Precision Tool Company

Kerrianne Dugan
Melissa Rosemond
Adriana Gladness
Amanda Tabshey
Rose Gallagher

1. X Using the data in Table 2, calculate the total flotation costs as a percentage of external funds
raised. How does this amount compare with published averages for the cost of selling new
common stock? (ignore value of the options)
Flotation costs include both the underwriting spread and the costs incurred by the
issuing company from the offering.
Underwriting costs & fees= $357,000 + 63,000= 420,000 (page 31)
External funds= 8,355,000 (page 31)
Total Flotation costs as a percentage of external funds raised: 420,000/8,355,000= 5.03%

2. Assume that precision tool’s stock price one year from now has the following probability
distribution:
a. What is the additional expected dollar benefit to Aberwald, Butler, Van Buren &
Company from the option package?

Probabilities Price
0.05 $ 3.50 $ 0.18
0.10 $ 7.00 $ 0.70
0.35 $ 12.50 $ 4.38
0.35 $ 13.90 $ 4.87
0.10 $ 19.40 $ 1.94
0.05 $ 22.90 $ 1.15
$ 13.20

$ 13.20 $ 8.50 $ 4.70

$ 4.70 $ 705,000
150,000

Calculations were found by the following:

Multiplied probability by probable price, summed it, and subtracted the price they
originally paid per share which was $8.50, then took that difference and multiplied it by the
number of shares Parks, Van Buren & Co. own which is 150K. That equal $705,000 which is the
dollar benefit Parks, Van Buren & Co. could expect from the options package.)
 b. Disregarding the time value of money, what would be the total underwriting expense
expressed as a percentage of funds raised.

Previous Cost Additional Dollar Benefit

$7,140,000 $ 705,000 $7,845,000 $392,250
$392,250 $ 63,000 $455,250
$455,250 $ 9,480,000 4.80%

Calculations were found by the following:

Added $705,000 to $7,140,000 which equals $7,845,000, 5% of that is $392,250, add the additional
$63K from page 31 Table 2 which equals $455,250, Add 705K from part a to $8755000 which equals
$9,480,000 which would be the new Public Stockholders total amount, then divide $455,250 by
$9,480,000 which equals 4.80%)

3. Considering that the public would be paying $8.50 per share, should Rodriguez and Fulton be
allowed to purchase their shares for $1.00? Should the public be informed that the “insiders” are
paying a lower price, and if so, how?
We have considered the public paying $8.50 per share while Aberwald, Butler, Van Buren &
Co. will be paying $1.00 per share. We feel the public need not know our employees price per share
since personal employee contract are not public. Giving that information would be irrelevant to the
public. We also considered that fact that the price differential could be the result of stock options in
their contracts.

4. In light of your answer to Question 3, should Aberwald, Butler, Van Buren & Company be
allowed to purchase its shares at $1.00 per share?
We believe that Aberwald, Butler, Van Buren Company should be allowed to purchase
its shares at $1.00 per share. If the Precision Tool Company believes that $1 is too low to sell the
securities to the underwriter, the shares should at least be sold at a discount. The investment
bank should not buy the shares at the same price of the public. Since there is only one
underwriter for the company they take on all of the risk associated with buying and reselling the
securities. Even if the securities don’t sell, Precision Tool Company is still guaranteed the funds.
Since the investment bank is purchasing almost the same amount of shares as the owners they
should be entitled to a discount. By having the investment bank sell their company shares it
makes the stock more marketable.

5. X As stated at the beginning of the case, Rodriguez & Fulton are motivated partly by the urge to
own and run their own firm. What would be the partners’ ownership position under the
proposal?
By entering into a partnership agreement, Rodriguez and Fulton will each own half of
the company. They will share the debts and liabilities of the company as well as the profits. A
 partnership offers tax advantages for the company because they will only be taxed once at a
personal level.

6. One goal of the proposal is to generate excess cash now that could potentially be used in the
future for acquisitions. What are the pros and cons of raising the funds now rather than when
needed?

PROS
Guaranteed funds for when they want to use it for acquisitions

Would have the funds if they encountered an emergency in which they

needed money

Create a more liquid company which would be more attractive to

potential investors
CONS
 Too much cash on the Balance Sheet

 Possible investors would question the management efficiency

and their use of cash

 Inflation ($1 today is worth more than a $1 tomorrow) Since

the cash would be worth more now the company could benefit
more from possible expansion or growth opportunities

 Forgoing any return or interest earned because they are just

holding the cash rather than investing it

7. X Now consider the junk bond financing alternative.

$6 million of “high yield” bonds, requiring an 18% coupon rate
a. Construct pro forma income statements for 1993 for the two financing alternatives.

Alternative 1: $6 million in common shares

Precision Tool Company
Income Statement
For the year ended December 31, 1993
Sales 14,135,000
COGS (-) (7,976,097)
Gross Margin 6,158,903
General/Administrative Expenses 1,945,900
Lease Expense 600,000
Depreciation 850,000
 EBIT 2,763,003
Interest Expense (850,000)
EBT 1,913,003
Taxes (40%) (-) (765,201.20)
Net Income $1,147,801.80

Alternative 2: $6million in “high yield” bonds

Precision Tool Company
Income Statement
For the year ended December 31, 1993
Sales 14,135,000
COGS (-) (7,976,097)
Gross Margin 6,158,903
General/Administrative Expenses 1,945,900
Lease Expense 600,000
Depreciation 850,000
EBIT 2,763,003
Interest Expense (1,930,000)
EBT 833,003
Taxes (40%) (-) 333,201.2
Net Income $499,801.80

Calculations:
Alternative 1:
Sales: 12,850,000*.10=1285000
12,850,000+1,285,000=14,135,000
COGS: 7,251,000/ 12,850,000=.56428
14,135,000*.56428= 7,976,097
G/A Expenses: 1769000/12,850,000=.137665
Tax rate=40% (page 30)

Alternative 2:
Sales: 12,850,000*.10=1285000
12,850,000+1,285,000=14,135,000
COGS: 7,251,000/ 12,850,000=.56428
14,135,000*.56428= 7,976,097
G/A Expenses: 1769000/12,850,000=.137665
14,135,000*.137665=1,945,900
Interest Expense: 6,000,000*.18= 1,080,000
1,080,000+850,000=1,930,000
Tax rate=40% (page 30)

b. What are the times-interest-earned, fixed charge coverage, and cash flow coverage
ratios under each alternative?
 Alternative 1:
Times-Interest-Earned: EBIT/Total Interest= 2,763,003/850,000= 3.25
Fixed Charge Coverage: same as tie?
Cash Flow Coverage: net income + depreciation and amortization/total debt payments=
(1,147,801.80+850,000)/

Alternative 2:
Times-Interest-Earned: EBIT/Total Interest= 2,763,003/1,930,000= 1.43
Fixed Charge Coverage: same as tie?
Cash Flow Coverage: net income + depreciation and amortization/total debt payments=
(499,801.80+850,000)/

8. X What should Rodriguez & Fulton’s final decision be? Fully support your answer. Are there any
other financing alternatives that should be considered?
Rodriguez and Fulton should

9. Assume that another alternative would be to use only $3 million of debt financing. In this
situation, the debt would be less risky and a 16 percent coupon would be sufficient. What would
be the leverage ratios for this scenario?

Debt/Equity = (Short-Term Debt + Long-Term Debt) / Total Equity

3,000,000 / 8,128,000

= .3691

We were told that $3 million of debt financing was going to be used. We used this number for the
Debt (numerator). Total Equity was found on the Balance Sheet.

The .3691 means that the company will comprise of 36.91% of debt

Interest Coverage = (Operating Income) / (Interest Expense)

2,380,000 / 850,000

= 2.8

Operating Income was found by calculating the following equation:

Sales-COGS = Gross Margin –General/administrative expenses-Lease expense-Depreciation

This is also equal to EBIT which was given on the company’s Balance Sheet. (2,380,000)
 Interest expense was also given on the company’s Balance Sheet. (850,000)

Debt Ratio= Total Debt/Total Assets

3,000,000 / 11,612,000

= .2584

We were told in the question that the company will be using a total debt of $3 million. We used this
number for the numerator and found total assets of 11,612,000 on the company’s balance sheet.
Since the ratio is below one it is not considered to be in good financial standing. The company may not
be able to pay its debt with their assets.

10. X Return to the $6 million debt scenario. What sales amount would result in a pro forma TIE of
1? A cash flow coverage of 1?

Times-Interest-Earned: EBIT/Total Interest

1=SALES-7,976,097-1,945,900-600,000-850,000 / 1,930,000
1= SALES -4,580,197 / 1,930,000
1*1,930,000= SALES – 4,580,197
1,930,000=SALES – 4,580,197
+4,580,197
$6,510,197 = SALES

In order to find the sales amount when TIE = 1, I set the equation equal to 1 and solved for sales. I took
the variable (sales) and subtracted COGS, Expenses and Depreciation to get Sales-4,580,197. I then just
solved the equation.