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29 Mar 2019

Question: How would you answer this students post with a paragraph or two with reference.

Dividends are corporate earnings passed on to shareholders. Since google is a growing tech company who is constantly trying to stay ahead of their competition, profits are better used within the company to fund new projects and ideas. By using income in this way, Google is investing in the success of their company thereby increasing the value of stockholder equity. The second piece of the puzzle is tax liability. Dividend tax is paid at the owner's marginal rate which could be up to 35%, and on the contrary, the sale of stock after holding it for one year is taxed at the capital gains tax of 15% (Fontinelle, 2016). It is also in the best interest of the shareholder to retain wealth and ownership in the company by holding the stock for at least one year before trading or selling to appreciate the tax savings. Google is the largest publicly traded company in the world with revenue of $66 billion in 2014 going up every year since 2002, and shares of stock are valued at $709.60 today. Much of Google's income is generated through advertising (Statista, 2016). The competitiveness of technology creates an environment where new ideas and projects must be pursued in order to retain shareholder value in the company.

Many mature companies do pay common stock cash dividends to entice people to purchase stock which provides the benefit of a constant income stream for the shareholder. Investors also see the payment of dividends as related to the strength of the business and that management has strong expectations for the company in the future (Fontinelle, 2016).

Investopedia. (2016). Why do some companies pay a divident when others do not? Retrieved from http://www.investopedia.com/ask/answers/12/why-do-some-companies-pay-a-dividend.asp

Statista. (2016). Annual revenue of google 2002-2014. Retrieved from http://www.investopedia.com/ask/answers/12/why-do-some-companies-pay-a-dividend.asp

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Elin Hessel
Elin HesselLv2
29 Mar 2019

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A CAPITAL BUDGETING CASE

The E-Check Company, a manufacturer of pollution detection systems, has enjoyed considerable success. In 2015, the company completed its 25th year in business and generated a return on common equity of 20%. Rusty Rivet, Company C.E.O., is certain the Company can continue this performance. One thing that contributes towards his confidence is that almost all of the Company’s sales are to governmental programs that, in order to help control pollution, force residents in communities located next to interstate highways to pay a fee to have their vehicle emissions systems tested. Given the high test pass-rates, the pollution in these areas obviously comes largely from traffic passing through the communities rather than from the local’s vehicles, but governments have come to rely on the income emission testing generates and are reluctant to cut the testing requirements. Another reason for his confidence is the fact that most of the Company’s top managers hold an advanced engineering degree awarded by a variety of prestigious universities. Rusty also believes that stockholders like the fact that the Company pays out all earnings not needed to pay preferred dividends as common dividends (and because he is the majority stockholder in the Company it is unlikely this policy will change). It is estimated that the common dividend will continue to grow annually at an 8% rate.

In January 2016, managers of the Company have expansion plans; they have just completed an evaluation of six capital budgeting projects. The net cash flows (in millions of dollars) and risk assessment of each project are shown below. Company policy requires that average risk projects have an IRR at least equal to the Company’s weighted average cost of capital (WACC). Policy also requires that the hurdle rate be increased (decreased) by 250 basis points when evaluating projects that are above (below) average risk. Management has determined that the Company’s WACC is 9.63% and, therefore, management is making plans raise $52 million to implement all of the projects except Project E. As a part of your management training, you have been asked to review the analysis. In particular, management wants you to verify both the WACC calculation and project selection.

Project A B C D E F

0 (10) (12) (15) (5) (11) (10)

1 3.15 4.3 7 2 0 1

2 3.15 4.3 6.4 2 0 3

3 3.15 4.3 5.5 1 0 5

4 3.15 4.3 .5 0 3

5 3.15 .5 0 .55

6 .5 0

7 0

8 22

Risk High Ave. Ave. Low Ave. Low

The Company has one outstanding bond issue. It has an annual stated rate of 8% with annual interest payments. $50,000,000 of the bond issue, with an original term to maturity of 15 years was publicly placed 7 years ago at face value. The most recent price at which a bond traded on the secondary market was $900 (a $100 discount from face value). Any new long-term debt would be raised in the form of a new bond issue. Matilda Angle, E-Check’s treasurer, has pointed out that the company would like any new bond issue to have an initial maturity of 15 years to lock in the interest rate for a long time, and she also points out that the good news is that the yield curve at this time is essentially flat. In addition, any new bond issues will be privately placed so there will be no flotation costs.

The company has 10 million shares of $1 par common stock outstanding. These shares are currently trading for $10.00 per share on the Cincinnati Stock Exchange. The company paid total dividends of $1,700,000 on these shares during 2015. The company’s underwriter will charge flotation costs equal to 10% of the value of any new shares sold.

The company also has 100,000 shares of $200 par preferred stock outstanding. These shares are currently trading at $175 per share. The preferred share annual dividend (paid quarterly) is 9.5%. The underwriter will charge flotation costs of 5% of the value of new shares sold.

Management’s WACC Calculation

Shown below are E-Check’s simplified financial statements for 2015. Managers used information from the balance sheet to come up with the weights for their WACC calculation.

E-Check

Balance Sheet

December 31, 2015

Current assets 30,000,000 Current liabilities 30,000,000

Long-term assets 88,000,000 Long-term liabilities 50,000,000

Total assets 118,000,000 Total liabilities 80,000,000

Common shares 10,000,000

Preferred shares 20,000,000

Retained earnings 8,000,000

Total equity 38,000,000

Total liabilities & equity 118,000,000

E-Check

Income Statement

2015

Revenues 200,000,000

Cost of goods sold 110,000,000

Gross profit margin 90,000,000

Operating expenses 80,000,000

Operating income 10,000,000

Interest expense 4,000,000

Taxable income 6,000,000

Income tax 2,400,000

Net income 3,600,000

Specifically, the WACC was calculated as follows:

WACC = (Kd * wtd) + (Kp * wtp) + (Ke * wte)

= (8 * (80/118)) + (9.5 * (20/118)) + (17 * (18/118))

= 5.423 + 1.61 + 2.593

= 9.63%

Maria Sliderule, Company controller, has explained to you that 8% was used as the cost of debt because this is the stated rate of interest on the firm’s existing bond issue; 9.5% was used as the cost of preferred shares because this is the dividend rate on the Company’s preferred stock, 17% was used as the cost of equity because dividends of $1.7 million were paid on the common shares with a book value of $10 million; and that the weights in the WACC calculation were derived directly from the balance sheet.

Internal announcement of the expansion possibilities has fostered some debate. One manager, Mel Lever, asserts that the Company should raise all the money needed in the form of debt, and since the cost of debt is only 8%, all projects should be accepted. Olm Meter, a Norwegian engineer who just joined the E-Check management team, argues that it makes no sense to invest in a project with an IRR less than the WACC. The input of all these individuals cannot be ignored because each is a valuable member of the management team and highly respected in the area of pollution detection technology. This is why you have been asked to review the analysis.

1. Please address the comments of Mr. Lever and Mr. Meter.

2. In which of the proposed capital budgeting projects should the Company invest?

3. What do you think is the Company’s WACC?

4. List any errors in the 9.63% calculation?

Over the past few years, the number of start-up companies attracted to either doing business themselves in the cloud, or specifically creating applications for others to use in the cloud, has grown significantly. A few but very promising enterprises have launched applications in “container” technology, which enables companies, programmers, or other enterprises to both launch and run applications solely in the cloud. There is still a lot of room in this emerging marketplace, and you are diving in. The product you’ve developed has a unique angle to tap into the local-grown/local-made/local-paid movement that’s also growing larger every day. Your initial market is your own small city, which operates independently but which is linked economically and via public safety provision to another small city sitting directly across a river separating the two. Once you’ve been able to launch your company in your city, you plan to approach the “sister city” leaders, then the county, state, and eventually go national. It’s too soon now, but your future plans entail an IPO offering to accomplish all this. Eventually, you hope to be able to re-imagine your product to go global. You have big plans, are close to being tapped out financially and you now need to plan for additional investors. Address the following considerations as they apply to your product launch. 1.Describe an agency relationship and how it may/will take shape for your small company. As the sole employee and investor in your startup, what agency conflicts might arise? 2.Six months have transpired, and you’ve been able to add two employees. In this new arrangement, what agency disputes might now develop that need to be addressed, and how might you address them? What resources do you need to use or consider? 3.Another three months have passed. You are now ready to expand to your sister city and you need more capital. You decide the wisest path is to sell some stock to outside investors, but you will maintain control over your company by holding onto the majority of the stock. In this new scenario, what type of agency conflict might occur? How can you address this in advance? 4.The IPO was a success, and you have a robust number of shareholders. With board support, you determine it is time to hire a financial manager to help your firm achieve current goals and set new ones appropriate to the firm’s growth strategy. What professional strengths and skills will an individual seeking this position need to possess? 5.Another consideration you feel you need to address at this point, now that your firm’s stock is publicly traded, is how to sustain the high ethical standards you’ve fostered thus far as you move into the firm’s future. What strategies can your management team implement to conduct your business with both personal and professional integrity? What steps can you take to ensure that ethical considerations for financial and other management decisions are embedded into the firm’s culture? 6.Congratulations - you are now at Year One, and everything is moving along faster than you anticipated. While this is great, you are at the point where you need to raise additional capital from outside lenders. With this decision, what type of agency costs might the company incur? How might a lender mitigate any agency costs? 7.Year Two rolls around. Your company has been able to expand beyond your local communities and into to localities and governments in half the counties of the state. The stakes are getting bigger and you welcome the idea of high-level input to ensure the company keeps growing and expanding. You cash out the majority of your stock and turn the company over to an elected board of directors. Neither you nor any other stockholders own a controlling interest (which is also the situation at most public companies). List six potential managerial behaviors the new board might take that could harm your company’s value, and what steps overall can put into place to avoid or mitigate these. 8.You are also aware from your prior career and from your research, that corporate governance can affect shareholder value. This greatly concerns you, as you still have lofty plans for your company’s growth and eventual global trajectory. Questions you’ve identified that need to be addressed at this stage include: a) What is corporate governance?; b) What five corporate governance provisions are internal to a firm and are under its control?; c) What characteristics of the board of directors usually lead to effective corporate governance?; d) What characteristics of the board of directors signal ineffective or problematic governance practices?; e) How can regulatory agencies and legal systems affect corporate governance? If there are differences in local versus national levels, expand upon these. 9.Lastly, one of your new board members is very concerned with “blockholders.” What is block ownership? How does it affect corporate governance? Explain the pros and cons.

Over the past few years, the number of start-up companies attracted to either doing business themselves in the cloud, or specifically creating applications for others to use in the cloud, has grown significantly. A few but very promising enterprises have launched applications in “container” technology, which enables companies, programmers, or other enterprises to both launch and run applications solely in the cloud. There is still a lot of room in this emerging marketplace, and you are diving in. The product you’ve developed has a unique angle to tap into the local-grown/local-made/local-paid movement that’s also growing larger every day. Your initial market is your own small city, which operates independently but which is linked economically and via public safety provision to another small city sitting directly across a river separating the two. Once you’ve been able to launch your company in your city, you plan to approach the “sister city” leaders, then the county, state, and eventually go national. It’s too soon now, but your future plans entail an IPO offering to accomplish all this. Eventually, you hope to be able to re-imagine your product to go global. You have big plans, are close to being tapped out financially and you now need to plan for additional investors. Address the following considerations as they apply to your product launch. Describe an agency relationship and how it may/will take shape for your small company. As the sole employee and investor in your startup, what agency conflicts might arise? Six months have transpired, and you’ve been able to add two employees. In this new arrangement, what agency disputes might now develop that need to be addressed, and how might you address them? What resources do you need to use or consider? Another three months have passed. You are now ready to expand to your sister city and you need more capital. You decide the wisest path is to sell some stock to outside investors, but you will maintain control over your company by holding onto the majority of the stock. In this new scenario, what type of agency conflict might occur? How can you address this in advance? The IPO was a success, and you have a robust number of shareholders. With board support, you determine it is time to hire a financial manager to help your firm achieve current goals and set new ones appropriate to the firm’s growth strategy. What professional strengths and skills will an individual seeking this position need to possess? Another consideration you feel you need to address at this point, now that your firm’s stock is publicly traded, is how to sustain the high ethical standards you’ve fostered thus far as you move into the firm’s future. What strategies can your management team implement to conduct your business with both personal and professional integrity? What steps can you take to ensure that ethical considerations for financial and other management decisions are embedded into the firm’s culture? Congratulations - you are now at Year One, and everything is moving along faster than you anticipated. While this is great, you are at the point where you need to raise additional capital from outside lenders. With this decision, what type of agency costs might the company incur? How might a lender mitigate any agency costs? Year Two rolls around. Your company has been able to expand beyond your local communities and into to localities and governments in half the counties of the state. The stakes are getting bigger and you welcome the idea of high-level input to ensure the company keeps growing and expanding. You cash out the majority of your stock and turn the company over to an elected board of directors. Neither you nor any other stockholders own a controlling interest (which is also the situation at most public companies). List six potential managerial behaviors the new board might take that could harm your company’s value, and what steps overall can put into place to avoid or mitigate these.

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