company must maintain audited financial statements;
the company must maintain a minimum specified level of
working capital or a minimum specified current ratio; the
company must maintain any collateral in good working
order. The negative side of positive covenants is that the
company is restricted in its actions. The positive covenant
may force the company into actions in the future that it
would rather not undertake.

A negative covenant would reduce the coupon rate. The


presence of negative covenants protects bondholders from
actions by the company that would harm the bondholders.
Remember, the goal of a corporation is to maximize
shareholder wealth. This says nothing about bondholders.
Examples of negative covenants would be: the company
cannot increase dividends, or at least increase beyond a
specified level; the company cannot issue new bonds
senior to the current bond issue; the company cannot sell
any collateral. The downside of negative covenants is the
restriction of the companys actions.

ond Issue

Case #5 - Refresh Ltd


Input area:
Balance sheets R'000
Shareholders' equity
Deferred taxation
Long-term loan
Capital employed
Non-current assets
Capitalised expenses
Investment in associate
Other investments

Inventory
Accounts receivable
Cash
Current assets
Accounts payable
Provisions
Tax owing
Short-term borrowings
Current liabilities
Net current assets
Net assets

Income statements
Gross profit
Depreciation
Other expenses
Abnormal items
Profit before interest
Interest
Profit before tax
Tax
Net profit after tax
Income from associate
Dividends paid
Transfer to non-distributable reserve
Retained profit for the year

Inflation from 2010 onwards


Corporate income tax rate
Weighted average cost of capital
Surrender value of key person policies

2007
111,427
4,232
38,574
154,233

2008
108,693
4,895
28,554
142,142

2009
110,697
5,268
14,226
130,191

2010
113,623
5,569

120,919
2,006
2,712

99,135
2,438
2,856
2,712

77,551
1,625
3,706
2,712

87,968
812
4,556
2,712

34,485
43,656
204
78,345

39,182
48,895
241
88,318

42,770
52,953
332
96,055

47,502
57,984
465
105,951

37,887
1,847
3,573
6,442
49,749
28,596
154,233

41,958
2,445
2,866
6,048
53,317
35,001
142,142

45,067
2,644
3,747
51,458
44,597
130,191

49,169
2,544
4,608
26,486
82,807
23,144
119,192

2007
76,151
-22,471
-28,675
6,116
31,121
-4,335
26,786
-7,234
19,552
787
-12,500
-787
7,052

2008
83,451
-24,784
-31,211
-2,644
24,812
-7,364
17,448
-7,032
10,416
850
-14,000
-850
-3,584

2009
89,018
-25,584
-33,699

2010
94,191
-34,584
-25,419

29,735
-4,883
24,852
-8,698
16,154
850
-15,000
-850
1,154

34,188
-4,071
30,117
-10,541
19,576
850
-17,500
-850
2,076

10%
35%
20.83%
4,335

119,192

Output area:

Opening balance on tax owing


Charge for the year
Deferred tax
Closing balance
Tax effect of interest
Cash taxes paid
Opening non-current assets balance
Depreciation
Closing non-current assets balance
Capital expenditure for the year

Gross profit
Other expenses
Abnormal items
Cash taxes
NOPAT

2008
-3,573
-7,032
663
2,866
-2577
-9,653

2009
-2,866
-8,698
373
3,747
-1709
-9,153

2010
-3,747
-10,541
301
4,608
-1425
-10,804

120,919
-24,784
-99,135
-3,000

99,135
-25,584
-77,551
-4,000

77,551
-34,584
-87,968
-45,001

2008
83,451
-31,211
-2,644
-9,653
39,943

2009
89,018
-33,699
0
-9,153
46,166

2010
94,191
-25,419
0
-10,804
57,968

-3,000
-4,697
-5,239
4,071
-2,438
598
-10,705

-4,000
-3,588
-4,058
3,109
813
199
-7,525

-45,001
-4,732
-5,031
4,102
813
-100
-49,949

29,238

38,641

8,019

2009
26,467

After 2010
-5,000
48,020
487,739
2010
2010
4,546
276,480

Capital expenditure
Inventory
Receivables
Payables
Capitalised expenses
Provisions
I
FCF = NOPAT - I
WACC

20.83%

Assumed capex after 2010


Sustainable continuous cash flow after 2010
Growth model valuation of post-2010 cash flow at growth rate = inflation
PV of FCF
Total PV
Less debt
Plus cash
Plus investment in associate
Surrender value of key person policies
Value of equity

2008
24,197

331,689
-45,016
204
2,006
4,335
293,218

Case #6 - Crystal Electronics


Input Area:

Equipment
Salvage value
R&D
Marketing study

Sales(units)
Depreciation rate
Sales of old PCB
Lost sales
Price
VC
FC
Price of old PCB
Price reduction
of old PCB
VC of old PCB
Tax rate
NWC percentage
Required return
Sensivity analysis
New price
Quantity change

R20,000,000
R3,000,000
R750,000
R200,000

sunk cost
sunk cost

Year 1
70,000
50.00%
80,000
15,000

Year 2
80,000
30.00%
60,000
15,000

Year 3
100,000
20.00%

Year 4
85,000

Year 5
75,000

R250
R86
R3,000,000
R240
R20
R68
29%
20%
12%

R260
100 NOTE: Change in units per year

Output Area:

Sales
New
Lost sales
Lost rev.
Net sales

Year 1
R17,500,000
3,600,000
1,300,000
R12,600,000

Year 2
R20,000,000
3,600,000
900,000
R15,500,000

Year 3
R25,000,000

Year 4
R21,250,000

Year 5
R18,750,000

R25,000,000

R21,250,000

R18,750,000

R6,020,000
1,020,000
R5,000,000

R6,880,000
1,020,000
R5,860,000

R8,600,000

R7,310,000

R6,450,000

R8,600,000

R7,310,000

R6,450,000

Sales
VC
Fixed costs
Dep
PBT
Tax
NPAT
+Dep
OCF

R12,600,000
5,000,000
3,000,000
10,000,000
(R5,400,000)
(1,566,000)
(R3,834,000)
10,000,000
R6,166,000

R15,500,000
5,860,000
3,000,000
6,000,000
R640,000
185,600
R454,400
6,000,000
R6,454,400

R25,000,000
8,600,000
3,000,000
4,000,000
R9,400,000
2,726,000
R6,674,000
4,000,000
R10,674,000

R21,250,000
7,310,000
3,000,000
0
R10,940,000
3,172,600
R7,767,400
0
R7,767,400

R18,750,000
6,450,000
3,000,000
0
R9,300,000
2,697,000
R6,603,000
0
R6,603,000

NWC
Beg
End
NWC CF

R0
2,520,000
(R2,520,000)

R2,520,000
3,100,000
(R580,000)

R3,100,000
5,000,000
(R1,900,000)

R5,000,000
4,250,000
R750,000

R4,250,000
0
R4,250,000

Net CF

R3,646,000

R5,874,400

R8,774,000

R8,517,400

R10,853,000

Salvage
BV of equipment
Taxes
Salvage CF

R0
-870,000
R2,130,000

VC
New
Lost sales

Net CF

Payback period
PI
IRR
NPV

Time
0
1
2
3
4
5

(R20,000,000)
R3,646,000
R5,874,400
R8,774,000
R8,517,400
R12,983,000
3.200
1.348
22.80%
R6,963,417.30

Sensitivity to change in price


Sales
New
Lost sales
Lost rev.
Net sales

Year 1
R18,200,000
3,600,000
1,300,000
R13,300,000

Year 2
R20,800,000
3,600,000
900,000
R16,300,000

Year 3
R26,000,000

Year 4
R22,100,000

Year 5
R19,500,000

R26,000,000

R22,100,000

R19,500,000

R6,020,000
1,020,000
R5,000,000

R6,880,000
1,020,000
R5,860,000

R8,600,000

R7,310,000

R6,450,000

R8,600,000

R7,310,000

R6,450,000

Sales
VC
Fixed costs
Dep
PBT
Tax
NPAT
+Dep
OCF

R13,300,000
5,000,000
3,000,000
10,000,000
(R4,700,000)
(1,363,000)
(R3,337,000)
10,000,000
R6,663,000

R16,300,000
5,860,000
3,000,000
6,000,000
R1,440,000
417,600
R1,022,400
6,000,000
R7,022,400

R26,000,000
8,600,000
3,000,000
4,000,000
R10,400,000
3,016,000
R7,384,000
4,000,000
R11,384,000

R22,100,000
7,310,000
3,000,000
0
R11,790,000
3,419,100
R8,370,900
0
R8,370,900

R19,500,000
6,450,000
3,000,000
0
R10,050,000
2,914,500
R7,135,500
0
R7,135,500

NWC
Beg
End
NWC CF

R0
2,660,000
(R2,660,000)

R2,660,000
3,260,000
(R600,000)

R3,260,000
5,200,000
(R1,940,000)

R5,200,000
4,420,000
R780,000

R4,420,000
0
R4,420,000

Net CF

R4,003,000

R6,422,400

R9,444,000

R9,150,900

R11,555,500

Salvage
BV of equipment
Taxes
Salvage CF

R0
-870,000
R2,130,000

VC
New
Lost sales

Net CF

Time
0
1
2
3
4
5

NPV

(R20,000,000)
R4,003,000
R6,422,400
R9,444,000
R9,150,900
R13,685,500
R8,997,140.38

NPV/P

R203,372.31

Sensitivity to change in quantity


Sales
New
Lost sales
Lost rev.
Net sales

Year 1
R17,525,000
3,600,000
1,300,000
R12,625,000

Year 2
R20,025,000
3,600,000
900,000
R15,525,000

Year 3
R25,025,000

Year 4
R21,275,000

Year 5
R18,775,000

R25,025,000

R21,275,000

R18,775,000

R6,028,600
1,020,000
R5,008,600

R6,888,600
1,020,000
R5,868,600

R8,608,600

R7,318,600

R6,458,600

R8,608,600

R7,318,600

R6,458,600

Sales
VC
Fixed costs
Dep
PBT
Tax
NPAT
+Dep
OCF

R12,625,000
5,008,600
3,000,000
10,000,000
(R5,383,600)
(1,561,244)
(R3,822,356)
10,000,000
R6,177,644

R15,525,000
5,868,600
3,000,000
6,000,000
R656,400
190,356
R466,044
6,000,000
R6,466,044

R25,025,000
8,608,600
3,000,000
4,000,000
R9,416,400
2,730,756
R6,685,644
4,000,000
R10,685,644

R21,275,000
7,318,600
3,000,000
0
R10,956,400
3,177,356
R7,779,044
0
R7,779,044

R18,775,000
6,458,600
3,000,000
0
R9,316,400
2,701,756
R6,614,644
0
R6,614,644

NWC
Beg
End
NWC CF

R0
2,525,000
(R2,525,000)

R2,525,000
3,105,000
(R580,000)

R3,105,000
5,005,000
(R1,900,000)

R5,005,000
4,255,000
R750,000

R4,255,000
0
R4,255,000

Net CF

R3,652,644

R5,886,044

R8,785,644

R8,529,044

R10,869,644

Salvage
BV of equipment
Taxes
Salvage CF

R0
-870,000
R2,130,000

VC
New
Lost sales

Net CF

NPV
NPV/Q

Time
0
1
2
3
4
5

(R20,000,000)
R3,652,644
R5,886,044
R8,785,644
R8,529,044
R12,999,644
R7,003,764.16
R403.47

Case #7 - SDC's Cost of Capital


Input Area:

Risk-free rate
Market risk premium
Beta of SDC
Number of shares in issue
Share price
Book value of ordinary shareholders' interest
Book value of outside shareholders interest
Coupon rate on new debt
Coupon rate on existing debt
Tax rate
Book value of long-term debt
Life of existing long-term debt

10%
6%
1.5
24,000,000
R5
R 80,000,000
R 10,000,000
15%
12%
29%
R 60,000,000
10

Output Area:

Cost of equity
After-tax cost of debt
Market value of ordinary shareholders' equity
Book value of ordinary shareholders' equity
Market-to-boook value of ordinary shareholders' intere
Assuming same market-to-book value for outside
shareholders' interest:
Market value of outside shareholders interest
Market value of total shareholders interest
Market value of existing debt
Market value debt-capital ratio
Market value equity-capital ratio
WACC

19.00%
10.65%
R 120,000,000
R 80,000,000
1.5

R 15,000,000
R 135,000,000
R 50,966,216
27.4%
72.6%
16.71%

NOTES
a)
Deferred taxation
Deferred taxation has no cost, as it is an interest free loan from the
Receiver of Revenue. Although, as in the case with depreciation,
deferred taxation has an opportunity cost, it is treated like depreciation
and is not included in the calculation of the weighted average cost of
capital.
b) subsidiaries
Outside shareholders
interest
As the
are in similar lines
of business and have similar risk
and growth prospects, we assume that their cost is the same as
ordinary shares.
c)

Bank overdraft

If there is any permanent portion, it should be included. However, an


analysis of the balance sheet shows that the overdraft represents only a
very small fraction of the current assets and a small decline in current
assets would eliminate the need for the overdraft. The conclusion is
therefore that no portion of the bank overdraft is permanent and is thus
not included in the calculation of the cost of capital.

Case #8 - Spinning Wheels Ltd

Case #8 - Spinning Wheels Ltd


The dividend decision is in fact a financing decision - should the firm retain the funds (thereby increasing its
equity), or should it relinquish the funds to the shareholders. It all depends on the use the firm will make of
the retained profits. In theory retain if positive NPV projects are available.
In practice there is a strong message from the market that firms should not cut dividends, even if they give
reasons of the existence of positive NPV projects for making the cut. Although this seems illogical, it
probably results from long years of experience by shareholders, who have learned to be highly suspicious of
the information management offers to explain decisions made.
The payment of a dividend is akin to directors 'putting their money where their mouths are' in the sense that
the payment of the dividend is a statement to shareholders that the prospects of the firm are sufficiently
good to allow for the cash dividend to leave the company without seriously impairing its operating ability.
Spinning Wheels is no longer quite a start-up company, but they have been ploughing money heavily into
R&D. Investors would presumably have been told that the firm did not anticipate paying a dividend, at least
during its start-up and high growth phases. The questions therefore that might be posed are:
Has the firm reached the end of its high growth period?
Will continued investment in R&D be required?
Does the establishment of a set of test equipment mean that new investment in this area may be winding
down now?
What if the firm's growth in fact slows down in the future.
Conversely what if international expansion becomes a reality?
The bare facts of the case seem to indicate that a dividend could be considered, since:
new investment in the test laboratory will reduce in the future, reducing the need to conserve cash
profitability is on the increase, providing an increasing source of cash flow to fund both new investment as
well as a cash dividend
On the other hand what if:
The contract is broken after 8 months?
Interest rates rise rapidly, eating into operating profits?
International markets open up rapidly, requiring an injection of cash into new machinery for the factory?
An important consideration when establishing a dividend policy is the realisation that having declared a
dividend, it is very difficult to go back to a zero dividend policy, or even to cut the dividend, without raising
shareholder ire. Dividend stability is valued very highly by the investment community.
If the firm decides to pay dividends, it does need to consider the clientele effect. This concept suggests that
there are different clienteles amongst the investment community, some preferring no dividends, some low
dividends and some high dividends, relative to earnings. By changing dividend policy a firm may just land up
exchanging one clientele for another.
So what possible policies can be used?
Residual policy - leads to variable dividends and investor insecurity. Will firm's demand for new cash
investment fluctuate up and down over the years? Probably not.
Fixed proportion of profits. Also leads to fluctuating dividends if profits are variable. Are profits likely to be
variable? Yes if new product development is an important part of the firm's goals.

Fixed rand amount. Sets a base level of dividends and this can't be easily cut. However does lead to good
information transfer to investors as prospects are usually good and sustainable when dividends are raised.
Scrip dividends. Saves cash but enables firm to transmit information on size of dividend to investors.
However subject to the same issues discussed with cash dividends in terms of any dividend cuts.
On balance it seems that it is probably one year too early to consider the dividend. They should await the
finalisation of the contract (in 8 months time). Then, if no international expansion appears, and the firm
settles into a more mature mode, a dividend could be considered, starting at a low level for safety sake.
On the other hand, if management is contemplating an ongoing high level of R&D, the time to tell
shareholders is now that the current no dividend policy will continue. It will be important however to ensure
that they are given sufficient information about future plans to enable them to assess the likelihood of
positive NPV projects in the years ahead. Otherwise the share price will suffer, making it difficult for the firm
to raise new equity capital in the future.
All in all, the decision to commence paying a dividend is one that needs very careful consideration, since
once the firm steps down that road, reversal of the decision has serious consequences. Most important of all
is the need for management to be certain that they will be able to maintain a steady profit stream to support
the dividends

Case #9 - Winter Woolies Manufacturing


Input Area:
Customers paying in:
30 days
60 days
90 days
Discount for prompt payment
Labour % of expected sales
Materials % of expected sales
Office salaries
Expenses
Depreciation (per month)
Cost of loan
Loan outstanding
Life of loan (years)
Computer
Tax rate
Tax payment due in February
Tax payment due in August
Cash balance end December

30%
60%
10%
2%
25%
35%
R 30,000
R 22,000
R 5,000
16%
R 300,000
6
R 15,000
30%
R 20,000
R 23,000
R 5,000
Oct

Sales

Nov
Dec
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000

Output Area:

Seasonal production
Oct
Nov
Dec
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sales
R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000
Discounts: 2% of 30% of last month's
sales
R 1,140
R 900
R 720
R 840
R 900
R 1,200
R 1,440
R 972
Net cash received after discount
R 55,860
R 44,100
R 35,280
R 41,160
R 44,100
R 58,800
R 70,560
R 47,628
On time net payers
R 72,000 R 114,000
R 90,000
R 72,000
R 84,000
R 90,000 R 120,000 R 144,000
Late payers
R 12,000
R 19,000
R 15,000
R 12,000
R 14,000
R 15,000
R 20,000
R 24,000
Cash from receivables
R 139,860 R 177,100 R 140,280 R 125,160 R 142,100 R 163,800 R 210,560 R 215,628
Labour
Materials
Expenses
Office salaries
Cash out
Net operating cash flow
Tax due
Computer
Loan repayment
Net cash flow for the month
Opening cash balance
Available cash
Level production
Expected sales for next 8 months
Average expected monthly sales

R 37,500
R 42,000
R 22,000
R 30,000
R 131,500

R 50,000
R 49,000
R 22,000
R 30,000
R 151,000

R 60,000
R 52,500
R 22,000
R 30,000
R 164,500

R 40,500
R 70,000
R 22,000
R 30,000
R 162,500

R 30,000
R 84,000
R 22,000
R 30,000
R 166,000

R 8,360

R 28,600

R 780

-R 6,340

-R 8,900

-R 700

R 48,060

R 49,628

R 8,360
R 5,000
R 13,360

R 23,000

R 8,600
R 13,360
R 21,960

R 19,676
-R 18,896
R 21,960
R 3,064

-R 6,340
R 3,064
-R 3,276

-R 23,900
-R 3,276
-R 27,176

R 19,676
-R 20,376
-R 27,176
-R 47,552

R 48,060
-R 47,552
R 508

R 26,628
R 508
R 27,136

R 1,282,000
R 160,250
Nov
Dec
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
R 100,000 R 120,000 R 190,000 R 150,000 R 120,000 R 140,000 R 150,000 R 200,000 R 240,000 R 162,000 R 120,000

Net operating cash flow


Tax due
Computer
Loan repayment
Net cash flow for the month
Opening cash balance
Available cash

R 1,140
R 55,860
R 72,000
R 12,000
R 139,860

R 900
R 44,100
R 114,000
R 19,000
R 177,100

R 720
R 35,280
R 90,000
R 15,000
R 140,280

R 840
R 41,160
R 72,000
R 12,000
R 125,160

R 900
R 44,100
R 84,000
R 14,000
R 142,100

R 1,200
R 58,800
R 90,000
R 15,000
R 163,800

R 1,440
R 70,560
R 120,000
R 20,000
R 210,560

R 972
R 47,628
R 144,000
R 24,000
R 215,628

R 40,063
R 42,000
R 22,000
R 30,000
R 134,063

R 40,063
R 66,500
R 22,000
R 30,000
R 158,563

R 40,063
R 52,500
R 22,000
R 30,000
R 144,563

R 40,063
R 56,088
R 22,000
R 30,000
R 148,150

R 40,063
R 56,088
R 22,000
R 30,000
R 148,150

R 40,063
R 56,088
R 22,000
R 30,000
R 148,150

R 40,063
R 56,088
R 22,000
R 30,000
R 148,150

R 40,063
R 56,088
R 22,000
R 30,000
R 148,150

R 5,798

R 18,538

-R 4,283

-R 22,990

-R 6,050

R 15,650

R 62,410

R 67,478

R 20,000

R 23,000
R 15,000

R 5,798
R 5,000
R 10,798

-R 1,463
R 10,798
R 9,335

R 19,676
-R 23,959
R 9,335
-R 14,624

-R 22,990
-R 14,624
-R 37,614

-R 21,050
-R 37,614
-R 58,664

R 19,676
-R 4,026
-R 58,664
-R 62,690

R 62,410
-R 62,690
-R 280

R 44,478
-R 280
R 44,198

Thhe costs of labour change with immediate effect in January where labour costs rise from R37 500 to R40 063. Later in the year level production labour costs drop below those of
seasonal production. The model assumes level production in line with average expected sales
Cash outflows for materials will only change in March under level production, since payment terms for purchases are 60 days.

Winter Woollies Manufacturing Cash Budget


R 60,000

R 40,000

R 20,000
Cash at month end

(2)

R 35,000
R 52,500
R 22,000
R 30,000
R 139,500

R 15,000

Labour (1)
Materials (2)
Expenses
Office salaries
Cash out

(1)

R 30,000
R 66,500
R 22,000
R 30,000
R 148,500

R 20,000

Oct
Sales
Discounts: 2% of 30% of last month's
sales
Net cash received after discount
On time net payers
Late payers
Cash from receivables

R 37,500
R 42,000
R 22,000
R 30,000
R 131,500

R0

-R 20,000

-R 40,000

-R 60,000

-R 80,000
Jan

Feb

Mar

Apr
Level

May
Seasonal

Jun

Jul

Aug

The net result, as we see from the graph, is that a higher overdraft level from March through July will be needed if the production process is changed from seasonal to level. What the firm needs to establish is whether
the increased financing costs (note that level production will result in a build up of inventories) can be offset by any savings in labour costs as a result of not having to hire and fire workers with the season. These
potential savings are not discussed in the case.

Case #10 - S&S Air's Convertible Bond


Input area:

Industry PE
Company EPS
Conversion price (stock)
Maturity (years)
Convertible bond coupon
Conversion value of bond
Plain vanilla coupon

R
R

12.5
1.60
25.00
20
6%
800
10%

Output area:

1 Share price

R20.00

Intrinsic bond value

R656.82

Floor value

R800.00

Conversion ratio
Conversion premium

32.00
25.00%

Chris is suggesting a conversion price of R25 because it means the share price will have
increase before the bondholders can benefit from the conversion, in this case 25 per cent
though the company is not publicly traded, the conversion price is important. First, the com
go public in the future. The case does discuss whether the company has plans to go publi
so, how soon it might go public. If the company does go public, the bondholders will have
market for the shares if they convert. Second, even if the company does not go public, the
bondholders could potentially have an equity interest in the company. This equity interest
sold to the original owners, or someone else. The potential problem with private equity is t
market is not as liquid as the market for a public company. This illiquidity lowers the value
shares.

The floor value of the bond is R800. This means that if the company offered bonds with th
coupon rate and no conversion feature, they would be able to sell them for 656,82. Howev
the conversion feature the price will be R800. In essence, the company is receiving R143,
conversion feature.

Thandi's argument is wrong because it ignores the fact that if the company does well, bon
will be allowed to participate in the company's success. If the share price rises to R40, bon
are effectively allowed to purchase shares at the conversion price of R25
3

Mark's argument is incorrect because the company is issuing debt with a lower coupon
they would have been able to otherwise. If the company does poorly, it will receive the be
lower coupon rate

4 Reconciling the two arguments requires that we remember our central goal: to increase th
of the existing shareholders. Thus, with 20-20 hindsight, we see that issuing convertible b
turn out to be worse than issuing straight bonds and better than issuing common stock if t
company prospers. The reason is that the prosperity has to be shared with bondholders a
convert.

In contrast, if a company does poorly, issuing convertible bonds will turn out to be better th
straight bonds and worse than issuing ordinary shares. The reason is that the firm will hav
benefited from the lower coupon payments on the convertible bonds

Both of the arguments have a grain of truth; we just need to combine them. Ultimately, wh
is better for the company will only be known in the future and will depend on the performa
company. The table below illustrates this point.

Convertible bonds
issued instead of
straight bonds

If the company does poorly


Low share price and no
conversion
Cheap financing because
coupon rate is lower (good
outcome).

If the comp
High share
conversion
Expensive f
bonds are co
dilutes exist
outcome).

5 The call provision allows the company to redeem the bonds at the company's discretion. I
company's shares appear to be poised to rise, the company can call the outstanding bond
be possible that the bondholders would benefit from converting the bonds at that point, bu
eliminate the potential future gains to the bondholders

R25 because it means the share price will have to


efit from the conversion, in this case 25 per cent. Even
d, the conversion price is important. First, the company may
cuss whether the company has plans to go public, and if
mpany does go public, the bondholders will have an active
ond, even if the company does not go public, the
uity interest in the company. This equity interest can be
lse. The potential problem with private equity is that the
public company. This illiquidity lowers the value of the

means that if the company offered bonds with the same


hey would be able to sell them for 656,82. However, with
800. In essence, the company is receiving R143,18 for the

nores the fact that if the company does well, bondholders


any's success. If the share price rises to R40, bondholders
s at the conversion price of R25

he company is issuing debt with a lower coupon rate than


. If the company does poorly, it will receive the benefit of a
lower coupon rate

hat we remember our central goal: to increase the wealth


0-20 hindsight, we see that issuing convertible bonds will
bonds and better than issuing common stock if the
e prosperity has to be shared with bondholders after they

uing convertible bonds will turn out to be better than issuing


dinary shares. The reason is that the firm will have
s on the convertible bonds

th; we just need to combine them. Ultimately, which option


wn in the future and will depend on the performance of the
point.

If the company does poorly


Low share price and no
conversion
Cheap financing because
coupon rate is lower (good
outcome).

If the company prospers


High share price and
conversion
Expensive financing because
bonds are converted, which
dilutes existing equity (bad
outcome).

redeem the bonds at the company's discretion. If the


rise, the company can call the outstanding bonds. It could
enefit from converting the bonds at that point, but it would
bondholders