case study, Financial management

case study, Financial management
This is one of a series of cases dealing with various financial issues that Powerline Network Corporation has faced. Background material on the company may be found in the document entitled Background Information on Powerline Network Corporation (pNC). PNC’s seminar leaders used the case to introduce participants to the topics that were to be covered in detail in the seminar series.

[We use it on the first day of our finance course to give students an idea of what will be covered in the class. Students are probably not familiar with all the terms used in the case, but that’s OK, since the ‘

point of the case is to get things started. Unclear items can be covered in the class discussion.)

As noted in the Background Information document, PNC’s chairman Ray Reed, asked his CFO Bill Bostic to set up a financial education program for the directors. Bill then drafted his assistant-Sue Chung- -and one of his former professors–Sam De Felice-to help him with the program.

Bill, Sue, and Sam decided on a 12-session program, with each session to cover one important
topic. Each session will last two hours, and will be held immediately before monthly board meetings. All except the first session will focus on an actual decision that PNC faces and that the board must consider, so they will combine education with consideration of real problems that the company faces. Topics include risk analysis, stock and bond valuation, the cost of capital, capital budgeting, capital structure, dividend policy, financial forecasting, working capital management, lease financing, and merger analysis. Bill wants the topics to build on one another, with the stock and bond valuation sessions leading into the cost of capi- tal, which is then used in capital budgeting, and so forth. Taken together, the sessions should reveal finan- cial management as an integrated body of knowledge wherein individual conceptual topics blend together
to help managers maximize firm value.

In the first session, which uses the current case, Bill plans to first review basic valuation principles and financial statements, then go on to briefly describe other topics that will be covered. Several weeks before the first session, Bill asked the directors what specific things they would like to cover, and several mentioned that they would like some coverage of Excel spreadsheets. PNC frequently provides information to the directors in the form of Excel spreadsheets, and these directors wanted to help in understanding how spreadsheets are made and used.

Sam De Felice, an award-winning executive program teacher, conducts his classes by asking a series of questions that address the issues at hand. The questions generate discussion among the students, and Sam guides the class to the extent needed. He suggested that a question-based approach be taken, and Bill agreed. Bill, Sam, and Sue discussed the course and identified the key issues to be discussed, and then Bill asked Sue to develop some questions to guide the discussion through those issues. The discussion issues are listed in Table 1. Bill also asked Sue to use Excel to quantify the analysis and, at the same time, help the directors learn more about Excel. Assume that you are Sue Chung, and you must now prepare for the session.

Table 1. Issues to be discussed in Session 1

1. General Valuation Equation. Specify a general equation that can be used to value securities and long-term business assets, and then indicate the types of assets for which the equation is most appropriate and least appropriate.

2. Tax Effects. Discuss how different investors’ tax status might affect their estimates of an asset’s value, and how a change in tax laws-like the 2003 law that lowered the maximum personal tax rate on dividends from 38.6% to 15o/o–might affect the values of different types of investments.

3. Market Equilibrium. Define the term “marginal investor” and explain how this concept is used in financial assets and markets analysis. Discuss whether the EnronIWorldCom scandals (which involved fraud or serious misrepresentations by company executives, accountants, security analysts, lawyers, and bankers) might either narrow or widen differences between different investors’ views of individual stocks’ values.

4. Corporate Sanctions. Significant differences have arisen with regard to people’s views of how corporate officers found guilty of wrongdoing should be punished. For example, many thought Martha Stewart should go to jail for an extended period, but many others thought
she deserved no more than a slap on the wrist. In one major case (Health-South, where cor- porate officers fraudulently overstated profits by $3 billion) the Federal Prosecutor asked the judge to sentence the treasurer to 5 years in jail, but the judge imposed no jail time whatever. Discuss, from an economic standpoint, the likely effects of harsh versus lenient sentences, i.e., would harsh punishments be more likely to help or hurt the economy?

5. Firm Goals. Finance textbooks generally indicate that a publicly traded company’s primary goal should be to maximize the wealth of its stockholders. Would the firm’s managers, employ- ees, customers, suppliers, and “clear-headed citizens” all agree that management should focus primarily (if not solely) on wealth (share price) maximization? What other goal or goals might management focus on? If a firm’s directors believe that management should focus primarily on shareholder wealth maximization, what actions could they take to ensure that management focuses on this goal?

6. Financial Statements and Financial Strength. Based on a quick review of Tables 2, 3, and 4 in the Background Material document, does PNC seem to be doing relatively well, badly, or about average? Relate this issue with the earlier questions dealing with corporate sanctions and security values.

7. The Cost of Capital. How could you use the data in the tables to find a discount rate for use in evaluating an average-risk capital budgeting project? For this purpose, assume that PNC’s target capital structure calls for 18% debt, 2% preferred stock, and 83% common equity, all based on market values. How might your recommendation be affected by the following events: (a) the Federal Reserve tightens credit, (b) the stock market declines sharply, pulling down PNC’s stock, or (c) PNC’s management learns that a proposed project is actually much riskier than an average project? Note: These issues are explored in depth in later cases, so conclusions reached now may need to be modified later.

8. Capital Structure. IfPNC increased its target debt ratio, how would this affect (1) the price of its stock and (2) the size of its optimal capital budget, i.e., the amount it should invest in capital projects during the coming year?

9. Dividend Policy. PNC actually retained all of its earnings during 2004, so its payout ratio was zero, versus 20% for the average company in its industry. If it announced that it would begin paying a regular dividend in 2005, how would that announcement affect its stock price?

10. Leasing; Suppose PNC needed new assets that cost $10 million, and it could either raise capital and buy the assets or else obtain the use of the assets through a long-term lease. In very general terms, how should management analyze the lease-versus-buy decision? Would this decision affect the firm’s financial ratios and thus its apparent financial strength?

11. Mergers. IfPNC were considering the acquisition of another company, how should it approach the decision of how much to offer for the targeted firm?