? Advanced Engineering Company was founded by two spouses: Meredith Gale and Shelley Yeaton. shortly after they graduated from technology school. Within five old ages the spouses had built a thriving concern. chiefly through the development of a merchandise line of mensurating instruments based on the optical maser rule. Success brought with it the demand for new lasting capital. After careful computation. the spouses placed the sum of this demand at $ 1. 2 million.
This would replace a term loan that was about to maturate and supply for works enlargement and related on the job capital. At first. they sought a affluent investor. or group of investors. who would supply the $ 1. 2 million in return for an involvement in the partnership. They shortly discovered. nevertheless. that although some investors were interested in take parting in new ventures. none of them was willing to take part as spouse in an industrial company because of the hazards to their personal lucks that were built-in in such an agreement.
Gale and Yeaton hence planned to integrate the Innovative Engineering Company. in which they would have all the stock. After farther probe. they learned that Arbor Capital Corporation. a venture capital house. might be interested in supplying lasting funding. In believing about what they might suggest to Arbor. their first thought was that Arbor would be asked for $ 1. 2 million. of which $ 1. 1 million would be a long-run loan. For the other $ 100. 000. Arbor would have 10 per centum of the Innovative common stock as a “sweetener.
” If Arbor would pay $ 100. 000 for 10 per centum of the stock. this would intend that the 90 per centum that would be owned by Gale and Yeaton would hold a value of $ 900. 000. Although this was well higher than Innovative’s net assets. they thought this sum was appropriate in position of the profitableness of the merchandise line they had successfully developed. A small computation convinced them. nevertheless. that this thought ( afterlife. proposal A ) was excessively hazardous. The ensuing ratio of debt to equity would be greater than 100 per centum. which was considered unsound for an industrial company.
Their following thought was to alter the debt/ equity ratio by utilizing preferable stock in stead of most of the debt. Specifically. they thought of a bundle consisting of $ 200. 00 debt. $ 900. 000 preferable stock. and $ 100. 000 common stock ( proposal B ) . They learned. nevertheless. that Arbor Capital Corporation was non interested in accepting preferable stock. even at a dividend which exceeded the involvement rate on debt. Thereupon. they approached Arbor with a proposal of $ 600. 000 debt and $ 600. 000 equity ( proposal C ) .
For the $ 600. 000 equity. Arbor would have 6/15 ( i. e. . 40 per centum ) of the common stock. . . . Assignment 1. For each of the four proposals. cipher the return on common shareholders’ equity ( net income after preferable dividends divided by common shareholders’ equity ) that would be earned under each of the three income premises. Round computations to the nearest $ 1. 000 and 1/10 per centum. 2. Calculate the pre-tax net incomes and return on its $ 1. 2 million investing to Arbor Capital Corporation under each of the four proposals.
Assume that Arbor receives a dividend equal to its part of common stock ownership times Innovative’s net income after preferable dividends ( if any ) ; presume a “negative dividend” if Innovative has a net loss. 3. Be the spouses correct in rejecting proposals A and B? 4. Remark on the likeliness that Innovative Engineering Company could happen a more attractive funding proposal than proposal D. Answer: A. 1. 100k long term loan. 100k = 10 % of Common Stock. B. 200k Debt. 900k Preferable Stock. 100k Common Stock. C. 600k Debt. 600k Equity. arbor will acquire 40 % of the equity D. 300k debt. 900k equity. 50 % Interest 8 % Dividend 10 %
