Case Study-AW29

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Case Information

 

International Technology Systems(ITS)is an IT company that develops and manufactures IT products and services worldwide. Its major operating segments include Global Technology Services, Global Business Services, Software, Systems and Technology, and Global Financing. The majority of the company’s enterprise business, which excludes the company’s original equipment Manufacturer(OEM)technology business,occurs in industries that are broadly grouped into six sectors financial services,public,industrial,distribution and communications as well as small and medium sized businesses.Inspite of the current global financial crisis,ITS appears to be doing very well.In Januaryof2009,it announced better than expected fourth quarter earnings with net income of US$4.4 billion,up from US $4 billion the previous year.According to its CEO,ITS“performed well in a next remely difficult economic environment”in year N+4 and that the company will“enter the year in a very strong position”.
 
Table1 summarizes the recent trend across some of the popular parameters

Consolidated results($ in millions) Year N+4 Year N+3 Year N+2
Net Sales $103,630 $ 98,786 $ 91,423
Net Sales Growth 4.91% 8.1% 0.31%
Operating Profit $15,938 $13,516 $11,928
Operating Profit Growth

Diluted            EPSExcluding

 17.91% 13.31% 27.21%
Extraordinary Items 8.93% 7.18% 6.06%
GrowthRate 24.37% 18.48% 23.42%

 

Table1:ITS’s Summary Financial Data (N+2 through N+4)

The table presents a summary of consolidated results of ITS’s financial data from N+2 toN+4 years.

 

The Consolidated Income Statement of ITS is presented in Table2 pertaining to the years,Year N through Year N+3.

 

Table2:ITS Income Statement (N–N+3)Values in Millions (Except for pershare items)

 

Year N+3 Year N+2 Year N+1 Year N
Period End Date 12/31/N+3 12/31/N+2 12/31/N+1 12/31/N
Period Length 12 Months 12 Months 12 Months 12 Months
Stmt Source 10-K 10-K 10-K 10-K
Stmt Source Date 02/26/N+4 02/26/N+4 02/26/N+4 02/27/N+3
Stmt Update Type Updated Reclassified Reclassified Reclassified
Revenue 98,785 91,423 91,134 96,293
Other Revenue, Total 1 0 0 0
Total Revenue 98,786 91,423 91,134 96,293
Cost of Revenue, Total 57,057 53,129 54,602 60,724
Gross Profit 41,728 38,294 36,532 35,569
Selling/General/Administrative Expenses, Total 22,060 20,259 21,314 20,079
Research & Development 6,153 6,107 5,842 5,874
Depreciation/Amortization 0 0 0 0
Interest Expense (Income), Net Operating 0 0 0 0
Unusual Expense (Income) 0 0 0 0
Other Operating Expenses, Total 0 0 0 0
Operating Income 13,516 11,928 9,376 9,616
Interest Income (Expense), Net Non-Operating -217 293 -220 -139
Gain (Loss) on Sale of Assets 18 41 0 0
Other, Net 1,172 1,054 3,070 1,192
Income Before Tax 14,489 13,316 12,226 10,669
Income Tax – Total 4,071 3,901 4,232 3,172
Income After Tax 10,418 9,415 7,994 7,497
Tax rate 28.10%
Minority Interest 0 0 0 0
Equity In Affiliates 0 0 0 0
U.S. GAAP Adjustment 0 0 0 0

 

Net IncomeBeforeExtra.Items 10,418 9,415 7,994 7,497
TotalExtraordinaryItems 0.0 76.0 -60.0 -18.0
Net Income 10,418 9,491 7,934 7,479
TotalAdjustments to NetIncome 0.0 0.0 0.0 0.0
BasicWeightedAverage Shares 1,423.04 1,530.81 1,600.59 1,674.96
BasicEPSExcluding Extraordinary Items 7.32 6.15 4.99 4.48
BasicEPSIncludingExtraordinaryItems 7.32 6.2 4.96 4.47
DilutedWeightedAverage Shares 1,450.57 1,553.54 1,627.63 1,707.23
Diluted EPS Excluding Extraordinary Items 7.18 6.06 4.91 4.39
Diluted EPS Including Extraordinary Items 7.18 6.11 4.87 4.38
DividendsperShare-CommonStockPrimary Issue 1.5 1.1 0.78 0.7
GrossDividends-CommonStock 2,147 1,683 1,250 1,174
InterestExpense,Supplemental 611 278 220 139
Depreciation,Supplemental 4,038 3,907 4,147 3,959
NormalizedEBITDA 18,717 16,911 14,564 14,531
NormalizedEBIT 13,516 11,928 9,376 9,616
NormalizedIncomeBeforeTax 14,471 13,275 12,226 10,669
NormalizedIncome After Taxes 10,405 9,386 7,994 7,497
NormalizedIncomeAvailabletoCommon 10,405 9,386 7,994 7,497
BasicNormalized EPS 7.31 6.13 4.99 4.48
DilutedNormalized EPS 7.17 6.04 4.91 4.39
AmortizationofIntangibles 1,163 1,076 1,041 956

This table presents the consolidated income statement of ITS from N toN+3years

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The consolidated  BalanceSheet of ITS is presented in Table3 pertaining to theyears,YearNthroughYearN+3.

 

Table3:ITS Consolidated Balance Sheet(in millions)(N through N+3)Financial data in$1 millions(Except for pershare items)

 

 

Year N+3 Year N+2 Year N+1 Year N
PeriodEndDate

 

StmtSource

 12/31/N+3

 

10-K

 12/31/N+2

 

10-K

 12/31/N+1

 

10-K

 12/31/N

 

10-K
StmtSource Date

StmtUpdateType

 02/26/N+4

Updated

 02/27/N+3

Updated

 02/28/N+2

Updated

 02/28/N+2

Restated
Assets

CashandShortTermInvestments

  

16,146

  

10,656

  

13,686

  

10,570
TotalReceivables,Net 28,789 26,848 24,428 28,136
TotalInventory 2,664 2,810 2,841 3,316
Prepaid Expenses 3,891 2,539 2,941 2,708
Other CurrentAssets,Total 1,687 1,806 1,765 2,413
TotalCurrentAssets 53,177 44,659 45,661 47,143
 

Property/Plant/Equipment,Total- Net

  

15,082

  

14,439

  

13,756

  

15,175
Goodwill,Net 14,285 12,854 9,441 8,437
Intangibles,Net 2,107 2,203 1,663 1,789
Long TermInvestments 5,248 4,501 3,142 2,444
NoteReceivable-Long Term 11,603 10,068 9,628 10,950
Other Long TermAssets,Total 18,930 14,509 22,457 25,065
Other Assets,Total 0.0 0.0 0.0 0.0
TotalAssets 120,432 103,233 105,748 111,003
 

LiabilitiesandShareholders’Equity

AccountsPayable

  

 

8,054

  

 

7,964

  

 

7,349

  

 

9,444
Payable/Accrued 0.0 0.0 0.0 0.0
AccruedExpenses 10,546 9,967 8,558 10,340
NotesPayable/ShortTerm Debt 8,545 6,134 4,228 4,491
CurrentPort.ofLTDebt/CapitalLeases 3,690 2,768 2,988 3,608
Other CurrentLiabilities,Total 13,475 13,257 12,029 11,903
TotalCurrent Liabilities 44,310 40,090 35,152 39,786
TotalLong Term Debt 23,039 13,780 15,425 14,828
DeferredIncomeTax 1,064 665 1,616 1,770
Minority Interest 0.0 0.0 0.0 0.0
Other Liabilities,Total 23,549 20,192 20,457 22,931
TotalLiabilities 91,962 74,727 72,650 79,315
RedeemablePreferredStock 0.0 0.0 0.0 0.0
PreferredStock – Non Redeemable,Net 0.0 0.0 0.0 0.0
CommonStock 35,188 31,271 28,926 26,673
Retained Earnings(AccumulatedDeficit) TreasuryStock-Common 60,640

-63,945

 52,432

-46,296

 44,734

-38,546

 38,148

-31,072
Other Equity,Total -3,414 -8,901 -2,016 -2,061
TotalEquity 28,469 28,506 33,098 31,688
TotalLiabilities&Shareholders’ Equity 120,431 103,233 105,748 111,003
TotalCommonSharesOutstanding 1,385.23 1,506.48 1,573.98 1,645.59
TotalPreferredSharesOutstanding 0.0 0.0 0.0 0.0

This table presents the consolidated balance sheet of ITS from N to N+3 years

 

The detailed composition of total long term debtofUS$23,039millionreportedon the consolidated Balance Sheet fortheyearN+3is presented in Table 4. The table provides details for debt securities of various maturities along with the coupon rates payable on them.

 

Table4:Details of Long-Term Debt ($ in millions)

 

Coupon Interest Rate Maturities Balanceon N+3 AnnualInterestExpense
4.48% N+4–N+7 $12,295*** $551
5.34% N+8–N+9 3,545 189
5.69% N+10–N+14 3,026 172
8.375% N+15 750 63
7.00% N+21 600 42
6.22% N+23 469 29
6.50% N+24 313 20
5.875% N+28 600 35
7.00% N+41 150 11
7.125% N+92 850 61
 

Othercurrencies(average interest rateat December31, N+3,in parentheses)
Euros(3.4%) N+4–N+9 2,466 84
Yen(2.2%) N+6–N+10 767 17
Swissfrancs(1.5%) N+4 442 7
Other (2.7%) N+4–N+9 89 2
Weightedaverageinterest rate

= $1,283/$26,362=4.87%

   26,362 1,283
Less: Netunamortizeddiscount   65  
Add: SFAS No.133fair value   432  
    26,729  
Less:Currentmaturities   3,690  
Total   23,039  

Thistableprovidesadetailedbreak-downofthecompositionofLong-termdebtofITSreportedonitsconsolidated

BalanceSheetfortheyearN+3

 

 

All ITS bonds are rated Aaa by Moody’s and AA Aby Standard&Poor’s.Interpretation of bond rating categories normally assigned by both the credit rating agencies are summarized in Table5.

Table5:Credit Rating Categories

 

Rating Description

 

 Moody’s Ratings

 

 Standard&Poor’sRatings

 

 Rating Grades

 
HighestQuality Aaa AAA InvestmentGrade
HighQuality Aa AA  
Upper Medium A-1,A A  
Medium Baa-1,Baa BBB  
Speculative Ba BB NotInvestmentGrade
HighlySpeculative B,Caa B,CCC,CC  
Default Ca,C D  

 

 

Currently, in the capital budgeting arena, each ITS division has its own method of calculating  the cost of capital resulting indifferent hurdle rates; thus, it leads to non-uniformity with regard to accept/reject decisions on capital investments. ITS feels that in order to maximize share holder value, it has to come up with company-wideguidelinesfor calculating its cost of capital and standardize the hurdle rates and accept or reject decisions through out the company.  For the year N+6,ITS is considering the following capital budgeting projects with these projects spread around the globe

 

 

Table6:ITS’s N+6 New Projects Under Consideration

 

Project Net Investment Cost ($1 millions) Proposed

Location

 Estimated IRR Typeof Project
1 $500 Europe 26.3% Existingproduct,new market
2 $400 USA 13.5% Newproduct,newmarket
3 $650 Asia 8.6% Expand existingproduct inexistingmarket
4 $1,500 Asia 23.4% Newproduct,existingmarket
5 $350 USA 24.6% ReplaceEquipment
6 $750 Europe 10.2% Expand existing productinexisting market
7 $250 Asia 26.7% Existingproduct,newmarket
8 $325 Asia 18.8% Newproduct,existingmarket

Thistableprovidesdetailsofnewprojectsunderconsideration byITSinyearN+6

 

Further,ITS has a to tal budget allocation(capital constraint)of US$ 4.2 billion for the N+6capital investment budget. Pro ject risk tends to vary with project type, as described in table 7.

 

 

Table7:Type of project and degree of risk

 

Typeof Project Degree ofRisk
Routine replacement of equipment Minimal Costreduction
Low Expand existing products in existing markets Moderate
Add new products in existing markets Moderate-High
Expand existingproductsin newmarkets Moderate-High
Add new products in new markets High

This table describes the risk profiles of different kinds of projects normallyundertaken by businesses.

 

 

You have been provided with an excellent opportunity to assist Gordon Crown and Helen Change in your first exposure to areal world scenario.  Having recently completed MBA Finance from a leading University, this is your best chance to launch your career in corporate finance by applying relevant concepts that you may have come across in the classroom discussions at your University. A further challenge is to justify the basis of your analysis in them ost convincing manner to address Helen Chang’s concerns,being an MBA herself. Gordon Crown is now eagerly awaiting your recommendations.

 

 
QUESTIONS
 

After a quick glance at the available information and the decision making requirements of the Gordon Crown, you have decided that at the minimum you have to do the following

 

Question 1:For component costs

A.Compute the before-and after-tax costs of ITS debt.

B.Compute the cost of equity(assuming all funds come from internal sources)

  1. i. Using the constant growth Gordon Dividend Valuation Model
  2. ii. Using the Security Market Line Equation(SML)from the CAPM

 

Question2:Compute the Weight ed Average Cost of Capital(WACC)based on cost of equity estimated under the Gordon’s Constant Growth Dividend Valuation Model

A.Using book value weights for debt and equity

B.Usingmarketvalueweightsfordebtandequity

 

Question 3:Compute the WACC based on cost of equity estimated under the CAPM

A.Using book value weights for debt and equity

B.Using market value weights for debt and equity

 

Question4:Address the pros and cons of using market value weights versus book value weights and reconcile the divergent views of Crown and Chang.

 

Question5:Compute the Required Rate of Return for the project(s), adding appropriate risk premiums subjectively to the WACC’s in questions 2 and 3.These risk premiums can differ depending on the nature and continental location of the projects.

 

Question 6:Make are commendation as to which,if any,of the investments identified in Table 6 should be accepted taking into account the capital constraint.

 

 

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Summary