9 Case 8 Johnson Window Company Capital Structure Directed As a builder in San Diego, Mark Johnson observed a rapid expansion in the use of custom win¬dows and window treatments such as vertical blinds and drapes in both residential and commercial constru

69

6uru:ee] ebe6ue3 1o ped e'utepapl-qrnos 166t @

eql euruuelep 01 FJusseceu sB^\ 1I 'polg eq plnoc JeUBI{c aql oJoJeq 'JeleirroH 'eJuqs Jed 0I$ Jo eclJd B

t€ sJolse^ul eplslno ol somqs enssl 01 pu8 'luelBd eW ol I $ Jo enl?^ B uBIssB 01 'I{cBe 0I'0$ Jo eclJd

B lB se^lesueql ol seruqs enssr 01 peprcep puu suollepue(uuoceJ osaql qll^\ peer8u sJopunoJ eqJ, 'peu8rsse eq oruqs Jed 0I'0$ Jo enl€^ JBd e luql puu JeUuqc oluJodJoc eq1 uI pezlJoqln€ aq seJuqs

uorllrr 0I 1gql pelseSSns oslB ,(eurolle eqJ 'pesrBr sI IslIdBc eplslno ,(ue eroJeq ',(lelutpeulur peler -odJocur eq plnoqs sseursnq eql lBql sqqrD puB 'sdulqd 'uosuqof pesl^pB ,(eurollu Fcol Y

.IBlrdBc ernlue1 ,(1rnbe 8ur,(1ddns ur lserelur uB pessardxa pBI{ Sulsuuug dn-pels uI sezllBlceds

qrrg,r ruJg ofiBJe{orq leuor8eJ B puu 'lelrdec lqep Sulpl^ord uI tseJelul uE pesserdxe ,(peeqe pBq solu

-€d1lloc ecuurnsur IBuorEoJ puB s{uBq lerol IBJe^es 'lcBJ uI 'uoISoJ lloquns aql ut qtlrorE uorlepdod

Suorls pue lcnpord eql uo siloder pooE;o esneceq pltduc ,$rnbe ro lqep epl$no Eutsrcr uI elqnor

elllll peludrcrlue ,(eql '1u1rdec leuonlppu peeu plnoa sJapunoJ aerql eql q8noqllv 'lseJelul dlqs -Jeu,ro IuBcIJISBIS € el?q plno,t 'uoSuqOI qlIA\ 3uo1e ',(eq1 'Sseulsnq

^\eu eql ut ,(auour puB eIIIn

qloq lso^ur o1 peer8u ureqlJo qceg'Suqunocce pue ecueug ro3 elqrsuodseJ sBlt\ 'ecuBug ur perofuru

pgq oq,,11 ,sqqlD rro.I elq^\ 't-uJrJ eql ol ^\oq-A\ou{

Surrnlce;nueu lq8no.rq 'leeutEue eql 'sdIIIIqd

ur{o[ .lsrlgrceds ecuuug e puu reeur8ue uorlcnpoJd u qlr,t dn pelueel oq 'ue]s 01, 's1(opulry\ pelull

oql aJnlc€Jnuuu 01 uIJIJ e ez:rue?to o1 uu8eq uosuqof'penssr sB1( lueled eql eJoJeq uelg 'sresEqcrnd ,(uuru ol snld u eq ppo^l

Surppnq oq1 eprsur sseulq8rrq Jo lo^el luulsuoc B SuIuIBluIBlu;o e8eluu,tpe aql (eJouJequnC 'ecua

-regrp ecgd eql JoJ dn eluu uuql eJoru plno,r\ slsoc Eurlooc pue Suueaq ro,t\ol qll^\ pelelcossB sBuI -^es eql .srue,( e,rg

Jo porJod B JeAo 'leql salururlse rurg SuuoeulSue eprslno ue ,(q petcnpuoc ,(pn1s

,Qrlrqrsee; e ,s^\opur,ry\ ssey8 puoqrpeJl ueql eclJd uI reluar8 luecrad 91 ,(pueu arem ssu13 A\ou eq1

qlr^t epeur s,/r\opul^\ q8noqlly 'e8uloo; ,tropult\ Jo lol B uleluoc qclq^\ sEulpllnq lueuuedu pue acuJo

roJ pelrns-lloru ,(yrelncrlmd eq plnom ssu13 ,treu eql lloJ uosuqol 'Joloc lull puu Ie^el lun IeIlIuI eql

lcales plnoc reruolsnc eql 'uoqrppu uI '8sJe^ ecIA puB Je{rBp sluoceq plno,t\ /Y\opulu eql ut ssu13

eqt ,relqfug eueceq uns eqt sv 'pe8uuqc uns eqt go sseutq8rrq eql sB lull pe8ueqc qcII{^\ /t\opul^\ ssu13 paluq go ed,(1

^\eu B peluelgd puu pauflrsep uosuqol le1wru Ftluelod e8nq e suirr lq8noqt eq

leq.r\ uo ezllulrdec oI',,rropul1rr ,(1rpnb-re11eq'u8tsep-pe,tordrut ue SB,lr uollnlos snol^qo eq.|,'lunoluu

elqpuosgeJun uu ,(q Surlooc puu Surleeq Jo lsoc eql pesuoJcur ,(11ucrd,(1 se8eloo3 ,t\opul^\ 33JBI

1nq .s3urplnq Jreql olur elqrssod su 1q8r1 luJnluu qcnu se Surrq o1 pelue,{ e1doe4 'uollcnrlsuoc

IgroJerrluoc pue lgnueprser qloq ur sederp pue spuqq I€cIUeA su qcns sluelulBoJl ^\opul1\\

pue s^\op

-ur1( uolsnc Jo asn eql ur uorsuedxe prdur B pe^resqo uosuqol {JBI I 'oBeIC UBS uI Jepllnq B sV

polooJ:G

ernlcnrls lulrdBf,

dueduro3 MopuIM uosuqof

8 0SeЭ

6

０ 〓 ” 「 ”● 『 ０ ¨ 」 ０

， ⊃ ∽ 〇 つ く く ３ ａ ｏ ≦

Ｏ ｏ Ｂ Ｏ ∞ ⊃ ヽ

０ 「̈① ｏ ①́ Ｑ

number ol'share s that could be issued to the tbunders at $0. l0 each and still have sufhcient value leli in rhe firm to raise enough ecluity capital at $10 per share to meel. the firm's initial capital recluire- rnents. Thus, Gibbs concluded that she should create a business plan that not only described thc product, the rnarkcts to be served, and the firm's production plans, but which also outlined the anticipated financing requirements in some detail.

The initial marketing plan called fbr selling thc tinted windows directly to large contractors and usin-9 sevcral wholesalers to distribute the items to architects and small contractors. At a pro-

.jected average selling price of $750 per unit, they had little doubt that sales would be strong. How- cver, thc tintcd windows will be used prirnarily in new construction, and this industry has always been subject to highly cyclical sales. Further, although the sunbelt region is continuing to L'xperience relatively strong commercial and residential markets, other sunbelt areas such as Houston have been sufl'ering liom high commercial vacancy rates and depressed residential markets. Thus. Gibbs t'elt uncomlitrtable about using a point cstimate tbr unit sales. st'r she developed estimates firr threc pos-

sible scenarios: rlost likely, optirnistic, and pessimistic, with probabilities ol occurrence of 0.50, 0.25, and 0.25, respectively. Of course, Cibbs realizes that unit sales could assume almost any value. but I'rer discrete distribution is roughly cornparable to a continuons norrnal distribution which has a range of plus or n.rinus 2 standard deviations abttut the mean:

Scenario Probability Unit Sales Dollar Sales Pessimistic Most likely Optimistic

0.25

050 025

52,200

67,500

82,800

$39,150,000

50,625,000

62,100,000

After an in-depth study, Phillips, the engineer-production manager, identified two alternative production processes that could be employed, and he asked Gibbs to evaluate the financial irnplica- tions of the alternatives and to recornnrend a course of action. Plan A involves only a sn.rall amount of automated equiprnent, as most of the window cornponents would bc purchased ticlm local sub- contractors. Under this plan, annual fixcd costs are estimated to be $7,769,900. while variable costs would be $585 per unit produced. The second alternative. Plan B, would recluire the firm to make a significant investment in fabrication machinery, resulting in a fixed cost estintate ol'$17,845,000 per year and variable costs clf $4 l5 per unit. Neither l'ixed cost estimate includes interest expense, since thc capitalization mix is still uncertain. The company plans to set the initial sales price at $750 per unit regardless of which production process is chosen. Total capital requirernents lbr both current and fixed assets. as well as start-up operating tunds, are estimated to be $14.0 million under Plan A and $20.0 million under Plan B.

To help with the capitalization decision. Gibbs had extensive meetings with investment bankers, venture capitalists, cornmercial bankers, insurance exccutives. and mutual-l'und managers. On the basis of these rreetings, shc constructed the following estimates lbr the relationship between financial leverage and capital costs:

Amount Borrowed Cost of Debt Cost of Equity

S O million

4 million

8 nlilllon

12 1nillion

16 milllon

00Sを

H.0 120 140 170

140% 150 17.0

200 24.0

@ 1994 South-Western, a part of Cengage Learning

70

レZ

6uru:ee1 e6e6ua3 1o ued e 'urelsoM-Ulnog 7551 a

lueurlsa^ul eql',{llueplcul 'suo4rpuot lo{rerr lreuer 01 ecrJd leIJEru eql ol sluel,ulsnlpB luenbesqns aleur {eql ueql 'ecud aruqs pue soJuqs Jo Jequnu ..uorlurrrrxoJddu lsrg,, B eletu

-Ilse ol osn.(ll?crd,q sJe{uBq luerulse^ur euo oql sr esBc eql ur JoJ pelleJ eJnpecord eql'eJnp -a3ord roqlle Jepun eIrrBS eql aq Ur1t\ onlp^ - seJuqs x ecrJd lcnpoJd eql sB 'ornpoJoJd Jaqlre

Jepun lBcrluepl eq III^\ srolso^ur eqt ot qllBe,r pelelncpc eql 'srepunoJ oqt JoJ Sururuurer pu? sJOpISlno 01 penssl saftI{s eql leE ol scud uruJqrlrnba srql Iq ,(1rnbe eprslno peJrnbeJ

eql epl^Ip uew pue 'ereqs red eclJd runlrqrlrnbe eql 13E ol seJEqs (q,$rnbe epr^rp 'enssr 01 soJuqs Jo Jequrnu euros [Jrcads ',(trnbe eqlJo enp^ oql puu ol eq plno^\ alnpecoJd e^rleu -relle uv 'seJBqs Sururuuer eql qlr^\ srepunoJ eql e^Bel ueql puB 'srolso^ur eprslno 01 seJuqs

Jo Jequnu perrnbor oql uErssB '8urpue1s1no oq IIy( l8r{1 seJBqs Jo reqrunu eql ouruuotop o1 eruqs rad ecud peuroeds eq1 ,(q eprzrrp ',firnbe er{l Jo enls^ eql oleurlse IIy!\ sqqlD luql eloN

',(1mbe go

lsoc - s{ pue

lqep yo lsoc = p1

',(1rnba;o enp^ la{JBr.u = S 'lgep Jo enlB^ la{Juru - C ,eJeH

trl

(J:t)(cBr-Jtfla) ?c=

S+ C=A

:s,rolloJ sB JIgg pelcedxe go srseq eql uo peterurlsa eq uec 'A 'tuJU eql Jo enp^ eql os .s/(og qsuc pnlod.red peurnssu osp sqqrD (7) '>1co1s rrorl JoJ Suqlou pred srepuno; eqt rcql petunsse

sqqrg',(trcldrurs ro;'acuaq iperou8r eq ueo uorlnqrluoc .sJepunog eql 'ecud enssr eql Jo qDSI/I sr srapunoJ eqt ,(q pmd eruqs red 0l'0$ eql ecurg (1) :suoudrunssu o,tu eputu seq sqqlg 'srs,(pue eqt ,(grldrurs o1 'acud e"tuqs .red 0I$ eW ,(ed ol srolse,rur eprslno ecnpur IIns

puB se^lesueqt o1 enssr uB3 srepunoJ eql 1Bql seJBqs Jo roqrunu aql puu 01 seq sqqrD .0Ig

te tes eq ot sr ecud {oots eqt ecurs 'srepunoJ s.uuu eqt ,{q pleq {Jots erlJo enlu^ eql ezru -rxeru IIr^\ qcrqa eJnlcnls yelrdec 1eql esooqc o1 sr poE s.sqqlD ,le,te,trog .plrdec;o uorllru

g'g7g permbeJ eql esruJ 01 eJuqs red 6yg tB plos eq uec sereqs uorllrtu 0'Z ,pesn sr tqep ou JI lBql polsclpul sJe{uug luetulse^ul s(uosuqof 'g uBId uo pesBq orE esBc eql ur uerr.r8 lelrdec

Jo slsoc luauoduoc puu e8ure,tal IBIcuEug uee^Ueq sdrqsuorluler eql Jo sel€urlse eql leql pue 'uorllru 0'02$ sl uuld srqt lraJJe 01 /hopurlA uosuqol ,(q perrnber plrdec IElol 3r{l 1Br{1 ,g ue14 tdope ol oputu sI uorsrcop eql lBql etunssB '1 uoqsen| ur uorsnlcuoc rno,( go sselpru8eg

('eprn8 u sB I elqeJ esll 'uorsrcep uorlcnpord eql qlr^\ pe^lo^ur senssr oql lnoqu ,(po {ulql uorlsenb srqt ro3 lnq 'suorsrcep Eurcueug pue uorlcnpord qloq so^lo^ul lBql uorsrcep lurol e sr uorsrcop pug eql lBql eloN 'qcee Jo ssaur

-)sIJ eqt ssesse ueql pue sueyd qloq Japun [lueurlserrur uo u.rn1e.r] IOU pu€ 11gg petcedxe eqt pue lurod ue^e{BaJq erp etBInclBJ :1urg) 6pueuuocor sqqrg ppoqs ueld uorlcnpord qcrq11.I

SNOl■SヨnO

're^\suB ol 'luBlsrssB req 'no,{ o1 pessud eqs qcrq,ry\ 'suoqsanb;o 1es Surmolyo; eql parederd sBq sqqro 'uolslcep eql qllt\ dlaq o1 'xrru Surcueug pue poqlou uorlcnpord eql roJ suouepuetutuocer dolezrep tsnru A\ou sqqrg 'purur ur srql IIB r{lll11 'Jelsusrp B eq ol eaord plnoc fl u?ld r{l!^\ EuroE ,suoltel -cedxe moleq ,(u,n sr puuuep Jr 'esrnoc JO 'uorlqeduoc puu ,fu1ue Iurluelod JJo pueq lqEru slrlJ 'g ueld qllit\ seo8 lt JI pueuop slqt teaIII o1 ,(lprder e^ou plnoc ,(uuduroc eql Eo se1e1 ,(11ee.r le{JBru eql JI 'snql 'v uEId Jopun ueqt g uuld repun reqEq qonru oq plnom 1nd1no Ierluelod Ietot arlJ

・ z

０ の も ① 」 一ロ

ス ｃ Ｏ Ｑ Ｅ ｏ ０

３ ｏ Ｏ 三 ≧ ′ ｃ ｏ ∽ ｃ ｃ ｏ 「 ”０ 』 豊 五 ｇ 〓 ０

辟

餡

Ｏ

Ｆ ” 「

， ０ 『 ０ ” 」 〇 す コ ∽ 〇 ⊃

く ≦

⊃ Ｑ Ｏ 〓

〇 〇 ヨ

ｏ ｏ コ く ¨ ∪ マ ① Ｏ ” ① Ｑ

bankers invariably put on a "road show" where they, along with company executives, travel around lhe country and meet with institutional investors and security analysts to pre-sell the stock and gct an idea of the interest in the company. The final price is adjusted to re{lect investor reactions. with this background, answer the fbllowing questions: a. If the firm's tax rate, T, is estimated at 40 percent, what amount ol' financial leverage

would maximize the value ctf the firm'l b. How many shares will the tbunders receive? What is the value of their shares'l c. Calculate Johnson Window's weighted average cosr ol'capiral (WACC) at each debt

levcl. What is the relationship between Johnson's value and its WACC ? d. Suppose an investor purchased shares at $ I 0. learneri that the fbunders had bought their

shares tor onty $0.10, and then f'elt cheated and threatened to sue the cornpany and its lbunders. Would this person have a good case'l Should the SEC protect investors liom this kind of thing'/

Gibbs is well aware of the t'act that the average manutacturing company has a tinres-interest- earned (TIE) ratio of about 6. Using TIE as a risk measure, together with your answer to Question 2, how risky does the company appear to be?

Supptrse Johnson is planning to raise debt by issuing a2}-year term loan. What would be the annual payment, including both interest and principal amortization'l Use this intbrrnation to calculate Jclhnson's expected first-year debt service coverage ratio, clefined here as EBIT/(Interest expense + Befbre-tax principal repayment). If the average manutacturing firm has a coverage ratio of about 4. what does this indicate about Johnson's riskiness?

Suppose this were your company. Would your choice of debt level be inlluenced by your other asset holdingsT That is, would it matter whether your entire net worth was invested in the company as opposed to the situation where you owned rnillions of dollars ol'stocks in other cornpanies in addition to your holdings in Johnson Window,l

The entire analysis depends on (a) Gibbs's estimates ol'the costs of debt and equity at diffbr- ent capital structures, and (b) the validity of the ecluation given in euestion 2. a. How confident are you in Gibbs's sstimates olku and k.? Could changes in these esti-

mates af'fbct the capital structure decision l b. What assulnptions underlie the equity valuation equation? Is it likcly that Johnson meets

these assumptions?

A theory has been expressed in the finance literature that "intbrmation asymrnetries" cause investors to interpret the sale of stock by a company as a "signal" that things nlay gct worse in the future, whereas the use of debt is taken as a positive signal. In general, what implica- titlns does this have lbr capital structure policy? Does it matter il'the flrrn in cluestion is a mature company or a start-up firm? Would it matter if the lounders planne<J to sell some 9f thcir shares at the time of the initial public of fbring, to rnake a f urther investment of their own capital by buying some more stock, or to neither buy nor sell shares'l

Should the issue of control of the company be taken into account in the capital structure decision? If so, how would it aftbct things'?

Cibbs has heard rumors that Califbrnia rnay repeal its corporate taxes, resulting in a lower, 34 percent, tax rate. What impact might this have on Johnson's oprimal debt level? If you are using the Lotus model, calculate Johnson's value at the diflbrent debt levels assuming a 34 percent tax rate.

4.

5.

6.

8

9.

@ 1994 South-Western, a part of Cengage Learning

72

8′

6urureal e6e6ue3 1o ued e'uralseM-grno5 y661 ,

Sι8`III

X X 000`ICI

シIτ`Cシ

OSι`811`Iτ

X X t100`01ε`Iτ

εシI`τεシ̀Oτ$

000`000`91

000`000`ZI

000`000`8

000`000`レ

0$

00・シτ

00・Oτ

Oll・ιI

00・SI

%00・シI

00.ιI

∞ ・ レI

CICl・τI

00・II

%CICl・0 SOIむЧS`SIOpunoこ

JO■OqШnN OnIセA ШIIJ

9ι0

%τI・81

%シ8・6τ

9ι ・ 0

9ιτ̀レτ9`C$

00S`ι9ι`17$

X X

パ

'Inba J03SOЭ ,qo⊂

%6ι ・ 1-

(000`8St‐ $)

3qocI

JO'SOЭ rS"0″η

"″ η9∂町徽

(IOu)AЭ

(Iou)cs (Iou)■

CtLI■■)AЭ (』18■)cls

(」LIED■

IOu tLI■■

SlS00 01qマIIIBA

S,SOO pЭxII

OnuOA31 SOrS

(IOu)AЭ

(lou)cs (Iou)3

(」LI狂■)AЭ

(ェ18■)CIS

(ェI■■)■

IOu 」IIEE

SlS00 01q21JttA

SISOO pOxIJ

OnuOAOI S012S

%ιレ ・ 6シ

000`ε68`6$

000`τ9ε`シε$

000`Sレ8`ιI

000`001`τ9$

Ｘ

Ｘ

Ｘ

000`ε99`Iτ

000`gシ8`ιI

000`OSI`6ε$

Эl'SIШI'dO

%60てシ

001`τ68`S

000`8εシ̀8シ$

X X

A10■1■

'S03ヽ

CS・0

%gι ・ τI

X CS・0

X 009`ι9C`ε

X 009`ι9ε

`ε

00S`ι8レ`6C

006`69ι`ι

000`gZ9`OS

X 006`69ι

`ι

000`OSI`6t~

opsltulssod

rS"οr′η "″

ηЭ rOy′ "υ

こrg2‐g"arJ

%τ09 X

Ｏ ① ち ①

・ Ｌ Ｏ

ふ ｃ ω Ｏ Ｅ ｏ ０

３ ｏ Ｏ 三 ≧ ′ ｃ Ｏ ∽ ｃ ｃ Ｏ つ ”０ 』 ■ ■ ● 〓 ０

Э13SIШI,dOパ10Hl■lSOItt ЭI'SIuIISSOd rSγο″ηη″29 rθど′

"υ 」rg2‐y"FrJ

BlB0 esBJ palralas

L f'l8vl

isuBld uollcnpoJd o^U eql pr?^\ol s,tat^ rno,( eBuEqJ slql seoc 'Y usld JoJ orJBuecs qcuo repun Iou eql eutuJotop 'esB3 slql JoJ lepoul sr?/o7 eql SuISn erB nofJI euolsrcep uorlcnpord oql uo e^Bq plno^{ srq] e^erleq nor op lc?dtul lBqad 'llun Jod szg$ 01 v uBId JoJ eleluuse lsoc olqBrrB^ IBurSrJo Jerl sesr^er sqqrc 'snqJ 'cllsllesl erB salElu

-rlse lsoc elqBrJBA eql Jeqleqlr Jepuo/!\ 01 sulSeq eqs puB 'srue,{ ,4Ae; lxau eql J3.\o asll [lL1\ slsoc Joqsl leql olEclpul q)I,Ilt loutnof parls llDA aLlJur selctuB Iero^as pPal sEq sqq]D '0I

TABLE l

Weight of Debt

Weight of Equity

Cost of CapitalけｕｑＥｂｅＤ

ｏｆ

” 耐 ．卿

Ｃ

Ｅ

０

〓 ” 「 〔 ● 『 ０ ” 」 〇 コ ⊃ ∽ Ｏ つ

く ≦

つ Ｑ Ｏ 〓

〇 〇 ヨ

ｏ ① ⊃ ヽ

∪ 〓 ① ｏ 一 ① Ｑ

Ｉ

‐

OS′ グC″滋′働た “ 滋励

“ sr

After‐ Tax Cost of Debt

0.00%

660 X 840 1020

1400% $o 1500 4,000,000

X x 20.00 12,000,000

2400 16,000,000

20,432,143

17,310,000

X 9,262,500

5,118,750

000% 1877 X 5644 7576

10000% 14.00% 81.23 1342

X x 4356 1345 2424 1354

Selected Case Data (continued)

@ 1994 South-Western, a part of Cengage Learning

74