financial management3161

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@ Prof. Nahum Biger 1

Financial Management

Professor Nahum BigerGraduate School of Management

Haifa, Israel

The MBA

Nahum Biger is a Professor of Finance at The graduate school of management at the university of Haifa, Israel.He is also a professor of finance at TUI University, Pepperdine University and at the Peter F. Drucker GraduateSchool of Management in California, U. S. A. He has been a business school academic for over thirty years andhe has considerable international experience having taught MBA students and executives in the USA, Canada,Europe, Japan, North and South Africa.

Nahum Biger has published over 50 academic papers in academic and applied journals oncapital asset pricing, options pricing, market listings of securities and in the legal,economics and finance interface. His commercial consulting experience ranges frommeasuring corporate value and risk to assessing portfolio performance and efficiency.

Nahum holds a BA (economics and statistics), MA (economics) and PhD in FinancialEconomics from York University, Ontario, Canada. He also holds a degree in actuarialstudies. He served as a consultant on several missions by the world bank and theinternational finance corporation (IFC).

1. Introduction

This course in corporate finance consists of eight sessions and a final examination. Students are also expected tospend a significant amount of time individually and in their groups preparing for each of the sessions.

There are three major objectives of the corporate finance program. First, the course aims to provide students with aconceptual and theoretical framework for understanding corporate finance. Secondly, through the use of assignmentsand case studies, students are expected to be able to develop an understanding of the practical aspects of corporatefinancial management and the relationship between theory and practice. By the time the course ends, students willhave been exposed to the three central issues in modern corporate finance, namely; the overall valuation process, theinvestment decision, and the financing decision. Finally, the course lays the necessary foundation for the course onfinancial investments and for the course on International financial management that are offered in the more advancesstages of the MBA program

Upon completion of the course students should be able to:

Assess financial health of companies be reviewing their financial statements

Perform financial forecasting and project future financing needs of a corporation

Calculate present value and understand the concept of opportunity cost of capital. Understand the importance of free cash.

Understand the relationship between risk and value.

Make rational investment decisions.

Understand the relationship between financing and investment.


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2. Prerequisites and completion requirements

The financial management course builds on material forming part of accounting, economics and data analysis orstatistics. In particular, it is assumed that students can:

Interpret financial statements and perform basic ratio analyses.

Understand the concept of supply and demand and the factors that cause shifts in the two.

Perform regression analysis and interpret the necessary statistical output.

Process data on a spreadsheet package.

Preparation and submission requirements

Students are expected to individually prepare for each session by reading the prescribed chapters and confirmingtheir understanding by attempting some questions at the end of each assigned chapter.

Although the cases included in the course pack do not require the presentation of a written analysis prior to theassigned session, students are expected to analyze the cases so that they are able to intelligently discuss theirconcerns and possible solutions during the lecture sessions.

Consistent with the global MBA education philosophy, students will be divided into groups of four and the groupshares responsibility for ensuring that all members are prepared prior to lectures. Students may be called upon at

random to represent the group. Additionally, each group will be required to make two types of submissions.

All groups are to prepare both Case 1 and Case 4, and submit a written report of these cases. The casesshould be prepared for a class discussion. Several groups will be chosen at random to present their analysisin class. The presentation should include a brief analysis of the companies chosen by each group. I t is the

responsibil ity of the students to make sure that no two groups choose the same company for analysis.

Companies should not be any fi nanci al insti tut ion (banks, insurance companies etc.). This discussionmust extend beyond the specifics of the case and reference the broader theoretical principles. Note: thewri tten case submission must include the brief f inancial statement translated to Engli sh. All groups areto prepare Cases 2, 3 and 5 for class discussion but not for submission. These three cases will not be gradedbut will be thoroughly discussed in class.

Groups are required to submit their pre-lecture problems and group report in hard copy to the lecturerbefore the start of the lecture designated above. Groups 1 and 4 submit the first set of problems on the first

session, and the 6th

set on the fifth session of the course. Groups 2 and 5 submit their first set on the secondsession and the 7'Th set on the sixth session of the course and so on. Late group submissions will not beaccepted. The problem set appears in the course web site. Allocations are as follows:

S e s s i o n

Assignments 1s 2n 3r 4 5 6 7 8

Group1 PP.2 PP.6

Group2 PP.3 PP.7

Group3 PP.4 PP.8

Group4 PP.2 PP.6

Group5 PP.3 PP.7

Group6 PP.4 PP.8

Group7 PP.5 PP.9

Requirements for successful completion of the course

Students are expected to actively contribute during their group meetings and lecture sessions. The grading for thecourse is as follows:

Assigned pre-lecture problem submission ............................................................................................... 15%

Case presentation by groups (this is the 'class participation" component of the final grade) .................. 15%

Final in-class examination ....................................................................................................................... 70%


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3. TextbookTexts: Richard A. Brealey and Stewart C. Myers, Franklin Allen, Principles of Corporate Finance, 9th edition,

McGraw-Hill, Irwin, 2008. (BMA)

An additional, more executive-oriented text is:

Robert C. H iggins, Analysis for F inancial M anagement, Nin th Editi on, McGraw-Hi ll, I rwin, 2007.

The author of the textbook, Robert C. Higgins, has prepared a web site for users of the textbook and participants areencouraged to refer to the site frequently. http://www.mhhe.com/higgins8e;http://highered.mcgraw-

hill.com/sites/0073041807/student_view0/index.html

4. Time table, topics, readings and cases of assignments

Sessio

n

T o p i c R e a d Cases or problems

1 Interpreting FinancialStatementEvaluating Financial

Performance

BMA, Ch. 1, 2, 3 andCh. 29- sections 1, 2, 3

Higgins, Ch. 1, 2.

Case 1: Local company's "Financials"

Ch. 2: Problems 2, 4,

2 Financial Forecasting BMA, Ch. 29- sections4, 5

Higgins, Ch. 3

Case 2:Sam Woo LumberCh. 3: Problems 2, 4, 6

3 Common stocks and ManagingGrowth

BMA, Ch. 5Higgins, Ch. 4

Ch. 4: Problems 2, 4, 6

4 Financial Instruments andMarkets

BMA, Ch. 4, 5,Higgins, Ch. 5

Case 3: D ivi dend growthand Tesco

cost of Equi tyCh. 5: Problems, 4, 5, 8, 10

5 The Financing Decisions BMA, Ch. 15, 18, 19,20Higgins, Ch. 6

Ch. 6: Problems 5, 6, 7, 8, 10

6 Investment decisions and DCF

techniques

BMA, Ch. 7, 10

Higgins, Ch.7, 8

Case 4: An I sraeli publi ccompanys cost

of capital and investment analysis.Ch. 7: Problems 2, 6, 7, 10

7 Risk analysis and InvestmentDecisions

BMA, Ch. 9, 10, 11Higgins, Ch. 8,

Ch. 8: Problems 2, 4, 6, 8

8 Dividend policy; BusinessValuation

BMA, Ch. 17, 20Higgins, Ch. 9.

Ch. 9, Problem 4

Case 5: M ing Publi shing

5. Case studies

Case 1: Local company 'Financials'

Obtain from the Internet the past five years balance sheets and income statements of one of the industrial

companies that is listed and whose stocks are traded on the Tel Aviv Stock Exchange. You can find it in the'Investors relation' section of the companys web site. Review chapters 1 and 29 of the BMA textbook and/or

any of the web sites that provide you with descriptions of financial statement analysis (see below final page

of the course detailed syllabus) and use the lessons you learned from the readings and from your course on

accounting (remember???) in order to prepare a brief analysis of the financial performance of the company

over the past four years. Please communicate between the different groups in order to make sure that no two

teams choose the same company for analysis. A power point presentation of the company's financial

perf ormance and the rati o analysis is desirabl e.

The Balance Sheet and the Income Statement must be translated into English and submitted in class
http://www.mhhe.com/higgins8ehttp://www.mhhe.com/higgins8ehttp://www.mhhe.com/higgins8ehttp://highered.mcgraw-hill.com/sites/0073041807/student_view0/index.htmlhttp://highered.mcgraw-hill.com/sites/0073041807/student_view0/index.htmlhttp://highered.mcgraw-hill.com/sites/0073041807/student_view0/index.htmlhttp://highered.mcgraw-hill.com/sites/0073041807/student_view0/index.htmlhttp://highered.mcgraw-hill.com/sites/0073041807/student_view0/index.htmlhttp://highered.mcgraw-hill.com/sites/0073041807/student_view0/index.htmlhttp://www.mhhe.com/higgins8e


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Case 2 (not to be submitted): Sam Woo Hardware Limited

1. Why has Sam Woo Lumber borrowed increasing amounts despite its consistent profitability?

2. How has Mr. Sam Woo met the financing needs of the company during the period 2005 through2007? Has the financial strength of Sam Woo Lumber improved or deteriorated?

3. How attractive is it to take the trade discounts?

4. Do you agree with Mr. Sam Woos estimate of the companys loan requirements? How much

will he need to finance the expected expansion in sales to $5.5 million in 2008 and to take alltrade discounts?

5. As Mr. Sam Woos financial advisor, would you urge him to go ahead with, or top reconsider,

his anticipated expansion and his plans for additional debt financing? As a banker, would youapprove Mr. Sam Woos loan request, and, if so, what conditions would you put on the loan?

Sam Woo Hardware L imited1

After rapid growth in its business during recent years, the Sam Woo Lumber Company, in the spring of 2008,anticipated a further substantial increase in sales. Despite good profits, the company had experienced a shortage orcash and had found it necessary to increase its borrowing from the County National Bank to $399,000 in the spring

or 2008. The maximum loan that County National would make to anyone borrower was $400,000, and Sam Woohad been able to stay within this limit only by relying very heavily on trade credit. In addition, County National wasnow asking that Mr. Sam Woo guarantee the loan personally. John Sam Woo, sole owner and president of the SamWoo Lumber Company, was therefore actively looking elsewhere for a new banking relationship in which he wouldbe able to negotiate a larger loan that did not require a personal guarantee.

Mr. Sam Woo had recently been introduced by a friend to Mr. Chang, an officer of a much larger bank, the NorthernNational Bank. The two men had tentatively discussed the possibility that Northern might extend a line of credit toSam Woo Lumber up to a maximum amount of $750,000. Mr. Sam Woo thought that a loan of this size wouldimprove profitability by allowing him to take full advantage of trade discounts. Subsequent to this discussion, Mr.Chang had arranged for the credit department of the North-western National Bank to investigate Mr. Sam Woo andhis company.

The Sam Woo Lumber Company had been founded in 1983 as a partnership by Mr. Sam Woo and his brother-in-

law, Mr. Ming. In 2006, Mr. Sam Woo bought out Mr. Ming's interest for $200,000. Mr. Ming had taken a note for$200,000 to be paid in 2007 and 2008, in order to give Mr. Woo time to arrange for the necessary financing. Thisnote carried an interest rate of 11 % and was repayable in semi-annual instalments of $50,000, beginning June 30,2007.

The business was located in a growing suburb of a large city in the Northern part of the country. The companyowned land with access to a major highway, and four large storage buildings had been erected on this land. Thecompany's operations were limited to the retail distribution of lumber products in the local area. Typical productsincluded plywood mouldings, and sash and door products. Quantity discounts and credit terms of net 30 days onopen account were usually offered to customers.

Sales volume had been built up largely on the basis-of successful price competition, made possible by carefulcontrol of operating expenses and by quantity purchases of materials at substantial discounts. Most of the mouldingsand sash and door products, which constituted significant items of sales, were used for repair work. About 55% of

1Professor Nahum Biger amended this case as the basis for class discussion rather than to illustrate either effectiveor ineffective handling of a management situation.

The original form of the case carries a Copyright 1996 by the President and Fellows of Harvard College. Itappeared in Butters, J.K., Fruhan, W.E., Mullins, D.W. and Piper, T.R. Case Problems in Finance, 10th edition,Richard D. Irwin, Inc., pp. 46-50. No part of this publication may be reproduced, stored in a retrieval system, used ina spreadsheet, or transmitted in any form or by any means electronic, mechanical, photocopying, recording, orotherwise.For internal GSB academic use only


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total sales were made in the six months from April through September. Annual sales of $2,921,000 in 2005,$3,477,000 in 2006, and $4,519,000 in 2007 yielded after-tax profits of $60,000 in 2005, $68,000 in 2006, and$77,000 in 2007. Operating statements for the years 2005-2007 and for the three months ending March 31, 2008, aregiven in Exhibit 1.

Mr. Sam Woo was an energetic man, 49 years of age, who worked long hours on the job. He was helped by anassistant, who in the words of the investigator of the Northern National Bank, "has been doing and can do about

everything that Mr. Sam Woo does in the organization." Other employees numbered 15 in early 2008, 8 of whomworked in the yard and drove trucks, and 7 of whom assisted in the office and in sales.

As part of its customary investigation of prospective borrowers, the Northern National Bank sent inquiriesconcerning Mr. Sam Woo to a number of firms that had business dealings with him. The manager of one of his largesuppliers, the Xian Company, wrote in answer:

The conservative operation of his business appeals to us. He has not wasted his money indisproportionate plant investment. His operating expenses are as low as they could possibly be. He haspersonal control over every feature of his business; and he possesses sound judgment and awillingness to work harder than anyone I have even known. This, with a good personality, gives him agood turnover; and from my personal experience in watching him work, I know that he keeps closecheck on his own credits.

All the other trade letters received by the bank bore out this opinion.

In addition to owning the lumber business, which was his major source of income, Mr. Sam Woo held jointly withhis wife an equity interest in their home. The house had cost $172,000 to build in 1990 and was mortgaged for$138,000. He also held a $70,000 life insurance policy, payable to Mrs. Sam Woo. Mrs. Sam Woo ownedindependently a half interest in another house worth about $85,000. Otherwise, they had no sizable personalinvestments.

The bank gave particular attention to the debt position and current ratio of the business. It noted the ready market forthe company's products at all times and the fact that sales prospects were' favorable. The bank's investigatorreported: "Sales are expected to reach $5.5 million in 2008 and may exceed this level if prices of lumber should risesubstantially in the near future." On the other hand, it was recognized that a general economic downturn might slowdown the rate of increase in sales. Sam Woo Lumber's sales, however, were protected to some degree fromfluctuations in new housing construction because of the relatively high proportion of its repair business. Projectionsbeyond 2008 were difficult to make, but the prospects appeared good for continued growth in the volume of Sam

Woo Lumbers business over the foreseeable future.

The bank also noted the rapid increase in Sam Woo Lumber's accounts and notes payable in the recent past,especially in 2007 and in the spring of 2008. The usual terms of purchase in the trade provided for a discount of 2 %for payments made within 10 days of the invoice, date. Accounts were due in 30 days at the invoice price, butsuppliers ordinarily did not object if payments lagged somewhat behind the due date. During the last 2 years, Mr.Sam Woo had taken very few purchase discounts because of the shortage of funds arising from his purchase of Mr.Ming's interest in the business and the additional investments in working capital associated with the company'sincreasing sales volume. Trade credit was seriously extended in the spring of 2006 as Mr. Sam Woo strove to holdhis bank borrowing within the $400,000 ceiling imposed by the County National Bank.

Balance sheets at December 31, 2005-2007, and March 31, 2008, are presented in Exhibit 2. Statistics for a sampleof lumber outlets across the country are provided in Exhibit 3.

The tentative discussions between Mr. Chang and Mr. Sam Woo had been in terms of a revolving, secured, 90-day

note not to exceed $750,000. The specific details of the loan had not been worked out, but Mr. Chang had explainedthat the agreement would involve the standard covenants applying to such a loan. He cited as illustrative provisionsthe requirement that restrictions on additional borrowing would be imposed; that net working capital would have tobe maintained at an agreed level; that additional investments in fixed assets could be made only with the priorapproval of the bank; and that limitations would be placed on withdrawals of funds from the business by Mr. SamWoo. Interest would be set on a floating-rate basis at 2% percentage points above the prime rate. Mr. Changindicated that the initial rate to be paid would be approximately 11 % under conditions in effect in early 2008. Bothmen also understood that Mr. Sam Woo would sever his relationship with the County National Bank if he enteredinto, a loan agreement with the Northern National Bank.


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EXIBIT 1

Operating Expenses for Years Ending December 31, 2005-2007, and for First Quarter 2008 (thousands of dollars)

2005 2006 2007

1st Quarter

2008

Net sales $2,921 $3,477 $4,519 $1,026a

Cost of goods sold

Beginning inventory 330 337 432 587

Purchases 2,209 2,729 3,597 819

$2,539 $3,066 $4,011 $1,406

Ending inventory 337 432 587 607

Total cost of goods sold $2,202 $2,634 $3,424 $ 799

Gross profit 719 834 1,095 263

Operating expensesb 622 717 940 244

Earnings before interest and taxes $ 97 $ 126 $ 155 $ 19

Interest expense 23 42 56 13

Net income before tax $ 74 $ 84 $ 99 $ 6Provision for income taxc 14 17 22 1

Net income $ 60 $ 67 $ 77 $ 5

a. In the first quarter of 2008, sales were $903,000 and net income was $7,000.b. Operating expenses include a cash salary for Mr. Sam Woo of $75,000 in 2005; $80,000 in 2006; $85,000 in 2007; and

$22,500 in the first quarter of 2008.c. Sam Woo Lumber was required to estimate its income tax liability for the current tax year and pay four quarterly estimated

tax instalments during that Year. The first $50,000 of pre-tax profits were taxed at a 15% rate, the next $25,000 were taxedat a 25% rate; the next $25,000 were taxed at a 34% rate; and profits in excess of $100,000 but less than $335,000 weretaxed at a 39% rate.


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EXHIBIT 2

Balance Sheets at December 31, 2005-2007, and March 31, 2008(thousands of dollars)

2005 2006 20071s Quarter

2008

Cash $ 43 $ 52 $ 56 $ 53Accounts receivable, net 306 411 606 583Inventory 337 432 587 607

Current assets 686 895 1,249 1,243Property, net 233 262 388 384

Total assets $ 919 $1,157 $1,637 $1,627

Notes payable, banka ---- $ 60 $ 390 $ 399Notes payable to Ming, current portion ---- 100 100 100Notes payable, trade ---- ---- 127 123Accounts payable 213 340 376 364Accrued expenses 42 45 75 67Term loan, current portion c 20 20 20 20

Current liabilities $ 275 $ 565 $ 1,088 $ 1,073Term loan c 140 120 100 100

Notes payable, Mr. Ming ----- 100 ------ -------Total liabilities $ 415 $ 785 $ 1,188 $ 1,173

Net worth 504 372 449 454

Total liabilities and not worth $ 919 $ 1,157 $ 1,637 $ 1,627a. Interest is computed on the average outstanding loan balance at the rate of prime plus 2.5%.

b. Interest is fixed at 11% times the outstanding balance.

c. Interest is fixed at 10% times the outstanding balance; the term loan is secured by the fixed' assets and is repayable in semi-

annual instalments of $10,000.

EXHIBIT 3

Selected Statistics on Lumber Outlets

Low-Profit

Outlets a

High-Profit

Outlets

Percent of sales:

Cost of goods 76.9% 75.1%Operating expense 22.0 20.6

Cash 1.3 1.1

Accounts receivable 13.7 12.4

Inventory 12.0 11.6

Fixed assets, net 12.1 9.2

Total assets 39.1 34.3

Percent of total assets:

Current liabilities 52.7% 29.2%

Long-term liabilities 34.8 16.0

Equity 12.5 54.8Current ratio 1.31 2.52

Rate of return on sales (0.7%) 4.3%

Rate of return on assets (1.8%) 12.2%

Rate of return on equity (14.3%) 22.1%

a. Defined as the bottom 25% and as the top 25%, respectively, of all surveyed companies, based on return on sales.

Case 3: Dividend Growth of Tesco


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The requirements for this case are as follows: Get the financial information of Tesco, the British giant food storeschain in order to derive the average rate of return on the company's investment over the past few years and if there isa trend in this ratio you should extend the trend into the future. In addition find out the typical retention rate and thetypical dividend payout ratio of the company. Then, based upon the dividend-growth model, use the most recentprice of the stock of the company (you may find it by browsing the Internet) in order to estimate the cost of equitycapital, or the required rate of return on equity, that is implicit in the recent stock price if indeed the dividendgrowth model applies.

Case 4: An Israeli public company capital structure and cost of capital estimations andInvestment Analysis

Part I: The case involves a selection of the company that the team chose for the first Case: a company that is listedon the Shanghai Stock Exchange. You are required to obtain the most recent financial statement of the company andalso collect data on the weekly rates of return on the stocks of this company, and on the Shanghai Stock ExchangeIndex for the past two to three years. Your task is to analyze the capital structure of the company and estimate themarket value capital structure. Then you'll be using the data on the rates of return on the company and on the Indexto estimate the "beta coefficient' of your company. With the estimated beta coefficient you'll estimate the "cost ofequity" or the "required rate of return on the company's equity", and then the weighted average cost of capital of thecompany.

Part II: Assume that your company is contemplating an investment in an expansion project. A team of expertsfrom different units of the company came up with the following projections regarding the required investment andschedule, costs and revenues emanating from the investment over the next several years:

Year Investment inMachinery and

equipment

Purchase of

materialsDirect and

indirect labourMarketing

expensesRevenues

0 8,000 0 0 400 01 8,000 1,600 4,800 800 8,0002 4,000 2,200 5,600 690 13,0003 0 2,200 5,600 690 13,0004 0 2,200 5,600 690 13,0005 0 2,200 5,600 690 13,0006 0 2,200 5,600 690 13,000

Assume that the systematic risk coefficient of the proposed project is estimated to be equal to the operatingsystematic risk coefficient of your company.

Assume also that in computing taxable income, the company is allowed to depreciate the investment in Machineryand equipment on a straight line basis over 4 years. The company is of the opinion that at the end of year 6 it maybe able to sell the M&E for7,000. (Note: this estimation has no bearing on the companys ability to depreciate theentire investment). The companys tax rate is the combined federal and state corporate income tax of 34% is

applicable. (If your own company has accumulated large losses that appear on its balance sheet (where?) then the taxconsiderations are irrelevant.)

Here are the deliverables for Part II of this Case:

a. Prepare and present a side table of the effects of depreciation, year by year, on the companys future cash flow,including the tax shields of depreciation and the tax rebates emanating from the deductibility of depreciation

for tax purposes.

b. Assess the Net Present Value of the proposed project and write a short memo to management recommendingacceptance/rejection of the proposal by your company.

Case 5: (Not to be submitted) Ming Publishing Limited


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What are the expected after-tax operating cash flow implications of expanding the production facility and relocatingto the new facility? Should Ming Limited undertake the relocation?

Case: MING PUBLISHING LIMITED (2008)2

Patricia Ming, managing director of Ming Publishing Limited, picked up the telephone to call Ross Smith, thecompany sales manager. Smith had sent her an e-mail suggesting that Ming Publishing would increase its profits

substantially if production capacity could be increased.Your suggestion interests me, said Ms. Ming, but I cant give you an answer until the financial implications have

been fully assessed. As soon as you have firm estimates for sales and how much is required for advertising andpromotion, forward them to Dean Jordan in the finance department. He can get the other data necessary frompurchasing and production, and I will ask that the projections be sent to me by early next week. If the proposal is asprofitable as you believe, we will move on it immediately.

Ming Publishing Limited has been in business in the same location for over 20 years. Although a conglomerateacquired the company in the 1990s, it continues to operate autonomously. In addition to the title of plant manager,Patricia Ming also serves as a director of the parent conglomerate in charge of publishing and printing.

Before sending the e-mail to Ming, Smith discussed the expansion idea with John Taylor, head of the productiondepartment. According to Taylor, there is no room to expand production capacity in the present facility. It is locatedin an industrial zone several miles from the main plant, and other tenants presently occupy all of the available land

and buildings adjacent to it. However, Taylor knows of a company that has recently been placed in liquidationwhose manufacturing facility is both very near the main plant and available for lease. It has the required floor spaceand utilities in place and it can be leased for five years at 3,250,000 per year3. I have wanted to get rid of thecurrent facility for years, said Taylor. It is a real inconvenience for me to have to go all the way over there

whenever they have a problem - and they have quite a few since they have to operate at full capacity all the time.Moving to a location practically across the street from the main plant and expanding capacity would really makethings easier for me. I also believe that we can easily sub-let the existing facility for the remainder of the existingleases. You can count on my help in convincing the boss to make the move. Working with Taylor, Smith preparedthe preliminary estimates shown in Exhibit 1.

As he gave this exhibit (along with the supporting documentation contained in Exhibit 2) to Dean Jordan, Smithremarked that an eleven-month payback was hard to beat. He also noted that Ming wanted to move on the projectquickly, so he hoped that Jordan would not delay in passing the proposal on to Patricia Ming with his full support.

After glancing at the figures shown in Exhibits 1 and 2, Jordan noticed two problems. First the sales and expensenumbers shown are not expected to be achieved until Year 3. Hence, the apparent profitability is probablyoverstated. Second, they represent total sales and expenses. Ming Publishing is already producing 100,000 units inits existing location, and Jordan believes that it would be improper to use profits on existing sales to justify theexpansion. In other words, what he wants is an incremental analysis of the costs and benefits that are associated withmaking the move that would not occur if the proposal were rejected.

The figures for the first two years shown in Exhibit 2 represent an introduction period in which marketing efforts areto be directed at several potential customers. Jordan knew that sales increases of this order of magnitude wouldrequire substantial amounts of new working capital. From other expansion decisions that had been undertaken in thepast, Jordan estimated that the current level of 4,200,000 would be sufficient if the move is not made to the new

2 This case was prepared as the basis for class discussion rather than to illustrate either effective or

ineffective handling of a management situation. Names and other identifying information may have beendisguised to protect confidentiality.

No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, ortransmitted in any form or by any means electronic, mechanical, photocopying, recording, or otherwise without the permission of the authors.

3 All costs and revenues are stated in current value terms. General inflation is expected to average 6% per annum for theforeseeable future.


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location, but, if the move is made, a total of 7,250,000 will be needed in the first year (that is, an increase of3,050,000 is required), rising to a total of 10,040,000 in Year 2, and a further increase to a total of 13,410,000 inYear 3.

Jordan also questioned Taylor about the equipment that is to be moved from the old to the new facility. That is

mainly the handling equipment. It is still on the books at a value of 150,000, and the depreciation is 50,000 peryear for the next three years. It will cost us 250,000 to dismantle it, move it to the new building, and reinstall it. If

we wanted to get rid of it and buy all new equipment, I could probably sell it for its book value, but new equipmentwe would have to buy costs over 1,000,000. I see no reason to replace the current equipment since it is all in goodshape.

Both Jordan and Smith agree that the new facility should be able to operate profitably for many years. Jordandecided that a study life of five years, the standard used by the company, would be employed in the analysis. At theend of five years the plant and equipment is estimated to be worth 2,500,000, and it is assumed that the full valueof the working capital will be recovered.

A recently produced report of the finance department is contained in Exhibit 3. It presents information about theoptimal capital structure for Ming Publishing Limited and estimates of the costs of debt and equity capital asassessed by the companys merchant bankers. Jordan believes that rigorous project appraisal should use either theweighted average cost of capital (WACC) or adjusted present value (APV) approaches. For the envisagedexpansion, the company will raise 8,000,000 of new debt at 8% per annum. The debt will have to be amortized

over the life of the project.


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Exhibit 1:MING PUBLISHING LIMITEDPreliminary profitability estimates

Sales (200,000 units at 500) 100,000,000Cash Expenses

Cost of goods sold 58,000,000

Building lease 3,250,000

Marketing expenses 2,530,000

Other expenses 3,000,000

Total expenses 66,780,000

Contribution to profit 33,220,000

Equipment required

New equipment to be purchased 19,500,000

Old equipment to be moved 150,000

Cost of moving and installation 250,000

Total capital cost 19.900,000

Payback period = 19,900,000 / ( 0.65 x 33,220,000 ) = 0.92 years = 11 months

Exhibit 2: MING PUBLISHING LIMITEDEstimated sales and marketing expenses

Annual sales Annual marketing expenses

Units Revenue

Status quo 100,000 50,000,000 875,000

New Facility

Year 1 120,000 60,000,000 2,875,000

Year 2 150,000 75,000,000 2,870,000

Year 3 andafter

200,000 100,000,000 2,530,000

Production cost estimates

Annual fixed costs

Variable costs

per unit

Lease Depreciation Other

Status quo 300.0 1,000,000 50,000 500,000

New Facility

Year 1 297.5 3,250,000 3,950,000 3,000,000

Year 2 292.5 3,250,000 3,950,000 3,000,000Year 3 290.0 3,250,000 3,950,000 3,000,000

Year 4-5 290.0 3,250,000 3,900,000 3,000,000


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12

Exhibit 3: MING PUBLISHING LIMITED

Internal Memorandum

Cost of Equity Capital (RE) 14.00%

Cost of medium/long-term Debt (RD) 8.00%

Optimal debt/equity ratio (D/E) 0.500

Weighted Average Cost of Capital (WACC)

WACC = [RE *E + D*(1Tc) RD ]/ (D+ E )

Cost of unlevered Equity Capital (RU)

RU = RL / [1 + (1T)(D/E)]

Typical five year debt repayment schedule (8% interest)

Opening Balance Interest payment Principal Repayment

1,000,000 80,000 170,450

829,543 66,363 184,092

645,451 51,636 198,820

446,631 35,730 214,725

231,905 18,552 231,905

Exhibit 4

MING PUBLISHING LIMITED

Companies and Close Corporationstax ratesCorporate tax rate 33.0%

Depreciationfor tax purposes:

Machinery, plant and equipment (new) 4 years

(Straight line)


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13

6. Formulae

A formulae sheet is provided for your convenience.

GENERAL FORMULAE

rgallfor

gr

CFPVperpetuityGrowing

rrrCFPVAnnuity

r

CFPVPerpetuity

PVINPVandr

CFPVnformulatioGeneral

T

tt

t

1

1

1

0

1

:

1

11:

:

1:

BOND FORMULAE

TT

T

T

T

T

TrTr

IRR

valueface

IRR

coupon

IRR

coupon

IRR

coupon

r

valueface

r

coupon

r

coupon

r

couponPV

PVFvaluefacePVAFcouponPV

1...

11

1...

11

21

2

2

1

1

%,%,

EQUITY FORMULAE

ratioPayoutratiotention

EarningsDividendsratioPayout

equityofvaluebookyearofBeginning

investorsequitytoEarningsROE

ratioretentionROEgwhere

PVGOr

E

gr

DP

r

P

r

D

r

D

r

D

r

DP

T

T

T

T

tt

t

1Re

;

11...

111

11

0

2

2

1

1

10


14/15

14

PORTFOLIO THEORY FORMULAE

M

SMS

S

fMSfS

BAABBABBAAP

BA

BBAAP

RRERRE

xxxx

xx

RExRExRE

,

22222 2

0.1

CAPITAL STRUCTURE FORMULAE

DCLL

L

E

LL

L

DUC

L

L

UE

C

L

U

C

U

CLUL

RTDE

DR

DE

EWACC

RRTE

DRR

WACC

TEBITV

R

TEBIT

V

TDVV

1

1

1

1

)()(

)(

)()(

)(

)(

)(

)(


15/15

15

Corporate FinanceWeb sites for course basic concepts

Finance Glossaryhttp://www.duke.edu/~charvey/Classes/wpg/bfgloso.htm

Finance tutor:http://www.mhhe.com/business/finance/corpfinonline/

Financial Statement:http://www.investopedia.com/university/financialstatements/

Financial Statements and Ratio Analysis:http://cpaclass.com/fsa/ratio-01a.htm ; http://cwmulford.com/CoAnalysis.htm

CFO Magazn:http://www.cfo.com/

What does it take to become a CFO?http://www.aicpa.org/pubs/jofa/dec2000/gray.htm

Time Value of Moneyhttp://money.zezenetwork.com/articles/time_value.htm

Present values and Rates of Return:http://www.moneychimp.com/articles/finworks/fmpresval.htm

Study Finance:http://www.studyfinance.com/lessons/timevalue/index.mv

Capital Budgeting:

http://www.studyfinance.com/lessons/capbudget/index.mv

Meta-site on capital budgeting:http://www.swlearning.com/finance/students/capital_bgt.htm

The top 10 things to consider when making a capital budgeting decisionhttp://www.topten.org/content/tt.AI19.htm

A Primer on Capital Structure:http://welch.econ.brown.edu/academics/capitstruct.pdf

Harveys survey on CFOs:http://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdf

Glossary of terms:http://www.investorwords.com/
http://www.duke.edu/~charvey/Classes/wpg/bfgloso.htmhttp://www.duke.edu/~charvey/Classes/wpg/bfgloso.htmhttp://www.mhhe.com/business/finance/corpfinonline/http://www.mhhe.com/business/finance/corpfinonline/http://www.investopedia.com/university/financialstatements/http://www.investopedia.com/university/financialstatements/http://cpaclass.com/fsa/ratio-01a.htmhttp://cpaclass.com/fsa/ratio-01a.htmhttp://cwmulford.com/CoAnalysis.htmhttp://cwmulford.com/CoAnalysis.htmhttp://www.cfo.com/http://www.cfo.com/http://www.aicpa.org/pubs/jofa/dec2000/gray.htmhttp://www.aicpa.org/pubs/jofa/dec2000/gray.htmhttp://money.zezenetwork.com/articles/time_value.htmhttp://money.zezenetwork.com/articles/time_value.htmhttp://www.moneychimp.com/articles/finworks/fmpresval.htmhttp://www.moneychimp.com/articles/finworks/fmpresval.htmhttp://www.studyfinance.com/lessons/timevalue/index.mvhttp://www.studyfinance.com/lessons/timevalue/index.mvhttp://www.studyfinance.com/lessons/capbudget/index.mvhttp://www.studyfinance.com/lessons/capbudget/index.mvhttp://www.swlearning.com/finance/students/capital_bgt.htmhttp://www.swlearning.com/finance/students/capital_bgt.htmhttp://www.topten.org/content/tt.AI19.htmhttp://www.topten.org/content/tt.AI19.htmhttp://welch.econ.brown.edu/academics/capitstruct.pdfhttp://welch.econ.brown.edu/academics/capitstruct.pdfhttp://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdfhttp://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdfhttp://www.investorwords.com/http://www.investorwords.com/http://www.investorwords.com/http://faculty.fuqua.duke.edu/~charvey/Research/Published_Papers/P76_How_do_CFOs.pdfhttp://welch.econ.brown.edu/academics/capitstruct.pdfhttp://www.topten.org/content/tt.AI19.htmhttp://www.swlearning.com/finance/students/capital_bgt.htmhttp://www.studyfinance.com/lessons/capbudget/index.mvhttp://www.studyfinance.com/lessons/timevalue/index.mvhttp://www.moneychimp.com/articles/finworks/fmpresval.htmhttp://money.zezenetwork.com/articles/time_value.htmhttp://www.aicpa.org/pubs/jofa/dec2000/gray.htmhttp://www.cfo.com/http://cwmulford.com/CoAnalysis.htmhttp://cpaclass.com/fsa/ratio-01a.htmhttp://www.investopedia.com/university/financialstatements/http://www.mhhe.com/business/finance/corpfinonline/http://www.duke.edu/~charvey/Classes/wpg/bfgloso.htm

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