Arley Merchandise Corporation - Case Study Example

Arley Merchandise Corporation: Money-back Guarantee The alternative of meeting the money-back guarantee by issuing a ten year was included in the proposal because the possibility exists that the company may not be in a position to pay out cash. Additionally, it may not be in the best interest of the company to issue additional shares if the value of the shares is less than $8 when the option is exercised. All the other alternatives have corresponding negative implications for Arley Merchandise.

Paying out cash of $6 million could involve the company borrowing funds in whole or in part. The company has a lot of debt, with a debt ratio (total debt to total assets – 29,683/39,977) of approximately 75% which will only be reduced to approximately 60% if the company goes ahead with the IPO. Any increase in debt would in addition to increasing the company’s financial risk, also place the company in a position where it would not be able to obtain loans at favourable interest rates in the near future.

The weighted average cost of debt is 14.4% (See Appendix 1) which represents the industry average. Arley’s interest rate may be higher because it is a smaller business compared to those on the market and the company also has a higher debt ratio then the industry. If the company sought to issue $8 per share in market value of common stock then the earnings per share would be further diluted as if the shares are valued at less than $8 on the stock market at the exercise date. The company does not currently pay dividends and do not expect to pay dividends in the future.

It means that shareholders would have to manufacture there own dividends. Selling shares to obtain income (manufacturing dividends) will involve additional costs such as broker fees and therefore does not represent an attractive option for the investors. The ten year note is therefore a more favourable option as it will prevent the company of going outside. The rate of 128% above treasury rate is just 1% higher than the rate of 127% which was offered in January 1983. Although issuing the ten year note increases debt, it does not involve a negotiation of interest rate; neither does it consider the level of debt currently available.

Arley Merchandise would only be paying interest on the notes which is fixed. Interest expense is an allowable deduction for tax purposes. If the company decides to pay divide pay dividend in the future it would be a less advantageous option to investors. Furthermore, the ten year note is a less risky option for investors as they have prior claim over shareholders should the company go into bankruptcy. It would therefore attract more investors to buy the company’s shares. The fact that it pays interest quarterly makes it even better.

Part 2 This option has a positive effect on the value of the guarantee to purchasers as it results in a positive NPV of $666,927 as shown in the table below. With the ten year note the NPV became positive starting from year 3. Investors would therefore be attracted to the offer because of this reason. Any other proposal is uncertain and depends on the price of the shares. See additional supporting calculations in Appendix 2. The table shows that up to the end of year 2 a payment of cahs to investors would be worth $4,698,600, representing a loss in value of the amount initially invested of $1,301,400 as shown in the table.

The share offer at $8 would be uncertain. Value of 10 Tear Treasury Note Option Year Cash Flow PV Factor (13%) PV Cash Flow Cummulative 0 -6,000,000 1 -6,000,000 1 0 0.885 0 2 6,000,000 0.7831 4698600 -1,301,400 -1,301,400 3 1,680,000 0.6931 1164408 -136,992 4 1,680,000 0.6133 1030344 893,352 5 1,680,000 0.5428 911904 1,805,256 6 1,680,000 0.4803 806904 2,612,160 7 2,580,000 0.4251 1096758 3,708,918 8 2,328,000 0.3762 875793.6 4,584,712 9 2,076,000 0.3329 691100.4 5,275,812 10 1,824,000 0.2946 537350.

4 5,813,162 11 1,572,000 0.2607 409820.4 6,222,983 14 1,920,000 0.2307 442944 6,665,927 NPV $665,927 Appendix 1 Calculation of Industry Average Cost of Debt Straight Debt Yield Amount Sold ($'000) Yield X Amount sold Occidental Petroleum 14.50% 1200 174.00 Horn & Hardart 14.50% 50 7.25 MacLeod-Stedman 15.50% 30 4.65 Showboat, Inc 15.80% 58 9.16 Cannon Group 15.40% 70 10.78 Chrysler Financial 13.00% 200 26.00 Elsinore Finance 15.50% 115 17.83 Lear Petroleum 14.50% 180 26.10       1903 275.77           Weighted Average Cost of Debt (1903/275.77) 14.49% Appendix 2 Sinking Fund Payment Interest calculation Principal Payment Total Payout Year 7 900,000 7 28% x $6mn 1680000 900000 2580000 8 900,000 8 28% x $5.

1mn 1428000 900000 2328000 9 900,000 9 28% x $4.2 1176000 900000 2076000 10 900,000 10 28% x $3.3 924000 900000 1824000 11 900,000 11 28% x $2.4 672000 900000 1572000     12 28% x $1.5 420000 1500000 1920000