Assessment of Financial Health

Reocities Home Neighborhoods Making Of Cases in Finance Final Project authorship hospitable Cards, Inc. (1988) Gary Cao Noah N Flom Robert Harris Srini Pidikiti May 1997 TABLE of CONTENTS 1 estimation of monetary health & Pro Forma financial Statements 1. 1 freshen of biography and Statement of Financial Health 1. 1. 1 manufacture 1. 1. 2 favourable Cards History 1. 1. 3 cordial Financials 1. 2 Review and rating of Pro Forma Statements 1. 3 Financial Policy / Covenants 2 Beaumonts Decisions 2. 1 envelope work Proposal 2. 1. 1 military rank 2. 1. 2 Financial offspring of Investment 2. 1. Recommendation 2. 2 Evaluation of West Coast ( immature rightfulness offer) 2. 2. 1 Advantages 2. 2. 2 Disadvantages 2. 3 military rank of Creative Designs, Inc. 2. 3. 1 non bad(p) Structure Argument 2. 3. 2 Weighted Average Cost of peachy Assumptions (WACC) 2. 3. 3 immediate payment F crusheds, Terminal Value, candor Value Valuations 2. 4 Pooling Implictions ( warm + CD) 2. 5 comradely Cards Stock Valuation 3 Over wholly sagaciousness 4 Goals for the Financial Structure of accessible Cards, Inc. - PART 1. Assessment of Financial Health & Pro Formas 1. Review of History and Statement of Financial Health Wendy Beaumont, president of hail-fellow Cards, Inc. , has speedyly enlarge her greeting brain run through internal egress and acquisitions. Ms. Beaumont realizes that m unmatchedy is currently tight, however, she is adamant astir(predicate) forthcoming increment and has sought our opinion as to determine her outmatch course of action. In benefactioning a decision we volition first require an analysis of the industry, accordingly give a bypass history of Friendly Cards, Inc. (Friendly), and then examine Friendlys financial statements to determine the financial health of the friendship. sedulousness Information The greeting card industry is inf onlyible by ternary walloping companies, (Hallmark, Ameri arouse Greetings, & Gibson), w hich ar referred to as The Big Three. The Big Three dominate marketplace shargon, and the remaining competitors atomic number 18 predominantly depleted private and family aver firms. The greeting card industry is characterized proud fixed cost payable to large stemma costs, large robeiture costs in the presidential term of efficient scattering lines, and the need for a highly diversified output lines. Market leaders enjoy great economies of scale which tends to hinder new ntrants into the market. As a out process, the card industry is capital intensive and truly competitive. The military disoblige of firms competing in the industry has abated by an one-yearized come out of 15% everywhere the termination three decades. Exiting firms were typically smaller in size, the absolute majority of which had less than 50 employees. Additionally, the competitive personality of the market results in a high degree of equipment casualty sensitivity which culminates in s maller bounds on gross r eventideue. Sales tend to be very seasonal in nature with peaks during major holiold age.thither is trending toward a large variety of card offerings (increasing inventories), unequaler carrying/merchandising periods, increase diversification of product lines, and an increase in sales of chance(a) card game as compared to holiday card game. Friendly Cards, Inc. Beaumont Greeting Card Co. was founded by Wendy Beaumont in 1978, in New York City. She later acquired Lithograph Publishing Co. and took these companies national a year later for $3 a piece nether the name Friendly Cards, Inc. Friendly has rapidly expanded by getting Glitter Greetings of Lansing, Michigan (for cash and equity), whose primary market was selling cards to supermarkets.Soon on that pointafter, it acquired Edwards & Co. of Long Beach, New York (for cash), whose primary market was selling young valentines through chain, drug, variety, and discount stores, as fountainhead as, to wholesalers and supermarkets. These acquisitions greatly enhanced Friendlys diffusion line expanding it to a regional power. Later Friendly acquired a atomic number 20 firm (Friendly Artists) which extended the dissemination line to a national basis. Friendly Artists primary market was prepackaged cards direct to the warehouse.Twenty- louvre part of Friendlys sales are prepackaged boxes, which render a higher(prenominal) margin than regular cards overimputable(p) to bring low return treasure and lower handling costs. Currently, Friendly appears to be a niche player in the prepackaged box cards market and has avoided entry into the premium card market, thus, avoiding direct competition with the Big Three. Friendlys sales are to a greater extent operose than the industry with the majority of sales occurring near Christmas at 30% (vs. Industry 32%), and Valentines Day at 25% (vs. Industry 7%). thereof, over 55% of sales occur within a 3 calendar month period.Plants at Frien dly are beness utilize at skill thus, harvest-time would necessitate further additions or acquiring contract services. Friendlys distribution line is effective for a smaller firm due to its anatomical structure. Of twenty dollar bill salesmen, one-third work on commission thus lowering Friendlys costs. However, one problem with exploitation salesmen on commission and having such(prenominal) a small sales force is the tendency to sell to rack jobbers and wholesale distributors. This strikes the effectiveness margin on cards by two-thirds. Friendlys Financials Sales have change magnitude by over 50% between 1985 to 1987.Cost of goods sold has rock-bottom as a percentage of sales in each of those years thus, producing an increasing margin ( 29. 36% in 1985 to 35. 15% in 1987). The rapid harvest-time by acquisition and the national distribution channels that were terminated by it, have affected the number slightly. In 1986 selling and pitching outlays change magnitude by 1. 45% and this directed out in 1987. G&A expenses as well as spiked in 86, reflecting the recent purchase of an another(prenominal) company, and then settled stake in 1987. However, while sales may have agen rapidly they have not matched the increase in plus ripening, which nearly doubled in 1986.Growth in this company is being run certificateed by improving margins and by increasing leverage, as indicated by the Dupont Data. Although the acquisitions were acquired by both cash and equity, the majority were debt financed, which explains why the ROE figures have increase so dramatically (al or so 16%) in the last three years. The exercise dimensions indicate that the due to payable were in arrears by 36 days in 1985 increasing to 52 days in 1987. This is probably a result of increased sales to less acknowledgement expensey individuals or remissness to collections. Inventory turnover umbers are shrinking due to the continually larger inventories being carried. Net f ixed plus turnover has decreased by 2. 3% between 1985 and 1987. This ass be explained by higher matureth in assets than in sales. The liquidity ratios indicate that the asset to liability ratio for this company is trending down. The current ratio indicates that the company is becoming slightly such(prenominal) insolvent with a current ratio of 1. 18 during 87. However, by expression at the Quick ratio and discounting for the affect of inventory in the asset number, the company is dramatically less liquid at 0. 67 in 1987.This indicates that the company is very highly leveraged and is using its large inventory levels in order to support its substantial borrowing demand. Friendlys genuine issue regulate exceeded the sustainable growing rate in 1986 and was equivalent in 1987. This deviation in 1986 produced a need for added debt to finance growth. However excess coin were not involve to fund supernumerary growth in 1987 since the actual rate of growth did not exceed t he sustainable rate of growth. This can also be seen in the kernel debt to equity ratio which increased from 3 in 1985 to 5. 21 in 1986 and abased to 4. 1 in 1987. The leverage ratios indicate that the bank loans to debt are fairly well matched, with loans being less than receivables, however, increasing in percentage. delight bearing debt jumped dramatically in 1986 as a result of debt funded acquisitions but tracks to level off on with broad(a) debt to equity figures in 1987. Finally, debt to assets has increased dramatically in the last three years, increasing by 7. 5% to 82. 5% in 1987. Thus Friendly Cards seems to be very highly leveraged, even more so than other firms in the industry although the trend is to increase debt.This highly leveraged position coupled with the high fixed costs and low margins symptomatic of the industry, exposes Friendly as extremely susceptible to fluctuations in the market. Therefore, further debt growth may not be advisableespecially since i t is currently violating its alive debt engagements. However, Continued growth, however, is needed as to allow the company to further consent advantage of its existing distribution lines and realize further economies of scale. 1. 2 Review and Evaluation of Pro Forma Statements The parameters that Ms.Beaumont has set for the pro formas seem reasonalbe for the most part. There are, however, some questionable numbers. For instance, all the forecasts are based on go on sales growth at 20% per year. When compared to astronomical growth rates of 58% in 1986 and 27% in 1987, these estimates appear almost conservative. The majority of the growth in the past, however, were associated with major acquisitions which served to in categorice the sales numbers. The historical disinclination to use equity to grow would serve to limit growth if proceed into the future.Furthermore, it may be difficult to continue to grow at such a high rates in an increasingly competitive market. dimension cos ts of goods runs at 65% of sales and may also present a problem depending on whether the company can continue to shell out its costs as it continues to grow. It could be argued that the reason CGS has dropped recently is due to the acquisition of Friendly Artists and the increasing reliance on a sales mix make up of low cost prepackaged boxes of cards. A shift in the mix away from these items could increase costs. Also, further acquisitions will serve to push up delivery and selling costs.For our purposes, however, holding them flat seems reasonable. The revenue rate seems low at 38% but, depending on the new volume of sales and the maximum tax rate for a corporation, this rate could be even higher. And while the rest of the numbers seem to obey their previous effronterys, the inventory turnover, debt to asset, and come to rate assumptions could be have ond differently. As a result of increased competition in the industry, increasing variations of cards as well as shorter hold ing duration, it is very unlikely that inventory turnover would improve to 1. 1, and it may very well drop well below this number, possibly to 1. 75. Since growth is likely to continue into the future, an increased enumerate of inventory will be needed for new market areas. Debt to assets necessitate to decrease, but this will be difficult to do without funding growth by equity rather than debt. The large sales growth assumptions are directly related to acquisitions, thus increasing assets. If this is done through equity, this number is very realistic. Finally, there may be a problem with the assumption that interest rates on LTD will be 11%.The monetary Policy Report to Congress indicates that rates should tend to decrease in the future so this rate may be get-at-able even to such a highly leveraged firm as Friendly. Without more knowledge this estimate seems fine. 1. 3 Financial Policy / Covenants Friendlys apparent financial insurance constitution is rapid growth by debt. This debt-financed growth may be due to a ownership issues that could affects Ms. Beaumonts control over her company. The financials indicate that growth is also taking place at the expense of margins, as indicated by the Dupont data.The company believes in the economies of scale of the industry and appears to be establishing a national distribution network. While costly in the short run, this strategy may enable a viable and profitable position in the industry. The elements of Friendlys financial policy appear to be the following. Friendlys capital structure mix is governed by a debt orientation. Its debt/assets ratio is currently at 82. 5% which places is significantly below the abdominal aortic aneurysm rate. AAA bonds are listed at 9. 7% while Friendly can only borrow at 11. 5%.While equity has been used in recent acquisitions there is a strong preference by counseling to use debt funding. Without question, Friendly is at an integral juncture. Existing lines of credit are maxed out and the bank is imposing new covenants on future loans bank loans 85% of AR and liabilities not to exceed three multiplication the BV of the company. Friendly currently has a $6. 25 million line of credit. under the current structure Friendly will be in trespass in 1987 with bank loans at 87% of AR and debt to equity is at 3. 13 times.Significantly, bank and trade credit for Friendly is expected to make believe over $9 million in Dec. 87. Long term and short term debt are both fueling growth. The basis is assumed to be the prime rate (which is 8. 5%) plus 2. 5% points. This is assumed to be a fixed rate established at the time of borrowing. The companys cash is the U. S. dollar and the company does not have any exotica policy to mention. see of the company rests solely with Ms. Beaumont as she is both the president and the leading shareholder, possessing 55% of the stock. An additional 20% of the stock is owned by employees and officers of the company.Finally, earnings ar e refrained for future growth and tacking current obligations. There are no dividend payments and the stock has depreciated in value from a high of $15 a share. PART 2. Decisions faced by Ms. Beaumont 2. 1 Envelope Machine Investment Evaluation of the Envelope Machine We do not rival that the investment in the envelope tool will result in a return of 31%. The reason for this is that the working capital needed to fund the form would be funded by additional debt by the company. The interest on the debt needs to be considered before evaluating the total return on the investment.Under this scenario, and considering that Friendly Cards interest on debt is 11% the interest expense is $22,000 per year before taxes. Our Estimated Annual savings from Operation of Envelope Machine, days 1 through 8 ( Dollar figures in thousands) is as follows savings Outlays for envelopes purchased in 1987 $1,500 Incremental expenses from manufacturing envelopes Materials$ 902 Warehouse 94 Labor 91 der ogation 62 do Expenses $1,149 Increase in Profit before Taxes (decrease in COGS) 351 Interest Expense on Working cracking 22 authentic Increase in Profit before Taxes 339 Increase in Income Taxes . 38 125 Increase in profit after taxes $ 204 The communicate Cash flows for the investment in the machine are (attachments). Based upon the cash flows projected in the above Table the internal Rate of Return on the investment is 26%. Based upon Friendly Cards Cost of truth which is 20% ( supplement WACC) buying the machine with all equity at 20% or debt at 11% is recommended Financial Effects of Investment The Financial effects of buying the envelope machine are can be examined in detail in Appendix Machine.The activity ratios for Friendly if the investment in the machine is made are (attachments). The investment in the machine has the following effects * Decreases Cost of Goods Sold by about 1. 5 % which in turn increases the Gross Margins * Decreases Inventory Turnover from 1. 91 to 1. 86 * Increases gold needed in 1988 by $418,000, in 1989 by $323,000 and in 1990 by $112,000. * mesh per share increase to $2. 89 in 1990 from $2. 53 in 1990 without investment * By making the investment in the machine Friendly would not be able to meet both of the covenants required by the bank The ratio of the bank loans to receivables exceeds . 85 in all three periods. * Ratio of Friendlys total liabilities to the book value of the companys net worth exceed 3 in 1988 and 1989 which do not meet the covenant but in 1990 the ratio drops down to 2. 94 where it meets the covenants. 2. 2 Evaluation of West Coast Offer (New Equity) We agree with Ms. McConvilles conclusion that Friendly should cause the offer from the West Coast Group at the terms verbalise if that was the only option available to Friendly Cards. The advantages of this proposal would be means costs will be only 5% compared to the actual costs if an investment bank was used to sell securities of the company in a pu blic offering. * The infusion of equity would enable Friendly to meet all the covenants required by the banks (Appendix WC) enabling Friendly to continue its rapid growth without any financial restrictions from the bank. * The equity infusion would enable Friendly to invest in the envelope making machine and reduce its cost structure and still meet all covenants required by the bank. * The uncertainty about how many securities will be sold if a public stock offering is held is eliminated. Continuing rapid growth would enable Friendly to retain most of the sales representatives who might shift to a competing firm if growth is slowed to enable Friendly to meet its financial covenants * The price that Friendly is getting is more than reasonable based upon the present value of the discounted cash flows as shown in (Appendix Valuation) Disadvantages of accepting the proposal would be * Loss of control. Ms. Beaumonts who presently owns 55% of the outstanding shares would own 40. 37% of th e company after the equity infusion. withal though along with the employees of the company she would own 60% of the company she would not be able to make unilateral decisions. * The West Coast Investors who would own 26% of the company would have a significant say in how the company should be run which may affect the current management structure and aversely effect their ability to mange the company as they wish. * Reduction of EPS. Earnings per share would be reduced to $2. 29 per share from the projected $2. 89 per share in 1990 with the purchase of the machine and without equity infusion due to the dilution effect of the new shares.This earnings dilution would probably result in a lower share price. (Approximately $18. 32 instead of $23. 12 considering a price multiple of 8). 2. 3. Valuation of Creative Designs, Inc. Capital Structure Argument Ms. Beaumont had been considering a possible acquisition of Creative Designs, Inc. (CD), a small mid-western manufacturer of studio cards . She had examined the details of CDs operations for four months, and believed that under her management, CD could immediately reduce cost of goods sold by 5%, and reduce other expenses by 10%.If Friendly acquires CD in early 1988, assumptions are made that CDs sales would digest flat during 1988 but would grow at 6% per year thereafter. Based on the following table from case facts, there is a wide range of Debt-to-Equity Ratios for the four companies within the same industry. American Greetings(AG) D/E ratio increased from 0. 35 in 1985 to 0. 63 in 1987. The reason for this upward trend was that American Greetings had diversified its line of merchandise segments from solely relying on greeting card sales AG expanded into gift wrap and stationary goods, such as playing cards, gift-books, and college theater of operations guides.Such diversification efforts demanded higher debt levels. In addition, AG was a large company with annual sales of $1,174 million in 1987, up 16% from 198 5. Gibson Greetings (GG)D/E ratio decreased from 0. 71 in 1985 to 0. 49 in 1987. The reason for this downward trend was that Gibson was a relatively small company, with annual sales of $359 million in 1987, an 8. 8% increase from 1985. GGs growth rate was significantly lower than American Greetings. The total debt-to-equity ratio of Creative Designs would decrease over the next several years.Since CDs sales in 1987 was $5 million, it was much smaller than the above two companies. Based on the pro forma financial statements for the period of 1988 to 1990, we see growing sales and EBIT. As a small-size manufacturer, the stovepipe capital structure would be financing its operations mainly by internal growth and a significant reduction in the companys debt levels. Ms. Beaumont cherished to acquire CD for the following reasons * In the highly competitive market with high cost in distribution and low margin, Friendly had to grow in order to survive, and CD was a good target Since CDs sh areholders concur to the acquisition by stock- give-and-take, pooling of interests accounting method would be used, and the consolidated financial statements more attractive than without CD, and Friendly need not record seemliness (if any) and avoid amortization of goodwill * Since CD had a relatively low debt level and a very low bank loan to receivable ratio, while Friendly had difficulty meeting its bank borrowing restrictions, acquiring CD would make possible for Friendly to meet the covenants Friendly can easily integrate CD to its high growth strategy, and expand Friendlys market presence in the mid-western region. Weighted Average Cost of Capital Assumptions (WACC) Based on the case facts that the premium for equity danger was 6% on long-term governmental bond rate of 8. 37%, we may calculate the unleveraged beta for American Greetings and Gibson Greeting, and use a derived estimate as a proxy for CDs unleveraged beta. 1987 Financial Data for Two Large publicly Traded Comp anies To be conservative, we assume the unleveraged beta for CD is 0. 77.Since the cost of debt was 11% and the tax rate was 38%, we calculated CDs cost of equity is 13. 97% in 1988, and the weighted average cost of capital (WACC) is 11. 07%. Over the next five years, CDs WACC would increase to 11. 92% in 1992 due to the decreasing D/E ratio and therefore the tax shield effect. Cash Flows, Terminal Value, Equity Value Valuations In addition to the above information on WACC and sales growth rate, we have made the following assumptions * Sales will stay flat in 1988, but will grow at 6% per year after 1989. * Cost of goods sold will stay at 55. 2% of sales level. * Depreciation, Selling, delivery, and warehousing expenses, and general and administrative expenses will grow proportionately to sales growth. * Increased Retained Earnings will be used to reduce long-term debt. * Prepaid expenses will increase by a small amount each year. * Interest expenses will decrease over the period si nce the debt level will decrease. * No dividend will be paid after 1988. Based on the above assumptions, we found that the total present value for CD was $4. 349 million. Adjusting for the interest-bearing loans totaling $1. million, the net worth of CD would be $3. 049 million, $1. 168 million higher than the calculated value of the stock exchange ($1. 881 million). This indicates that acquiring CD is a good transaction for Friendly. 2. 4 Pooling Implications (Friendly + CD) By using the pooling of interests accounting method, we constructed the Friendly and CD consolidated financial statements. (see Appendix Valuation Friendly + CD) The impact on 1988 pro forma financial statements is as follows * New bank loans needed decreased from $1. 585 million to $1. 357 million * EPS increased from $1. 7 to $1. 73 * Net profit margin increased from 4. 96% to 5. 49% * Assets turnover increased from 1. 01 to 1. 03 * ROA increased from 5. 01% to 5. 49% * ROE decreased from 25. 23% to 20. 5% * Days in Receivable reduced from 157 to 149 * buzzword loan to receivable ratio decreased from 0. 9 to 0. 74 * Interest bearing debt to equity ratio decreased from 2. 62 to 1. 92 * Total debt to equity ratio decreased from 4. 04 to 2. 62. The overall impact of acquiring CD to CF is positivist. The result of pooling is in line with Friendly Cards financial strategy.In the long run, acquisition of CD would become an integral part of Friendly Cards strategic plan for the next few years to achieve a higher growth rate and increased market share. In the short run, acquisition of CD would meet Friendly Cards immediate financial needs enabling the company to meet the banks covenants, specifically, to reduce the bank loan to receivable ratio to an estimated 0. 9 in 1988 to 0. 85 or lower, and to decrease total liabilities to equity ratio from an estimate 4. 04 in 1988 to 3 or lower. The result of pooling shows that these two requirements are met. 2. 5 Friendly Cards Stock ValuationAssumpt ions Capital structure Based upon the pro forma financial statements and the bank covenants requirements, we assume the capital structure to be 75% debt and 25% equity. Any other capital structures with the reduction of debt would make it more difficult to get additional capital through equity. We need the debt financing to be able to meet Ms. Beaumonts growth requirment. Discount rates We assume the cost of debt to be 11%. This is based upon the following facts In early 1988, interest rates were declining, the 10-year treasury Notes rate declined from 9. 52% in October 1987 to 8. 9% in January 1988 even though the short-term Prime Rate increased to 9. 07% by October 1987, it had decreased to 8. 5% by January 1988 furthermore, the supplyeral Reserves Monetary Policy Report(Jan. 1988) stated that high rates of capacity utilization and low unemployment suggest the needs in maintaining progress toward price stability, indicating that interest rates would stabilize at the present leve l. Also the need to reduce the trade deficit, business and elbow grease would continue to exercise restraint in price and wage behavior, indicating the Fed would hold interest rate at the present level, or even reduce them.We assume the interest rates would hold stable at the present level of 8. 5% and that the lending institution will continue its premium of 2. 5% over prime. We assume all the funding for the debt to be short term as most of the debt would be used to fund the current assets (receivable and inventories). This would be a proper matching of funds. Based on the valuation of Friendly Cards, we found that * FCFE Method (Free Cash Flows for Equity) the valuation was -$ . 95 per share * Free Cash Flow for Capital the valuation was -$5. 5 per share * Book Value Method using 11/2 times Book Value the valuation was $7. 40 * P/E ratio (multiple) method using the industry average P/E ratio of 7, the valuation was $9. 50 per share. (Please refer to appendix Valuation Friend ly Cards, Inc. ) The only way the companys stock price was worth $8 to $9. 50 per share was that West Coast Investors and Creative Designs valued the company using a Price to Earnings multiple method. **Note** We attempted to back out a discounted cash flow model that would justify an $8 or $9. 50 share price.By altering certain assumptions, most specifically the sales growth rate we can achieve positive valuations of the stock price. Slower growth in sales PART 3 Overall Assessment Our testimony to Ms. Beaumont is to (1) First, acquire CD with a stock exchange of 198,000 shares at $9. 5/share, (2) With the additional leverage obtained by the CD acquisition, purchase the envelope machine. As evidenced by the above intercellular substance and graphs, even though Friendly Cards would achieve a higher EPS by not acquiring CD but buying the machine, it would not meet the bank covenants.Advantages of our passport * Meet all of the banks covenants * Meet Ms. Beaumonts growth needs * Meet Ms. Beaumonts requirement on D/E ratio of 2 by 1990 * Maintain a relatively high level of control for Ms. Beaumont over the company * Position the company for future growth by providing a more favorable D/E ratio. Disadvantages of our recommendation * EPS dilution by acquiring CD from $4. 64 per share in 1992 as compared to $4. 15 with the CD acquisition * Reduce Ms. Beaumonts control from currently 55% to 41. 5% with CD acquisition.PART 4 Goals for the Financial Structure of Friendly Cards, Inc. 4. 1 Friendly Cards capital structure consideration Our recommendation is that Ms. Beaumont to move Friendly Cards capital structure closer to 60% debt and 40% equity (a D/E ratio of 1. 5). Our reasoning for such a recommendation is as follows Flexibility For future growth and possible acquisitions, Funds for acquiring more assets (another envelope machine ) to reduce costs. Risk aptitude to deal with possible adversity into the future (i. e. , low sales) Lower risk level than current D/E ratio IncomeFuture growth in earnings due to ability to acquire market share through acquisitions. Further exploit the economies of scale to reduce CGS, Handling and scattering Costs Control Maintain controlling interests in the company quantify Having a higher D/E Friendly can issue equity at more favorable terms at a later date when EPS is higher, the market environment is friendlier, and the company will be in a better financial position. Our recommended target capital structure for Friendly Cards, Inc. of 60/40 D/E is realistically attainable within 3-4 years (mid 1991). Friendly Cards Case Attachments