Chapter 6: Discussion Question: #4 p. 223
It is usually easier to forecast sales for a seasoned firm contrast to an early-stage venture because an early-stage venture has limited access to bank credit lines, short-term lending markets, cash flow, and historical data. (Leach, p. 193) A seasoned firm will have a history of sales and operations to base their projections on. Averages will be more reliable in a seasoned firm. (Leach, p.203) An early-stage firm will have to rely more on market industry averages, and not averages specific to its own venture. (Leach, p. 205)
Chapter 6: PharmaBioTech Mini Case: pp. 229 - 230 Part A
The Pharma Biotech Corporation spent several years working on developing a DHA product that can be used to provide a fatty-acid supplement to a variety of food products. DHA stands for docosahexaenoic acid, an omega-3 fatty acid found naturally in coldwater fish. The benefits of fatty fish oil have been cited in studies of the brain, the eyes, and the immune system. Unfortunately, it is difficult to consume enough fish to get the benefits of DHA, and most individuals might be concerned about the taste consequences associated with adding fatty fish oil to eggs, ice cream, or chocolate candy. To counter these constraints, Pharma Biotech and several competitors have been able to grow algae and other plants that are rich in DHA. The resulting chemical compounds then are used to enhance a variety of food products.
Pharma Biotech's initial DHA product was designed as an additive to dairy products and yogurt. For example, the venture's DHA product was added to cottage cheese and fruit-flavored yogurts to enhance the health benefits of those products. After the long product development period, Pharma Biotech began operations in 2009. Income statement and balance sheet results for 2010, the first full year of operations, have been prepared.
Pharma Biotech, however, is concerned about forecasting its financial statements for next year because it is uncertain about the amount of additional financing for assets that will be needed as Pharma Biotech Corporation the venture ramps up sales. Pharma Biotech expects to introduce a DHA product that can be added to chocolate candies. Not only will consumers get the satisfaction of the taste of the chocolate candies, but they will also benefit from the DHA enhancement. Because this is anticipated to be a blockbuster new product, sales are anticipated to increase 50 percent next year (2011), even though the new product will come online in midyear. An additional 80 percent increase in sales is expected the following year (2012).
PHARMA BIOTECH CORPORATION
|
INCOME STATEMENT FOR DECEMBER 31, 2010 (THOUSANDS OF DOLLARS)
|
|
Sales
|
15,000
|
|
Operating expenses
|
-13,000
|
|
EBIT
|
2,000
|
|
Interest
|
-400
|
|
EBT
|
1,600
|
|
Taxes (40% rate)
|
-640
|
|
Net income
|
960
|
|
Cash dividends (40% payout)
|
-384
|
|
Added retained earnings
|
576
|
PHARMA BIOTECH CORPORATION
|
BALANCE SHEET AS OF DECEMBER 31, 2010 (THOUSANDS OF DOLLARS)
|
|
Cash and marketable securities
|
$ 1,000
|
Accounts payable
|
$ 1,600
|
|
Accounts receivable
|
2,000
|
Bank loan
|
1,800
|
|
Inventories
|
2,200
|
Accrued liabilities
|
1,200
|
|
Total current assets
|
5,200
|
Total current liabilities
|
4,600
|
|
|
|
Long-term debt
|
2,200
|
|
|
|
Common stock
|
2,400
|
|
Fixed assets, net
|
6,800
|
Retained earnings
|
2,800
|
|
Total assets
|
$12,000
|
Total liabilities and equity
|
$12,000
|
Pharma Biotech is interested in developing an initial "big picture" of the size of financing that might be needed to support its rapid growth objectives for 2011 and 2012.
A. Calculate the following financial ratios (as covered in Chapter 5) for Pharma Biotech for 2010: (a) net profit margin, (b) sales-to-total-assets ratio, (c) equity multiplier, and (d) total-debt-to-total-assets. Apply the return on assets and return on equity models. Discuss your observations.
A.
a. Net Profit Margin = Net Income / Net Sales
960,000 / 15,000,000 = 0.064 = 6.4%
b. Sales-to-total-assets Ratio = Net Sales /Average Total Assets
15,000,000 / 12,000,000 = 1.25
c. Equity Multiplier = Average Total Assets / Owner's Average Equity
12,000,000 / 12,000,000 = 1
d. Total-debt-to-total-assets Ratio = (Short Term Debt + Log Term Debt) / Total Assets
(4,600,000 + 2,200,000) / 12,000,000 = 6,800,000 / 12,000,000 = 0.567
Rate of Return on Assets = Net Profit Margin x Sales-to-total-assets
6.4% x 1.25 = 8%
Rate of Return on Equity = Net Income / Shareholder's Equity
960,000 / 12,000,000 = 8%
The ROA (venture's ability to create sales from assets and create a profit from those sales) and ROE (rate of return on investment) (p. 172) are both at 8%. "Many professional investors look for a ROE of at least 15%... Few professional money managers will consider stocks with an ROA of less than 5%." (Simpson) Based on Pharma Biotech's ROE, investors may not be interested. That being said, their ROA may allow them to consider stocks.
B. Estimate Pharma's sustainable sales growth rate based on its 2010 financial statements. [Hint: You need to estimate the beginning of period stockholders' equity based on the information provided.] What financial policy change might Pharma Biotech make to improve its sustainable growth rate? Show your calculations.
???Sustainable Sales Growth Rate (g)= (Ending Equity - Beginning Equity) / Beginning Equity =
C.Estimate the additional funds needed (AFN) for 2011, using the formula or equation method presented in the chapter.
C. AFN (2011) = Required Increase in Assets - Spontaneously Generated Funds - Increase in Retained Earnings = [(TA0/NS0)(??S)] - [(AP0+AL0)/NS0 x ??S] - [NS1 x (NI0/NS0) x RR0] =
[(12,000,000/15,000,000)(6,800,000)] - [(1,600,000 + 1,200,000)/15,000,000 x 6,800,000] - [ ? x (960,000/15,000,000) x ? ] =
D.Also, estimate the AFN using the equation method for Pharma Biotech for 2012. What will be the cumulative AFN for the two-year period?
D. AFN for 2012 = Required Increase in Assets - Spontaneously Generated Funds - Increase in Retained Earnings
Chapter 7: Exercise/Problems: #11 pp. 262 - 263
[Weighted Average Cost of Capital] Kareem Construction Company has the following amounts of interest-bearing debt and common equity capital:
|
FINANCING SOURCE
|
DOLLAR AMOUNT
|
INTEREST RATE
|
COST OF CAPITAL
|
|
Short-term loan
|
$200,000
|
12%
|
|
|
Long-term loan
|
$200,000
|
14%
|
|
|
Equity capital
|
$600,000
|
|
22%
|
Kareem Construction is in the 30 percent average tax bracket.
A. Calculate the after-tax WACC for Kareem.
A. After Tax WACC =
[(1 - Tax Rate) x (Debt Rate) x (Debt to Value)] + [Equity Rate x (1 - Debt to Value)=
[(1 - .30) x
B. Show how Kareem's WACC would change if the tax rate dropped to 25 percent and the estimated cost of equity capital were based on a risk-free rate of 7 percent, a market risk premium of 8 percent, and a systematic risk measure or beta of 2.0.
Chapter 7: Exercise/Problems: #12 p. 263
[CAPM Estimate of Cost of Equity Capital] Voice River, Inc., has successfully moved through its early life cycle stages and now is well into its rapid-growth stage. However, by traditional standards this provider of media-on-demand services is still considered to be a relatively small venture. The interest rate on long-term U.S. government securities is currently 7 percent. Voice River's management has observed that, over the long run, the average annual rate of return on small-firm stocks has been 17.3 percent, while the annual returns on long-term U.S. government securities has averaged 5.7 percent. Management views Voice River as being an average small-company venture at its current life cycle stage.
A. Determine the historical average annual market risk premium for small-firm common stocks.
B. Use the CAPM to estimate the cost of common equity capital for Voice River.
Chapter 7: Castillo Mini Case: pp. 264 - 265
MINI CASE: Castillo Products Company
The Castillo Products Company was started in 2008. The company manufactures components for personal digital assistant (PDA) products and for other handheld electronic products. A difficult operating year, 2009, was followed by a profitable 2010. The founders (Cindy and Rob Castillo) are interested in estimating their cost of financial capital because they are expecting to secure additional external financing to support planned growth.
Short-term bank loans are available at an 8 percent interest rate. Cindy and Rob believe that the cost of obtaining long-term debt and equity capital will be somewhat higher. The real interest rate is estimated to be 2 percent, and a long-run inflation premium is estimated at 3 percent. The interest rate on long-term government bonds is 7 percent. A default-risk premium on long-term debt is estimated at 6 percent; plus Castillo Products is expecting to have to pay a liquidity premium of 3 percent due to the illiquidity associated with its long-term debt. The market risk premium on large-firm common stocks over the rate on long-term government bonds is estimated to be 6 percent. Cindy and Rob expect that equity investors in their venture will require an additional investment risk premium estimated at two times the market risk premium on large-firm common stocks.
Following are income statements and balance sheets for the Castillo Products Company for 2009 and 2010.
|
CASTILLO PRODUCTS COMPANY
|
|
INCOME STATEMENT
|
2009
|
2010
|
|
Net sales
|
$ 900,000
|
$1,500,000
|
|
Cost of goods sold
|
540,000
|
900,000
|
|
Gross profit
|
360,000
|
600,000
|
|
Marketing
|
90,000
|
150,000
|
|
General and administrative
|
250,000
|
250,000
|
|
Depreciation
|
40,000
|
40,000
|
|
EBIT
|
-20,000
|
160,000
|
|
Interest
|
45,000
|
60,000
|
|
Earnings before taxes
|
-65,000
|
100,000
|
|
Income taxes
|
0
|
25,000
|
|
Net income (loss)
|
$ -65,000
|
$ 75,000
|
|
BALANCE SHEET
|
2009
|
2010
|
|
Cash
|
$ 50,000
|
$ 20,000
|
|
Accounts receivable
|
200,000
|
280,000
|
|
Inventories
|
400,000
|
500,000
|
|
Total current assets
|
650,000
|
800,000
|
|
Gross fixed assets
|
450,000
|
540,000
|
|
Accumulated depreciation
|
-100,000
|
-140,000
|
|
Net fixed assets
|
350,000
|
400,000
|
|
Total assets
|
$1,000,000
|
$1,200,000
|
|
Accounts payable
|
$ 130,000
|
$ 160,000
|
|
Accruals
|
50,000
|
70,000
|
|
Bank loan
|
90,000
|
100,000
|
|
Total current liabilities
|
270,000
|
330,000
|
|
Long-term debt
|
300,000
|
400,000
|
|
Common stock ($0.05 par value)
|
150,000
|
150,000
|
|
Additional paid-in-capital
|
200,000
|
200,000
|
|
Retained earnings
|
80,000
|
120,000
|
|
Total liabilities and equity
|
$1,000,000
|
$1,200,000
|
| |
|
|
|
|
|
A. Calculate the net profit margin, total-sales-to-total-assets ratio, the equity multiplier, and the return on equity for both 2009 and 2010 for the Castillo Products Corporation. Describe what happened in terms of financial performance between the two years.
B. Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the Castillo Products Corporation.
C. Although, Castillo Products paid a low effective tax rate in 2010, a 30 percent income tax rate is considered more appropriate when looking to the future. Estimate the after-tax cost of short-term bank loans, long-term debt, and the venture's common equity.
D. Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation using the book values of interest-bearing debt and stockholders' equity capital at the end of 2010.
E. Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2010. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2010. Estimate the market value-based weighted average cost of capital for Castillo Products.
F. Would you recommend to Cindy and Rob that they use the book value-based WACC estimate or the market value-based WACC estimate for planning purposes? Why?