Case Study-AW29 Online Services
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)
- i. Using the constant growth Gordon Dividend Valuation Model
- 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.
Product code: Case Study-AW29
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