2. Introduction
Environgard corporation was formed in 1980.
Manufacturer of air pollution scrubbing equipment.
Due to the competition in the market, it wanted to come up
with new equipment and remodeling of existing product.
Corporation required $34million capital.
Three options to raise capital:
I. question of common stock
II. question of bonds
III. question of preferred stock
3. Objective of study
To analyse the case of Environgard corporation.
To deal with the problem of case and find appropriate
alternatives for financing.
To recommend best alternatives (common, Bond and
preferred) to raise the capital of $34 million
4. Question 1.
Assuming that the new funds earn the same rate of return
currently being earned on the firm’s assets (earnings
before interest and taxes/total assets), what would earnings
per share be for 2017 under each of the three financing
methods? Assume that the new outside funds are employed
during the whole year of 2017, the sinking fund payment
for 2018 is ignored and retained earnings for 2017 are not
employed until 2018. Under which methods of financing
alternatives, EPS is highest and why?
5. Earning Per Share
paeticulars Before
Financing
2016
After Financing 2017
Common
stock
Bond Preferred
stock
EBIT $53.7 $60.61 $60.61 $60.61
Less: Interest $1.2 $1.2 $1.2 $4.6 $1.2
Earnings before tax $52.5 $59.41 $56.01 $59.41
Less: tax @48% $25.2 $28.5182 $26.88 $28.5182
Earning after interest and
tax
27.3 30.893 29.125 30.893
Less: preferred Dividend 0 0 0 6.8
Earnings Available to
Stockholder
27.3 30.895 29.125 24.095
Number of shares 10m 10m 11.0625 10m
EPS 2.73 2.79 2.913 2.41
6. Question 2
Calculate the debt ratio at the year-end 2017 under each
alternative method of financing. Assume that 2017 current
liabilities remain at their current level and additions to
retained earnings for 2017, total $20.5 million. Compare
Environgard Corporation’s figures with the industry
average as given in Table 4
7. Comparison of Debt Ratio with Industrial
Average
Financing Methods Debt Ratio Industry Average comment
Alternative 1: Common
stock
17.58% 35% Less Risky(Good)
Alternative 2: Bond 28.25% 35% Less Risky (Better)
Alternative 3: Preferred
stock
17.58% 35% Less Risky(Good)
8. Question 3
Calculate the before-tax times-interest-earned coverage for
2017 under each of the financing alternatives. Then
compare Environgard Corporation’s coverage ratios with
the industry average.
9. Times Interest Earned
Financing Methods
Common stock Bond Preferred stock
Times Interest Earned 50.51 times 13.176 times 50.51times
Industry Average 9 times 9 times 9 times
10. Interpretation
The times interest earned under common stock
financing and preferred stock financing are extremely
high
This shows that Environgard has not been using debt
financing than common stock and preferred stock.
The TIE of 13.17 times in case of bond financing is
good and little high than the industry average.
This shows that the company has a good mix of debt
and equity financing and it has earnings available for
meeting its debt obligation.
11. Question 4
Calculate the fixed charge coverage under each of the three
alternatives for the year 2017. Ignore the sinking fund
payment in the debt alternative. Then compare your results
with the industry average. Calculate the debt service coverage
ratio (the fixed coverage ratio including the sinking fund
payment) for the bond alternative. What effect will the
sinking fund covenant have on Environgard Corporation’s
ability to meet its other fixed charges? Do you think that the
company will be able to meet fixed obligations? In the event
that the company incurred a loss, do you think that the
company can meet the fixed obligations?
13. Fixed Charge Coverage Ratio
Fixed Charge Coverage =
𝐸𝐵𝐼𝑇+𝐿𝑒𝑎𝑠𝑒 𝑜𝑏𝑙𝑖𝑔𝑎𝑡𝑖𝑜𝑛
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒+𝐿𝑒𝑎𝑠𝑒 𝑜𝑏𝑙𝑖𝑔𝑎𝑡𝑖𝑜𝑛
Fixed Charge coverage ratio is the ratio that indicates a firm's
ability to satisfy fixed financing expenses, such as interest and
leases.
Interpretation
Industry average is lower than all the three alternatives of
financing.
Higher the coverage ratio, higher will be firm’s ability to cover
the fixed charges.
Company has the ability to cover the fixed charges like interest
and lease payments.
14. Calculation of Debt Service Coverage Ratio
(DSCR) for bond:
The debt service coverage ratio (DSCR), also known as "debt
coverage ratio." (DCR) is the ratio of cash available for debt
servicing to interest, principal and lease payments.
Debt Service Coverage =
𝐸𝐵𝐼𝑇+𝐿𝑒𝑎𝑠𝑒 𝑜𝑏𝑙𝑖𝑔𝑎𝑡𝑖𝑜𝑛
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑥𝑝𝑒𝑛𝑠𝑒+𝐿𝑒𝑎𝑠𝑒 𝑜𝑏𝑙𝑖𝑔𝑎𝑡𝑖𝑜𝑛+𝑠𝑖𝑛𝑘𝑖𝑛𝑔 𝑓𝑢𝑛𝑑
EBIT= $60.61 million
Lease Obligation= $2.4 million
Interest Expense= $4.6 million
Sinking Fund= 3% of 34 million =$1.02 million
DSCR = 7.86 times
15. Interpretation
The debt service coverage ratio of Environgard
Corporation is 7.86times
Without considering sinking fund FCC is 9 times
This shows that the ability to meet fixed charges has
turned down by 1.14 (i.e., 9 -7.86) times.
This shows that the amount of cash flows is available to
meet annual interest and principal payments on debt,
including sinking fund payments.
16. QUESTION: 5
Assume that after the new capital is raised, fixed operating
charges are $20 million (not including Depreciation) and
the ratio of variable cost to sales stays the same. How
much would sales have to drop before the equity financing
would be preferable to debt in terms of EPS? (Hint:
Calculate the breakeven level of sales at which EPS will
be equal under bond or stock financing)
18. Interpretation
From the graphical presentation above, the indifference point
between stock and bond financing is $36.61
At the present condition the company, debt financing best suits for
the financing for future expansion. But if the company wants to
choose equity financing the company must decrease its sales from
$323.97 to $249.69. $249.69 being sales breakeven of the
indifference point, the company can choose from debt financing or
equity financing.
If the company decreases sales by more than $249.69 than equity
financing is more preferable to debt financing. Since, the EPS
would be higher below the indifference point of 36.61
19. Question 6
Based on the data developed in question 2, 3, and 4
discuss the pros and cons of each of the financing
methods that Hellriegel is considering.
20. Pros of Common Stock
There is no fixed burden or legal obligation in payment of dividend.
There is no maturity date on the security. So, the invested capital does not
have to be repaid.
The sale of common stock increases the credit worthiness of the company .
The offering of common stock has the potential to raise large amounts of
money.
Common stock
Alternative 1 Industry
average
Alternative 1 Industry average
Debt Ratio 20.02% 35%
Times Interest Earned 50.50 Times 9 Times
Fixed Coverage Charge 17.5 Times 6 Times
21. Cons of Common Stock
There is loss of control of the management within the
company.
The sale of common stock dilutes the earnings per share
as the company has to share its ownership with
investors.
The costs of underwriting and distributing common
stock are higher than debt and preferred stock
22. Bonds
Pros of bonds
The cost of bonds to Environgard is fixed as interest and principal.
Interest payments are tax deductible and beneficial for Environgard .
The ownership interest in the corporation will not be diluted by adding more bond
holders.
Bonds offer safety of principal and periodic interest income.
Alternative 2 Industry average
Debt Ratio 30.38 35%
Times Interest Earned 20.02 Time 9 Time
Fixed Coverage Charge 9 Times 6 Times
23. Cons of bonds
The disadvantages of bonds include rising interest rates, market
volatility and credit risk.
Environgard will have the legal obligations to pay the fixed
charges or interest.
Bonds have a maturity date and the capital invested must be
repaid to investors.
The issuance of bonds adds more risk to the Environgard
Corporation .
24. Preferred stock
Pros of preferred stock
Preferred stock payments are fixed and the company does not need to pay
higher dividends in case of higher earnings.
If a corporation cannot pay its preferred shareholders, the company can pay
later, when it has the ability to pay.
It carries no voting rights.
Alternative 3 Industry average
Debt Ratio 20.02% 35%
Times Interest Earned 50.508 Times 9 Times
Fixed Coverage Charge 17.5times 6 times
25. Cons of preferred stock
It may be difficult to sell preferred stock, since returns
are fixed and the company's preferred stock price is hard
to track.
Issuance of preferred stock will burden the company with
inescapable preferred dividend payments.
The dividends from preferred stock are not tax deductible
as dividends are distributed using after-tax profits
26. Question 7
Determine the PE ratio for 2016. If the goal is to maximize
the price of firm’s stock, calculate the prices of common
stock for 2017 under various financing arrangements for
PE ratio of 18, 16, 15, 14, 13, 12, and 10 times. Which
alternative has the higher market price per share?
27. Calculation of market price per share for 2016 in different financing
alternatives; if PE ratios are: 18, 16, 15, 14, 13, 12, and 10 times.
We have,
Price Earning (PE) Ratio =
PE ratio (in times) Market price in difference Alternatives($)
Common stock
(2.7927 * PE ratio)
Bond (2.9125 *
PE ratio)
Preferred
stock (2.4095
* PE ratio)
18 50.2686 52.425 43.371
16 44.6832 46.6 38.552
15 41.8905 43.6875 36.1425
14 39.0978 40.775 33.733
13 36.3051 37.8625 31.3235
12 33.5124 34.95 28.914
10 27.925 29.125 24.095
28. Interpretation:
we can clearly see that financing alternative 2 i.e. bond financing
has higher market price per share at higher PE ratio.
This is because if financing is made though bond it will not
increase the numbers of common share outstanding.
Net profit is divisible for existing common shareholders. This will
increase Earnings Per Share (EPS). And higher EPS in a given PE
ratio yields higher market price per share (MPS).
29. Question 8
Calculate the profit after taxes to total assets and profit
after taxes to net worth for 2017 under each of the
alternatives. Then compare these ratios with the industry
average under each of the alternatives.
30. Calculation of profit after taxes to total assets for 2017 under each of the financial
alternatives:
We have,
Profit after taxes to total assets =
Net profit before tax = 60.61
Interest expenses = 1.2
Total Asset = Current assets + Fixed assets + New Capital(through financing)
= $104 + $160+ $34 = $298
Financing Alternative Profit after taxes /Total
assets Industry Average
1:Common stock 10.37% 8%
2:Bond 9.95% 8%
3: Preferred stock 10.37% 8%
31. Calculation of profit after taxes to net worth for 2016 under each of the financing
alternatives:
Profit after taxes to net worth 2018 (ROE) =
Common stock financing
Net worth 2017 (ROE) = Net worth 2016+ New share capital = 208+34 = $242 million
Financial Alternative Profit after taxes/net
worth Industry Average
1. Common stocks 12.77% 12%
2. Bond 14.25% 12%
3. Preferred stock 12.77% 12%
32. Question :9 How does stock exchange
membership affect the decision?
A stock exchange is a form of exchange which provides
services for stock brokers and traders to trade the stocks
bonds and others securities.
Stock exchange membership affects the decision by:
1. Organized stock exchange market.
2. Over the Counter (OTC) market.
33. Benefits:
Creating a market for the company's shares.
Enhancing the status and financial standing of the company.
Increasing public awareness and public interest in the company and its products.
Providing the company with an opportunity to implement share option schemes for their
employees.
Accessing to additional fund raising in the future by means of new questions of shares or other
securities
Environgard corporation American stock exchange will obviously help in increasing its capital.
The company can sale its common stock and released its preferred stocks but Environgard
corporation is a small firm having a total assets of a only $264 million. The company can sell 10%
of bonds for the period of 25 years, this can help the company to minimized the cost like floating
cost, thus the stock exchange membership doesn’t affect decision by much extent because the
option of selling its shares doesn’t yield better profit to the Environgard corporation.
34. Question .10: Do you think 2:1 current ratio requirement appear
too restrictive? And also do you think that covenant prohibiting the
payment of dividends out of retained earnings appears to be overly
burdensome?
Current ratio:
In the case of Environgard Corp, the company has to maintain the current ratio of
2:1. This means that the company should have the assets twice as much as its
liabilities.
By the end of 2016, the company had the current assets of value $104 million and
current liabilities of value $40.0 million, resulting to the current ratio of 2.6:1, still
exceeding the company requirements.
So, the current ratio requirement of 2:1 seems to be too restrictive. This forces the
company to have half of its current assets unused to pay liabilities when needed.
35. Dividend on Retained Earning
It is beneficial for the company if the dividends are not paid out of
retained earnings. Retained earnings are used for development,
expansion and investment process of the company.
If the dividends are paid out of retained earnings, there will be
lesser amount to fund any kind of investment for the company.
No, the covenant prohibiting the payment of dividends out of
retained earnings doesn’t appear to be overly burdensome.
Actually it is beneficial for the company if the dividends are not
paid out of retained earnings.
36. Question .11:What method would you
recommend to the board?
Financing method Earnings per share
Plan A: stock financing 2.79
Plan B: Bond financing 2.913(best alternative)
Plan C: preferred stock financing 2.41
37. Bond financing is the best option for Environgard Corporation:
Earning per share (EPS) :
It indicates the profitability which is highest under bond
financing that is 2.913
Debt ratio :
Industry debt ratio is 35% ; still company’s debt ratios under
the three alternatives financing method are lower than the
industry average.
Times interest earned ratio :
In the year 2016 the times interest earned ration is 50.50 times
for both common stock financing and preferred stock financing.
For bond financial the times interest earned ratio is 13.17times in
comparison to industry average of 9 times.
38. Summary and Conclusion
In conclusion from case study and analysis, the best source of financing is
alternative 2 i.e. Bond financing because of following reasons:
● EPS of Bond financing is highest.
● Debt ratio under bond financing will increase but is below industry
average.
● TIE ratio is also satisfactory to meet the obligations.
● ROE is also highest among three options.
● ROA is above industry average under Bond Alternative.
● Cost of equity is comparatively more as interest on bond is tax
deductible.
