The Ralston 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 1,000 Accounts Payable 1,000 Accounts Receivable 3,000 Bank Loans 2,000 Inventory 3,000 Long-term Debt 4,000 Plant & Equipment 3,000 Equity 3,000 Total Assets 10,000 Total Liabs. & Equity 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 1,000 Accounts Payable 500 Accounts Receivable 500 Bank Loans 500 Inventory 2,500 Long-term Debt 1,500 Plant & Equipment 1,000 Equity 2,500 Total Assets 5,000 Total Liabs. & Equity 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 250 Accounts Payable 1,500 Accounts Receivable 1,000 Bank Loans 2,000 Inventory 1,000 Long-term Debt -0- Plant & Equipment 1,750 Equity 500 Total Assets 4,000 Total Liabs. & Equity 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 non- compete 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?