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Innovative Engineering Company Case Study

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Innovative Engineering Company was founded by two partners, Meredith Gale and Shelley Yeaton, shortly after they had graduated from engineering school. Within five years, the partners had built a thriving business, primarily through the development of a product line of measuring instruments based on the laser principle. Success brought with it the need for new permanent capital. After careful calculation, the partners placed the amount of this need at $1.2 million. This would replace a term loan that was about to mature and provide for plant expansion and related working capital.
At first, they sought a wealthy investor, or group of investors, who would provide the $1.2 million in return for an interest in the partnership. They soon discovered, however, that although some investors were interested in participating in new ventures, none of them was willing to participate as partner in an industrial company because of the risks to their personal fortunes that were inherent in such an arrangement. Gale and Yeaton therefore planned to incorporate the Innovative Engineering Company, in which they would own all the stock.
After further investigation, they learned that Arbor Capital Corporation, a venture capital firm, might be interested in providing permanent financing. In thinking about what they should propose to Arbor, their first idea was that Arbor would be asked to provide $1.2 million, of which $1.1 million would be a long-term loan. For the other $100,000, Arbor would receive 10 percent of the Innovative common stock as a "sweetener." If Arbor would pay $100,000 for 10 percent of the stock, this would mean that the 90 percent that would be owned by Gale and Yeaton would have a value of $900,000. Although this was considerably higher than Innovative's net assets, they thought that this amount was appropriate in view of the profitability of the product line that they had successfully developed.
A little calculation convinced them, however, that this idea (hereafter, proposal A) was too risky. The resulting ratio of debt to equity would be greater than 100 percent, which was considered unsound for an industrial company.
Their next idea was to change the debt/equity ratio by using preferred stock in lieu of most of the debt. Specifically, they thought of a package consisting of $200,000 debt, $900,000 preferred stock, and $100,000 common stock (proposal B). They learned, however, that Arbor Capital Corporation was not interested in accepting preferred stock, even at a dividend that exceeded the interest rate on debt. Thereupon, they approached Arbor with a proposal of $600,000 debt and $600,000 equity (proposal C). For the $600,000 equity, Arbor would receive image (i.e., 40 percent) of the common stock.
The Arbor representative was considerably interested in the company and its prospects but explained that Arbor ordinarily did not participate in a major financing of a relatively new company unless it obtained at least 50 percent equity as part of the deal. They were interested only in a proposal for $300,000 debt and $900,000 for half of the equity (proposal D). The debt/equity ratio in this proposal was attractive, but Gale and Yeaton were not happy about sharing control of the company equally with an outside party.
Before proceeding further, they decided to see if they could locate another venture capital investor who Page 275might be interested in one of the other proposals. In calculating the implications of these proposals, Gale and Yeaton assumed an interest cost of debt of 8 percent, which seemed to be the rate for companies similar to Innovative, and a dividend rate for preferred stock of 10 percent. They assumed, as a best guess, that Innovative would earn $300,000 a year after income taxes on operating income but before interest costs and the tax savings thereon. They included their own common stock equity at $900,000.
They also made pessimistic calculations based on income of $100,000 (instead of $300,000) per year and optimistic calculations based on income of $500,000 a year. They realized, of course, that the $100,000 pessimistic calculations were not necessarily the minimum amount of income; it was possible that the company would lose money. On the other hand, $500,000 was about the maximum amount of income that could be expected with the plant that could be financed with the $1.2 million. The applicable income tax rate was 34 percent.

•For each of the four proposals, calculate the return on common shareholders' equity (net income after preferred dividends ÷ common shareholders' equity) that would be earned under each of the three income assumptions. Round calculations to the nearest $1,000 and image percent.
•Calculate the pretax earnings and return on its $1.2 million investment to Arbor Capital Corporation under each of the four proposals. Assume that Arbor receives a dividend equal to its portion of common stock ownership times Innovative's net income after preferred dividends (if any); assume a "negative dividend" if Innovative has a net loss.
•Were the partners correct in rejecting proposals A and B?
•Comment on the likelihood that Innovative Engineering Company could find a more attractive financing proposal than proposal D.

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Solution Summary

Compute the Return on common stock equity under different scenarios

See Also This Related BrainMass Solution

Apple: SWOT Analysis, Value Chain Analysis, Resource-Based View

View the discussion questions at the end.

The words are printed in such small type on the back of Apple's (AAPL ) tiny new iPod Shuffle MP3 player that you have to squint to read them. But they speak volumes about why Apple is standing so far out from the crowd these days. At a time when rivals are outsourcing as much design as possible to cut costs, Apple remains at its core a product company -- one that would never give up control of how those products are created.

In this age of commodity tech products, design, after all, is what makes Apple Apple. This focus is apparent to anyone who has used one of its trailblazing products. While the Silicon Valley pioneer sells only a few dozen models, compared to the hundreds offered by many of its rivals, many of those "designed in California" products are startling departures from the norm -- and they often set the directions for the rest of the industry. Examples abound, from the iPod, to the flat screen look of the new iMac, to the simple smallness of the new Mac mini PC.

What's the secret? The precise details are almost impossible to get, because Apple treats its product-development processes like state secrets -- going so far as to string black drapes around the production lines at the factories of the contract manufacturers it hires to assemble its products. In one case, says a source who once worked on an Apple project, the outfit even insisted that its wares be built only on the midnight shift, when fewer prying eyes might be around.

"INSANELY GREAT." But the general themes are clear. Most CEOs are focused on achieving their financial and operational goals, and on executing a strategy. But Apple's Steve Jobs believes his company's ultimate advantage comes from its ability to make unique, or as he calls them, "insanely great" products.

Jobs's entire company is focused on that task. That means while rival computer makers increasingly rely on so-called outsourced design manufacturers (ODMs), for key design decisions, Jobs keeps most of those tasks in-house. Sure, he relies on ODMs to manufacture his products, but the big decisions on Apple products are made in Silicon Valley.

Jobs himself is a crucial part of the formula. He's unique among big-time hardware CEOs for his hands-on involvement in the design process. Even product-design experts marvel at the power of the Jobs factor.

FIRST, AN IDEA. "I've been thinking hard about the Apple product-development process since I left," says design guru Donald Norman, co-founder the design consultants Nielsen Norman Group, who left Apple in 1997. "If you follow my [guidelines], it will guarantee good design. But Steve Jobs doesn't want good design. He wants great design, and my method will never give you that. That takes a rare leader, who can bring both the cohesion and commitment and style. And Steve has it."

Many executives believe that outsourcing design allows them to lower the salaries they must pay, and lets them have engineers working on the products across all time zones. Jobs thinks that's short-sighted. He argues that the cost-savings aren't worth what you give up in terms of teamwork, communication, and the ability to get groups of people working together to bring a new idea to life. Indeed, with top-notch mechanical, electrical, software, and industrial designers all housed at Apple's Infinite Loop campus in Cupertino, Calif., the company's design capability is more vertically integrated than almost any other tech outfit.

Typically, a new Apple product starts with a big idea for an unmet customer need. For the original iPod, it was for an MP3 player that, unlike earlier models, could hold and easily manage your entire music collection. Then, Apple's product architects and industrial designers figure out what that product should look like and what features it should have -- and, importantly, not have. "Apple has a much more holistic view of product design," says David Carey, president of design consulting firm Portelligent. "Good product design starts from the outside, and works its way inside."

HALF MEASURE. Already, that's different from the process by which the bulk of tech products are made. Increasingly, tech companies meet with ODMs to see what designs they have cooked up. Then, the ODMs are asked to tweak those basic blueprints to add a few features, and to match the look and feel of the company's other products.

That's where the "design" input might end for most companies. But since it's almost always trying to create one-of-a-kind products, Apple has to ask its own engineers to do the critical electrical and mechanical work to bring products to life.

In the iPod Shuffle, for example, designers cut a circuit card in two and stacked the pieces, bunk-bed style, to make use of the empty air space created by the height of the battery in the device. "They realized they could erase the height penalty [of the battery] to help them win the battle of the bulge," says Carey, whose company did a detailed engineering analysis of the iPod Shuffle.

SCREW-FREE. Even more important, Apple's products are designed to run a particular set of programs or services. By contrast, a Dell (DELL ) or Gateway (GTW ) PC must be ready for whatever new features Microsoft (MSFT ) comes out with, or whatever Windows program a customer opts to install.

But Apple makes much of its own software, from the Mac operating system to applications such as iPhoto and iTunes. "That's Apple's trump card," says one Apple rival. "The ODMs just don't have the world-class industrial design, the style, or the ability to make easy-to-use software -- or the ability to integrate it all. They may someday, but they don't have it now."

Of course, Apple also sets its self apart by designing machines that are also little works of art -- even if it means making life difficult for manufacturers contracted to build those designs. During a trip to visit ODMs in Asia, one executive told securities analyst Jim Grossman of Thrivent Investment Management about Steve Jobs's insistence that no screws be visible on the laptop his company was manufacturing for Apple. The executive said his company had no idea how to handle the job and had to invent a new tooling process for the job. "They had to learn new ways to do things just to meet Apple's design," says Grossman.

TOUGH CUSTOMER. That's not to say Apple is completely bucking the outsourcing trend. All its products are manufactured by ODMs in Asia. Just as it buys chips and disk drives from other suppliers, sources say Apple lets ODMs take some role in garden-variety engineering work -- but not much. "This is an issue for Apple, because the A-team engineers [at the ODMs] don't like working with Apple. It's like when you were a kid, all your dad let you do was hold the flashlight, rather than let you try to fix the car yourself," says an executive at a rival MP3 maker.

In fairness, Apple's reliance on a smaller number of products than its rivals and go-it-alone design means it's always a dud or two from disaster. But at the moment, it's proving that "made in Cupertino" is a trademark for success.

Discussion Questions:

1. Apply the three internal analysis frameworks -SWOT analysis, value chain analysis, and the resource-based view-as a way to explain and evaluate aspects of Apple's internal environment highlighted in the Chapter Case about Apple and the interview with Steve Jobs.

a. What are Apple's strengths and weaknesses, opportunities and threats?
b. Roughly what would Apple's value chain look like, and how might it differ from other companies mentioned in this case?
c. Where are Apple's key resources and capabilities? Which are most valuable? Why?

2. Which is the most meaningful type of comparison you make use of in conducting each approach to internal analysis at Apple?
3. Which approach to internal analysis works best in your internal analysis of the aspects about Apple covered in this case? Why?
4. In your opinion, would it be best to use that approach (your answer to question 3) alone or to use it along with the other two approaches if you were a manager responsible for conducting an internal analysis of your company as part of its strategic management process?

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