Page 212 - DMGT409Basic Financial Management

Unit 13: Theory and Forms of Dividend

Notes

Case Study Future Earnings Per Share
Ramesh Products Case
This case allows the reader to apply the concept of future EPS in evaluating a course of
action in terms of its effect on the market value of the firm’s common stock.

Ramesh Products (RKP) is a medium-sized producer of chemicals and vinyl coating used in
a variety of industrial processes. The company’s main facilities are located in an industrial
park in East Baltimost, a central site by a rail line that is linking the firm with its major

customers on the east coast.

Last year the firm recorded over $200 million in sales, showed a net income of $53 million
and concluded a very successful year. For the coming year, the firm expects a 15 per cent

improvement in sales and operating income fi gures.

The firm’s management committee, consisting of the president and the vice-presidents of
production, marketing, and finance, will be meeting with in a week to discuss a major

new activity for the next year. Products has been invited to bid on a long-term contract to
produce a line of plastics for a large chemical company in Wilmington, Delaware. It appears
that the fi rm can easily get the $50 million contract which should yield an additional $14
million in operating income. These figures are for next year only, and the fi rm estimates

even higher sales and profits in the future.

Chowdhary vice -president of finance, has been studying the financial data related to the
new line of plastics. The production manager knows of a small plastic company located
about three miles from RKP’s facilities. The plastics company has all the equipment needed
to produce the new line of plastics; the company is for sale for $104 million. This price
represents largely the value of the assets, since the company has lost its only large contracts.
Chowdhary Prasad has discussed the purchase of this plastics company with a local real

estate agent and has confirmed that it is available for $100 million.

Chowdhary Prasad figures that RKP has sufficient working capital to add the new plastics

line but does not have the cash to buy the 100 million of machinery and equipment needed
to begin the production. Discussion with a representative of a large Baltimore bank reveals
that RKP can borrow $39 million through a 12 per cent mortgage on its main facilities.

A mortgage company has indicated that it would help finance the plastic machinery with
a $51 million, 13.6 per cent mortgage. Chowdhary Prasad is considering these choices but
knows that RKP has traditionally kept its debt-asset ratio below 41 per cent He does not
want to borrow if the additional debt causes the ratio to exceed 41 per cent.

Chowdhary Prasad discussed equity financing with RKP’s investment banker on a recent

trip to New Jersy City. He learned that the firm could probably issue upto $150 million in
15 per cent preferred stock or class A common stock. If the common stock were offered, it
could net $20 per share to RKP. Chowdhary Prasad called new Jersy and confi rmed that
these options were still open to the fi rm.
In making decision on new investments, Chowdhary Prasad believes in the validity of the
future-earnings per share technique. He knows that RKP has traditionally traded at a 6/1
price-earning multiple and he expects that this will hold. Thus, if a new project increases
future earnings per share, it will increase the value of the firm for its shareholders.

Question
According to the future earning share approach and after detailed analysis what do you
feel about the plastic project. Is it worth while to accept.

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