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Thus, Gibbs concluded that she should create a business plan that not only described thc product, the rnarkcts to be served, and the firm's production plans, but which also outlined the anticipated financing requirements in some detail. The initial marketing plan called fbr selling thc tinted windows directly to large contractors and usin-9 sevcral wholesalers to distribute the items to architects and small contractors. At a pro.jected average selling price of $750 per unit, they had little doubt that sales would be strong. Howcver, thc tintcd windows will be used prirnarily in new construction, and this industry has always been subject to highly cyclical sales. Further, although the sunbelt region is continuing to L'xperience relatively strong commercial and residential markets, other sunbelt areas such as Houston have been sufl'ering liom high commercial vacancy rates and depressed residential markets. Thus. Gibbs t'elt uncomlitrtable about using a point cstimate tbr unit sales. st'r she developed estimates firr threc possible scenarios: rlost likely, optirnistic, and pessimistic, with probabilities ol occurrence of 0.50, 0.25, and 0.25, respectively. Of course, Cibbs realizes that unit sales could assume almost any value. but I'rer discrete distribution is roughly cornparable to a continuons norrnal distribution which has a range of plus or n.rinus 2 standard deviations abttut the mean: Probability Unit Sales Pessimistic 0.25 52,200 Most likely Optimistic 050 025 67,500 82,800 Scenario Dollar Sales $39,150,000 50,625,000 62,100,000 After an in-depth study, Phillips, the engineer-production manager, identified two alternative production processes that could be employed, and he asked Gibbs to evaluate the financial irnplications of the alternatives and to recornnrend a course of action. Plan A involves only a sn.rall amount of automated equiprnent, as most of the window cornponents would bc purchased ticlm local subcontractors. Under this plan, annual fixcd costs are estimated to be $7,769,900. while variable costs would be $585 per unit produced. The second alternative. Plan B, would recluire the firm to make a significant investment in fabrication machinery, resulting in a fixed cost estintate ol'$17,845,000 per year and variable costs clf $4 l5 per unit. Neither l'ixed cost estimate includes interest expense, since thc capitalization mix is still uncertain. The company plans to set the initial sales price at $750 per unit regardless of which production process is chosen. Total capital requirernents lbr both current and fixed assets. as well as start-up operating tunds, are estimated to be $14.0 million under Plan A and $20.0 million under Plan B. To help with the capitalization decision. Gibbs had extensive meetings with investment bankers, venture capitalists, cornmercial bankers, insurance exccutives. and mutual-l'und managers. 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The final price is adjusted to re{lect investor reactions. with this background, answer the fbllowing questions: a. If the firm's tax rate, T, is estimated at 40 percent, what amount ol' financial leverage would maximize the value ctf the firm'l b. How many shares will the tbunders receive? What is the value of their shares'l c. Calculate Johnson Window's weighted average cosr ol'capiral (WACC) at each debt levcl. What is the relationship between Johnson's value and its WACC ? d. Suppose an investor purchased shares at $ I 0. learneri that the fbunders had bought their shares tor onty $0.10, and then f'elt cheated and threatened to sue the cornpany and its lbunders. Would this person have a good case'l Should the SEC protect investors liom this kind of thing'/ Gibbs is well aware of the t'act that the average manutacturing company has a tinres-interestearned (TIE) ratio of about 6. Using TIE as a risk measure, together with your answer to Question 2, how risky does the company appear to be? 4. Supptrse Johnson is planning to raise debt by issuing a2}-year term loan. What would be the annual payment, including both interest and principal amortization'l Use this intbrrnation to calculate Jclhnson's expected first-year debt service coverage ratio, clefined here as EBIT/(Interest expense + Befbre-tax principal repayment). If the average manutacturing firm has a coverage ratio of about 4. what does this indicate about Johnson's riskiness? 5. Suppose this were your company. Would your choice of debt level be inlluenced by your other asset holdingsT That is, would it matter whether your entire net worth was invested in the company as opposed to the situation where you owned rnillions of dollars ol'stocks in other cornpanies in addition to your holdings in Johnson Window,l 6. The entire analysis depends on (a) Gibbs's estimates ol'the costs of debt and equity at diffbrent capital structures, and (b) the validity of the ecluation given in 2. a. How confident are you in Gibbs's sstimates mates af'fbct the capital structure decision l euestion olku and k.? Could changes in these esti- b. What assulnptions underlie the equity valuation equation? Is it likcly that Johnson meets these assumptions? A theory has been expressed in the finance literature that "intbrmation asymrnetries" cause investors to interpret the sale of stock by a company as a "signal" that things nlay gct worse in the future, whereas the use of debt is taken as a positive signal. In general, what implicatitlns does this have lbr capital structure policy? Does it matter il'the flrrn in cluestion is a mature company or a start-up firm? Would it matter if the lounders planne
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