Environgard Corporation "Youve 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 board of directors. "We are continually being snipped at by smaller but faster-moving competitors. Thus, we must carry out the plant monetization immediately to begin production of our new Scrub King line." Environgard was formed in 1980 in the Chicago area and had dominated the air pollution scrubbing equipment market ever since their 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 it embodies. A threat to their 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 Environment Protection Agency (EPA) emission regulations that are due to take effect in the near future. Environgard observed this trend early and 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 not only the remodeling of the existing plant but also 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 2007, and no additional long-term funds have been acquired since that date to keep the level of long-term debt constant (see tables 1 and, 2)

Table 1: Year ended December 31, 2006 (Millions of Dollars) Current assets $104 Fixed assets 160 Total assets Current liabilities (accruals & payables) Long-term debt (7.5%) Common stock ($1 par, 10 million shares outstanding) Retained earnings Total liabilities & net worth $40 16 10 198

$264

$264

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 firms 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 firms currently outstanding common stock is not disturbed

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.

Table 2: year ended December 31, 2006 (Millions of Dollars) Sales Cost of goods solda Gross profit General & administrative expenses Lease payment of equipmentb Earnings before interest Interest charges Earnings before tax Tax (48 percent, marginal tax rate) Net income Dividends Addition to retained earnings Notes: a. includes depreciation charges of $16 million. b. Five-year lease for equipment.

$254.0 188.0 $66.0 $9.9 2.4 $53.7 $1.2 $52.5 $25.2 $27.3 $6.8 $20.5

2. The company can privately sell 25-year, l0 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 tl1e 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 not be invoked. No floatation costs would be incurred. 3. The third alterative available to the company is to sell 6 percent cumulative preferred stock. The issue would not be callable and would not have a sinking fund. The price of the preferred would be $32 per share, the usual dividend would be $6.00 per share, and the stock would be sold to net Environgard $30 per share. In preliminary discussions with Williard Arenberg, chairman of the board and the company's major stockholder, Hellriegel found out that he favors the sale of bonds. Arenberg believes that ination 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 rm'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 are sold, management's absolute control will be endangered, and the company might be subjected to a takeover by one of the major conglomerate companies. 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. Hellriegle also discussed the financing alterative 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 1999, when the company faced a decrease in demand due to a postponement of strict EPA regulations; in 2002, when the company was involved in a long, drawn-out labor dispute; and in 2004, 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 economists predicting that if huge budget deficits are not corrected soon, the falling dollar could precipitate a severe recession. If interest rates should increase even more as the Federal Reserve acts to stimulate the economy, now is not the time to issue debt.

Table 3: Selected Information Sales Profit after tax Year (Million $) (Million $) 2006 $254 $27.3 2005 229 20.6 2004 136 (4.1) 2003 187 17.8 2002 136 5.9 2001 190 13.1 2000 175 16.9 1999 99 (5.9) 1998 155 14.2 1997 142 12.8 Table 4: Industry Ratios Debt/Total assets Times-interest-earned Fixed charge coverage Profit after taxes/total assets Profit after taxes/net worth Price/earnings

Dividends Per share $0.68 0.60 0.60 0.60 0.30 0.30 0.30 0.30

Earnings per share $2.73 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

35% 9v 6v 8% 12% 18v

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 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 nterest rate on the bonds would be 10 percent and that the company could not call the bonds for l0 years. Kushner then points out one final factor to Hellriegel: the company's stock is currently traded over-thecounter, although the management group would like to obtain an American Stock Exchange listing. When the company made a tentative application for listing 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 that the floating supply would not be sufficient to meet American Stock Exchange requirements; and

(2) The floating supply of stock does not have the board geographic distribution required by the American Stock Exchange. Kushner emphasizes that if stock is sold through investment bankers, the distribution will be sufficiently broad and the number of shares outstanding sufficiently large to qualify Environgard Corporation for listing. Hellriegel herself wonders if the preferred stock alterative might not overcome Arenberg's objection to common stock and Kushner's objections to bonds,-thus representing the best financing choice. Questions l. Assuming that the new funds earn the same rate of return currently being earned on the rms assets (earnings before interest and taxes/total assets), what would earnings per share be for 2007 under each of the three financing methods? Assume that the new outside funds are employed during the whole year of 2007, the sinking fund payment for 2007 is ignored, and retained earnings for 2007 are not employed until 2008. Under which methods of financing alterative, EPS is highest and why? Do you think that the firm can go for the alterative providing highest EPS? 2. Calculate the debt ratio at year-end 2007 under each alternative method of nancing. Assume that 2007 current liabilities remain at their current level and additions to retained earnings for 2007 total $20.5 million. Compare Environgard Corporation's figures with the industry averages as given in Table 4. 3. Calculate the before-tax times-interest-earned coverage for 2007 under each of the nancing alterative. Then compare Environgard Corporation's coverage ratios with the industry average. 4. Calculate the fixed charge coverage under each of the three alterative for the year 2007. Ignore the sinking fund payment in the debt alterative. Then compare your results with the industry average. Calculate the debt service coverage ratio (the xed charge coverage ratio including the sinking fund payment) for the bond alterative. What effect will the sinking fund covenant have on Environgard Corporation's ability to meet its other fixed charges? Do you think that the company will be able to meet fixed obligations? In the event that the company incurred a loss, do you think that the company can meet the fixed obligations? 5. Assume that after the new capital is raised, fixed operating charges are $24 million (not including depreciation of $20 million) and the ratio of variable cost to sales stays the same. How much would sales have to drop before the equity financing would be preferable to debt in terms of EPS? (Hint: calculate the breakeven level of sales at which EPS will be equal under bond or stock financing.) 6. Based on the data developed in Questions 2, 3, and 4, discuss the pros and cons of each of the financing methods that Hellriegel is considering. 7. Determine the PE ratio for 2006. If the goal is to maximize the price of firm's stock, calculate the prices of common stock for 2007 under various financing arrangements for PE ratio of l8, 16, l5,14, l3, 12, and 10 times. Which alterative has the higher market price per share? 8. Calculate the profit after taxes to total assets and profit after taxes to net worth for 2007 under each of the alternatives. Then compare these ratios with the industry average under each of the alterative. 9. How does stock exchange membership affect the decision? l0. Do you think 2:1 current ratio requirement appear too restrictive? And also do you think that covenant prohibiting the payment of dividends out of retained earnings appears to be overly burdensome? 11. Which method would you recommend to the board?