The Rondo Company For MBAF 602 - Financial Decision Making A context is required for a student working on a case study. In this case assume that your...

The Rondo Company For MBAF 602 - Financial Decision Making A context is required for a student working on a case study. In this case assume that your point of view is that of the CFO of Rondo analyz ing its strategies on January 1 of the current calendar year. The Rondo Company is a medium size ma nufacturing company that manufactured copper, steel, and iron pipe. The company was founded by Bill Ron do, the current president and board chairman. Mr. Rondo owns the majo rity of the company’s outstanding stock. The stock is active ly traded on the NASDAQ exchange. Key financial, ownership and market information on Rondo is include d in Appendi x A . In addition to the normal course of busine ss, Rondo has two interesting opportu nities that it is considering.

The first opportunity is a special c ontract with a long-time customer. The customer wants to enter into a five-year agreement to have Rondo produce a new type of pipe. Key expected financial information on this special projec t is included in Appendix B . In order to take advantage of t he project, Rondo would hav e to invest the amount noted in Appendix B in special purpose equipment. It is unlikely that the contract would be renewed and also unlikely that the new equipment could be adapted to other production. Since the equipment would be s pecial purpose, the expected salv age value is zero.

The second opportunity is the possibility of acquirin g a company that makes PVC pipe. This company, Poly Pipe Incorporated (P oly), is smaller than Rondo. It had been started by several previous Rondo managers to take advantage o f the new poly vinyl chloride pipe making technology. Although both companies are in the pipe business, their customer bases do not ov erlap signific antly. Metal pipe and PVC pipe are used in different applications. Poly is traded on the NASDAQ pink sheets. The market is not active. The majority of the stock is still ow ned by the three founders. The remainder of the stock is owned by several hundred stockhol ders; its ownership is not concentrated. Key financial, market and owner ship informa tion on Poly Pipe Inc. is included in Appendix C . In addition to these opportunities, Rondo co ntinues its modest growth. While the company’s growth rate has varied over the last 10 years, it currently expects this historical gr owth rate to continue. However, Rondo is operating near its capacity. As a practical matter, growth will require in cremental additions to production equip m ent. MBAF 602 1 of 4 Revise d SP20 05 8W 1 Rondo’s Board of Directors has established several policies. While the Board prefers that these polic ies be followed, they would modify the polic ies if it made sense for the company. • The dividend payout ratio should be between 40% and 50%. • The debt to total assets ratio should not be higher than 50 %. Moreover, the Board’s int ention is to maintain total deb t, including current liabi litie s, at 55% of assets or lower. • Annual company growth shoul d continue in the 5% to 10 % range. The board will measure growth in the annual incr ease in Ear nings Per Share. • The company should maintain flexibility in financial transactions. No high risk transactions should be used, nor should the company tie its hands with financial arrangements. In addition, Mr. Rondo wants to maintain hi s family ownership in the company at a minimum of 30%. He does not want to be re quired to purchase any additional stock. Since the Rondo family counts on the divi dend payments, he is also adamant about continuing the dividend pay ments near their current per share rate. A preliminary analysis by one of the company’ s interns yielded the following information about other companies in Rondo’s industry. Industry Average Current Ratio Average Collection Period Days to Sell Inventory (based on cost of goods sold) Total Asset Turnover Cash as a Percent of Sales Total Debt to Total Assets Gross Profi t Margin Profit Margi n Return on Assets Return on Equity 1.40 45 Days 40 Days 1.10 3% 0.40 35% 10% 11% 20% MBAF 602 2 of 4 Revise d SP20 05 8W 1 Pol y Pipe Incorporated Purchase Poly is a small company that manufactures PVC pipe. They have been in business for 10 years. Growth has been relatively consis tent for the last five years. Poly’s products do not compete directly with Rondo’s.

Poly’s managers want to sell the company. If the sale is to be a cash sale they will require a premium of 50% above the current “m arket” price to cover taxes and still leav e a profit. They would be willing to se ll by exc hanging shares with an appropriate company, possibly on more favorable terms. Sources o f Funds The company has investigated several sour ces of funding for the new project and for future needs. Detailed information and terms on each potential funding \ sour ce is provided in Appendix D . Terms are those required by t he provider of funds. While some conditions may be negotiable, most are cast in stone. The potential funding options are summarized below:

Common Stock New common stock could be issued at the curr ent market price, however, underwriting and other associated costs (noted in Appendix D) must be consider ed in calculating the total “proceeds” that R ondo would receive. Mortgage Bond The ABC I nsurance Company, the company t hat provided the original mortgage bond, is willing to refund it. The current bond would be replaced with a new one, on the terms noted in Appendix D. The loan would be sec ured by all the assets of Rondo, including any assets acquired in the future.

Convertible Bond The XYZ Insurance Co mpany is willing to iss ue a convertible bond. XYZ wants to be able to share in Rondo’s succes s but also reta in the ability to re main a creditor if the Company is not successful. Each $1,000 bond would be convertible into a\ certain number of shares of Rondo co mmon stock, as noted in Append ix D. In addition, cash dividends would be restricted. Cash div idends could not be paid unless net income was 20% of the value of the bonds outstanding. Preferred Stock The MNO Insurance Company wa s willing to o ffer a preferred stock arrangement. In addition to the preferred sto ck, MNO wanted warrants to sweeten the deal. Each share MBAF 602 3 of 4 Revise d SP20 05 8W 1 of preferred stock would cont ain warrants that allowed the purchas e of a certain number of shares of Rondo Common stoc k at the exercise price out lined in Appendix D. In addition, if four consecutive dividends were missed, the preferred stockholders would elect 50% of the board of directors. Bank Loan The current bank loan could be extended with additional amounts available, as noted in Appendix D. Foreign Denominated Loan A local bra nch of a Swiss bank is willing to provide Ro ndo with a loan denom inated in Swiss Francs (meaning the proc eeds and all payments will be in Swiss Franc s). The terms and expected exchange rates are fo und in Appendix D. Note: for si mplicity this case assum es t hat all interest pay ments on loans, bonds, and preferred stock are paid annually . You should know that bank loans have a wide variety of interest-pay ment arrangem ents, virt ually all bonds have sem iannual interest pay ments and preferred stock divi dends ar e generally paid quarterly. Key Stud y Questions Throughout the course you will be ask ed to address the following is sues: • How is Rondo doing at this point in time? • What are R ondo’s financing needs for the next 6 years? Include the new project in your calculations but don’t include the purchase of Poly. • Is the new project a g ood deal? Why or why not? • Are funds available int ernally? • Are there any Board of Directors po lic ies that you would suggest be changed? Why? • Evaluate the Swiss Frank loan • Which financing sourc e should be used to fi nance the new project and the company’s continuing growth? • Should Rondo purchase Poly? What should the offer be? MBAF 602 4 of 4 Revise d SP20 05 8W 1 RONDO CASE - APPENDIX A BALANCE SHEET (as of 12/31) 2003 2004 2005 ASSETS Current Asset s Cash 1,469,000 2,032,500 2,460,000 Accounts Receivable 9,000,000 9,375,000 9,750,000 Inventory 4,125,000 4,625,000 5,250,000 Total Current Assets 14,594,000 16,032,500 17,460,000 PP E Equipment 19,000,000 18,375,000 17,500,000 Property and Plant 16,000,000 15,375,000 14,750,000 Total PP&E 35,000,000 33,750,000 32,250,000 TOTAL ASSETS 49,594,000 49,782,500 49,710,000 LIABILITIES Current Liabilitie s Accounts Payable 1,500,000 2,250,000 2,500,000 Current Portion of Bank Loan 2,500,000 2,500,000 2,500,000 Accruals 3,375,000 3,500,000 3,750,000 Total Current Liabilities 7,375,000 8,250,000 8,750,000 Long-Term Deb t Bank Loan 10,000,000 7,500,000 5,000,000 Mortgage Bond 5,000,000 5,000,000 5,000,000 Total Long-Term Debt 15,000,000 12,500,000 10,000,000 Total Liabilities 22,375,000 20,750,000 18,750,000 Equity Common Stock 9,587,500 9,587,500 9,587,500 Retained Earnings 17,631,500 19,445,000 21,372,500 Total Equity 27,219,000 29,032,500 30,960,000 TOTAL LIABILITIES & EQUITY 49,594,000 49,782,500 49,710,000 Notes to Rondo's Balance Sheet:

Bank Loan Information Original Amount Borrowed 15,000,000 Current Amount Outstanding 7,500,000 Interest Rate 6.00% Principal Payment Amt per Year 2,500,000 Year of Final Payment 2008 Interest & Principal Pmts Due December Mortgage Bond Information Original Amount Borrowed 5,000,000 Current Amount Outstanding 5,000,000 Interest Rate 7.50% Principal Payment Amt per Year 500,000 Principal Payments Begin in Year 2010 Year of Final Payment 2019 Interest and Principal Pmts Due December New Appendices.xls -- Appendix A7/18/2005 3:07 PM INCOME STATEMENT (for year ending 12/31) 2003 2004 2005 Sales 41,250,000 46,250,000 50,000,000 Cost of Goods Sold (28,875,000) (32,375,000) (35,000,000) Gross Profit 12,375,000 13,875,000 15,000,000 Selling, General & Admin (4,560,000) (5,205,000) (5,850,000) Depreciation (1,500,000) (1,500,000) (1,750,000) Earnings Before Interest & Taxes 6,315,000 7,170,000 7,400,000 Interest (1,275,000) (1,125,000) (975,000) Earnings Before Taxes 5,040,000 6,045,000 6,425,000 Income Tax @ 40% (2,016,000) (2,418,000) (2,570,000) NET INCOME 3,024,000 3,627,000 3,855,000 Shares Outstanding 1,000,000 1,000,000 1,000,000 Earnings per Share 3.02 3.63 3.86 Dividends Paid 1,512,000 1,813,500 1,927,500 Increase in Retained Earnings 1,512,000 1,813,500 1,927,500 Market Price Per Share 62 Mr. Rondo's Share Ownership 60.00% Rondo Company Beta 1.20 New Appendices.xls -- Appendix A7/18/2005 3:07 PM Appendix B - Special Project Information Term of the Agreement (Years) 5.00 Initial Capital Expenditure for equipment ($ millions) 6.25 Expected Annual EBIT Contribution ($ millions) 2.00 Expected Annual Sales ($ millions) 7.50 Expected Salvage Value of equipment ($ millions) 0.00 Poly Incorporated - Appendix C Balance Sheet Income Statement for the Year Ending December 31 2005 for the Year Ending December 31 2005 ASSETS Sales 31,250,000 Cost of Goods Sold 21,875,000 Current Assets Gross Profit 9,375,000 Cash 2,250,000 Accounts Receivable 5,250,000 Selling, General & Admin 2,229,168 Inventory 8,125,000 Depreciation 1,437,500 Total Current Assets 15,625,000 Earnings Before Interest & Taxes 5,708,333 PPE Interest 500,000 Equipment 9,375,000 Earnings Before Taxes 5,208,333 Property and Plant 5,000,000 Total PP&E 14,375,000 Income Tax @ 40% 2,083,333 TOTAL ASSET S 30,000,000 NET INCOME 3,125,000 LIABILITIES Shares Outstanding 1,100,000 Earnings per Share 2.84 Current Liabilities Dividends Paid 0 Accounts Payable 4,375,000 Market Price of One Share of Stock 36 Accruals 1,875,000 Total Current Liabilities 6,250,000 Long-Term Debt Bank Loan 5,000,000 Total Long-Term Debt 5,000,000 Total Liabilities 11,250,000 Equity Common Stock 2,500,000 Retained Earnings 16,250,000 Total Equity 18,750,000 TOTAL LIABILITIES & EQUIT Y 30,000,000 Potential Funding Sources - Financial Terms (Appendix D) Common Stock Terms Price at which new stock could be issued $62 Underwriting Costs per Share $9 Mortgage Bond Total Amount Offered w/out Poly Pipe Purchase $8 mm Total Amount Offered w/ Poly Pipe Purchase $13 mm Interest Rate 9.00% Repayment of Principal per Year (% of Loan) 10.00% Total Term of Loan (years) 10 years Payments Annual Payment Date December Convertible Bond Total Amount Offered $10 mm Interest Rate 8.63% Repayment of Principal per Year (% of Loan) none Total Term of Loan (years) 10 years Payments Annual Payment Date December # of Shares per $1000 bond if converted 15.625 Preferred Stock Total Amount Offered w/out Poly Pipe Purchase $8 mm Total Amount Offered w/ Poly Pipe Purchase $13 mm Dividend Rate 9.38% Dividend Payments Annual Dividend Payment Date December Par Value per Share $100 Callable after 15 years at price per share of $105 Number of Warrants per Preferred Stock Share 13 Strike Price of each Warrant ($ per Rondo share) $77.00 Bank Loan Total Amount Offered w/out Poly Pipe Purchase $10 mm Interest Rate 11.50% Principal Payments per Year $2 mm Principal Repayment Begins 2006 Payments Annual Payment Date December Swiss Loan Total Amount Offered w/out Poly Pipe Purchase (Francs) 10 mm sf Total Amount Offered w/ Poly Pipe Purchase 18 mm sf Interest Rate 6.75% Repayment of Principal per Year (% of Loan) 10.00% Total Term of Loan (years) 10 years Payments Annual Payment Date December Payment Currency Swiss Franc Expected Exchange Rates (Swiss Francs / Dollar) Year Avg Rate 2005 1.33 2006 1.29 2007 1.25 2008 1.21 2009 1.17 2010 1.14 2011 1.10