Q23. Jean Baptiste Prudhomme and Sons, Inc. is a publicly-traded housing and construction company that has been operated by

     five generations of the Prudhomme family. Xavier Prudhomme, the current CEO, believes that the firm’s future success

     depends on finding a way to mitigate the inherent cyclicality of the construction industry. He and the COO, his cousin, Michel     

     Sanscartier, have decided to invest in a firm that operates in a counter-cyclical industry.

Prudhomme is in a strong financial position to make an investment in another firm. The company has 1 million shares outstanding. When the books closed for the year on December 31, 2003, the stock closed at $72 per share.

The firm Prudhomme Inc. chose to invest in was outplacement counselors Quality Connections, Inc. The firms completed the transaction on December 31, when both companies closed their 2003 books.

Quality is a much smaller firm than Prudhomme, with total assets of $2 million when the transaction closed, compared to Prudhomme’s $30 million. However, Quality is more liquid than Prudhomme: half of Quality’s assets were current assets, compared to only one-third of Prudhomme’s. In addition, current liabilities at Quality accounted for only 10% of total liabilities plus owners’ equity as of the transaction date, with common stock equal to another 40%. (The remainder was retained earnings.)

Prudhomme does have some financial advantages over Quality, however. Prudhomme’s long history means that it has much higher retained earnings than Quality: Retained earnings at Prudhomme accounted for two-thirds of total liabilities plus owners’ equity when the transaction closed. (The remainder was equally divided between current liabilities and common stock.)

Prudhomme also does a much better job than Quality of turning assets: 2004 revenue at Prudhomme was twice the level of assets the firm had on its December 31, 2003 balance sheet, while Quality’s revenue was only 1.5 times assets. Despite the lower turnover, however, Quality is far more profitable. Net income at Quality in 2004 reached 20% of revenue, while net income at Prudhomme came in at only 10% of revenue. (The remainder at both companies is Cost of Goods Sold (COGS).)

The greater and more stable profitability at Quality is reflected in dividend payments: Quality paid out half its 2004 net income in dividends, while Prudhomme paid out only one-third. This high and stable dividend payment is a key reason that Xavier Prudhomme and Sanscartier were interested in investing in Quality.

Sanscartier also considered Quality undervalued. He believed that Quality’s low investor profile – it trades on a small, regional exchange – prevented the firm’s dividend sustainability from being fully reflected in the company’s share price. Quality’s market capitalization at the close of 2003 trading was twice 2004 revenues (with 1 million shares outstanding), a figure Sanscartier believes is too low given the profitability of the firm and its excellent growth prospects. 

Although Xavier Prudhomme and Sanscartier were both generally very happy with their investment in Quality Connections, they shared one significant concern about the timing. At the time the transaction closed, the economy appeared to be slowing, and both men expected a cyclical decline in stock values. They were right: Prudhomme, Inc. stock dropped by $12 per share by year-end 2004. Quality Connections, Inc. stock dropped from $6 to $5 per share by December 31, 2004.

Xavier Prudhomme and Sanscartier shared a common worry about the potential damage to Prudhomme Inc.’s 2004 income statement from a decline in Quality Connections’ stock price. Before the transaction settled, Xavier Prudhomme argued forcibly that Prudhomme should buy at least 20% of Quality so the market fluctuations in the stock wouldn’t affect Prudhomme’s reported income. He favored buying 25% of Quality’s shares outstanding on December 31, 2003 for a 10% discount from market, in cash.

Sanscartier favored purchasing 100,000 of Quality’s shares outstanding on December 31, 2003 at the closing market price, also for cash. He suggested that if they made that investment, Prudhomme could avoid having fluctuations in Quality’s share price flow through Prudhomme’s income statement if Quality were no longer traded publicly and its fair value was not readily determined.

Regarding Xavier Prudhomme and Sanscartier’s remarks about the impact of the investment in Quality on Prudhomme Inc.’s income statement, which of the following is correct?

A)   Prudhomme’s statement is correct and Sanscartier’s statement is correct.

B)   Prudhomme’s statement is correct and Sanscartier’s statement is incorrect.

C)   Prudhomme’s statement is incorrect and Sanscartier’s statement is correct.

答案和详解如下：

If a firm has a non-controlling interest of between 20% but no more than 50%, it is usually deemed to wield significant influence, and the firm will use the equity method of consolidation. In the equity method, the parent’s reported income is not affected by changes in the market value of the investee, unless the value decline is considered permanent or realized losses are incurred upon sale of the investment. The decline in value at Quality is cyclical and not permanent. Thus, with a 25% investment in the firm Prudhomme would use of the equity method and thus avoid any affects on its net income.

If the investment were more than 50%, SFAS 94 would require the use of the consolidated method. In the consolidated statements, the fluctuations in market value of Quality would not affect Prudhomme’s income statement. Thus, Xavier Prudhomme’s statement that buying at least 20% of Quality’s stock would prevent having fluctuations in the stock price affect Prudhomme’s income statement is correct.

Sanscartier’s suggestion of purchasing 100,000 shares of Quality would represent a 10% interest in the firm. Ownership of less than 20% is typically viewed as a non-controlling interest and the two firms are treated as separate entities. If there were no public market for Quality’s shares and no readily determined fair value, the cost method would have to be used. In that case, changes in market value would be recognized only on the sale of the securities. Thus Sanscartier’s statement is also correct.

[此贴子已经被作者于2009-1-7 15:43:09编辑过]

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