B Brand-name Corporation (A) rand-name Corporation was a pro- divided among several dozen smaller con- ducer of a broad line of men's and tracts. While Brand-name had maintained women's clothing. However, Brand- its major sales relationships for over two name was not widely recognized by the decades, there were no long-term con- public because its products almost always tracts. The customers could, in theory, carried someone else's name. Brand-name shift to a new supplier with no obligations sold to major department store chains, other than contracts calling for delivery with the label reflecting the name of the over a period of no more than a year. department store. Almost half of Brand- The apparel industry had experienced and sales growth averaging 11 percent a year name's sales went to two department store chains, with the other half of sales being net income growth averaging 17 percent a 642 Part Five Financing Decisions and Required Return year for the past 5 years. As a result, stock ist a bo ernization would not add significantly to prices of many companies in the industry capacity. To complete the modernization program, Brand-name needed $20 million of new external capital. The moderniza tion was expected to increase net operal- ing income by $5 million and increase de preciation by $1 million, with no increase Managers wanted to choose a financing method that would have the most favor- ecutives at Brand-name. able impact on the company's stock price. A modernization program was part of Brand-name company could raise money price. A plant modernization would allow by selling 20-year bonds at an interest rate of 9.8 percent before tax. The new bonds more profitable in the highly competitive would be retired through equal annual payments over the 20-year period. The ex- markets in which it operated. The mod- had increased sharply in recent years. Un- fortunately, the stock market had been less kind to Brand-name. As shown in Table 18-6, Brand-name's price-earnings ratio had generally been below the indus- try average. Lackluster stock market per- formance was of great concern to the ex- in sales. plan to increase stock Brand-name to price aggressively and be TABLE 18-6 Seven-Year History of the Financial Performance of Brand-name (in $ millions) 1990 1989 1991 1988 1992 YEAR: 1987 1986 589,101 501,997 484,823 Sales 591,823 607,812 572,988 582,688 49,868 44,270 44,138 47,197 47,330 33,046 55,575 Net op. inc. 15,378 8,676 14,950 8,674 7,601 8,772 7,430 Interest 9.985 9,851 25,386 25,403 8,355 20,704 Other expenses 10.959 3,570 13,253 15,806 Earn bef. tax 19,469 18,775 31,241 37,186 29 4,758 4,916 Tax 3,473 4,906 10.154 13,201 3,541 8,495 Net income 10.890 14,563 15,302 21,087 23,985 Depreciation 8,521 8,368 9,176 9,198 8,903 9,911 10,487 Cur. Assets 223,472 224,086 224,982 201,539 222,467 181,889 203,865 Fixed assets 84,025 64.716 67,670 67.799 69,463 77,116 92,565 Total assets 307,497 288,802 292,652 269,338 291,930 259,005 296,430 Current liab. 167,272 148,486 145,082 50,739 71,801 60,576 74,249 L T. debt 60,771 55,683 56,414 116,132 123,784 67,713 70,192 Equity 79,454 84,633 91,156 102,467 96,345 130.716 151.989 TL&NW 307 497 288,802 292,652 269,338 291.930 259,005 296,430 Earnings 0.35 0.78 1.05 1.35 1.49 1.82 2.05 Dividends 0.13 0.13 0.13 0.28 0.35 0.44 Price-earnings ratio 9.28 4.31 5.89 7.58 5.42 6.87 14.1 PE/Industry 1.23 0.83 1.05 0.94 0.69 0.56 0.82 per share 0.55 per share oBrand-name's price earnings ratio divided by the industry average price earnings ratio. Chapter 18 Capital Structure Decisions 643 isting long-term debt was selling at par for a yield to maturity of 8.9 percent, and was In preparing for a financing decision, being repaid at a rate of $5 million a year. the treasury department at Brand-name The interest rates on U.S. Treasury bills prepared a study of competitors, which is and Treasury bonds were 5.76 percent and puted an estimated cost of capital for each summarized in Table 18-7. They com- 7.11 percent respectively. Brand-name could sell common stock at a price of $25 competitor, using the capital asset pricing a share, after flotation costs. Brand-name model and the market yield on the com- had a beta of 1.10. petitor's debt. These weighted average cost of capital estimates also appear in Table 18-7. TABLE 18-7 Analysis of Competing Apparel Manufacturers Data in this table are based on the 1992 financial statements of the major competitors. % OF CAPITAL SALES BOOK MARKET/ VALUE/ BOOK P-ES SALES COMPANY BETA PFD. DEBT TIE SHARE VALUE EPS RATIO WACCO GROWTH 0.91 0.00 0.47 3.70 10.81 1.26 1.29 10.59 10.98 29% B 1.36 0.00 0.36 1.70 12.21 1.81 0.71 31.21 14.56 21 0.64 0.00 0.12 9.70 22.37 0.96 0.96 22.35 12.05 -13 D 1.01 0.00 0.18 7.80 17.51 1.43 1.20 20.81 13.87 3 E 1.34 0.00 0.00 NA 5.62 7.03 2.00 19.74 17.37 53 F 1.04 0.02 0.43 NA 13.61 1.03 (0.10) NA 11.31 -8 G 0.81 0.00 0.44 2.70 8.60 1.56 0.58 23.19 11.24 17 H 0.94 0.00 0.12 6.40 12.21 1.19 0.93 15.68 13.89 1 1 0.86 0.00 0.10 9.50 27.24 1.41 3.00 12.82 13.60 J 1.06 0.00 0.13 20.50 6.34 2.44 1.08 14.32 14.90 11 4 K 14.19 0.91 0.06 0.02 22.00 21.01 1.36 2.65 10.79 L 0.10 0.74 0.16 0.14 8.49 1.11 1.35 7.01 11.94 6 9.64 M 1.30 3 0.61 0.00 0.36 17.16 0.73 0.50 24.97 1.32 11.94 14.33 5.78 2.73 N 4 1.06 0.01 0.26 10.30 15.03 14.55 O 12 11.26 2.74 2.05 1.01 0.00 0.16 13.70 Times interest earned (earnings before interest and lax + interest expense). bEarnings per share. Price earnings ratio. Weighted average cost of capital. Average annual growth rate per year for the past 3 years. 644 Part Five Financing Decisions and Required Return level above which earnings per share Case Questions below which earnings per share will be will be higher with debt financing and 1. Compare Brand-name to the industry with regard to times interest earned higher with equity financing). and long-term debt to total capital ra- 4. Estimate the marginal cost of capital tios for both the debt and equity fi- for the $20 million, for both debt and nancing alternatives. Would either of the financing alternatives place Brand- equity financing 5. Study the relationships between finan name outside of industry norms? cial leverage and weighted average 2. Suppose there is no change in sales from 1992. Assume no change in ra- cost of capital for the apparel indus try. Based on this information, what tios of current assets and current lia- bilities to sales. Assume the new equip- conclusions can you reach concerning investor response to capital structure ment is placed in service at the beginning of 1993. What level of net in this industry? operating income is needed to meet 6. Study the profitability trends at Brand the financial obligations if debt fi- name. Indicate any positive or nega- nancing is used? if equity financing is tive trends you observe. used? 7. Should Brand-name use debt or eq- 3. Find the crossover point in net operat- uity financing? ing income (the net operating income B Brand-name Corporation (A) rand-name Corporation was a pro- divided among several dozen smaller con- ducer of a broad line of men's and tracts. While Brand-name had maintained women's clothing. However, Brand- its major sales relationships for over two name was not widely recognized by the decades, there were no long-term con- public because its products almost always tracts. The customers could, in theory, carried someone else's name. Brand-name shift to a new supplier with no obligations sold to major department store chains, other than contracts calling for delivery with the label reflecting the name of the over a period of no more than a year. department store. Almost half of Brand- The apparel industry had experienced and sales growth averaging 11 percent a year name's sales went to two department store chains, with the other half of sales being net income growth averaging 17 percent a 642 Part Five Financing Decisions and Required Return year for the past 5 years. As a result, stock ist a bo ernization would not add significantly to prices of many companies in the industry capacity. To complete the modernization program, Brand-name needed $20 million of new external capital. The moderniza tion was expected to increase net operal- ing income by $5 million and increase de preciation by $1 million, with no increase Managers wanted to choose a financing method that would have the most favor- ecutives at Brand-name. able impact on the company's stock price. A modernization program was part of Brand-name company could raise money price. A plant modernization would allow by selling 20-year bonds at an interest rate of 9.8 percent before tax. The new bonds more profitable in the highly competitive would be retired through equal annual payments over the 20-year period. The ex- markets in which it operated. The mod- had increased sharply in recent years. Un- fortunately, the stock market had been less kind to Brand-name. As shown in Table 18-6, Brand-name's price-earnings ratio had generally been below the indus- try average. Lackluster stock market per- formance was of great concern to the ex- in sales. plan to increase stock Brand-name to price aggressively and be TABLE 18-6 Seven-Year History of the Financial Performance of Brand-name (in $ millions) 1990 1989 1991 1988 1992 YEAR: 1987 1986 589,101 501,997 484,823 Sales 591,823 607,812 572,988 582,688 49,868 44,270 44,138 47,197 47,330 33,046 55,575 Net op. inc. 15,378 8,676 14,950 8,674 7,601 8,772 7,430 Interest 9.985 9,851 25,386 25,403 8,355 20,704 Other expenses 10.959 3,570 13,253 15,806 Earn bef. tax 19,469 18,775 31,241 37,186 29 4,758 4,916 Tax 3,473 4,906 10.154 13,201 3,541 8,495 Net income 10.890 14,563 15,302 21,087 23,985 Depreciation 8,521 8,368 9,176 9,198 8,903 9,911 10,487 Cur. Assets 223,472 224,086 224,982 201,539 222,467 181,889 203,865 Fixed assets 84,025 64.716 67,670 67.799 69,463 77,116 92,565 Total assets 307,497 288,802 292,652 269,338 291,930 259,005 296,430 Current liab. 167,272 148,486 145,082 50,739 71,801 60,576 74,249 L T. debt 60,771 55,683 56,414 116,132 123,784 67,713 70,192 Equity 79,454 84,633 91,156 102,467 96,345 130.716 151.989 TL&NW 307 497 288,802 292,652 269,338 291.930 259,005 296,430 Earnings 0.35 0.78 1.05 1.35 1.49 1.82 2.05 Dividends 0.13 0.13 0.13 0.28 0.35 0.44 Price-earnings ratio 9.28 4.31 5.89 7.58 5.42 6.87 14.1 PE/Industry 1.23 0.83 1.05 0.94 0.69 0.56 0.82 per share 0.55 per share oBrand-name's price earnings ratio divided by the industry average price earnings ratio. Chapter 18 Capital Structure Decisions 643 isting long-term debt was selling at par for a yield to maturity of 8.9 percent, and was In preparing for a financing decision, being repaid at a rate of $5 million a year. the treasury department at Brand-name The interest rates on U.S. Treasury bills prepared a study of competitors, which is and Treasury bonds were 5.76 percent and puted an estimated cost of capital for each summarized in Table 18-7. They com- 7.11 percent respectively. Brand-name could sell common stock at a price of $25 competitor, using the capital asset pricing a share, after flotation costs. Brand-name model and the market yield on the com- had a beta of 1.10. petitor's debt. These weighted average cost of capital estimates also appear in Table 18-7. TABLE 18-7 Analysis of Competing Apparel Manufacturers Data in this table are based on the 1992 financial statements of the major competitors. % OF CAPITAL SALES BOOK MARKET/ VALUE/ BOOK P-ES SALES COMPANY BETA PFD. DEBT TIE SHARE VALUE EPS RATIO WACCO GROWTH 0.91 0.00 0.47 3.70 10.81 1.26 1.29 10.59 10.98 29% B 1.36 0.00 0.36 1.70 12.21 1.81 0.71 31.21 14.56 21 0.64 0.00 0.12 9.70 22.37 0.96 0.96 22.35 12.05 -13 D 1.01 0.00 0.18 7.80 17.51 1.43 1.20 20.81 13.87 3 E 1.34 0.00 0.00 NA 5.62 7.03 2.00 19.74 17.37 53 F 1.04 0.02 0.43 NA 13.61 1.03 (0.10) NA 11.31 -8 G 0.81 0.00 0.44 2.70 8.60 1.56 0.58 23.19 11.24 17 H 0.94 0.00 0.12 6.40 12.21 1.19 0.93 15.68 13.89 1 1 0.86 0.00 0.10 9.50 27.24 1.41 3.00 12.82 13.60 J 1.06 0.00 0.13 20.50 6.34 2.44 1.08 14.32 14.90 11 4 K 14.19 0.91 0.06 0.02 22.00 21.01 1.36 2.65 10.79 L 0.10 0.74 0.16 0.14 8.49 1.11 1.35 7.01 11.94 6 9.64 M 1.30 3 0.61 0.00 0.36 17.16 0.73 0.50 24.97 1.32 11.94 14.33 5.78 2.73 N 4 1.06 0.01 0.26 10.30 15.03 14.55 O 12 11.26 2.74 2.05 1.01 0.00 0.16 13.70 Times interest earned (earnings before interest and lax + interest expense). bEarnings per share. Price earnings ratio. Weighted average cost of capital. Average annual growth rate per year for the past 3 years. 644 Part Five Financing Decisions and Required Return level above which earnings per share Case Questions below which earnings per share will be will be higher with debt financing and 1. Compare Brand-name to the industry with regard to times interest earned higher with equity financing). and long-term debt to total capital ra- 4. Estimate the marginal cost of capital tios for both the debt and equity fi- for the $20 million, for both debt and nancing alternatives. Would either of the financing alternatives place Brand- equity financing 5. Study the relationships between finan name outside of industry norms? cial leverage and weighted average 2. Suppose there is no change in sales from 1992. Assume no change in ra- cost of capital for the apparel indus try. Based on this information, what tios of current assets and current lia- bilities to sales. Assume the new equip- conclusions can you reach concerning investor response to capital structure ment is placed in service at the beginning of 1993. What level of net in this industry? operating income is needed to meet 6. Study the profitability trends at Brand the financial obligations if debt fi- name. Indicate any positive or nega- nancing is used? if equity financing is tive trends you observe. used? 7. Should Brand-name use debt or eq- 3. Find the crossover point in net operat- uity financing? ing income (the net operating income