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.
Compute the Return on common stock equity under different scenarios