PHANTASIES, INCORPORATION

DEBT VERSUS EQUITY FINANCING

FM-135 (MWF- 9:00 am to 10:00 am)

Group members:

Ramirez, Sheila B.

Saing, Krezil

Sechico, Devie Mae D.

Tagac, John Angelo J.

Taguibulosan, Ivan
 SUMMARY:

Phantasies, Inc. was owned by Whitney Richard. It was a company which was
established to provide and games for “grown-up children”. Richard’s first commercial
venture was a type of plastic, three-dimensional tic-tac-toe game. He made a modest
profit from initial sales of the game and then sold it to a larger toy manufacturer. From
this start Richards moved into more complicated, more expensive toys. Using the profits
from the sale of the game he formed his corporation. The firm also produced electronic
executive toys. One of the most successful of these was a two-handed blackjack
calculator game. After the development of the blackjack calculators, Phantasies had
branched out into pinball machines. They eventually owned (and franchised) a small
chain of arcades operating on the west coast under the name of Wizards. The chain was
sold in 1983 for a substantial profit.

Richards was actually a very astute businessman. He knew his products, his
customers’ tastes, and the business had grown rapidly. Operations were profitable as
follows:

EXHIBIT 1: Phantasies, Inc. Income Statement, Fiscal 1986

Revenues $1,146,000

Fixed costs $305,600

Variable costs 515,700

Total expenses (821,300)

EBIT $ 324,700

Interest expense 32,700

EBT $ 292,000

Tax (40%) 116 ,800

Net Income $ 175,800

E.P.S $ .88
 The firm is now fourteen years old reasonably well established. It is soundly
financed with stock trading at about 10 1/2 to 11 1/2 over-the-counter on the west
coast. Richard still owns 70 percent of the firm’s 200,000 shares outstanding.However,
Richards has a new toy which will require outside financing. The idea of this new toy
came from a toy one of Richards’ children received for Christmas. The technology for this
electronic toy was by no means simple but it was not all that complicated by modern
standards. The new owners of Wizards were more than willing to lease arcade size
versions of the “Monster”. Richards had also designed a machined to be used specifically
for the Monster. Richards’ marketing staff objected that such a product would simply be
too expensive for most taste. The problem as Richards saw it was not whether people
would buy the Monster but how to finance its initial manufacture.He estimated the
initial capital needs at $400,000-a lot of money to be raised by a company the size of
Phantasies that shows as follows:

EXHIBIT 2: Phantasies, Inc. Balance Sheet as of December 31,1986

Cash $ 62,860 Accounts payable $ 55,868

Accounts Receivable 181,306 Accrued wages 7,317

Inventory 187,300 Taxes payable 34,012

Total Current Asset $431,466 Bank loan 207,300

Total Current Liabilities $304,497

Plant and Equipment $875,040 Common stock (Par $.50) $100,000

Accumulated depreciation (218,759) Retained earnings 683,250

Net plant and equipment 656,281 Net worth 783,250

Total assets $1,087,747 Total claims $1,087,747

The $400,000 would be used for essentially two purposes; $200,000 would be spent
for equipment and plant modifications and the rest would be spent to acquire the
necessary components (inventory) to make the machines. Two financing alternatives
have been identified. A west coast insurance company has agreed to make a secured,
ten-year loan to the company at a rate of 15 1/2 percent. The loan amount would be
$607,300 but the loan agreement stipulated that $207,300 of that would be used to
retire an existing bank loan.

The other alternative was to sell common stock. A local underwriter felt it could sell
40,000 shares of Phantasies at a price that would net the company ten dollars per share.
The spread between ten dollars and the current market price os $11.25 would be
retained by the underwriter as a compensation for its services.

Either financing alternative would supply the necessary capital and Richards was
determined to pursue the project, but he had to decide which financing alternative to
choose. He was aware that the profitability of the investment would affect which
method of financing was better, so he had tried to assess the probable profitability of
the Monster. Sales depend on the machines’ popularity. He estimate that he could sell or
lease $350,000 worth of the machines to the Wizard’s arcade operations. If the
machines caught on, first-year sales could easily reach $600,000. This did not even
consider the possible future sales of the desktop “executive toy” version.

Richards felt much more certain of his cost estimates. Gearing up to produced the
Monster would add $80,000 in annual fixed costs. Variable costs would be 60 percent of
the additional sales.

QUESTIONS WITH ANSWERS:

1. Assuming 51 percent stock ownership is necessary to retain control, does the sale of
the additional 40,000 shares jeopardize Richards’ control of the firm?

 ANSWERED BY: SAING, KREZIEL

Answer: $ 200,000 outstanding shares

x 70%
$ 140,000 Richards’ share on the company

$ 200,000 outstanding shares

 + 40,000 additional shares
$ 240,000 total new outstanding shares

$ 140,000 Richards’ shares

$ 240,000 outstanding shares
= 58.33% percentage of shares owned by Richards

 Thus, it will not jeopardize Richards’ control on the company, since, he still
has 58.33% control it.

2.Prepare a pro forma balance sheet for each financing alternative.

 ANSWERED BY: Sechico, Devie Mae D.

Debt Financing Pro Forma Balance Sheet

Cash $ 62,860 A.P $ 55,868

A.R 181,306 Accrued wages 7,317

Inventory Taxes Payable 34,012

(187,300 + 200,000) Bank loan 0

387,300 Long term loan 607,300

Total Assets $ 631,466 Total Current Liabilities $ 704,497

Plants & Equip. Common stock

(875,040 + 200,000) 1,075,040 (par $ .50) $ 100,000

Accumulated dep. (218,759) R.E 683,250

Net Plant & Equip. 856,281 Net worth 783,250

Total Assets $ 1,487,747 Total Claims $ 1,487,747

 Equity Financing Pro Froma Balance Sheet

Cash $ 62,860 A.P $ 55,868

A.R 181,306 Accrued wages 7,317

Inventory Taxes Payable 34,012

(187,300 + 200,000) Bank loan 207,300

387,300

Total Assets $ 631,466 Total Current Liabilities $ 304,497

Plants & Equip. Common stock (par $ .50)

(875,040 + 200,000) 1,075,040 $ 100,000 + 400,000 500,000

Accumulated dep. (218,759) R.E 683,250

Net Plant & Equip. 856,281 Net worth 1,183,250

Total Assets $ 1,487,747 Total Claims $ 1,487,747

3. Although Phantasies does not fit well into any particular industry, assume that a
total debt-to-total assets ratio of 45 percent is considered reasonable. Does the firm
meet this requirement if it borrows from the insurance company?

 ANSWERED BY: RAMIREZ, SHEILA B.

Yes, the company meets the requirement, and it’s okay for them to borrow from
insurance company. It is considerable and reasonable for the following reason.

10 year rate of 5 1/2

Amount of loan 607 300

Less: amount to retire an existing loan 207,300

Amount of cash received 400,000

Cash (52,600 + 400,000) 452,660 AP

55,868
AR 161,906 Wages 7,317

Inventory 187,300 Taxes payable 34,012

Net Plant and Equipt. 656,281 Longterm loan 607,300

Total Assets 1,458,147 704,497

Total Assets = 1,458,147 = 2.07

Total Debt 704,497

4. Prepare pro forma income statements for each financing alternative at the lower
and higher sales estimates for the Monster. (Assume all other revenues and expenses
would remain constant.) ANSWERED BY: TAGAC, JOHN ANGELO J.

Pro Forma Income Statement for Debt Financing

Lower sales Higher Sales

Revenues $ 1,896,000 $ 2,146,000

Fixed Cost 385,600 385,600

Variable Cost 518,400 668,400

Total Expense $ 904,000 $ 1,054,000

E.B.I.T 992,000 1,092,000

Interest Expense 126,831.50 126,831.50

EBT 865,168.50 965,168.50

Tax (40%) 346,067.40 386,067.40

Net Income $ 519,101.10 $ 579,101.10

EPS $ 2.60 $ 2.90

 Pro Forma Income Statement for Equity Financing

Lower sales Higher Sales

Revenues $ 1,896,000 $ 2,146,000

Fixed Cost 385,600 385,600

Variable Cost 518,400 668,400

Total Expense $ 904,000 $ 1,054,000

E.B.I.T 992,000 1,092,000

Interest Expense 32,700 32,700

EBT 959,300 1, 059,300

Tax (40%) 383,720 423,720

Net Income $ 575,580 $ 635,580

EPS $ 2.88 $ 3.18

5. Which method of financing is preferable?

 ANSWERED BY: Taguibulosan, Ivan

Based on what have we computed we choose Equity Financing to finance Richards’

initial manufacture because we have come up with $ 2.88 earnings per share for lower
sales estimation and $ 3.18 earnings per share for higher sales in equity financing, which
is more favorable than Debt Financing having $ 2.60 earnings per share for lower sales
and $2.90 earnings per share in higher sales estimation.