9 case 8 johnson window company capital structure directed as a

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Case 8

Johnson Window Company

Capital Structure

Directed

As a builder in San Diego, Mark Johnson observed a rapid expansion in the use of custom win­dows and window treatments such as vertical blinds and drapes in both residential and commercial construction. People wanted to bring as much natural light as possible into their buildings, but large window footages typically increased the cost of heating and cooling by an unreasonable amount. The obvious solution was an improved-design, better-quality window. To capitalize on what he thought was a huge potential market, Johnson designed and patented a new type of tinted glass window which changed tint as the brightness of the sun changed. As the sun became brighter, the glass in the window would become darker and vice versa. In addition, the customer could select the initial tint level and tint color. Johnson felt the new glass would be particularly well-suited for office and apartment buildings which contain a lot of window footage. Although windows made with the new glass were nearly 75 percent greater in price than traditional glass windows, a feasibility study conducted by an outside engineering firm estimates that, over a period of five years, the sav­ings associated with lower heating and cooling costs would more than make up for the price differ­ence. Furthermore, the advantage of maintaining a constant level of brightness inside the building would be a plus to many purchasers.

Even before the patent was issued, Johnson began to organize a firm to manufacture the tinted windows. To start, he teamed up with a production engineer and a finance specialist. John Phillips, the engineer, brought manufacturing know-how to the firm, while Lori Gibbs, who had majored in finance, was responsible for finance and accounting. Each of them agreed to invest both time and money in the new business. They, along with Johnson, would have a significant owner­ship interest. Although the three founders would need additional capital, they anticipated little trouble in raising outside debt or equity capital because of good reports on the product and strong population growth in the sunbelt region. In fact, several local banks and regional insurance compa­nies had already expressed an interest in providing debt capital, and a regional brokerage firm which specializes in start-up financing had expressed an interest in supplying equity venture capital.

A local attorney advised Johnson, Phillips, and Gibbs that the business should be incorpo­rated immediately, before any outside capital is raised. The attorney also suggested that 10 million shares be authorized in the corporate charter and that a par value of $0.10 per share be assigned. The founders agreed with these recommendations and decided to issue shares to themselves at a price of $0.10 each, to assign a value of $1 to the patent, and to issue shares to outside investors at a price of $10 per share. However, before the charter could be filed, it was necessary to determine the

1994 South-Western, a part of Cengage Learning

69

Text Box: Chapter 9: Johnson Window Company: DirectedText Box: Amount Borrowed Cost of Debt Cost of Equity  $ 0 million 0.0% 14.0%  4 million 11.0 15.0  8 million 12.0 17.0  12 million 14.0 20.0  16 million 17.0 24.0Text Box: © 1994 South-Western, a part of Cengage Learning  70Text Box:number of shares that could be issued to the founders at $0.10 each and still have sufficient value left in the firm to raise enough equity capital at $10 per share to meet the firm’s initial capital require­ments. Thus, Gibbs concluded that she should create a business plan that not only described the product, the markets to be served, and the firm’s production plans, but which also outlined the anticipated financing requirements in some detail.

The initial marketing plan called for selling the tinted windows directly to large contractors and using several wholesalers to distribute the items to architects and small contractors. At a pro­jected average selling price of $750 per unit, they had little doubt that sales would be strong. How­ever, the tinted windows will be used primarily in new construction, and this industry has always been subject to highly cyclical sales. Further, although the sunbelt region is continuing to experience relatively strong commercial and residential markets, other sunbelt areas such as Houston have been suffering from high commercial vacancy rates and depressed residential markets. Thus, Gibbs felt uncomfortable about using a point estimate for unit sales, so she developed estimates for three pos­sible scenarios: most likely, optimistic, and pessimistic, with probabilities of occurrence of 0.50, 0.25, and 0.25, respectively. Of course, Gibbs realizes that unit sales could assume almost any value, but her discrete distribution is roughly comparable to a continuous normal distribution which has a range of plus or minus 2 standard deviations about the mean:

Scenario

Probability

Unit Sales

Dollar Sales

Pessimistic

0.25

52,200

$39,150,000

Most likely

0.50

67,500

50,625,000

Optimistic

0.25

82,800

62,100,000

 

After an in-depth study, Phillips, the engineer-production manager, identified two alternative production processes that could be employed, and he asked Gibbs to evaluate the financial implica­tions of the alternatives and to recommend a course of action. Plan A involves only a small amount of automated equipment, as most of the window components would be purchased from local sub­contractors. Under this plan, annual fixed costs are estimated to be $7,769,900, while variable costs would be $585 per unit produced. The second alternative, Plan B, would require the firm to make a significant investment in fabrication machinery, resulting in a fixed cost estimate of $17,845,000 per year and variable costs of $415 per unit. Neither fixed cost estimate includes interest expense, since the capitalization mix is still uncertain. The company plans to set the initial sales price at $750 per unit regardless of which production process is chosen. Total capital requirements for both current and fixed assets, as well as start-up operating funds, are estimated to be $14.0 million under Plan A and $20.0 million under Plan B.

To help with the capitalization decision, Gibbs had extensive meetings with investment bankers, venture capitalists, commercial bankers, insurance executives, and mutual-fund managers. On the basis of these meetings, she constructed the following estimates for the relationship between financial leverage and capital costs:

The total potential output would be much higher under Plan B than under Plan A. Thus, if the market really takes off, the company could move rapidly to meet this demand if it goes with Plan B. This might head off potential entry and competition. Of course, if demand is way below expec­tations, going with Plan B could prove to be a disaster. With all this in mind, Gibbs now must develop recommendations for the production method and financing mix. To help with the decision, Gibbs has prepared the following set of questions, which she passed to you, her assistant, to answer.

QUESTIONS

1.   Which production plan should Gibbs recommend? (Hint: Calculate the breakeven point and the expected EBIT and ROI [return on investment] under both plans and then assess the risk­iness of each. Note that the final decision is a joint decision that involves both production and financing decisions, but for this question think only about the issues involved with the production decision. Use Table 1 as a guide.)

2.   Regardless of your conclusion in Question 1, assume that the decision is made to adopt Plan B, that the total capital required by Johnson Window to effect this plan is $20.0 million, and that the estimates of the relationships between financial leverage and component costs of capital given in the case are based on Plan B. Johnson’s investment bankers indicated that if no debt is used, 2.0 million shares can be sold at $10 per share to raise the required $20.0 million of capital. However, Gibbs’s goal is to choose that capital structure which will maxi­mize the value of the stock held by the firm’s founders. Since the stock price is to be set at $10, Gibbs has to find the number of shares that the founders can issue to themselves and still induce outside investors to pay the $10 per share price. To simplify the analysis, Gibbs has ‘made two assumptions: (1) Since the $0.10 per share paid by the founders is 1/100th of the issue price, the founders’ contribution can be ignored; hence, for simplicity, Gibbs assumed that the founders paid nothing for their stock. (2) Gibbs also assumed perpetual cash flows, so the value of the firm, V, can be estimated on the basis of expected EBIT as follows:

V=D+S

= D + (EBIT — kdD) (1— T)

ks

Here, D = market value of debt, S = market value of equity, kd = cost of debt, and ks = cost of equity.

Note that Gibbs will estimate the value of the equity, divide by the specified price per share to determine the number of shares that will be outstanding, assign the required number of shares to outside investors, and then leave the founders with the remaining shares. An alter­native procedure would be to find the value of the equity, specify some number of shares to

issue, divide equity by shares to get the equilibrium price per share, and then divide the required outside equity by this equilibrium price to get the shares issued to outsiders and remaining for the founders. The calculated wealth to the investors will be identical under either procedure, as the product Price x Shares = Value will be the same under either proce­dure. The procedure called for in the case is the one investment bankers typically use to esti­mate a “first approximation” number of shares and share price, then they make subsequent

adjustments to the market price to reflect market conditions. Incidently, the investment

© 1994 South-Western, a part of Cengage Learning

bankers invariably put on a “road show” where they, along with company executives, travel around the country and meet with institutional investors and security analysts to pre-sell the stock and get an idea of the interest in the company. The final price is adjusted to reflect investor reactions. With this background, answer the following questions:

a.     If the firm’s tax rate, T, is estimated at 40 percent, what amount of financial leverage would maximize the value of the firm?

b.     How many shares will the founders receive? What is the value of their shares?

c.      Calculate Johnson Window’s weighted average cost of capital (WACC) at each debt level. What is the relationship between Johnson’s value and its WACC?

d.     Suppose an investor purchased shares at $10, learned that the founders had bought their shares for only $0.10, and then felt cheated and threatened to sue the company and its founders. Would this person have a good case? Should the SEC protect investors from this kind of thing?

3. Gibbs is well aware of the fact that the average manufacturing company has a times-interest­earned (TIE) ratio of about 6. Using TIE as a risk measure, together with your answer to Question 2, how risky does the company appear to be?

4. Suppose Johnson is planning to raise debt by issuing a 20-year term loan. What would be the annual payment, including both interest and principal amortization? Use this information to calculate Johnson’s expected first-year debt service coverage ratio, defined here as EBIT/(Interest expense + Before-tax principal repayment). If the average manufacturing

firm has a coverage ratio of about 4, what does this indicate about Johnson’s riskiness?

5. Suppose this were your company. Would your choice of debt level be influenced by your other asset holdings? That is, would it matter whether your entire net worth was invested in the company as opposed to the situation where you owned millions of dollars of stocks in other companies in addition to your holdings in Johnson Window?

6. The entire analysis depends on (a) Gibbs’s estimates of the costs of debt and equity at differ­ent capital structures, and (b) the validity of the equation given in Question 2.

a.   How confident are you in Gibbs’s estimates of kd and ks? Could changes in these esti­mates affect the capital structure decision?

b.   What assumptions underlie the equity valuation equation? Is it likely that Johnson meets these assumptions?

7. A theory has been expressed in the finance literature that “information asymmetries” cause investors to interpret the sale of stock by a company as a “signal” that things may get worse in the future, whereas the use of debt is taken as a positive signal. In general, what implica­tions does this have for capital structure policy? Does it matter if the firm in question is a mature company or a start-up firm? Would it matter if the founders planned to sell some of their shares at the time of the initial public offering, to make a further investment of their own capital by buying some more stock, or to neither buy nor sell shares?

8. Should the issue of control of the company be taken into account in the capital structure decision? If so, how would it affect things?

9. Gibbs has heard rumors that California may repeal its corporate taxes, resulting in a lower, 34 percent, tax rate. What impact might this have on Johnson’s optimal debt level? If you are using the Lotus model, calculate Johnson’s value at the different debt levels assuming a 34 percent tax rate.

© 1994 South-Western, a part of Cengage Learning

72

 

10. Gibbs has read several articles in The Wall Street Journal which indicate that labor costs will rise over the next few years, and she begins to wonder whether the variable cost esti­mates are realistic. Thus, Gibbs revises her original variable cost estimate for Plan A to $625 per unit. What impact do you believe this would have on the production decision? If you are using the Lotus model for this case, determine the ROI under each scenario for Plan A. Does this change your views toward the two production plans?

 

TABLE 1

Selected Case Data

 

Plan A – EBIT and

ROI Calculations: Pessimistic

Most Likely

Optimistic

Sales revenue

39,150,000

50,625,000

X

Fixed costs

7,769,900

7,769,900

X

Variable costs

X

39,487,500

$48,438,000

EBIT

X

3,367,600

5,892,100

ROI

6.02%

X

42.09%

E(EBIT)

 

3,367,600

 

SD(EBIT)

 

X

 

CV(EBIT)

 

0.53

 

E(ROI)

 

X

 

SD(ROI)

 

12.75%

 

CV(ROI)

 

0.53

 

 

Sales revenue Fixed costs Variable costs EBIT

ROI

E(EBIT) SD(EBIT) CV(EBIT) E(ROI) SD(ROI) CV(ROI)


$39,150,000
17,845,000

21,663,000

($ 358,000)

—1.79%


Most Likely X X X  X X

$4,767,500

$3,624,276

0.76

23.84%

18.12%

0.76


Optimistic

$62,100,000 17,845,000 $34,362,000  $ 9,893,000

49.47%

Value Calculations:

Cost of                Cost of                                                                                    Number of

Debt                   Equity                        Debt                 Firm Value                 Founders’ Shares

0.00%

14.00%

$0

$20,432,143

43,214

11.00

15.00

4,000,000

21,310,000

131,000

12.00

17.00

8,000,000

X

X

14.00

20.00

12,000,000

X

X

17.00

24.00

16,000,000

21,118,750

111,875

 

© 1994 South-Western, a part of Cengage Learning

TABLE 1

Cost of Capital Calculations: After-Tax

Cost of Debt

Cost of
Equity

Debt

Equity

Weight of
Debt

Weight of
Equity

Cost of Capital

0.00%

14.00%

$0

20,432,143

0.00%

100.00%

14.00%

6.60

15.00

4,000,000

17,310,000

18.77

81.23

13.42

X

X

X

X

X

X

X

8.40

20.00

12,000,000

9,262,500

56.44

43.56

13.45

10.20

24.00

16,000,000

5,118,750

75.76

24.24

13.54

 

Selected Case Data (continued)

Text Box: 74© 1994 South-Western, a part of Cengage Learning