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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

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    https://brainmass.com/business/options/financing-alternatives-207242

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    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

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