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# What is the rate of return on common stock equity for 2011?

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The following data are provided:

December 31
2011 2010
Cash \$ 375,000 \$ 250,000
Accounts receivable (net) 400,000 300,000
Inventories 650,000 550,000
Plant assets (net) 2,000,000 1,625,000
Accounts payable 275,000 200,000
Taxes payable 50,000 25,000
Bonds payable 350,000 350,000
10% Preferred stock, \$50 par 500,000 500,000
Common stock, \$10 par 600,000 450,000
Paid-in capital 400,000 325,000
Retained earnings 1,000,000 875,000
Net credit sales 3,200,000
Cost of goods sold 2,100,000
Operating expenses 725,000
Net income 375,000

Additional information: Depreciation included in cost of goods sold and operating expenses is \$305,000. On May 1, 2011, 15,000 shares of common stock were issued. The preferred stock is cumulative. The preferred dividends were not declared during 2011.

What is the rate of return on common stock equity for 2011?

#### Solution Preview

See attached file.

The balance sheet doesn't balance so there is some ...

#### Solution Summary

The formula and the computation is shown for you in Excel where a balance sheet and income statement is created to help you "see" the items needed.

\$2.19
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## VC Valuation and Deal Structuring

In 2005 Dub Tarun founded a firm using \$200,000 of his own money, \$200,000 in senior (bank) debt, and an additional \$100,000 in subordinated debt borrowed froma family friend. The senior debt pays 10% interest, while the sub-debt pays 12% interest and is convertible into 10% of the firm's equity ownership at the option of the investor, J Martin Capital. Both debt issues have 10-year maturities. In March 2006 the firm's financial structure appears as follows: (the table is attached in the spreadsheet)

Dub has determined that he needs an additional \$250,000 if he is going to continue to grow his business. To raise the necessary funds, he intends to use an 8% convertible preferred stock issue.

Dub projects that the firm's EBITDA (earnings before interest, taxes, depreciation, and amortization) in five years will be \$650,000. Although Dub isn't interested in selling his firm, his banker recently told him that businesses like this
typically sell for five to seven times their EBITDA. Moreover, by March 2011 Dub expects that the firm will have \$300,000 in cash and the firm's pro forma debt and equity will be as follows: (the table attached in the spreadsheet)

a. What would you estimate the enterprise value of Dub Tarun, Inc. to be on March 2011? (hint: Enterprise value is typically estimated for private companies using a multiple of EBITDA plus the firm's cash balance.) If the sub debt converts to common in 2011, what is your estimate of the value of the equity of Dub Tarun in 2011?

b. If the estimated enterprise value of the firm equals your estimate in question a, what rate of return does the sub debt holder realize if he converts in 2011? Would you expect the sub debt holder to convert to common stock?

c. If the new investor were to require a 45% rate of return on his \$250,000 purchase of convertible preffered stock, what share of the company would he need, based on your estimate of the value of the firm's equity in 2011? What is your estimate of the ownership distribution of Dub Tarun's equity in 2011, assuming the new investor gets what he requires (to earn his 45% required rate of return) and the sub debt holder converts to common? What rates of return do each of the equity holders in the firm expect to realize by 2011 based on your estimate of equity value? Does the plan seem reasonable from the perspective of each of the investors?

d. What would be Dub Tarun's expected rate of return if the EBITDA multiple were five or seven?

e. What is the post-investment and pre-investment value of Dub Tarun's equity in 2006 based on the investment of the new investor?

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