It is proposed to consider the financial aspects of the business of Tonka, one of the oldest toy manufacturing industries in Minneapolis, USA. This company enjoyed virtual supremacy in the industry for several decades, before new technology, loss of demand for products, and stronger competition forced it to seek alliances with Hasbro in order to maintain its existence and sale of its many toy products.
Is there competition in the toy industry?
The toys industry is filled with cut-throat competition. Whatever change has been taken place in the world the toys do not lose their demand. Because the children of the all the era are interested in playing with toys. But there may be differences in the interests of the children. Therefore, the companies are trying to make changes according to the interests of the children. This results in increasing the amount of competition. The reason is that when one company makes new innovations or changes, the other companies or better say competitors also make changes resulting in increased competition. The toy industry is not like any other industry as the toys are subjected to fads. That are some toys may suddenly get expired. This increases the competitive element in the industry. The manufacturers of the toys will always be trying for making innovations in the industry by introducing new and attractive products. Therefore, in order to survive in the industry, the manufacturers may be testing new ways of sales promotion techniques to increase sales. When one company tried an attractive advertisement, the rival manufacturers will also go for trying an advertisement like that or better than that. The main competitors for the Tonka Corporation and the like companies are the Chinese toys manufacturers. They manufacture toys at a cheaper price and make them available all over the world at a very cheap price.
It is seen that in the context of Tonka during 1983 the top five companies have had 32.7% of the market segment, whereas in just three years this number rose to 44.2%. The market share imbalances are evident in that 5 companies among themselves hold 40% share, while there are 800 small-timers which compete for the rest of the market (60%).” (Final examination Tonka Corporation).
What is Tonka’s strategy? How effectively has this strategy mitigated any of the toy‑industry risks? How well has Tonka performed under this strategy?
It is seen that Tonka’s strategy has been one of quite conservatism, in terms of financial strategy and wanting to remain liquid with little debts. It is seen that prior to diversification, people would think of Tonka in terms of metal toy trucks, but over the years all this has undergone sea changes. The Company diversified into making dolls for girls, and also launched Gobots during 1984, which was able to rake up nearly $100M sales. Their Pound Puppies was a resounding success, which added nearly $156M in revenues. Further diversification plans led the fortunes of the company to rise from $ 81M to $293M. Since the top management at Tonka was well aware of short product life cycles, there were constantly innovating and reaching out to customers by providing new and creative products.
One of the typical traits that characterise the toy industry in the US has been the short life cycles of toy products and the hit-or-miss nature of new product lines. Eager to keep up with the competition, Tonka launched an array of new products, all of which may not have succeeded in the marketplace.
Also, they may not be knowing much about the detailed and intricate technical aspects of complicated toy making.
Only money-spinners like Gobots and Pound Puppies were able to contribute handsomely to the bottom line and most of the other products were unmitigated disasters. It is seen that in a business having around 800 toymakers in the US, only 5 companies were in a position to undertake reorganization or restructuring in terms of size, volume and diversification programs.
The toy industry is also affected by demographic, cyclical and seasonal demand fluctuations which hit sales. The time around Christmas is when most toy business does brisk business, and during other periods, it may be dull and sales graphs may plunge dramatically.
However, the one-star product was not sufficient for Tonka to survive and grow in a fiercely competitive toy market and it needed new areas for diversification and expansion to maintain a competitive stranglehold on markets and rivals. (Final examination Tonka Corporation).
It could be said that although Tonka was a well-established company in its own right, starting operations way back in 1946, it entered into long-range planning and systematic growth and diversification plans only by 1968, and although they could have done much better by diversifying into a wide range of product lines earlier on, they could not do so and their real break came with the launching and consolidation of Puppies Brand. While with one product line, they were successful in raking large profits, they were not very successful in reducing total market and commercial risks to the business.
Due mainly to uncompetitive business climates, and burgeoning costs, with a lack of demand for their major product lines, the Company were finally sold out, or became a part of Mattel Group during 1991. It is seen that what could have possibly gone wrong with Tonka’s marketing strategies was that, although it was excellent on paper, it was not in sync with the present market trends and inconsistencies in the marketplace, which perhaps they were not well aware of.
More than trying to create and fulfil demand, or sell products, which people wanted, they were interested in pushing products to customers, which could not be accepted as a long-term marketing policy. Due to a chain of marketing failures, coupled with one or two brands that had some market standing, the others were not successful. Thus, the inevitable happened, and Tonka was formerly re-inducted with Hasbro l groups during 1991, which although resulted in increased visibility for the group as such, Tonka ceased to have any separate identity of its own in the US Toy industry, and became a part and parcel of Mattel since 1991. It could also be seen in terms of the fact that a consumer company, a toy industry at that, had failed to come to terms with current marketing planning and evolving plans and strategies that could address business objectives and goals.
How much potential value, if any, can Tonka create for its shareholders at each of the proposed levels of debt? How would leveraging up affect the company’s taxes?
Tonka’s top management wanted to assess the impact of different dozes of leverage on its financial performance and scaled leverage at 20%, 40% and 60%
It is seen that the debt ratio of Tonka could be calculated as follows:
- Total debts are $16.7(actual) and $22.7, $45.2 and $67.8 at 20%, 40% and 60% levels of debt /total capital. Total assets remain constant at $113.
- Thus, debt ratios are 14.77, 20.08, 40 and 60 respectively. It is thus seen that the debt ratio is increasing with an increase in leverages.
- We shall now apply the increase in debt ratio with the cost of capital
|Percentages||Cost of debt Lower||increased debt ratio|
This could be primarily due to the lowering of interest rates during the period under review that could have probably reduced the cost of debt.
When the Exhibits are analysed, it is seen that Tonka commands a lower share and growth rate as compared to its competing firms. For instance, 3.5 % in a 44.5 stake may be quite low. (Exhibit 1).
Coming to Exhibit 2, it is seen that the current ratio of Tonka works out to 134.6/53.5, or 2.5 times, which is satisfactory in terms of liquidity position. The R0E is also good at 23.2% and it has been a consistent dividend paying company.
From Exhibit 4 it is surmised that nearly 28% of sales of Tonka come from action toys/dolls while plush animal toys make up around 15%. This is important since Tonka needed to concentrate its marketing on best-selling products and eliminate slow or non-moving products, or aspects about which they have no knowledge. Exhibit 5 tells us that during 1986, Consumer Price Index has fallen by 1-2 percentage points, unemployment levels have been more or less consistent at 7% and prime lending rates have also fallen from 9% in the first quarter of 1986 to 7.5 in the last quarter. These indicators should have favoured the industry as a whole and stimulated growth, but it is believed that due to inherent and market-related issues in the toy industry, it could not capitalise on a good economic climate.
Coming to Exhibit 6, it is seen that 45% of taxes ($18M) has eroded the earnings during 1986 to just $22.3M. It is necessary that the impact of tax be cushioned through tax saving or tax planning techniques that could enhance the bottom line of Tonka.
The Corporate tax rate for Tonka is 45% on earnings. Thus during 1989, it is seen that the actual total earnings of $40.3M would be subject to tax @45%.
Thus the profit tax liability would be as follows:
At current actual levels it is 45% of 40.3 = $18.13
At 20% level it is 45% of 39.7 = $17.9
At 40%level it is 45% of 37.6 = $16.9
At 60% level it is 45% of 35.4= $16.0
Thus, it is seen that the level of taxation goes down with increased leverage. This is because of the interest rates that need to be paid out of income before taxes, which adds to the cost of funding and lowers the net income. In other words, leveraging tends to increase tax liability while reducing the income available for distribution to shareholders. It could be argued that what rightfully is due to shareholders is now being paid to outside creditors in the form of mandatory interests’ payments. It is also seen that there has not been a hike in dividends paid to shareholders remaining at 2.24% of earnings. (Exhibit 12: Tonka Corporation)
Leveraging up has reduced the tax liability while increasing the cost of debt servicing which needs to be paid off, unlike equity dividends that do not always need to be paid at higher rates.
However, for a company like Tonka Corpn., debt is preferable to paying taxes, as this would be additional costs, and a high-risk venture like toys need to have more debt in that the ultimate risks could e shared by creditors and not only by equity holders who may not be holding substantial controls and yet may have to bear a large part of risks of the Company.
How much financial risk would Tonka face at each of the proposed levels of debt shown in case Exhibit 12?
What could be the possible response from the capital markets regarding the decision of the company to enhance the utilization of debt-equity composition in its capital structure.
The level of financial risk that a company could face can be evidenced by its beta coefficient. This is defined as the amount of risk that the stock contributes to the market portfolio. Thus, a stock with a high correlation will have high beta, and, thereby, higher risks. (Brigham and Ehrhardt, 221).
The following table would give the values of beta for Tonka:
|Increase in the level of activity||Beta coefficient of Tonka|
If the company decided to increase its capital debt structure, it would go in for outside borrowings. In the case of Tonka, it is seen that it had borrowed $622 M for acquiring Kenner, another toy company, this amount is seen to be nearly 86% of the capital constituent of Tonka.
Although it is seen that later, the debt level was reduced to around 70%, still, Tonka‘s debt-equity was higher, when compared to industry standards.
The capital markets should react positively to Tonka’s decision to increase their debt capital structure since this would increase the overall cost of capital of the firm and also enhance returns on capital investments. The other positive aspect of debt capital is that interests’ payments are tax-deductible and thus, it would reduce the level of taxation that Tonka would have to pay in later years. As a matter of fact, most observers would view increased use of debt capital as a strategy to reduce a firm’s tax burden.
By maintaining a high debt as compared to equity, it is possible for a company to increase earnings to stockholders, through more profits gained through trading and other business indulged by the company. However, there are also high-risk factors involved in that in highly geared companies, liquidation costs would also be high.
Highly leveraged companies constantly face the risks of having their autonomy compromised and actions controlled by outside creditors and also severe erosion of its bottom line by high interest and loan servicing costs. (Loth).
What capital structure would you recommend as appropriate for Tonka?
Comparisons between risks and returns form the vital constituents of major decision-making analysis, not only in capital finance but perhaps in major life decisions. This could also lead to optimum profit achievements, and this risk/return trade-off could as well underpin sound financial decision-making.
(Financial Analysis Revised).
There are two aspects to the kind of operation that Tonka, a toy manufacturing company indulges in. In the first place, the market conditions are often determined by customers, and young people at that, and the competition is intensely fierce and unabating.
Again, the profits are also alluring and high, which may justify the risks that are being taken for earning larger revenues and profits. During 1990, Tonka was in the red having accumulated a loss of nearly $10.3 Million and was in financial disarray. Under such circumstances, their takeover was imminent and sure enough during April 1991 the deal with Hasbro was struck and Tonka was taken over for around $490 million. (Tonka Corporation).
Since Tonka as a separate business entity does not exist, since it has been merged with Mattel Inc., it is believed that the 1:1 (50% debt and 50% equity) debt-equity ratio would be quite substantial. The blend between debt and equity would ensure parity in the sense that only the benefits could be seen and not the losses or drawbacks, in the event the company relies heavily, on debt over equity, or vice versa. If equity is more pronounced, there would be higher controls and creditors would be circumspect on doing business; however, again if the debt is paramount, payments of interests and repayments of loans upon maturity would also figure prominently during board meetings.
Since the toy industry in the US is going through tough times due to global economic meltdown and high recession, it would not be prudent to invest in borrowed funds, since the repay ability and regular interest payment is major issue.
Thus, what Tonka needs to do is to establish par with equity and debt in order that heavy debts do not accumulate, which would affect its bottom line adversely.
How might Tonka implement an aggressive capital‑structure policy?
What are the alternative tactics for leveraging up?
An aggressive capital structure planning needs to consider the benefits and costs that are involved in such a policy. Moreover, the present economic climate and other factors are also involved, which needs to be carefully considered. While the element of risks and returns may be possible, this may be eclipsed by the risks of endangering liquidation and bankruptcy costs, due to non-payment of dues to creditors and Third-Party Liabilities.
A lowly geared company has high equity shareholders who need to be paid dividends. Although not mandatory, a good company’s track record for future investments is based on a dividend-paying track record.
A highly geared company may have bondholders who need to be compulsorily paid interests. If interests are pending for long, they may sue for winding up proceedings.
Moreover, once claims remain unpaid, stakeholders have a justification in taking action to protect their interests against that of bondholders. Thus, if there are unpaid claims, the company’s goal of optimizing the value of the firm and equity is not the same. Thus, in such instances, there may be a conflict of interests between bondholders and equity shareholders in areas of lowering of unpaid claims, dividend payouts and exchange of assets.
The alternative for leveraging up could be seen in terms of the fact that firms with relatively high debts with high returns could prosper only when the economy is normal, but they are forced to go into hibernation if the economy is recessionary.
Under high incomes, it is possible to pay high interests costs, while when revenues fall it would be difficult to sustain the debt servicing capabilities of the firm.
A suitable alternative would be for Right issues or internal capital generated by the owners and shareholders to mop up excess funds for being capitalized, which would not carry such risks as outside loans.
Right or restricted issues of shares would restrict entry and thus reduce attendant risks entailed in public issues, etc.
What arguments would you advance to persuade Tonka’s management to adopt your recommendation?
The main aspects that need to be considered is whether Tonka would be in a position to service loan debts equitable without seeking recourse to further borrowings, thus creating further risk factors. The debt costing needs to consider the following aspects:
- Fluctuations in the demand side, if present, could enhance business risks
- Inconsistencies in selling prices lead to more business risks as compared to consistent pricing policies
- Output process needs to match input costs, and if this is possible it is possible that revenues would be consistent and dependable.
- Coverage of foreign risk exposures. Companies like Tonka for whom sizeable earnings are from export business need to take steps against exchange rate fluctuations, which, if unmanaged could result in losses.
Only if Tonka could meet and overcome such inconsistencies and business vicissitudes could it be possible for it to move into a further debt burden. Another aspect is that the interest costs on debts need to be lower than profits derived out of the use of borrowed funds.
Thus, it is necessary that the business needs to consider a plethora of factors before considering the best debt-equity mix. While factors are subjective and differ from time to time even within the same unit, it is necessary that the correct focus and direction on debt-equity be maintained in order to avoid future losses for the company.
While the predictable return of an investment is the simple weighted average of the expected returns of its component securities, portfolio risk must also judge the connection among the returns of different securities. Since part of the price fluctuation of security is distinctive, it does not respond to price changes of other securities held. This allows the investor to expand, or eradicate, a portion of each security’s risk. With added analysis, the subset of portfolios with the highest expected return for a given risk level can be recognized. If a risk-free asset can also be transacted, then there is a unique combination of risky securities that will allow all investors to achieve superior returns for a given risk level. (Portfolio Management Theory).
The debt structuring of Tonka needs to consider the wider aspects of its stake holdings, its lowered profits over the years, and the need to revitalize its market position in the competitive global toy market in the years to come. It is also necessary that innovation is critical in the toy industry, due to changing consumer choices and toy preferences, and a lot of competitors, big and small in the business.
- Brigham, Eugene F. and Ehrhardt, Michael C. Financial Management: Theory and Practice. 10th Edition. The Concept of Beta. 2004.
- Final examination Tonka Corporation. FINC 6290. 2009. (Provided by customer)
- Financial Analysis Revised: Session 2: Risk and Return Measurement: Introduction. NetTel. 2009.
- Loth, Richard. Evaluating a Company’s Capital Structure: is There an Optimal Debt-Equity Relationship. Investopedia: A Forbes Digital Company. 2009.
- Portfolio Management Theory. Business Reference. 2007. Web.
- Tonka Corporation. (Provided by customer).