Sara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing her
presentation one last time before her upcoming meeting with the board of directors.
Meritâs business had been brisk for the last 2 years, and the companyâs CEO
was pushing for a dramatic expansion of Meritâs production capacity. Executing the
CEOâs plans would require $4 billion in capital in addition to $2 billion in excess
cash that the firm had built up. Saraâs immediate task was to brief the board on options
for raising the needed $4 billion.
Unlike most companies its size, Merit had maintained its status as a private
company, financing its growth by reinvesting profits and, when necessary, borrowing
from banks. Whether Merit could follow that same strategy to raise the $4 billion
necessary to expand at the pace envisioned by the firmâs CEO was uncertain,
although it seemed unlikely to Sara. She had identified the following two options for
the board to consider.
Option 1: Merit could approach JPMorgan Chase, a bank that had served Merit
well for many years with seasonal credit lines as well as medium-term loans. Lehn
believed that JPMorgan was unlikely to make a $4 billion loan to Merit on its own,
but it could probably gather a group of banks together to make a loan of this magnitude.
However, the banks would undoubtedly demand that Merit limit further borrowing
and provide JPMorgan with periodic financial disclosures so that it could
monitor Meritâs financial condition as Merit expanded its operations.
Option 2: Merit could convert to public ownership, issuing stock to the public
in the primary market. With Meritâs excellent financial performance in recent years,
Sara thought that its stock could command a high price in the market and that many
investors would want to participate in any stock offering that Merit conducted.
Becoming a public company would also allow Merit, for the first time, to offer
employees compensation in the form of stock or stock options, thereby creating
stronger incentives for employees to help the firm succeed. On the other hand, Sara
knew that public companies faced extensive disclosure requirements and other regulations
that Merit had never had to confront as a private firm. Furthermore, with
stock trading in the secondary market, who knew what kind of individuals or institutions
might wind up holding a large chunk of Merit stock?
TO DO
a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are the
most positive aspects of this option, and what are the biggest drawbacks?
b. Do the same for option 2.
c. Which option do you think that Sara should recommend to the board, and why?
Sara Lehn, chief financial officer of Merit Enterprise Corp., was reviewing her
presentation one last time before her upcoming meeting with the board of directors.
Meritâs business had been brisk for the last 2 years, and the companyâs CEO
was pushing for a dramatic expansion of Meritâs production capacity. Executing the
CEOâs plans would require $4 billion in capital in addition to $2 billion in excess
cash that the firm had built up. Saraâs immediate task was to brief the board on options
for raising the needed $4 billion.
Unlike most companies its size, Merit had maintained its status as a private
company, financing its growth by reinvesting profits and, when necessary, borrowing
from banks. Whether Merit could follow that same strategy to raise the $4 billion
necessary to expand at the pace envisioned by the firmâs CEO was uncertain,
although it seemed unlikely to Sara. She had identified the following two options for
the board to consider.
Option 1: Merit could approach JPMorgan Chase, a bank that had served Merit
well for many years with seasonal credit lines as well as medium-term loans. Lehn
believed that JPMorgan was unlikely to make a $4 billion loan to Merit on its own,
but it could probably gather a group of banks together to make a loan of this magnitude.
However, the banks would undoubtedly demand that Merit limit further borrowing
and provide JPMorgan with periodic financial disclosures so that it could
monitor Meritâs financial condition as Merit expanded its operations.
Option 2: Merit could convert to public ownership, issuing stock to the public
in the primary market. With Meritâs excellent financial performance in recent years,
Sara thought that its stock could command a high price in the market and that many
investors would want to participate in any stock offering that Merit conducted.
Becoming a public company would also allow Merit, for the first time, to offer
employees compensation in the form of stock or stock options, thereby creating
stronger incentives for employees to help the firm succeed. On the other hand, Sara
knew that public companies faced extensive disclosure requirements and other regulations
that Merit had never had to confront as a private firm. Furthermore, with
stock trading in the secondary market, who knew what kind of individuals or institutions
might wind up holding a large chunk of Merit stock?
TO DO
a. Discuss the pros and cons of option 1, and prioritize your thoughts. What are the
most positive aspects of this option, and what are the biggest drawbacks?
b. Do the same for option 2.
c. Which option do you think that Sara should recommend to the board, and why?
Related questions
The Stone Meat Corporation is a mediumâsized agricultural products company headquartered in Ogden, Utah. Its primary products are beef, pork and poultry and include packaged deli meats to half animals sold directly to in-store butcher markets in the retail grocery stores. They also supply their own butcher packs to various retail outlets including grocery stores, big box stores, and restaurants. In addition, they have their own factory store. The firm's products are well recognized within the markets in terms of quality and food safety. During the 2000's and the early 2010's sales and earnings had grown rapidly. Sales in 2002 were approximately $60 million, but had reached $180 million by 2012. Per share earnings and dividends more than kept pace. The relevant figures are contained in Exhibit 1. In order to support the firm's expansion, substantial expenditures on plant and equipment were required during the period indicated. The majority of funds came from retained earnings and the private placement of debentures with insurance companies. In 2004, however, the company was forced to sell additional common stock because it felt that the debt level, which would ensue from trying to borrow the money to keep up its expansion program, would be excessive. In particular, possible adverse effects in its stock price were feared since, at the time, the firm's ratio of debt to total capitalization was already somewhat above the industry average of 30 percent. The firm's balance sheet as of December 31, 2012 is shown in Exhibit 1. Originally, the company's Board of Directors had established a policy of paying out half its annual earnings as dividends. The actual percentage varied from year to year because an attempt was made to stabilize the dividends despite fluctuating profit. By the late 2000's, this policy had been revised to set oneâthird of earnings as the target payâout ratio due to the continuing need for capital. At their last annual meeting, the Directors announced that the 2012 dividend would be 60 cents per share, payable quarterly in 15 cent installments. The company's stock is listed on the AMEX and trades actively. The range of yearly stock prices is included in Exhibit 1. The closing price on June 30, 2012 was $24. Market data indicated that Stone was somewhat less risky than the market as a whole with a beta of .80. Returns on the market were averaging approximately 12% and risk free borrowing was still low following the financial meltdown of 2008. These rates averaged 3.5%. Preferred stock, which had been issued many years ago as a part of a financial deal, was selling at $90 per share. Tax rates had averaged 30% over the last few years. Early in 2012, the treasurer of Stone was reviewing its investment and financing strategies with an eye toward improving both. The question as to an appropriate cutâoff ratio of return on new investments was of special concern. The treasurer was of the opinion that many capital expenditures had been made in the past without proper analysis. He wanted a figure he could justify to the firm's managers as a cost of capital in order to achieve a more accurate capital budgeting procedure throughout the organization. He felt this was an especially timely move in view of an article he had just read in the WSJ and which is reproduced in Exhibit Ill. Stone's own longârange planning group had earlier forecast a trend not unlike that indicated in the Journal. The treasurer was well aware that financing did not come free and that the costs of issuance of preferred stock would cost 8%, bonds would cost 4% and equity 12%. He thought it important to determine how such costs would inflate the costs of any proposed projects the company might pursue in the futures. Thus he wanted to determine what the total cost of a $1,000,000 investment would be after considering any financing costs
Exhibit 1
Year Sales eps dps Stock Price
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Exhibit II
Balance Sheet As of 12/31/2012 (figures in Millions)
Cash 20 Accounts Receivable 10 Inventories 30 Plant and Equipment, net 60 Total Assets 120 Accounts Payable 20 Misc Accruals 10 Preferred Stock (5%) 10 Long term Debt 24 Common Stock (2.5 million shares) 12 Capital Surplus 4 Retained Earnings 40 Total Liabilities and Equity 120 The firm's bonds carried a 6% coupon, a 12/31/2022 maturity and were selling for $960 as of 6/30/2012.
What is the cost of preferred stock?
