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Assess the financing proposals in terms of attractiveness in cost and associated risk. Please evaluate the following financing alternatives: commercial bank loan, mortgage bond, common stock, preferred stock with warrants and convertible bond to fund the special project. Your answer should include qualitative and quantitative issues.

The Rondo Company

For MBAF 602 - Financial Decision Making

A context is required for a student working on a case study. In this case assume that your point of view is that of the CFO of Rondo analyzing its strategies on January 1 of the current calendar year.

The Rondo Company is a medium size manufacturing company that manufactured copper, steel, and iron pipe. The company was founded by Bill Rondo, the current president and board chairman. Mr. Rondo owns the majority of the company's outstanding stock. The stock is actively traded on the NASDAQ exchange. Key financial, ownership and market information on Rondo is included in Appendix A.

In addition to the normal course of business, Rondo has two interesting opportunities that it is considering.

The first opportunity is a special contract with a long-time customer. The customer wants to enter into a five-year agreement to have Rondo produce a new type of pipe. Key expected financial information on this special project is included in Appendix B. In order to take advantage of the project, Rondo would have to invest the amount noted in Appendix B in special purpose equipment. It is unlikely that the contract would be renewed and also unlikely that the new equipment could be adapted to other production. Since the equipment would be special purpose, the expected salvage value is zero.

The second opportunity is the possibility of acquiring a company that makes PVC pipe. This company, Poly Pipe Incorporated (Poly), is smaller than Rondo. It had been started by several previous Rondo managers to take advantage of the new poly vinyl chloride pipe making technology. Although both companies are in the pipe business, their customer bases do not overlap significantly. Metal pipe and PVC pipe are used in different applications. Poly is traded on the NASDAQ pink sheets. The market is not active. The majority of the stock is still owned by the three founders. The remainder of the stock is owned by several hundred stockholders; its ownership is not concentrated. Key financial, market and ownership information on Poly Pipe Inc. is included in Appendix C.

In addition to these opportunities, Rondo continues its modest growth. While the company's growth rate has varied over the last 10 years, it currently expects this historical growth rate to continue. However, Rondo is operating near its capacity. As a practical matter, growth will require incremental additions to production equipment.

MBAF 602 1 of 4 Revised SP2005 8W1

Rondo's Board of Directors has established several policies. While the Board prefers that these policies be followed, they would modify the policies if it made sense for the company.
? The dividend payout ratio should be between 40% and 50%.
? The debt to total assets ratio should not be higher than 50%. Moreover, the Board's intention is to maintain total debt, including current liabilities, at 55% of assets or lower.
? Annual company growth should continue in the 5% to 10% range. The board will measure growth in the annual increase in Earnings Per Share.
? The company should maintain flexibility in financial transactions. No high risk transactions should be used, nor should the company tie its hands with financial arrangements.

In addition, Mr. Rondo wants to maintain his family ownership in the company at a minimum of 30%. He does not want to be required to purchase any additional stock. Since the Rondo family counts on the dividend payments, he is also adamant about continuing the dividend payments near their current per share rate.

A preliminary analysis by one of the company's interns yielded the following information about other companies in Rondo's industry.

Industry Average
Current Ratio
Average Collection Period
Days to Sell Inventory (based on cost of goods sold)
Total Asset Turnover
Cash as a Percent of Sales
Total Debt to Total Assets
Gross Profit Margin
Profit Margin
Return on Assets
Return on Equity
1.40
45 Days
40 Days
1.10
3%
0.40
35%
10%
11%
20%
MBAF 602 2 of 4 Revised SP2005 8W1
Poly Pipe Incorporated Purchase
Poly is a small company that manufactures PVC pipe. They have been in business for 10 years. Growth has been relatively consistent for the last five years. Poly's products do not compete directly with Rondo's.
Poly's managers want to sell the company. If the sale is to be a cash sale they will require a premium of 50% above the current "market" price to cover taxes and still leave a profit. They would be willing to sell by exchanging shares with an appropriate company, possibly on more favorable terms.

Sources of Funds
The company has investigated several sources of funding for the new project and for future needs. Detailed information and terms on each potential funding source is provided in Appendix D. Terms are those required by the provider of funds. While some conditions may be negotiable, most are cast in stone. The potential funding options are summarized below:

Common Stock
New common stock could be issued at the current market price, however, underwriting and other associated costs (noted in Appendix D) must be considered in calculating the total "proceeds" that Rondo would receive.

Mortgage Bond
The ABC Insurance Company, the company that provided the original mortgage bond, is willing to refund it. The current bond would be replaced with a new one, on the terms noted in Appendix D. The loan would be secured by all the assets of Rondo, including any assets acquired in the future.

Convertible Bond
The XYZ Insurance Company is willing to issue a convertible bond. XYZ wants to be able to share in Rondo's success but also retain the ability to remain a creditor if the Company is not successful. Each $1,000 bond would be convertible into a certain number of shares of Rondo common stock, as noted in Appendix D. In addition, cash dividends would be restricted. Cash dividends could not be paid unless net income was 20% of the value of the bonds outstanding.

Preferred Stock
The MNO Insurance Company was willing to offer a preferred stock arrangement. In addition to the preferred stock, MNO wanted warrants to sweeten the deal. Each share
MBAF 602 3 of 4 Revised SP2005 8W1
of preferred stock would contain warrants that allowed the purchase of a certain number of shares of Rondo Common stock at the exercise price outlined in Appendix D. In addition, if four consecutive dividends were missed, the preferred stockholders would elect 50% of the board of directors.

Bank Loan
The current bank loan could be extended with additional amounts available, as noted in Appendix D.

Foreign Denominated Loan
A local branch of a Swiss bank is willing to provide Rondo with a loan denominated in Swiss Francs (meaning the proceeds and all payments will be in Swiss Francs). The terms and expected exchange rates are found in Appendix D.
Note: for simplicity this case assumes that all interest payments on loans, bonds, and preferred stock are paid annually. You should know that bank loans have a wide variety of interest-payment arrangements, virtually all bonds have semiannual interest payments and preferred stock dividends are generally paid quarterly.

Key Study Questions
Throughout the course you will be asked to address the following issues:
? How is Rondo doing at this point in time?
? What are Rondo's financing needs for the next 6 years? Include the new project in your calculations but don't include the purchase of Poly.
? Is the new project a good deal? Why or why not?
? Are funds available internally?
? Are there any Board of Directors policies that you would suggest be changed? Why?
? Evaluate the Swiss Frank loan
? Which financing source should be used to finance the new project and the company's continuing growth?
? Should Rondo purchase Poly? What should the offer be?
MBAF 602 4 of 4 Revised SP2005 8W1
RONDO CASE - APPENDIX A
BALANCE SHEET (as of 12/31)
2003
2004
2005
ASSETS
Current Assets
Cash
1,469,000
2,032,500
2,460,000
Accounts Receivable
9,000,000
9,375,000
9,750,000
Inventory
4,125,000
4,625,000
5,250,000
Total Current Assets
14,594,000
16,032,500
17,460,000
PPE
Equipment
19,000,000
18,375,000
17,500,000
Property and Plant
16,000,000
15,375,000
14,750,000
Total PP&E
35,000,000
33,750,000
32,250,000
TOTAL ASSETS
49,594,000
49,782,500
49,710,000
LIABILITIES
Current Liabilities
Accounts Payable
1,500,000
2,250,000
2,500,000
Current Portion of Bank Loan
2,500,000
2,500,000
2,500,000
Accruals
3,375,000
3,500,000
3,750,000
Total Current Liabilities
7,375,000
8,250,000
8,750,000
Long-Term Debt
Bank Loan
10,000,000
7,500,000
5,000,000
Mortgage Bond
5,000,000
5,000,000
5,000,000
Total Long-Term Debt
15,000,000
12,500,000
10,000,000
Total Liabilities
22,375,000
20,750,000
18,750,000
Equity
Common Stock
9,587,500
9,587,500
9,587,500
Retained Earnings
17,631,500
19,445,000
21,372,500
Total Equity
27,219,000
29,032,500
30,960,000
TOTAL LIABILITIES & EQUITY
49,594,000
49,782,500
49,710,000
Notes to Rondo's Balance Sheet:
Bank Loan Information
Original Amount Borrowed
15,000,000
Current Amount Outstanding
7,500,000
Interest Rate
6.00%
Principal Payment Amt per Year
2,500,000
Year of Final Payment
2008
Interest & Principal Pmts Due
December
Mortgage Bond Information
Original Amount Borrowed
5,000,000
Current Amount Outstanding
5,000,000
Interest Rate
7.50%
Principal Payment Amt per Year
500,000
Principal Payments Begin in Year
2010
Year of Final Payment
2019
Interest and Principal Pmts Due
December
New Appendices.xls -- Appendix A
7/18/2005 3:07 PM
INCOME STATEMENT (for year ending 12/31)
2003
2004
2005
Sales
41,250,000
46,250,000
50,000,000
Cost of Goods Sold
(28,875,000)
(32,375,000)
(35,000,000)
Gross Profit
12,375,000
13,875,000
15,000,000
Selling, General & Admin
(4,560,000)
(5,205,000)
(5,850,000)
Depreciation
(1,500,000)
(1,500,000)
(1,750,000)
Earnings Before Interest & Taxes
6,315,000
7,170,000
7,400,000
Interest
(1,275,000)
(1,125,000)
(975,000)
Earnings Before Taxes
5,040,000
6,045,000
6,425,000
Income Tax @ 40%
(2,016,000)
(2,418,000)
(2,570,000)
NET INCOME
3,024,000
3,627,000
3,855,000
Shares Outstanding
1,000,000
1,000,000
1,000,000
Earnings per Share
3.02
3.63
3.86
Dividends Paid
1,512,000
1,813,500
1,927,500
Increase in Retained Earnings
1,512,000
1,813,500
1,927,500
Market Price Per Share
62
Mr. Rondo's Share Ownership
60.00%
Rondo Company Beta
1.20
New Appendices.xls -- Appendix A
7/18/2005 3:07 PM
Appendix B - Special Project Information
Term of the Agreement (Years)
5.00
Initial Capital Expenditure for equipment ($ millions)
6.25
Expected Annual EBIT Contribution ($ millions)
2.00
Expected Annual Sales ($ millions)
7.50
Expected Salvage Value of equipment ($ millions)
0.00
Poly Incorporated - Appendix C
Balance Sheet
Income Statement
for the Year Ending December 31
2005
for the Year Ending December 31
2005
ASSETS
Sales
31,250,000
Cost of Goods Sold
21,875,000
Current Assets
Gross Profit
9,375,000
Cash
2,250,000
Accounts Receivable
5,250,000
Selling, General & Admin
2,229,168
Inventory
8,125,000
Depreciation
1,437,500
Total Current Assets
15,625,000
Earnings Before Interest & Taxes
5,708,333
PPE
Interest
500,000
Equipment
9,375,000
Earnings Before Taxes
5,208,333
Property and Plant
5,000,000
Total PP&E
14,375,000
Income Tax @ 40%
2,083,333
TOTAL ASSETS
30,000,000
NET INCOME
3,125,000
LIABILITIES
Shares Outstanding
1,100,000
Earnings per Share
2.84
Current Liabilities
Dividends Paid
0
Accounts Payable
4,375,000
Market Price of One Share of Stock
36
Accruals
1,875,000
Total Current Liabilities
6,250,000
Long-Term Debt
Bank Loan
5,000,000
Total Long-Term Debt
5,000,000
Total Liabilities
11,250,000
Equity
Common Stock
2,500,000
Retained Earnings
16,250,000
Total Equity
18,750,000
TOTAL LIABILITIES & EQUITY
30,000,000
Potential Funding Sources - Financial Terms (Appendix D)
Common Stock Terms
Price at which new stock could be issued
$62
Underwriting Costs per Share
$9
Mortgage Bond
Total Amount Offered w/out Poly Pipe Purchase
$8 mm
Total Amount Offered w/ Poly Pipe Purchase
$13 mm
Interest Rate
9.00%
Repayment of Principal per Year (% of Loan)
10.00%
Total Term of Loan (years)
10 years
Payments
Annual
Payment Date
December
Convertible Bond
Total Amount Offered
$10 mm
Interest Rate
8.63%
Repayment of Principal per Year (% of Loan)
none
Total Term of Loan (years)
10 years
Payments
Annual
Payment Date
December
# of Shares per $1000 bond if converted
15.625
Preferred Stock
Total Amount Offered w/out Poly Pipe Purchase
$8 mm
Total Amount Offered w/ Poly Pipe Purchase
$13 mm
Dividend Rate
9.38%
Dividend Payments
Annual
Dividend Payment Date
December
Par Value per Share
$100
Callable after 15 years at price per share of
$105
Number of Warrants per Preferred Stock Share
13
Strike Price of each Warrant ($ per Rondo share)
$77.00
Bank Loan
Total Amount Offered w/out Poly Pipe Purchase
$10 mm
Interest Rate
11.50%
Principal Payments per Year
$2 mm
Principal Repayment Begins
2006
Payments
Annual
Payment Date
December
Swiss Loan
Total Amount Offered w/out Poly Pipe Purchase (Francs)
10 mm sf
Total Amount Offered w/ Poly Pipe Purchase
18 mm sf
Interest Rate
6.75%
Repayment of Principal per Year (% of Loan)
10.00%
Total Term of Loan (years)
10 years
Payments
Annual
Payment Date
December
Payment Currency
Swiss Franc
Expected Exchange Rates (Swiss Francs / Dollar)
Year
Avg Rate
2005
1.33
2006
1.29
2007
1.25
2008
1.21
2009
1.17
2010
1.14
2011
1.10

Attachments

Solution Preview

Assess the financing proposals in terms of attractiveness in cost and associated risk. Please evaluate the following financing alternatives: commercial bank loan, mortgage bond, common stock, preferred stock with warrants and convertible bond to fund the special project. Your answer should include qualitative and quantitative issues.

Financing options available

Issue of Capital structure
A firm's optimal capital structure is that mixture of debt and equity than minimizes its weighted average cost of capital (WACC). Since the after-tax cost of debt is lower than equity for many corporations, why not use debt only or mostly? It turns out that, while debt reduces a company's tax liability because interest payments are deductible expenses, increasing amounts of debt raise both the cost of equity capital and the interest rate on debt because of the increasing probability of bankruptcy. In other words, higher amounts of debt raise the financial risk of a company, and this risk is reflected on the cost of all the types of capital the company uses.

Thus, the relationship between financial leverage and WACC is not a straight line, but more of a U-shaped curve, with a minimum WACC between the extremes of debt utilization.

Apart from the risk associated with a firm's fundamental operations known as operating risk, risk can be introduced by the use of financial instruments with fixed payments, more commonly known as debt. Thus the advantage of taking debt is its lower cost, no share in profits. The limitation is that it increases financial risk.

Let us discuss the options available with the Rondo
Equity Financing
Equity means sharing in the ownership. Thus this involves contribution by the owners of the organization. Equity can be raised either by private placement or by public. Wesco has a strong track record; thus it can use this route to raise money. It has following features:

 Claim on Income and Assets:
Shareholders have the claim on income and assets of the firm.
 Right to Control
 Voting Rights
 Pre-Emptive Rights
 Limited Liability
(Pandey, I.M.)

Other ways of raising equity

Venture capital fund managers generally purchase equity of new businesses with the potential for rapid growth. Because of the very high risk associated with such investments, venture capitalists require a high-expected rate of return, typically in the 20-40 percent range. When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company.

Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft and Genentech are famous examples of companies that received venture capital early in their development.

Advantages of raising shares
1) Permanent Capital: It need not be paid back
2) Borrowing Base: It can be used to trade on equity
3) Dividend Payment Discretion: The payment of dividend is in the hands of management
4) No Mortgage
Unlike debt this does not involve the mortgage. Thus assets are free of any encumbrance.
5) Wealth creation tool
This can be used to create wealth for employees and shareholders.

Disadvantages
1) Cost: It is more costly than debt
2) Earnings Dilution: It involves reduction in EPS.
3) Ownership Dilution: It involve sharing of ownership
4) Higher Opportunity cost
This has got the highest opportunity cost as it has the maximum risk
5) No tax shield
Unlike debt the payment of dividend has got no tax shield.

Debt Financing
This is raising money from the lenders. They pay interest to the lenders. The various option of debt is:
Bonds

It is a fixed income (debt) instrument issued for a period of more than one year with the purpose of raising capital. The central or state government, corporations and similar institutions sell bonds. A bond is generally a promise to repay the principal along with fixed rate of interest on a specified date, called as the maturity date.

Issue Convertible Debenture
It is issuing of convertible debentures to which will be convertible into equity after few years. It involves selling of ordinary shares in future at a higher price.
Convertible warrants

A warrant entitles the purchaser to buy a fixed number of ...

Solution Summary

This evaluates various financing alternatives

$2.19