## Introduction

This section gives an estimation of the initial – pro forma statements of Koss Corporation for two years, namely, 2013 and 2014. Pro – forma income statement and summarized pro – forma balance sheet will be prepared. From the financial analysis in part one it is evident that the financial position of the company declined from the year 2011 to 2012. This decline was attributed to an increase in the cost of production and a decline in sales in foreign markets. The pro – forma financial statements of the company will be prepared based on the assumption that the company will take necessary measures to ensure that the decline trend reverts. Thus, conservative rates will be used to grow the financial statements of the company for the two years. All items will grow by 8% both in 2013 and 2014. The table below shows the pro – forma income statement and a summarized balance sheet.

## Pro – forma income statement

From the estimates shown above, the net income for 2013 is $3,175,648.20. It is further estimated to increase up to $3,429,700.06. These values are quite conservative and once the management addresses the increase in the cost of production and declining sales, then the profitability of the company may increase at a higher rate. The table below shows a summarized pro forma statement of financial position.

From the tables above, the total assets will increase from $28,748,909 in 2012 to $31,048,821.72 in 2013. It will further increase to $33,532,727.46 in 2014. The total increase from 2012 to 2014 is 16%. It is achievable considering the nature of the company.

## Capital structure, funding analysis and valuation

A capital structure gives the mix of various capital sources that are used to fund the operation of the business. Analyzing the capital structure of a company is of utmost importance because it determines the rate at which a company grows. Further, it also dictates the amount of working capital that is available for the company. The capital structure shows the amount of various ways of funding that the company uses. The management of the company needs to maintain an optimal mix of various sources of funds because the mix has an impact on the profitability, cash flows and amount attributed to shareholders. The capital structure that a company decides to use depends on the market the company operates in. The table below shows the current capital mix of Koss Corporation for the year 2012.

Source of data – Koss Corporation 36

The current capital structure of the company comprises debt and equity financing. The total debt amounts to $3,085,653 which is equivalent to 15.29% while the total equity amounts to $17,095,239. It is equivalent to 84.71% of the capital structure. It is clear that equity financing is greater than debt financing. The capital structure shows that the company has room for growth since total debt can be increased until the optimal mix of debt and equity is attained. The capital structure of the company can be presented in a pie chart as shown below.

## Cost of debt and cost equity

Determination of optimal capital structure is a vital decision on financing options to use. Optimal level of debt is the level at which the cost of capital is minimized. It is the level beyond which a firm should not borrow. There are various studies that have been conducted to show the optimal debt – equity mix. The most popular theory is the Miller and Modigliani model, which asserts that in the absence of transaction cost, the capital structure of the company has no effect on the value of the firm. Therefore, the capital mix a firm uses is of no importance. The theory further asserts that the capital structure of a company is irrelevant. However, various scholars greatly criticized this model. They argue that the Miller- Modigiliani model is based on unrealistic assumptions of absence of taxes, efficient market, absence of agency cost, and perfect information. In the contemporary business world, these assumptions are quite unrealistic and cannot hold.

An example of a scholar with a contrary opinion is the Aswath Damodaran. He argues that capital structure has an impact on the value of the firm. Damodaran argues that the amount of debt in the capital structure of the company affects cash flow thus changing the amount of debt changes cash flows to equity because cash flow is attained from assets after repayment of debt and making reinvestment for future growth. Further, as debt increases, equity becomes riskier and the cost of equity will definitely increase. The optimal debt ratio depends on a number of factors. These are the tax rate, the pre – tax returns on firm, variations in earnings, and default spread.

Computation of optimal debt, cost of debt and cost of equity will be based on the Damodaran model, thus, the amount of debt has an effect on the capital structure of the firm. The weighted average costs of capital approach will be used to calculate the required rate of return.

## Determination of cost of debt

A number of firms consider it as a cheap source of finance. It is based on the fact that debt attracts a predetermined rate of interest which is payable at a fixed period of time. A company’s cost of debt is based on the cost of bonds. Bonds are sources of long term debt for a firm. In most cases, they are preferred to bank loans. When calculating cost of debt of a company, it is important to use recently issued bonds because they reflect fair interest rates than bonds issued earlier. However, when the company has not issued bonds, it can use the cost of debt for companies in the same industry. It is imperative to point out that the cost of underwriting the bonds and floatation costs is ignored in the calculation of the cost of the bonds since they are regarded as immaterial. The interest on bonds are tax deductible, therefore, necessary adjustments should be made at the coupon rate using the tax rate. The cost of debt is the rate a company pays on its debt.

Calculation of cost of debt for the company will be based on the theoretical models. Thus, the cost of debt of the company is determined by a number of factors which are the rate at which the company can borrow long term today (risk free and a default spread) and the tax rate. “The cost of debt is not similar to the interest rate at which a company obtains debt” (Eugene and Michael 265). The cost of debt is computed as shown below.

Cost of debt = (risk free rate + default spread) (1 – t)

Risk free rate =5%

Default spread = 0.4

Tax rate = 34% (corporate tax in the US is 34%)

Substitute the values

(5% + 0.4) 0.66 = 3.564%

The cost of debt is 3.564%. It is based on a risk free rate of 5% and a default spread of 0.4%. Determination of the optimal amount of debt majorly depends on the objective the firm. Use of debt is cheap and it reduces the weighted average cost of capital. “However, increasing the amount of debt increases the amount of weighted average cost of capital as gearing, financial risk and beta equity goes up” (Eugene and Michael 265). If a company’s objective is to maximize shareholders’ wealth, then the company must reduce the amount of debt thus reducing beta equity. Further, the amount of debt is inversely related to its risk.

## Determination of cost of equity

“Cost of equity denotes the annual rate of return investors anticipate to receive when investing in shares of a company” (Eugene and Michael 265). The return investors expected at the end of the year comprises two elements, which are the fluctuations (positive or negative) on the market price of the shares and the dividends paid by the company. Cost of debt is a central element of stock valuation because shareholders expect their shares to grow annually at the rate of cost of equity. In addition, the cost of equity is used in calculating the fair value of an investment in a company. It is worth noting that the amount of debt in the capital structure has an impact on the cost of equity. High amount of debt increases risk of equity thus increasing the risk premium that shareholders will require for their investment.

## Capital asset pricing model

There are two models that are commonly used for calculating the cost of equity. These are the dividend growth model and the capital asset pricing model. Dividend growth model is the easiest to use though it assumes that the dividends paid by the company grows at a constant rate. The assumption is unrealistic, therefore, the capital asset pricing model is often preferred to dividend growth model. The capital asset pricing model is a model that is used to ascertain the required rate of return of an asset. The model takes into account risks arising from the market in which the asset trades. The systematic risk is represented by the beta factor. The model computes the price of a single portfolio; it is based on several assumptions. The first assumption is that the investors are risk averse and aim to maximize their returns. Secondly, it is assumed that the investors have diversified their portfolio so that they do not have their investments in one basket. Thirdly, it is assumed that the investors do not have control over prevailing prices in the market. They take prices as given. The model has a number of weakness. First, the model assumes that all investors in the market have uniform information about trends in the market. It is not feasible. The model is also based on the assumption of an arbitrary interest rate. Finally, the model assumes zero transaction cost and lack of taxes. This feasibility is real life. These assumptions cast doubts on the practicality model. The capital asset pricing model that will be used to compute the cost of equity is shown below:

Cost of equity = risk free rate + Beta * Risk premium

## Risk free rate

Risk free rate is the rate of interest that does not have default risk, no reinvestment risk and is of the same currency. It represents the rate of interest for an investment that does not incur any losses. An example of such an investment is the US treasury bonds and bills. It is the rate which potential investors would require when they expect an investment that is does not have risk. For this analysis, the risk free rate is 5%.

## Asset Beta

Asset beta is used in the capital asset pricing model. It measures the volatility of a company’s stock relative to the market changes. Computation of asset beta is founded on historical returns which may not give an estimate of the firm’s future share prices. A number of factors can make the value of asset beta to fluctuate. Some of the factors are risk of the business, operation risk, financial risk, and sales risk. Asset beta is the sum of beta equity and beta debt. The firm’s asset beta is 1.2. The value can be incorporated in the capital asset pricing model to get the unlevered cost of capital. Unlevered cost of capital refers to the cost of capital if the firm does not have debt in its capital structure; the unlevered cost of capital is 5.0%.

## Risk premium

Risk premium can be denoted as the incentives for investing in a risky asset. The risk premium is the amount over and above the risk premium. An investor will demand for compensation for the risk element in securities which are risky. Risk premium measures the market risk in which the group operates in. Beta depends on the type of business, operating leverage and financial leverage. Finally, risk premium shows the premium for the average risk of investment. Financial risk management can help reduce the amount of risk premium required by shareholders. Considering the fact that the company operates in two markets, it is exposed to currency and interest risks. If left unmanaged, the risks can impact greatly the earnings of the company and thus the risk premium.

Calculation of cost of equity is shown below

Cost of equity = 5% + 1.2 * 4.96% = 10.952%

The calculations above show that the cost of equity is 10.952%. The market risk premium for the industry is 4.96%. The risk premium and the beta factor are relatively high due to the nature of the industry in which the company operates.

## Weighted average cost of capital

Weighted average cost of capital is neither cost of debt nor equity. It is an average rate that a company should pay to fund its assets. Alternatively, it is the rate of return which a firm must make from the assets to satisfy the people who provide funds to the company, they are the shareholders and creditors. A company receives funds from various sources. The Weighted average cost of capital takes into account the relative weights of each component in the capital structure of the firm, which shows that one must have required rate of return for each component of the capital structure. This facilitates the calculation of the weighted average rate cost of capital. In most cases, the individual firm’s weighted average rate cost of capital is different from that of the industry. However, over time the weighted average rate cost of capital for all firms in the industry should converge to the industry weighted average rate cost of capital.

The weighted average cost of the capital = cost of equity * proportion equity the capital

structure + cost of debt * proportion debt in the capital structure.

Weighted average cost of capital =10.952 * 84.7% + 3.564% * 15.29% = 9.82%

The calculations above can be summarized as shown in the table below.

From the table, the weighted average cost of capital for the company is 9.82%. This is relatively low and it reflects the stability of the business. The company should maintain a capital mix that will maximize shareholders’ wealth. Debt offers a cheap source of financing though it reduces shareholders’ wealth. The optimal level of debt in the capital structure should not be more 50% of the total amount of debt.

## Future cash flow and funding needs

Funding is required to achieve the growth in operating profit forecasted above (as shown in the pro forma income statement). The funding should be adequate so as to meet the working capital and capital expenditure needs. From the income statement of the group, it is evident that the a great proportion of revenue originates from the sale of earphones. Therefore, it is important that the company incurs adequate amount of money in ensuring that the amount of sales increases. As seen above, the current capital structure allows the growth of the capital and asset base. This can be done until the optimal debt level is attained. Increase debt will have the effect of reducing the cost of the weighted average cost of capital.

## Value of debt and equity

The value of debt can be indicated by the interest rate for the US treasury bonds. The rate is 4.23%. The cost of debt is equal to its intrinsic value. Valuation of equity shows the value of a company based on the current assets and its position in the market. The valuation is of significance to potential shareholders and debt providers so as to know how the shares of the company perform in the market. There are a number of models that can be used to value equity of the company; these are price earnings ratio, dividend discount model, and dividend growth model. Valuation of equity will be carried out using a price earning ratio. It is a ratio of market value per share and earnings per share. Using this valuation model, the value of equity is $5.20. The current share price is $5.67. It is evident that the company’s shares is been trading at a price that is slightly greater than the intrinsic value of the shares.

## Dividend Policy

The company paid dividends for the period between 2010 and 2012. The dividends paid were relatively stable for the three years reviewed. The table below summarizes the share price and dividends paid by the company for the past one year.

From the share prices shown in the table above, share prices for Koss Corporation were fairly stable. It ranged between $4.68 and $5.41 for the past one year. It shows that the prices for the company ranged by a small margin of $0.73. Further, the company paid a total annual dividend amounting to $0.24 paid quarterly. Further, it is evident that the shares of the company were trading at a fairly stable price as shown in the chart below.

From the review of the financial performance of the Koss corporation, performance of shares, and payment of dividends reveals that the company has reached maturity stage in its growth hence the decline in sales. There is no potential for future growth in the company unless a turnaround strategy is implemented.

## Investment Decision

### Criteria for evaluating future funding needs

Investment decisions require adequate review before injecting funds into the investments for several reasons. The first reason is that capital investments require a large amount of initial capital outlay. Secondly, the benefits of such investments flow in for a long period. Thirdly, capital investment decisions in most cases deal with an organization’s optimal capital structure, that is, in terms sourcing for funds. Therefore, the analysis of the project should be done before searching for funds. As such, these projects are irreversible. Finally, capital is a limited resource. There are competing demands for capital, as a result, funds should only be channeled to most viable ventures. There are a number quantitative criteria that can be used to evaluate an investment. The firm’s key goal is to reduce leverage and increase returns. A significant quantitative approach is the net present value approach. It shows the present value of net benefits that a firm expects. It is a superior method of evaluating project because it uses cash flow generated in the entire project life. The management can alsouse the internal rate of return to evaluate the project. The other methods that can also be used are the discounted payback period and break even analysis.

### Discounted cash flow assumptions

The company is considering the possibility of acquiring an equipment that costs $3,500,000. The average fee per unit produced is $950 while the variable cost is $100. The management of Koss Corporation needs to purchase the equipment to facilitate the turnaround strategy. The equipment is expected to operate for 4 years, thereafter it will be written off. The operating cost per annum is estimated at $15,000. The streams of income expected during the five years and calculation of NPV are summarized in the table. Assume the required rate of return is 10%.

### Break even analysis

Break even analysis gives a number of units that must be processed with the machine so that the total cost equals the total revenue earned.

Total revenue (P * Q) = total cost [Variable (C *Q) + fixed cost]

950 * Q = 100* Q + 3,500,000

950Q – 100Q = 3,500,000

850Q = 3,500,000

Q = 3,500,000/850 = 4,117.65 units per year.

This implies that in order to cover all costs the company needs to produce and sell 4,117.65 units. However, to make profits the company will need to sell more than 4,117.65 units. Break even analysis helps in estimating the feasibility of a project while taking into account fixed costs, variable costs and selling price.

### Net present value

Net present value measures the difference between the present value of net cash flow. That is, it measures the present value of the net benefit from a project. This technique looks at both benefits and cost of a project. Also, it takes into account the time value of money which is necessary because one dollar now might not have the same value in the future. It may happen due to market uncertainties, such as inflation, change of consumer preferences and change in political climate among other factors. Incremental cash flows expected from a project needs to be computed when using this approach. The total of the present value of the net incremental cash flow for the life of the project forms the basis for making decisions. A project is accepted if the net present value of total incremental cash flow is positive. However, if the total is negative, a project manager needs to reject the project (Eugene and Michael 96). The net present value method will involve selection of a rate which is acceptable to the management or that equals the cost of finance. The table below summarizes the calculations of the net present value.

From the table, the net present value of the project is $216,471. Since the value is positive and relatively large, it implies that the project is viable and worth pursuing. Therefore, the management needs to invest in the project to help in the growth of the forecast sales.

### Internal rate of return

IRR is a tool of capital budgeting that gives the discount rate at which the net present value of the project is zero. Interpolation will be used to estimate the value of IRR. A project is accepted when the internal rate of return is greater that the required rate of return (Eugene and Michael 98). The calculations of internal rate of return and the net present value of 20% are shown below.

The net present value (at 10%) = 216,271

The net present value (at 20%) = – 497,164

Through interpolation IRR =10% + (10 * 216,271) / 280,893 = 17.7%

From the calculations above it is clear that the IRR is 17.7%. It is higher than the required rate of return implying that the purchase of the machine is profitable. Revenue for the company will grow as a result of the acquisition of the machine.

### Discounted payback period

The capital decision analysis tool gives the duration of time that the business will take to recover the initial cost of investment. This tool of analysis is significant for ranking projects or for assessing projects high risk projects. In such projects, the investors require return within a short duration. A project with a shorter payback period is often preferred (Eugene and Michael 76).

Discounted payback period = Present value of cash inflows / initial investment

To calculate the discounted payback period, it will be necessary to obtain the cumulative present value of the equipment. The values of the cumulative present value of cash flows are shown in the table below.

The discounted payback period for the project is 3 years and 6 months. This implies that the company will recover the cost of investment over 3 years and 6 months which is towards the end of the project. If the management finds it necessary to recoup the cost of investment within a short time, then this project will not be viable.

### Investment Choices

Based on the three criteria used above, it is evident that the project is viable and worth pursuing. The net present value and internal rate of return are relatively high and indicate that the company will earn positive returns by the end of the project. However, it will take the management a period close to the life of the project to recover the cost of the project.

### Sensitivity analysis

Sensitivity analysis is carried out to ascertain how profitability of the company changes when certain variables such as the price of the commodity, cost of production or operating expenses changes. It is important to find out the key factors that affect the profitability of the business under different conditions. Sensitivity analysis helps in assessing how profitability will change in a worst case and a best case scenario. In conducting a sensitivity analysis, sales levels can be up-scaled by increasing product prices (Eugene and Michael 275). To ascertain a desired NPV a, prices can be adjusted upward. Marketing strategies should, therefore, be formulated to support the ascertainment of the desired NPV level. Thus, sensitivity analysis is a vital tool for analysis in a business cycle. In carrying out sensitivity analysis, it will be assumed the revenue and cost of sales increase. All other variables will be constant. Sensitivity analysis will be carried out for projection of 2013. A worst case and a best case scenario will be used to carry out sensitivity analysis. A worst case scenario will assume that sales decline by 10% while cost of sales increases by 5%. On the other hand, a best case scenario will assume that sales increase by 15% while cost of sales remains constant. The results are shown in the table below.

From the sensitivity analysis above, the Koss corporation is likely to make a loss amounting to $2,173,909.64 in a worst case scenario. While in a best case scenario the company can make gains amounting to $9,309,902.45. This is quite favorable. Such analysis would help the management to get ready for a worst case scenario.

## Conclusion

The nature of a company defines its financial strengths and weaknesses. Comprehensive analysis of financial performance of a company like incorporation may prove complex depending on the number of industries it operates in and the number of subsidiaries it owns. Koss corporation operates in one industry. Further, it has a few of subsidiaries, thus, carrying out financial analysis is not as complex as in other large companies that operate in several industries. As indicated in the above analysis, it is apparent that profitability of this multinational company declined from 2011 to 2012. This was mainly attributed to unexpected increase in the cost of importing raw materials and finished goods from china. Despite a low performance in 2012, Koss Corporationhas exhibited a steady capital structure and dividend though earnings per share declined. This can mainly be attributed to the fact that the company has reached maturity in growth in its performance. Thus, a negligible growth is expected in the coming years.

Contemplatively, due to strategic position, the company was in a position to meet its current obligations every year. The current assets exceeded the current liabilities during the period under review. From the analysis of profitability using return on equity, return on assets, gross profit margin, and net profit margin, it is apparent that the performance of this company is probable and very even. Thus, creditors and investors are not only safe but are assured in returns on their investments in short and long term. The current capital structure allows expansion of the business since it is very profitable and operates below the optimal debt level. The amount of debt in the capital structure is 15%. This implies that the company is not highly levered and there is a large potential for expansion. Finally, based on the efficiency ratios, we can deduce that the level of activity of the company is relatively good.

As indicated in the above financial analysis, Koss Corporation operates in a very competitive market with very large competitors expanding steadily. The company faces risks that arise from trading in the foreign markets. Some of these risks are foreign exchange fluctuations caused by factors such an inflation in the foreign countries among others. This can heavily impact the profitability of the organization as was the case in 2012. This is indicated by a dismal performance in 2010 associated with the global depression of the early 2009. From the ratio analysis, it is apparent that the company is in a steady position to benefit from the competitive advantage that they have attained by selling quality products and with life time warranty, while at the same time expand without serious difficulties as it has displayed consistence in performance over the years (The Wall Street Journal 1; Hoover’s Inc. 1).

As a matter of fact, the steady and lower rates of equity are an indication of stability which in turn is an assurance to creditors and investors of the company’s credit worthiness. Notably, the debt to equity ratio remains low and within the ideal despite slight inconsistence, incorporation efficiency in balancing net worth and total sales. At present, the current positioning of the firm can be extrapolated and used to make future forecasting because of consistencies in profitability and operations efficiency. In addition, its current capital structure guarantees potential investors and creditors high return rates on every investment. Therefore, as reflected in the comprehensive financial analysis, the company is viable and safe to invest since there is a great potential to invest and reach the markets that have not been tapped. Besides, it has a stable capital structure that can support expansionary investments with short term and long term positive returns. Incorporation of the market forces analysis in the management of this successful incorporation is directly linked to its consistency, profitability, and efficiency (ABC News Network 1).

## Recommendation

The current state of the company indicates that the management of the company is not keen on ensuring that the company rises and grows. However, it is worth noting that the company has a high competitive advantage over its competitors and this is a great opportunity to enable it to increase its market share. The management should be keen to ensure that they make decisions that would ensure that the declining state of the company reverts. An example of a strategy will be acquisition of the machines discussed under investment decision. This will aid in increase production of earphones and thus increasing the sales. Management should be keen on pursuing the turnaround strategies until the company fully reaches its full potential. Finally, the management may also consider managing various risks it is exposed to so as to reduce the risk premium. This will help reduce the weighted average cost of capital. An examples of ways of reducing the risks is signing for future contracts using fixed rates. Secondly, management can also consider using hedging to reduce the risks associated with exchange rate fluctuations (Eugene and Michael 265).

## Works Cited

*ABC News Network *2013, Company Profile. Web.

Eugene, Brigham, and J. Michael.*Financial management theory and practice, *USA: South-Western Cengage Learning, 2009. Print.

Hoover’s Inc. 2013, *Koss Corporation Company Information*. Web.

Koss Corporation 2012, *Annual Report 2012*. PDF file.

*The Wall Street Journal* 2012, Headphone Makers Battle Over Form And Function. Web.