125.330 S1 2023 Assignment#1

Assignment#1 – 25 marks Total

125.330 S1 2023 - Due date: Thursday 6th April 2023

Part A: Integrated Analysis of a Company’s Profitability (7 marks)

Po Concept Home (PCH) used to be a well-established but rather stable furniture company traded in the share market. The trading volume of company’s stock in the Exchange was even thin. As a result, in an attempt to boost interests in PCH shares, its board of directors has recently appointed the new charismatic CEO, Jack Mars, who is also known to be financially aggressive in turning around a stagnant company. To the board of directors’ delight, PCH share prices have been largely boosted lately.

The rise of PCH shares has just caught the eyes of Cassie Yuan, who is responsible for the managing of ‘The Fundamentals Strike Back’ mutual fund (FSB). Cassie asks you, her assistant, to evaluate the value/fundamental aspects of PCH accordingly.

Details of PCH and its industry (furniture and home products) are given as follows:

PCH             Industry

(Note: N/A stands for “not available” and that you need to calculate it.)

(D/E ratio appeared above includes ALL debts in the company (both S/T and L/T))

Questions:

1)  In an integrated framework, identify whether investors would be happy with PCH performance. Indicate the firm’s strengths and weaknesses. (5 marks)

2)  Provide a suggestion/note to Cassie on whether FSB should add PCH stocks into the portfolio, based on the above analysis. In the process, you can discuss how a potential investor could look further into PCH (i.e., Aspects the company can improve or maintain with its financial management; Any cautions to pay attention to, if any; and so on)                (2 marks)

Part B: Investment decision under uncertainty and its link to Real Options (18 marks)

Sanjay Ventilation Corp

Neena Mishra is about to make her first major decision as Chief Financial Officer and Chief Executive Officer of Sanjay Ventilation Corporation (SVC), a manufacturer/provider of heat pump and ventilation instruments and systems for clients in lower North Island NZ. In 2010, the corporation was founded by three former employees ofa reputable and dominant company in the same industry. The company’s records of growth and profitability were extraordinary during the period 2010-2013, with earnings amounting to over $10 million in the third year of operation.  Because private  investors  in  the  area  assumed that this  earnings  trend would continue, the company’s share value is estimated to be 20 times earnings during 2013, e.g., P/E ratio = 20, giving the firm a total market value of $200 million. At that point, each of the company’s three founders held about 10 percent of the share and had a paper net worth of approximately $20 million on an initial investment of about $100,000. The remaining 70 percent of the share was owned by private funds, mainly large individual investors in the area.

The extraordinary expansion during the first three years of the new company’s life was financed partly by the sale of shares now owned by the private funds and partly by bank credit. Most ofthe bank credit consisted of short-term loans used to finance heating/cooling equipment purchased “off the shelf” and integrated into the smart air-conditioning systems sold to clients. In general, each client bought a package that included the air-conditioning units and systems, along with routine maintenance package especially designed by SVC’s marketing team to meet the client’s individual preference.

Despite its astonishing growth, the three founders made two mistakes.  First, they put up their own SVC shares as collateral for personal bank loans that they used to buy the shares of other competitors in the same region (to quickly expand customer base and get rid of competition at the same time). Second, SVC purchased a large quantity of cooling units just before the announcement that the regulators over the industry were releasing significant tax benefits for new technology that are more environmentally friendly than what SVC has just acquired. Due to ever-increasing awareness toward sustainability (and tax advantages), SVC was forced to adapt its recently acquired units to the new standards at an extremely high cost. It could not recover this cost, though, by charging higher prices to consumers. Thus, profits never reached the levels that had been anticipated. The net result was that profits dropped from $10 million in 2013 to $1 million in 2014, then to a loss of 8 million in 2015.

The sharp earnings decline, coming at a time when industrial shares were also weak, drove the estimated value of the share down from its 2013 high to a low of $3.33 per share. The fall in the estimated value of the share reduced the value of the share that the three founders had put up as collateral for their personal bank loans. When the (estimated) market value of the securities dropped below the amount of the loans, the bank, acting under a clause in the loan contract, sold the pledged securities on the potential interested parties (vultures) to generate funds to repay the bank loan. This fire sale (30% of ownership) further depressed the perceived value of SVC’s stock. The proceeds from this share sale were not sufficient to retire the bank loan as a result. Finally, the three men declared personal bankruptcy. Thus, in just six years, each of the founders saw his net worth go from $100,000 to $20 million to zero.

Sanjay Ventilation Corporation (SVC) itself was badly damaged by this series of events, but it remained intact. When the three major stockholders lost their shares in the company, the remaining private funds, and a group of individual investors, who now had control of the firm, decided to put in a completely new board of directors and to install Neena Mishra as CFO and CEO. These controlling investors would naturally have preferred to sell their holdings of the stock. But they realized that if they attempted to do so they would further depress the market; they were “locked in” and needed to navigate with SVC, at least for another while.

Ms. Mishra was given significant stock options in the company and was told that she was expected to return the firm’s lost luster. At the last annual meeting, there had been some debate among the dominating controlling groups of investors concerning the firm’s underlying philosophy. The more aggressive investors (e.g., private funds) wanted the company to take more chances, while the conservative holders (e.g. large individual investors) preferred a cautious approach. The issue was never resolved, and Neena concluded that she could decide the risk intake of the firm for herself.

Neena Mishra was certain that her own position would be on solid ground if she followed a high-risk, high-(average/expected) return policy and was successful. After all, Private fund group is now having more saying on the company’s direction. Her stock options under these conditions would be extremely valuable, and her salary would be assured. But what if the opposite would be realized, in such an uncertain environment?

The first major decision Neena must make involves a new ventilation add-on filter technology that helps handling Fine Particulate Matter (PM2.5) (and especially severe pollens in the region) with absolute perfection. In general, this is risky but very potentially rewarding. Originally, the investment proposal is that Dusty-rid Inc (the company with best expertise and experience in the region, but smaller in  size and operation scale) would sell to  SVC all necessary equipment and know-how. The initial one-time cost of this route to SVC would be $10 million upfront. SVC will then be in full control of the sales and services to customers (on this new PM2.5 perfect filter technology) afterwards. The potential benefits of this deal can be great if the new super-filter would become particularly popular among customers in the region. Elements for estimated items to calculate (expected) cash flows (and thus NPV) are given down below.

Original Proposal: (all expected numbers are ‘incremental’)

Initial outlay = $ 10 million

Earnings Before Interest and Tax (end of year 1) =  $1.5 million

Corporate Tax rate = 28%

Depreciation & Amortization = $ 1 million

Change in Current Assets = $100,000

Change in Current Liability = $70,000

Salvage value = NONE

Note: The projects’ initial outlay will be incurred RIGHT IN THE BEGINNING OF the first year (e.g. t = 0). For lack of better information, Mishra estimates that the actual first-year cash inflow (e.g. t = 1) from the project will continue for the entire ten-year life.

However,  being  concerned  about  uncertainty  around  this  new  investment, Neena proposed another alternative to Dusty-rid that calls for a partnership (co-investment) with SVC. To mitigate the risk to SVC even further, Neena added to this alternate deal that Dusty-rid must provide SVC with an exit strategy. Specifically, after five years of the super-filter project, SVC can choose to sell the part of the project that it owns to Dusty-rid at a fixed price. Neena then asked Dusty-rid management to name the price. In a few days, Dusty-rid came back with the price as $3 million. Apparantly, the partnership alternative represents a smaller scale operation to SVC. Projected numbers based on this alternative itself are given as follows:

Alternative Proposal: (all expected numbers are ‘incremental’ , and to SVC)

Initial outlay = $ 7 million

Earnings Before Interest and Tax (end of year 1) =  $ 1,100,000

Corporate Tax rate = 28%

Depreciation & Amortization = $ 700,000

Change in Current Assets = $50,000

Change in Current Liability = $35,000

Salvage value = NONE

Note: Same as the original proposal, the projects’ initial outlay will be incurred RIGHT IN THE BEGINNING OF the first year (e.g. t = 0). For lack of better information, Mishra estimates that the actual first-year cash inflow (e.g. t = 1) from the project will continue for the entire ten-year life.

Other relevant pieces of information are given as follows:

-  The discount rate that reflects the riskiness in air-conditioning industry is 9%

-  The New Zealand 10 Year Government Bond yield is 4.38%

-  The variance of share returns on renovation industry in New Zealand is 36%

-  The decay rate can be assumed as equal in each year throughout the life of the project

-  Let’s use e = 2.71828

Neena realises how important her first major decision is (to prove her worthiness to the board of directors), not only to SVC but also to her own future. Therefore, she has asked you, the financial analyst under her supervision, to evaluate and compare the above two alternatives.

QUESTIONS

1.   With the uses of Excel (Neena will later need to use those Excel files to adjust   numbers herselfjust in case), calcuate the worth of each alternative accordingly. (12 Marks)

2.   At what Exit price would the two alternatives be identical in their worths. (2.5  Marks)

3.   Write a two-page (maximum 3 pages) Executive Summary to Neena to advise which alternative should be pursued by SVC. In the process, make use of numbers you calculated from Questions 1 and 2 for justifications. Also provide the points to be cautious about in your analysis.                   (3.5 Marks)

Notes:

- The due date for the assignment is Thursday April 6th, 2023 (at 11.55 pm online submission on Stream). Late assignment is penalised 10% of the total score each day. This is unless you have valid justifications and are in contact with Jeff before time. Having mentioned that, anything submitted    after the solution is made public (about two weeks after due date in normal scenario) will receive no score.

- Use Microsoft Excel application wherever possible. This is for Part B, when you work with NPV, real option, and goal seek. Submit your Excel work file along with the answers well written in a Words file.

- There is no particular setting of how many pages the overall assignment should contain (except for Part B Question 3). It should be complete and yet concise (e.g., not over 20 1.5-spaced pages of a Word file).