Download The Ralston Company/The Balboa Company

THE RALSTON COMPANY
I am the Chairman of the Board of the Ralston Company, a small but publicly traded
manufacturing firm, and you have been retained as a financial consultant to help me. My
company’s products are profitable and well-established in their various markets, and from all
indications Ralston will continue to expand at a respectable, but not abnormally high, growth
rate for the foreseeable future. I anticipate that a steady stream of additional financing will be
required to support this growth since internally generated funds are not expected to be solely
sufficient. The Ralston Company has over the years maintained a debt to asset position in the
vicinity of 50%, and while the Board of Directors is not committed to this particular capital
structure, they would become somewhat concerned if it were to deviate too much from this
norm.
Half of the Ralston Company is owned by the management of the firm with the remainder being
held by individual investors. Based upon my best judgment and that of the other members of
the Board, Ralston’s long-established policy of paying annual dividends (which are generally
equal to about 60% of earnings) is what supports the price of the stock in the marketplace.
Although most of the management stockholders do not really need the dividend income, neither
do they want the price of the stock to drop since many of them have personal loans secured by
their shares of the stock.
Basically, the problem is this: If Ralston continues its current dividend policy, there will not be
enough equity in the company as a basis for borrowing against to meet its expansion needs and
Ralston’s debt to equity ratio would become unacceptable within a very short time. The present
stock price and P/E multiple, however, are currently reflective of the general depressed market
conditions, and unfortunately nobody expects the stock market to improve significantly over the
next year or two. Consequently, we do not anticipate being able to sell new equity in the market
at a reasonable price for quite awhile, and floating an equity issue now is totally unacceptable to
everyone. What we need to do is somehow increase our equity gradually in the coming months
and years (cutting dividend payout by about half would be sufficient but price considerations
virtually preclude this option) to provide us with the internal cash flow and equity basis against
which to borrow so as to meet our planned capital budgeting program. As a financial
consultant, what are your thoughts and suggestions on this dilemma?
THE BALBOA COMPANY
The Balboa Company is a very profitable manufacturer of technical equipment for public and
private hospitals. The company has been quite prosperous during the last few years and
security analysts agree that Balboa’s long-run outlook is bright. The company’s management is
considered very aggressive and intent on expanding the firm’s operations. A balance sheet for
Balboa is presented below (000’s):
Cash
Accounts Receivable
Inventory
Plant & Equipment
Total Assets
1,000
3,000
3,000
3,000
10,000
Accounts Payable
Bank Loans
Long-term Debt
Equity
Total Liabs. & Equity
1,000
2,000
4,000
3,000
10,000
The recent downturn in the economy and the anticipated recession is creating some unique
situations for Balboa. First, customers are beginning to delay some of their payments on
accounts receivable, and while not a particularly serious problem now, management suspects it
could get worse over the next 2-3 years as the recession deepens. The second situation
caused by the general state of the economy is that numerous firms are selling at depressed
prices. Balboa’s management has identified two firms – Ash Company and Horn, Inc. – as
being both reasonably priced and potentially high quality acquisition candidates.
The Ash Company is an old-line producer of metal school furniture – desks, chairs, tables, etc.
These product lines have persistently been reasonably profitable and have exhibited remarkable
resiliency to economic swings in the past. As shown on the balance sheet below, the Ash
Company has maintained a conservative capital structure and is fairly cash-rich (000’s):
Cash
Accounts Receivable
Inventory
Plant & Equipment
Total Assets
1,000
500
2,500
1,000
5,000
Accounts Payable
Bank Loans
Long-term Debt
Equity
Total Liabs. & Equity
500
500
1,500
2,500
5,000
The Ash Company is owned in part by the Ash family and in part by individual investors. To
purchase Ash, the minority shareholders (public) would have to be paid in cash (with the market
value of their shares being worth approximately $1,000,000). The Ash family, though, has
indicated a willingness to accept a long-term note at fairly reasonable terms for their interest in
the amount of $2,000,000.
The other candidate, Horn, Inc., is also in the hospital supply business. It has carved a niche in
the market with a unique blood analysis machine and is an extremely profitable enterprise.
Equally important, Balboa sees Horn, Inc., as a vehicle for expanding the market for its own
products. Horn’s balance sheet is shown below (000’s):
Cash
Accounts Receivable
Inventory
Plant & Equipment
Total Assets
250
1,000
1,000
1,750
4,000
Accounts Payable
Bank Loans
Long-term Debt
Equity
Total Liabs. & Equity
1,500
2,000
-0500
4,000
Horn is owned by the individuals who developed the blood analyzer but they are tired of the
rigors of the business. They have indicated a willingness to sell all of Horn, Inc. (and a noncompete agreement) for $1,000,000 cash.
Balboa is torn between the two acquisition candidates. Both are attractive for different reasons
but Balboa’s management feels that it can only afford (largely due to limited managerial
capabilities) one of the two companies at this time. Considering all of the factors, what would
you suggest Balboa do and why?