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Present Worth Analysis of Two Different Designs

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Julia must choose between two different designs for a safety closure, which will be in use indefinitely. Model A has a life of three years, a first cost of $8000, and maintenance of $1000 per year. Model B will last four years, has a first cost of $10,000, and has maintenance of $800 per year. A salvage value can be estimated for Model A using a depreciation rate of 40% and declining-balance depreciation, while a salvage value for Model B can be estimated using straight-line depreciation and the knowledge that after one year its salvage value will be $7500. Interest is at 14%. Using a present worth analysis, which design is better?

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Model A:

Depreciation rate= 40%
Cost= 8,000
Year Depreciation WDV
1 3,200 =40.%*8000 4,800 =8000-3200
2 1,920 =40.%*4800 2,880 =4800-1920
3 1,152 =40.%*2880 1,728 =2880-1152

Salvage value at the end of 3 years= 1,728

Cash flow for Model A

Year Cost Maintenance Salvage Total
0 -8,000 -8,000
1 -1,000 -1,000
2 -1,000 -1,000
3 -1,000 1,728 728

Cash inflow is positive, cash outflow is negative

Let us find the Present value (PV) of cash flows
Discount rate used is interest rate = 14%

Year Cash flow Discount factor @ Discounted cash ...

Solution Summary

Using the present worth analysis of two different designs for a safety closure, which will be in use indefinitely, the better design is identified.

See Also This Related BrainMass Solution

Long Term Financial Decisions

Sun Coast Savings Bank was founded in l97l in Safety Harbor, Florida, which is just across the
bay from Tampa. Safety Harbor is very popular with people who work in Tampa but do not wish
to live within the city itself. Per-capital income in Safety Harbor is substantially above the national
average; in fact, the town has a reputation for having the greatest population of BMWs and
Mercedes Benzes per capita in the United States. The combination of an increasing population,
high per capita income and a huge demand for funds to finance new home construction has made
Sun Coast the fastest-growing association in the state in terms of both assets and earnings.

Although Sun Coast is very profitable and has experienced rapid growth in earnings, the
company's quick expansion has put it under severe financial strain. Even though all earnings have
been retained, the net-worth-to-assets ratio has been declining to the extent that, by 2000, it was
just above the minimum required by federal regulations(see T able l).

Table 1

Sun Coast Savings Bank
Balance Sheet for Year Ended December 31, 2000

Cash & Marketable Securities $83,441,700
Mortgage Loan 815,235,000
Fixed Assets 60,423,300
Total Assets $959,100,000

Savings Account $817,153,200
Other Liabilities 83,077,000
Capital Stock ($100 par value) 900,000
Retained Earnings 57,969,800
Total Claims $959,100,000

***Note: Federal law requires the ratio of capital plus retained earnings-to-assets to be at least 6%.

Sun Coast now has the opportunity to open a branch office in a new shopping center. If the office is opened, it will bring in profitable new loans and deposits, further increasing the company's growth. However, an inflow of deposits at the present time would cause the net-worth-to-assets ratio to fall below the minimum requirements. Consequently, Sun Coast must raise additional equity funds of approximately $3 million if it is to open the new branch.

Even though Sun Coast has a ten-man board of directors, the company is completely
Dominated by the three founders and major stockholders: Jim Evans, chairman of the board and
owner of 35 percent of the stock; Tony McCoy, president and owner of 35 percent of the stock;
and Vincent Culverhouse a, builders serving as a director of the company and owner of 20 percent
of the stock. The other seven directors own the remaining l0 percent of the stock. Evans and
Culverhouse both have substantial outside financial interests most of McCoy's net worth is
Represented by his stock in Sun Coast

Evans, McCoy, and Culverhouse agree that Sun Coast should obtain the additionally equity funds to make the branch expansion possible. They are not in complete agreement, however, as to how the additional funds should be raised. They could raise the additional capital by having Sun Coast sell newly issued shares to a few of their friends and associates. The other alternative is to sell shares to the general public. The three men themselves cannot put additional funds into the company at the present time.

Evans favors the private sale. He points out that he, McCoy, and Culverhouse have all been receiving substantial amounts of ancillary, or indirect, income from the savings bank operation. The three men jointly own a holding company, which operates an insurance agency that writes insurance for many of the homes financed by Sun Coast, and a title insurance corporation that deals with the company. Also, Culverhouse owns a construction company that obtains loans from the association. Evans maintains that these arrangements could be continued without serious problems if the new capital were raised by selling shares to a few individuals, but questions of conflict of interest would probably arise if the stock were sold to the general public. He also opposes a public offering on the grounds that the flotation cost would be high for a public sale, but would be virtually zero if the new stock were sold to a few individual investors.

McCoy disagrees with Evans. He feels that it would be preferable to sell the stock to the
general public rather than to a limited number of investors. Acknowledging that flotation costs on
the public offering are a consideration, and that conflict-of-interest problems may occur if shares
of the company are sold to the general public, he argues that there would be several offsetting
advantage if the stock were publicly traded: ( l) the existence of a market-determined price would
make it easier for the presents stockholders to borrorw money using their shares in Sun Coast as
collateral for loans; (2) the existence of a public market would make it possible for current
shareholders to sell some of their shares on the market iff they needed cash for any reason;( 3)
having the stock publicly traded would make executive stock-option plans more attractive to key
employees of the company;( 4) establishing a market price for the shares would simplify problems
of estate tax valuation in the event of the death of one of the current stockholders (;5 ) selling stock
at the present time would facilitate acquiring additional equity capital in the future.

Culverhouse, whose 20% ownership of the company gives him the power to cast the deciding vote, is unsure whether he should back the public sale or the private offering. He thinks that additional information is needed to help clarify the issues.

The board therefore instructed Madeline Brown, Sun Coast's chief financial officer, to study the issue and to report back in 2 weeks. As a first step, Brown obtained the data on Sun Coast's earnings give in Table 2. Brown then collected information on 4 publicly traded financial institutions; this data is shown in Table 3. She then set about the task of coming up with a recommendation for the board of directors.

Table 2
Sun Coast Savings Bank
Selected Information

Year Net Profit Earnings per Share
2000 $8,562,780 $951.42
1999 7,476,390 830.71
1998 6,521,490 724.61
1997 5,231,610 581.29
1996 4,712,220 523.58
1995 3,905,550 433.95

Table 3
Data on Publicly-Traded
Financial Institutions

Assets (Mil.) Net Worth (Mil.) Book VPS Price EPS 2000 EPS '95
Virginia Fed. Inc. $14,000 $950 $30.30 $32.00 $5.25 $2.50
Southland Fin. 30,500 2,020 16.15 17.00 2.00 0.83
Texas Fed., Inc 24,000 1,130 38.95 25.00 5.40 1.59
Great Southern 27,000 1,400 56.50 28.00 6.25 3.94

1. Table 1 presents Sun Coast's balance sheet at the end of 2000. Using information contained in the balance sheet, calculate Sun Coast's net-worth-to-assets ratio, the number of shares of stock outstanding, and the book value per share of common stock.

2. Using the data in Table 2, calculate Sun Coast's average annual growth rate in earnings per share from 1995 to 2000. (Hint: In your calculations, use only the data for 1995 and 2000.)

3. For the four S&L's listed in Table 3, calculate the following:
A. The net worth/assets ratios for 2000.
B. Compound annual growth rates in earnings per share for the 5 yr period.
C. The price/earnings ratios in 2000.
D. The market value/book value ratios for 2000.

4. Considering your answers to Question 1 through 3, develop a range of values that you think would be reasonable for Sun coast's market/book ratio if it were a publicly held company.

5. Regardless of your answers to Questions 4, assume that 0.8x is an appropriate market value/book value ratio for Sun Coast. What would be the market value per share of the company?

6. Investment bankers generally like to offer the initial stock of companies that are going public at a price ranging from $10 to $30 per share. If Sun Coast stock were to be offered to the public at a price of $20 per share, how large a stock split would be required prior to the sale?

7. Assume that Sun Coast chooses to raise $3 million through the sale of stock to the public at $20 per share.

A. Approximately how large would the % flotation cost be for such an issue? Base your answer on available published statistics.
B. How many shares of stock would have to be sold in order for Sun Coast to pay the flotation cost and receive $3 million net proceeds from the offering?

8. Assume that each of the 3 major stockholders decided to sell half of his stock.

A. How many shares of stock and what total amount of money (assuming that the stock split occurred and that these shares were sold at a price of $20 per share) would be involved in this secondary offering? (A secondary offering is defined as the sale of stock that is already issued and outstanding. The proceeds of such offerings accrue to the individual owners of the stock, not to the company.)

B. Approximately what percentage flotation cost would be involved if the investment bankers were to combine the major stockholders' secondary offering with the sale by the company of sufficient stock to provide it with $3 million.

9. Assume that the major stockholders decide that Sun Coast should go public. Outline in detail the sequence of events from the first negotiations with an investment banker to Sun Coast's receipt of the proceeds from the offering.

10. Can you see why Evans and McCoy might have personal differences of opinion on the question of public ownership?

11. The analysis was based on the comparability of Sun Coast with 4 other savings institutions. What factors might tend to invalidate the comparison?

12. All things considered, do you feel that Sun Coast should go public? Fully justify your conclusion.

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