Financial Management Cases NEU 2013 (Lores)

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Finance 400

Financial Management Cases.NEU 2013

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Acknowledgements

The content of this text has been adapted from the following product(s):

Source Title: Randolph Corporation: Directed

ISBN10: 9780324530667

Source Title: Johnson Window Company: Directed

ISBN10: 9780324531091

Source Title: Computer Concepts/Computech: Directed

ISBN10: 9780324530902

Source Title: Swan-Davis, Inc.: Directed

ISBN10: 9780324530926

Source Title: Northern Forest Products: Directed

ISBN10: 9780324531312

Source Title: The Western Company: Directed

ISBN10: 9780324531107

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Table Of Contents

Computer Concepts/Computech: Directed 1

Swan-Davis, Inc.: Directed 9

The Western Company: Directed 23

Johnson Window Company: Directed 39

Randolph Corporation: Directed 45

Northern Forest Products: Directed 51

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In recent years, it has become fairly common for computer hardware and software companies tomerge with one another in an effort to gain economies of scale and scope and thus be better able tocompete with larger rivals in the marketplace. The mergers are generally either horizontal (for exam-ple, when two software companies merge to expand their product lines) or vertical (for example,when a hardware company acquires a software company to obtain software to package with itscomputers.)

CompuTech Industries was recently bitten by the merger bug. The company was founded byMarco Garibaldi in the basement of his parents home in 1983. Garibaldi had no intentions of com-peting with the giants in the industry (Microsoft, Lotus, etc.), but rather finding a market niche ofhis own. Garibaldi envisioned selling software to individuals at a low economical price and grabbingthe low-price end of the market.

Garibaldi was a mathematical wizz and computer hacker who had dropped out of collegebecause he was not intellectually challenged. The idea for CompuTech actually originated fromone of Marcos other hobbieswriting science fiction novels. Although Marco enjoyed concoctinghis sci-fi stories, he hated spending endless hours retyping manuscripts to correct his typographicalerrors. He surmised that college students probably disliked this chore at least as much as he did, sohe set out to develop a user-friendly word processing computer program aimed at high school andcollege level students. He called the computer software program WordPro Easy, and it was anovernight success. In fact, the program received wide acceptance from both the academic and thebusiness communities. Marco had not foreseen how quickly CompuTech would grow and theamount of capital that would be necessary to fund its growth. However, he received numerous offersfrom venture capital funds, and this supported early growth. Marcos goal was to take the firm pub-lic, which he did in 1990. By December 31, 1995, CompuTechs stock was selling for $25 per share,and there were 10 million shares outstanding.

During the companys 12 years of existence, CompuTech developed a solid reputation foringenuity, reliability, and timely introduction of new products. In addition, unlike many of itsrivals, CompuTech maintains a toll-free telephone technical support service for users, and it usesinformation from the service both to identify and correct potential program bugs and to get ideasfor product improvements. Consequently, WordPro Easy has been updated frequently, enabling it tomaintain its strong market position. More recently, the firms programmers created a presentation

Copyright 1994. The Dryden Press. All rights reserved.

Case 70

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package called Chart Easy that has also received wide market acceptance because, like WordProEasy, it is innovative, easy to use, and relatively free from errors.

However, when CompuTech attempted to enter the financial spreadsheet market, it foundthe going much rougher. Its product, Spreadsheet Easy, has simply not caught on, partly due toCompuTechs late entrance into the market, partly due to the markets perception that the firmsexpertise is not financial software, and partly because other firms spreadsheet programs have anestablished hold on the market. This failure to enter the financial spreadsheet market has Garibaldiworried, because rival software companies are increasingly bundling their word processing, pre-sentation, and financial software programs into one office suite. Garibaldi fears, correctly, that ifCompuTech were to follow the market and bundle its software programs into an office package, thepackage would fail because Spreadsheet Easy doesnt have a strong market following. Garibaldibelieves that CompuTechs continued success lies in finding a firm which enjoys a similar reputa-tion to CompuTechs, but one that specializes in financial spreadsheet programs and brings with ita strong market following.

One potential acquisition candidate is Computer Concepts Inc. (CCI), a firm that specializesin accounting, finance, and tax return software programs. Like CompuTech, CCI was founded in theearly 1980s, expanded with the help of venture capitalists, and went public in 1993. (Three millionshares had been offered at $1.25 per share, and 2.5 million shares were actually sold to raise $2.5 mil-lion, net of underwriting fees.) CCIs financial spreadsheet program, Model Pro, was an initial suc-cess and has been continually updated to meet changing market demands. Consequently, it has anexcellent market following. Also, Model Pro was written so that a spreadsheet created by it could beincorporated as text into most word processing programs (including WordPro Easy). The firms oneperceived weakness is its lack of diversity in software product offerings. Garibaldi views a mergerwith CCI as a perfect fit with CompuTechsuch a merger would provide a way for CompuTech toenter the financial software market and thus solve his office suite problem.

The primary issues now facing CompuTech are (1) how much to offer for CCIs stock and(2) how to approach CCIs management. Marco Garibaldi and his staff are good at developingcomputer software programs, but they are not finance experts and are not experienced with acquisi-tions. So, rather than taking a chance on making a mistake, they decided to bring your consultingfirm in to advise them on the CCI merger.

Table 1 provides some information on CCI. The stock is traded infrequently and in smallblocks, and while the last trade was at a price of $1.50, it would probably run up sharply if a largebuy order were placed. CCIs beta coefficient is 1.6, and that number is close to the average betafor publicly traded computer software companies. If the acquisition takes place, CompuTech wouldincrease CCIs debt ratio from 10 to 25 percent, and consolidation of income for tax purposeswould move CCIs 30 percent federal-plus-state tax rate up to that of CompuTechs, 40 percent.

CCIs management owns about 30 percent of the stock, which is substantial but not enough tocompletely block a merger. They might fight to keep the firm independent if CompuTech makes anoffer, but there is a chance that they would welcome a chance to sell out. They also might want toremain active, but would appreciate being acquired by a firm which would provide them with prod-uct diversity, something that it is currently lacking. To the best of Marco Garibaldis knowledge,CCIs managers have had no discussions with anyone about a merger, and the few analysts who fol-low the stock have not said anything about the possibility of a takeover. However, Garibaldi isafraid some other software company might force a bidding war if CompuTech decides to make anoffer. CCI does not appear to be large enough to interest companies like IBM or Microsoft, but sucha company might decide to buy CCI for its accounting and tax applications and then cultivate them.

Marco Garibaldi wants your opinion on how CompuTech should approach CCIs manage-ment, should he decide to make an offer. One possibility would be to go to its management with arelatively low offer which could later be increased if necessary. Another would be to come in witha high offer and attempt to preempt any outside challenge. A third plan would be to by-pass man-


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agement altogether and make a tender offer directly to CCIs stockholders. So, part of your task isto discuss the pros and cons of these approaches, plus any others you might think of.

CompuTech has, in the past, built its software business from the ground up rather thanthrough acquisitions, and some of Garibaldis managers prefer internal expansion to acquisitions.Therefore, Garibaldi wants you to include, in your report and presentation, a discussion of mergersversus business creation to achieve CompuTechs strategic objectives. He also wants you to com-ment on whether there might be any legal impediments to a merger with CCI. A discussion of thepros and cons of a hostile versus a friendly merger would also be helpful.

The proper price to offer is a critical issue. CCIs most recent stock price was $1.50 per share,and there are 3,000,000 shares outstanding. That suggests that CCIs value is $4.5 million. However,analysts often look at other data when appraising the value of stocks such as CCI for acquisition pur-poses, and they consider valuation multiples such as those shown in Table 1. The weights given tothe different multiples are somewhat arbitrary, and they vary from situation to situation. Also,some analysts rely almost totally on a DCF calculation and use the multiples, if at all, simply as acheck to see if their DCF analysis is in the right ballpark. The multiples given in Table 1 are recentaverages for software companies, but actual multiples for individual companies vary substantiallydepending on the circumstances. Higher multiples are generally used for more rapidly growing firms,or for firms with more growth potential, while lower multiples are used for highly leveraged firms.

In addition, the stock prices of independent companies are frequently bid up over their goingconcern values once investors start thinking of them as acquisition candidates. Garibaldi does notthink such a merger premium is reflected in CCIs current stock price, but he is not sure about this.If no merger premium is currently embodied in the price, then CompuTech would probably have tooffer a premium to get CCIs stockholders to agree to sell. So, Garibaldi wants to know the maxi-mum price CompuTech could afford to pay without diluting its own value. He also wants to knowthe minimum price CCIs stockholders are likely to accept. Then, if the price CompuTech can affordexceeds the price CCI will accept, a merger is at least feasible.

To find the maximum price CompuTech can pay, Garibaldi wants you to develop pro formafinancial statements and then use them to determine the cash flows CompuTech would realize if itbuys CCI. The present value of those cash flows can then be used to estimate the maximum offerprice. Of course, Garibaldi would like to buy CCI at a lower price, because the merger will notbenefit CompuTechs current stockholders unless it can be completed at a price less than the PV ofthe cash flows.

It may turn out that CCIs management would welcome a merger, in which case they maynot bargain too hard. However, since the management team owns 30 percent of the stock, they willwant to get a high price, and that (plus a legal obligation to do so) might lead them to solicit com-peting bids. Also, you know that CCIs management team is relatively young and aggressive, so theyprobably will not want to retire. Therefore, what they are offered in terms of employment, and theircompensation package, will have an effect on their attitude toward a merger. Garibaldi wants youto address that issue.

Table 2 contains some pro forma financial data that Garibaldis people worked up from the setof data CCI disclosed as a part of its recent public offering. The data in Table 2 assume a takeoverby CompuTech. The required addition to retained earnings represents the amounts that would benecessary to finance the projected growth. Although specific estimates were only made for 1996through 1999, the acquired company would be expected to grow at a 5 percent rate in 2000 andbeyond. However, actual growth could be greater or less than the expected growth rate, and thiswould significantly affect CCIs value.

One important part of the merger analysis involves determining a discount rate to apply tothe estimated cash flows. In its merger work, your consulting firm uses a procedure developed byProfessor Robert Hamada of the University of Chicago to adjust betas to reflect differing degreesof financial leverage. Hamadas basic equations are given below:


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Formula to unlever beta: bu =bL

1+(1T)(D/S) .

Formula to relever beta: bL = bu[1+(1T)(D/S)].

Here bU is the beta that CCI would have if it used no debt financing (the inherent beta of theassets), T is the applicable corporate tax rate, and D/S is the applicable market value debt-to-equityratio. As shown in Table 1, the T-bond rate is 6.5 percent, and your firms economists estimate thatthe market risk premium is currently 5 percent.

Your task now is to complete a report in which you first address the issue of whether or notCompuTech should attempt to take over CCI. Based on your discussions with Garibaldi, you knowthat you should consider questions such as the following: If an attempt is to be made, how muchshould CompuTech offer, what is the maximum price it can afford to pay, and how would CCIs cur-rent management be likely to respond? Would CompuTech want CCIs current management team tostay on, or would CompuTech be better off if it replaced CCIs managers with its own people? Dothe ratios provided in Table 2 look reasonable, or do they cast any doubts on the forecasts? ShouldCCIs stockholders be offered cash, debt securities, or stock in CompuTech? In addition to the pro-jected cash flows, is there the potential for some strategic option value if CCI is acquired, and ifso, how should this be factored in? Recognize that either Garibaldi or one of the other CompuTechmanagers could ask you follow-up questions, so you should thoroughly understand the implica-tions of your analysis. To help structure your report, answer the following questions.

QUESTIONS

1. Several factors have been proposed as providing a rationale for mergers. Among the moreprominent ones are (1) tax considerations, (2) diversification, (3) control, (4) purchase ofassets below replacement cost, and (5) synergy. From the standpoint of society, which ofthese reasons are justifiable? Which are not? Why is such a question relevant to a companylike CompuTech, which is considering a specific acquisition? Explain your answers.

2. Briefly describe the differences between a hostile merger and a friendly merger. Is there anyreason to think that acquiring companies would, on average, pay a greater premium over tar-get companies pre-announcement prices in hostile mergers than in friendly mergers?

3. Complete CCIs cash flow statements for 1996 through 1999. Why is interest expense typi-cally deducted in merger cash flow statements, whereas it is not normally deducted in capitalbudgeting cash flow analysis? Why are retained earnings deducted to obtain the free cashflows?

4. Conceptually, what is the appropriate discount rate to apply to the cash flows developed inQuestion 3? What is the numerical value of the discount rate? How much confidence canone place in this estimate, i.e., is the estimated discount rate likely to be in error by a smallamount, such as 1 percentage point, or a large amount, such as 4 or 5 percentage points?Would an error in the discount rate have much of an effect on the maximum offer price?

5. What is the terminal value of CCI, that is, what is the 1999 value of the cash flows CCI isexpected to generate beyond 1999? What is CCIs value to CompuTech at the beginning of1996? Suppose another firm was evaluating CCI as a potential acquisition candidate. Wouldthey obtain the same value? Explain.


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6. a. CCIs management has a substantial ownership interest in the company, but not enoughto block a merger. If CCIs managers want to keep the firm independent, what are someactions they could take to discourage potential suitors?

b. If CCIs managers conclude that they cannot remain independent, what are some actionsthey might take to help their stockholders (and themselves) get the maximum price fortheir stock?

c. If CCIs managers conclude that the maximum price others are willing to bid for thecompany is less than its true value, is there any other action they might take that wouldbenefit both outside stockholders and the managers themselves? Explain.

d. Do CCIs managers face any potential conflicts of interest (agency problems) in theirnegotiations with CompuTech? If so, what might be done to reduce conflict of interestproblems.

7. CCI has 3 million shares of common stock outstanding. The shares are traded infrequentlyand in small blocks, but the last trade, of 500 shares, was at a price of $1.50 per share.Based on this information, and on your answers to Questions 5 and 6, how much shouldCompuTech offer for CCI, and how should it go about making the offer?

8. Do you agree that synergistic effects probably create value in the average completedmerger? If so, what determines how this value is shared between the stockholders of theacquiring and acquired companies? On average, would you expect more of the value to go tothe acquired or to the acquiring firm? Explain your answers.

9. A major concern when analyzing any merger is the accuracy of the cash flows. How wouldthe maximum price vary if the variable cost percentage were greater or less than theexpected 80 percent? If you are using the spreadsheet model, do a sensitivity analysis on thevariable cost ratio, and also determine the maximum percentage that would justify a price of$3.50 per share. If you do not have access to the spreadsheet model, simply discuss theissue, and explain why managers would be interested in such a sensitivity analysis.

10. What rate of return on equity is projected in the analysis? Should the projected ROE makeyou want to question the assumptions that went into the cash flow and financial statementprojections?

11. Would the response of CCIs stockholders be affected by whether the offer was for cash orfor stock in CompuTech? Explain.

12. What are your final conclusions? Should CompuTech make an offer, and if so, should theytry for a friendly deal; what price per share should they offer; how should they make pay-ment; and should they try to retain the present management?


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TABLE 1Selected Data Related to the Potential CCI Merger

Data on CCI1995 Assets (end of year) $ 3,000,0001995 Sales 10,000,0001995 Net Income 425,000Estimated beta coefficient 1.6Debt ratio 10.0%Tax rate 30.0%Shares Outstanding 3,000,000Latest price per share $1.50

Pro forma Data Assuming CCI is operated by CompuTech starting in 1996:1996 Assets (end of year) $ 3,450,0001996 Sales 12,000,0001996 Net Income 808,650Debt ratio 25.0%Tax rate 40.0%Sales growth, 19961999 20.0%Assets growth, 19961999 15.0%Long-run growth rate in sales and assets 5.0%

Other Data and Assumptions, Post-Merger:Risk-free rate 6.5%Market risk premium 5.0%Companys cost of debt 10.0%Variable costs/sales 80.0%Fixed costs/assets 20.0%Depreciation/assets 8.0%

Valuation Multiples (averages for young, rapidly growing software firms):Value as a multiple of cash flow 10.0Value as a multiple of sales 0.5Value as a multiple of net income 12.0Value as a multiple of Market/Book 3.5

The weights given to valuations based on these multiples are judgmental, not set by some formula.Note too that some people would give no weight whatsoever to valuations based on these multiples,relying instead only on DCF, i.e., giving 100 percent of the weight to the PV of cash flows.


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TABLE 2Pro Forma Data on CCI Assuming CompuTechs Management

Balance Sheet Information (end of year):1996 1997 1998 1999

Assets $ 3,450,000 $ $ 4,562,625 $ 5,247,019Debt 862,500 1,140,656 1,311,755

Income and Cash Flow Statements:1996 1997 1998 1999

Net sales $12,000,000 $ $17,280,000 $20,736,000Var. operating costs 9,600,000 13,824,000 16,588,800Depreciation 276,000 365,010 419,762Fixed operating costs 690,000 912,525 1,049,404Interest expense 86,250 114,066 131,175

Earnings before taxes $ 1,347,750 $ $ 2,064,399 $ 2,546,859Taxes 539,100 825,760 1,018,744

Net income $808,650 $ $ 1,238,640 $ 1,528,116Plus depreciation 276,000 365,010 419,762

Cash flow $ 1,084,650 $ $ 1,603,650 $ 1,947,877Reqd addn to equity 388,125 513,295 196,763

Available CF $ 696,525 $ $ 1,090,354 $ 1,751,114Expected terminal value

Free cash flow $ 696,525 $ $ 1,090,354 $

Maximum total offer, total: $Maximum offer price per share: $

Ratios:1996 1997 1998 1999

Return on Sales 6.74% % 7.17% 7.37%Return on Assets 23.44% % 27.15% 29.12%Return on Equity 31.25% % 36.20% 38.83%Total Asset Turnover 3.48 3.79 3.95Debt/Assets 25.00% % 25.00% 25.00%


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Swan-Davis, Inc. (SDI) manufactures equipment for sale to large contractors. The company hadbeen founded in 1976 by Tom Stone, the current chairman. It went public in 1980 at $1 per share,and the stock currently sells for $15. Stone owns 14 percent of the stock, and officers and directorsas a group control 27 percent of the shares. The industry is highly cyclical and quite competitive,so profits are somewhat unstable. Also, competition from both domestic and foreign firms has helddown SDIs profit margins. Tables 1, 2, and 3 provide historical balance sheets, income statements,and ratios for the company for the period 1994-1996. Table 4 provides industry average data for19941996 and Tables 5, 6, and 7 provide forecasted data on the company based on assumptionsset forth later in the case.

On Tuesday morning Bob Wilkes, SDIs treasurer, received a call from Isabelle Ramirez,senior vice president of First National Bank and SDIs loan officer. The banks computerized anal-ysis system indicated that SDI is in violation of some of the covenants in their loan agreement. Tech-nically, if the violations are not corrected within a 30-day period, the bank could call SDIs loanfor immediate repayment, and then, if the loan is not repaid within 10 days, force the company intobankruptcy. The covenants in question are the current ratio, which should be kept at 1.75, and thetimes-interest-earned ratio, which should remain above 3.5. Isabelle went on to say that she wouldavoid calling the loan if at all possible, as she knew this would back the company into a cornerfrom which it might not be able to emerge.

Bob told Isabelle he would look into the situation and get back to her. She agreed to hold offtaking any action for two weeks, but she also said that given the covenant violations, she would needto see a specific, feasible, and credible plan for getting SDI out of its difficulties. Bob then calledTom Stone, president and chairman of the board. Bob had been warning Tom about the companysworsening financial condition for some time, and some SDI directors, especially those with financeand accounting backgrounds, had expressed similar concerns. Tom called a meeting for 4 PM thatafternoon, asking Bob, the vice presidents for sales and manufacturing, and your consulting firmto attend.

Tom began the meeting by stating that since his management team had created the problem, hethought it best to have outside consultants help formulate a corrective plan. Accordingly, your firmwas hired to do the analysis and then make a recommendation to management. You were asked tofocus primarily on things from the banks perspective, but to also consider the situation from thestandpoint of the following parties:


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1. Banker. First and foremost, what must SDI do to solve its problem with the bank? Is thebank likely to continue supporting SDI, or might it call the loan for repayment?1

2. Management. Do SDIs financial ratios reveal any strengths that management can exploit, orweaknesses that should be strengthened?

3. Trade creditors. From a suppliers standpoint, is SDI the kind of company one would behappy extending credit to? Might it become difficult for SDI to continue getting normaltrade credit?

4. Customers. Would its customers have any reason to be concerned about SDIs financialposition? How might that affect operations?

5. Commercial paper dealers and buyers. Many firms finance with commercial paper. If thebank decides to call the loan, could SDI take up the slack by using commercial paper?

6. Long-term creditors. Would it be easier for SDI to obtain long-term or short-term debtfinancing on reasonable terms? Do you think the companys long-term debt would becloser to triple A or to junk bond status?

7. Common stockholders. Should common stockholders be happy or unhappy with the com-panys recent performance as reflected in its financial statements? How would its perfor-mance be reflected in its stock price? Would investment bankers find it easy or difficult toraise new equity capital for SDI by issuing common stock?

8. Board of Directors. One of the Boards principal duties is to elect officers and set executivecompensation. How might the board use financial analysis to help it carry out these func-tions? How involved should the board be with helping management correct any problemsthat might exist?

9. Other parties. Is there any reason to think that SDIs labor union might be interested in thefinancial analysis? What about non-unionized employees, investment bankers, corporateraiders, or competitors?

To convince the bank to continue supporting SDI, the company will have to present strong andcredible evidence that its difficulties are only temporary. Therefore, it must show that appropriateactions to overcome the problems have been taken, and that the chances of reversing any adversetrends are good. However, Isabelle (and most other bankers) know that if the bank demands imme-diate repayment, and if that puts SDI in an untenable position, the company will file for protectionunder Chapter 11 of the Bankruptcy Act. Bankruptcy has some bad effects for all parties, includingthe bank, so Isabelle will not want to force a bankruptcy if it can be avoided.

First, the bankruptcy filing will be widely publicized, and the banks other customers will takenote of the fact that their bank forced one of its long-term customers into bankruptcy. Second, aftera Chapter 11 filing, the bankrupt company will be granted an automatic stay during which credi-tors cannot collect interest or principal on a loan, or take possession of collateral securing their loans.Third, the companys management will be allowed to continue running the firm as a debtor in pos-session, and management will be given the right, if the Bankruptcy Court agrees, to raise newmoney as debtor-in-possession financing, which is senior to all unsecured debt, including the

1One measure of the quality of a loan is the Altman Z score, which for SDI was 2.13 for 1996, well below the 3.20 mini-mum that Isabelles bank uses to identify strong firms with little likelihood of bankruptcy in the next two years. A Z scoremuch less than 3 indicates a good chance that the firm will go into default. (SDIs score for 1995 and 1996 dropped well belowthe banks 3.20 minimum.) SDIs sub-normal Z score will put the bank under increased pressure to reclassify SDIs loan asa problem loan to set up a reserve to cover potential losses, and to take whatever steps are necessary to reduce the banksexposure. Setting up the loss reserve would have a negative effect on the banks profits and reflect badly on Isabelles per-formance. However, if Isabelle takes no action and the loan later goes into default, that will look even worse on her record.


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banks debt. (First Nationals loan is unsecured.) Management may even be authorized to sell offassets to cover operating expenses and legal fees, and that reduction of assets could adverselyaffect the banks ability to recover its investment. Bob Wilkes recalls a discussion with IsabelleRamirez about the situation with Eastern Airlines, which was permitted to continue in business under Chapter 11 for many years. Eastern sold off assets to get cash to meet payrolls, to buy fuel, and soon, and Isabelles bank had lost money on its loan to Eastern as a direct result of the bankruptcyjudges misguided attempts to keep the company afloat.

Under the Bankruptcy Act, management is given 120 days to file a plan of reorganizationdetailing how it proposes to operate in the future, its proposed new capital structure, and the like.More likely than not, the 120 days would be extended, and once managements plan is filed, credi-tors would have about 90 days to review it, to protest against it, and, if they choose, to file a reorga-nization plan of their own. Generally, and in SDIs case, there are a number of classes of creditors,and each class can file a reorganization plan of its own. All of this takes time, during which man-agement remains in control and can incur expenses which may have priority over the banks claimand perhaps sell off assets and use the money to cover legal fees and operating losses. Of course,the companys employees, customers, and suppliers will all know about the filing, and that wouldadversely affect morale, productivity, sales, supplier relationships, and financing costs.

Bankruptcies of companies as large as SDI are rarely resolved in less than a year, and two tothree years is more likely. During this time, the banks money would be tied up, the loan would beclassified as non-performing by the banks examiners, and SDIs assets might be dissipated. SinceIsabelle is well aware of all this, including the negative effects on perceptions of the banks loyaltyto customers, she will not want to take actions which would lead to a Chapter 11 filing except as alast resort. However, if she thinks bankruptcy is inevitable, she will want to get on with it as soonas possible.

SDIs problems began with the construction slump of 1995. The slump led to a drasticdecrease in the demand for construction equipment. SDI responded by aggressively reducing pricesin hopes that this would lead to a bounce-back in sales. However, the price cut stimulated sales lessthan management expected. As a result, 1996 sales and profits remained low, and inventoriesincreased sharply.

As inventories began to rise in early 1996, SDI relaxed its credit standards and lengthened itsalready favorable credit terms in an effort to boost sales. Again, the expected increase in sales did notmaterialize, but the longer credit terms led to a dramatic increase in accounts receivable, which exac-erbated the companys cash flow problems. During this entire period, SDI had continued to investheavily in plant and equipment, even though sales were not rising, because of Tom Stones opti-mistic belief that the downturn was only temporary.

SDI has traditionally issued long-term debt, preferred stock, and common stock, plus short-term debt. However, in 1995 the rapidly rising levels of inventories and receivables caused thesesources to be insufficient, so the company began to delay payments on accounts payable. SDIssuppliers complained, but they continued to ship to the companythus far.

Two days after the banks call, Tom received another piece of bad news. The company hadrecently signed a binding contract for a plant expansion that would require an additional $20 mil-lion of capital during the second quarter of 1997. Tom had been confident that SDI could obtainthe necessary money with a short-term bank loan to be repaid with higher cash flows resultingfrom the expansion. Tom now wishes he could cancel the expansion plans, but that would be pro-hibitively expensive because of high cancellation penalties built into the contract. Therefore, it iscritical that the $20 million be obtained.

Your consulting firm has a spreadsheet model that can be used to forecast financial state-ments and ratios, and data produced by the model are given in Tables 5, 6, and 7. Like all models,the output is only as good as the inputs, and the term GIGO, or Garbage in, garbage out, applieshere. The assumptions used in the forecast are summarized below:


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1. If SDIs current business plan were carried out, sales would grow by about 10 percent peryear during 19971999.

2. If SDI reverses its recent policy of aggressive pricing and extending easy credit, this wouldboost profits and cash flows.

3. These changes would enable the company to reduce the cost of goods sold (excluding depre-ciation) from 85 percent in 1996 to 80 percent in 1997 and thereafter.

4. Similarly, the company should be able to reduce administrative and selling expenses from1.5 percent of sales in 1996 to 1 percent in 1997 and thereafter.

5. Miscellaneous (other) expenses would remain at the 1996 percentage of sales, while depreci-ation would equal the industry average percent of sales.

6. In Bob Wilkes judgment, all of these cost reductions would represent trimming the fat, sothey would not affect product quality or the effectiveness of sales efforts.

7. To appease suppliers, future bills will be paid promptly, and to convince the bank how seri-ous management is about correcting the companys problems, cash dividends on commonstock (but not preferred stock) will be eliminated, and executive salaries will be frozen.

8. The levels of receivables and inventories will be reduced so as to force turnover levels up toindustry average levels in 1997. Fixed assets as a percentage of sales will also be reduced,but this will take longerit would be difficult to sell off fixed assets, hence improvementshere must come primarily from increased sales.

9. The bank will continue supporting SDI, and it will lend the additional $20 million in 1997.However, this credit does not show up on the projected 1997 balance sheet because cashflows generated by reducing receivables and inventories will be used to retire the loan.

As Bob probed the situation, it became clear that if the bank refuses to roll over the existingloan and provide the additional $20 million as a short-term loan, the company will have to either findanother source for the necessary funds or else file under Chapter 11. Therefore, he asked you todevelop a forecast that ignores the possibility of a reduction in the credit line and which assumes thatthe bank will increase the line of credit by $20 million.

SDI has been borrowing at the prime rate, which is currently 8.5 percent. The companysoutstanding long-term debt bears interest at a rate of 11 percent. The bank may want to increase therate it charges, if it does not call in the loan, but Bob is hopeful the loan will remain at the prime rate.Also, the federal-plus-state tax rate should remain at 40 percent. Finally, if the bank cooperates andthe companys fortunes improve, the P/E ratio should stabilize at about 14.

SDIs 1996 debt-plus-preferred-to-assets ratio was 65.8 percent compared to an industry aver-age ratio of 42.4 percent. However, the plan calls for reductions in receivables and inventories, and40 percent of the funds generated will be used to reduce notes payable and 60 percent will be used toreduce long-term debt. Also, any future capital needed will be financed in accordance with a new tar-get capital structure which calls for 60 percent equity and 40 percent debt, with half of the debt short-term and the other half long-term.

The projected financial information in Tables 5, 6, and 7 can be used to help assess the com-panys financial position. Such statements might also convince Isabelle that the banks loan is safeand that a larger line of credit is warranted. However, Bob has heard Isabelle state that she hasnever seen a bad forecast from a company seeking funds, so credibility is the key. Bob notes that inthe recent past SDI has operated at or better than other firms in its industry, and that it should be ableto get its inventory turnover and days sales outstanding to industry-average levels. He also thinks thatcash and securities and net plant and equipment can be lowered to industry average levels (as mea-sured by percentage of sales), but that other current assets and other assets will remain at the com-panys 1996 percentages of sales. Accounts payable and accruals should drop to industry averagelevels, but other current liabilities, minority interest, and deferred taxes should remain at the firms1996 percentage of sales. Finally, SDI may be able to sell some of its excess fixed assets.


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Tom wants you to analyze the forecasted financial statements for 19971999. Tables 5, 6,and 7 represent SDIs projected balance sheets, income statements, and ratios for those years asdeveloped by the forecasting model, based on the assumptions set forth above. Note, though, that the1997 ratios are missing in Table 7, so you need to fill them in.

It is apparent that if everything goes as projected, SDI will survive and the banks loan willbe safe. However, forecasts do not always work out as projected. Therefore, it would be useful if youcould, as part of your consulting report, inform management (and the bank) as to how sensitive theresults are to changes in such things as the sales growth rate, the cost of goods sold as a percentageof sales, and so forth. If the results still look good even if those assumptions prove to be a bit too opti-mistic, the bank should have greater confidence in extending the requested credit. On the other hand,if small changes in these variables lead to poor results, the bank would be more reluctant to grant anew loan or even extend the current one.

Your job now is to analyze the situation and then write a report which describes what manage-ment should do, and how the bank and other parties are likely to respond. You can use the modeloutput given in Tables 5, 6, and 7, but you should note that the output is based on the assumptions pro-vided by Bob Wilkes. You are not expected to verify the correctness of the assumptions, but it wouldbe helpful if you could provide information as to how sensitive the results are to the assumptions. Tohelp start the process, Bob Wilkes and Tom Stone provided you with the following set of questions:

QUESTIONS

1. Apply the DuPont equation (ROE = Profit margin x Total assets turnover x Equity multi-plier) to SDIs data to obtain a general overview of the firms financial condition. ConsiderSDI relative to its industry, its historical trend, and its forecasted trend.a. What areas of strength, what weaknesses, and what needed corrective actions are

revealed by the historical data?b. Does the discussion in the case, and the forecasted data, indicate that management is

addressing the proper issues, and doing so correctly? Think about liquidity, asset utiliza-tion (turnover), financial leverage, profitability, and market value indicators.

2. Banks typically make two types of loans, (1) history loans, where the firms history indi-cates that, if current trends continue, the loan can be repaid on schedule, and (2) forecastloans, where the historical data are not strong enough to justify the loan but the companysforecasts look good and the bank has confidence in the forecasts. If history does not justifythe loan, and if the forecasts are not credible, then the loan will be denied.a. Do you think the bank would make a history loan to SDI at this time?b. Do you think the bank would make a forecast loan to SDI? If so, would you expect this

capital to cost less, the same, or more than the cost of SDIs existing loan?c. If the bank would not renew the loan and advance another $20 million, can you suggest

other capital providers who might supply the needed capital?

3. While an analysis of historical financial statements can provide useful information concern-ing a companys operations and financial condition, such analysis does have some inherentproblems and limitations that necessitate care and judgment. For example, the reportedinventory may be obsolete, or the turnover ratios may be distorted by seasonal factors. Dis-cuss some problems and limitations of ratio analysis.


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4. Based on the information in the case, would you believe SDIs forecasts? If you were adirector, the banker, a security analyst, or some other user of the forecasts, what questionsmight you ask to help establish in your own mind the companys chances of actually achiev-ing the forecasted results?

5. How much inventory would SDI have at the end of 1997 if it remained at its 1996 inventoryturnover ratio? How much accounts receivable would SDI have at the end of 1997 if itremained at its 1996 days sales outstanding level?

6. SDIs forecast for 1998 and 1999 assumes that it will reduce its net plant and equipment as apercentage of sales to the industry average level, which implies that it will utilize its plantand equipment at the same rate as an average firm. However, it is generally much more diffi-cult to make adjustments to fixed assets than to working capital.a. What assumption does the company make in its forecast for 1997?b. Is this a reasonable assumption?

7. Consider the concept of EVA, and think about how it is calculated. No specific numbers arerequiredjust answer the following questions conceptually.a. If sales remained at 1996 levels, but SDI was able to decrease inventory to the industry

average level, what would you expect to happen to EVA?b. How would you calculate the new EVA, given the old EVA and the situation set forth in

Part A?c. How would an improvement in the operating profit margin affect EVA?d. If SDI reduced its use of debt, what would be the effect on EVA?e. If investors judged SDI to be getting less risky as a result of its forecasted financial

improvement, how would that affect EVA?f. The spreadsheet model used to generate Tables 5, 6, and 7 was based on the assumptions

set forth above, which included a movement toward industry average ratios. However,the forecasts could have been based on the assumption that all expense ratios and percent-age of sales ratios would remain at the companys 1996 levels. What do you think wouldhappen to EVA if 1996 company data had been used for the forecasts, and how would theforecasted EVA have compared with an EVA based on SDIs assumptions? Assume a10% sales growth. (Note: If you have a copy of the spreadsheet model, you can actuallychange the data and generate 19971999 forecasts based on alternative assumptions.)

g. Based on the above, if management compensation were based on EVA, would this seemto motivate managers to do what stockholders want them to do, namely, maximize thestock price?

8. What would you expect to happen to EPS and EVA if the following things occurred? (If youare using the spreadsheet model, you can examine the sensitivity of EPS and EVA tochanges in these variables. Note, though, that certain changes might have effects that are notcaptured in the model. For example, an increase in the sales growth rate might lead to higherEPS and a higher EVA, which would be reflected in the model, but a higher rate might alsolead to a higher P/E ratio, hence a higher stock price, but the model does not automaticallychange the P/E ratio.)a. Sales growth increased or decreased from the current assumptions?b. The profit margin rose or fell?c. The debt ratio were increased or decreased?d. The turnover ratios were higher or lower?


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9. The bank is concerned about the TIE and current ratios. Consider the sensitivity of the 1997TIE and current ratios to changes in sales growth, cost of goods sold, and so forth. Howmight a sensitivity or scenario analysis affect the banks decision on the loan?

10. How might management use the forecasting model when it is formulating its plans and bud-gets for the coming year or years? How might security analysts use such a model? Could anoutside analyst get data for use in a forecast of a company such as SDI? Would the companybe willing to share its assumptions with stock analysts? With debt analysts, includingbankers? With its own stockholders?

11. What should the role of outside members of the board of directors be in all this? Should theboard, as a board, be concerned with ratios such as the inventory turnover and days salesoutstanding, or would such concern amount to meddlesome micro-management?


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TABLE 1Historical Balance Sheets for Years Ended December 31

(Millions of Dollars)

1994 1995 1996AssetsCash & Securities $ 89.4 $ 87.6 $ 22.5Accounts receivable 72.8 82.6 112.4Inventories 80.1 88.2 100.6Other current assets 1.0 1.0 1.0

Total current assets $243.3 $259.4 $236.5

Gross plant and equipment $242.2 $343.2 $460.8Accumulated depreciation 78.7 104.4 131.2Net plant and equipment $163.5 $238.8 $329.6

Other assets 1.0 1.0 1.0

Total assets $407.8 $499.2 $567.1

Liabilities And EquityAccounts payable $ 58.8 $ 68.5 $ 78.3Notes payable 9.0 38.5 44.7Accruals 17.4 34.8 23.7Other current liabilities 1.0 1.0 1.0

Total current liabilities $ 86.2 $142.8 $147.6

Long-term debt $120.6 $135.5 $137.1Minority interest & other liabilities 1.0 1.0 1.0Deferred taxes & other credits 1.0 1.0 1.0

Total liabilities $208.8 $280.2 $286.8

Preferred stock $ 34.4 $ 34.4 $ 86.3

Common stock (Par = $1) $ 11.9 $ 11.7 $ 13.6Retained earnings 152.6 172.8 180.4

Total common equity $164.6 $184.6 $194.0

Total liabilities & equity $407.8 $499.2 $667.1


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TABLE 2Historical Income Statements for Years Ended December 31

(In Millions Except for Per Share Data)

1994 1995 1996

Sales $650.0 $589.0 $572.0Costs and expenses:COGS excluding depreciation 540.8 490.0 485.0Depreciation 22.9 25.7 26.8Selling/administrative expenses 9.8 8.8 8.6Other expenses 3.3 2.9 2.9Total costs $576.7 $527.5 $523.2

Net operating income (EBIT) $ 73.3 $ 61.5 $ 48.8Interest 10.3 13.8 14.5

Earnings before taxes (EBT) $ 63.0 $ 47.6 $ 34.3Taxes (40%) 25.2 19.1 13.7

Net income before preferred dividends $ 37.8 $ 28.6 $ 20.6Dividends to preferred 2.8 2.8 5.9Net income available to common $ 35.1 $ 25.8 $ 14.7

Dividends to common $ 4.8 $ 5.6 $ 7.1Additions to retained earnings $ 30.3 $ 20.2 $ 7.6

Millions of shares1 11.9 11.7 13.6Stock price year end2 $ 35.0 $ 22.0 $ 15.0

Earnings per share $ 2.94 $ 2.20 $ 1.07Dividends per share $ 0.40 $ 0.48 $ 0.52Price/earnings 11.9 10.0 14.0Dividend yield 1.14% 2.18% 3.47%

1Number of shares is equal to Common Stock/Par value.2Stock price can be calculated as P/E x EPS.


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TABLE 3Swan-Davis, Inc., Selected Financial Ratios

1994 1995 1996

Liquidity:Current 2.8 1.8 1.6Quick 1.9 1.2 0.9

Asset Management:Inventory turnover (S/I) 8.1 6.7 5.7Days sales outstanding 40.3 50.5 70.7Fixed assets turnover 4.0 2.5 1.7Total assets turnover 1.6 1.2 1.0

Debt Management:Debt + Preferred ratio 59.6% 63.0% 65.8%Equity multiplier 2.5 2.7 2.9Times interest earned 7.1 4.4 3.4

Profitability:Profit margin 5.4% 4.4% 2.6%Basic earning power 18.0% 12.3% 8.6%Return on assets 8.6% 5.2% 2.6%Return on equity 21.3% 14.0% 7.6%

Market Value:Price/Earnings 11.9 10.0 14.0Market/Book 2.5 1.4 1.1

DuPont Analysis:Profit margin 5.4% 4.4% 2.6%Total assets turnover 1.6 1.2 1.0Equity multiplier 2.5 2.7 2.9 Return on equity 21.3% 14.0% 7.6%

Payout ratio 13.6% 21.8% 48.4%

Altmans Z Score: 4.47 2.98 2.53

The minimum Z score required by SDIs bank is 3.20.Z Score Equation:Z = 0.012 (NWC/TA) + 0.014 (RE/TA) + 0.033 (EBIT/TA) + 0.006 (MVC + PF) /BVD + 0.999 (S/TA).The Z score is the multiple discriminant statistic. Discriminant analysis combines various ratios in an effort to predictwho will default and who wont. The higher the Z score, the lower the probability of default. The procedure is used toevaluate bonds, credit card applicants, and other consumer loans. Its called credit scoring.


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TABLE 4Electrical Equipment Industry, Selected Financial Ratios

1994 1995 1996

Liquidity:Current 2.6 2.8 2.6Quick 1.7 1.5 1.4

Asset Management:Inventory turnover (S/I) 8.2 8.9 9.3Days sales outstanding 35.8 32.1 36.2Fixed assets turnover 2.3 2.5 2.1Total assets turnover 1.7 1.5 1.4Cash as % of sales 1.0% 1.0% 1.0%Other current assets as % of sales 1.0 1.0 1.0Other assets as % of sales 1.0 1.0 1.0

Debt Management:Debt + Preferred ratio 39.2% 41.2% 42.4%Equity multiplier (A/E) 1.6 1.7 1.7Times interest earned 7.9 6.5 6.1A/P as % of sales 3.0 3.0 3.0Accruals as % of sales 2.71 2.71 2.71Other current liabilities as % of sales 0.1 0.1 0.1Minority interest as % of sales 0.1 0.1 0.1Deferred taxes as % of sales 0.1 0.1 0.1

Profitability:Profit margin 5.1% 4.9% 6.4%Basic earning power 15.9 14.6 20.3Return on assets 9.1 8.7 9.0 Return on equity 14.2 12.6 15.6 COGS as % of sales 78.0 78.0 78.0Depreciation as % of sales 5.69 5.69 5.69Selling/administrative expenses as % of sales 1.50 1.50 1.50Other costs as % of sales 0.29 0.29 0.29

Market Value:Price/Earnings 12.9 13.8 15.0Market/Book 2.1 2.6 2.6

DuPont Analysis:Profit margin 5.1% 4.9% 6.4%Total assets turnover 1.7 1.5 1.4Equity multiplier 1.6 1.7 1.7

Return on equity 14.2% 12.6% 15.6%Payout ratio 35.0 35.0 35.0


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TABLE 5Pro Forma Balance Sheets for Years Ended December 31

(Millions of Dollars)

1997 1998 1999

Cash $ 6 $ 7 $ 8Accounts receivable 63 70 77Inventories 68 74 82Other current assets 1 1 1

Total current assets $138 $152 $167

Gross plant and equipment $461 $536 $612Accumulated depreciation 167 206 250Net plant and equipment $294 $330 $363Other assets 1 1 1

Total assets $433 $483 $531

Accounts payable $ 19 $ 21 $ 23Notes payable 2 3 2Accruals 17 19 21Other current liabilities 1 1 1

Total current liabilities $ 39 $ 44 $ 47

Long-term debt $ 74 $ 75 $ 74Minority interest & other liabilities 1 1 1Deferred taxes & other credits 1 1 1

Total liabilities $115 $121 $124

Preferred stock $ 86 $ 86 $ 86

Common stock (Par = $1) $ 14 $ 14 $ 14Retained earnings 218 262 308

Total common equity $231 $276 $321Total liabilities & equity $433 $483 $531


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TABLE 6Pro Forma Income Statements for Years Ended December 31

(In Millions Except for Per Share Data)

1997 1998 1999

Sales $629 $692 $761Costs and expenses:COGS excluding depreciation 503 554 609Depreciation 36 39 43Selling/administrative expenses 6 7 8Other expenses 3 3 4Total costs $549 $603 $664

Net operating income (EBIT) $ 81 $ 89 $ 98Interest 8 8 8Earnings before taxes (EBT) $ 72 $ 80 $ 89Taxes 29 32 36Net income before preferred dividends $ 43 $ 48 $ 54Dividends to preferred 6 6 6Net income available to common $ 37 $ 42 $ 48

Dividends to common $ 0 $ 0 $ 0

Additions to retained earnings $ 37 $ 42 $ 48

Millions of shares2 13.64 13.69 13.64Stock price3 $38.46 $43.18 $48.86Earnings per share $ 2.75 $ 3.08 $ 3.49Dividends per share $ 0.00 $ 0.00 $ 0.00P/E (Ind Avg = 15) 14.0 14.0 14.0Dividend Yield 0.00% 0.00% 0.00%

2Number of shares is equal to Common Stock/Par value.3Stock price can be calculated as P/E x EPS.


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TABLE 7Swan-Davis, Inc., Selected Forecasted Financial Ratios

Projected1997 1998 1999

LiquidityCurrent 3.5 3.5Quick 1.8 8

Asset Management:Inventory turnover (S/I) 9.3 9.3Days sales outstanding 36.2 36.2Fixed assets turnover 2.1 2.1Total assets turnover 1.4 1.4

Debt Management:Debt + Preferred ratio 42.9% 39.5%Equity multiplier 1.8 1.7Times interest earned 10.5 11.7

Profitability:Profit margin 6.1% 6.3%Basic earning power 18.4 18.4Return on assets 8.7 9.0Return on equity 15.3 14.8

Market Value:Price/Earnings 14.0 14.0Market/Book 2.1 2.1

DuPont Analysis:Profit margin 6.1% 6.3%Total assets turnover 1.4 1.4Equity multiplier 1.8 1.7Return on equity 15.3% 14.8%

Payout ratio 0.0% 0.0% 0.0%Z score: 6.22 6.43 6.77

Altmans Z score equation:Z = 0.012(NWC/TA) + 0.014(RE/TA) + 0.033(EBIT/TA) + 0.006(MVC + PF)/BVD + 0.999(S/TA).The Z score is the multiple discriminant statistic. Discriminant analysis combines various ratios in an effort to predictwho will default and who wont. The higher the Z score, the lower the probability of default. The procedure is used toevaluate bonds, credit card applicants, and other consumer loans. Its called credit scoring.


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Tina Clark, Chief Financial Officer of The Western Company, an electric utility holding company,recently hired your consulting firm to study Westerns dividend policy. Western owns two utilitycompanies plus Western Enterprises, Inc. (WEI), whose main business is building and operatinggenerating plants in conjunction with large industrial companies. Westerns utility subsidiaries areregulated by the public utility commissions of their respective states. Although its operations are notsubject to regulation, WEI faces intense business competition.

Westerns executives have been debating dividend policy, but no consensus has emerged. Likemost utilities, Western pays a relatively high percentage of its earnings out as dividends. Some exec-utives think the high payout should be continued, because stockholders seem to prefer this policy.However, others disagree, pointing out that deregulation and the breakdown of the utility indus-trys monopoly structure is leading to increased competition, and in this new environment a lowerpayout ratio is appropriate.

Tina sees merits in both positions. Surveys of Westerns stockholders show a strong prefer-ence for dividendsthey want the company to maintain if not increase the payout ratio. If the divi-dend were cut, a number of stockholders would be forced to sell their stock and switch to anotherstock with a higher payout, and those sales would depress Westerns stock price. On the otherhand, Western is facing increased competition, most competitive firms have payout ratios that areless than half that of Western, and Tina thinks Western should generate more capital internally anduse it to reduce debt.

Currently, Western is still the sole supplier of power in its service area to all except a fewindustrial firms. Moreover, Western is relatively efficient, and its low costs will help it ward off com-petition. Still, it does have some plants that are relatively inefficient, and the possibility exists forsome new producer to move in and take away business.

One executive who advocates a high payout sent Tina Table 1, along with some news clip-pings describing recent dividend actions taken by companies and groups of companies. Industrialcompanies typically pay out about 40 percent of earnings, though the ratio rises in recessionary yearswhen dividends are maintained even though earnings decline. Telephone companies, which areabout 10 years ahead of the electrics in terms of exposure to competition, have reduced their targetpayout ratios as competition has increased.

Tina had employed an intern from the local university during the fall, and the intern pro-duced a report on utilities dividend policy. Here are her conclusions:


Case 80

The Western CompanyDividend Policy

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1. Until the 1970s, utilities provided safe, dependable dividends. Their stocks were calledwidow and orphan stocks and were bought by retirees and others seeking safe cashincome. Utilities were growing more rapidly than most other companies, but they couldfinance growth by issuing stocks and bonds.1 This led them to pay high dividends and thusto attract stockholder clienteles who wanted high dividends.

2. The situation changed during the 1970s. Inflation accelerated, driving up utilities costs, butregulators, under intense political pressure, did not allow adequate cost pass-throughs. Thiseroded profits and stock prices.

3. Many utilities recognized that their payout ratios were too high, but they felt compelled tomaintain or even increase their dividends. Partially completed plants were in the pipeline,and capital was needed to finish those plants. Debt was being used to the max, and equitywas required to support the rising debt. Most companies discussed with their investmentbankers the pros and cons of obtaining equity by cutting dividends versus issuing new stock.The investment bankers argued as follows:a. A dividend cut would lower the stock price, increase the number of shares needed to raise

a given amount of money, and thus lead to a dilution of future earnings. Those lowerearnings would lead to still lower stock prices, and a downward spiral could set in. Thefear of this spiral kept utilities from cutting their dividends.

b. The amount of new equity generated by cutting dividends would not be adequate to meetthe companys needs, so new stock would still have to be issued. Selling stock after a div-idend cut is especially difficult and expensive.

c. Investors expected annual dividend increases, and a failure to meet those expectationswould lead to disappointment and a lower stock price. However, if the dividend wereincreased, this would benefit the stock price and make it easier to issue stock. Some West-ern executives noted that the investment bankers recommendations were self-serving,because the higher the payout, the more stock companies would have to sell, hence themore the bankers would earn. Nevertheless, Western followed the bankers advice andkept its payout ratio high.

4. The typical utility entered the 1990s with a payout ratio which exceeded that of most com-petitive companies, even as utility competition increased. Many utility executives wanted tobetter align their financial policies with the new market realities, but they were afraid ofwhat might happen to stock prices if they cut the dividend or even increased it by less thaninvestors expected.

5. The telephone companies had experienced similar developments, but about 10 years earlier.Table 1 shows that telco payout ratios have been declining in recent years, and that declineis continuing and will probably accelerate.

1A major drawback to issuing stock is the fact that the announcement of a stock offering is generally taken by investors tobe a negative signal regarding managements outlook for the future. If future prospects looked brighter to management thanto investors, hence the stock was in managements view undervalued, then the company would want to finance with debtrather than stock so as to avoid unnecessary dilution. On the other hand, if management was more pessimistic than the aver-age investor, it would regard the stock as being overvalued, and in this situation existing stockholders would be better offfinancing with stock than with debt. Investors know that this is the way management can be expected to act, so the announce-ment of a stock offering is taken by investors as a negative signal, hence stock prices tend to decline when stock offeringsare announced.The strength of the effects of a stock offering announcement depends on the extent of information asymmetry betweenmanagement and investors. If investors know a great deal about a company and its operations, then the announcement (andthe reasons for it) will have been anticipated, and there will be relatively little pressure on the stock price. Because of regu-lation, investors know more about utilities than about most other companies, so the price pressure when utilities issue stockis relatively small. Therefore, other things held constant, utilities are better able to provide stockholders with cash dividendsand then raise equity by issuing stock.


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6. A number of utilities reduced or omitted their dividends in recent years, but all the cuts wereby companies that had taken write-offs associated with high-cost nuclear plants or hadsevere operating problems. Thus, dividend reductions resulted from earnings reductions, anddividend cuts always led to large stock price declines. Note, though, that it was not clear ifthe stock price declines were caused by the dividend cuts or the operating problemstheeffect of a stock price decline might be caused by either operating problems or by lowerdividends. Still, utilities never cut their dividends except under extreme circumstances.

7. However, on May 9, 1994, FPL Group, the holding company which owns Florida Power &Light, dropped a bombshell on the financial communityit reduced its annual dividend by32 percent, from $2.48 to $1.68 per share. In its announcement, FPL stressed that it hadstudied the situation carefully and had concluded that maintaining a high payout rate (over90%) in an increasingly competitive environment was not in shareholders best interests.The company needed flexibility to deal with the volatile competitive environment, and try-ing to maintain a dividend as high as it was then paying would not provide much flexibility. FPL knew that a dividend reduction would probably be viewed as a negative signal bystockholders, at least initially, so management tried to ease the blow by simultaneouslyannouncing (1) that the cut was motivated by a desire to establish a more fundamentallysound financial position, not by financial difficulties, (2) that a major stock repurchase pro-gram would be undertaken, and (3) that the actions taken would lead to accelerated growthin earnings and dividends.It is worth noting that, in the 1980s and under a former management team, FPL decided todiversify into a number of unregulated businesses that had nothing to do with its core elec-tricity business. Pursuant to its diversification program, FPL acquired a major insurancecompany, a cable TV company, a citrus-growing company, an information services com-pany, a real estate development company, and a company which builds power plants for oth-ers. This diversification effort was not successful, and by 1995 most of the non-energybusinesses had been disposed of at a loss of almost $1 billion, which lowered the companysearnings base, hence its earnings per share. Since it had continued to increase the dividendannually, even though earnings were depressed by the write-offs, FPLs payout ratio hadclimbed to over 90 percent.

Prior to the dividend announcement, FPLs management had dropped hints that it mightreduce the dividend, but the hints had been picked up by few analysts. However, on May 5,four days before the companys announcement, Merrill Lynchs utility analyst did release areport stating that FPL might cut the dividend, and the stock fell by $2 (5.9%) that day. Hereare some data related to the cut:

April 29, 1994 closing price: $35.375. May 5 Merrill Lynch suggests that the dividend might be cut. The stock price declined

by $2. May 9 FPL announces a 32 percent dividend reduction, a new target payout ratio of 60

to 65 percent, and a large stock repurchase program.Management also suggested that the dividend would grow faster in the future

and that capital gains would replace some of the old dividend yield. Still, theannouncement led to another drop of $4.375 (13.7%), to $27.50, down 22.3percent in just 10 days.Investor reactions were initially negative. Here is a typical comment: The

company should have warned us this was coming. I bought the stock expectingto receive a good dividend, and for them to cut it even though the cash is avail-able is just not fair.


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Analysts recommendations on FPL:On April 29, 1994 On June 29,1994 On April 29,1995

(10 days prior) (2 months after) (1 year after) Number recommending each action:

Buy 3 15 21Hold 28 18 10Sell 2 0 0Buys as % of total: 9% 45% 68%

FPLs stock price has mirrored the trend in analysts recommendations:Average FPL Price/Avg.

FPL Utility Util. PriceDecember 1993 $36 $36 100%May 9, 1994 27 32 84December 1994 35 31 113December 1995 46 38 121

Thus, FPLs stock dropped relative to the industry average from the end of 1993 until just after the divi-dend cut, but its performance was significantly better than that of the average electric after the cut.

8. Even though FPLs payout ratio hit 91 percent in 1993, projections at the time indicatedthat the payout would decline to the industry average (79%) by 1998 or 1999 if the com-pany (1) held the dividend growth rate to 1 percent per year and (2) experienced itsthenprojected earnings growth rate. However, it would have taken well into the 21st Cen-tury to grow into the target payout of 60 to 65 percent.

9. After FPL reduced its dividend and experienced its stock price bounce-back, security ana-lysts expected several other large, healthy utilities to follow FPLs lead and reduce their div-idends. However, more than a year later, none had done so. There are rumors that severalcompanies managements wanted to reduce their dividends, but their boards of directors hadvetoed their plans.

10. Table 1 provides some information on dividend policy among electrics, telephone, andindustrial companies. Two points are worth noting: (1) The utilities have historically hadhigh payout ratios relative to unregulated, competitive firms, and (2) the telephone compa-nies, which in recent years have been subjected to competition much like that the electricsare now facing, have been lowering their payout ratios.

11. Table 2 gives selected financial information on Western. Note that Westerns payout isabout equal to the industry average. It is well below that of FPL at the time FPL cut its divi-dend, but it is well above the level FPL achieved after its cut. It is not shown in the table, butWesterns payout will remain above 75 percent on into the foreseeable future if its earningsand dividends grow at their predicted rates, because earnings and dividends are projected togrow at the same rate.

12. Table 3 gives some information on who currently owns Westerns stock plus relevant resultsfrom questionnaires which Western sent to its stockholders in 1985 and 1995.

13. Table 4 provides information on Westerns earnings, cash flows, capital expenditures, anddividends from 1990 through 1995, with projected data from 1996 through 2000. The pro-jected data were calculated with a spreadsheet model. The projections are obviously subjectto a lot of uncertainty, because new investment opportunities could appear, projects thatcurrently appear promising could be reappraised downward, profits could be higher orlower than forecasted, and so on. Indeed, the increasingly competitive environment makesthe forecasts of both profits and investment opportunities far less certain than was true inthe past. Assume that Westerns weighted average cost of capital (WACC) for evaluating


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average-risk capital expenditures is currently estimated to be 10 percent. That figure isbased on the use of retained earnings; it would be somewhat higher if it were necessary toissue new common stock. Obviously, though, the WACC could change over the next 5years, and it would be higher if the company were required to raise a substantial amount ofnew equity by issuing stock. (Some stock will be sold through the firms dividend reinvest-ment plan and issued to employees through Westerns stock purchase plan. Those fundswere taken into account in the 10 percent WACC estimate.)

The data on capital expenditures for the period 1996-2000 as shown in Table 4 representsthe financial staffs estimate at this time of the dollar amounts of projects that will havepositive risk-adjusted NPVs, assuming a corporate WACC of 10 percent.

14. Table 5 gives data on price/earnings ratios, market/book ratios, returns on equity, and otherfinancial information for Western, FPL, the S&P electrics, and the S&P 400 industrial com-panies. This material might be useful when considering Westerns dividend policy.

15. FPL stated that it was replacing some of its cash dividends with stock repurchases, and itgave two reasons for this action: (1) The company would have more flexibility as to whenand if it carried out the repurchase program versus payment of cash dividends. If funds wereneeded internally, or if cash flows were reduced for any reason, the repurchases could bedelayed. Cash dividends, on the other hand, cannot be omitted or reduced without causingserious upset. FPL reasoned that one reduction was bad enough, but going into an increas-ingly competitive environment with a high payout ratio could lead to frequent dividendreductions unless the payout ratio was lowered significantly. (2) Stockholders who pay taxeswould be better off having the company distribute excess cash through repurchases ratherthan through cash dividends.

After reviewing the information in the interns report, Tina was not sure what step to take next.She could see some merit in following FPLs lead and lowering the payout ratio down toward therange competitive, unregulated companies generally use. However, she knew that Westerns boardwas proud of the fact that the company had never reduced the dividend over its entire life. She alsoknew (from Table 3 as well as from discussions with and letters from stockholders) that stockhold-ers would be upset if the dividend were cut. Indeed, Tinas own mother had invested a high per-centage of her retirement savings in Westerns stock, and she needed the quarterly dividend check.If that check were reduced, it would create a real financial hardship for her.

At that point, Tina decided to ask your consulting firm to help her analyze the situation andto decide what recommendation to make to the board. The choice, really, seemed to be either tomaintain the current dividend of $1.18 per share, to increase the dividend by a relatively small per-centage such as 2 percent, or to cut it as FPL had done. At any rate, your task is to study the situa-tion and help Tina decide what to recommend to the board. She wants you to prepare a reportdiscussing all the issues, and, possibly, to make a presentation to the board. To help you get started,she provided you with the following set of questions.

QUESTIONS

1. What has happened to the electrics dividend payout ratios over time? Is this developmentconsistent with growing competition in the industry?

2. Do investors in general prefer dividends to retained earnings? What about Westernsinvestors?


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3. Do Westerns investors appear to approve of its dividend policy? If it changed the dividendpolicy, would the new policy appeal to more or fewer investors than the current policy?

4. How should investment opportunities influence dividend policy? As a part of your answer,construct a hypothetical graph that can be used to show the relationship between a firmscost of capital, its investment opportunities, the size of its capital budget, and its optimaldividend policy. Show dollars on the horizontal axis and percent on the vertical axis, usingreasonable but hypothetical data as opposed to company-specific numbers, but relate yourgraph to Western.

5. What signals do companies send investors through dividend actions? Should Western beconcerned about signaling effects if it plans to alter its dividend policy? If so, how should sig-naling be taken into account? Would the FPL situation have any effect on the signaling effectof a dividend cut by Western, i.e., would the signaling effect on Western be different giventhat FPL recently cut its dividend versus the signaling effect if FPL had not cut its dividend?

6. How should a firms stockholder clientele affect its dividend policy? Is it possible that itwould be in the best interests of its current stockholders if Western cut its dividend?

7. Can dividend policy reduce agency costs, and what effect would that have on firms stockprices in general and for Western in particular? Are agency costs more likely to be an issuefor companies if officers and directors own a large or a small percentage of the shares? If alarge or small percentage of its officers and directors wealth and income is dependent onthe companys stock price performance?

8. When establishing a firms dividend policy, in general and for Western in particular,a. how should the target payout ratio be set?b. how stable should dividends be, and what does stability mean?c. should the dividend policy be formally announced?

9. If a companys current dividend policy is not appropriate, how should it make the transitionto a new policy? Would it ever be appropriate to conclude that the desires of the currentstockholders are inconsistent with the dividend policy that would maximize the firms valuein the long run, and then set a policy that would lead to a change in the composition of thefirms stockholders? If the conclusion is reached that a change in composition is warranted,but that the stock price will be below the equilibrium price during some transition period,should the company make an effort (and incur costs) to minimize the price decline? Whatactions might the company take in this regard?

10. Is repurchasing stock a good alternative to cash dividends (a) on a regular basis and (b) underspecial conditions? (Note: No large, publicly owned company has ever been challenged bytax authorities on its repurchase program, and no challenge is likely to occur.)

11. What are the pros and cons of dividend reinvestment plans, in general and for Western inparticular? If Western reduces its dividend, would this increase or decrease the importanceof a dividend reinvestment plan?

12. What are the pros and cons of stock dividends and stock splits, and how are those actionsrelated to cash dividends? Should Western pay a stock dividend or split its stock? Would adividend reduction increase or decrease the probability, or the timing, of a split for Western?


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13. Should dividend policy (or the cash distribution policy) and capital structure be establishedjointly or independently? If Western decided to change its capital structure, how would thatchange feed back into its dividend policy? Might a change in dividend policy lead to achange in capital structure policy? Specifically, if Western reduced its cash dividend, wouldthis be more likely to lead to an increase or a decrease in the use of debt. Also, if Westernwants to avoid reducing its dividend, or at least minimize any reduction, might a change incapital structure policy be desirable?


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TABLE 1Dividend Payout Ratios of Different Companies

SelectedElectric Telephone S&P 400

Year Western FP&L Utilities Companies Industrials1965 60% 50% 66% 59% 51%1970 63 52 71 66 591975 65 41 69 64 431980 69 67 75 68 401985 72 62 66 62 521990 75 88 80 58 511995 78 58 79 55 361999E 79 59 75 48 35

Notes: 1. Western compares itself with 10 electrics that are generally comparable in terms of size and operating char-acteristics. Estimated 1999 data were obtained from Value Line and other investment advisory services.

2. FP&L hit a high of 91% in 1993.

TABLE 2Selected Financial Information on The Western Company

Year-EndYear EPS BVPS Price P/E M/B Payout ROE1965 $0.59 $ 4.55 $10.0 17.1x 2.2x 60% 12.9%1970 0.58 4.06 7.3 12.6 1.8 63 14.31975 0.62 5.60 5.6 9.1 1.0 65 11.01980 0.77 6.50 5.2 6.8 0.8 69 11.81985 1.28 8.83 10.6 8.3 1.2 72 14.51990 1.18 9.53 14.3 12.1 1.5 75 12.41995 1.52 12.69 20.0 13.2 1.6 78 12.0


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TABLE 3 Results of Western Stockholder Questionnaire

I. Current Classification of Stockholders:Individuals 56.1%InstitutionsPension funds 20.2%Mutual funds, money managers 14.3Other financial institutions 5.0Money managers 4.3Total 43.8

Officers and directors 0.1100.0%

II. Individual stockholders responses to questionnaire:Responses:

1995 1985Question: Which statement best describes your position:

I hold the stock primarily for the cash dividends it provides. 72.8% 78.6%I give equal weight to dividends and capital gains. 27.2 21.4

Question: Would you prefer to have the company use income to increase the dividend or reinvest in the businessand thus provide capital gains?

a. Pay higher dividends. 70.6% 79.3%b. Reinvest earnings to provide capital gains. 29.4 20.7

Question: Is your taxable income:a. $20,000 or less 15.1% 18.7%b. Over $20,000 but below $50,000 61.5 62.8c. $50,000 to $100,000 20.2 16.2d. Over $100,000 3.2 2.3


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TABLE 3 (Continued) Results of Western Stockholder Questionnaire

Responses: 1995 1985

Question: What percentage of your total portfolio doesWesterns stock represent?

a. 100 percent 9% 11%b. Over 75 but less than 100 percent 3 7c. Over 50 but less than 75 percent 4 6d. Over 25 but less than 50 percent 17 18e. Over 20 but less than 25 percent 18 16f. Over 15 but less than 20 percent 19 17g. Over 10 but less than 15 percent 13 11h. Over 5 but less than 10 percent 12 10i. 5% or less 5 4

Notes: 1. The questionnaire was administered by a polling company, and only data on individual investors arereflected in the table. Informal telephone surveys of other types of investors suggested dividends andcapital gains were given equal weight, except that money managers showed a slight preference for divi-dends because their clients wanted dividends.

2. 1985 income data were adjusted upward to reflect inflation and to make them comparable to 1995 data.3. The questionnaire had been sent out before Tina joined the company, but she wondered how the results

would be changed if the responses had been based on number of shares held rather than stockholdersregardless of the number of shares they held. While the questionnaire did not ask for number of shares,Tina had asked the polling company to conduct some telephone surveys, and her intern had gone over theresponses. The intern concluded that the results would have been quite different had the responses beenbased on shares held. In particular, stockholders with more shares seem to put greater weight on capitalgains than those with fewer shares, hence larger stockholders would be more willing to see the companyretain more of its earnings. Also, stockholders with more shares tend to have higher incomes, hence arein higher tax brackets. The intern also estimated that if the results had been weighted by number of sharesheld, over 80 percent of the stock held by individuals would have been held by investors whose Westernshares represent 10 percent or less of their total portfolios, and less than 1 percent of the shares were heldby undiversified investors. Considering that 44 percent of the stock is held by institutional investors, theintern concluded that the vast majority of the stock (but not the individual stockholders) is held in rea-sonably diversified portfolios.


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TAB

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1990

$14,4

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1993

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Documents

Financial Management Cases NEU 2013 (Lores)