Butterfly Tractors had $14 million in sales last year. Cost

Butterfly Tractors had $14 million in sales last year. Cost of goods sold was $8 million, depreciation expense was $2 million, interest payment on outstanding debt was $1 million, and the firm’s tax rate was 21%.

a. What was the firm’s net income?

b. What was the firm’s cash flow?

c. What would happen to net income and cash flow if depreciation were increased by $1 million?

d. Would you expect the change in depreciation to have a positive or negative impact on the firm’s stock price?

e. What would be the impact on net income if depreciation was $1 million and interest expense was $2 million?

f. What would be the impact on cash flow if depreciation was $1 million and interest expense was $2 million?

Here are the 2018 and 2019 (incomplete) balance sheets for

Here are the 2018 and 2019 (incomplete) balance sheets for Newble Oil Corp.

a. What was shareholders’ equity at the end of 2018?

b. What was shareholders’ equity at the end of 2019?

c. If Newble paid dividends of $100 in 2019 and made no stock issues, what must have been net income during the year?

d. If Newble purchased $300 in fixed assets during 2019, what must have been the depreciation charge on the income statement?

e. What was the change in net working capital between 2018 and 2019?

f. If Newble issued $200 of new long-term debt, how much debt must have been paid off during the year?

South Sea Baubles has the following (incomplete) balance sheet and

South Sea Baubles has the following (incomplete) balance sheet and income statement.

INCOME STATEMENT, 2019
(Figures in $ millions)

Revenue……………………………………………….$1,950
Cost of goods sold………………………………….1,030
Depreciation……………………………………………..350
Interest expense……………………………………….240

a. What is shareholders’ equity in 2018?

b. What is shareholders’ equity in 2019?

c. What is net working capital in 2018?

d. What is net working capital in 2019?

e. What are taxes paid in 2019? Assume the firm pays taxes equal to 21% of taxable income.

f. What is cash provided by operations during 2019? Pay attention to changes in net working capital, using Table 3.4 as a guide.

g. Net fixed assets increased from $800 million to $900 million during 2019. What must have been South Sea’s gross investment in fixed assets during 2019?

h. If South Sea reduced its outstanding accounts payable by $35 million during the year, what must have happened to its other current liabilities?

Phoenix Motors wants to lock in the cost of 10,000

Phoenix Motors wants to lock in the cost of 10,000 ounces of platinum to be used in next quarter’s production of catalytic converters. It buys 3-month futures contracts for 10,000 ounces at a price of $900 per ounce.

a. Suppose the spot price of platinum falls to $800 in 3 months’ time. Does Phoenix have a profit or loss on the futures contract?

b. Has it locked in the cost of purchasing the platinum it needs?

c. How does your answer to part (a) change if the spot price of platinum increases to $1,000 after 3 months?

d. How does your answer to part (b) change?

A gold-mining firm is concerned about short-term volatility in its

A gold-mining firm is concerned about short-term volatility in its revenues. Gold currently sells for $1,200 an ounce, but the price is extremely volatile and could fall as low as $1,100 or rise as high as $1,300 in the next month. The company will bring 1,000 ounces of gold to the market next month.

a. What will be the total revenues if the firm remains unhedged for gold prices of (i) $1,100, (ii) $1,200, and (iii) $1,300 an ounce?

b. The futures price of gold for delivery 1 month ahead is $1,220. What will be the firm’s total revenues if the firm enters into a 1-month futures contract to deliver 1,000 ounces of gold?

c. What will be the total revenues if the firm buys a 1-month put option to sell gold for $1,150 an ounce? The put option costs $30 per ounce.

Mutt.Com was founded in 2015 by two graduates of the

Mutt.Com was founded in 2015 by two graduates of the University of Wisconsin with help from Georgina Sloberg, who had built up an enviable reputation for backing new start-up businesses. Mutt.Com’s user-friendly system was designed to find buyers for unwanted pets. Within 3 years, the company was generating revenues of $3.4 million a year and, despite racking up sizable losses, was regarded by investors as one of the hottest new e-commerce businesses. Therefore, the news that the company was preparing to go public generated considerable excitement.

The company’s entire equity capital of 1.5 million shares was owned by the two founders and Ms. Sloberg. The initial public offering involved the sale of 500,000 shares by the three existing shareholders, together with the sale of a further 750,000 shares by the company in order to provide funds for expansion.

The company estimated that the issue would involve legal fees, auditing, printing, and other expenses of $1.3 million, which would be shared proportionately between the selling shareholders and the company. In addition, the company agreed to pay the underwriters a spread of $1.25 per share (this cost also would be shared).

The roadshow had confirmed the high level of interest in the issue, and indications from investors suggested that the entire issue could be sold at a price of $24 a share. The underwriters, however, cautioned about being too greedy on price. They pointed out that indications from investors were not the same as firm orders. Also, they argued, it was much more important to have a successful issue than to have a group of disgruntled shareholders. They therefore suggested an issue price of $18 a share.

That evening, Mutt.Com’s financial manager decided to run through some calculations. First, she worked out the net receipts to the company and the existing shareholders assuming that the stock was sold for $18 a share. Next, she looked at the various costs of the IPO and tried to judge how they stacked up against the typical costs for similar IPOs. That brought her up against the question of underpricing. When she had raised the matter with the underwriters that morning, they had dismissed the notion that the initial day’s return on an IPO should be considered part of the issue costs. One of the members of the underwriting team had asked: “The underwriters want to see a high return and a high stock price. Would Mutt.Com prefer a low stock price? Would that make the issue less costly?” Mutt.Com’s financial manager was not convinced but felt that she should have a good answer. She wondered whether underpricing was only a problem because the existing shareholders were selling part of their holdings. Perhaps the issue price would not matter if they had not planned to sell.

Is the initial day’s return on the IPO a real cost to the firm? How much would that cost be if the stock is offered at $18 but actually could be sold for $24? How would you respond to the underwriter’s questions, “Would Mutt.Com prefer a low stock price? Would that make the issue less costly?”

In March 2020, the management team of Londonderry Air (LA)

In March 2020, the management team of Londonderry Air (LA) met to discuss a proposal to purchase five shorthaul aircraft at a total cost of $25 million. There was general enthusiasm for the investment, and the new aircraft were expected to generate an annual cash flow of $4 million for 20 years.

The focus of the meeting was on how to finance the purchase. LA had $20 million in cash and marketable securities (see table), but Ed Johnson, the chief financial officer, pointed out that the company needed at least $10 million in cash to meet normal outflow and as a contingency reserve. This meant that there would be a cash deficiency of $15 million, which the firm would need to cover either by the sale of or by additional borrowing. While admitting that the arguments were finely balanced, Mr. Johnson recommended an issue of stock. He pointed out that the airline industry was subject to wide swings in profits and the firm should be careful to avoid the risk of excessive borrowing. He estimated that in market value terms, the long-term debt ratio was about 59% and that a further debt issue would raise the ratio to 62%.

Mr. Johnson’s only doubt about making a stock issue was that investors might jump to the conclusion that management believed the stock was overpriced, in which case the announcement might
prompt an unjustified selloff by investors. He stressed, therefore, that the company needed to explain carefully the reasons for the issue. Also, he suggested that demand for the issue would be
enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management’s confidence in the future.

These arguments cut little ice with LA’s chief executive. “Ed,” she said, “I know that you’re the expert on all this, but everything you say flies in the face of common sense. Why should we want to
sell more equity when our stock has fallen over the past year by nearly a fifth? Our stock is currently offering a of 6.5%, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. What’s more, I don’t see the point of paying out more money to the stockholders at the same time that we are asking them for cash. If we hike the dividend, we will need to increase the amount of the stock issue; so we will just be paying the higher dividend out of the shareholders’ own pockets. You’re also ignoring the question of dilution. Our equity currently has a book value of $12 a share; it’s not playing fair by our existing shareholders if we now issue stock for around $10 a share.

“Look at the alternative. We can borrow today at 6%. We get a tax break on the interest, so with a 21% tax rate, the after-tax cost of borrowing is (1 − .21) × 6% = 4.74%. That’s less than the cost of
equity. We expect to earn a return of 15% on these new aircraft. If we can raise money at 4.74% and invest it at 15%, that’s a good deal in my book.

“You finance guys are always talking about risk, but as long as we don’t go bankrupt, borrowing doesn’t add any risk at all.

“Ed, I don’t want to push my views on this—after all, you’re the expert. We don’t need to make a firm recommendation to the board until next month. In the meantime, why don’t you get one of your
new business graduates to look at the whole issue of how we should finance the deal and what return we need to earn on these planes?”

Use the most recently available financial data from 2019 to help evaluate Mr. Johnson’s arguments about the stock issue and dividend payment as well as the reply of LA’s chief executive. Who is correct? What is the required rate of return on the new planes?

Capstan Autos operated an East Coast dealership for a major

Capstan Autos operated an East Coast dealership for a major Japanese car manufacturer. Capstan’s owner, Sidney Capstan, attributed much of the business’s success to its no-frills policy of competitive pricing and immediate cash payment. The business was basically a simple one—the firm imported cars at the beginning of each quarter and paid the manufacturer at the end of the quarter. The revenues from the sale of these cars covered the payment to the manufacturer and the expenses of running the business, as well as providing Sidney Capstan with a good return on his equity investment.

By the fourth quarter of 1990, sales were running at 250 cars a quarter. Because the average sale price of each car was about $20,000, this translated into quarterly revenues of 250 × $20,000 = $5 million. The average cost to Capstan of each imported car was $18,000. After paying wages, rent, and other recurring costs of $200,000 per quarter and deducting depreciation of $80,000, the company was left with earnings before interest and taxes (EBIT) of $220,000 a quarter and net profits of $140,000.

The year 1991 was not a happy year for car importers in the United States. Recession led to a general decline in auto sales, while the fall in the value of the dollar shaved profit margins for many dealers in imported cars. Capstan, more than most firms, foresaw the difficulties ahead and reacted at once by offering 6 months’ free credit while holding the sale price of its cars constant. Wages and other costs were pared by 25% to $150,000 a quarter, and the company effectively eliminated all capital expenditures. The policy appeared successful. Unit sales fell by 20% to 200 units a quarter, but the company continued to operate at a satisfactory profit.

The slump in sales lasted for 6 months, but as consumer confidence began to return, auto sales began to recover. The company’s new policy of 6 months’ free credit was proving sufficiently popular that Sidney Capstan decided to maintain the policy. In the third quarter of 1991, sales had recovered to 225 units; by the fourth quarter, they were 250 units; and by the first quarter of the next year, they had reached 275 units. It looked as if, by the second quarter of 1992, the company could expect to sell 300 cars. Earnings before interest and taxes were already in excess of their previous high, and Sidney Capstan was able to congratulate himself on weathering what looked to be a tricky period. Over the 18-month period, the firm had earned net profits of more than half a million dollars, and the equity had grown from just over $1.5 million to about $2 million.

Sidney Capstan was, first and foremost, a superb salesman and always left the financial aspects of the business to his financial manager. However, there was one feature of the that disturbed Sidney Capstan—the mounting level of debt that, by the end of the first quarter of 1992, had reached $9.7 million. This unease turned to alarm when the financial manager phoned to say that the bank was reluctant to extend further credit and was even questioning its current level of exposure to the company.

Mr. Capstan found it impossible to understand how such a successful year could have landed the company in financial difficulties. The company had always had good relationships with its bank, and the interest rate on its bank loans was a reasonable 8% a year (or about 2% a quarter). Surely, Mr. Capstan reasoned, when the bank saw the projected sales growth for the rest of 1992, it would realize that there were plenty of profits to enable the company to start repaying its loans.

Mr. Capstan kept coming back to three questions: Was his company really in trouble? Could the bank be right in its decision to withhold further credit? And why was the company’s indebtedness increasing when its profits were higher than ever?

Garnett Jackson, the founder and CEO of Tech Tune-Ups, stared

Garnett Jackson, the founder and CEO of Tech Tune-Ups, stared out the window as he finished his customary peanut butter and jelly sandwich, contemplating the dilemma currently facing his firm. Tech Tune-Ups is a start-up firm, offering a wide range of computer services to its clients, including online technical assistance, remote maintenance and backup of client computers through the Internet, and virus prevention and recovery. The firm has been highly successful in the 2 years since it was founded; its reputation for fair pricing and good service is spreading, and Mr. Jackson believes the firm is in a good position to expand its customer base rapidly. But he is not sure that the firm has the financing in place to support that rapid growth.

Tech Tune-Ups’ main capital investments are its own powerful computers, and its major operating expense is salary for its consultants. To a reasonably good approximation, both of these factors grow in proportion to the number of clients the firm serves.

Currently, the firm is a privately held corporation. Mr. Jackson and his partners, two classmates from his undergraduate days, have contributed $250,000 in equity capital, largely raised from their parents and other family members. The firm has a with a bank that allows it to borrow up to $400,000 at an interest rate of 8%. So far, the firm has used $200,000 of its credit line. If and when the firm reaches its borrowing limit, it will need to raise equity capital and will probably seek funding from a venture capital firm. The firm is growing rapidly, requiring continual investment in additional computers, and Mr. Jackson is concerned that it is approaching its borrowing limit faster than anticipated.

Mr. Jackson thumbs through past and estimates that each of the firm’s computers, costing $10,000, can support revenues of $80,000 per year but that the salary and benefits paid to each consultant using one of the computers is $70,000. Sales revenue in 2018 was $1.2 million, and sales are expected to grow at a 20% annual rate in the next few years. The firm pays taxes at a rate of 21%. Its customers pay their bills with an average delay of 3 months, so at any time are usually around 25% of that year’s sales.

Mr. Jackson and his co-owners receive minimal formal salary from the firm, instead taking 70% of profits as a “dividend,” which accounts for a substantial portion of their personal incomes. The remainder of the profits are reinvested in the firm. If reinvested profits are not sufficient to support new purchases of computers, the firm borrows the required additional funds using its with the bank.

Mr. Jackson doesn’t think Tech Tune-Ups can raise venture funding until after 2020. He decides to develop a financial plan to determine whether the firm can sustain its growth plans using its and reinvested earnings until then. If not, he and his partners will have to consider scaling back their hoped-for rate of growth, negotiate with their bankers to increase the or consider taking a smaller share of profits out of the firm until further financing can be arranged.

Mr. Jackson wiped the last piece of jelly from the keyboard and settled down to work.

Can you help Mr. Jackson develop a financial plan? Do you think his growth plan is feasible?

McPhee Food Halls operated a chain of supermarkets in the

McPhee Food Halls operated a chain of supermarkets in the west of Scotland. The company had had a lackluster record, and since the death of its founder in late 2009, it had been regarded as a prime target for a takeover bid. In anticipation of a bid, McPhee’s share price moved up from £4.90 in March 2014 to a 12-month high of £5.80 on June 10, despite the fact that the London stock market index as a whole was largely unchanged.

Almost nobody anticipated a bid coming from Fenton, a diversified retail business with a chain of clothing and department stores. Though Fenton operated food halls in several of its department stores, it had relatively little experience in food retailing. Fenton’s management had, however, been contemplating a merger with McPhee for some time. The managers not only felt that they could make use of McPhee’s food retailing skills within their department stores, but they also believed that better management and inventory control in McPhee’s business could result in cost savings worth £10 million.

Fenton’s offer of 8 Fenton shares for every 10 McPhee shares was announced after the market closed on June 10. Because McPhee had 5 million shares outstanding, the acquisition would add an additional 5 × (8/10) = 4 million shares to the 10 million

Fenton shares that were already outstanding. While Fenton’s management believed that it would be difficult for McPhee to mount a successful takeover defense, the company and its investment bankers privately agreed that the company could afford to raise the offer if it proved necessary.

Investors were not persuaded of the benefits of combining a supermarket with a department store company, and on June 11 Fenton’s shares opened lower and drifted down £.10 to close the day at £7.90. McPhee’s shares, however, jumped to £6.32 a share.

Fenton’s financial manager was due to attend a meeting with the company’s investment bankers that evening, but before doing so, he decided to run the numbers once again. First, he reestimated the gain and cost of the merger. Then, he analyzed that day’s fall in Fenton’s stock price to see whether investors believed there were any gains to be had from merging. Finally, he decided to revisit the issue of whether Fenton could afford to raise its bid at a later stage. If the effect was simply a further fall in the price of Fenton stock, the move could be self-defeating.

Does the market believe that the merger will create net gains? What are the costs and benefits of the proposed merger for Fenton’s shareholders? Would Fenton be wise to raise its bid?