Part A
Fundamental Analysis:

Company Overview:
Southern skylights Inc. starts its business plan with a new design of prefabricated skylight that could be mass produced and sold profitably at a significant lower cost than custom units. Chris Marcella, an architect and founder of Skylights is planning to construct the capital structure of the company with co-founders.

Economy analysis:
Investors must make judgments about the financial markets both in the current scenario as well as in the future scenario. Stock prices are one of the leading indicators that typically lead the economy. So we are trying to start by assessing the company’s optimal capital structure that would affect stock prices.

In this case, we have seen three types of scenario (Pessimistic, Most likely, Optimistic) have been developed by the financial analyst. From the very beginning the company is concerned about the financing as well as production planning. According to the financial analyst of the company there are two types of production plans (Plan-A & Plan-B) available for the company. On the other hand for initial capital the company is planning for taking debt, issuing share to outside investors ($10 per share). The founders also agree for their initial investments ($0.10 per share).
We will analyze how much equity and debt could maximize the firm’s value. We will also analyze what production plan could bring good earnings at tolerable level of risks.

Industry analysis:
The purpose of industry analysis is to analyze the economic and market forces that will ultimately influence an industry’s profit potential.

To analyze industries, a useful first step is to examine their stage in the life cycle, which in its simplest form consists of the fragmentation, shake-out, and maturity stages followed by a decline stage. Most investors will usually be interested in the shake-out stage, in which growth is rapid and risk is tolerable.

A second industry analysis approach is Porter’s five factors analysis.

The Industry Life Cycle

The industry lifecycle imitates the human lifecycle. The stages of industry lifecycle include fragmentation, shake-out, maturity and decline.

Fragmentation Stage:
Fragmentation is the first stage of an industry. This is the stage when a new industry develops the business. At this stage, the new industry normally arises when an entrepreneur overcomes the twin problems of innovation and invention, and works out how to bring the new products or services into the market.
Shake-out Stage:
Shake-out is the second stage of the industry lifecycle. It is the stage at which a new industry emerges. During the shake-out stage, competitors start to realize business opportunities in the emerging industry. The value of the industry also quickly rises in this stage.
Maturity Stage:
Maturity is the third stage in the industry lifecycle. Maturity is a stage at which the efficiencies of the dominant business model give these organizations competitive advantage over competition. The competition in the industry is rather aggressive because there are many competitors and product substitutes. Price, competition, and cooperation take on a complex form. Some companies may shift some of the production overseas in order to gain competitive advantage. Our assigned company is in this stage.

Decline Stage:
Decline is the final stage of the industry lifecycle. Decline is a stage during which a war of slow destruction between businesses may develop and those with heavy bureaucracies may fail. In addition, the demand in the market may be fully satisfied or suppliers may be running out.
In the stage of decline, some companies may leave the industry if there is no demand for the products or services they provide, or they may develop new products or services that meet the demand in the market. In such cases, this will create a new industry.

In our case analysis Southern skylights Inc is in Fragmentation stage.

Porter Five Forces’ Analysis

Porter’s analysis of the ‘five forces’ determining industry competitiveness allow strategists to identify the root causes of the level of competitiveness of a given industry, and thus the drivers of its return on capital. In so doing, the work connected the theory of competitive markets with the reality of business and industry strategy. 5 forces are:

In our cases the Southern skylights Inc status as per Porter’s five forces analysis has been depicted in the below table: Sl | Force Name | Status | Comment | 1 | Threat of new entrants | Low | Without newly invented product no one could influence the market | 2 | Bargaining power of buyers | Low | Larger buyer in booming housing sector | 3 | Rivalry between existing competitors | High | Matured business | 4 | Threat of substitute products or services | High | Anyone could develop new technology for skylights | 5 | Bargaining power of suppliers | Low | Availability of equipment in local markets |
Company Analysis:
Company analysis shows the qualitative as well as quantitative factors specifically affecting the concerned business entity.

SWOT Analysis

SWOT analysis is a basic, straightforward model that provides direction and serves as a basis for the development of marketing plans. It accomplishes this by assessing an organization’s: 1. Strengths (what an organization can do) and 2. Weaknesses (what an organization cannot do) in addition to 3. Opportunities (potential favorable conditions for an organization) and 4. Threats (potential unfavorable conditions for an organization).
SWOT analysis is an important step in planning and its value is often underestimated despite the simplicity in creation. The role of SWOT analysis is to take the information from the environmental analysis and separate it into internal issues (strengths and weaknesses) and external issues (opportunities and threats). Once this is completed, SWOT analysis determines if the information indicates something that will assist the firm in accomplishing its objectives (a strength or opportunity), or if it indicates an obstacle that must be overcome or minimized to achieve desired results (weakness or threat). SWOT analysis for Southern Skylights Inc. has been given below:
Opportunities
Threats
Weakness
* Population growth in the region. * It has less competitive environment as the product’s price is comparatively low. * It is a low risk as demand is high in housing sector. * It has to consider projected demand for different standards for projects of different risk * New technology may be a threat to the product. * The company has only two types of production plan. * It needs a huge amount of capital * Relevant risk will be higher when demand will fall * The company has developed newly invented skylights which has patented to the company. * The product will be less costly that custom built skylights * The product gets good report and financial institutions are interested about investing in the company
Strength

Part B
Analysis of Questions:

Question 1
1. Dale should recommend production Plan A. Break even Analysis | | plan A | Plan B | Fixed Cost | 5095000 | 11979500 | Sales price | 500 | 500 | Variable cost | 390 | 275 | Break even quantity | 46318.18182 | 53242.22222 | Break even approx | 46319 | 53243 | Break even sales | 23159500 | 26621500 |

| A | B | | Pessimistic | Most Likely | Optimistic | Pessimistic | Most Likely | Optimistic | Sales Revenue | 26100000 | 33750000 | 41400000 | 26100000 | 33750000 | 41400000 | fixed Cost | 5095000 | 5095000 | 5095000 | 11979500 | 11979500 | 11979500 | Variable cost | 20358000 | 26325000 | 32292000 | 14355000 | 18562500 | 22770000 | EBIT | 647000 | 2330000 | 4013000 | -234500 | 3208000 | 6650500 | | | | | | | | Investment | | 11000000 | | | 15000000 | | ROI | 5.88 | 21.18 | 36.48 | -1.56 | 21.39 | 44.34 | | | | | | | | E(EBIT) | | 2330000 | | | 3208000 | | SD(EBIT) | | 1190060 | | | 2434215 | | CV(EBIT) | | 0.51 | | | 0.76 | | E(ROI) | | 21.18 | | | 21.39 | | SD(ROI) | | 10.82 | | | 16.22 | | CV(ROI) | | 0.51 | | | 0.76 | |

Break-even quantity and sales for plan A is lower than plan B eventhough the variable cost of plan A production process is higher than plan B. The expected earnings before tax and interest of plan A is lower than plan B but the standard deviation of EBIT is lower in plan A than in plan B. A higher standard deviation implies higher risk. The expected reurn on investment in plan A is 21.18 where as expected return in plan B is 21.39. The standard deviation of ROI is higher in plan B than plan A. So, in order to minimize risk Dale should recommend plan A. If the market is really good like in the optimistic situation than plan B might be fruitful but if the market response is not upto that mark the company may face greater loss. Production plan B requires higher investment than plan A. As the market demand is cyclical, so a larger production process which has occasional demand is less preferable. Hence, production process A should be recommended.
Question 2
In this question we consider only plan B where cash requirement for starting business is 15 million. Company’s investment banker suggest that if no debt is used 1.5 million shares can be sold at $10 per share to raise the required 15.0 million capital. But their ultimate goal is to maximize the firm value. For firm value maximization the company takes debt and the remaining money is collected from equity holder and founder. The firm value can be calculated by this equation.
V = D + S
Or, = D +
Here, D = Market value of debt S = Market value of equity Kd = Cost of debt Ks = Cost of equity T = Tax rate
From this equation we can calculate the maximum firm value of the company.
Question 2(a): What amount of financial leverage will maximize the firm’s value?
In case of 40% tax rate the maximum firm value of company under different debt level.

Amount Borrowed | Cost of debt | Cost of equity | Most Likely | 0 | 0 | 0.128 | 3208000 | 3000000 | 0.1 | 0.14 | 3208000 | 6000000 | 0.11 | 0.16 | 3208000 | 9000000 | 0.13 | 0.19 | 3208000 | 12000000 | 0.16 | 0.23 | 3208000 | | | Value of the firm | 15037500 | | 15462857 | | 15555000 | | 15435789.47 | | 15360000 |

For this calculation we consider only the most likely condition. Because under pessimistic condition EBIT is negative. It is no possible to continue business under this condition. And optimistic condition is very risky. From this table we see under most likely condition our firm value maximum under the 3million debt level.
Question 2(b): How many shares will founder receive? What is the value of the share?
The number of funder share and its value can be calculated by value of the firm. Under most likely condition the founder collect required cash by taking debt and selling share to outside investor at $10 per share. The extra firm value will be the founder share and they buy this at $0.1 per share. So, under highest firm value the number of founder share and its value is highest. Under most likely case number of founder shares are 55500 and its value is 555000.

Most Likely | Firm value | No. of founder share | Value of the founder share | 15037500 | 3750 | 37500 | 15462857 | 46285 | 462857 | 15555000 | 55500 | 555000 | 15435789.47 | 43578 | 435789 | 15360000 | 36000 | 360000 | Question 2(c): What is the weighted average cost of capital at each debt level?
Weighted average cost of capital (WACC) is the combination of weight of debt and equity and the cost of debt and equity. We select the WACC only under most likely condition on which debt level the firm value is maximum.
WACC = WdKd + WsKs

Most Likely | Amount Borrowed | Cost of debt | Cost of equity | Firm value | WACC | 0 | 0 | 0.128 | 15037500 | 12.80% | 3000000 | 0.1 | 0.14 | 15462857 | 13.22% | 6000000 | 0.11 | 0.16 | 15555000 | 14.07% | 9000000 | 0.13 | 0.19 | 15435789.47 | 15.50% | 12000000 | 0.16 | 0.23 | 15360000 | 17.53% |

Question 2(d): Would the issue of $10 for outside investors lead to a good case for investors? Should SEC protect investors from this kind of thing?

In Bangladesh when a company goes for raising capital from public it has to submit financial statement of last 3 years. The company has to make profit in those 3 years. If there any accumulated loss exists the company will not eligible for public issue.(SEC rules issue of capital 2001 & public issue 2006).
In our case Southern is a start-up company. For a start-up company share issuing at $10 can lead to a good case for investors. If the company fails to show how they will make profit and will value to the firm then it may lose the case.

SEC should protect investors from this kind of things. Otherwise investor’s money will go in vain if any misrepresentation of information by the company.

Question 3
Time interest earned measure the firm’s ability to make contractual interest payment. The higher its value the better able the firm is to fulfill its interest obligations. The time interest earned ratio is calculated as:
Time interest earned (TIE) =
Interest = Debt x Cost of debt Most Likely | Amount Borrowed | Cost of debt | TIE | 3208000 | 0 | 0 | 3208000 | 3208000 | 3000000 | 0.1 | 10.6933 | 3208000 | 6000000 | 0.11 | 4.8606 | 3208000 | 9000000 | 0.13 | 2.7419 | 3208000 | 12000000 | 0.16 | 1.2291 |

The average TIE ratio of average manufacturing company has 6X. But under our debt level the TIE ratio is 4.86. So, the company faces some problem in paying interest against its debt taken.
Question 4

Question 4: For 20 years term loan what would be the annual payment, including both interest and principal amortization? Annual Payment of debt | Debt Amount (PVAn) | 6000000 | Time | 20 yr | Interest rate | 11% | PVIFA11,20 | 7.963 | Loan Payment | 753484.8675 |

End of Year | Beginning of year Principle (1) | Loan Payment(2) | Interest (0.11x(1))(3) | Principle ((2) –(3))(4) | End of year Principle ((1) – (4))(5) | 1 | 6000000 | 753484.9 | 660000 | 93484.9 | 5906515.1 | 2 | 5906515.1 | 753484.9 | 649717 | 103768.2 | 5802746.9 | 3 | 5802746.9 | 753484.9 | 638302 | 115182.7 | 5687564.1 | 4 | 5687564.1 | 753484.9 | 625632 | 127852.8 | 5559711.3 | 5 | 5559711.3 | 753484.9 | 611568 | 141916.7 | 5417794.6 | 6 | 5417794.6 | 753484.9 | 595957 | 157527.5 | 5260267.1 | 7 | 5260267.1 | 753484.9 | 578629 | 174855.5 | 5085411.6 | 8 | 5085411.6 | 753484.9 | 559395 | 194089.6 | 4891322.0 | 9 | 4891322.0 | 753484.9 | 538045 | 215439.5 | 4675882.5 | 10 | 4675882.5 | 753484.9 | 514347 | 239137.8 | 4436744.7 | 11 | 4436744.7 | 753484.9 | 488042 | 265443.0 | 4171301.7 | 12 | 4171301.7 | 753484.9 | 458843 | 294641.7 | 3876660.0 | 13 | 3876660.0 | 753484.9 | 426433 | 327052.3 | 3549607.7 | 14 | 3549607.7 | 753484.9 | 390457 | 363028.1 | 3186579.6 | 15 | 3186579.6 | 753484.9 | 350524 | 402961.1 | 2783618.5 | 16 | 2783618.5 | 753484.9 | 306198 | 447286.9 | 2336331.6 | 17 | 2336331.6 | 753484.9 | 256996 | 496488.4 | 1839843.2 | 18 | 1839843.2 | 753484.9 | 202383 | 551102.2 | 1288741.0 | 19 | 1288741.0 | 753484.9 | 141762 | 611723.4 | 677017.6 | 20 | 677017.6 | 753484.9 | 74472 | 679013.0 | -1995.3 |

The firm’s coverage ratio indicates the firm’s ability to meet certain fixed payment obligation. The average manufacturing company has a coverage ratio of 4X. The higher the value the better for the company. coverage ratio =
Our company has a coverage ratio more than 4X. So, company is in good condition of fixed payment obligation. EBIT | Interest expense | Principle Payment | Coverage ratio | 3208000 | 660000 | 93484.9 | 4.26 | This ratio is same for all time for which the loan payment is continued. |

Question 5
Suppose this were your company. Would your choice of debt level be influenced by your other asset holdings?

A debt is created when a creditor agrees to lend a sum of assets to a debtor. Debt is usually granted with expected repayment; in modern society, in most cases, of the original sum plus interest. We have seen in Q 2 that southern has maximum value when it uses debt of 6000000. When the firm receives relatively higher cash flows it will not bother for liquid asset holdings. But when firm’s expected cash flow will decrease, shareholders will aim liquid assets. There is an empirical relation between debt and asset holdings. High level of debt will lead to high level of asset holding. On the other hand low level of debt will stand for low level of assets. So when the debt level changes it influences the asset holdings of the company.
Question 6 a) How confident are you in Dale’s estimates of k d & k s? Could changes in these estimates affect the capital structure?

There are some controllable factors affecting k d & k s. Here we will analyze Dale’s estimation of k d & k s.
These are the factors affecting cost of capital that the company has control over: 1. Capital-structure policy: When a firm has control over its capital structure, targeting an optimal capital structure. As more debt is issued, the cost of debt increases, and as more equity is issued, the cost of equity increases. Dale’s estimation mainly based on the capital structure of that company. As it is a fragmented company it has to target for an optimal capital structure.

2. Dividend policy: When the firm has control over its payout ratio, the breakpoint of the MCC schedule can be changed. For example, as the payout ratio of the company increases the breakpoint between lower-cost internally generated equity and newly issued equity is lowered. But here Dale doesn’t calculate anything regarding dividend policy.

3. Investment policy: It is assumed that, when making investment decisions, the company is making investments with similar degrees of risk. If a company changes its investment policy relative to its risk, both the cost of debt and cost of equity change. Here Dale’s estimation about the return of the investment is good.

There are some uncontrollable factors affecting kd & ks.

These are the factors affecting cost of capital that the company has no control over:

1. Level of interest rates: The level of interest rates will affect the cost of debt and, potentially, the cost of equity. For example, when interest rates increase the cost of debt increases, which increases the cost of capital. Dale has taken different rates of kd & ks at different level. But it was unexplained when the interest rate will increase how the company will cover interest expenses.

2. Tax rates: Tax rates affect the after-tax cost of debt. As tax rates increase, the cost of debt decreases, decreasing the cost of capital. In our case the tax rate is fixed at 40 percent.

Finally, the sensitivity of k d & k s has not been shown in Dale’s estimation. If k d & ks becomes more sensitive to each other then the firm will face difficulty in future. If they show less sensitiveness then it will be sustainable.

b) What assumptions underlie the equity valuation equation? Is it likely Southern meets these assumptions?

In the view of fundamental analysis, stock valuation based on fundamentals aims to give an estimate of their intrinsic value of the stock, based on predictions of the future cash flows and profitability of the business. Fundamental analysis may be replaced or augmented by market criteria – what the market will pay for the stock, without any necessary notion of intrinsic value. These can be combined as "predictions of future cash flows/profits (fundamental)", together with "what will the market pay for these profits?” These can be seen as "supply and demand" sides – what underlies the supply (of stock), and what drives the (market) demand for stock? Here, Dale has estimated future cash flows and profitability of the firm.

The Dividend Discount Model (DDM) is a method used for valuing the price of a stock for a company which pays out dividends. The model assumes that the price of a stock is equivalent to the sum of all of its future dividend payments discounted to the present value. The model is simple in theory but have various scenarios due to the different ways that dividends could be paid out. This spreadsheet allows you to value a stock using the Dividend Discount Model in the following scenarios: * Price of Stock with Zero Growth Dividends * Price of Stock with Constant Growth Dividends (Gordon Model)
Dale doesn’t predict any future dividends or growth rate for equity valuation equation.

Question 7
Using of debt and sale of stock by company conveys signal to the investors. What implication does this have for capital structure policy?

Investors interpret selling of shares by a company as a negative sign that things may go even worse but selling of shares to repay debt to remain on the optimal debt level is a positive sign. Investors interpret issuing of debt by a company as a positive sign but issuance of debt beyond the optimal debt level where the marginal tax rate benefit of debt is below the marginal cost debt is a negative sign. A company should use the signaling like issuance of debt only when profits are expected to increase. If the firm issues extra debt just to fool investors to signal that the company has high profit potential, after some time investors will realize that the company is not highly profit potential and then the price of the share would fall below than if it had not issued the debt. Selling of shares of mature company is a signal that things may go even worse but issuing of debt is a signal that the company has still profit potential. When a mature company issue debt to buy back shares it is a signal that it has low profit potential and wants to reduce profit earning instruments.

Question 8
Should the issue of control of the company be taken into the account in the capital structure decision? If so how it would affect things?

Shareholders are the owners of the company but debt holders are lenders who have priority of getting back their portion of investment prior than shareholders or owners. Control of the company should be taken into accout in the capital structure decision. Issuance of debt should be allowed upto a limit where the marginal tax rate benefit equals to the marginal cost of debt. Issuance of beyond the optimal debt level increases the expected distress costs. Change of leverage acts as signaling to the investors and hence managers should use such signal only which benefits investors not to fool them.

Question 9
What impact of tax reduction on Southern’s debt level?
Reduction in corporate Tax rate reduces the amount of Tax shield in the income statement. As a result in calculating the company’s value, amount gained from this tax shield is reduced which means the investors will be less interested to borrow debt with higher cost. Again, fewer amounts of debt and reduced tax rate means less amount of interest to be paid and increase in the net income which will increase the equity part in calculating the company’s value. In our calculation model with a reduction in corporate tax rate the optimal debt amount reduces from 6 million to 3 million to maximize the company’s value. Effect of tax rate on different debt amount can be seen from the following table.

Amount Borrowed | Cost of debt | Cost of equity | Value of the Company (In most likely scenario) | | | | Tc=40% | Tc=34% | - | 0% | 13% | 15,037,500 | 16,541,250 | 3,000,000 | 10% | 14% | 15,462,857 | 16,709,143 | 6,000,000 | 11% | 16% | 15,555,000 | 16,510,500 | 9,000,000 | 13% | 19% | 15,435,789 | 16,079,368 | 12,000,000 | 16% | 23% | 15,360,000 | 15,696,000 |
Question 10
How rise of labor cost may affect Southern’s production decision?

If the variable cost increases, the break-even sales amount will be increase. Hence it will increase the riskiness of the Plan. Again the increment in the cost means the reduction in EBIT & ROI, as a result the plan will be less attractive to the investors. In this case of southern skylights Dale might be interested to choose Plan-B as the EBIT of both the plans is negative in pessimistic scenario but Plan-B shows better results in other scenarios. Effect of rise in variable cost is shown in the following Table- Effect of Variable Cost on Plan-A
(Most Likely Scenario) | | Previous Plan A | Revised Plan A | Fixed Cost | 5,095,000 | 5,095,000 | Sales price | 500 | 500 | Variable cost | 390 | 410 | Break even Quantity | 46,319 | 56,612 | Break even sales | 23,159,500 | 28,306,000 | E(EBIT) | 2,330,000 | 980,000 | SD(EBIT) | 1,190,061 | 973,686 | CV(EBIT) | 0.51 | 0.99 | E(ROI) | 21.18 | 8.91 | SD(ROI) | 10.82 | 8.85 | CV(ROI) | 0.51 | 0.99 |

Conclusion: From the above observation we can understand different financial and risk condition of Southern Skylights, Inc. From this observation we can select what straragy will maximize the firm value and also the benefit of the shareholder.