Accounting

The Rondo Company is a medium size manufacturing company that manufactures copper, steel, and iron pipe. The company was founded by Bill Rondo, the current president and board chairman. Mr. Rondo owns the majority of the company’s outstanding stock. The stock is publicly traded. Key financial, ownership and market information on Rondo is included in Appendix A.

In addition to the normal course of business, Rondo has two interesting opportunities that it is considering.

The first opportunity is a special contract with a long-time customer. The customer wants to enter into a five-year agreement to have Rondo produce a new type of pipe. Key expected financial information on this special project is included in Appendix B. In order to take advantage of the project, Rondo would have to invest the amount noted in Appendix B in special purpose equipment. It is unlikely that the contract would be renewed and also unlikely that the new equipment could be adapted to other production. Since the equipment would be special purpose, the expected salvage value is zero.

The second opportunity is the possibility of acquiring a company that makes PVC pipe. This company, Poly Pipe Incorporated (Poly), is smaller than Rondo. It had been started by several previous Rondo managers to take advantage of the new poly vinyl chloride pipe making technology. Although both companies are in the pipe business, their customer bases do not overlap significantly. Metal pipe and PVC pipe are used in different applications. Poly is publicly traded. The market is not active. The majority of the stock is still owned by the three founders. The remainder of the stock is owned by several hundred stockholders; its ownership is not concentrated. Key financial, market and ownership information on Poly Pipe Inc. is included in Appendix C.

In addition to these opportunities, Rondo continues its modest growth. While the company’s growth rate has varied over the last 10 years, it currently expects this historical growth rate to continue. However, Rondo is operating near its capacity. As a practical matter, growth will require incremental additions to production equipment.

Rondo’s Board of Directors has established several policies. While the Board prefers that these policies be followed, they would modify the policies if it made sense for the company.
• The dividend payout ratio should be between 40% and 50%.
• The debt to total assets ratio should not be higher than 50%.
• Annual company growth should continue in the 5% to 10% range. The board will measure growth as the annual increase in Earnings Per Share.
• The company should maintain flexibility in financial transactions. No high risk transactions should be used, nor should the company tie its hands with financial arrangements.

In addition, Mr. Rondo wants to maintain his family ownership in the company at a minimum of 30%. He does not want to be required to purchase any additional stock. Since the Rondo family counts on the dividend payments, he is also adamant about continuing the dividend payments near their current per share rate.

Potential Poly Pipe Incorporated Purchase

Poly is a small company that manufactures PVC pipe. They have been in business for 10 years. Growth has been relatively consistent for the last five years. Poly’s products do not compete directly with Rondo’s.

Poly’s managers want to sell the company. If the sale is to be a cash sale they will require a premium of 50% above the current “market” price to cover taxes and still leave a profit. They would be willing to sell by exchanging shares with an appropriate company, possibly on more favorable terms.

Potential Sources of Funds

The company has investigated several sources of funding for the new project and for future needs. Detailed information and terms on each potential funding source is provided in Appendix D. Terms are those required by the provider of funds. While some conditions may be negotiable, most are cast in stone. The potential funding options are summarized below:

Common Stock

New common stock could be issued at the current market price, however, underwriting and other associated costs (noted in Appendix D) must be considered in calculating the total “proceeds” that Rondo would receive.

Mortgage Bond

The ABC Insurance Company, the company that provided the original mortgage bond, is willing to refund it. The current bond would be replaced with a new one, on the terms noted in Appendix D. The loan would be secured by all the assets of Rondo, including any assets acquired in the future.

Convertible Bond

The XYZ Insurance Company is willing to invest in a convertible bond. XYZ wants to be able to share in Rondo’s success but also retain the ability to remain a creditor if the Company is not successful. Each $1,000 bond would be convertible into a certain number of shares of Rondo common stock, as noted in Appendix D. In addition, cash dividends would be restricted. Cash dividends could not be paid unless net income was 20% of the value of the bonds outstanding.

Preferred Stock

The MNO Insurance Company is willing to offer a preferred stock arrangement. In addition to the preferred stock, MNO wants warrants to sweeten the deal. Each share of preferred stock would contain warrants that allowed the purchase of a certain number of shares of Rondo Common stock at the exercise price outlined in Appendix D. In addition, if four consecutive dividends were missed, the preferred stockholders would elect 50% of the board of directors.

Bank Loan

The current bank loan could be extended with additional amounts available, as noted in Appendix D.

Note: for simplicity this case assumes that all interest payments on loans, bonds, and preferred stock are paid annually. You should know that bank loans have a wide variety of interest-payment arrangements, virtually all bonds have semiannual interest payments and preferred stock dividends are generally paid quarterly.

Key Questions

Throughout address the following issues:

• How is Rondo doing at this point in time?
• What are Rondo’s financing needs for the next 6 years?
• Is the new project a good deal? Why or why not?
• Are funds available internally?
• Are there any Board of Directors policies that you would suggest be changed? Why?
• Which financing source should be used to finance the new project and the company’s continuing growth?
• Should Rondo purchase Poly? What should the offer be?

RONDO CASE – APPENDIX A
BALANCE SHEET (as of 12/31)
2017 2018 2019

ASSETS
Current Assets
Cash 1,469,000 2,032,500 2,460,000
Accounts Receivable 9,000,000 9,375,000 9,750,000
Inventory 4,125,000 4,625,000 5,250,000
Total Current Assets 14,594,000 16,032,500 17,460,000
PPE
Equipment 19,000,000 18,375,000 17,500,000
Property and Plant 16,000,000 15,375,000 14,750,000
Total PP&E 35,000,000 33,750,000 32,250,000
TOTAL ASSETS 49,594,000 49,782,500 49,710,000

LIABILITIES
Current Liabilities
Accounts Payable 1,500,000 2,250,000 2,500,000
Current Portion of Bank Loan 2,500,000 2,500,000 2,500,000
Accruals 3,375,000 3,500,000 3,750,000
Total Current Liabilities 7,375,000 8,250,000 8,750,000
Long-Term Debt
Bank Loan 10,000,000 7,500,000 5,000,000
Mortgage Bond 5,000,000 5,000,000 5,000,000
Total Long-Term Debt 15,000,000 12,500,000 10,000,000
Total Liabilities 22,375,000 20,750,000 18,750,000

Equity
Common Stock 9,587,500 9,587,500 9,587,500
Retained Earnings 17,631,500 19,445,000 21,372,500
Total Equity 27,219,000 29,032,500 30,960,000
TOTAL LIABILITIES & EQUITY 49,594,000 49,782,500 49,710,000

Notes to Rondo’s Balance Sheet:
Bank Loan Information
Original Amount Borrowed 15,000,000
Amount Outstanding Dec 31, 2019 7,500,000
Interest Rate 6.00%
Principal Payment Amt per Year 2,500,000
Year of Final Payment 2022
Interest & Principal Pmts Due December 31
Mortgage Bond Information
Original Amount Borrowed 5,000,000
Amount Outstanding Dec 31, 2019 5,000,000
Coupon Interest Rate 7.50%
Principal Payment Amt per Year 500,000
Principal Payments Begin in Year 2024
Year of Final Payment 2033
Interest and Principal Pmts Due December 31

INCOME STATEMENT (for year ending 12/31)
2017 2018 2019

Sales
41,250,000
46,250,000
50,000,000
Cost of Goods Sold (28,875,000) (32,375,000) (35,000,000)
Gross Profit 12,375,000 13,875,000 15,000,000
Selling, General & Admin (4,560,000) (5,205,000) (5,850,000)
Depreciation (1,500,000) (1,500,000) (1,750,000)
Earnings Before Interest & Taxes 6,315,000 7,170,000 7,400,000
Interest (1,275,000) (1,125,000) (975,000)
Earnings Before Taxes 5,040,000 6,045,000 6,425,000
Income Tax @ 40% (2,016,000) (2,418,000) (2,570,000)
NET INCOME 3,024,000 3,627,000 3,855,000

Shares Outstanding
1,000,000
1,000,000
1,000,000
Earnings per Share 3.02 3.63 3.86
Dividends Paid 1,512,000 1,813,500 1,927,500
Increase in Retained Earnings 1,512,000 1,813,500 1,927,500
Market Price Per Share 62
Mr. Rondo’s Share Ownership 60.00%
Rondo Company Beta 1.20

Appendix B – Special Project Information
($ millions)

Term of the Agreement (Years)

5.00

Initial Capital Expenditure for equipment
$6.25

Expected Annual EBIT Contribution
$2.00

Expected Annual Sales
$7.50

Expected Annual Operating Expenses (including Depreciation of $1.25)
$5.50
Expected Salvage Value of equipment

$0.00

Poly Incorporated – Appendix C
Balance Sheet Income Statement
for the Year Ending December 31 2019 for the Year Ending December 31 2019
ASSETS Sales 31,250,000
Cost of Goods Sold 21,875,000
Current Assets Gross Profit 9,375,000
Cash 2,250,000
Accounts Receivable 5,250,000 Selling, General & Admin 2,229,168
Inventory 8,125,000 Depreciation 1,437,500
Total Current Assets 15,625,000 Earnings Before Interest & Taxes 5,708,333
PPE Interest 500,000
Equipment 9,375,000 Earnings Before Taxes 5,208,333
Property and Plant 5,000,000
Total PP&E 14,375,000 Income Tax @ 40% 2,083,333
TOTAL ASSETS 30,000,000 NET INCOME 3,125,000
LIABILITIES Shares Outstanding 1,100,000
Earnings per Share 2.84
Current Liabilities Dividends Paid 0
Accounts Payable 4,375,000 Market Price of One Share of Stock 36
Accruals 1,875,000
Total Current Liabilities 6,250,000
Long-Term Debt
Bank Loan 5,000,000
Total Long-Term Debt 5,000,000
Total Liabilities 11,250,000
Equity
Common Stock 2,500,000
Retained Earnings 16,250,000
Total Equity 18,750,000
TOTAL LIABILITIES & EQUITY 30,000,000

Potential Funding Sources – Financial Terms (Appendix D)
Common Stock Terms
Price at which new stock could be issued $62
Underwriting Costs per Share $9

Mortgage Bond
Total Amount Offered w/out Poly Pipe Purchase $8 mm
Total Amount Offered w/ Poly Pipe Purchase $13 mm
Interest Rate 9.00%
Repayment of Principal per Year (% of Loan) 10.00%
Total Term of Loan (years) 10 years
Payments Annual
Payment Date December 31
Convertible Bond
Total Amount Offered $10 mm
Interest Rate 8.63%
Repayment of Principal per Year (% of Loan) none
Total Term of Loan (years) 10 years
Payments Annual
Payment Date December 31
# of Shares per $1000 bond if converted 15.625
Preferred Stock
Total Amount Offered w/out Poly Pipe Purchase $8 mm
Total Amount Offered w/ Poly Pipe Purchase $13 mm
Dividend Rate 9.38%
Dividend Payments Annual
Dividend Payment Date December 31
Par Value per Share $1,000
Callable after 15 years at price per share of $1,050
Number of Warrants per Preferred Stock Share 13
Strike Price of each Warrant ($ per Rondo share) $77.00
Bank Loan
Total Amount Offered w/out Poly Pipe Purchase $10 mm
Interest Rate 11.50%
Principal Payments per Year $2 mm
Principal Repayment Begins 2020
Payments Annual
Payment Date December 31