A case analysis on Farnsworth Furniture Industries

Group A

CHAPTER I: INTRODUCTION Farnsworth Furniture established in 1932 is one of the largest manufacturers of Early American furniture in the United States. The keynote of Farnsworth has been to provide value excellence of design, pride in quality craftsmanship, and fair prices. Thus, most Wall Street analysts has pointed to this attitude of pride and the family atmosphere of Farnsworth furniture Industries as the key elements of the companys outstanding market success.

During the mid-1980s, the demand for pine early American furniture increased due to falling interest rates and willingness of homeowners to spend extra money furnishing their houses with long lasting quality furniture.

To meet the increased demand, Farnsworth Furniture Industries is undertaking a major capital expansion program with approximately $50 million in new capital out of which $25 million has already been borrowed as a long term loan form a group of five insurance companies. The loan agreement which was already been finalized required Farnsworth to raise an additional $25 million through the sale of common stock. The company is considering following alternative proposals:

1. The company can go for initial public offering (IPO) at a subscription price of $53 per share. Out of this amount $3 will be charged by an investment banker as a commission and the company would receive $50 per share.

2. The company can issue rights share to the existing shareholders at a subscription price of $50 and commission to the investment banker for the subscribed shares is $1.50 per share and the company would receive in net $48.5. Meanwhile, commission for the unsubscribed shares is $4 and in this case the company would receive in net $46 per share.

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A case analysis on Farnsworth Furniture Industries

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3. The company can issue rights share at a price of $44 per share with underwriting cost of $1 for each share subscribed and $4 for each unsubscribed share purchased by the investment banker. 4. Sell shares to current stockholders at a subscription price of $27 with underwriting cost of $0.25 for the subscribed shares by the stockholders and $4 per share taken by the investment banker. 5. Shares can be sold to current stockholders at a subscription price of $5 per share. Assistance of the investment banker would not be necessary as the company could be quite sure that all shares offered would be taken.

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A case analysis on Farnsworth Furniture Industries

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CHAPTER II: CASE ANALYSIS ISSUE 1: How many additional shares of stock would be sold under each of the proposal submitted by B. F. Hudson? Assume all shares are subscribed. Answer: Additional Required Funds = $25 million

If all the shares will be subscribed then the number of additional shares to be issued will be: Table No. 1: Calculation of No. of Additional share Proposal 1 2 3 4 5 Working Note: Number of additional shares Price Received per Share = = Required Funds Price received per share Subscription Price (PS) Floatation Cost (FC) Subscription Price (PS) $ 53 $ 50 $ 44 $ 27 $5 Floatation Cost (FC) $3 $ 1.5 $1 $ 0.25 0
Price Received per Share (PS - FC)

No. of Additional Share 5,00,000 5,15,464 5,81,395 9,34,579 50,00,000

$ 50 $ 48.5 $ 43 $ 26.75 $5

Above table show the No. of additional share that need to sale under the different proposal. For instance, in case of proposal 1, Subscription price of each share is $ 53 and floatation cost is $ 3. After deducting the floatation cost from subscription price we get the perceived value of share. Finally dividing the required additional fund by perceived value of share we get the additional that need to sale to raise the addition fund. We continued the same process in all proposals to get additional share required to sales. So 5,00.000, 5,15,464, 5,81,395, 9,34,579,and 50,00,000 are number of share required to sale under proposal 1, 2, 3, 4, and 5 respectively.

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ISSUE 2: How many rights will be required to purchase one new share under each of the four rights proposals? Answer: No. of Outstanding Shares (old) = 4,000,000 (From Balance sheet December 31st 2006) Table No. 2: Calculation of No. of Right Required No. of Old Share Proposal (A) 2 3 4 5 40,00,000 40,00,000 40,00,000 40,00,000 5,15,464 5,81,395 9,34,579 50,00,000 (B) 7.76 6.88 4.28 0.8 C=AB No. of New Share No. of Right

Working Note: For Proposal 2: No. of rights required to Purchase One share = = Thus required right to purchase to one new share = 7.76

Above table represent the number of required right to purchase additional one new share. We calculated the required right under different proposal using the formula as mention in above working note. 7.76, 6.88, 4.28, 0.8 are the required number of right to purchase additional one new share under proposal 2, 3, 4, and 5 respectively. If subscription price goes on decreasing then the number of fight purchase share is also declining. There is positive relation between number of right and subscription price.

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A case analysis on Farnsworth Furniture Industries

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ISSUE 3: What is the market value of each right under each of the proposals? Do you think that the average stockholder would bother to exercise the rights or to sell them at these prices? Use the rights formula to answer this question. Answer: Current market price (Po) = $54

Table No. 3: Calculation of Value of Right Market Price PO $ 54 $ 54 $ 54 $ 54 Subscription Price PS $ 50 $ 44 $ 27 $5 Value of right Vr = (PO PS) + 1 7.76 6.88 4.28 0.8 $ 0.457 $ 1.269 $ 5.114 $ 27.22

Proposal

Alpha()

2 3 4 5 Working Note:

Market value of each right

Above table show the value of right under each proposal. We calculated the value of right using formula mention is working note. The value of right under each proposal 2, 3, 4, and $5 are $0.457, $1.269, $5.114, and $27.22 respectively. The relation between subscription price and value of right is negative. As increase in value of rights, is decreasing the subscriptions price of share. So, lower value of right less dilute the market price of share.

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ISSUE 4: What is the price per share immediately after issue of new shares under each of the four proposals? Use the rights formula to answer this question. Answer: Ex-right price is price that will prevail after the right issue. As we know that the market price of stock will be decreased by value of right offering after the right share offering. The value of right share refers to the ratio of difference between current market price and subscription price to number of rights. Thus, ex - right Market Price per Share is the difference between MPS before right offering and Value of right. Using rights formula, Market Price per Share (Ex - Right) = MPS before right offering Value of right Table No. 4: Calculation of MPS (Ex-right) Market Price Per Proposal Share (MPS) [A] 2 3 4 5 $ 54 $ 54 $ 54 $ 54 Value of right (Vr) [B] $ 0.457 $ 1.269 $ 5.114 $ 27.22 Market Price per Share (Ex-right) [C = A-B] $ 53.543 $ 52.731 $ 48.886 $ 26.78

Above table represent the Ex - right Market Price per Share, we can observe from give table that the as the subscription price goes on declining, the ex-right price is also goes on declining. There is positive relation between subscription price and ex-right price.

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ISSUE 5: Selling stock through a rights offering with the subscription price set below the current market price has an effect that is similar to that of a stock split or stock dividend. What is the percentage of the stock dividend that would have to be declared to have the same effect that is, produce the same final price per share as each of the proposals for rights offering? Answer: There is common effect of decreasing market price per share (MPS) after stock split, stock dividend, and right offering, but their proportion of decreasing market price per share may not be the same in all case. Table No. 5: Calculation of stock dividend in percentage Market Price Per Market Proposal Share Share (PE) (PO) 2 3 4 5 Working note: For proposal 2: Stock Dividend (%) =( = ( = 0.854% Where, PO = Market Price $ 54 $ 54 $ 54 $ 54 Price per Stock Dividend (Ex-right) =( 0.854% 2.407% 10.461% 101.643%

$ 53.543 $ 52.731 $ 48.886 $ 26.78

PE = Ex-right Market Price per share We used same formula for all four proposals. If we undertake the right offering this is equivalent to stock dividend, whether we pay higher or lower stock dividend. As a subscription price goes on decrease, percentage of stock dividend goes on increasing. There is a negative relation between subscription price share and percentage of stock dividend.

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ISSUE 6: Assume that the company increases its total assets by $25 million in net proceeds by issuing common stock at the start of 2007? (Ignore all other sources of funds, such as debt or retained earnings, for this calculation.) The company earns 10 percent after interest and taxes on its beginning assets in 2007. Spelled out in more detail, this implies that: (a) the company earns 10 percent after interest and taxes on total assets in 2007; (b) the company obtained only $25 million of new equity financing during2007; that is, the debt financing is deferred until 2008; (c) new outside capital is fully employed during the entire year of 2007; (d) additions to retained earnings in 2007are not employed until 2008; and (e) that current liabilities remain at their 2006 level. (Note: the companys stock issue was sold to the market for more than $25 million, but the investment bankers retained the difference to cover flotation charges. Therefore, capital stock increases by exactly $25 million.) What will the rate of return on net worth, earnings per share, and the price per share of the stock (assuming a price/ earnings ratio of 20) is in 2007 under each of the alternative methods? Do not use the formula to answer this question. Answer: Table No. 6: Balance sheet of 2007 based on the above assumptions Amount in Millions $ 155.61 $ 25 Amount in Millions $ 16.12 $ 22.94 $ 39.06 $ 33 $ 22 $ 25 $ 61.55 $ 108.55 $ 180.61

Assets Old assets Add: New assets

Liabilities and Capital Accounts Payable Bank Loans Total current liabilities Long-term debt Capital Stock Add: New Common stock Retained earning Total Equity

Total assets

$ 180.61

Total liabilities & capital

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A case analysis on Farnsworth Furniture Industries

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Calculation of return on Total assets: Total Earnings after interest and tax in 2007 = = = Again, Net worth = = = Now, Return on net worth (for all alternatives) = (Earnings = ($18.06 = Calculation of Earnings per share (EPS) EPS Where, Number of total outstanding shares = no. of old share Newly issued no. of share Ps FC = = Subscription price Floatation cost = fund to be raised + newly issued share (Ps- FC) = Total earnings number of total outstanding shares 16.64% Net worth) $108.55) x x 100% 100% Total liabilities & capital $(180.6 72.05) million $108.55 million total liabilities 10% of total assets $(0.10 x 180.6) million $18.06 million

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A case analysis on Farnsworth Furniture Industries

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Table No. 7: Calculation of Earnings per share Proposal 1 2 3 4 5 Where, TE NAS = = Total Earning Newly issued additional share Number of total outstanding share Earnings per share TE (A) $18.06 $18.06 $18.06 $18.06 $18.06 NAS (B) 5,00,000 5,15,464 5,81,395 9,34,579 50,00,000 NTOS (C) = 4 million + (B) 45,00,000 45,15,464 45,81,395 49,34,579 90,00,000 EPS (D) = A C $4.013 $4 $3.942 $3.66 $2.007

NTOS = EPS =

This table shows the total earning of company after issued of common stock, newly issued no. of share, no. of total outstanding share and Earning Per Share (EPS) of different proposal. We can see the decreasing trend of EPS as the proposal change from first to fifth. Thus as the subscription price goes on declining, EPS also decline consequently MPS also decline, so there is positive relationship between them. Table No. 8: Calculation of Market price per share (MPS) According to question P/E ratio=20 Proposal 1 2 3 4 5 P/E Ratio 20 20 20 20 20 EPS $4.013 $4 $3.942 $3.66 $2.007 MPS = P/E Ratio EPS $80.26 $80 $78.84 $73.2 $40.14

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Market price per share is the multiple of P/E ratio and EPS. The market price per share under each proposal 2, 3, 4, and $80.26 are $80, $78.84, $73.2, and $40.14 respectively, which can observed in above table. In first proposal the MPS is $82.6; we can see the MPS is decreasing in coming proposal of 2, 3, 4 and 5 th. As the subscription price goes on declining, earning per share as well as market price per share is also declining. So, there is a positive relation between subscription price and earnings per share and market price per share.

ISSUE 7: Why do the pricepershare figures in Question 6 differ from those found in Question 4? Which seem more realistic? Answer: Table No. 10: Calculation of Ex-right Market Price per Share Proposal 1 2 3 4 Ex- Right MPS as per Issue 4 $ 53.543 $ 52.731 $ 48.886 $ 26.78 Ex- Right MPS as per Issue 6 $ 80 $ 78.84 $ 73.2 $ 40.14

Price per share of issue 6 differs vastly from issue 4. We have two type of market price per share i.e. in issue 4 and other in issue 6. In issue 6 market price per share is higher than the current market price per share in issue 4. Here, issue 4 seems more realistic and issue 6 is not realistic because these calculations are based on Price earnings ratio. Price earnings ratio should be used carefully. The prices per share after issue of the new shares under each of the four proposals in question number 4 is calculated using formula method. And in case of question number 6, the prices per share after issue of the new shares under each of the four proposal without using formula is calculated using five assumptions which are as follows:
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a) Earning is assumed to be 10 percentage of total asset: The earning may not be 10% which is not realistic. b) Current liabilities remain at 2006 level: Amount of liabilities may vary according to the operation business, so it is not sure that liabilities will remain in same level of 2007. c) The assumption of new outside capital will employed be fully may be wrong because it is affected by different factors affect it. d) Price earnings ratio is assumed to be 20 which may not be true in reality. All these assumptions tend to make the result from issue 6 is unrealistic and far from reality. The value of issue 4 is more close to reality as it has less assumptions and has used formula for calculating the value of price which is practical than that of issue 6.Therefore we can conclude that value of shares in issue 4 is more realistic as compared to issue 6.

ISSUE 8: What are the maximum and minimum floatation costs under each of the proposals? Assume that the probability of the subscription percentage may be estimated by using the following probabilities for maximum and minimum floatation costs: Proposal Probability of no rights being exercised 1 2 0.25 0.75 3 0.15 0.85 4 0.05 0.95 5 0.00 1.00

Probability of 100% of the rights being -

exercised What are expected floatation costs as a percentage of gross funds raised under each proposal? What specific conditions might generate the maximum cost? Answer: The maximum and minimum floatation costs and the expected floatation costs as a percentage for each of the proposal are calculated below: For Proposal 1: The maximum and minimum floatation costs are the same for proposal 1 because there is only one category of underwriting commission. (Because share is issuing to general

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public so there is no nothing about right share.) Hence, the expected floatation cost is also the same as floatation costs. Expected Flotation Cost = = = = Flotation Cost No. of shares to be issued Floatation cost per share 500,000 $1,500,000 $3

Expected Flotation costs in Percentage = Expected floatation cost Funds Required = ($1,500,000 $25,000,000) 100% = 6% For Proposal 2, 3, 4 & 5: Table No. 11: Calculation of flotation cost If no rights are exercised in Issue of share (If 0% right is exercise in Issue of share) Particulars Funds required Subscription Price per share Floatation Cost per share (A) Price Received per Share for Unsubscribed Shares No. of New Share to be Issued (B) Total flotation cost (A B) Proposal 2 25,000,000 50 4 Proposal 3 Proposal 4 Proposal 5 25,000,000 25,000,000 25,000,000 44 4 27 4 5 0

46

40

23

543,478

625,000

1,086,957

5,000,000

$2,173,913

$2,500,000 $4,347,826

No. of shares to be issued = Total Fund required Price received per share Price received per share Flotation cost = Subscription price Underwriting cost = Number of shares to be issued Floatation cost per share.
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Above table shows the maximum flotation cost under each proposal. It describes subscriptions price, flotation cost per share of no rights is exercised and total flotation cost of each of proposal. We can see total fund requirement in each proposal is $ 25 million. We have calculated the no of new share to be issued if no one of existing investor exercises the right of preemptive right share. Table No. 12: Calculation of flotation cost If all rights are exercised in Issue of new share (If 100% right is exercise) Particulars Funds required Subscription Price per share Floatation Cost per share (A) Price Received per Share for Unsubscribed Shares New Share to be Issued (B) Total flotation cost (A B) Proposal 2 25,000,000 50 1.5 1 Proposal 3 25,000,000 44 Proposal 4 25,000,000 27 0.25 0 Proposal 5 25,000,000 5

48.5

43

26.75

515,464 $773,196

581,395 $581,395

934,579 $233,645

5,000,000 0

This table shows the minimum floatation cost for each proposal. It describes the total flotation cost of each proposal whenever existing shareholders have exercised their right to buy right share. If all the investor are interested to buy additional share then only minimum flotation const will be incurred. In proposal 2 flotation cost per share is only $ 1.5 as compare to the $4 per share of floatation cost that investment bank charge for each unsubscribed share. Thus total flotation cost for each proposal is lower than those of unsubscribed share.

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Table No. 13: Calculation of expected flotation cost Particulars Probability (no rights are Proposal 2 Proposal 3 Proposal 4 Proposal 5

exercised) - A Probability (all rights are

0.25

0.15

0.05

exercised) B Flotation cost (no rights are exercised) C Flotation cost (all rights are exercised) D Expected flotation cost

0.75

0.85

0.95

$2,173,913 $2,500,000

$4,347,826

$773,196

$581,395

$233,645

$1,123,375 $869,186 [(AC) + (BD)] Expected Flotation costs in % 4.494% 3.477%

$439,354

1.757%

Expected Flotation costs in percentage = Expected floatation cost Funds Required This table explains the expected flotation cost for issuing the right share. Since the proposal 1 is not related with right share so it is excluded here. The total expected flotation cost has been calculated on the basis of probability of right share being exercised. E.g. in proposal 2 probability of right share being exercised is 0.75 so 75% of total flotation cost will be covered by lower underwriting cost of investment banker and remaining 25% to total flotation cost will be covered by those of higher cost incurred for unsubscribed of right share. As subscription price goes on declining, floatation cost also decline and vice-versa. Hence we can say that here is positive relationship between them. The highest floatation cost has incurred in proposal 1, which has 6% of expected flotation costs.

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ISSUE 9: What effects do you think a rights offering, as opposed to an offering to the general public, would have on stockholders loyalty to the company? Answer: If the company undertakes rights offering, as opposed to an offering to the general public then it will enhance the shareholders loyalty. In addition existing shareholder get following benefits: a. In the right offering the existing stockholders get the first option to buy any issue of new stock. b. The subscription price is less than the current market price of the stock. Therefore stockholders are able to buy additional shares at a price lower than the prevailing market price. c. Right offering would also preserve the control power and ownership of the existing stockholders. d. Reduce chance of dilution in earnings per share of the company; it means the earnings of the company would not be distributed among large number of stockholders. Thus, if company is offering the rights to its stockholders, it is said to be showing loyalty to existing stockholders than by offering to the general public. ISSUE 10: Examine advantages and disadvantages of each proposal and decide which method of financing Hruska should recommend to the board of directors? Answer: The advantages and disadvantages of each proposal are given below: Proposal 1: Advantages a. Wider distribution of stock to throughout the market. b. Increase large number of knowledgeable shareholder. c. Public awareness towards company will increase.
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d. Dilution of earnings per share is less, because no of share to be issued is less Disadvantage: a. No loyalty to existing shareholders b. Floatation cost is highest c. Issue could be a failure because subscription price is higher. Proposal 2: Advantage a. Loyalty to existing shareholders will increase. b. Dilution in earnings per share is less i.e. No. of share outstanding is 5, 15,464. Disadvantage: a. Small shareholders may not exercise the right because subscription price is $44. b. Expected Floatation cost is still higher i.e. 4.49% c. Small discount margin is currently available in company share. d. Issue could be failure because subscription price is higher. e. Stock dividend effect is Non-noticeable is here, stock dividend rate is only 0.85%. f. No wider distribution of stock to throughout the market. Proposal 3: Advantage: a. Loyalty to existing shareholders will increase. b. Expected Floatation cost is relatively low i.e. 3.44% c. Dilution in earnings per share is less i.e. No. of share outstanding is 5,81,395 Disadvantage: a. Stock dividends is still not noticeable i.e. 2.407% b. Right have low value, here VR = $ 1.269 c. Issue could be failure because subscription price is $ 44. d. Small shareholder may not exercise the right.
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e. No wider distribution of stock to throughout the market. Proposal 4: Advantage a. Loyalty to existing shareholder b. Subscription price is considerably lower so chance of exerting right would increase. c. Expected floatation cost is quite low i.e. 1.757% d. Huge discount margin ($ 54 - $ 27 = $ 27) is the major benefit to shareholder. e. Noticeable stock dividend effect i.e. 10.461% Disadvantage a. $ 5.114 is high right value. b. Dilution in earnings per share is more because we are going to issue 9, 34,579 shares which are large in number. c. No wider distribution of stock to throughout the market. Proposal 5: Advantage a. Issue cannot be a failure because subscription price is lowest i.e. $ 5. b. Floatation cost in zero. c. 101.643% of a large stock dividend effect from which existing shareholder will largely benefit. d. Huge discount margin ($ 54 - $ 5 = $ 49) is the major benefit to shareholder. Disadvantage: a. Dilution in earnings per share is more, here number is additional share is 5 millions b. Cost of administrating the share will goes up. c. If any shareholders are not able to exercise the right, he/she is going to suffer a loss.
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d. High value of right i.e. $ 27.22 e. Investment bank will become unhappy. f. No wider distribution of stock to throughout the market. Decision: After analyzing each of the alternatives separately we arrive to the conclusion that the Hruska should recommend the proposal 4 to the board of directors as the best method of common stock financing. Proposal 4 seems to be more favorable than other alternative proposals, because of the following reasons: a. Floatation cost is relatively low. b. Issue cannot be a failure because subscription price is considerably lower so chance of ex-right would increase. Offer huge discount margin ($ 54 - $ 27 = $ 27) to shareholders. c. No chance to hurt company image and maintain the stock in a popular trading range. d. Lastly, proposal 1 and 5 seems too extreme type of proposal and proposal 4 is average type of proposal in compare to other offer proposal 2 and 3.

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A case analysis on Farnsworth Furniture Industries

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CHAPTER III: CONCLUSION Farnsworth Furniture Industries is facing with the problem of establishment of additional $25 million of funds. It has identified several alternatives and each one of it has several provisions in it that makes Farnsworth in dilemma in choosing the best one. So throughout the case we came with several scenarios and discussed in what case the alternatives would be best to choose. While choosing the alternative we need to consider various aspects of the company. In one way the cost of flotation might be lower but it may harm the company reputation from the side of existing shareholder if issued to outsiders. Meanwhile, in other way the existing shareholder might be happy but in certain cases we might need to go for wide distribution of shares and our current choice of being limited to current shareholder might not be possible. So, choosing one alternative on the basis of cost, loyalty towards the current shareholders, or other factors may be dangerous. So, in this case also the alternative one although would have promoted the company shares in the market to large audience is not free from demerits like loss of existing rights of current shareholder. Meanwhile, the option 2 also overlaps the above problem however the subscription price and flotation cost is still higher. The alternative 3 and 5 is also not free from demerits. Thus eventfully we come to choose alternative 4 due to low floatation cost; subscription price is lower and no outrage from existing shareholder. Hence several factors do play crucial role in issue of additional funds in form of common stock because it affects the compa nys flexibility, control and dilution of ownership.

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