Orton Enterprises Limited(OEL), based in Brampton, Ontario,began as a retail fashion outlet in 1988. The business was established by Dylan and Nina Ginnish and Austin and Cassandra Hunter.Nina's aunt, Lorraine Leger, who had retired from the fashion industry invested in the company at start-up.
Nina had worked briefly in the fashion industry prior to immigrating to Canada in 1987 in order to complete a Diploma in Fashion Design from LaSalle College in Montreal. She met Dylan Ginnish who had recently completed a Bachelor of Commerce degree in Entrepreneurial Management and the two were married in 1987. Austin Hunter's background was in fashion design and he had travelled internationally working as a model prior to meeting and marrying Cassandra. Cassandra had studied commerce at the same university as Dylanand the two couples had been planning to go into business together.
HISTORICAL OPERATIONS
After three years of successful operations, the shareholders embarked on an ambitious five year plan for expansion, opening six new locations in the Greater Toronto area. They had designed their own clothing line, "Trinity" for office and casual wear for young business executives. The Trinity label was extremely successful. Rather than opening additional stores after 1996, the company began marketing their line through other retail outlets.
In 1998, the Board of OEL decided it should diversify and developed a ten year plan to invest in other small businesses. There was an immediate opportunity to purchase a toy company with four locations in Toronto, as the owners were ready to retire. Although OELhad a significant cash balance available for investing, it required some additional funds which were provided by Rogers Ventures Inc., an investment company, in exchange for a 20% interest in OEL. Over the next ten years, OEL acquired five other businesses with the right fit and synergies to enable it to continue its growth according to plan. The company went public in 2008and the additional funds provided by the initial public offering allowed the company to reduce its debt and permitted the original shareholders the opportunity to withdraw funds that were outstanding as shareholder loans.
CAPITALIZATION
The authorized capital of OELconsists of an unlimited number of common shares, with no par value, together with 1,000,000 preferred shares with a stated value of $50.00 each. There are currently 700,000 common shares issued and outstanding. Each common share is entitled to one vote. No preferred shares have been issued to date. The table below shows the allocation of the common shares of OEL since the company went public:
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Shareholders
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# Shares
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Dylan and Nina Ginnish
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175,000
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Austin and Cassandra Hunter
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175,000
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Lorraine Leger
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50,000
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Rogers Ventures Inc.
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100,000
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Other shareholdings - widely dispersed
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200,000
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Total
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700,000
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FINANCIAL MATTERS
As part of its long-term financial planning, the chief financial officer for OEL has assigned an analyst in the accounting office to evaluate the firms' current stock price. The analyst has determined that the current risk free rate of return is 4%, while the market rate of return is 11%. The common shares of OEL are currently trading at $43.50 per share on the TSX.
Since 2008, the company has paid regular quarterly dividends of $1.25 per share. The Board of Directors wants to increase the dividend payment and feels that the company could maintain a dividend growth rate of 5% per year for each of the next 2 years and 3% per year thereafter.
OEL generally evaluatesits capital projects on the basis of a 10 year project life, except in the case of asset replacement, in which case the expected life of the new asset would be used. Appendix 3 provides a table indicating the potential for capital projects for 2012 to 2014. OEL evaluates all capital projects using the CAPM rate. Appendix 3 also indicates the optimal capital structure approved by the Board for any future financing. Any income tax considerations would be calculated at OEL's average tax rate.
FUTURE EXPANSION POSSIBILITIES
One of the businesses owned by OELis a printing company, Violet Field Printing Inc. It has experienced steady growth over the past five years but is now looking at the possibility of replacing its four-colour printing press. With the advanced technology available in the new press, Violet Field expects it would be able to handle the steadily increasing demand for complex printing jobs using a four-colour press.The senior accountant at OELhas begun to provide the information needed to determine whether or not to replace the press in 2012.Replacing the current machine would cost $525,000, net of the trade in value of the old machine. In addition, there would be $5,000 installation costs. The anticipated sales and operating expenses expected to be achieved with the new machine are provided in Appendix 4. In addition, the new machine would result in the need for an increased investment in working capital of 10% of sales. After eight years, the machine could be sold for its book value of $12,000.
A business associate of Dylan's has advised him of an opportunity to purchase a modular furniture business, DIY Enterprises, in the Brampton area. The business is up for sale due to the failing health of the owner. The furniture company had recently expanded through the purchase of two other small businesses and there is an opportunity for continued growth. For a cash purchase, a price of $1.2 million will be accepted. Dylan has discussed the situation with the Board and there is interest in proceeding if appropriate financing can be arranged. Dylan has been charged with investigating whether the company should use debt financing through issuing bonds, or equity financing through the issue of preferred or common shares in order to raise the capital required for the project. To begin his analysis, Dylan has been reviewing OEL's financial performance to date. The financial statements for OEL for 2010 and 2011 are in Appendices 1 and 2.
FINANCING
Working with the staff in the accounting office, Dylan has determined that OEL has the following options for financing if the company decides to go ahead with the acquisition of DIY Enterprises:
Debt: The firm can sell a 10-year, $1,000 par value bond paying semi-annual interest at an8 percent coupon rate. Flotation costs of 2 percent of the par value, before tax, will be incurred as well as a discount of $30 per bond.
Preferred equity: OEL can sell its preferred shares at a 14 percent (annual dividend) rate for its stated value. The after-tax cost of issuing and selling the preferred shares is expected to be $5 per share.
Common equity:OEL can issue new common shares at a price of $62.00, with net after-tax flotation costs of 2 percent.
REQUIRED
1. Calculate the following amounts for Orton Enterprises Limited as of the 2011 year end:
(a) Book value per share
(b) Price Earnings ratio
2. (a) For each of the following independent situations, calculate the value of OEL's common shares at December 31, 2011, assuming a market rate of return of 11%:
i. assuming that there will be no growth in dividends in the foreseeable future.
ii. assuming a constant annual 3 percent growth rate in all future dividends.
iii. assuming OEL could maintain an annual 5 percent growth rate in dividends per share over the next 2 years and 3 percent thereafter.
(b) Compare the current price of the common shares and the values you determined in Questions #1(a) and #2(a). Discuss the reasons for the differences in these values. Which valuation method do you feel best represents the true value of OEL's common shares? Why?
3. Calculate the required rate of return and risk premium for OEL's common shares using the capital asset pricing model, assuming a beta of 1.25. What would be the effect on the required return if the beta rises?
4. Prepare a cash flow forecast for Violet Field Printing Inc. to determine the expected annual after-tax cash flows assuming the company replaces the printing press. Income tax for the forecast would be at the average tax rate and paid in the year it is incurred. Determine the NPV, IRR and the payback period and discuss whether or not the project would be financially justified.
5. Complete the following analysis in relation to the potential purchase of the modular furniture business:
(a) Examine and discuss the financial performance ofOELfor 2010 and 2011, including ratio analysis, to determine the liquidity, leverage and profitability of the company.
(b) Discuss in qualitative terms how additional debt financing would affect these ratios and how it would affect the company overall.
6. Determine the cost of capital for each of the financing options being considered: debt, preferred shares and new common shares. Discuss in qualitative terms, the effects of issuing preferred shares or new common shares. Calculate the weighted average cost of capital based on the optimal capital structure approved by the board.
7. Discuss the viability of the two future investments contemplated by OEL by reviewing all risks, pros and cons that you think are relevant and the results from your answers to the previous questions.