Scope City Inc

INCEIF The Global University of Islamic Finance

FN 5033: Corporate Finance

Case Study: Scope City, Incorporated

Prepared by: Md. Akther Uddin (ID# 1400225) Mohammed Zubair (ID#1400047) Mohammed Kaleemuddin (ID#1400232) Syed Najibullah (ID#1300177)

Prepared for: Dr. Merouane Lakehal-Ayat Professor of Finance, Bittner School of Business, St. John Fisher College, Rochester, New York & Visiting Fellow, INCEIF

November 14, 2014

Table of Contents

0.0 Background of the case…………………………………………………………….…1 1.0 Core business and market served………………………………………………..……1 2.0 Compound average annual rates of growth………………………………...…………2 2.1 CAGR and Value of the potential acquisition………………….………..……..…4 3.0 Historical cost of equity……………………………………………...………………..4 4.0 Historical cost of long-term debt………………………………………..…………….5 5.0 Impact of current liabilities on the cost of capital calculation ………………………..6 6.0 SCI’s historical weighted-average cost of capital (WACC)………………… ………..6 7.0 Growth, historical cost of capital and future investment………………………..……..7 8.0 Additional information and potential questions…..………………..………….……….7 Appendix…………………………………………………………...………….……….8

0.0 Background of Scope City, Incorporated (SCI) Scope City, Incorporated (SCI) was a regional leader in quality optical products. It was initially manufacturing, reselling and importing advanced optical equipment including consumer (amateur) telescopes, nautical optics, and accessories. The company had grown from a small repair shop in east Texas to a regional leader in the optical products market over the past thirty years. Friendly service and quick turnaround made SCI’s retail and catalog operations famous in this segment of market. Scope City’s shares were being successfully traded regionally after an initial public offering several years ago. Most analysts considered SCI to be closely-held but now SCI is looking for institutional investors to expand the company. 1.0 Core Business and Market Served: Scope City, Incorporated (SCI) was a manufacturer, reseller and importer of optical equipment, including consumer (amateur) telescopes, nautical optics and accessories. SCI’s retail and catalog operations were known for friendly service and quick turnaround, and the firm’s ability to repair even the most obscure instruments made them somewhat unique in the market. SCI had diverse customer from amateur to professional astrologists. During the comet craze amateur telescopes sales to school pupils and university students helped SCI to grow when it was struggling as a repair shop and reseller. The business had been going well and they had enough repair and wholesale business to allow it to remain profitable throughout the year, and it has a reputation sufficient to give it an advantage when the Christmas season arrived. Moreover, SCI was the sole U.S importer for several different optics manufacturers in Taiwan and Japan. Each month SCI held free seminars at its stores to educate customers on the value of quality of optics and tried to help customers avoid the temptation to buy cheaper, mass-produced telescopes and binoculars. Although such telescopes were fairly common and inexpensive during the last few months of the year, most serious amateurs agreed that someone new to the hobby could easily be discouraged if the newcomer’s introduction to the night sky was marred by an instrument of poor quality and workmanship. The SCI staff and management felt that education was the best method for building their customer base, and these efforts had been repaid over time. SCI had also been a pioneer in using the Internet to provide information to consumers. The

firm’s free publication “A Beginner’s Guide to Skywatcing” was very popular at astronomy clubs and star parties around the country. 2.0 Compound average annual rates of growth for SCI’s revenue and net income Diagram 1: Annual growth rate of Sales and Net Income (year on year) 60% 50% 40% 30%

Sales

20%

Net Income

10% 0%

Table 1: Compounded Annual Growth Rate of Sales and Net Income at 2003 9- year CAGR (at 2003) Year 1994 $

Sales

Net Income

75,00,000.00 $

9,00,000.00

1995 $ 1,03,12,500.00 $

12,67,500.00

1996 $ 1,20,00,000.00 $

14,40,000.00

1997 $ 1,87,50,000.00 $

21,56,250.00

1998 $ 2,13,75,000.00 $

22,50,000.00

1999 $ 2,32,50,000.00 $

26,73,750.00

2000 $ 2,73,75,000.00 $

30,11,250.00

2001 $ 3,18,75,000.00 $

32,25,000.00

2002 $ 3,41,25,000.00 $

33,75,000.00

2003 $ 3,86,25,000.00 $

34,22,700.00

Sales

Net Income

19.97%

16.00%

2.1 CAGR and value of the potential acquisition As we can see that growth of revenue(sales) and net income fluctuates year on year basis but the 9-year CAGR represents sales and net income would have grown had they grown at a constant rate in order to achieve the final year sales amount $ 3,86,25,000 in 2003 and net income $ 34,22,700. If we look at the year on year basis the revenue growth had declined since 1997 when it was nearly 55% and since then 1997 SCI’s sales growth were below 20%. It indicates that it was necessary to increase revenue by increasing customer base or acquiring small competitors to increase the market share or diversifying products in the related industry. We can say that the potential acquisition could help SCI to expand its market subsequently which would increase sales and net income. In other words, when Dillon and Damodaran examine the potential acquisition of the other telescope company, they should make sure that the new operation will add to these numbers rather than cannibalizing the existing growth. 3.0 SCI’s historical (book) cost of equity Cost of Equity Calculation: EPS in 2003 Dividen payout ratio

$

Growth in net income (compounded annual growth), g

(1+g) Current Market Price, P0

Cost of equity,

$ $

4.56 32% 16% 1.69 18.00 25.40%

*Assuming a 32 percent dividend pay-out and net income growth of 16 percent.

4.0 SCI’s historical (book) cost of long-term debt Cost of Long-Term Debt Calculation: Coupon rate (SCI's outstanding long-term debt) Marginal tax rate for SCI (recent), T Cost of Long-Term Debt*,

0.075 30% 5.3%

5.0 Impact of current liabilities on the cost of capital calculation Companies use short-term debt primarily to finance seasonal working capital needs. Seasonal debt fluctuates during the year, often dropping close to zero, so it is not a permanent source of financing for most companies. In addition to that it is often cited that the costs of the long-term capital reflect the short-term costs of doing business and the increased risk that having short-term debt imposes on the firm. Therefore, we usually do not include short-term debt when estimating the cost of capital. However, many companies, especially those in Japan, do use relatively large amounts of shortterm debt on a consistent basis. For such companies, we should include short-term debt as a capital component when estimating the WACC. Most short-term debt is in the form of bank loans, often with an interest rate that is tied to the prime rate or to the London Interbank Offered Rate (LIBOR). The interest rate on short-term debt is its pre-tax cost, and it must be adjusted to determine its after-tax cost. Also, there are normally no flotation costs for short-term debt, so flotation adjustments are not required. 6.0 SCI’s historical weighted-average cost of capital (WACC) Cost of Long-Term Debt Calculation: Coupon rate (SCI's outstanding long-term debt) Marginal tax rate for SCI (recent), T Cost of Long-Term Debt*, Cost of Equity Calculation: EPS in 2003 Dividen payout ratio

0.075 30% 5.3% $

Growth in net income (compounded annual growth), g

(1+g) Current Market Price, P0

Cost of equity,

$ $

4.56 32% 16% 1.69 18.00 25.40% 20.75%

* [Coupon rate, SCI's outstanding long-term debt is used as it is the cost of historical debt]

7.0 Growth, historical cost of capital and future investment The company had been growing quite steadily from 1994 till 2003 and had opportunities to expand its business by diversifying into niche markets for optical products and acquiring business in the same industry with lower market value but high potential. As analysis shows historical cost of capital for SCI was 7.50% which was above the 10-year US T-bond (5.10%) and yield on AAA corporate debt (6.0%). Historical average return on a broad market average of common stock was 16% while the historical WACC of SCI was 20.75%. Historical costs are relevant for discussing future investment decision because it shows how efficiently a company had managed its financing side while maintaining a relatively stable and reasonable return (adjusted for inflation and risk premium) to its shareholders. At the same time, we know that when the cost of capital for issuing new common stocks, preferred stocks and long term-debt is higher than their expected rate of return it is not feasible for a company to go for financing in this way. Therefore, Tom and Ruby should be very careful when predicting growth for new investors. The firm's record should be positive enough that they won't need to overestimate the potential for success in the future. They should also be careful to point out that their historical costs are just that relevant for measuring the performance of SCI versus other firms in the industry, but not really useful when forecasting returns in the future. Consequently, historical costs of various components of capital help to predict the future value and potential earning capacities of a company but there is no reason to suggest that future costs will follow those of the past. 8.0 Additional information and potential questions Most importantly, Ruby Damodaran should be ready to discuss the nature of the firm and its business with potential investors. Investors might need information about the optics market, the import business, the hobby and professions of astronomy, and the customers that SCI serves. That type of information is not readily available outside the industry, and Tom and Ruby will do a great service to their investors by bringing these things up during the presentation. There may be following potential questions from investors’ side: How large is the market? Who are the

major competitors in the market? What is the SCI’s market share? What trends are taking place in amateur and professional astronomy? How do customers buy telescopes (Internet versus personal sales)? What types of profitability can be expected in telescope accessories? What opportunities exist for expansion? What are the potential weaknesses of manufacturing overseas and licensing SCI's telescope designs? All of these things need to be addressed before investors will feel comfortable with SCI. In addition, Ruby must be equipped to present various sources of information that she uses when preparing her presentation (including financial statements: income statement, balance sheet, cash flow statements, statement of retained earnings). Moreover, trade-related and popular publications such as "Sky and Telescope" often provide a great deal of important information regarding competition and trends in the industry. As mentioned above, institutional investors are more likely than individual investors to push SCI to ensure growth and a long-term vision, who may tend to focus on short-term returns. Furthermore, institutional investor will play a more "active" role in the management of the firm, and may even try to get exclusive representation on the board of directors. In general, institutional investors will watch things more closely and expect more attention from the managers at the SCI.

Bibliography: Brigham, E., & Ehrhardt, M. (2013). Financial management: theory & practice. Cengage Learning. pp.335-378 http://zanders.eu/nl/publicaties/artikel/wacc-practical-guide-for-strategic-decision-making-part-1 http://thatswacc.com/ http://www.investopedia.com/terms/c/cagr.asp

Appendix

Exhibit 1. Scope City, Incorporate Balance Sheet, December 31, 2003 (dollars, in thousands) Current Assets Fixed Assets Total Assets

5625 5625 11250

Current Liabilities Long-Term Debt

1500 2250

Common Stock ($2 par value) Retained Earnings

1500 6000

Total Liability & Equity

11250

Exhibit 2. Scope City, Incorporated. Revenue and Earnings Year

Sales

Net Income

EPS

1994

$75,00,000.00

$9,00,000.00

$1.20

1995

$1,03,12,500.00

$12,67,500.00 $1.69

1996

$1,20,00,000.00

$14,40,000.00 $1.92

1997

$1,87,50,000.00

$21,56,250.00 $2.88

1998

$2,13,75,000.00

$22,50,000.00 $3.00

1999

$2,32,50,000.00

$26,73,750.00 $3.57

2000

$2,73,75,000.00

$30,11,250.00 $4.02

2001

$3,18,75,000.00

$32,25,000.00 $4.30

2002

$3,41,25,000.00

$33,75,000.00 $4.50

2003

$3,86,25,000.00

$34,22,700.00 $4.56

Exhibit 3. Scope City Inc: Book Values, Market values and Target Capital Structure (thousands in dollars, December 31,2003) Balance Sheets

Assets Current Assets Fixed Assets

Total Assets

5625 5625

11250

Liabilities and Equity Current Liabilities Long-Term Debt Total Liabilities Common Stock ($2 par value) Retained Earnings Total common equity Total Liability & Equity

1500 2250 3750 1500 6000 7500 11250

Exhibit 4. Scope City Inc: Book Values, Market values and Target Capital Structure (thousands in dollars, December 31,2003) Balance Sheets Investor-Supplied Capital Book(Historical) Market

Assets Current Assets

5625

Fixed Assets

5625

Total Assets

11250

Liabilities and Equity Current Liabilities

Percentage Book of Total value 1500 13.3%

Long-Term Debt Total Liabilities Common Stock ($2 par value)

2250 3750 1500

20.0% 33.3% 13.3%

2250 2250 1500

23.08% 23.08% 15.38%

6000 7500 11250

53.3% 66.7% 100.00%

6000 7500 9750

61.54% 76.92% 100%

Retained Earnings Total common equity Total Liability & Equity

Percent of Total

Market value

2250 2250

Percent of Total

Target Capital Structure

𝑤𝑑 =14% 14%

𝑤𝑠 =86% 13500 15750

86% 100%

100%