Making Long Term FM Decisions - Integrative Case
Title: Analyzing Long Term Financial Decision Making in the Firm (Learning Demonstration 3)
Initial Steps to Completion:
1. Organize your team, choose a leader, and accept accountability for being the lead analyst for one or more parts of this list of tasks.
2. Complete your draft assigned task(s) and post in a common area for review by your team members.
3. Review, comment on, and suggest changes to draft completed tasks by the team.
4. Discuss and resolve differences and come to a consensus on the best responses.
5. Organize your analysis, conclusions, and recommendations
Course Deliverable: Write a report responding to the tasks assigned to your team. Clearly organize your report and effectively communicate the team’s analysis, conclusions and recommendations (if appropriate) associated with each task. Provide the details supporting your analysis as attachments. You should be completing tasks along the way – do not wait until the end of the course to complete your tasks.
Introduction: As a special analytical group set up by ACME Iron by the firm’s Controller, you have been tasked to respond to the following issues raised in a meeting with the CFO.
You and your team must look over several prospective financial strategies to aid in the successful growth of ACME Iron.
You are to work over an 8 to 12 week period on several projects, detail your work as you proceed on these projects, and assemble the report for the CFO to make to the board on the items listed while you work in a team environment. Management will be looking at the team over this period on how well they self-organize and analyze the research areas which will include:
Capital investment analysis
CAPM – Capital Asset Pricing Model determination for the company
WACC – Weighted Average Cost of Capital computations
EVA – Economic Value Analysis
MVA – Market Value Added
Capital structure of the company
Dividend policy
Stock repurchase and option pricing strategy
Bankruptcy risk analysis
Decision Tree Creation
Real option analysis of projects
The CFO wants to test your team out on a simple project in the first task before you get into preparing items for his board presentation in subsequent tasks and projects. He wants to see how well you perform tasks as a team as well as how accurate and thoughtful you are in your work. Details are important to him as well as good organization/presentation and communication.
Financial Statements for use on Tasks
ACME Iron
Balance Sheet
Assets
Current assets:
2014
2015
change
Cash
500,000
600,000
100,000
Investments
1,000,000
1,025,000
25,000
Inventories
110,000,000
117,000,000
7,000,000
Accounts receivable
11,750,000
12,500,000
750,000
Pre-paid expenses
2,500,000
2,600,000
100,000
Other
0
0
...
Making Long Term FM Decisions - Integrative Case Title An.docx
1. Making Long Term FM Decisions - Integrative Case
Title: Analyzing Long Term Financial Decision Making in the
Firm (Learning Demonstration 3)
Initial Steps to Completion:
1. Organize your team, choose a leader, and accept
accountability for being the lead analyst for one or more parts
of this list of tasks.
2. Complete your draft assigned task(s) and post in a common
area for review by your team members.
3. Review, comment on, and suggest changes to draft completed
tasks by the team.
4. Discuss and resolve differences and come to a consensus on
the best responses.
5. Organize your analysis, conclusions, and recommendations
Course Deliverable: Write a report responding to the tasks
assigned to your team. Clearly organize your report and
effectively communicate the team’s analysis, conclusions and
recommendations (if appropriate) associated with each task.
Provide the details supporting your analysis as attachments.
You should be completing tasks along the way – do not wait
until the end of the course to complete your tasks.
Introduction: As a special analytical group set up by ACME
Iron by the firm’s Controller, you have been tasked to respond
to the following issues raised in a meeting with the CFO.
2. You and your team must look over several prospective financial
strategies to aid in the successful growth of ACME Iron.
You are to work over an 8 to 12 week period on several
projects, detail your work as you proceed on these projects, and
assemble the report for the CFO to make to the board on the
items listed while you work in a team environment.
Management will be looking at the team over this period on how
well they self-organize and analyze the research areas which
will include:
Capital investment analysis
CAPM – Capital Asset Pricing Model determination for the
company
WACC – Weighted Average Cost of Capital computations
EVA – Economic Value Analysis
MVA – Market Value Added
Capital structure of the company
Dividend policy
Stock repurchase and option pricing strategy
Bankruptcy risk analysis
Decision Tree Creation
Real option analysis of projects
The CFO wants to test your team out on a simple project in the
first task before you get into preparing items for his board
3. presentation in subsequent tasks and projects. He wants to see
how well you perform tasks as a team as well as how accurate
and thoughtful you are in your work. Details are important to
him as well as good organization/presentation and
communication.
Financial Statements for use on Tasks
ACME Iron
Balance Sheet
Assets
Current assets:
2014
2015
change
Cash
500,000
600,000
100,000
Investments
1,000,000
1,025,000
25,000
Inventories
110,000,000
117,000,000
7,000,000
5. Total fixed assets
235,000,000
255,500,000
20,500,000
Other assets:
2014
2015
change
Goodwill
75,000,000
70,000,000
(5,000,000)
Total other assets
75,000,000
70,000,000
(5,000,000)
Total assets
435,750,000
459,225,000
23,475,000
Liabilities and owner's equity
Current liabilities:
2014
2015
change
Accounts payable
40,500,000
42,400,000
1,900,000
6. Accrued wages
85,000,000
90,500,000
5,500,000
Accrued compensation
10,000,000
10,855,000
855,000
Income taxes payable
4,024,000
4,697,000
673,000
current portion of LT debt
5,500,000
10,350,000
4,850,000
Other
0
0
-
Total current liabilities
145,024,000
158,802,000
13,778,000
Long-term liabilities:
2014
2015
change
Long term debt
125,000,000
130,000,000
5,000,000
Total long-term liabilities
125,000,000
130,000,000
5,000,000
7. Owner's equity:
2014
2015
change
Common stock
122,000,000
122,000,000
-
Preferred stock
16,725,000
16,725,000
-
Accumulated retained earnings
27,001,000
31,698,000
4,697,000
Total owner's equity
165,726,000
170,423,000
4,697,000
Total liabilities and owner's equity
435,750,000
459,225,000
23,475,000
Task 1
Capital Asset Pricing Model (CAPM):
Your team needs to investigate certain items to compute the
required rate of return of your company. The expected market
return for the coming year is 6%, you need to find the current
rates for the 10 year Treasury bond to establish a risk-free rate.
Please remember to cite your source of this data and justify
your reasoning for using this source or data.
Your team will also need to find a rationale for estimating beta
8. since you do not have a long history on the stock market since
you are recently listed. You realize that ACME Iron is capital
intensive so the beta for the company will be influenced by this
point. Since ACME Iron is an iron producer its beta should be
in line with similar companies. Your team will need to analyze
other companies or this industry to come up with a beta
calculation for ACME Iron. Please document your investigation,
sources and justify your choice of beta for Acme.
Concept Check: The Capital Asset Pricing Model is a model that
separates market risk from individual asset risk. We look at
Market risk through the lens of inflationary impact on asset
returns and the opportunity cost of the risk free rate. Market
risk effects all assets so we utilize Beta as a measure of the
volatility of price changes in the particular asset we are
analyzing versus the market of that particular asset class.
Helpful Hint: Discuss strategy of finding financial resources
with your team. Sources should be current and dependable.
Government resources are usually the best since they are free of
charges and free of bias.
Now that you all are comfortable working together as a team
you will be given a series of tasks to help prepare the CFO for
this quarter’s board meeting and investor call.
The objective here is to determine if your company has the
correct capital structure for the strategic initiatives the CFO
wants to pursue this coming year.
In this first task of this series; (Task 2) we prepare for the board
meeting by first establishing the required rate of return our
investors will expect given the current market conditions and
our risk profile.
Task 2
9. Capital Structure and Weighted Average Cost of Capital:
We must now continue to build our models to help explain our
financial strategy to the analysts, shareholders and (of course)
senior management.
In this task we are examining the current capital structure of
ACME Iron and determining the WACC of the company.
Assume that ACME’s tax rate is 40%.
To compute the WACC you must first find the after-tax cost of
debt, the cost of equity and the proportions of debt and equity
in the firm. You can assume that the cost of debt before tax is
8% for the firm. Please clearly show how you derive each of
these values:
After-tax cost of debt =
Cost of equity =
Proportions of debt and equity in the firm =
How do we compute the WACC in this circumstance? Why do
we need to be concerned with the WACC?
Any insights into the capital structure of ACME Iron?
Concept Check: Capital structure for a public company consists
of both debt and equity. We must take into account the ability to
write off interest payments in the calculation of our cost of debt
which results in an after-tax cost of debt being used in our
WACC calculation.
The weighted average cost of capital is the weighted average of
the cost of equity and the after-tax cost of debt. Another way of
10. looking at this is computing the effect of the capital structure
on expected returns by investors.
WACC= S/B+S x Rs + B/B+S x RB x (1 – tc )
Where
S = value of equity
B = value of debt
Rs = cost of equity
After tax cost of debt: RB x (1 – tc )
Helpful Hint: One thing to bring up here is WACC is needed to
determine risk on several levels. To determine risk we need to
remember the following items:
1. Risk is deviation from expectations.
2. We need to set expectations for our investments in relation to
risk and return. Higher risk = higher return.
3. Capital is obtained from the marketplace in two forms; equity
and debt. This is the capital structure of a corporation and
impacts the profits of a company depending on how this is
managed.
4. We use our cost of capital to discount any cash flows from
new investments (NPV and IRR analysis).
5. If cost of capital rises then our risk rises and the projects we
undertake to increase sales and return to our investors is
reduced.
11. 6. If debt rises then our obligation to make payments on interest
increases and profits can decrease if sales do not increase
rapidly enough.
7. If risk increases our beta will increase to show the increase in
risk. This will increase our required rate of return to
stockholders (CAPM) and thus increase our required rate of
return we must use in discounting future cash flows.
Task 3
To illustrate and further support our strategic financial planning
systems we need to show the CFO and management team an
example of the application of the previously constructed
WACC. The CFO thinks that showing management how we can
validate and choose projects based on expected returns
developed from the WACC will help reduce risk of our
investor’s capital thus lowering the required rate of return we
would have to provide to those investors. If we lower our
expected return we can then do more projects and grow at a
faster rate.
He has asked your team to evaluate the following project:
Capital investment: Acme is planning construction of a new
loading ramp for its single iron mill. The initial cost of the
investment is $1 million. Efficiencies from the new ramp are
expected to reduce costs by $100,000 for the life of the plant
which is currently estimated at another 30 years. When will this
project break-even on a simple cash basis and a discounted cash
basis. What is the NPV of the project if Acme has an after tax
cost of debt of 8% and a cost equity of 12% (they are currently
funded equally by debt and equity)?
Concept Check: We need to adjust cash flows to account for
things like inflation, our cost of capital and opportunity costs.
12. Simply looking at cash flow not adjusted for some of these costs
will lead to taking on projects which are not really adding to the
value of the organization.
Helpful Hint: The first step in conducting an NPV analysis is to
include all the relevant cash flows. This includes savings from
taxes and any expenses directly related to the venture.We reject
any project with a negative NPV.
Task 4
An aspect of investment analysis that you and your team had
thought about was the different outcomes that may happen when
managing projects and how to adjust management’s
expectations for return in light of the real options or
probabilities that alternative scenarios may develop depending
on available information.
You determine the best activity for your team to explain this to
the CFO and management is to use a real example from a
project you are currently evaluating.
The most recent example was the company decision whether to
invest $50 Million in developing and implementing a new
enterprise system to help manage resources and meet customer
demand in the face of considerable technological and market
uncertainty.
There can be a good and bad result for this investment.
Good Result: A good result has a probability of .5 of occurring.
Here the planned cost reductions have been realized and better
integration of the supply chain is possible. These benefits are
leveraged by strong market demand for the firm's product.
There have also been feedback benefits, the enterprise system
has significantly improved perceived quality and service from
13. the customer's point of view. Annual benefits under this
scenario equal $15 million in after tax cash flow per year over
the life of the system which has been estimated as 10 years.
Bad Result: The system proves to be more difficult to
implement and improvements in management of the supply
chain are less. In addition, the growth in market demand for the
product is lower. Annual benefits under this scenario are $2
million in after tax cash flow per year for the 10 years.
Real Options: For these capital investments you must analyze
the nature of risk in this capital investment and decide on how
to adjust for that risk. You have decided to utilize an NPV
analysis of the project. Now you must define project risks and
utilize the concepts in real options to adjust or plan for that
risk.
It will be best for you to provide an option tree graphic to show
the options and then provide a table with the computations
showing how you would compute the value of this project.
Scenario #1: Use 10% cost of capital in computations and
compute the good result and poor result NPVs. Calculate the
real option NPV using the results computed.
Scenario #2: Use a risk adjusted cost of capital against the good
scenario above which can adjust for risk variables such as;
experience with the focus of the project, chance of change to
estimated variables (revenue, costs, timing, etc) and/or the
potential change in cost of capital in the future.
Compute the new NPV using a variety of risk adjusted discount
rates. Justify your computations in determining how you have
adjusted discount rates for risk. Discuss the outcomes from your
adjustments and how you would apply them in capital
expenditure justification.
14. Concept Check: Risk in finance is deviation from expectation.
We use this concept in computing beta by mathematically
computing the Security Market Line (SML) for assets and then
computing the deviation of the individual assets against the
market. The utilization of real option analysis in project
evaluation is similar to these concepts and the concept of
weighted average cost of capital.
Helpful Hint: Risk adjustment in project management can be
achieved in several manners. In the case of real options we first
need to identify the different paths our investments can take and
then the probability that each event may occur.
Task 5
This leads the CFO to ask you team to look at how the market
value of ACME is compared to the industry and research how
you can show not only this value but come up with justification
for the capital investments being made.
Your team discusses this and has determined EVA (Economic
Value Added) as well as MVA (Market Value Added) concepts
need to be established for the corporation.
Use the following table as a guide:
*12% here is a plug number. This will be different than the
number you calculated in Task 3.
Compute the P/E ratio and market capitalization for everyone.
Compute the MVA and EVA for all.
Compare and contrast the ratios; what do the ratios convey to
the investing public? How would you present these internally
15. and externally? Make recommendations to management from
your analysis.
Concept Check: Market value added focuses on the market price
and relation to invested capital while economic value is based
on operational profitability compared to invested capital. These
measures help us evaluate our organization internally and
externally to help identify gaps and opportunities.
Helpful Hint: Ratios, by themselves, tell us very little; it is only
when they are placed in context of the market, industry or
competition that they truly can be powerful.
Task 6
Reach out to team members and assign roles. You all need to
contribute. Rotating responsibilities is a suggested strategy in
this team environment.
Leasing: You are to use your critical thinking skills,
collaboration techniques, creative problem solving tools and
communication skills under the following scenario:
Your company (Acme Iron) is considering leasing a new
computer, you and your team need to perform analysis to
support the decision making process. The lease lasts for 9 years.
The lease calls for 10 payments of $10,000 per year with the
first payment occurring immediately. The computer would cost
$70,650 to buy and would be straight-line depreciated to a zero
salvage over 9 years. The actual salvage value is negligible
because of technological obsolescence. The firm can borrow at a
rate of 8%. The corporate tax rate is 30%.
a) What is the after-tax cash flow from leasing relative to the
after-tax cash flow from purchasing in years 1-9?
16. b) What is the after-tax cash flow from leasing relative to the
after-tax cash flow from purchasing in year 0?
c) What is the NPV of the lease relative to the purchase?
d) What would the after-tax cash flow in year 9 be if the asset
had a residual value of $500 (ignoring any possible risk
differences)?
e) Do you have a recommendation?
Concept Check: Understanding which cash flows are relevant is
key to determining best financing methods or project
acceptance. It helps to detail all you assumptions within the
model since questions may arise years after the initial
construction of the model.
Helpful Hint: Creating a time-line with corresponding cash
flows is usually helpful. You should also do the NPV
calculations showing your formula so if anyone wishes to
change the variables they will know how to proceed.
Task 7
In your discussions with the CFO you have talked about the
impact of a dividend on your company’s market price and
financial statements. He has asked that you and your team
evaluate the impact of issuing a dividend.
Use the income statement and balance sheet provided to make
recommendation for the amount of dividend (if any). How are
retained earnings impacted and what does this mean for the
organization?
Compute the Internal Growth Rate and Sustainable Growth Rate
using current (2015) financial information and then if we issue
17. a dividend payment of $3 million ($0.20 per share times 15
million shares).
Explain your thought process and rationale for a recommended
dividend strategy.
Concept Check: Dividends are distributions of profits to your
investors who placed their capital at risk for you. Theoretically
every company should eventually provide a dividend
distribution to their investors.
Helpful Hint: Dividends are voted on every quarter by the Board
of Directors for a company; the amount of the dividend or if any
is paid can be decided at that time.
Task 8
Share repurchase proposal: Currently, the firm has available
capital (cash and net income) of approximately $5,000,000.
There is a large block of stock available at $25 a share.
If the firm decides to spend this amount of excess cash on a
share repurchase program, how many shares of stock will be
outstanding after the stock repurchase is completed?
What are the benefits of repurchasing shares? How will this
affect the capital structure of the company? How can this be
interpreted in the marketplace?
Would a dividend be better? Please discuss the pros and cons of
dividends and share buybacks. Make a recommendation to
management.
Concept Check: There are tax ramifications which tend to get
very complex; for the sake of this exercise let us disregard tax
implications and effects.
18. Helpful Hint: Think about the impact on the ratios that
companies usually are measured by in the marketplace. Look at
these policies through the eyes of current and potential
investors as well as management of ACME.
Task 9
Evaluation of potential acquisition: Martin & Sons has $4.2
million in net working capital. The firm has total assets with a
book value of $48.6 million and a market value of $53.4
million. They currently carry no debt on their balance sheet,
sales are expected to be $45 million next year, and their tax rate
is similar to ACME at 40%. Through a mixture of synergistic
savings and increased market share this acquisition should add
$2 million in net profit per year for the next 10 years. Acme
Iron is considering buying the company for $60 million in cash.
The acquisition will be recorded using the purchase accounting
method.
What is the amount of goodwill that Acme will record on its
balance sheet as a result of this acquisition?
How do you recommend the firm finance this transaction?
Is there a danger that ACME could damage their finances to the
point that bankruptcy is a potential?
Concept Check:
5-factor model of the Altman Z-score (a for private
manufacturing firms):
Z-score = 0.717T1 + 0.847T2 + 3.107T3 + 0.42T4 + 0.998T5
where,
19. T1 = Working Capital / Total Assets
T2 = Retained Earnings / Total Assets
T3 = Earnings Before Interest and Taxes / Total Assets
T4 = Equity / Total Liabilities
T5 = Sales / Total Assets
Zones of Discrimination:
1.23 or less – “Distress” Zone
from 1.23 to 2.9 – “Grey” Zone
2.9 or more – “Safe” Zone
Interpretation of Altman Z-Score
The Z-Scores are helpful in predicting corporate defaults as
well as an easy-to-calculate measure of control for financial
distress status of companies in academic studies. A Z-Score
above 2.6 (2.9) indicates a company to be healthy. Besides,
such a company is also not likely to enter bankruptcy. However,
Z-Scores ranging from 1.1-2.6 (1.23-2.9) are taken to lie in the
grey area.
Helpful Hint:
Course Deliverable: Review the scenarios 1 through 9.
Assemble a report responding to the tasks you have been given
by the Controller. Structure your report so it is clear which task
you are addressing. Summarize the results of each task in the
body of your report and refer to the detailed supporting
calculations contained in your excel work sheet.
20. Frequently Asked Questions:
How long should my paper be in terms of pages?
Since this is a comprehensive report to management it should be
summarized with an executive summary, contain details on each
scenario analysis with supporting calculations. Expectations
would be 10-12 pages including cover page, executive summary
and references. You should also include an Excel sheet with all
detailed calculations with each problem clearly titled and
references to any templates or material from other sources.
Who is the audience for my paper?
This is a report which will go to your immediate supervisor and
senior management in your organization.
Rubric:
Learning Competency
Highly Proficient
Proficient
Low/No Proficiency
90-100
70-89
0-69
1 Communication: Learners demonstrate ability to communicate
clearly both orally and in writing.
2 Critical Thinking: Learners demonstrate ability to apply
logical, step-by-step decision-making processes to formulate
clear, defensible ideas and to draw ethical conclusions.
21. 3 Quantitative Reasoning: Learners demonstrate the ability to
use mathematical operations and analytical concepts and
operations to address problems and to inform decision-making.
5 Financial Management Knowledge: Learners will demonstrate
applied understanding of financial management concepts as
used in the professions.
6 Integrated Thinking and Application: Apply knowledge of
accounting and financial management in an integrated way to
solve problems faced by individuals and organizations.
8 Data/Information Analysis: Learners gather and analyze data
and information for information sharing, problem solving,
decision making and other purposes.