Making a choice
Earnings per share and net income have an impact in the same direction. An increase in net income is likely to increase earnings per share. Earnings per share come from sharing part of the net profit. In some cases, it also comes from increases in the market value of shares. The market value of shares may increase when a company has reported a promising financial performance. Growth prospects may also increase the market value of stocks. In the Competition Bikes situation, earnings per share are derived from the net income of possible alternatives. The alternative with the highest net income provides the highest value to shareholders. From this analysis, value is derived from the net income.
Table 1: Earnings per share (EPS) results from alternative capital sources
|9% Bonds||50% Preferred |
(5%, $50 par) and
50% Common Stock
9% Bonds and Common Stock
9% Bonds and Common Stock
9% Bonds and Common Stock
|EPS Year 9||0.002||0.027||0.027||0.023||0.017|
|EPS Year 10||0.009||0.032||0.032||0.028||0.023|
|EPS Year 11||0.019||0.039||0.038||0.035||0.031|
|EPS Year 12||0.031||0.048||0.046||0.043||0.040|
|EPS Year 13||0.042||0.057||0.054||0.052||0.049|
Table 2: Net income results from alternative capital sources
|9% Bonds||50% Preferred |
(5%, $50 par) and
50% Common Stock
9% Bonds and Common Stock
9% Bonds and Common Stock
12% Bonds and Common Stock
|Net income Year 9||2,240||49,040||39,680||30,320||20,960|
|Net income Year 10||9,179||55,979||46,619||37,259||27,899|
|Net income Year 11||18,452||65,252||55,892||46,532||37,172|
|Net income Year 12||29,957||76,757||67,397||58,037||48,677|
|Net income Year 13||41,361||88,161||78,801||69,441||60,081|
The results show that financing expansion using 50% preferred shares and 50% common stock maximizes EPS during the five years. It should be selected if maximizing shareholder value takes the first priority. The capital structure that maximizes shareholder value is derived from the one that maximizes net income as can be seen in table 2. The mean value indicates the overall best value.
From table 1, it is easy to notice that the greater the percentage of bonds the company uses to finance the expansion, the lower the mean EPS. Financing with the lowest number of bonds provides the best option. Bonds incur interest at a rate of 9% annually which reduces the amount that remains to be shared as dividends. For this reason, 50% preferred shares and 50% common stock provides the best option. It does not use any bonds. On the other hand, 100% use of bonds that pay 9% interest provides the lowest value in EPS. However, interest on bonds reduces the amount paid as tax when preferred shares’ dividends do not.
Decision rules for NPV and IRR
Competition Bikes, Inc. considers a 10% rate of return to be the cost of raising capital. For a multinational, the cost of raising capital is determined through the weighted average cost of capital (WACC). Khoury (2002) explains that the “discounting factor used in capital-budgeting is the cost of capital to the firm” (p. 171). The discounting factor may incorporate the risk involved in operating in a particular business environment. Manufacturing Titanium frames in the U.S. come with uncertainty because it is a new product in the environment. Uncertainty may be discounted as risk.
The results indicate that using a 10% discounting factor for the new product is unfeasible under low demand because it has a negative NPV of $26,740. If it is launched in the market and meets moderate demand, it is feasible because the NPV indicates a positive value of $2,243. The risk involved is higher than the returns that are expected from the new product should it yield positive results. The NPV value indicates that the new product should not be developed because it does not offer positive earnings that match the risk involved. A project with an NPV of zero or 1 is considered feasible (Moyer et al. 2012). The two options provide the best-case scenario and the worst-case scenario.
When considering the IRR, moderate sales provide a return rate that is slightly higher than the discounting factor (10.1% compared to 10%). Low sales provide a return rate that is lower than the discounting factor (8.7% compared to 10%). The product provides a high risk if the demand is low. It provides a low opportunity of exceeding the cost of raising capital when the demand is moderate. It can be considered a high-risk product that should not be developed. Moyer et al. (2012) state that companies should carry on with projects “whose internal rate of return is greater than or equal to the cost of capital” (p. 363).
In this case, the IRR and NPV provide similar results. The possibility of moderate sales provides an opportunity when the likelihood of low demand poses risk. Using IRR, the risk has a higher negative value (-1.3%) compared to the opportunity (+0.1%). These are the values obtained from the difference between the internal rate of return values and the cost of raising capital. Competition Bikes should avoid the project because the risk it poses is 13 times (1.3/0.1) the value of the opportunity.
Leasing a factory utilizes the least amount of cash ($283,752) compared to purchasing ($399,774). Purchasing utilizes the highest amount of cash because of the down payment, depreciation costs, interest, and loan repayment. Interest paid on loans also uses more working capital but its effect is reduced by tax shields. It follows the fact that tax is deducted after interest on loans has been paid. Loan repayment may be partially recovered when the purchased factory is sold at the end of the period at a value of $300,000. It would make the outflow value of the purchasing option to be less by $149,400, the NPV of $300,000 (0.747 * 300,000 = $149,400). In that case, $250,374 (= 399,774 – 149,400) for the purchasing option would appear less than $283,752 for the leasing option. Since the main objective is to preserve the highest amount of working capital, leasing should be chosen instead of purchasing the factory.
Leasing does not incur depreciation costs and interest on the loan. Depreciation costs are valued at $20,000 a year adding up to a total of $100,000 without incorporating the discounting factor. The amount of interest to be paid on the loan amounts to $65,444 within the five-year period. These are additional costs incurred when the factory is purchased.
Managing working capital
Working capital is the difference between current assets and current liabilities. Competition Bikes had a net working capital of $1,275,631 (= $1,575,831 – $300,200). Current assets may be termed as gross working capital (Working capital management, 2010).
Managing inventories means keeping quantities that prevent shortages but minimize idle stock. Competition Bikes, Inc. has been maintaining work-in-process and raw material inventory that is about 5% of total assets. It maintained raw materials at 2.1% and work in process at 3.0% in the year 8. It was almost constant in the past 3 years. It is low enough to reduce inventory costs. Monthly inventory to sales ratios compared with the industry average may be the best measure for better inventory management. Managing inventories also requires smoothening of production to avoid seasons when workers are laid off because of reduced sales.
Managing account receivables and payables involves using invoices and reducing the number of days when payment is made. Competition Bikes, Inc. sells a lot of products on credit than it purchases raw materials. Competition Bikes has more in account receivables ($609,960) than it is having on accounts and notes payable ($ 261,200). Under these conditions, it will need more working capital than when there is a balance on the two accounts. Selling products on credit increases sales because customers do not have to wait to receive their income before spending. It appears Competition Bikes prefers more sales to the requirement to keep a higher amount of working capital. Competition Bikes can reduce the amount of time that account payables are held. It should seek to increase the amount of time it can keep invoices. If that happens, it would require less working capital.
Competition Bikes can use its large cash holdings to make prompt payments to creditors who offer discounts. The firm may also use discounts to encourage prompt payment. However, holding a lot of cash involves losing the opportunity cost of idle money.
In year 8, Competition Bikes held $414,038 (9.7% of the total assets) in cash and cash equivalents compared to $92,376 (2.2% of the total assets) in year 7. The amount of cash that is held as working capital should increase as sales increase. Year 7 (133.3% of year 6) has a higher percentage of net sales compared to year 8 (113.3% of year 6). Sales declined in the year 8 ($5,083,000) from year 7 ($5,980,000) but working capital increased from $1,119,344 to $1,275,631. Competition Bikes appears to be holding more cash than its current financial needs. It should invest some of the cash in short-term investments to increase shareholder value.
The forecasted trend analysis for net sales indicates that sales will increase gradually from year 9 to year 11. Competition Bikes should plan to increase working capital gradually each year. As sales increase, more activities need financing. Holding adequate cash reduces the cost of raising additional capital because the firm will be considered less risky by creditors.
Forecasting the amount of working capital needed is another method of managing working capital. Taking the cost of goods sold in the year 8 as $3,711,600 and assuming that Bikes wants to maintain a cash balance of $100,000. The formula for forecasting the working capital = (estimated cost of goods sold x operating cycle) + desired cash balance (Working capital management, 2010). It gives $1,015,189 which is close to what Competition Bikes has kept as working capital (($3,711,600 x 90 days/365 days) + $100,000). The calculation assumes a 3-month operating cycle. The operating cycle is the duration from when raw materials are bought until payment for goods sold is received (Preve & Sarria-Allende, 2010).
Sources of working capital
Working capital should be obtained from long-term sources such as issuing equity or selling bonds. Competition Bikes can obtain working capital from retained earnings of $1,180,631 which it may use to finance the working capital. These are derived from profits. Competition Bikes may also decide to sell the treasury bonds that it holds worth $100,000. However, in the current situation Competition Bikes has excess working capital and may need to buy more securities.
Overdrafts from banks may only be used when anticipated cash flows fail to meet expectations. Competition Bikes has not used short-term debts to an overdraft. Preve & Sarria-Allende (2010) suggest that using a large portion of long-term debt and equity to finance working capital gives the company the option of using short-term debts during shocks in the market.
Competition Bikes may easily access short-term loans because it had a promising quick ratio at the end of year 8 (balance sheet). However, short-term debt may incur higher costs in the form of interest.
- Quick ratio = current assets less inventory/ current liabilities
- Quick ratio = $1,575,831 – (130,260+91,573) / $300,200 = 4.51
Preve & Sarria-Allende (2010) explain that firms can raise working capital in financial markets with more favorable terms and pass them over to the other subsidiaries. The company may consider raising capital in the U.S. financial markets or the Canadian financial market. It may choose the one which lowers the cost of raising capital.
Merge or Acquire
The merge option allows the two companies to combine their values into one. Canadian Biking, Inc. shareholders are issued with Competition Bikes shares. Canadian Biking shares were valued at $1.10 each at the end of year 8. The merger takes the application where 3 Canadian Biking, Inc. shares are exchanged for 1 Competition Bikes, Inc. share. The company will have to determine a new share price after the merger. The value of the synergy is unknown. The calculation uses the pre-merger values of the two companies.
- New share price = pre-merger market value/ new number of shares
- New share price = (975,000 X $0.70) + (200,000 X $1.10) / (975,000 + 200,000/3)
- New share price = ($682,500 + $220,000) / 1,041,667 = $0.87
- Value issued to Canadian Biking = (200,000/3) X $0.87 = $58,000.30
The value of Canadian Biking, Inc at the end of year 8 is $1.10 X 200,000 = $220,000. Exchanging 3 Canadian Biking shares for 1 Competition Bikes share may be unacceptable on the side of Canadian Biking shareholders because it offers a price that is much lower than their market value. The offer value of $58,000.30 is much lower than $220,000. The option is unlikely to be accepted on the side of Canadian Biking, Inc.
Competition Bikes, Inc. has the option to acquire Canadian Biking, Inc. at a price that is 30% higher than the market capitalization. It gives 200,000 * 1.10 * 1.30 = $286,000. The amount the company would incur in a merger is lower than the amount it would use in the acquisition. Mellen & Evans (2010) claim that the premium issued for acquisitions in the U.S. has been within a range of 30% to 40% over the last decade. The merger is $227,999.70 (= 286,000 – 58,000.30) less costly than the acquisition. The merger would become the best option for Competition Bikes shareholders. It gives them the same value at a lower cost.
Using an alternative valuation, Canadian Biking, Inc. shares are offered at a value of $286,000 (= 1.43 * 200,000). Khoury (2002) explains that cash flows are considered instead of net profits because net profit may vary depending on accounting practices applied. It has cash inflows NPV of $212,138 within five years. The NPV of cash inflows in the five-year period is 74.2% that of the offer price ($286,000). The calculation shows that only 25.8% of the acquisition value may be considered under uncertainty because 74.2% is recovered within the five-year period.
Mellen & Evans (2010) explain that the purchase price should not be higher than the maximum investment value. The maximum investment value of Canadian Biking is the market value and the goodwill. Goodwill justifies a higher value than the market capitalization value. Goodwill has to be estimated because it is not a tangible asset. It may include acquired worker experience, technical knowledge, supply and distribution channels, customer loyalty, and recognition. These are values that help the acquiring company to operate smoothly despite venturing into a new market. They take years to build. They involve costs such as advertising and training. Without them, some opportunities will be lost because of unfamiliarity with the business environment.
Merging provides the best option for competition Bikes shareholders but is unlikely to be accepted by Canadian Biking shareholders.
In the merger, the number of Competition Bikes, Inc. shares increase from 975,000 to 1,041,667 (= 975,000 + 66,667). There is shares dilution. The effect will be felt at the time of paying dividends. There is no additional cost of raising capital such as interest on corporate bonds. Risk is also shared among many shareholders than in an acquisition.
Risk is reduced when the customer base is spread over a large number of customers (Coffey, Garrow & Holbeche, 2012). In both cases, the sales would extend from the Canadian customer base into the American market. It would result in less risk because of the expansion of the customer base.
The earnings per share after the merger are higher than Competition Bikes by itself. Before the merger, Competition Bike’s earnings per share are $0.032. After the merger, they would become $0.053. When the price-earnings ratio is higher, the market is likely to inflate the value of a company considering its future profit earnings and potential for growth (Coffey, Garrow & Holbeche, 2012). Higher earnings per share for Competition Bikes shares may make them more attractive to investors. It would be followed by gains in the stock prices and market capitalization.
Coffey, J., Garrow, V., & Holbeche, L. (2012). Reaping the benefits of mergers and acquisitions. Woburn, MA: Butterworth-Heinemann.
Khoury, S. (2002). Transnational mergers and acquisitions in the United States. Washington, D.C.: Beard.
Mellen, M.C., & Evans, C.F. (2010). Valuation for M&A: Building value in private companies. Hoboken, NJ: John Wiley & Sons.
Moyer, C.R., McGuigan, R.J., Rao, P.R., & Kretlow, J.W. (2012). Contemporary financial management (12th ed.). Mason, OH: South-Western Cengage Learning.
Preve, L., & Sarria-Allende, V. (2010). Working capital management. New York, NY: Oxford University Press.
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