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Case Study:
Team members
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COPORATE FINANCE DEPARTMENT
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SECTION 2 Introduction
2.1 Background
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• Does the company have residual cash after considering all of
the above?
Therefore, the total net cash flow of the Company in 1994 is $ 17.5
million (See Exhibit 1).
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3.2 Forecast of Net Income (1995 – 1997)
In the years since the current management has taken over, the
performance of the company has improved significantly. Operating
margins have improved steadily from 5.4% in 1991 to 8.8% in
1994. We expect this improvement to continue until reaching 10%
in 1997. As a result, we forecast that the net income of the
Company will grow by an average of 15% a year in the next three
years.
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sales by 1997, with emerging market sales accounting for one
forth of the sales (Exhibit 4).
After paying off all the debt this year, the Company’s effective
gearing (total liabilities / total assets) is forecast to be 37% (Exhibit
2). As the Company’s target gearing is 50%, the Company has
room to raise debt to finance future expansion and M&A activities
without exceeding the target gearing ratio.
Considering all the factors above, the total cash required in 1995 is
between $26.5 million and $33.5 million.
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A successful IPO is an accomplishment for any company and by
offering shares to the general public, we have successfully
marketed Champion Road to the investor community. Of the
shares owned by the public, 70% were sold to institutional
investors and 30% were sold to retail investors.
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regard, making a cash distribution seems to go against this
objective, unless it is determined that there are no worthwhile
investment opportunities in a reasonable time horizon.
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manufacturer and also more overseas investment to support
international sales growth, the Company should more or less follow
the ‘residual dividend policy’.
Last but not least, this residual dividend policy approach could
avoid incurring additional issuance and time costs in financing
(debt and/or equity) in case good investment opportunities arise
after excess dividend payments.
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message of confidence to the existing and potential investors on
its long-term profitability and growth.
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investment and the possibility that the acquisition will not be able
to meet our return on capital requirement cannot be ruled out. In
case we could not identify suitable targets in 1995, there will be
residual cash in the Company and a one-off cash distribution to the
shareholders should be the best option. This could avoid the
possibility that the Company would accumulate more cash than it
could invest profitably. With the one-off nature of the distribution
in the form of special dividend or share repurchase, the company
could avoid an expectation by the investment community for a
recurring dividend.
This option may not agree well with the Pecking Order Theory and
extra issuance and time costs are inevitable if additional financing
is required for new investment opportunities, but the management
should weigh them against the opportunity costs of holding idle
cash sitting in the company for a prolonged period.
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• Pecking Order Theory: whether the option promotes the best
cash management practice in accordance with the Pecking
Order Theory
Pecking
Oder 2 3 1 2
Theory
Growth 4 3 1 2
Majority
Sharehold 3 3 1 1 2
ers
Minority
Sharehold 1 3 2 2 1
ers
Weighted
3.0 1.1 1.7 1.9
Score
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However, we recognize that it is possible that we will be unable to
identify suitable value creating projects within the next 9 months,
in which case the Company will have residual cash. Therefore we
propose a “wait-and-see” approach to a one-off distribution in the
form of share repurchase.
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($'000)
Net Income 8,100
Add: Proceeds from IPO 26,600
Add: Deferred Tax adjustment 523
Less: Capital Expenditure (net of
depn) (3,000)
Less: Increase in Working Capital (2,382)
Less: Repayment of Debt (12,302)
Net Cash Flow 17,539
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1994
($'000)
Balance Sheet
Assets:
Bank and Cash 17,539 balancing figure
Accounts Receivable 18,354 % of sales
Notes Receivable 1,886 % of sales
Inventory 25,057 % of sales
Prepaid Expenses 349 % of sales
63,184
add $3M capital
Property, Plant and expenditures (net of annual
Equipment 13,253 depreciation)
Other Assets 622 % of sales
77,059
Liabilities:
Bank Indebtedness 0 assume all cleared
Accounts Payable 23,532 % of sales
Income Tax Payable 4,139 ratio based on tax P/L
Current Portion of Long
Term Debt 0 assume all cleared
27,671
Long-Term Debt 0 assume all cleared
Deferred Income Taxes 1,178 ratio based on tax P/L
Shareholders' Equity:
add the net IPO proceeds
Share Capital 28,178 ($26.6M)
add current yr forecast P/L
Retained Earnings 20,032 $8.1M
77,059
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$ (‘000)
Total Sales 155,000
@ 5% 7,750
@ 10% 15,500
10% net margins 775
12% net margins 1860
ROC 15%
Lower Bound Investment Cost 5,167
Upper Bound Investment Cost 12,400
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1994 1997
North America 72% 55%
Western Europe 20% 20%
Latin America 5% 15%
Eastern Europe 2% 9%
Other Regions 1% 1%
($'000) ($'000)
15 23
Total 5,000 5,736
11 12
North America 1,600 9,655
3 4
Western Europe 1,000 7,147
3
Latin America 7,750 5,360
2
Eastern Europe 3,100 1,216
100% 1%
2% 1%
5% 9%
Percetage of total Sales
90%
20% 15%
80%
70%
20%
60%
50%
40%
72%
30% 55%
20%
10%
0%
1994 1997
Year
North America Western Europe Latin America Eastern Europe Other Regions
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Market Price of Champion Road: 12 $
If Champion
followed the
Dividend yields same yield
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CANADA
Dividend
$1,000Income
Tax
$294 paid
Effective tax rate on
29.4% dividend
$1,000Capital Gains
Tax
$327 paid
Effective tax rate on
32.7% dividend
UNITED
STATES
Dividend
$1,000Income
Tax
$396 paid
Effective tax rate on
39.6% dividend
$1,000Capital Gains
Tax
$280 paid
Effective tax rate on
28.0% dividend
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