Capital expenditures of the firms - corporate stockholders, Financial Accounting

The concern uppermost in Sonia Burdett's mind at present was how to effectively communicate to the firm's Board of Directors the soundness of her financial policies. Ms. Burdett is CFO of XYZ Manufacturing, Inc., (MM, Inc.), a position she has held for the past five years. In three days the Board of Directors would meet to consider several issues, all of which had implications for the strategic direction of the firm. Sonia Burdett's role in that meeting would be to provide assistance to the firm's president as he sought to explain the relationship among the firms free cash flow, capital investment opportunities, and capital structure.

MM, Inc., had operated profitably since 1985. Its primary business was the manufacture and sale of turbines for the electric utilities industry. The firm enjoyed a reputation for high-quality products and very reliable service once a unit was sold. The capital intensity of the industry eradicated ease of entry for potential new competitors. As a result, the industry enjoyed relatively stable revenue and earnings growth, and such growth was relatively easy to forecast. In terms of forecasting sales and earnings growth for the industry, trade groups and others indicated in published material that the industry would grow at the approximate rate of the nominal GDP for the foreseeable future. The generation of electric power in the United States would be based upon improved operating efficiencies within the plants that currently existed.

New construction, nuclear or otherwise, was at a virtual standstill for a number of reasons. It seemed that the utilities industry was poised for some type of major transition, as yet unknown. The replacement of turbines and related machinery, including software and other ancillary items related to the operation of the turbines, was now the major source of revenue for MM, Inc., and the firms against which it competed.

The upcoming meeting, for which Burdett intended to be "doubly prepared," as she had remarked to a colleague, concerned issues that were being considered and discussed across a wide range of industries. Such issues bore directly upon corporate financial policy and reflected a fundamental change that was still evolving in terms of the relationship between stockholders and managers. If managers were "agents" of the stockholders, what were the implications of that relationship for such matters as compensation, monitoring of management's performance, and the overall financial viability of the firm? For example, what effect, if any, should the
agency relationship have upon the firm's capital structure? Moreover, was such a consideration an appropriate area of inquiry for the Board of Directors? It was these questions to which Burdett had, for the past weeks, given her full attention. Table l, provides the firm's most recent balance sheet.

Table 1

XYZ Manufacturing, Inc.

Balance Sheet December 30, 1995 ($000s)

 

 

 

 

Cash

$1,860

Accounts payable

$2,976

Account receivable

417

Accruals

744

Inventory

2,187

Notes payable

3,255

Total current assets

$4,464

Total current liabilities

$6,975

 

 

 

 

Land

12,927

Long-term debt

7,734

Buildings

15,438

Total liabilities

14,709

Equipment

22,971

 

 

 

 

Common Stock

13,284

Total fixed assets

$51,336

Retained earnings

27,807

 

 

Total equity

$41,091

 

 

 

 

Total assets

$55,800

Total liabilities and equity

$55,800

Burdett believed that the board was particularly interested in the firm's financial
policies relative to its future use of the firm's free cash flow. [Free cash flow is described as Earnings before Interest and Taxes (1 - tax rate) + Depreciation - Capital Expenditures - Additions to Net Working Capital]. Such cash flow had accumulated due to the comparatively small number of capital expenditure projects available to MM, Inc. The slowdown in industry growth was the main contributor to that situation. The board's use of the term "free cash flow" referred to cash flow available after all acceptable capital projects was funded.

The day of the Board of Directors meeting was finally over, and Sonia Burdett wondered about the long-term effect some of the discussion would have upon MM, Inc. Most prominent among the directors' concerns was the use to which the firm's financial staff would put the firm's free cash flow. The members of the board seemed to believe that such a substantial amount of money should not just become "play money" for the financial staff, as one board member had put it. Free cash flow had increased by 15 percent compounded over the past five years. Specifically, the consensus among the board members seemed to be that the firm should increase its level of long-term debt. An increase in long-term debt would accomplish two very important goals, according to the board's thinking. First, a portion of the outstanding common stock could be retired, thereby increasing the return on equity (ROE) for the remaining shareholders; and second, the payment of interest on the additional debt would assure that the increasing free cash flow would be put to good use.

Ms. Burdett considered the foregoing suggestions in View of the changing nature of the relationship between shareholders and managers. In essence, shareholders were intent upon holding managers more closely responsible for their actions, and making sure such actions were in keeping with the goals of the shareholders. Shareholders could easily monitor the relationship between flee cash flow and debt service payments. Such monitoring was not so easily accomplished when the cash flow was available for expenditures the risk and return for which was essentially unknown to shareholders.

Burdett wondered what effect the additional long-term debt would have upon the firm's debt rating, its interest coverage ratios, and its capital structure in relation to other firms in the industry. These were questions that were of great concern to company management, because even with the forecasted modest growth, the firm wished to maintain its reputation in the industry. The need to raise funds quickly and at competitive rates was important in that regard. Selected industry data are shown in Table 2 below.

TABLE 2
XYZ Manufacturing, Inc
Selected industry Data*

 

Total debt-to-total assets

35%

 

Times interest

9

    Return on equity

25%

*Data for companies that make up 80 percent of industry capacity, year-end 1994.

In addition to the foregoing data and information, the average interest on M.M., Inc.'s
debt in 1995 was 7 percent. The yield curve was relatively flat during this period. Burdett believed that long-term funds borrowed within the next 12 to 18 months would carry an interest rate of approximately 8 percent. Profit after tax in 1995 was $1 1,152, and the firms tax rate is 30 percent for the combination of federal and all local taxes.

QUESTIONS

1. Why are managers considered "agents" of corporate stockholders? Is the description justified? Explain your reasoning.

2. The ?1m's Board of Directors wishes to have more control over the managers' use of the firm's free cash flow by the increased use of debt. Is there a "cost" to this aspect of the agency relationship? If so, how would the cost be described? Discuss any alternatives to incurring such a cost.3. Of what relevance is the information provided in Table 2, given that it is 1994 data?

4. What is the meaning of a "flat" yield curve? How is such a curve relevant to Burdette's concerns?

5. Assume that Burdett will double the firm's long term debt and use the funds to retire equity. (Assume that the common stock data shown in Table 1 is market value data.) What is MM, Inc.'s total debt-to-total-assets ratio, times interest earned, assuming no change in EBIT, and ROE before and after the acquisition of the additional debt?

6. Assess the change in the ratios calculated in Question 6.
7. Would the board members' concerns be better addressed if they requested detailed and ongoing information concerning the f11m's capital expenditures? What are the likely costs and benefits to such a request?

8. Are there any specific recommendations that Burdett should make to the board? Why?

Posted Date: 3/26/2013 7:20:35 AM | Location : United States







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