Innovative Engineering

Company

Grp. 5
Darwin Clemente
Raymond Martinez
Jose Erwin Sebastian
Synthesis
Innovative Engineering Company,

 Is business partnership between Meredith Gale

and Shelley Yeaton
 Product is measuring instruments based on the
laser principle.
 Five years of successfully operations
 Need for additional capitalization for growth
 Additional capitalization needed is $ 1.2 million.
 Plans to incorporate the Company
 Venture Capital to be provided by Arbor Capital
Corporation.
Point of View

 Because of the complexity and in

order for us to answer the issues of
concern of this case, the group
decided to take the point of view of
both parties, the Partners Gale and
Yeaton, as well as the point of view
of Arbor Capital Corporation.
 Problem Statement

1. In each of the four proposals, how much will be the

return on common shareholder’s equity under the
three income assumptions provided in the case?
2. How much will be the pre-tax earnings and return on
its $1.2 million investment to Arbor Capital
Corporation under each of the four proposals
assuming that Arbor receives a dividend equal to its
proportion of common stock ownership times
Innovative’s net income after preferred dividends, if
any? (Assume a negative dividend if Innovative has a
net loss)
3. Were the partners correct in rejecting proposals A and
B?
Objectives

1. To be able to carefully evaluate the

implications in relation to ownership,
debt to equity ratio, and the overall
viability of each proposal (A, B, C and D)
on both Innovative Engineering
Company and Arbor Capital Corporation.
2. To be able to asses the effect on
earnings, both for Innovative
Engineering Company and Arbor Capital
Corporation, of each of the three income
assumptions.
3. To be able to have a better appreciation
of how the different sources of capital
(debt and equity) affects the company’s
Areas of Consideration
Assumptions as provided in the case
1. $ 1.2 million capitalization is needed in order to
finance their growing business.
2. The interest cost is estimated to be 8% per
annum
3. Tax rate is assumed to be 34%
4. Dividend rate for preferred stock is 10%.
5. That there are three income assumptions
($100,000, $300,000,and $ 500,000) with which
to base the analysis for each financing proposal.
6. Par Value of Common Stock is $ 1.00 / share.
Areas of Consideration
Proposals
1. The partners would incorporate the company.
Arbor to invest $1.2 million as follows:
a. $ 1.1 million would be long-term loan @ 8%
interest p.a.
b. $ 100,000 in Common Stock.
2. The partners would incorporate the company.
Arbor to invest $ 1.2 million as follows:
a. $ 200,000 would be a loan @ 8% interest per
annum
b. $ 900,000 preferred stock at a dividend rate of
10% p.a.
c. $ 100,000 common stock.
Areas of Consideration
Proposals
3. The partners would incorporate the
company. Arbor to invest $1.2 million as
follows:
a. $ 600,000 would be debt @ 8% interest p.a.
b. $ 600,000 equity for 6/15 or 40% of the
common stock.
4. The partners would incorporate the
company.Arbor to invest $1.2 million as
follows:
a. $ 300,000 would be debt @ 8% Interest p.a.
b. $ 900,000 equity for 50% of the common
stock
 Analysis
Proposal 1 - Arbor Capital
Corporation
300,000 100,000 500,000 Project Income
454,545 151,515 757,576 Gross Income
Long Term Loan 1,100,000 8% 88,000 88,000 88,000
366,545 63,515 669,576 Pre-tax income
Retained earnings after
241,920 41,920 441,920 Taxes
0.2419 0.0419 0.4419 Dividend/share
Common Stock 1,000,000
Partners 900,000 217,728 37,728 397,728 Dividend to Partners
Arbor 100,000 24,192 4,192 44,192 Dividend to Arbor
Debt to Equity
Ratio 110% 112,192 92,192 132,192 Earning of Arbor
 Analysis
Proposal 2 - Arbor Capital
Corporation
300,000 100,000 500,000 Projected Income
454,545 151,515 757,576 Gross Income
Debt 200,000 8% 16,000 16,000 16,000 Interest Expense
438,545 135,515 741,576 Pre-tax income
289,440 89,440 489,440 Retained Earnings After Taxes
Preferred Stock 900,000 10% 90,000 90,000 90,000 Dividend on Preferred Stock
199,440 (560) 399,440 Retained Earnings After Preferred
Dividend per share on Common
Common Stock 1,000,000 0.1994 (0.0006) 0.3994 Stock
Partners 900,000 179,496 (504) 359,496 Dividend to Partners
Arbor 100,000 19,944 (56) 39,944 Dividend to Arbor
Debt to Equity
Ratio 20% 125,944 105,944 145,944 Earning of Arbor
 Analysis
Proposal 3 - Arbor Capital
Corporation
300,000 100,000 500,000 Projected Income
454,545 151,515 757,576 Gross Income
Debt 600,000 8% 48,000 48,000 48,000 Interest Expense
406,545 103,515 709,576 Pre-tax income
268,320 68,320 468,320 Retained Earnings After Taxes
Preferred Stock - 10% Dividend on Preferred Stock
268,320 68,320 468,320 Retained Earnings After Preferred
Dividend per share on Common
Common Stock 1,500,000 0.1789 0.0455 0.3122 Stock
Partners 900,000 160,992 40,992 280,992 Dividend to Partners
Arbor 600,000 107,328 27,328 187,328 Dividend to Arbor
Debt to Equity
Ratio 40% 155,328 75,328 235,328 Earning of of Arbor
 Analysis
Proposal 4 - Arbor Capital
Corporation
300,000 100,000 500,000 Projected Income
454,545 151,515 757,576 Gross Income
Debt 300,000 8% 24,000 24,000 24,000 Interest Expense
430,545 127,515 733,576 Pre-tax income
284,160 84,160 484,160 Retained Earnings After Taxes
Preferred Stock - 10% - - - Dividend on Preferred Stock
284,160 84,160 484,160 Retained Earnings After Preferred
Dividend per share on Common
Common Stock 1,800,000 0.1579 0.0468 0.2690 Stock
Partners 900,000 142,080 42,080 242,080 Dividend to Partners
Arbor 900,000 142,080 42,080 242,080 Dividend to Arbor
Debt to Equity
Ratio 17% 166,080 66,080 266,080 Earning of Arbor
 Problem 1 – Calculate the return on common shareholder’s
equity on each proposal based on the three income
assumptions.
Return on Common Shareholder's Equity

Proposal Income Innovative Arbor

Proposal A Assumption Common Stock Div./Share Div. Common Stock Div./Share Div.
300,000.00 900,000.00 0.2419 217,728.00 100,000.00 0.2419 24,192.00
100,000.00 0.0419 37,728.00 0.0419 4,192.00
500,000.00 0.4419 397,728.00 0.4419 44,192.00
Proposal B 300,000.00 900,000.00 0.1994 179,496.00 100,000.00 0.1994 19,944.00
100,000.00 -0.0006 -504 -0.0006 -56
500,000.00 0.3994 359,496.00 0.3994 39,944.00
Proposal C 300,000.00 900,000.00 0.1789 160,992.00 600,000.00 0.1789 107,328.00
100,000.00 0.0455 40,992.30 0.0455 27,328.20
500,000.00 0.3122 280,991.97 0.3122 187,327.98
Proposal D 300,000.00 900,000.00 0.1579 142,080.30 900,000.00 0.1579 142,080.30
100,000.00 0.0468 42,080.40 0.0468 42,080.40
500,000.00 0.269 242,080.20 0.269 242,080.20
The graph shows that under Proposal A, Innovative Engineering
Company can earn substantially bigger dividends on common shares
than Arbor Capital Corporation in all the three income assumptions.
This is mainly due to the fact that Innovative Engineering Company
still owns majority ownership in the business under the said proposal.

Div. on Common Shareholder's Equity

(Proposal A)

500,000.00
400,000.00
Dividend

300,000.00 Innovative Div.

200,000.00 Arbor Div.

100,000.00
-
300,000.00 100,000.00 500,000.00
Income Assumption
Under Proposal B, Innovative Engineering Company still has
greater share of dividends under the two income assumptions
(the 300K and 500K). However, operations may result to a
negative dividend if income will hit the 100K level.

Div. on Common Shareholder's Equity

(Proposal B)

400,000.00
350,000.00
300,000.00
250,000.00
Dividend

200,000.00 Innovative
150,000.00 Arbor
100,000.00
50,000.00
-
(50,000.00) 300,000.00 100,000.00 500,000.00
Income Assumption
Proposal C substantially increases the dividends on common shareholder’s
equity of Arbor Capital Corporation because of the fact that under such
scenario, Arbor stands to own 40% common share of Innovative. However,
Innovative still has the greater share of dividends in all the three income
assumptions.

Div.on Common Shareholder's Equity

(Proposal C)

600,000.00
500,000.00
Dividend

400,000.00
Innovative
300,000.00
Arbor
200,000.00
100,000.00
-
300,000.00 100,000.00 500,000.00
Income Assumption
Proposal D, gives both Innovative Engineering Company and Arbor Capital
Corporation equal share in common shareholder’s equity resulting to the 50/50
share in dividends. However, such scenario gives Arbor additional income
through the interest that they will charge against the $300,000 debt of
Innovative that is estimated to be $24,000 computed at 8% per annum.

Div. on Common Shareholder's Equity

(Proposal D)

300,000.00
250,000.00
Dividend

200,000.00
Innovative
150,000.00
Arbor
100,000.00
50,000.00
-
300,000.00 100,000.00 500,000.00
Income Assumption
Problem 2 – Compute the pre-tax earnings and
return on its $1.2 million investment (Arbor Capital
Corporation)
Pre-tax Earnings and
Dividends

Arbor Capital Corporation

Pre-tax
Earnings Income Dividend Dividend
Propos Assumed from Preferred Common Total
al Income Innovative Interest Stock Stock Earnings
A 300,000.00 454,545.45 88,000.00 24,192.00 112,192.00
100,000.00 151,515.15 88,000.00 4,192.00 92,192.00
500,000.00 757,575.76 88,000.00 44,192.00 132,192.00
B 300,000.00 454,545.45 16,000.00 90,000.00 19,944.00 125,944.00
100,000.00 151,515.15 16,000.00 90,000.00 -56 105,944.00
500,000.00 757,575.76 16,000.00 90,000.00 39,944.00 145,944.00
C 300,000.00 454,545.45 48,000.00 107,328.00 155,328.00
100,000.00 151,515.15 48,000.00 27,328.00 75,328.00
500,000.00 757,575.76 48,000.00 187,328.00 235,328.00
D 300,000.00 454,545.45 24,000.00 142,080.00 166,080.00
100,000.00 151,515.15 24,000.00 42,080.00 66,080.00
500,000.00 757,575.76 24,000.00 242,080.00 266,080.00
 Problem 3 – Were the partners right in rejecting Proposals A
and B?

Proposa Div. to Yield/Debt

l Pre-tax Earnings R.E. After Tax Interest Exp. Innovative Ratio Debt/Equity Ratio

A 454,545.45 300,000.00 88,000.00 217,728.00 0.197934545

151,515.15 100,000.00 88,000.00 37,728.00 0.034298182

757,575.76 500,000.00 88,000.00 397,728.00 0.361570909 110%

B 454,545.45 300,000.00 16,000.00 179,498.00 0.89749

151,515.15 100,000.00 16,000.00 -504 -0.00252

757,575.76 500,000.00 16,000.00 359,496.00 1.79748 20%

C 454,545.45 300,000.00 48,000.00 160,992.00 0.26832

151,515.15 100,000.00 48,000.00 40,992.00 0.06832

757,575.76 500,000.00 48,000.00 280,992.00 0.46832 40%

D 454,545.45 300,000.00 24,000.00 142,080.00 0.4736

151,515.15 100,000.00 24,000.00 42,080.00 0.140266667

757,575.76 500,000.00 24,000.00 242,080.00 0.806933333 16.66%

Problem 3 – Were the partners right in rejecting
Proposals A and B?

 Yes with regards to proposal A.

 High Debt to equity ratio
 High probability for financial difficulty should
business encounter temporary set-backs.
 Yes, in relation to proposal B
 Since few financing institutions will agree to
the proposal
 They will still be required to pay a fixed
amount of dividends despite poor performance
 Possibility of Loss is high based on pessimistic
income estimate.
Problem 4 – What is the likelihood that Innovative
Engineering Company could find a more attractive
financing proposal than Proposal D?

 There is a high probability that the

Company may be able to find a
more attractive proposal which is
found in proposal C.
 Lower debt to equity ratio
 Better level of Control over the
company 60/40
 Interest expense deductible to tax