Final Case: Friendly Cards, Inc.

FINAN 4210

Lutz

Jonathan Matsen

05/01/2013
Problem Identification

Wendy Beaumont, president of Friendly Cards, is currently faced with 3 time sensitive issues
that need to me dealt with immediately. As a relatively small company in the fiercely
competitive greeting card industry, Ms. Beaumont must make some quick yet intelligent
decisions to ensure the continued success of her company.

To be more specific, she must decide upon:

 The investment in equipment to enable the company to make rather than buy their own
envelopes
 The acquisition of Creative Designs Inc., a small Midwestern manufacturer of studio
cards
 The possibility of going to the market to raise additional equity capital in order to relieve
pressure on its financial position

Identification of Relevant Facts

Friendly’s position in the industry

As of early 1988, the main issues facing the greeting card industry were:
 Continued industry consolidation (a decline of 15% per decade since 1954)
 Cyclical revenues
 The presence of high fixed costs

Threat of Industry Consolidation

Since its inception in 1978, Friendly Cards reacted to the looming threat of industry
consolidation by rapidly expanding internally and through various acquisitions. These
acquisitions allowed Friendly to access new markets and demographics that would have been
previously unavailable to them. For example, through their acquisition of a California firm, the
company gained West Coast distribution access and a more profitable form of distribution that
cut out the middle-man/men (which ate away at profit margins), and a new branding opportunity
through the creation of “Friendly Artists”.

Friendly also diversified their product offerings with a full line of greeting cards (1200 designs)
for the upcoming 1988 year, which was uncharacteristic of a small company. They were also
active in the packaged box card market, which was a less active industry segment for giants like
American Greetings (they focused more heavily on the sale of packaged cards). Friendly’s
presence in the packaged box segment also cut costs due to the non-return nature of the product
once the package was opened, unlike the high chance of individual card returns (which were a
constant source of increased costs and a headache for those in the industry).

Cyclical Nature of the Industry

Concerning the cyclical nature of the industry, Friendly realized 30% of dollar sales by
Christmas and 25% by Valentines. The remainders of sales were made-up by spring and
everyday cards. Currently none of Friendly’s cards were “studio cards” which were defined in
the industry as higher fashion items. With its primary demographic of over-40 year olds, the
majority of their customer base was cost conscious. All production was done in-house, but
printing work could be done outside of necessary. Another key issue was the fact that Friendly
currently purchases all of their envelopes from outside manufacturers.

High Fixed Costs

Expensive production, the need for large inventories, and long lead times were the main
contributors to this particular industry quality. These costs were natural to the industry and more
or less unchangeable.

While these costs could not be reduced, sales costs could. The large companies used their own
sales force to sell directly, while Friendly relied on its sales force of 25 employees who sold
either directly to the central buyers of national chains, rack jobbers, and wholesalers.

Friendly’s reliance on this method of sales had a direct effect on their low profit margins. There
were often two “middle-men” or intermediaries that were in-between the final customer and
Friendly – it was estimated that retail dollar sales of Friendly Cards were 3x the sales figures
seen on the income statement.

Friendly’s Financial Issues

Due to the capital-intensive nature of the operating in the industry, Friendly had always faced
some sort of financial hardship. Thankfully, they had good relationships with their banks, which
has contributed to their success.

Facts specific to Friendly that will be useful in analyzing their current issues include
 A $6.25 million line a credit
 A borrowing rate of 2.2% above the current prime rate of 8.5%
 December and January were peak times of need for bank and trade credit, with low points
in April where needs were 50% less

The company is currently heavily debt financed, with current liabilities/equity ratio of 4.72 (it
had previously reached 5.22 just a year prior!). Taking this into consideration, Ms. Beaumont is
currently being urged to seek more equity capital. Her bankers are insisting that Friendly take
action before the peak-borrowing season in at the end of 1988 to make sure that it will be able to
comply with the following lending restrictions which will take effect in 1989:
 Bank loans outstanding could not exceed 85% of Friendly’s A/R
 Total liabilities could not exceed 3x the BV of the company’s net worth

To remain safely within these boundaries, Ms. Beaumont would like to keep Friendly’s ratio of
all interest bearing debt/equity to a max of 2 to 1.
Analysis

The Envelope Machine

Adequate information needed to calculate an appropriate WACC to discount CF’s was not given,
so instead an IRR for the machine’s projected future cash flows was calculated assessing the
economic impact of its purchase.

Since the depreciation of 62,000 per year totaled the purchase price of the machine and no
terminal value was given, it was assumed to have a TV of 0 at the end of year 8. Subsequently a
TV was not considered in the projected cash flows. An IRR of 41% was derived from the
following cash flow analysis:

Since Friendly is currently in a tough financial situation, the capital needed to purchase the
equipment will probably need to come from more expensive sources, such as the sale of common
stock to the West Coast investors (which will be examined in more detail below).

It should also be noted that the “cash flows” calculated in reality are reductions in the current
COGS on Friendly’s income statement (since they are currently paying the $1,500,000 “revenue”
this project would generate on envelopes from outside manufacturers).

Creative Designs Acquisition

Building upon their previous strategy of utilizing acquisitions to sustain growth, Friendly needs
to examine the economic implications of acquiring Creative Designs. There are two scenarios
that need to be looked at when considering this acquisition – projected cash flows and valuations
with Ms. Beaumont’s proposed abilities to increase sales and reduce costs and without.
Regardless of which scenario would actually happen, it was necessary to calculate CAPM (which
required estimating CD’s beta) and WACC. To estimate CD’s equity beta, from Exhibit 5 was
used to unlever the equity betas of the two companies, take the average, and derive a beta of 1.20
for creative designs to be used in the CAPM.

Moving on to CAPM, the T-bill rate of 6.1% was used for the risk-free rate and the average of
the bond rates was used for the market rate (all from Exhibit 5). Using these figures, I came up
with a CAPM of 10.9% for CD. For the cost of debt I used the 11.5% number given in Exhibit 5,
which stated that it was for a corporate bond of similar quality to Friendly Cards.

The next step was to calculate WACC. For the D/V and E/V weights, I used the 45% debt to
total number given in the case suggestions and a tax rate of 40% was used. The CAPM of 10.9%
was used for the cost of equity. Using all of these numbers, I came up with a WACC of 9.06%.

The following was assumed/inferred when analyzing the two scenarios

Under the proposed sales increases/cost reductions

 Tax Rate of 40%

 Sales increase of 6% starting in 1989 (stated in case)
 5% Reduction from 1987 COGS (stated in case),
 COGS after 1987 equaling 58% of yearly sales which was derived from the Exhibit 6
and dividing COGS by Net Sales from 1985-1987 and taking the average minus the 5%
proposed reduction by Ms. Beaumont
 10% Reduction of non-COGS expenses starting in 1988 (stated in case), with non-COGS
expenses equaling 28% of yearly sales which was derived from Exhibit 6 in the same
fashion as COGS
 Depreciation as 13% of net fixed assets which was derived from Exhibit 6 by taking an
average of depreciation cost as a percentage of net fixed assets over the years 1986-1987
 CAPEX equaling 190 each year

To calculate the terminal values used to get the NPV, the Gordon Growth model was used. I used
the CF in year 5 as the final CF, 6% proposed sales increase as the growth percent and the 9.06%
WACC. When utilizing the above assumptions, I came up with an NPV (or firm value) of
$15,039.46.

Under current conditions

 Tax Rate of 40%

 Increase of sales of 9% per year which was derived from looking at Exhibit 6 and taking
the average of sales growth from 1985-1987
 COGS as 61% of net sales
 Other expenses as 32% of net sales
 Depreciation as 13% of net fixed assets which was derived from Exhibit 6 by taking an
average of depreciation cost as a percentage of net fixed assets over the years 1986-1987
 CAPEX equaling 190 each years
To calculate the terminal values used to get the NPV, the Gordon Growth model was used. I used
the CF in year 5 as the final CF, 9% average sales increase as the growth percent and the 9.06%
WACC. When utilizing the above assumptions, I came up with an NPV (or firm value) of
$7,121.90.

Raising additional equity funds through the West Coast Investors

There are many issues to think about when considering issuing equity to raise funds. Ms.
Beaumont would need to consider the fact that issuing new equity dilutes the value of previously
held shares (she would own less of the company), and it is generally considered to be a more
expensive form of funding (which would raise the WACC).

The case also mentions that Ms. Beaumont’s financial advisor, Ms. McConville, after speaking
with an investment banker recommended that $8 a share is a very good deal right now. Raising
equity funds within the current economic climate will be difficult for the firm due to the stock
market crash at the end of 1987. Even though Friendly’s shares have hit $15 dollars in the past,
due to the economic climate, the investment banker says that even $8 per share is a lofty request.

When taking into account the precarious situation that Friendly Cards is currently in, seriously
considering issuing new equity would seem to be a good way to go. The West Coast Investors
are asking to buy 200,000 common shares are $8 per share. This would infuse $1,600,000 into
the firm. This extra cash would alleviate the current pressure on the debt to equity ratio as well as
provide the firm with more flexibility to pursue opportunities such as the envelope-making
machine. The other stipulation to the deal is that Friendly would have to pay a finders fee of
$80,000 or 10,000 shares to the individual who had brought this deal to Ms. Beaumont’s mind

The advantages of taking this deal are that the finder’s fee is only 5% of the total issue amount,
which is going to be cheaper than if an investment bank did a public issue, the infusion of cash
would most likely allow Friendly to meet the covenants given to them by the bank, and the
uncertainty about how many securities will be sold if a public offering is held will be eliminated.

The disadvantages of this deal are the loss of majority control by Ms. Beaumont (she would not
be able to make unilateral decisions). She currently holds 55% of the stock, but with the new
issue her portion of ownership would drop to 41%. Also, the West Coast investors would hold
26% of shares and would have a significant say in the way that the company was run. This would
likely be a big issue for Ms. Beaumont who grew the company from nothing by herself.

As previously mentioned, the issuance of new stock will increase their WACC due to the higher
cost of equity financing (it doesn’t have the tax saving benefits of debt). Due to the fact that
issuing more shares will erode the value that each share has to existing stockholders, they will
need to achieve a higher rate of return on their projects to ensure shareholder value does not
decrease. This shouldn’t be an issue considering the high rate of expected growth the company is
expecting.
Generally speaking a company should only issue equity if they need the capital to finance growth
or if they are overleveraged (which Friendly Cards currently is). Also, with a predicted sales
growth of 27%, they are going to need to finance that growth with either outside financing or
external funds. They have pretty much utilized debt to the greatest extent they can so the only
other way to fund this growth is to insanely increase sales or issue more equity.

To further drive the point that Friendly Cards is overleveraged, they have a debt-to-asset ratio of
82%, a quick ratio of .67 and a market value debt to equity ratio, of 245%. All of his suggests
that they company is severely overleveraged. With such a low quick ratio they should have
issues paying off short-term debt if their sales took a nosedive for some unforeseen reason.

When comparing their market value debt to equity ratio of 245% with industry big players
American and Gibson Greetings, 63% and 49% respectively, is particularly alarming since those
companies are much larger/more diversified and would be more equipped to handle an
unforeseen occurrence such as a drop in sales.

On top of all the above reasons pointing to the essential acceptance of the offer, the company is
essentially being forced to issue new equity by their bankers. With a debt/equity ratio forecasted
to remain above 4, this would violate the stipulation that they get the ratio under 3.

Recommendations

Envelope Machine

With a calculated IRR of 41%, it would be a very good idea for Friendly Cards to purchase the
machine. It would reduce their costs and contribute to their bottom line. The only issue with
purchasing the machine is the funds available to purchase it. This could easily be alleviated by
the issuance of new equity.

Acquisition of Creative Designs

At a purchase price of $1,881,000, even if the proposed refinements to the company’s sales and
cost structure are not able to be achieved (both valuation situations have an NPV above the
purchase price) this would be a good deal for Friendly Card to go through with.

Also Creative Designs is in the business of studio cards, which Friendly is currently not
producing. This would be a great addition to the existing product line and would continue the
tradition of accessing new market share through acquisitions. Also, since CD is in the same
business as Friendly, Ms. Beaumont’s projections should be easily achievable.

Issue of New Equity to West Coast Investors

As can probably be seen in the analysis section, I would recommend that Friendly Cards go
through with the issuance. The financial advisor, current bankers, and ratios all point to the fact
that this deal will be good for the continued success of the business. The world is not perfect and
Ms. Beaumont will have to get over the fact that she will not have majority control of the
company anymore.