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Finance for Managers

Critique the analysis and proposals made by the Vice President for Finance of Adheron, Inc., as described in the attached case. Specific assignment questions to guide that critique are listed on page 5. Feel free, however, both to integrate your responses to those various questions and to go beyond the particular issues they raise, in order to develop a coherent capital structure, cost of capital, and investment decision framework for the firm, according to what you consider to be the correct conceptual approach to such matters. Thus, do not be reluctant to display the full range of your talents, even if they do not fit neatly into the guidelines provided. Assume that the reader of your critique will be knowledgeable in the relevant areas, but is interested in finding out whether you are. Limit your written response to 6 pages (one side), including any exhibits you may wish to provide; this is a firm limit, not merely a suggestion. You have four hours in which to complete your analysis.


In early 2008, the Vice President-Finance of Adheron, Inc., completed a study of the company`s existing capital budgeting and financing procedures and was preparing to recommend major policy changes to management and the Board of Directors. Prior to presenting his ideas formally, however, he planned to review them with several of his colleagues who would be most affected by the changes he had in mind.

Adheron was a leading manufacturer of adhesives, pressure-sensitive papers, and packaging and household tapes. It had been founded in the late 1950`s on the basis of several proprietary adhesives innovations, and had grown steadily--and profitably--since. By 2008, it had plant locations in 12 states and 4 foreign countries, and employed nearly 15,000 individuals. Annual revenues were comprised approximately 75 percent of sales to other manufacturers and 25 percent to the consumer marketplace. Some 20 percent of sales were made outside the US.

The company`s reputation and competitive position were founded primarily on high product quality; price was not a major competitive concern in most of its markets. For that reason, the company emphasized the latest technology in its production processes, and was a relatively fixed-asset-intensive firm. Profit margins on sales had consistently been above average and, indeed, had improved in recent years. While Adheron`s businesses had some cyclical elements, the company had been able to prosper over a broad range of economic conditions, and it anticipated continued strong growth.

Adheron`s financial policies had evolved over time in response to the needs of the company`s capital investment programs. Earlier, company policy had dictated a relatively high dividend payout of earnings and heavy reliance on borrowed funds. By the late 1990`s, however, the company had adopted a target long-term book debt ratio of 50% and a reduced dividend payout also averaging about 50%. As an important corollary policy, management and the Board of Directors generally opposed the sale of additional common stock, out of a desire to avoid earnings dilution. This policy had been put aside only once in recent years when the company, in 2001, had found it necessary to issue shares to finance large capital expenditures and to retire some debt. The net effect of these policies had been to limit the aggregate amount of the firm`s capital expenditures over the years primarily to funds provided by depreciation, retained earnings, and the additional long-term debt permitted by its target debt ratio.

Thus, in evaluating capital expenditure proposals, a critical determinant of each decision was the availability of sufficient funds from internal sources and new debt issues. Tactical, strategic, and intangible factors inevitably associated with major expansion projects were also given due consideration, and many of the company`s most important investment decisions had been based heavily on such grounds. In most of those decisions, at least to the extent project economics had been analyzed in quantitative terms, estimates generally had been framed in terms of a project`s net impact on reported profits. This emphasis on contribution to profits arose from the fact that outsiders seemed to evaluate the performance of both management and the company on that basis. It seemed only reasonable to apply the same standard internally and therefore--other things being equal--projects had been looked on favorably if they promised to contribute something to accounting profits, after allowing for estimated financing costs.

In his review of these procedures and investment criteria, the Vice PresidentFinance concluded that the company should change its approach to investment decisions in some respects. He summarized his ideas in the memorandum included in the following Appendix. While he continued to think that the potential impact of a project on reported earnings was an important consideration, he thought that more than this was involved. The alternative procedure outlined in his memorandum was a variant of the cost-of-capital/internal-rate-of-return method that was presently widely used throughout industry. Unlike Adheron`s past practice, his proposal took the cost of retained earnings into account.

While he was reasonably confident of the merits of his policy recommendations, he planned to review them informally with several of his colleagues before trying to push them any further. In particular, he was aware of the fact that his memorandum implicitly made the assumption that the company should still limit the amount of its capital expenditures to the funds supplied by retained earnings, depreciation, and new debt at the target ratio, and he wondered how, if at all, he should change his thinking on that aspect of the proposal. He also wondered whether the cost of capital calculation he envisioned would require any modification if Adheron were to contemplate investments in businesses other than just its current ones.

ASSIGNMENT: Appraise the logic of the Finance Vice President`s proposals and analysis. In doing so, you should address somewhere along the way the following issues, in specific terms:
  1. His assessment of the respective "costs" of each of the various individual sources of capital available to the firm-i.e., debt, retained earnings, common stock.
  2. The appropriate procedure for weighting those individual costs, to come up with an over-all cost of capital for the firm.
  3. The determination of the degree of leverage which the firm should have in its capital structure, and the criteria which would bear on that decision.
  4. Whether the firm`s cost of capital should be expressed as a before-tax or an after-tax figure.
  5. How the firm should decide whether to restrict its expansion capital expenditures to the amount which can be accommodated solely by retained earnings and the additional borrowing capacity created by retentions.
  6. The criteria that bear on the establishment of a proper dividend policy for the firm to adopt.
  7. The company`s sustainable long run growth rate under its present financial policies.
  8. Whether the procedure proposed on page 11 for appraising the desirability of new investment projects is appropriate.
  9. What modifications should be made to any of the foregoing recommendations, if the firm should decide to undertake investments in areas outside its current line of business.
This list is intended to be suggestive, but not necessarily exhaustive.
If you feel other matters should be discussed, please do so.
Exhibit 1


Consolidated Ten-Year Summary
(Dollar amounts in millions, except per-share figures)

Net Income Dividends
% of Per Per % of Net Number of Shares
Year Revenue Amount Revenue Share Share Income Outstanding

1998 $ 393 $18 4.6% $ 1.63 $ .80 49% 10,944,560
1999 514 24 4.7 2.18 .90 41 10,944,560
2000 573 26 5.1 2.36 1.00 42 10,944,560
2001 657 29 4.1 2.23 1.10 49 13,106,720
2002 656 32 4.9 2.44 1.20 49 13,106,720
2003 639 36 5.6 2.74 1.35 49 13,106,720
2004 681 41 6.0 3.13 1.45 46 13,106,720
2005 696 42 6.0 3.20 1.60 50 13,106,720
2006 795 48 6.0 3.66 1.80 49 13,129,420
2007 822 52 6.3 3.97 2.00 50 13,129,500

Fixed Assets Long-Term Debt
% Total
Year Gross Net Total Capitalization Depreciation Net Worth

1998 $705 $423 $215 60% $15 $ 143
1999 755 435 244 61 21 156
2000 783 442 234 58 23 171
2001 797 476 215 47 24 231
2002 837 471 202 45 25 247
2003 862 476 217 45 27 265
2004 923 508 207 42 28 286
2005 1059 612 309 50 34 307
2006 1088 601 295 47 40 331
2007 1190 660 334 * 48 41 356

*Average coupon interest rate = 8%
Exhibit 2


Stock Price Information

Adheron, Inc.
Average Market Index* Standard & Poor`s Index*
Year Price per Share Market Price P/E Ratio Market Price P/E Ratio
1998 $11.75 100 100 100 100
1999 14.00 121 94 115 110
2000 14.25 123 83 131 109
2001 14.75 126 78 135 109
2002 19.25 163 112 134 104
2003 20.75 179 110 155 122
2004 23.50 200 106 184 133
2005 20.50 175 92 195 135
2006 28.25 241 112 251 159
2007 32.00 274 119 241 145
2008* 35.00** 298 -- 256 --

*With 1998 = 100 **Year to Date


Memorandum on Proposed Capital Budgeting Procedures

I. Introduction

Discussions with investment bankers, corporate financial people, business administration professors, and economists indicate very clearly that there is no general acceptance of a single well-defined concept of the true cost of capital for a particular company. The purpose of this memorandum is to develop one approach which is being used in a growing number of companies.

Agreement on a true cost of capital for Adheron is particularly important because the company must continue to make substantial new investments each year in order to maintain the growth rate achieved in recent years.

II. Problem

Identify the cost of capital and provide a means of measurement which can be compared with the expected rate of return on new investment opportunities. The latter is usually expressed as an annual percentage figure.

III. The Approach

For a company like Adheron, any particular financing should be regarded as a part of a continuing program. If we assume that a 50% book debt ratio is satisfactory, then new debt cannot be contemplated at a point in time without the expectation that new equity will be provided later (from reinvested earnings or sale of stock) in order to restore and preserve the balance in the capital structure.

This rationale is the basis for Adheron`s current thinking on the subject of cost of capital which applies the current rate on bonds to 50% of the capital in a project. This theory assumes retained earnings to be essentially a cost free source of funds. The weakness in the theory that retained earnings are cost free can best be illustrated by considering a company that finances all its requirements from internally generated sources. If this company`s cost of capital is zero, does it not follow that any project which can be expected to earn a rate of return higher than zero should be undertaken?

It is suggested for consideration that the cost of capital be defined and calculated in terms of an average cost of new capital--weighted according to the proportions of the various sources of funds which the company can be reasonably expected to use.

Most companies do have a pattern of the proportions of various sources of capital used in past years which can be used as a basis for calculating the weighted cost of capital for evaluating new projects. Below is a statement indicating Adheron`s sources of funds for the ten-year period 1998-2007, over and above the reinvestment of depreciation:

(Millions) %
Long-term Debt, net $129 36%
Common Stock 47 13
Retained Earnings 182 51
$358 100%

Before considering the question of weighting, consideration will be given to suggesting a cost of capital for each source.

IV. Cost of Debt

The cost of funds obtained from long-term borrowing is simply the after-tax interest rate on the debt. The only question here is what rate to consider as a realistic measure of Adheron`s future average cost of debt. Based on historical patterns of interest rates, and considering the probable economic environment during the next few years, a pre-tax rate of 7.5% is suggested. This is based on the belief that the interest cost of "A" rated debt will generally vary from 7% to 8%, and that any deviation from this range can be expected to be for relatively short periods of time. Interest coverage ratios for "A" rated long term debt in our industry have been in the vicinity of 4 to 5 times in recent years. At our current combined federal and state income tax rate of 40%, the after-tax cost of debt for us therefore would be 4.5%.

V. Cost of Common Stock

The cost of capital derived from an issue of new common stock is a difficult concept and one on which little agreement exists about its practical application. Most people will agree that common stock has a cost, but there are many criteria for measuring it.
The plurality of financial people seem to argue as follows: the cost of equity capital is that rate of return which must be earned on the incremental new money from the sale of stock so that the proportion in which total earnings increase is no less than the proportion in which total shares increase. Saying the same thing another way: It`s that rate of return which must be earned on the new money so that earnings per share after the new shares are issued will not be less than earnings per share before the issue.

This percentage is simply the relationship between earnings per share and the price of the common stock--the reciprocal of the price/earnings ratio. Assuming an average price/earnings ratio for Adheron of approximately 8 times, the earnings/price ratio would be in the vicinity of 12.5%. In other words, if every dollar obtained from the sale of stock were invested at 12.5%, earnings per share would be the same before and after the sale. For this purpose, I have ignored flotation costs.

VI. Cost of Retained Earnings

All net income not paid out as dividends by the firm is invested in short-term marketable securities until such time as the funds are used for an investment project. Viewed in this manner, the cost of retained earnings is the after-tax return on shortterm investments. In other words, the cost of using retained earnings to finance new facilities is the return given up by selling the marketable securities. Assuming a before-tax yield of 6% or less on short-term securities, the after-tax cost of retentions would be about 3.5%. There are a number of variations of this theory, but this is a start.

VII. Weighted Average Cost of Capital

Based on the foregoing analysis, the weighted cost of capital for Adheron is 5% after taxes. Theoretically, any project which can be expected to earn more than 5%, regardless of how it is financed, and before considering financing charges, would be desirable. The calculation is as follows:

Adheron, Incorporated: Cost of Capital 1998-2007

Source (millions) % of Total
After-Tax Cost Weighted
Debt $129 36% 4.5% 1.6%
Common Stock 47 13% 12.5% 1.6%
Retained Earnings 182 51% 3.5% 1.8%
$358 100% 5.0%

VIII. Appraisal of Capital Investment Opportunities

It is proposed that capital investment projects be required to earn at least this weighted average cost of capital. The method of appraising investment opportunities would be as follows:

(1) Operating revenues and expenses to be projected for no more than a ten-year period for each investment.

(2) The assumption is that 50% of the investment is financed from borrowed capital, and interest at 7.5% would be calculated on
the declining balance of this assumed loan. This imputed interest is included with the other operating expenses associated with the project.

(3) A tax rate of 40% is assumed.

(4) A rate of return on net investment is calculated for each year by comparing estimated profits after taxes to the undepreciated investment in the project. These rates are then averaged. A project with an average return on investment of less than the above cost of capital would be rejected, unless compelling strategic considerations were present.

Question Set #9

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