Competition Bikes Inc. is considering an expansion to Canada and is trying to determine whether to merge with or acquire the Canadian Biking Inc. facility. We take a look in this summary at capital structure approaches, Net Present Value and Internal Rate of Return and the concerns surrounding that. Competition Bikes working capital is discussed and finally an analysis on if the company should merge or acquire Canadian Biking Inc.
Capital Structure Approach
A1. This summary provides a report and recommendation of a capital structure that maximizes shareholder return. Capital Structure is how well a company finances its assets, operations and growth using short and long term debt, and common and preferred equities. Overall, more equity and less debt attracts investors. Equity is either common stocks, or preferred stocks. Competition Bikes Inc. is looking to expand to Canada. To expand, the company must have the most appropriate capital structure not only to be able to pay off debts, have an acceptable return on investment, and increase cash flow, but to have the appropriate funding to expand and for future stability and growth. Currently Competition Bikes has working capital, long term notes payable, common and preferred stocks, and retained earnings. We will use Earnings per Share (EPS) from the table below to make a recommendation as to what approach the company should use. This is what investors look into as well. There are five capital structure approaches Competition Bikes can take to generate the capital required for the expansion. The table below shows the calculated EPS for each structure which is discussed after.
9% Bonds Only. Bonds are risky because they require a fixed interest payment that could negatively affect shareholder earnings if sales projections are not as anticipated. Payments are typically made semi-annually which decreases the company’s income. This is regarded as a debt, not equity which takes more time to realize benefits. This option yields the highest interest and lowers Competition Bikes Income before Tax (EBT). The plus to this option is that bonds are debt financing and therefore tax deductible. In some smaller companies this is less expensive that using equity to finance debts. Competition Bikes does not fall into this category really because it is unknown if profits will increase or dividends will be diluted in future years. Future monies earned will be used to pay off the debts and not be reinvested into the company as new earnings. Using moderate expected earnings before interest and taxes amounts (EBIT), the EPS for stockholders over 5 years with this option is .103. The lower EPS is means less common stock shares outstanding, less equity, and fewer dividends. The risk is higher in this option as highly leveraged companies tend to have difficulties with cash flow.
50% Preferred Stock and 50% Common Stock. In this option the investors fund the expansion. Competition Bike’s equity is used rather than debts to finance growth into Canada. Investors have more of an invested interest in the company and Competition Bikes has less debt to income ratio. Preferred stockholders will earn dividend payouts on a regular basis while the Board of Directors determines if common stockholders receive dividends. Preferred stockholders also tend to hold on to their stocks longer preventing a declined value in them. There is no interest to pay back in this option therefore, all EBIT are retained. The EPS for this option over 5 years is .203, one of the highest two in this analysis. Investors will see an immediate return on investment beginning in year 9. This option yields the highest net income and preferred stock dividends. On a negative note, this option can be a lengthy process consuming time resources.
20% in 9% Bonds and 80% in Common Stock. The 20/80 option mix of bonds and common stock is a better option that 100% bonds. This option uses both debt and investors to fund the expansion and allows Competition Bikes to give less dividends if it so chooses. The debt to income ratio remains small here and interest low as only 20% is being used as debt. Over 5 years this option yields .197 EPS which is the close to the 50% preferred and common stock. There is more risk here as debts must be paid back on a strict schedule, regardless of income. However, EBT is higher and the total income available for common stock increases.
40% in 9% Bonds and 60% Common Stock. Like the previous option, this option uses both debt and investors to fund the expansion. While having 60% in common stock still keeps the company from forced dividend payouts, it’s not as safe as 20/80 option. The split in bonds and common stocks keeps interest low. Not as low as the 20/80 option, but not as high as the 60/40 option. The same holds true for available income. There is more available for common stock than 100% bonds. The EPS for this option is .182 because of the number of outstanding shares is higher than the 20/80 option.
60% in 9% Bonds and 40% in Common Stock. In this option, there is debt just as there is in the first option. The increase in interest (12%) causes less equity and fewer dividends. The income available for common stock is the low
in this option. It’s also important to note that Competition Bikes had declining sales the past two years. It is unknown if they will have enough sales to meet their interest payments on time and continue business as usual. The EPS over 5 years with this option is .16, the second lowest.
Recommendation. Capital structure as we can see can be tricky. It is the best balance of debt and equity to maximize returns, EPS. Excluding the 60/40 option, all the options show continued growth through the years. However, 50% common and preferred stock option yields the stronger EPS at .203 and is therefore the recommendation for Competition Bikes. The continued strength and growth in this option will maximize shareholder return, and yield addition dividends to investors with less risk. The increased EBIT will be retained in the company. The goals of this analysis were to ensure the highest EPS keeping shareholders satisfied while building strong net income in the business. The larger equity versus debt in the 50% Common Stock and 50% Preferred Stock accomplishes that. This option is recommended for Competition Bikes to improve the company’s financial position. The alternate capital structure would be the 20/80 option.
Net Present Value and Internal Rate of Return
A2. In this summary we discuss the Net Present Value (NPV) and Internal Rate of Return (IRR) methods in regards to the proposed investment. These areas determine if the investment is worth moving forward with the merger or acquisition without financially harming the company. The Capital Budget income statements were reviewed to make the following determinations.
NPV. This method appraises investments. The calculation for NPV is the investments total net cash flows minus initial costs. If the result is positive then the investment should be accepted. Negative results should be rejected. The NPV indicates the investment’s value, or profitability.
IRR. This method is more often used to make investment decisions with companies. The IRR calculation is the discount rate of interest that decreases the asset’s net present value to the cost of the investment, or back to zero. This is the true economic return earned. The IRR should be equal to or greater than the cost of the capital, or hurdle rate, to accept the investment. Competition Bikes requires a 10% hurdle rate to pursue the investment. Lower results should reject the investment. Growth is considered in this method. The IRR is the efficiency and yield of an investment.
Competition Bikes Inc. has provided the following five year projection on NPV and IRR. This is provided in both the low demand and moderate demand scenarios.
Concerns for NPV – Low Demand. After investing $600,000 in this scenario, the total present value of $573,260 yield a negative $26,740 NPV. Although this does not mean the company will lost money in this scenario, it does mean they will not meet their self-set 10% hurdle rate. Growth in sales is set at 49,000 or six units yet not enough to increase to a positive NPV in five years. This is an indication the company should not move forward with the expansion as investors will most likely not want for the cost of capital to be realized. The global economy is also at a low point which give Competition an even higher risk of not making its even low demand model sales expectations.
Concerns for NPV – Moderate Demand. After investing $600,000 in the moderate scenario, the total present value is $602,243 leaving a NPV of $2,243. While this is a positive number, it is not a high one so the company would have to decide if projections were more accurate in the moderate demand, or low. If Competition Bikes does not meet its projections by any margin, this NPV will move into a negative status. In addition the declined economy,
Competition Bikes has been over predicting sales in recent years. If the company follows this same pattern, the numbers in this scenario could be off.
Concerns for IRR – Low Demand. The rate of return for this scenario is 8.7%, 1.3% lower than Competition Bikes’ 10% threshold. This indicates the project will not be funded or profitable, steering investors away from investing.
Concerns for IRR – Moderate Demand. The rate of return for this scenario is 10.1%. Although it is above Competition Bikes’ set limit for moving forward, it barely meets the minimum. With the market in a down swing, its best to look at the low demand rather than moderate at this point. Having the moderate barely meet the 10% should raise concern for the company. Investors may not want to spend money for a venture that is marginally acceptable.
Not recommended. From the summaries above on the NPV and IRR, it is not recommended that Competition Bikes move into the Canadian market at this time. There is a possibility that the expansion would be a success, but the risks are too high. The 10% rate of return is not only rarely met in these scenarios, that threshold may be a little low too. Expansion into another country with additional building planned is much riskier than just an internal investment due to economic and regulatory issues. The cash flows used to create these scenarios are not exact either. Competition Bikes would need to leave itself a little more room for cash flow fluctuation. Although they will be spending more on advertising in the first year, it is unknown if it will increase sales. The expansion is something that could be reconsidered after the economy bounces back.
Working Capital for Canadian Expansion
A3. (1) Obtain Working Capital. Working capital is Assets minus Liabilities and can be obtained by several avenues. Competition Bikes will have to build working capital to afford the expansion. Below are some of the avenues the company can use to acquire working capital.
Debt financing. One time transaction bank loans is debt financing and usually comes with a higher closing cost. Loans can also be obtained through government loans such as the Small Business Administration. These type of loans can be long or short term but general hold high interest rates. SBA loans general have terms less restrictive than those at the bank because they are services through the loan guarantor, not the lender. Avoiding using outside monies to fund a project is optimal assuming a favorable cost/ benefit ratio.
Revolving Credit. Credit can be used continuously to fund multiple projects. Lines of credit tend to have lower payments than bank loans. Lines of credit can be used as working capital when appropriate. Interest is paid here and monthly payments cannot be missed or the company’s credit rating is at risk.
Liquidating Assets. Companies can sell unnecessary assets such as structures or buildings, land, machinery, etc. Competition Bikes can sell its excess parts.
Equity Financing. Offering preferred and common stock is a way to obtain working capital without going further into debt. Maximizing shareholder returns will raise funds for the company. Stocks will dilute ownership in the company but make the expansion possible without the threat of debt.
Increase Sales. Managing already existing finances such as paying off debts, increasing sales and capacity, investing in marketing and advertising, lowering production costs and growing the business can increase working capital. Retained earnings can be reinvested as working capital as well.
Lending. Working capital can be obtained from selling accounts receivable or increasing their accounts receivable collections system. Loaning more money with longer terms or reducing fixed and variable costs can also increase working capital.
A3. (2) Manage Working Capital. Managing or preserving working capital is done by budgeting, reinvestments, managing accounts payable and receivable, and inventory and asset management. There are other ways to manage or preserve working capital but these are discussed here.
Budgeting. Competition Bikes can maintain its working capital by budgeting properly. Controlling costs and managing debt and assets will maintain cash flow. The balance sheets showed errors and ambiguous spending. Good record keeping is essential to know where money is going and where it’s coming from. The company can improve their debt management to know where costs can be cut. Paying debts on time will decrease interest paid and worthy record keeping can help know when the debts are due.
Reinvesting. The company can reinvest working capital to preserve it. The 50% common stock and 50% preferred stock structure mentioned earlier will help the company manage working capital. This option yields the highest earnings per share building capital.
Increase Accounts Receivable Interest and Discounts. Competition Bikes currently invoices at net/30 days. This should be reviewed and shortened to less than 20 days. Discounts should not be offered in excess and should be careful managed. Smart cost control maximizes cash flow. Accounts payable credit terms can be negotiated with suppliers as well. This may decrease interest and help maintain working capital.
Inventory/ Asset Management. In addition to an acceptable record keeping system, inventory control can help the company in knowing what’s on hand, what’s incoming and outgoing. This can help determine what assets can be liquidated and used as working capital.
A3. (3) Lease vs. Buy. Deciding whether to lease or buy is a way to manage or preserve working capital. Competition Bikes needs to know which the better option to preserve their working capital is. The assessment below discusses the options.
Lease. The lease for Competition Bikes would be a 5 year lease with fixed monthly payments. There is a $50,000 buyout option at the end of the lease and no tax deductions are offered. There is a 6% interest rate on leasing the facility. The company would not be locked into keeping the building after the 5 years. Leasing would yield a lower NPV than purchasing the facility and sustains working capital.
Buy. If Competition Bikes chooses to purchase the Canadian facility, it would increase debt and still have fixed monthly payments. However, they would be able to take advantage of tax deductions. There is also a 6% interest rate in this option. Some considerations in purchasing are the depreciation of the facility, the down payment, and the maintenance upkeep. Purchasing the facility requires a $50,000 down payment which results in lower monthly payments than leasing.
Recommendation. Leasing seems to make the most financial sense for Competition Bikes in this scenario. Investing the $50,000 into the company to build revenue and manage working capital is a smarter decision than spending it on a down payment. This option will produce less debt and less risk of bad credit. Given that future growth is unknown, it is better to lease for five years and determine at that time how to expand based on how the market is doing at that time. There is lower inherent risk in leasing and better chance of increased returns. The overall lease payments will be less than purchasing so the company should lease, reassess after 5 years, and look into the option to buy at that time.
Merger or Acquisition
A4. Competition Bikes must consider to merge with or acquire Canadian Bikes Inc. If the company does nothing, it could be faced with market competition that slides the company under. Below we look into the options, the consequences, positives and negatives of each. A final recommendation is made for Competition Bikes based on all information thus far.
Merger. In a merger, the two companies would combine. Competition Bikes is a larger company with 975,000 shares of common stock versus Canadian Biking’s 200,000. Currently the earnings per share for Competition Bikes is .032 and Canadian Biking is at .121. If the companies merge, their earnings per share would increase to .053, an increase for Competition Bikes. In a merger, the acquiring company uses its own securities in exchange for the merged company’s so it will dilute shareholder equity. However, since the exchange would be 3:1 basis, this would result in 65% increase for Competition Bikes, holding as a positive for the company. Both companies have expected continued growth over the next five years becoming a stronger competitor. A Merger would mean increased technology, customer base, and pre-established business departments. The merge will also come with more employees and possible duplication of duties making layoffs inevitable.
Acquisition. In an acquisition, one company (in this case Competition Bikes) will take ownership of the target company (Canadian Biking). Canadian Biking Inc. will no longer exist and stocks for Competition Bikes Inc. will continue, expecting a return on investment. Competition Bikes is offering shares at 1.43, 30% premium over their current stock of 1.10. The projected cash flow does not meet the 10% hurdle rate Competition Bikes requires for investments. With an offer price of $286,000 and present value of $212,138, that would leave a negative NPV of $73,862. This will not leave the company with a return on investment. Since Competition Bikes has had decreased sales in the past few years, acquisition is riskier than a merger. In an acquisition Competition Bikes would acquire all of the patents and copyrights from Canadian Biking.
Competition Bikes Inc. is considering a Canadian expansion and is faced with the determination whether to merge with or acquire the Canadian Biking Inc. facility. We have analyzed the source and management of working capital to help the company in the decision to merge with Canadian Biking, Inc. or to acquire the company. After consideration of the items discussed, it is recommended that Competition Bikes merge with Canadian Biking Inc. The monies required to merge with Canadian Biking Inc. should come from 50% preferred and 50% common stock. The growth of the merged company yields more projected cash flow over five years than if Competition Bikes simply acquires Canadian Biking Inc.