Case Study:
Company E is developing educational software for the primary and secondary school markets. In order to maintain the market place the owner entrusted the
To determine:
Factors to be considered for decision making
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Financial Management: Theory & Practice
- David Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: e. Suppose the expected free cash flow for Year 1 is 250,000 but it is expected to grow faster than 7% during the next 3 years: FCF2 = 290,000 and FCF3 = 320,000, after which it will grow at a constant rate of 7%. The expected interest expense at Year 1 is 128,000, but it is expected to grow over the next couple of years before the capital structure becomes constant: Interest expense at Year 2 will be 152,000, at Year 3 it will be 192,000 and it will grow at 7% thereafter. What is the estimated horizon unlevered value of operations (i.e., the value at Year 3 immediately after the FCF at Year 3)? What is the current unlevered value of operations? What is the horizon value of the tax shield at Year 3? What is the current value of the tax shield? What is the current total value? The tax rate and unlevered cost of equity remain at 25% and 14%, respectively.arrow_forwardConsider the following thoughts of a manager at the end of the companys third quarter: If I can increase my reported profit by 2 million, the actual earnings per share will exceed analysts expectations, and stock prices will increase. The stock options that I am holding will become more valuable. The extra income will also make me eligible to receive a significant bonus. With a son headed to college, it would be good if I could cash in some of these options to help pay his expenses. However, my vice president of finance indicates that such an increase is unlikely. The projected profit for the fourth quarter will just about meet the expected earnings per share. There may be ways, though, that I can achieve the desired outcome. First, I can instruct all divisional managers that their preventive maintenance budgets are reduced by 25 percent for the fourth quarter. That should reduce maintenance expenses by approximately 1 million. Second, I can increase the estimated life of the existing equipment, producing a reduction of depreciation by another 500,000. Third, I can reduce the salary increases for those being promoted by 50 percent. And that should easily put us over the needed increase of 2 million. Required: Comment on the ethical content of the earnings management being considered by the manager. Is there an ethical dilemma? What is the right choice for the manager to make? Is there any way to redesign the accounting reporting system to discourage the type of behavior the manager is contemplating?arrow_forwardDavid Lyons, CEO of Lyons Solar Technologies, is concerned about his firms level of debt financing. The company uses short-term debt to finance its temporary working capital needs, but it does not use any permanent (long-term) debt. Other solar technology companies have debt, and Mr. Lyons wonders why they use debt and what its effects are on stock prices. To gain some insights into the matter, he poses the following questions to you, his recently hired assistant: d. Suppose that Firms U and L have the same input values as in Part c except for debt of 980,000. Also, both firms have total net operating capital of 2,000,000 and both firms are expected to grow at a constant rate of 7%. (Assume that the EBIT in part c is expected at t = 1.) Use the compressed adjusted present value (APV) model to estimate the value of U and L. Also estimate the levered cost of equity and the weighted average cost of capital.arrow_forward
- You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $810,000. Other data for the firm are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i. e., what is EPSL - EPSU? 0% Debt, U 60% Debt, L Oper. income (EBIT) $810,000 $810,000 Required investment $ 2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common equity $2,500,000 $ 1,000,000 Shares issued, $10/share 250,000 100, 000 Interest rate NA 10.00% Tax rate 25% 25% a. $0.75 b. $ 2.52 c. $3.36 d. $4.10 e. $2.90arrow_forwardA privately held corporation, is making plans for future investments that can increase growth. The company’s manager has recommended that the company “go public” by issuing common stock to raise the funds needed to support the growth. The current owners, who founded the firm, are worried that control of the firm will be diluted by this strategy. If the company undertakes an IPO, it is estimated that each share of stock will sell for $6.25, the investment banking fee will be 22 percent of the total value of the issue. The founders now hold all of the company’s stock: 8 million shares. If the company issues 8 million shares, what proportion of the stock will the founders own after the IPO?arrow_forwardA privately held corporation, is making plans for future investments that can increase growth. The company’s manager has recommended that the company “go public” by issuing common stock to raise the funds needed to support the growth. The current owners, who founded the firm, are worried that control of the firm will be diluted by this strategy. If the company undertakes an IPO, it is estimated that each share of stock will sell for $6.25, the investment banking fee will be 22 percent of the total value of the issue. If the founders must issue stock to finance the growth of the firm, what would you recommend they do to protect their controlling interest for at least a few years after the IPO?arrow_forward
- You read a story in the newspaper announcing the proposed merger of Dell Computer and Gateway. The merger is expected to greatly increase Gateway’s profitability. If you decide to invest in Gateway stock, you can expect to earn (a) above-average returns since you will share in the higher profits. (b) above-average returns since your stock price will definitely appreciate as higher profits are earned. (c) below average returns since computer makers have low-profit rates. (d) a normal return since stock prices adjusts to reflect expected changes in profitability almost immediately.arrow_forward4. You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $500,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU? Do not round your intermediate calculations. 0% Debt, U 60% Debt, L $500,000 $2,500,000 Oper. income (EBIT) Required investment % Debt $ of Debt $ of Common equity $500,000 $2,500,000 0.0% 60.0% $0.00 $1,500,000 $1,000,000 $2,500,000 NA Interest rate 10.00% Tax rate 35% 35% a. 11.21% b. 8.29% c. 9.75% d. 11.70% e. 8.78%arrow_forwardSheaves Corporation economists estimate that a good business environment and a bad business environment are equally likely for the coming year. Management must choose between two mutually exclusive projects. Assume that the project chosen will be the firm’s only activity and that the firm will close one year from today. The firm is obligated to make a $5,400 payment to bondholders at the end of the year. The projects have the same systematic risk, but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-VolatilityProject Payoff High-VolatilityProject Payoff Bad .50 $5,400 $4,800 Good .50 6,550 7,150 a. What is the expected value of the firm if the low-volatility project is undertaken? What if the high-volatility project is undertaken? (Do not round intermediate calculations and round your answers to the nearest whole dollar, e.g., 32.) b. What is the…arrow_forward
- Fountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm’s only activity and that the firm will close one year from today. The company is obligated to make a $4,100 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 4,100 $ 3,500 Good .50 4,600 5,200 a. What is the expected value of the company if the low-volatility project is undertaken? The high-volatility project? (Do not round intermediate calculations and round your answers to the nearest whole number, e.g., 32.) b. What is the expected value of the…arrow_forwardAs an analyst for Kingbird Inc., you are responsible for many firms, including ADFC. Currently you have a "hold" recommendation on ADFC. The current price of ADFC is $154. You have conducted an extensive analysis of the industry and you feel that the probability the firm will capture a substantial share of the new market is 25 percent. If the firm is able to capture the new market, you are expecting earnings to grow at a rate of 45 percent per year for the next five years. In that case, the stock price would rise to $234 due to the unusually high growth rate of future earnings. However, you feel there is a 35-percent probability that the firm will face serious difficulties in the near future, in which case the stock price will fall to $114, and the earnings growth rate will drop to 3 percent. There is a 40-percent chance that nothing will change for the firm and its earnings growth rate will remain at 12 percent. Calculate the expected price in the future. (Round intermediate…arrow_forwardFountain Corporation’s economists estimate that a good business environment and a bad business environment are equally likely for the coming year. The managers of the company must choose between two mutually exclusive projects. Assume that the project the company chooses will be the firm’s only activity and that the firm will close one year from today. The company is obligated to make a $4,200 payment to bondholders at the end of the year. The projects have the same systematic risk but different volatilities. Consider the following information pertaining to the two projects: Economy Probability Low-Volatility Project Payoff High-Volatility Project Payoff Bad .50 $ 4,200 $ 3,400 Good .50 4,600 4,900 a. What is the expected value of the company if the low-volatility project is undertaken? What if the high-volatility project is undertaken? (Do not round intermediate calculations.) b. What is the expected value of the company’s equity if the low-volatility…arrow_forward
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