Farnsworth Final Report

Farnsworth Furniture Industries

Rights Offerings

Introduction

Farnsworth Furniture is one of the largest manufacturers of Early American furniture in the

United States, organized in 1932. The company experienced a steady rate o growth in the

post-World war II period, when the demand for housing was particularly strong. The key note

of Farnsworth is to provide value excellence of design, pride in quality craftsmanship, and

fair prices. Most Wall Street analysts point to this attitude of pride and the “family”

atmosphere of Farnsworth furniture Industries as the key elements of the company’s

outstanding market success.

In the mid-1980s, the demand for pine early American furniture increased because of falling

interest rates due to which homeowners were willing to spend extra money furnishing their

houses with long lasting quality furniture. The demand for Farnsworth furniture also

increased due to increasing families after World War II. Another reason for increasing

demand for Farnsworth was that many young adults who were setting up household for the

first time were making higher than average salaries and were not averse to “upscale”

consumption, including expensive furniture. To meet the increased demand, Farnsworth

Furniture Industries is undertaking a major capital expansion program with approximately

$45 million in new capital out of which $22.5 million has already been borrowed as a long

term loan form a group of five insurance companies. The loan agreement which was already

been finalized required Farnsworth to raise an additional $22.5 million through the sale of

common stock. The company is considering following alternative proposals:

Proposal 1

The company can go for initial public offering (IPO) at a subscription price of $48 per share.

Out of this amount $ 2.5 will be charged by an investment banker as a commission and the

company would receive $45.5 per share.

Proposal 2

The company can issue rights share to the existing shareholders at a subscription price of $45

and commission to the investment banker for the subscribed shares is $1.5 per share and the

company would net $43.5 .commission for the unsubscribed shares is $3.5 and in his case the

company would receive $41.5 per share.

Proposal 3

The company can issue rights share at a price of $40 per share with underwriting cost of

$0.75 for each share subscribed and $3.5 for each unsubscribed share purchased by the

investment banker.

Proposal 4

Sell shares to current stockholders at a subscription price of $25 with underwriting cost of

$0.25 for the subscribed shares by the stockholders and $3.5 per share taken by the

investment banker.

Proposal 5

Shares can be sold to current stockholders at a subscription price of $5 per share. Assistance

of the investment banker would not be necessary as the company could be quite sure that all

shares offered would be taken.

Major issues

How can Farnsworth raise an additional $22.5 million in new equity funds?

Which proposal would be best suited for Farnsworth Furniture Industries to raise the

additional fund through the sale of common stock?

What would be the EPS and MPS of the company?

What would be the number of shares outstanding for the company?

Case Analysis

1. How many additional shares of stock would be sold under each of the proposal

submitted by B. F. Hudson? Assume all shares are subscribed.

Solution

Funds Required = $22.5 million

Number of additional shares = Funds Required/ Price received per share

Price Received per Share = Subscription Price – Floatation Cost

If all the shares will be subscribed then the number of additional shares to be issued will

be:

Proposal 1 Proposal 2 Proposal 3 Proposal 4 Proposal 5

Subscription Price (Ps) $48 $45 $40 $25 $5

Floatation Cost $2.5 $1.5 $0.75 $0.25 -

Price Received per Share $45.5 $43.5 $39.25 $24.75 $5

No. of additional shares 494, 506 517, 242 573, 249 909, 091 4,500,000

2. How many rights will be required to purchase one new share under each of the four

rights proposals?

Solution

No. of rights required = No. of old shares

No. of new shares

No. of Outstanding Shares (old) = 4,000,000

Proposal 2 Proposal 3 Proposal 4 Proposal 5

No. of new shares 517, 242 573, 249 909, 091 4,500,000

No. of Rights Required 7.73 6.98 4.4 0.89

3. What is the market value of each right under each of the proposals? Do you think

that the average stockholder would bother to exercise the rights or to sell them at

these prices? Use the rights formula to answer this question.

Solution

Current market price (Po) = $49

Market value of each right = Po – Ps

α + 1


Subscription Price (Ps) $45 $40 $25 $5

No. of Rights 7.73 6.98 4.4 0.89

Market value of right (MVR) $0.46 $1.13 $4.44 $23.28

An average stockholder would not bother either to exercise the rights or to sell them at

these prices. It is because if this price (Ex – right price) prevails in the market after issue

of the rights then the stockholder’s net assets would remain unchanged whatever

alternative is selected.

4. What is the price per share immediately after issue of new shares under each of the

four proposals? Use the rights formula to answer this question.

Solution

Using rights formula, the market price per share (MPS) will be the sum of Subscription

price and the product of value of right and number of rights. Therefore,

MPS (Ex Right) = Value of Right * No. of Rights + Ps


Value of Right $0.46 $1.13 $4.44 $23.28

No. of Rights 7.73 rights 6.98 rights 4.4 rights 0.89 rights

Subscription Price (Ps) $45 $40 $25 $5

MPS (Ex – Right) $48.56 $47.89 $44.54 $25.72

5. Selling stock through a rights offering with the subscription price set below the

current market price has an effect that is similar to that of a stock split or stock

dividend. What is the percentage of the stock dividend that would have to be

declared to have the same effect – that is, produce the same final price per share – as

each of the proposals for rights offering?

Solution

To have the same effect on final market price for stock dividend and rights issue,

following situation should prevail:

Stock Dividend (%) = (Current Total Wealth/ (Current Outstanding

Shares * Ex Right MPS) – 1) * 100%

Current Total Wealth = Current MPS * Current Outstanding Shares

Current Outstanding Shares = 4,000,000

Current MPS = $49

Current Total Wealth = $196,000,000


Ex Right MPS $48.56 $47.89 $44.54 $25.72

Stock Dividend (%) 0.91% 2.32% 10.01% 90.51%

6. Assume that the company increases its total assets by $22.5 million in net proceeds

by issuing common stock at the start of 1997? (Ignore all other sources of funds,

such as debt or retained earnings, for this calculation.) The company earns 10%

after interest and taxes on its beginning assets in 1997. Spelled out in more detail,

this implies that: (a) the company earns 10% after interest and taxes on total assets

in 1997; (b) the company obtained only $22.5 million of new equity financing during

1997; that is, the debt financing is deferred until 1998; (c) new outside capital is fully

employed during the entire year of 1997; (d) additions to retained earnings in 1997

are not employed until 1998; and (e) that current liabilities remain at their 1996

level. (Note: the company’s stock issue was sold to the market for more than $22.5

million, but the investment bankers retained the difference to cover floatation

charges. Therefore, capital stock increases by exactly $22.5 million.) What will the

rate of return on net worth, earnings per share, and the price per share of the stock

(assuming a price/ earnings ratio of 20) be in 1997 under each of the alternative

methods? Do not use the formula to answer this question.

Solution

The Balance Sheet of Farnsworth at year end 1997 will look like following after the issue

of shares worth $22.5 million:

Assets Amount

($)

Capital & Liabilities Amount

($)Total Current Liabilities 35,500,000

Long Term Debt 30,000,000

Capital Stock 42,500,000

Retained Earnings 55,950,000

Total Assets 163,950,00

0

Total Capital & Liabilities 163,950,00

0

Now,

Total Assets = $163,950,000

Net Income of the year = 10% of Total Assets

= 10% of $163,950,000

= $16,395,000

Net Worth = Capital Stock + Retained Earnings

= $42,500,000 + $55,950,000

= $98,450,000

No. of Shares Outstanding (Old) = 4,000,000

Price Earning Ratio (PE Ratio) = 20

Particulars Proposal 1 Proposal 2 Proposal 3 Proposal 4 Proposal 5

Net Income (Million $) 16,395,000 16,395,000 16,395,000 16,395,000 16,395,000

Net Worth (Million $) 98,450,000 98,450,000 98,450,000 98,450,000 98,450,000

Return on Net Worth 16.65% 16.65% 16.65% 16.65% 16.65%

No. of Additional Shares 494, 506 517, 242 573, 249 909, 091 4,500,000

Total Outstanding Shares 4,494,506 4,517,242 4,573,249 4,909,091 8,500,000

EPS 3.65 3.63 3.58 3.34 1.93

PE Ratio 20 20 20 20 20

MPS $73 $72.60 $71.60 $66.80 $38.60

Return on Net Worth = Net Income/ Net Worth * 100%

Total No. of Outstanding Shares = No. of Outstanding Shares (Old) + No. of

Additional Shares

Earnings per Share (EPS) = Net Income/ Total Outstanding Shares

Market Price per Share (MPS) = PE Ratio * EPS

7. Why do the price–per–share figures in Question 6 differ from those found in

Question 4? Which seem more realistic?

Solution

The summary of Ex Right MPS from Question 4 and Question 6 under each rights

proposal is given below:


MPS (Q 4) $48.56 $47.89 $44.54 $25.72

MPS (Q 6) $73 $72.60 $71.60 $66.80

The price–per–share figures in Question 6 differ from those found in Question 4 because

the share price figures in Question 6 are the year end price and takes in to account the

10% net income after interest and taxes on Total Assets for year 1997 as well besides the

issue of new capital. On the other hand, the share price figures in Question 4 are that of

the beginning of year and consider only the addition to share capital and not the earnings

of the year 1997. Due to this, the EPS in Question 6 are higher than those in Question 4

and thus, higher MPS.

The price–per–share figures in Question 4 seem more realistic because it contains fewer

assumptions than in Question 6. Question 6 assumes that the company will earn 10% net

income after interest and taxes on Total Assets in year 1997 and that the Price/Earning

Ratio of the company is 20. These two assumptions are realistic and hence, the figures

are not realistic as well. Since Question 4 does not contain such assumptions, the figures

are more realistic.

8. What are the maximum and minimum floatation costs under each of the proposals?

Assume that the probability of the subscription percentage may be estimated by

using the following probabilities for maximum and minimum floatation costs:

Proposal 1 2 3 4 5

Probability of no rights being exercised - 0.30 0.20 0.10 0.00

Probability of 100% of the rights being exercised - 0.70 0.80 0.90 1.00

What are expected floatation costs as a percentage of gross funds raised under each

proposal? What specific conditions might generate the maximum cost?

Solution

The maximum and minimum floatation costs and the expected floatation costs as a

percentage for each of the proposal are calculated below:

If no rights are exercised then all the shares will be absorbed by the underwriter. In this

case the number of shares to be issued would be calculated as follows:

No. of shares to be issued = Total Fund Required/ Price received per share

Price received per share = Subscription price – Underwriting cost


Funds Required $22,500,000 $22,500,000 $22,500,000 $22,500,000

Subscription Price $45 $40 $25 $5

Underwriting cost $3.50 $3.50 $3.50 -

Price received per share for unsubscribed shares $41.50 $36.50 $21.50 $5

No. of new shares to be issued 542,169 616,439 1,046,512 4,500,000

Now calculating Floatation costs and percentage floatation costs:

Under Proposal 1

The maximum and minimum floatation costs are the same for proposal 1 because there is

only one category of underwriting commission. Hence, the expected floatation cost is also

the same as floatation costs.

Expected Flotation Cost = Flotation Cost

= Number of shares to be issued * Floatation cost per share

= 494,506 * $2.5

= $1,236,265

Expected Flotation costs in percentage = Expected floatation cost/ Funds Required

= $1,236,265/ $22,500,000 * 100%

= 5.49%

Under Proposal 2

Probability of no rights being exercised = 0.3

Probability of 100% of the rights being exercised = 0.7

If no rights are exercised:

Flotation Cost = Number of shares to be issued * Floatation cost per share

= 542,169 * $3.5

= $1,897,592

This is the maximum flotation cost under this proposal.

If the shares are fully subscribed by the shareholders:


= 517,242 * $1.5

= $775,863

This is the minimum floatation cost under this proposal.

Expected flotation cost = 0.3 * $1,897,592 + 0.7 * $775,863

= $1,112,382


= $1,112,382/ $22,500,000 * 100%

= 4.94%

Under Proposal 3




Flotation cost = Number of shares to be issued * Floatation cost per share

= 616,439 * $3.5

= $2,157,537




= 573,249 * $0.75

= 429,937



= $775,457


= $775,457/ $22,500,000 * 100%

= 3.45%

Under Proposal 4




Flotation cost = Number of shares to be issued * Floatation cost per share

= 1,046,512 * $3.5

= $3,662,792




= 909,091 * $0.25

= $227,273



= $570,825


= $570,825 / $22,500,000 * 100%

= 2.54%

Under proposal 5

Probability of no rights being exercised = 0


The subscription price is so less under this proposal that the company is so sure of selling

all the shares to current shareholders without the assistance of investment bankers. Since

there is cent percent probability that all the right will be exercised and that assistance of

investment banker is not required under this proposal, there are no floatation costs and

hence floatation cost in percentage is 0%.

9. What effects do you think a rights offering, as opposed to an offering to the general

public, would have on “stockholders loyalty” to the company?

Solution

If the preemptive right is contained in the charter of the company, then the firm must

offer any new common stock to existing stockholders, which is called rights offering. The

terms and conditions of the rights offering are stated in a piece of paper called a right.

If the company undertakes rights offering, as opposed to an offering to the general public

then it would have great effect on the existing stockholders’ loyalty. In the right offering

the existing stockholders get the first option to buy any issue of new stock. The

subscription price is less than the current market price of the stock. Therefore

stockholders are able to buy additional shares at a price lower than the prevailing market

price. This would also preserve the control power and ownership of the existing

stockholders. There would not be any chance of reduction in earning per share of the

company; it means the earnings of the company would not be distributed among large

number of stockholders. Thus if company is offering the rights to its stockholders, it is

said to be showing loyalty to existing stockholders than by offering to the general public.

10. Examine advantages and disadvantages of each proposal and decide which method

of financing Hruska should recommend to the board of directors?

Solution

The summary of case analysis is given below:

Particular Proposal 1 Proposal 2 Proposal 3 Proposal 4 Proposal 5

Number of share outstanding 4,494,506 4,517,242 4,573,249 4,909,091 8,500,000

EPS 3.65 3.63 3.58 3.34 1.93

Ex-right price - 48.56 47.89 44.54 25.72

Price per share after 1 year 73 72.60 71.60 66.80 38.60

Floatation costs 5.49% 4.94% 3.45% 2.54% -

The advantages and disadvantages of each proposal are given below:

Proposal 1:

Advantages Disadvantages Allows greater distribution of stock

throughout the market Effects on the stockholders loyalty;

dilution in control power and earnings It can attract knowledgeable investors

with genuine interest in the operations and objectives of the company

Higher floatation costs i.e. about 5.49% (generally IPO is sold at discount price).

If issued at minimal discount this will result in minimum dilution in Market price and Earning per share

The company must conform to Securities and Exchange Commission (SEC) requirement, which is sometime very stringent

The company has to disclose the sensitive information to the outsiders.

Proposal 2:

Advantages Disadvantages Showing loyalty to the shareholders by

giving opportunity to maintain their position at a discount.

Absence of wider distribution of shares

Rights offering at high subscription price would result in the least amount of dilution of EPS

High flotation cost among the other four rights offering alternatives.

Lower number of shares outstanding results in higher EPS

High subscription price caters to a small percentage of the shareholders who may have immediate funds available for reinvestment, while leaving the large percentage of shareholders no choice but to sell their rights.

Proposal 3:

Advantages Disadvantages It provides an adequate margin of

safety against downward market price fluctuations

Absence of wider distribution of the shares

Protects the Shareholders form excessive equity dilutions and gives an appealing purchase at discount.

High subscription price compels large number of shareholders with no immediate funds to sell their rights

Lower flotation costs than that of proposal 1 and 2

Provides adequate safety margin but the ex-right price per share would be above the optimum trading range

Dilution in market price per share

Proposal 4:

Advantages Disadvantages Preserve the control power and

participation of the existing shareholders

Absence of wider distribution of shares to outside investors

Lower flotation cost comparing to alternatives 1,2 and 3

larger number of shares outstanding results in lower EPS

The resulting ex-right price would appeal to a wide range of investors

Excessive equity dilution

Subscription price of $25 put the stock in a popular trading range

Proposal 5:

Advantages Disadvantages Preserves the control power and

earnings of the existing shareholders Absence of wider distribution of

shares Low subscription price or $5 per share

would appeal to a wider range or shareholders

If the subscription price is low then the amount of capital would be low and number of shares would be large which is not good for company and investors.

There would be greater chance of acceptance of the rights by existing shareholders

Absence of assistance form investment bankers means the risk of not subscribing the shares by stockholders should be borne by the company itself

It will enhance the shareholders relations and maintain sound agency relationship in the company.

This proposal goes to opposite extreme and neglects the hard-earned reputation of the company’s share price.

It eliminates the need for assistance of investment bankers; this will reduce the flotation cost.

Final Decision:

After analyzing each of the alternatives separately we arrive to the conclusion that the

Hruska should recommend the proposal 4 to the board of directors as the best method of

common stock financing. Proposal 4 seems to be more favorable than other alternative

proposals, because of the following reasons:

This method of financing preserves the control power and earnings of the existing

shareholders, which shows that company is showing loyalty to its shareholders. This

will also reduce the agency problem and enhance the shareholders relationship.

The floatation cost is low comparing to proposal 1, 2 and 3. But it is higher than that

of proposal 5, yet this proposal is better than proposal 5 because the company does

not have to bear the risk of not exercising the rights by the existing stockholders due

to the absence of agent or intermediary (i.e. Investment Bank).

Low Subscription price of $25 put the stock in a popular trading range and the

resulting ex-right price would appeal to a wide range of investors. This means there is

very low chances of not subscribing the shares by the existing shareholders.

Documents

Farnsworth Final Report