Chapter 1

INTRODUCTION

General background

Environgard Corporation, coming up with the innovation in the market with the air
pollution equipment called scrub King and Daryl pierce are the president of the
corporation which now wants to remodel the existing plant which corporation was
formed in 1980 in the Chicago area. The scrubber was an innovation in the market
and Environgard owes a large measure of its successes to the development of the
technology it embodies. Environgard Protection Agency (EPA) emission regulations
that are due to take effect in the near be future. So, Environgard has observed this
trend early and proceed to develop and test its own improved model, the scrub king
that should allow the company to regain its competitive edge.

As a threat from the market development of new scrubber which is both cheaper and
effective Environgard now need to remodel of the existing plant and to purchase new
equipment and materials to initiate the scrub king marketing program, Environgard
will need approximately $100 million of new capital. In the past, in the form of
retained earnings, Environgard has always obtained equity funds. Short term debt in
modest amounts had been used on occasion, but no interest bearing short term debt is
currently outstanding. The company borrowed $48 million at 7% in 2008 and no
additional long term funds have been acquired since that date to keep acquired since
that date to keep the level of long term debt constant

To recommend a method of financing the required $100 million, Marcia Hellreigel,

vice president and controller of Environgard Corporation learned that the funds may
be obtained by three alternatives with the discussions with the firm’s investment
bankers. They are:

1) Common Stock financing method

2) Bond financing method
3) Preferred Stock method

For the effective decision to select the best alternatives, Hellreigel made the
discussion with Williard Arenberg, Chairman of the board and the company’s major
stockholder and found that he favors the sale of bonds.

1
Arenberg believes that inflation will increase in the near future as the value of the
dollar falls against foreign currencies and the dollar price of import goes up, so by
borrowing now, the company will be able to repay its loan with cheap dollars. P/E
ratio is also relatively low at present so the sale of common stock is unappealing.

Again, with the discussion with Gilbert Kushner, a long term director and chairman
of Environgard finance committee as well as president of Kushner & Company, an
investment banking firm, Kushner disagrees with selling of bond & suggests
Hellriegel to give consideration to common stock option because the company’s
sales have experienced some sharp downturns in the past and that similar downturns
in the future would endanger the viability of the firms. The danger of a major strike
is still present and that the economy in general is in tenuous position, with some
economists predicting that if huge budget deficits are not corrected soon, the falling
dollar could precipitate a severe recession. So, Hellreigel is wondering which
alternative of financing is better for her corporation. Marcia Hellriegel, Vice
president and controller learned that funds may be obtained by three alternative
methods.

Method 1: The Company can sell common stock to net $120 per share. Since the
current price of the stock is $114 per share, flotation cost $6 per share are involved.

Method 2: The Company can privately sell 25 year, 8 percent bonds to a group of life
insurance companies. The bonds would have a sinking fund calling for the
retirement, by a lottery method, of 2 percent of the original amount of the bond issue
each year. Covenants on the bond agreement stipulate that dividends be paid only out
of earnings subsequent to the bond issue that the retained earnings of the company
could not pay dividends on the common stock. The bond agreement would also
require that the current ratio be at the level of 2:1, and the bonds would not be
callable for a period of ten Years after which has no flotation cost.

Method 3: This alternative make the available to the company is to sell 12 percent
cumulative preferred stock. The price of the preferred would be $105 per share, the
usual dividend would be $12 per share and the stock would be sold to net
Environgard $100 per share.

2
1.2 Statement of Problem:

Environgard Corporation is trying to figure out the best alternative to increase the
investment of $34 million. For this there has been three alternative i.e Common
stock, Bond and Preferred stock to fulfil the required amount of money.
1.3 Objectives:
 To analysis the case of Environgard corporation.
 To deal with the problem of case
 To find appropriate alternatives for financing.
 To recommend best alternatives to raise the capital of $ 34 million.
 To analysis the stock exchange affects over decision.

3
 Chapter 2

ANALYSIS OF CASE

Issue 1: Assuming that the new funds earn the same rate of return currently
being earned on the firm’s assets (earnings before interest and taxes\ total
assets), what would earning per share be for 2018 under each of the three
financing methods? Assume that the new outside funds are employed during the
whole year of 2018 is ignored, and retained earnings for 2018 are not employed
until 2019. Under which methods of financing alternatives, EPS is highest and
why?

Solution:

According to question, the new funds earned the same rate of return currently being
earned on the firm’s assets i.e. year 2017:

For Year Ended December 31, 2017

Particulars Amount ($ millions

Earnings before interest and tax (EBIT 161.10

2017)

Total assets (2017) $792.0

Interest charge (2017) $3.84

Tax rate (2017) 40%

First calculate the basic earning power ratio of year 2017

We have,

𝐄𝐁𝐈𝐓
Basic Earning Power ratio (2017) = 𝐓𝐀

= 161.10/ 792.0

= 0.2034

4
As per our question: Assumed that the new funds earn the same rate of return
currently being earned on the firm’s assets.

2017(EBIT/ TA) = 2018(EBIT/TA)

Then, total assets of 2017 = Existing assets + New required fund

= 792 + 100

= 892

Therefore,

2018 EBIT = Total assets × Rate of return

= 892 × .2034

= 181.4328

The calculation of EPS under the three different alternatives are:

Method 1:

Market price per share (MPS) = $114

Old number of share = 120/10 =12

Number of new share = New required capital/ MPS

= 100/114

= .877 m

EPS= (EBIT- I) (1-T)/ total number of share

= (181.4328-3.84) (1-.4)/ (3+.877)

=27.48/share

Method 2:

Sells of bond to the private life insurance company = 8%

Sinking fund = 2%

No flotation cost

The new interest rate=8% of 100= 8

5
 EPS= (EBIT-I) (1-T)/ total number of share

(181.4328-(3.84+8)(1-.4)/3

=33.92

Method 3:

Sells of cumulative Preferred stock = 12%

Market Price of preferred stock= $105

Dividend = $12

Net sold of preferred stock= $100

𝐑𝐚𝐢𝐬𝐞𝐝 𝐅𝐮𝐧𝐝𝐬
Number of New Preferred stock = 𝐌𝐏𝐒

$100 Million
= $ 105

= 0.9523 Million shares

Therefore,

Preference Dividend = 0.9523Million share × 12 Per Share

= $ 11.43 Million

Now,

(𝐄𝐁𝐈𝐓−𝐈)(𝟏−𝐓)− (𝐏𝐫𝐞𝐟𝐞𝐫𝐞𝐧𝐜𝐞 𝐝𝐢𝐯𝐢𝐝𝐞𝐧𝐝)

EPS3 = 𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐜𝐨𝐦𝐦𝐨𝐧 𝐬𝐡𝐚𝐫𝐞𝐬 𝐨𝐮𝐭𝐬𝐭𝐚𝐧𝐝𝐢𝐧𝐠

(181.4328 −$ 3.84)(1−0.4)− ($ 11.43)

= 3

= $ 31.71 per Share

6
 Table: 2.1

Particular Common Bond Preferred

Stock
Stock

EBIT 181.4328 181.4328 181.4328

Less: Old interest 3.84 3.84 3.84

Less: New interest 0 8 0

Earnings before tax 177.5928 169.5928 177.5928

Less: Tax (40%) 71.011 67.83712 71.011

Earning after interest and 106.58 101.756 106.58

tax

less: Preferred Dividend 0 0 11.43

Earnings Available to 106.58 101.756 95.134

Stock

No. of Share outstanding 3.833 3 3

EPS 27.8058 33.918 31.71

The following shows the figure of the earning per share in different alternatives:

Figure 2.1

Earning Per share

EPS
3.5
3
2.5
2
1.5
1
0.5
0
common stock bond preferred stock

7
Interpretation:

From the above table, we see that Environgard Corporation financing alternatives
under common stock, bond, and preferred stock methods. Here the old interest rate
is 3.84 in all the stock i.e. 3.84 but the new interest rate for common stock and
preferred stock is 0 where the bond has the interest of 8%. From the calculation we
can observed that EPS is highest under Debt (Bond). This is because interest is paid
before the tax under debt financing method this reduce EBT as compare to common
stock and preferred stock. This leads to less tax payer and do not increase additional
share outstanding under Debt method. So EPS is higher under Debt (Bond)
Financing method i.e. 33.918 than other alternatives i.e. common stock and
preferred.

8
Issue 2. Calculate the debt ratio at year end 2018 under each alternative method
of financing. Assume that 2018 current liabilities remain at their current level
and additions to retained earnings for 2018 would be as shown in Table 2.
Compare Environgard Corporation’s figures with the industry averages as
given in Table 4.

Solution,
𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬 + 𝐋𝐨𝐧𝐠 𝐓𝐞𝐫𝐦 𝐃𝐞𝐛𝐭
𝐃𝐞𝐛𝐭 𝐑𝐚𝐭𝐢𝐨 =
𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬

According to question,

Calculation of debt ratio under each of the three financial alternatives for generating
the required funds of $ 100 Million:

We know,

𝐓𝐨𝐭𝐚𝐥 𝐃𝐞𝐛𝐭 𝐂𝐮𝐫𝐫𝐞𝐧𝐭𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬+𝐋𝐨𝐧𝐠𝐓𝐞𝐫𝐦𝐃𝐞𝐛𝐭

Debt Ratio= 𝐓𝐨𝐭𝐚𝐥 𝐀𝐬𝐬𝐞𝐭𝐬 = 𝐓𝐨𝐭𝐚𝐥𝐀𝐬𝐬𝐞𝐭𝐬

According to question,
From the information provided in the issue1 we know that Level of Current
Liabilities for 2018 = Level of Current Liabilities for 2017
Total Liabilities and Net worth for 2018 = Total liabilities and net worth for 2017 +
Additional Capital (either as debt or common/preferred stocks) + Retained earnings
for 2018
= $792 + 100 + 70.77
=$ 962.77 million
Therefore, Total Liabilities and Net worth 2018= $ 962.77 million
We know,
Total Assets = Total Liabilities and Net worth
Thus, Total Assets 2018 = $ 962.77 million

Alternative 1: Common Stock

Total Debt = Current Liabilities + Long Term Debt
= $ 120+ $ 48
= $168 Million

9
 Debt ratio = (168 \962.77) x 100
= 17.45%

Alternative 2: Bond
Total Debt = Current Liabilities + Long Term Debt + Additional Long Term
Debt (i.e. Bond)
=$120 + $48 + $100
=$ 268 Million
Debt ratio = (268 \962.77) x 100
= 27.83%

Alternative 3: Preferred Shares Financing

Total Debt = Current Liabilities + Long Term Debt
= 120+48
= $67.2 Million
Debt ratio = (168 \962.77) x 100
= 17.45%

Table 2.1
Comparison of Debt Ratio with Industry Average

Financing Methods Debt Ratio Industry Remarks

Average
Alternative 1: 17% 35% Poor
Common stock
Alternative 2: Bond 29.65% 35% Okay
Alternative 3: 17% 35% Poor
Preferred stock
Table 2: debt ratio under each of the three financial alternatives
From our calculation we can find that debt ratio under common stock and preferred
stock is 17% which is less than industry average of 35% which leads to rely more
on equity than on debt and it is costly for Environgard but debt ratio under bond is
29.65% which is only 35% less than industry average i.e.; near to industry average.

10
 Hence, Environgard should go for debt finances rather than common stock and
preferred stock to take advantage of tax saving. The highest debt ratio of bond is
higher than that of common stock and preferred stock but less than that of average
ratio which is good for the company. Company has been able to manage the debt
ratio and collect the loan on time.

Figure : 2.1
Comparison of Debt Ratio with industry average

Chart Title

35%
30%
25%
20%
15%
10%
5%
0%
Alternative 1: Common Alternative 2: Bond Alternative 3: Preferred
stock stock

Debt Ratio Industry Average

Interpretation:

From the analysis of table and bar chart ratio that is shown is three alternative for the
Environgard corporation. The measure gives an idea to the leverage of the company
along with the potential risks the company faces in terms of its debt-load.

From the above calculation we can find that debt ratio under common stock is 17%,
debt ratio under bond is 29.65% and debt ratio under preferred stock is 17%.Industry
average is 35%. Hence under common stock it is 17% less than the industry average
so it is rely more on equity than on debt, which is costly for Environgard. Under
bond method 5.35% less than the industry average so it is near to industry average.
Under preferred stock method 17% less than the industry average so it is rely more
on equity than on debt, which is costly for Environgard. Hence to take advantage of
tax saving Environgard should go for debt financing.

11
Issue 3: Calculate the before-tax times-interest-earned coverage for 2018 under
each of the financing alternatives. Then compare Environgard Corporation’s
coverage ratio with the industry average.

Industry average.

12
Times-interest-earned coverage:

Times-interest-earned (TIE) or interest coverage ratio is a measure of a company

ability to honor its debt payment. It can be calculated either EBIT or EBITDA
divided by the total interest payable.

𝐄𝐁𝐈𝐓
𝐓𝐢𝐦𝐞𝐬 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐚𝐫𝐧𝐞𝐝 𝐜𝐨𝐯𝐞𝐫𝐚𝐠𝐞 =
𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐞𝐱𝐩𝐞𝐧𝐬𝐞𝐬

When the interest coverage ratio is smaller than one, the company is not generating
enough cash from its operations EBIT to meet its interest obligations. The company
would then have to either use cash on hand to make up the difference or borrow
funds. Typically, it is a warning sign when interest coverage falls below 2.5xs.

Alternative 1: Common Stock

Common stock refers to the shares in a company that are owned by people who have
a right to vote at the company's meetings and to receive part of the company's profits
after the holders of preferred stock have been paid.

𝐓𝐢𝐦𝐞𝐬 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐄𝐚𝐫𝐧𝐞𝐝 = 𝐄𝐁𝐈𝐓 / 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐄𝐱𝐩𝐞𝐧𝐬𝐞𝐬

= 181.43/ 3.84

= 47.25 times

Alternative 2: Bond/ Debt

A bond, also known as a fixed-income security, is a debt instrument created for the
purpose of raising capital. They are essentially loan agreements between the bond
issuer and an investor, in which the bond issuer is obligated to pay a specified
amount of money at specified future dates.

Old interest = 3.84

Interest change on bond =8%

Addition capital = 100 million

New interest rate= old interest + new interest

= 3.84 +8

= 11.84

13
Times Interest Earned = EBIT \ Interest Expenses

= 181.43/ 11.84

= 15.32 times

Alternative 3: Preferred Shares

Preferred shares represent an ownership stake in a company -- in other words, a

claim on its assets and earnings. However, as the term suggests, "preferred" shares
carry certain advantages. While preferred shares usually do not carry the same voting
rights as common shares, they do have priority when it comes to dividends and
bankruptcy. And like common shares, preferred shares can be bought and sold
through a broker.

Times Interest Earned = EBIT \ Interest Expenses

= 181.43/ 3.84

= 47.25 times

Analytical Table 3:1

Financing Methods Times Interest Industry Remarks

Earned Average
Common stock 47.27 9x Poor
Bond 15.32 9x Good
Preferred stock 47.25 9x Poor

Fig 3.1: Time interest earned coverage ratio

14
 Chart Title

60

50

40

30

20

10

0
Common stock Bond Preferred stock

Times Interest Earned Industry Average

Interpretation

TIE ratio under the entire alternative is higher than industry average. However, TIE
ratio under common stock and preference stock is much higher than average. So,
based on TIE Ratio Company can option for issue of common stock and preference
stock share.

The industry average for Times-interest-earned is 9 times. The times interest earned
ratio for Environgard in the year 2018 is 55.67 times for the common stock financing
and preferred stock financing, whereas for bond financing the TIE is 13.97 times.

The times interest earned under common stock financing and preferred stock
financing are extremely high i.e. 55.67 times. This shows that, Environgard has not
been using debt financing much than common stock and preferred stock. The TIE of
13.97 times in case of bond financing is good and little high than the industry
average. This shows that the company has a good mix of debt and equity financing
and it has earnings available for meeting its debt obligation.

15
Issue 4: Calculate the fixed charge coverage under each of the three
alternatives for the year 2018. Ignore the sinking fund payment in the debt
alternative. Then compare your results with the industry average. Calculate
the debt service coverage ratio (the fixed coverage ratio including the
sinking fund payment) for the bond alternative. What effect will the sinking
fund covenant have on Environgard Corporation’s ability to meet its other
fixed charges? Do you think that the company will be able to meet fixed
obligations? In the event that the company incurred a loss, do you think that
the company can meet the fixed obligations?

Calculation of the fixed charge coverage under each of the three alternatives
for the year 2018:

Fixed Charge Coverage Ratio

The fixed charge coverage ratio is used to examine the extent to which fixed costs
consume the cash flow of a business. The ratio is most commonly applied when a
company has incurred a large amount of debt and must make ongoing interest
payments. If the resulting ratio is low, it is a strong indicator that any subsequent
drop in the profits of a business may bring about its failure. Conversely, a high ratio
indicates that a business can safely use more debt to fund its growth. The ratio is
typically used by lenders evaluating an existing or prospective borrower.

To calculate the fixed charge coverage ratio, combine earnings before interest and
taxes with any lease expense, and then divide by the combined total of interest
expense and lease expense. This ratio is intended to show estimated future results, so
it is acceptable to drop from the calculation any expenses that are about to expire.

The formula is:

Fixed Charge Coverage

EBIT (Earnings before Interest and tax)

16
In accounting and finance, earnings before interest and taxes (EBIT) are a measure of
a firm's profit that excludes all expenses except interest and income tax expenses. It
is the difference between operating revenues and operating expenses. When a firm
does not have non-operating income, operating income is sometimes used as a
synonym for EBIT and operating profit.

Lease obligation

In a lease, the property owner (lessor) gives the right to use property to a third party
(lessee) in exchange for a series of rental payments. The accounting for lease
obligations is determined based on the substance of the transaction.

Interest Expenses

This account is a non-operating or "other" expense for the cost of borrowed money
or other credit. The amount of interest expense appearing on the income statement is
the cost of the money that was used during the time interval shown in the heading of
the income statement, not the amount of interest paid during that period of time.

Alternative 4.1: Common Stock Financing

EBIT(2018) $ 181.43 Million

Lease obligations $ 7.2 Million

Interest Expense $ 3.84Million

Fixed Charge Coverage = 181.43+7.2/3.84+7.2

= 17.08 times

Alternative 2: Bond/Debt Financing

EBIT = 181.43

Interest rate = old + new interest

17
 = 3.84 + (8% of 100)

=$ 11.84

Fixed Charge Coverage = 181.43+7.2/11.84+7.2

= 188.63/19.04

= 9.90 times

Alternative 3: Preferred Shares Financing

Interest rate = 3.84

Fixed Charge Coverage = 181.43+7.2/3.84+7.2

=17.08 times

Analytical Table 4.2

Financing Methods Fixed Charge Industry Remarks

Coverage Average
Alternative 1: Common 17.08x 6x High
stock
Alternative 2: Bond 9.90x 6x Good
Alternative 3: Preferred 17.08x 6x High
stock
Table 3: the fixed charge coverage under each of the three alternatives for the year
2018

18
 Fig 4.1: Fixed Charge Coverage Ratio

Chart Title

18
16
14
12
10
8
6
4
2
0
Alternative 1: Common Alternative 2: Bond Alternative 3: Preferred
stock stock

Fixed Charge Coverage Industry Average

Interpretation:

Fixed Charge coverage ratio is the ratio that indicates a firm's ability to satisfy fixed
financing expenses, such as interest and leases. The table above shows that the
industry average is lower than all the three alternatives of financing. Higher the
coverage ratio, higher will be firm’s ability to cover the fixed charges. So, under all
the three alternatives, the company has the ability to cover the fixed charges like
interest and lease payments.

Debt service coverage ratio

The debt service coverage ratio (DSCR), also known as "debt coverage ratio" (DCR),
is the ratio of cash available for debt servicing to interest, principal and lease
payments. It is a popular benchmark used in the measurement of an entity's (person
or corporation) ability to produce enough cash to cover its debt (including lease)
payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also
used in commercial banking and may be expressed as a minimum ratio that is
acceptable to a lender; it may be a loan condition. Breaching a DSCR covenant can,
in some circumstances, be an act of default.

19
The formula is:

Debt Service Coverage =

Calculation of Debt Service Coverage for bond:

Given that,

EBIT= $191.43 million

Lease Obligation= $7.2 million

Interest Expense= $3.84 + 8 million= 11.84

Sinking Fund =2% of 100 million

Debt Service Coverage = 181.143+7.2 / 11.84+7.2+2

= 188.343\ 2

= 8.95 times

Interpretation

The debt service coverage ratio (DSCR), also known as "debt coverage ratio." (DCR)
is the ratio of cash available for debt servicing to interest, principal and lease
payments. The debt service coverage ratio of Environgard Corporation being 8.95
times shows that the amount of cash flows is available to meet annual interest and
principal payments on debt, including sinking fund payments.

The Debt Service Coverage Ratio is the ratio of cash available for debt
servicing to interest, principal and lease payment. The higher debt service
coverage ratio, the easier it is easier to obtain loan. It refers to the
measurement of the firms’ ability to produce enough amount cash to meet
annual interest and principal payment on debt, including sinking fund
payment.
20
If the Environgard Corporation incurred a loss than it will not able to meet the fixed
obligation because EBIT becomes negative it will cause coverage ratio and fixed
charge coverage ratio will also have negative value.

21
Issue 5: Assume that after the new capital is raised, fixed operating charges are
$60 million (not including depreciation) and the ratio of variable cost to sales
stays the same. How much would sales have to drop before the equity financing
would be preferable to debt in terms of EPS? (Hint: calculate the breakeven
level of sales at which EPS will be equal under bond or stock financing.)

According to question, ratio of variable cost to sales stays the same.

Cost of goods Sold = $564

Depreciation = $48

Sales = $762.0

Variable cost to sales = (Cost of Goods Sold- Depreciation)

Sales

=$564-$48 = 516\ 762.0

$762.0

= 0.6771%

Variable cost to sales explains that variable cost covers 67.71% of sales revenue.

Again,
We have,

Under debt financing:

Interest = 3.84 + 8% of 100 = 11.84

Number of share = 3 million

Under common stock financing:

Interest = 3.84

Number of share = 3.833

22
 For the computation of indifference point of common stock and bond:
EPS on bond financing=EPS on common stock financing

Or, EBIT−interest on debt financing EBIT−interest on common stock

Number of shares Numbers of shares

Or, EBIT−11.84 = EBIT−3.84

3 3.877

Or, 3.833(EBIT−11.84) = 3 (EBIT−3.84)

Or, EBIT−11.84 = 0.78 (EBIT−3.84)

Or, EBIT−11.84 = .78 EBIT−2.99

Or, .78EBIT – EBIT = 11.84 −2.99

Or, 0.22 EBIT= 8.85

EBIT= $40.23 Million

EBIT ($ 40.23 million) be the indifference point between debt financing and
common stock financing. This point is the intersection of the debt financing line and
the common stock line in the graph.

According to question,

Fixed operating charges = $60 Million (excluding depreciation)

Depreciation = $48 Million

Therefore,

Total fixed operating charges (F) =$60+$48

=$108 million (including depreciation)

Let, the Break-even sales for 2018 are S1, and then the variable cost for 2018 will be,

V=0.6771 x S1

23
Since, the fixed operating charges include the depreciation the total depreciation
amount to $48 million. This will be used in the calculation of breakeven sales level.

For the calculation of breakeven level of sales: (when the EBIT is 40.23)

EBIT = S1-V- F

Or, 40.23 = S1- (0.6771 x S1) – 108

Or, 148.23= S1 -0.6771S1

Or, 148.23 = 0.3229S1

S1= 459.058

Breakeven sales (S1) =$459.058 Million

Hence, the breakeven sales when EBIT = 40.23 is 459.08 million.

Again, from question 1 as we have kept the same rate of return we found EBIT2018 to
be $181.43. Let, the Break-even sales for 2018 are S2.

We have,

EBIT 2018 = S2 - V - F

Or, $181.43 = S2 - (0.6771 X S2) – 60

Or, $241.43= 0.3229S2

Sales (S2) = $ 747.69Million

With the EBIT 2018 = 181.43, we get breakeven sales to be $747.69 Million.

24
 Common stock

33.92

27.80
1.2
Indifference point
between stock and bond
financing

EBIT
3.84
11.84 40.23 181.43

Fig 5.1: Graphical presentation showing indifference point

From the graphical presentation alongside, the indifference point between stock and
0
bond financing is $40.23. As we know from the figure if the EBIT is greater than
40.23 then firm should use Debt financing because the earning per share is higher in
the debt financing line, left to the indifference point, while comparing debt line and
common stock line in the corresponding EBIT. And if the EBIT of the firm is lower
than the 40.23 the firm should stick with common stock financing, since the earning
per share of common stock line is higher than debt line in the corresponding EBIT.

At the present condition the company, debt financing best suits for the financing for
future expansion. But if the company wants to choose equity financing the company
must decrease its sales from $747.69 to $310.40. $310.40 being sales breakeven of
the indifference point, the company can choose from debt financing or equity
financing. If the company decreases sales by more than $310.40 than equity
financing is more preferable to debt financing. Since, the EPS would be higher below
the indifference point of 40.23.
For the percentage decrease the company should decrease by 58.48%

($747.69-$310.40)/($747.69)=58.48%

25
Issue 6: Based on the data developed in Questions 2, 3, and 4, discuss the pros
and cons of each of the financing methods that Hellriegel is considering.

Solution:

 Common Stock

Pros of common stock

 The offering of common stock has the potential to raise large amounts of
money.
 Environgard does not need to make obligatory interest payments to investors
and instead can make discretionary dividend payments when it has extra cash.
 Rather than adding more debt to a company's balance sheet Environgard
Company can take a less expensive by issuing common stock.
 There is no maturity date on the security so Environgard will not have the
burden of paying back the capital like in case of bonds.

Cons of common stock

 There is loss of control of the management within the company as it provides

voting rights to the holders to elect the board of directors.
 The extensive research and IPO decision-making process can be quite costly
to Environgard owners. These costs are part of the risks that Environgard
must assume during the stock offering process.
 Dividends paid to common shareholders are not tax deductible.

Bond

Pros of bonds

 Bonds offer safety of principal and periodic interest income, which is the
product of the stated interest rate or coupon rate and the principal or face
value of the bond.
 The cost of bonds to Environgard is fixed as interest and principal. The
dividend payments to shareholders are not tax deductible as dividends are
distributed using after-tax profits will not change with change in Environgard
earnings.

26
  The ownership interest in the corporation will not be diluted by adding more
bond holders. So it will not dilute earnings per share or control within the
company.
 Interest payments are tax deductible and beneficial for Environgard as
interest expenses paid on bonds are subtracted from revenue to arrive at a
lower taxable corporate income for the company.

Cons of bonds

 The disadvantages of bonds include rising interest rates, market volatility and
credit risk. Bond prices rise when rates fall and fall when rates rise. Bond
market volatility could affect the prices of individual bonds, regardless of the
issuers' underlying fundamentals.
 Environgard will have the legal obligations to pay the fixed charges or
interest regardless of available earnings or cash flow to the corporation.
 Bonds have a maturity date and the capital invested must be repaid to
investors. So, Environgard cannot utilize the fund for lifetime of the business
as it has to repay at the time of maturity.
 The issuance of bonds adds more risk to the Environgard Corporation as
nonpayment of interest and principal may result to bankrupt.

Preferred Stock

Pros of preferred stock:

 Preferred stock payments are fixed and the company does not need to pay
higher dividends in case of higher earnings.
 If a corporation cannot pay its preferred shareholders, the company can pay
later, when it has the ability to pay. In the event of a corporate bankruptcy,
preferred shareholders do not receive dividends until the company's creditors
are paid. So, preferred stock helps to reduce some of the burdens during its
hard times.
 It carries no voting rights, so Hellriegel will be able to keep full control over
the company.

27
Cons of preferred stock:

 It may be difficult to sell preferred stock, since returns are fixed and the
company's preferred stock price is hard to track.
 Issuance of preferred stock will burden the company with inescapable
preferred dividend payments, given that most preferred stocks are
cumulative. So, Environgard have to pay all the accumulated dividends from
its future prosper earnings.
 The dividends from preferred stock are not tax deductible as dividends are
distributed using after-tax profits. Thus, a company's preferred dividend
expense results to a higher taxable corporate income for the company.
Preferred holders will require a higher rate of return than bond holders because they
are second in repayment in event of a default which adds cost to the corporation

28
Issue 7: Determine the PE ratio for 2017. If the goal is to maximize the price of
firm’s stock, calculate the prices of common stock for 2018 under various
financing arrangement for PE ratio of 18, 16 , 15 ,14, 13, 12 and 10 times.
Which alternative as the higher market price per share.

Solution:

The price earnings ratio, often called the P/E ratio or price earnings ratio, is a market
prospect ratio that calculates the market value of a stock relative to its earnings by
comparing the market price per share by the earnings per share. In the word, the
price earnings ratio shows what the market is willing to pay for a stock based on its
current earnings.

Mathematically,
Market Price per share
Price Earning Ratio 2017 =
Earning per share

Earnings per share = net income \ number of share

= 94.36/ 3 = 31.45

= 114\ 31.45

= 3.625 x

Interpretation: As the Price earnings ratio is widely used to know the earning
potentiality of the common shareholders’ investment in the company on a per share
basis. Higher the ratios better the performance of the firm. However, 3.48x is less
than the industry average i.e. 18 which shows that the company is less attractive for
the common stock investor.

29
Calculation of market price per share for 2018 in different financing alternatives; if
PE ratios are: 18, 16, 15, 14, 13, 12, and 10 times.

Table 7.1: Market price in different Alternative

PE ratio in times Market price in different Alternative

Common stock Bond Preferred

27.805*PE ratio 33.918*PE ratio 31.71*PE ratio
18 500.49 610.05 570.78
16 444.88 542.69 507.36
15 417.075 508.77 475.65
14 389.27 474.85 443.94
13 361.465 440.934 412.23
12 333.66 407.016 380.52
10 278.05 339.18 317.1
From the above table P/E ratio is increasing. This is the result of financing that is
made though bond it will not increase the numbers of common share outstanding.
Net profit is divisible for existing common shareholders. This will increase Earnings
per Share (EPS). And higher EPS in a given PE ratio yields higher market price per
share (MPS).

Figure : 7.1

Common Stock
60

50

40

30

20

10

0
18 16 15 14 13 12 10

Common Stock

30
The figure shows the market price of the common stock. Here, when price earnings
ratio is 18 times the market price of common stock is 500.22. Likewise when the
price earnings ratio is the lowest i.e. 10 times then the market price of common stock
is 277.9.

Working Note:

For Common Stock

 If the PE ratio is 18 times ,

Common stock= 27.80

Market price per share= PE ratio × Common stock

= 18×27.80

=500.4

 For 16 times,

Market price per share= PE ratio × Common stock

=16×27.80

=444.80

 For 15 times,

Market price per share= PE ratio × Common stock

=15×27.80

=417.00

For 14 times,

Market price per share= PE ratio × Common stock

=14×27.80

=389.20

 For 13 times,

31
Market price per share= PE ratio × Common stock

=13×27.80

=361.40

 For 12 times,

Market price per share= PE ratio × Common stock

=12×27.80

=333.60

 For 10 times,

Market price per share= PE ratio × Common stock

=10×27.80

=278.00

For Bond:

A bond is a fixed income investment in which an investor loans money to an entity

(typically corporate or governmental) which borrows the funds for a defined period
of time at a variable or fixed interest rate. Bonds are used by companies,
municipalities, states and sovereign governments to raise money and finance a
variety of projects and activities. Owners of bonds are debt holders, or creditors, of
the issuer.

If the PE ratio = 18 times,

Market price per share= PE ratio × Bond

=18×33.918

=610.524

32
  For 16 times,

Market price per share= PE ratio × Bond

=16×33.918

=542.688

 For 15 times,

Market price per share= PE ratio × Bond

=15×33.918

=508.77

 For 14 times,

Market price per share= PE ratio × Bond

=14×33.918

=474.852

 For 13 times,

Market price per share= PE ratio × Bond

=13×33.918

=440.934

 For 12 times,

Market price per share= PE ratio × Bond

=12×33.918

=407.016

33
  For 10 times,

Market price per share= PE ratio × Bond

=10×33.918

=339.18

Figure : 7.2

Bond
60

50

40

30

20

10

0
18 16 15 14 13 12 10

Bond

The figure shows the market price of the debt financing. Here, when price earnings
ratio is 18 times the market price of debt is 610.38 Likewise when the price earnings
ratio is the lowest i.e. 10 times then the market price of common stock is 339.1.

For Preferred Stock :

A preferred stock is a class of ownership in a corporation that has a higher claim on

its assets and earnings than common stock. Preferred shares generally have
a dividend that must be paid out before dividends to common shareholders, and the
shares usually do not carry voting rights.

If the PE ratio=18

Market price per share= PE ratio × preferred stock

34
 =18×31.71

=570.78

 For 16 times,

Market price per share= PE ratio × preferred stock

=16×31.71

=507.36

 For 15 times,

Market price per share= PE ratio × preferred stock

=15×31.71

=475.65

 For 14 times,

Market price per share= PE ratio × preferred stock

=14×31.71

=443.94

 For 13 times,

Market price per share= PE ratio × preferred stock

=13×31.71

=412.23

 For 12 times,

Market price per share= PE ratio × preferred stock

=12×31.71

35
 =380.52

 For 10 times,

Market price per share= PE ratio × preferred stock

=10×31.71

=317.1

Preferred stock market place

Figure : 8.3

Preferred stock
50
45
40
35
30
25
20
15
10
5
0
18 16 15 14 13 12 10

Preferred stock

The figure shows the market price of the preferred stock financing. Here, when price
earnings ratio is 18 times the market price of preferred stock is 370.78. Likewise
when the price earnings ratio is the lowest i.e. 10 times then the market price of
preferred stock is 317.1.

Over all on this, we can clearly see that financing alternatives 2 i.e. bond financing
have higher market price per share at higher PE ratio. (i.e. when the PE ratio is 18
times the market price per share is 500.22 which is the highest) In addition to this,
financing in bond yields higher market price per share at lower PE ratio.(i.e. when
the PE ratio is 10 times then the market price per share is 277.9 which is also higher
in comparison to other stocks) This is because if financing is made through bond it

36
will not increase the number of common stock outstanding. Net profit is divisible for
existing common shareholders. This will increase Earnings per share (EPS). And
higher EPS in a given PE ratio yields higher market price per share (MPS)

37
Issue 8: Calculate the profit after taxes to total assets and profit after tax to net
worth for 2018 under each of the alternative. Then compare these ratio with
industry averages under each of the alternatives.

Solution:
a. Calculation of profit after tax to total assets for 2018 under each of the
financing alternatives;
Profit after Tax to total assets = Net profit after tax / total assets
= (EBIT –I) (1-T) \ total assets
For common stock:
Total assets : current Assets + Fixed assets +New capital
=312+ 480+ 100 =892

Profit after taxes to total assets2018 = (EBIT-I) (1-T)/ total assets

(181.43−3.84)(1−0.40)
= 892

= 106.554/892= 0.1195
=11.95%
Using the alternative of common stock financing the company is able to generate
11.95% as profit using total asset of $892 million.
For Bond :
Profit after taxes to total assets 2018 = (181.43-(3.84+8)(1-0.40))/892

= 101.756/892=0.1140

=11.40%

With the financing the company is able to generate 11.40% profit using its total
assets.

For preferred stock:

Profit after taxes to total assets = (181.43-3.84)(1-0.40))/892

= 106.554/892= 0.1195

=11.95%

38
Similarly the preferred stock financing the company is able to generate the 11.95%
as profit using total assets of 892 million.

Table 8.1

Financing alternatives Profit after tax to total Industry average

assets

1.Common stock 11.95% 8%

2.Bond 11.40% 8%

3.Preferred stock 11.95% 8%

Figure : 8.1 Comparison of profit after taxes to total assets

Chart Title
12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

0.00%
Common Stock Bond Preferred Stock

Profit after taxes to total asset Industry Average

The figure shows the comparison of profit after tax to total assets of three financing
method with the industry average. Profit after taxes to total assets is higher than
industry averages in three different financing alternatives. Financing alternatives 2
i.e. debt financing yield lower profit after taxes to total assets due to the treatment of
39
interest as expenses which reduces net profit after tax. But the company can enjoy
tax saving on interest expenses.

Finally, Profit after taxes on total assets measure how well a company uses it capital
structure to generate the income, rather than by using leverage. Regardless the
company size the ROA shows ability if the firm to generate profit with the efficient
utilization of its assets.

Comparing the profit after the tax of all the alternatives with the industry, we find
that the all the alternatives have higher ROA than the industry average. But if we
compare those alternatives individually, debt financing’s ROA is lower than the
common stock and the preferred stock. The ROA takes into the interest expense
account, the profit after the tax of debt financing decreases due to its interest
payment of 8% of 100 million which ultimately decrease the ROA. Since, preferred
stock and common stock does not involve interest payment there is no additional
interest charge, which gives a higher ROA than debt financing. The interest expenses
of 11.84 million is tax deducted and with the low tax payment the company is able to
increase reserve cash that will be added to the retained earning.

Calculation of profit after taxes to net worth for 2018 under each of the
financial alternatives:

Profit after tax to net worth= Net profit after tax \

Net worth :

For common stock :

Profit after taxes to net worth = (EBIT –I) (1-T) / ROE

ROE= Common stock + Retained earning + new capital

= 30+ 594+ 100

= 724

Then,

= (181.43-3.84)(1-.04)/ 724

40
= 106.554/724

=0.1472 = 14.72%

ROE under common stock financing explains the ability of firm to generate 14.71%
profit utilizing $724 million of equity.
For bond:

ROE= Retained earning + Common stock/ par

= 594 + 30\10

=597

Then,

= 101.754/ 597

=17.05%

With ROE under debt financing explains the ability of firm to generate =17.04%
profit utilizing $597 million of equity

For Preferred stock:

= 106.554 \7.24

=14.71%

ROE under the preferred share financing explain the ability of firm to generate the
14.71 % of profit utilizing $724 million of equity.

106.554m
Profit after taxes net worth 2018= 724m

=14.71%
ROE under preferred share financing explains the ability of firm to generate 14.71%
profit utilizing $724 million of equity.
TABLE : 9.2
Financial Alternative Profit after taxes/net Industry Average
worth

41
Common stocks 14.71% 12%

Bond 17.04% 12%

Preferred stock 14.71% 12%

The table shows profit after taxes to net worth. The profit after taxes to net worth of
two alternatives common stock financing and preferred stock financing is equal i.e.
14.71% as it do not bear any extra interest. Likewise the debt financing have interest
of 2 million extra so its profit after taxes to net worth is more than that of other
alternative.

Figure 9.2 Comparison of profit after taxes to total assets

Chart Title
14.5

14

13.5

13

12.5

12

11.5

11

10.5
common stock Bond Preferred Stock

profit after taxes to net worth Industry average

The figure shows the profit after taxes to net worth. The highest profit after taxes to
net worth is of debt financing i.e. of 14.71%. This is because interest in debt is tax-
deductible and it is fixed charge bearing financial alternative. In case of executing
highly profitable project financing from debt will lead to the increased profit after
taxes/net worth. The profit after tax to net worth of common stock financing and
preferred stock financing are similar.

42
Comparing profit after taxes/net worth of the company to its industry average of
financing alternatives, we get all three get all three alternatives satisfactory as they
are greater than industry averages. In relative term financing alternative 2 i.e. debt
financing has higher profit after taxes/ net worth. This is because interest in debt is
tax-deductible and it is fixed charge bearing financial alternative. In case of
executing highly profitable project financing from debt will lead to the increased
profit after taxes/net worth. This provides with the opportunity with huge Profit
Company has to pay only fixed portion to its creditors and providing higher return to
shareholders.

43
Issue 9:
How does stock exchange membership affect the decision?

Solution:

A stock exchange is the platform which provides services for stock brokers and
traders to trade the stocks bonds and others securities. Stock exchanges also provides
facilities for issue and redemption of securities and other financial instruments and
capital events includes share issued by companies unit trust, derivatives, pooled
investment products and bonds.

For trading securities on a stock exchange it must be listed in the securities board as
there is a central location and physical place as modern markets are electronic
networks which gives them advantages of increase speed and reduced cost of
transaction trade on an exchange is by the members only.

Benefits

The advantages of stock exchange are as pointed below:

 Creating a market for the company's shares.

 Enhancing the status and financial standing of the company.
 Increasing public awareness and public interest in the company and its
products.
 Providing the company with an opportunity to implement share option
schemes for their employees.
 Accessing to additional fund raising in the future by means of new issues of
shares or other securities.
 Facilitating acquisition opportunities by use of the company's shares and
Offering existing shareholders a ready means of realizing their investments.

In case Environgard corporation American stock exchange will surely help in

increasing its capital. The company can sale its common stock and released its

44
preferred stocks but Environgard corporation is a small firm having a total assets of a
only $792 million. The company can sell 8% of bonds for the period of 25 years, this
can help the company to minimized the cost like floating cost, thus the stock
exchange membership doesn’t affect decision by much extent because the option of
selling its shares doesn’t yield better profit to the company.

45
46
Issue 10: Do you think 2:1 current ratio requirement appear too restrictive?
And also do you think that covenant prohibiting the payment of dividends out
of retained earnings appears to be overly burdensome?
Current ratio is a financial ratio that measures whether a firm has enough resources
to pay its debts over the next 12 months. It compares a firm's current assets to
its current liabilities. It is expressed as follows

Current ratio = Current Assets \ Current Liabilities

Current ratio also indicates that how many assets is being used to pay the liabilities
of the company. If a company has its current ratio of 1:1, then it means that all the
assets is being used to pay its liabilities. This means that all of the assets are liquid
enough to pay the debts of the company.

In the case study of Environgard Corporation the company has to maintain the
current ratio of 2:1. This means that the company should have the assets twice as
much as its liabilities. This restricts the company to have half of its assets stalled
without any liquidity, as only half of the assets is required to pay its liabilities. By the
end of 2017, the company had the current assets of value $312 million and current
liabilities of value $120 million, resulting to the current ratio of 2.6:1, still exceeding
the company requirements.

Since Environgard Corp. is a small firm, it is beneficial to have lesser current ratio,
somewhere between 1 and 2. So, the current ratio requirement of 2:1 seems to be too
restrictive. This forces the company to have half of its current assets unused to pay
liabilities when needed.

No, the covenant prohibiting the payment of dividends out of retained earnings
doesn’t appear to be overly burdensome. Actually it is beneficial for the company if
the dividends are not paid out of retained earnings. Retained earnings are used for
development, expansion and investment process of the company.

If the dividends are paid out of retained earnings, there will be lesser amount to fund
any kind of investment for the company. In the context of Environgard Corp, the
company has to find ways to fund for its new expansion project of installing new
modeling plant, which will cost approximately $100 million to the company. The

47
retained earnings by the end of 2017 is $70.77. This means that the company has to
look for external equity of $29.23 million only, which would have increased if the
dividends are paid out of the retained earnings. Looking at this perspective, the
covenant prohibiting the payment of dividends out of retained earnings appears to be
less burdensome, thus covering greater part for its investment on its new plant.

48
Issue 11: What would you recommend to the board?
Solution:

From the analyzing the case issues from 1 to 10, it can be concluded that Bond
financing is the best option for Environgard Corporation. Being a company with
large percentage of the stock ownership by family members and limited geographic
distribution of shares, Stock option won’t be fruitful as management might be
reluctant to reduce majority shareholding by raising funds through shares.

The Earning per Share of the bond financing indicates the highest profitability
situation. We can clear from the following table:

Financing method Earnings per share

Plan A: stock financing 27.808

Plan B: Bond financing 33.918 ( Best alternative)

Plan C: preferred stock financing 31.71

The EPS under Bond Financing is higher because the interest on debt is deducted
before taxes, while in preferred stock, dividends are deducted after taxes.

Industry Debt Ratio is 35%, however, Environgard`s Debt Ratio under the three
alternate financing methods are lower than the industry average. Environgard is
relying on too less debt and more on equity financing, which is costly. Environgard
should opt to debt financing is any fund required so as to be in par with the industry
standards and take advantages of tax savings from debts as they are tax deductible.

The times interest earned ratio for Environgard in the year 2017 is 47.25times for the
common stock financing and preferred stock financing, whereas for bond financing
the TIE is 15.32 times, compared to the industry average of 9 times. Thus, bond
financing should be opted as it has earnings enough to meet interest obligations.

Higher Fixed Charge and Debt Charge Coverage Ratio shows that the firm has
ability to cover the fixed charges like interest and sinking funds. Thus, Environgard

49
can use Bond Financing. As the Market Price of Share under Debt financing is the
highest, under various price earnings ratio.

So, from overall analysis we could prefer Debt Financing and recommend to the
board for raising the capital of 100 million from bond financing and which could be
best alternative for the Environgard Corporation.

Issue 12: What are the lessons learnt from the case ?
1. We learnt to calculate EBIT, EPS, TIE, CR, DR, FC, VC, IPO, MPS,
NEPSE, OTC, P/E Ratio, Sales etc.
2. Bond financing is the best alternative among others.
3. TIE ratio is also satisfactory to meet the obligations.
4. ROE is highest among the options.
5. ROA is above the Industry average under bond alternative.

50