FINC Case Study

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Case Study

C&MDS, Inc.

Some time ago, at the beginning of 2010, an entrepreneur named Richard Alestar started a small business as a sole proprietor in Oregon - a business that manufactured sensors for cameras that could be used in motion detection systems. The business was very successful and he decided to incorporate in the latter part of 2011 under the name C&MDS, Incorporated. He wanted to name it Camera and Motion Detection Systems, but his marketing manager convinced him it was too difficult to remember. Alestar’s long-term plan was to obtain public funding to support growth anticipated in about 4-6 years. In the meantime, he hired electrical engineers and a solid management team capable of building an organization that would enable the company to eventually go public. He thought his proprietary sensors and equipment could not be duplicated for a number of years. There was only one competitor in the market niche where he competed that had a significant market share, but they were a follower, not a leader. Besides, he planned to grow the market himself, based on the increased focus and attention in the public arena on crime prevention, detection and surveillance using cameras with his sensors. He also was developing a host of other potential applications.

Alestar had developed a good relationship with his investment banker Sophia Pound, and had just begun discussions with respect to obtaining additional capital required to position the company to go public. These discussions also involved the chief financial officer (CFO), Mitch O. Dinero, who had brought up the issue of the appropriate capital structure (target capital structure) that C&MDS should consider. They both thought the current mix in the capital structure was close to optimal, and that only minor changes would be necessary. However, they would defer to the investment banker before they made any final decisions, and there were several tasks to be done before talking to her.

The initial work involved determining the firm’s cost of capital, and they would use the current balance sheet presented in Figure 1 to assess the weights of each of the capital components. Given that they were very close to the target capital structure, the difficult task would involve determining the appropriate cost to assign to each of the elements in the capital structure – debt, preferred stock, and common equity. And they thought the starting point was to gather data about the historical cost for issuing debt and preferred stock. That information is provided in Figure 2.

Figure 1

C&MDS Inc.

Statement of Financial Position: Balance Sheet

December 31, 2015

Assets
Current assets:
Cash		$ 500,000
Marketable securities		100,000
Accounts receivable	$ 2,450,000
Less: Allowance for bad debts	250,000	2,200,000
Inventory		5,400,000
Total current assets		$ 8,200,000
Fixed assets:
Plant and equipment, original cost	$ 31,300,000
Less: Accumulated depreciation	13,100,000
Net plant and equipment		18,200,000
Total assets		$ 26,400,000
Liabilities and Owners’ Equity
Current liabilities:
Accounts payable		$ 5,800,000
Accrued expenses		1,850,000
Total current liabilities		$ 7,650,000
Long-term financing
Bonds payable		$ 6,250,000
Preferred stock		1,120,000
Common stock Retained earnings	{ Common equity		6,230,000 5,150,000
Total common equity		11,380,000
Total long-term financing		18,750,000
Total liabilities and owners’ equity		$ 26,400,000

Although they felt they were making real progress in determining the cost of capital for the firm, they were not confident about component costs that they had identified and decided a call to Sophia was in order to make sure they were on the right track, and they set up a conference call for the following day. During the conference call with her, they explained what had been accomplished and raised the issue about historical costs for each of the elements in the capital structure. She voiced a concern about using historical costs that were somewhat dated. She reported that she knew of a comparable firm in the industry (that needed to remain unnamed), in terms of size and bond rating (Baa), that had issued bonds less than a year ago at a coupon rate of 8.7% at $1000 par value, and further reported that the bonds were currently selling for $930 and had 20 years remaining to their maturity date. This firm more recently had issued preferred stock for $60 per share, and was paying a $4.50 dividend. She also indicated that underwriting a new issue of preferred stock would cost $2.25 per share (underwriting fee or flotation cost).

Figure 2 Historical issue cost of debt and preferred stock

Security	Year of Issue	Amount	Yield
Bond	2012	$ 1,250,000	6.1%
Bond	2012	2,800,000	13.8%
Bond	2015	2,200,000	8.3%
Preferred stock	2011	595,000	12.0%
Preferred stock	2014	525,000	7.9%

After finishing the discussion about debt and preferred stock, their attention naturally progressed to the question about how to determine the cost of common equity. The CFO suggested that one approach would be to use the dividend valuation model. In reviewing the financial statements, he noted that earnings were $3.00 a share (EPS) and 40% of the earnings will be paid out in dividends (D1). Sophia also noted the dividends during the last four years had grown from $.85 per share to the current level, and the stock price was now (P0) $25 per share. She estimated the flotation costs for newly issued common stock would be $2.00 per share. Alestar and the CFO thanked her for the information and the assistance and told her they would get back with her after they had completed the preliminary calculations.

There were several other factors that needed to be considered, and they relate to the following discussions:

· Whether to use the historical weights for the capital structure components, or try to estimate or compute new market weights.

· Should they use an estimated growth rate, compute the simple average growth rate, or use time value of money (TVM) concepts to determine a more accurate growth rate to use in cost of common equity calculations (dividend valuation model)?

You have been chosen to assist the CFO in the analysis. Furthermore, several questions have been developed to help guide you, and they are listed below. However, there may be other issues that they have not thought of and that they want you to identify and address.

Case Questions (show all of your work)

1. Determine the weights of each component in the capital structure: Use the amount of retained earnings provided. The percentage composition (weights) in the capital structure for bonds, preferred stock, and common equity should be based on the current capital structure long-term financing section as shown in Figure 1 (indicated as $18.75 million). Common equity will remain at the current weight throughout the case, and the combined tax rate is 35%.

2. Determine the cost for each component in the capital structure (after-tax cost of debt, cost of preferred stock, cost of equity). Use your calculator to solve for the interest rate (I).

3. Given your results from questions 1 and 2 above, calculate the weighted average cost of capital (WACC).

4. Now assume that new common stock will be used in the capital structure (you will obtain new common stock with flotation costs). Also assume all the weights remain the same; common equity is now supplied by new common stock, rather than by retained earnings (debt and preferred stock costs remain the same).

Recalculate the weighted average cost using new common stock in the capital structure. Remember to consider flotation costs.

5. The increase in the cost of capital will take place at a certain level of financing, where the cost of financing increases (known as the marginal cost of capital):

What is this level of financing (dollar amount)? Determine this by dividing retained earnings by the percent of common equity in the capital structure (as noted in Question 1).

6. You have been told that the investment banker wishes to use the capital asset pricing model (CAPM, as shown on p. 388 in the 15th edition of the text), to compute the cost (required return) on common stock. Assume the risk free rate (rRF) is 4.9%, beta for the firm is 1.30, and the market risk premium (RPM) is 6.8%.

a. What is required rate of return for common equity using this method?

b. Secondly, how does it compare to the required rate of return computed in Question 1 above?