Assume you are the chief executive officer (CEO) for the company you have been a
ID: 2734073 • Letter: A
Question
Assume you are the chief executive officer (CEO) for the company you have been analyzing for the past 6 weeks. Based on your research over those past 6 weeks, formulate a major capital project that would benefit this company. For example, you could add a new product line, expand your operations into foreign markets, add new retail stores, replace manufacturing plants, etc. Assume that you have already briefed the board of directors about this proposed capital project. The board is interested but wants to see the options as to how the project will be financed.
Provide a summary of your analyses and a well-supported recommendation as to how the project should be funded. Quantify and consider the pros and cons of financing the capital improvement project through any one or a combination of: retained earnings, issuance of bonds (debt), issuance of additional common stock (stock offering), issuance of preferred stock, acquisition of venture capital, and any other methods you consider prudent. What form of financing should the company choose as to not put it at risk of losing money or putting the company at risk of not being able to pay the bills? Assume the capital project will cost $10 million dollars.
Balance Sheet
Get Balance Sheet for:
View: Annual Data
All numbers in thousands
Period Ending
Jan 30, 2016
Jan 31, 2015
Feb 1, 2014
Assets
Current Assets
Cash And Cash Equivalents
1,370,000
1,515,000
1,510,000
Short Term Investments
-
-
-
Net Receivables
-
-
-
Inventory
1,873,000
1,889,000
1,928,000
Other Current Assets
742,000
913,000
992,000
Total Current Assets
3,985,000
4,317,000
4,430,000
Long Term Investments
-
-
-
Property Plant and Equipment
2,850,000
2,773,000
2,758,000
Goodwill
-
-
-
Intangible Assets
-
-
-
Accumulated Amortization
-
-
-
Other Assets
638,000
600,000
661,000
Deferred Long Term Asset Charges
-
-
-
Total Assets
7,473,000
7,690,000
7,849,000
Liabilities
Current Liabilities
Accounts Payable
2,114,000
2,213,000
2,420,000
Short/Current Long Term Debt
421,000
21,000
25,000
Other Current Liabilities
-
-
-
Total Current Liabilities
2,535,000
2,234,000
2,445,000
Long Term Debt
1,310,000
1,332,000
1,369,000
Other Liabilities
1,083,000
1,141,000
973,000
Deferred Long Term Liability Charges
-
-
-
Minority Interest
-
-
-
Negative Goodwill
-
-
-
Total Liabilities
4,928,000
4,707,000
4,787,000
Stockholders' Equity
Misc Stocks Options Warrants
-
-
-
Redeemable Preferred Stock
-
-
-
Preferred Stock
-
-
-
Common Stock
20,000
21,000
55,000
Retained Earnings
2,440,000
2,797,000
14,218,000
Treasury Stock
-
-
-14,245,000
Capital Surplus
-
-
2,899,000
Other Stockholder Equity
85,000
165,000
135,000
Total Stockholder Equity
2,545,000
2,983,000
3,062,000
Net Tangible Assets
2,545,000
2,983,000
3,062,000
Income Statement
Get Income Statement for:
View: Annual Data
All numbers in thousands
Period Ending
Jan 30, 2016
Jan 31, 2015
Feb 1, 2014
Total Revenue
15,797,000
16,435,000
16,148,000
Cost of Revenue
10,077,000
10,146,000
9,855,000
Gross Profit
5,720,000
6,289,000
6,293,000
Operating Expenses
Research Development
-
-
-
Selling General and Administrative
-
-
-
Non Recurring
-
-
-
Others
-
-
-
Total Operating Expenses
-
-
-
Operating Income or Loss
1,524,000
2,083,000
2,149,000
Income from Continuing Operations
Total Other Income/Expenses Net
6,000
5,000
5,000
Earnings Before Interest And Taxes
1,530,000
2,088,000
2,154,000
Interest Expense
59,000
75,000
61,000
Income Before Tax
1,471,000
2,013,000
2,093,000
Income Tax Expense
551,000
751,000
813,000
Minority Interest
-
-
-
Net Income From Continuing Ops
920,000
1,262,000
1,280,000
Non-recurring Events
Discontinued Operations
-
-
-
Extraordinary Items
-
-
-
Effect Of Accounting Changes
-
-
-
Other Items
-
-
-
Net Income
920,000
1,262,000
1,280,000
Preferred Stock And Other Adjustments
-
-
-
Net Income Applicable To Common Shares
920,000
1,262,000
1,280,000
Balance Sheet
Get Balance Sheet for:
View: Annual Data
All numbers in thousands
Period Ending
Jan 30, 2016
Jan 31, 2015
Feb 1, 2014
Assets
Current Assets
Cash And Cash Equivalents
1,370,000
1,515,000
1,510,000
Short Term Investments
-
-
-
Net Receivables
-
-
-
Inventory
1,873,000
1,889,000
1,928,000
Other Current Assets
742,000
913,000
992,000
Total Current Assets
3,985,000
4,317,000
4,430,000
Long Term Investments
-
-
-
Property Plant and Equipment
2,850,000
2,773,000
2,758,000
Goodwill
-
-
-
Intangible Assets
-
-
-
Accumulated Amortization
-
-
-
Other Assets
638,000
600,000
661,000
Deferred Long Term Asset Charges
-
-
-
Total Assets
7,473,000
7,690,000
7,849,000
Liabilities
Current Liabilities
Accounts Payable
2,114,000
2,213,000
2,420,000
Short/Current Long Term Debt
421,000
21,000
25,000
Other Current Liabilities
-
-
-
Total Current Liabilities
2,535,000
2,234,000
2,445,000
Long Term Debt
1,310,000
1,332,000
1,369,000
Other Liabilities
1,083,000
1,141,000
973,000
Deferred Long Term Liability Charges
-
-
-
Minority Interest
-
-
-
Negative Goodwill
-
-
-
Total Liabilities
4,928,000
4,707,000
4,787,000
Stockholders' Equity
Misc Stocks Options Warrants
-
-
-
Redeemable Preferred Stock
-
-
-
Preferred Stock
-
-
-
Common Stock
20,000
21,000
55,000
Retained Earnings
2,440,000
2,797,000
14,218,000
Treasury Stock
-
-
-14,245,000
Capital Surplus
-
-
2,899,000
Other Stockholder Equity
85,000
165,000
135,000
Total Stockholder Equity
2,545,000
2,983,000
3,062,000
Net Tangible Assets
2,545,000
2,983,000
3,062,000
Explanation / Answer
Analyses and a well-supported recommendation as to how the project should be funded.
Retained Earnings :
The portion of profits not distributed among the shareholders but retained and used in business is called retained earnings. It is also referred to as ploughing back of profit. This is one of the important sources of internal financing used for fixed as well as working capital. Retained earnings increase the value of shareholders in case of a growing firm.
The important features of retained earnings as a source of internal financing have been summarized below:
1. Cost of Financing:
It is the general belief that retained earnings have no cost to the company.
2. Floatation Cost:
Unlike other sources of financing, the use of retained earnings helps avoid issue- related costs.
3. Control:
Use of retained earnings avoids the possibility of change/dilution of the control of existing shareholders that results from issue of new issues.
4. Legal Formalities:
Use of retained earnings does not require compliance of any legal formalities. It just requires a resolution to be passed in the annual general meeting of the company.
Advantages of Retained Earnings:
The advantages or benefits of retained earnings may be stated as under:
i. Cheaper Source of Financing:
The use of retained earnings does not involve any acquisition cost. The company has no obligation to pay anything in respect of retained earnings.
ii. Financial Stability:
Retained earnings strengthen the financial position of a business and thereby give financial stability to the business.
iii. Stable Dividend:
Shareholders may get stable dividend even if the company does not earn enough profit.
iv. Market Value:
Retained earnings strengthen the financial position of a company and appreciate the capital which ultimately increases the market value of shares.
Disadvantages of Retained Earnings:
Retained earnings are the result of conservative dividend policy of the company and are associated with following demerits:
i. Improper Utilization of Funds:
If the purpose for utilization of retained earnings is not clearly stated, it may lead to careless spending of funds.
ii. Over-capitalization:
Conservative dividend policy leads to huge accumulation of retained earnings leading to over-capitalization.
iii. Lower Rate of Dividend:
Retained earnings do not allow shareholders to enjoy full benefit of the actual earnings of the company. This creates not only dissatisfaction among the shareholders but also adversely affect the market value of shares.
Issuance of Bonds:
Advantages to issuing bonds
Let's look at some of the ways issuing bonds can be superior to those other ways of raising capital.
Retaining earnings: Issuing bonds allows a company to access capital much faster than if it first had to earn and save profits. As the saying goes, you have to spend money to make money.
Selling assets: To sell assets, a company needs to have assets it's willing to sell. Growing companies might decide to borrow money rather than selling assets because they're, well, growing and in the process of acquiring -- not selling -- assets. In down markets, on the other hand, a company may be reluctant to sell assets if it can't find a buyer willing to pay an acceptable price.
Issuing shares: Issuing bonds is much cheaper than issuing shares. When a company sells new shares, the value of its existing shares is diluted. Since shareholders take on more risk than bondholders (in the event of a bankruptcy they're further back in line to receive compensation), shareholders require a higher rate of return than do bond investors.
Issuing bonds offers tax benefits: One other advantage borrowing money has over retaining earnings or issuing shares is that it can reduce the amount of taxes a company owes. That's because the interest a company pays its lenders is counted as an expense, which means pre-tax profits are lower. Retaining earnings and issuing shares, on the other hand, may be more expensive to shareholders, but ironically they're not classified as expenses on an income statement.
Borrowing money may or may not provide tax advantages over selling assets. If the assets were sold for a gain, that gain is taxed, but if they were sold for a loss, the loss would offer its own tax benefits.
Issuance of additional common stock (stock offering) : ommon stocks are ordinary shares that companies issue as an alternative to selling debt or issuing a different class of shares known as preferred stock. The first time that a company issues common stock into the public markets, it does so via an initial public offering. Following an IPO, subsequent common stock offerings may be accomplished with a follow-on offering, which raises the total number of outstanding shares in the markets for investors to buy and sell.
Advantages of Common Stock:
Issuing common stock in the financial markets is an alternative to issuing debt. Rather than adding more debt to a company's balance sheet, which is a financial statement, and budgeting for the servicing of debt, a company can take a less expensive route and issue common stock. With stock, an organization does not need to make obligatory interest payments to investors and instead can make discretionary dividend payments when it has extra cash.
Disadvantages of Common Stock:
From a long-term perspective, issuing stock reduces your profit potential on future earnings. You have to share the income of the business with other investors. Additionally, issuing stock usually means you give up some level of control. If you don't take on large buyers, the loss of control is mitigated. Taking on large investors, though, usually comes with expectation or agreement for a voice or role in company operations.
Issuance of Preferred Stock:
Advantages of preferred stock
Preferred stock are advantageous from the viewpoint of the issuer and the investors.
Form the company’s viewpoint:
Risk less leverage advantage: Preferred shares increase financial leverage because, first of all, the preferred dividend is a fixed obligation and unlike debentures there is no default ever if the dividend is not paid. That means, non-payment of dividend doesn’t force the company into insolvency. Thus, there is an increased risk less financial leverage.
Repayment anxiety and dividend postponability: The maturity period of a perpetual preferred stock is not specified. Thus, there is no obligation to call the preferred stock within a specified time. This is a permanent source of financing, which will not result in liquidation ever if the dividend and par value/stock value is not paid for a longer period of time. The firm has no repaying anxiety and can easily postpone the payment of dividend.
Fixed dividend: The preferred dividends are restricted to the stated amount. Thus, preferred shareholders do not participate in excess profit as the ordinary shareholders do.
Control: preference shareholders do not have a voting right unless the dividend arrears exit. They do not have a voice in the management of the company, therefore the control of ordinary shareholders remains secure.
Flexibility: preferred stocks are free of maturity period. Besides, the dividend can be postponed if earning is insufficient or uncertain. Thus, this is a flexible source of financing.
Ease in expansion: It facilitates those firms that want to expand their business because preferred stock secures the interest of the shareholders as they have a prior claim on the earning and assets. Hence, the company can raise a greater fund by issuing preferred stocks than by issuing common stock
Participation in earning: Ordinary shareholders have equal participation in the earnings made through additional issuance of ordinary shares. But, such participation is not there in case of preferred stock. Their claim is restricted to a limited amount per share. Hence, preferred stocks are in flavor of the owners.
Disadvantage of preferred stock
Cost: It is costly because, generally, dividend rate on such shares is higher than interest rate payable on debentures. Similarly, preference dividend is paid out of earning after interest and tax. The higher the tax rate, the higher the cost of preference shares and it will be inefficient to raise fund through preferred stock issuance. In other words, it is costlier than debentures because it is not tax deductible.
Difficult to sell the stocks: Investors may not like to invest on preferred stocks because they go only a fixed amount of dividend even though unstable they may not get preferred dividend as such dividend even though the firms earning is too high. Besides, if the earning of the firm is low or unstable they may not get preferred dividend as such dividend is not an obligation to the firm. Thus, it is difficult to sell the stocks.
Seniority claim: The preferred stockholders have a prior claim over the earning and assets of the company. This adversely affects the claim of ordinary shareholders. Their claim will, however, be lower than that of preferred stockholders.
Commitment to pay dividend: Common stockholders cannot get dividend unless preferred dividend is paid. Thus, it becomes a sort of obligation to pay preferred dividend.
Acquisition of venture capital:
Business expertise. Aside from the financial backing, obtaining venture capital financing can provide a start-up or young business with a valuable source of guidance and consultation. This can help with a variety of business decisions, including financial management and human resource management. Making better decisions in these key areas can be vitally important as your business grows.
Additional resources. In a number of critical areas, including legal, tax and personnel matters, a VC firm can provide active support, all the more important at a key stage in the growth of a young company. Faster growth and greater success are two potential key benefits.
Loss of control. The drawbacks associated with equity financing in general can be compounded with venture capital financing. You could think of it as equity financing on steroids. With a large injection of cash and professional—and possibly aggressive—investors, it is likely that your VC partners will want to be involved. The size of their stake could determine how much say they have in shaping your company’s direction.
Minority ownership status. Depending on the size of the VC firm’s stake in your company, which could be more than 50%, you could lose management control. Essentially, you could be giving up ownership of your own business.
Mode of Financing:
The company chooses as to not put it at risk of losing money or putting the company at risk of not being able to pay the bills. This means that the company has to go for a optimum combination of various sources of finance. What source of fiancé is optimum and acceptable depends upon
The intention and willingness of the company
Risk premium.
Amount of risk the company is willing to take
Nature of industry in which company is present
Investor Requirements
Company’s bye laws etc
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