Venice InLine, Inc., was founded by Russ Perez to produce a specialized in-line skate he had designed for doing aerial tricks. Up to this point, Russ has financed the company with his own savings and with cash generated by his business. However, Russ now faces a cash crisis. In the year just ended, an acute shortage of high-impact roller bearings developed just as the company was beginning production for the Christmas season. Russ had been assured by his suppliers that the roller bearings would be delivered in time to make Christmas shipments, but the suppliers were unable to fully deliver on this promise. As a consequence, Venice InLine had large stocks of unfinished skates at the end of the year and was unable to fill all of the orders that had come in from retailers for the Christmas season. Consequently, sales were below expectations for the year, and Russ does not have enough cash to pay his creditors.

Well before the accounts payable were due, Russ visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Russ that there should not be any problem getting a loan to pay off his accounts payable—providing that on his most recent financial statements the current ratio was above 2.0, the acid-test ratio was above 1.0, and net operating income was at least four times the interest on the proposed loan. Russ promised to return later with a copy of his financial statements.

Russ would like to apply for a $125,000 six-month loan bearing an interest rate of 6% per year. The unaudited financial reports of the company appear below:

Required:

1-a. Based on the above unaudited financial statement of the current year calculate the following.

Current ratio

Acid-test ratio

Number of times of the net operating income to the interest on the proposed loan

1-b. Based on the statement made by the loan officer, would the company qualify for the loan?

2. Last year Russ purchased and installed new, more efficient equipment to replace an older plastic injection molding machine. Russ had originally planned to sell the old equipment, but found that it is still needed whenever the plastic injection molding process is a bottleneck. When Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the old equipment be sold or at least reclassified as inventory on the balance sheet because it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of $77,000. The bank does not require audited financial statements.

a. Calculate the following if the old machine is considered as inventory.

b. Based on the 2a above would the company qualify for the loan?

c. Calculate the following if the old machine is sold off.

d. Based on the 2c above would the company qualify for the loan?

Venice InLine, Inc., was founded by Russ Perez to produce a specialized in-line skate he had designed for doing aerial tricks. Up to this point, Russ has financed the company with his own savings and with cash generated by his business. However, Russ now faces a cash crisis. In the year just ended, an acute shortage of high-impact roller bearings developed just as the company was beginning production for the Christmas season. Russ had been assured by his suppliers that the roller bearings would be delivered in time to make Christmas shipments, but the suppliers were unable to fully deliver on this promise. As a consequence, Venice InLine had large stocks of unfinished skates at the end of the year and was unable to fill all of the orders that had come in from retailers for the Christmas season. Consequently, sales were below expectations for the year, and Russ does not have enough cash to pay his creditors. Well before the accounts payable were due, Russ visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Russ that there should not be any problem getting a loan to pay off his accounts payable—providing that on his most recent financial statements the current ratio was above 2.0, the acid-test ratio was above 1.0, and net operating income was at least four times the interest on the proposed loan. Russ promised to return later with a copy of his financial statements. Russ would like to apply for a $130,000 six-month loan bearing an interest rate of 8% per year. The unaudited financial reports of the company appear below. Venice InLine, Inc. Comparative Balance Sheet As of December 31 (dollars in thousands) This Year Last Year Assets Current assets: Cash $ 127.9 $ 265.0 Accounts receivable, net 115.0 65.0 Inventory 250.0 170.0 Prepaid expenses 45.0 38.0 Total current assets 537.9 538.0 Property and equipment 405.0 245.0 Total assets $ 942.9 $ 783.0 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 276.0 $ 150.0 Accrued liabilities 30.0 15.0 Total current liabilities 306.0 165.0 Long-term liabilities .0 .0 Total liabilities 306.0 165.0 Stockholders' equity: Common stock and additional paid-in-capital 150.0 150.0 Retained earnings 486.9 468.0 Total stockholders' equity 636.9 618.0 Total liabilities and stockholders' equity $ 942.9 $ 783.0 Venice InLine, Inc. Income Statement For the Year Ended December 31 (dollars in thousands) This Year Sales (all on account) $ 655.0 Cost of goods sold 383.0 Gross margin 272.0 Selling and administrative expenses: Selling expenses 98.0 Administrative expenses 147.0 Total selling and administrative expenses 245.0 Net operating income 27.0 Interest expense – Net income before taxes 27.0 Income taxes (30%) 8.1 Net income $ 18.9 Required: 1a. Based on the above unaudited financial statement of the current year calculate the following. (Round your answers to 2 decimal places.) 1b. Based on the statement made by the loan officer, would the company qualify for the loan? Yes No 2. Last year Russ purchased and installed new, more efficient equipment to replace an older heat-treating furnace. Russ had originally planned to sell the old equipment, but found that it is still needed whenever the heat-treating process is a bottleneck. When Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the old equipment be sold or at least reclassified as inventory on the balance sheet because it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of $82,000. The bank does not require audited financial statements. a. Calculate the following if the old machine is considered as inventory. (Round your answers to 2 decimal places.) b. Based on the 2a above would the company qualify for the loan? Yes No c. Calculate the following if the old machine is sold off. (Round your answers to 2 decimal places.) d. Based on the 2c above would the company qualify for the loan? Yes No

Illinois Bio Technologies

Illinois Bio Technologies (IBTECH) was founded in Rosemont, Illinois, in 1992 by Kelly O'Brien, David Roberts, and Barbara Smalley. O'Brien and Roberts, both MDs, were on the research faculty at the Chicago Medical School at the time; O'Brien specialized in biochemistry and molecular biology, and Roberts specialized in immunology and medical microbiology. Smalley, who has a PhD, served a department chair of the Microbiology Department at the same school.

The company started as a research and development firm, which performed its own basic research, obtained patents on promising technologies, and then either sold or licensed the technologies to other firms which marketed the products. In recent years, however, the firm has also contracted to perform research and testing for larger genetic engineering and biotechnology firm, and for the U.S. government. Since its inception, the company has enjoyed enormous success - even its founders were surprised at the scientific breakthrough made and the demand for its services. One event that contributed significantly to the firm's rapid growth had been the AIDS research. Both the U.S. government and private foundations have spent billions of dollars in AIDS research, and IBTECH had the right combination of skills to garner significant grant funds, as well as perform as a subcontractor to other firm receiving AIDS research grant.

The founders were relatively wealthy individuals when they started the company, and they had enough confidence in the business to commit most of their own funds to the new venture. Still, the capital requirement brought on by extremely rapid growth soon exhausted their personal funds, so they were forced to raise capital from outside sources. First, in 2001, the firm borrowed heavily, and then in 2003, when it used up its conventional debt capacity, it issued $15 million of preferred stock. Finally, in 2006, the firm had an initial public offering (lPO) which raised $50 million of common equity. Currently, the stock trades in the over-the-counter market, and it has been selling at about $25 per share.

IBTECH is widely recognized as the leader in an emerging growth industry, and it won an award in 2008 for being one of the 100 best-managed small companies in the United States. The company is organized into two divisions: (1) the Clinical Research Division and (2) the Genetic Engineering Division. Although the two divisions are housed in the same buildings, the equipment they use and their personnel are quite different. Indeed, there are few synergies between the two divisions. The most important synergies lay in the general overhead and marketing areas. Personnel, payroll, and similar functions are all done at the corporate level, while technical operations at the divisions are completely separate.

The Clinical Research Division conduct most of the firm' AIDS research. Since most of the grant and contracts associated with AIDS research are long-term in nature, and since billion of new dollars will likely be spent in this area, the business risk of this division is low. Conversely, the Genetic Engineering Division works mostly on in-house research and short-term contracts where the funding, duration, and payoff are very uncertain. A line of research may look good initially, but it is not unusual to hit some snag, which preclude further exploration. Because of the uncertainties inherent in genetic research, the Genetic Engineering Division is judged to have high business risk.

The founders are still active in the business, but they no longer work 70-hour week. Increasingly, they are enjoying the fruits of their past labor, and they have let professional managers take over day-to-day operations. They are all on the board of director, though, and David Roberts is chairman.

Although the firm's growth has been phenomenal, it has been more random than planned. The founders would simply decide on new avenue of research, and then count on the skills of the research teams-and good luck-to produce commercial successes. Formal decision structures were almost nonexistent, but the company's head start and its bright, energetic founder easily overcame any deficiencies in its managerial decision processes. Recently, however, competition has become stiffer, and such large biotechnology firms such as Genentech, Amgen, and even Bristol-Myers Squibb have begun to recognize the opportunities in IBTECH's research line. Because of this increasing competition, IBTECH's founders and board of directors have concluded that the firm must apply state-of-the-art technique in its managerial processes as well as in its technological processes. As a first step, the board directed the financial vice president, Gary Hayes, to develop an estimate for the firm's cost of capital and to use this number in capital budgeting decisions. Hayes, in turn, directed IBTECH's treasurer, Julie Owens, to have a cost of capital estimate on his desk in one week. Owens has an accounting background, and her primary task since taking over as treasurer has been to deal with the banks. Thus, she is somewhat apprehensive about this new assignment especially since one of the board members is her former Kean University finance professor.

Table 1

Illinois Bio Technologies, Inc.

Balance Sheet for the Year Ended December 31, 2019

(In Millions of Dollars)

To begin, Owen reviewed IBTECH's 2019 balance sheet, which is shown in Table 1. Next, she assembled the following data:

• IBTECH's long-term debt consists of 9.5 percent coupon, semiannual payment bonds with fifteen year remaining to maturity. The bonds last traded at a price of $891 per $1,000 par value bond. The bonds are not callable and they are rated BBB.
• The founders have an aversion to short-term debt, so the firm uses such debt only to fund cyclical working capital needs.
• IBTECH' federal-plus-state tax rate is 40 percent.
• The company’s preferred stock pays a dividend of $2.50 per quarter and has a par value of $100. It is non-callable and perpetual, and it is traded in over-the-counter market at a current price of $104 per share. A flotation cost of $2 per share would be required on a new issue of preferred stock.
• The firm's last dividend (D₀) was $1.09, and dividends are expected to grow at about a 10 percent rate in the foreseeable future. Some analyst expect the company' recent growth rate to continue, other expect it to go to zero as new competition enter the market, but the majority anticipate that a growth rate of about 10 percent will continue indefinitely.
• An important minority of analyst have noted that over the last few years, the company has had a 14 percent average return on equity (ROE) and has paid out about 25 percent of its net income as dividends. They believe the firm' expected future growth rate, g should be based on this information and used to estimate the cost of capital.
• The firm's per share dividend payment over the past five year has been a follow

• IBTECH’s common stock now sells at a price of about $25 per share. The company has 5 million common shares outstanding.
• The current yield on long-term T-bonds is 8 percent, and a prominent investment-banking firm has recently estimated that the market risk premium is six percentage points over Treasury bond. The firm' historical beta, as measured by several analysts who follow the stock, is 1.2.
• The required rate of return on an average (A-rated) company's long-term debt is 10 percent.
• IBTECH is forecasting reinvested earnings of $1,800,000 and depreciation of 4,500,000 for the coming year.
• IBTECH's investment banker believes that a new common tack issue would involve total flotation costs - including underwriting costs, market pressure from increased supply, and market pressure from negative signaling effect- of 30 percent.
• The market value target capital structure call for 30 percent long-term debt, 10 percent preferred stock, and 60 percent common stock.

Now assume that you were recently hired as Julie Owen’s assistant, and she has given you the task of helping her develop the firm's cost of capital. You will also have to meet with Gary Hayes and, possibly, with the president and the full board of directors (including the Kean University Professor) to answer any question they might have. With this in mind, Owens wrote up the following questions to get you started with your analysis. Answer them, but keep in mind that you could be asked further questions about your answer, so be sure you understand the logic behind any formula or calculation you use. In particular, be aware of potential conceptual or empirical problems that might exist.

7. Use the bond-yield-plus-risk-premium method to estimate IBTECH's cost of reinvested earnings (r_s).

FRAUD CASE :

JANNIE’S JEWELRY STORES

Jannie’s Jewelry Stores is a large corporation founded in 1998 that operates 23 retail jewelry stores located throughout the Southeastern United States. Jannie’s tailors its product line to middle-class shoppers, and specializes in engagement and wedding rings. Each store offers a large variety of jewelry (approximately 1,200 different items) with a fairly narrow price range ($50 to $3,500). Although sales increased rapidly during the first years of Jannie’s operations, sales during the last three years were flat. In an effort to increase sales, Jannie’s recently initiated its own credit card program.

The credit card program required new manual and new IT systems. Among other things, a credit department was established and an accounts receivable (AR) IT program was installed. The credit department’s responsibilities include approving customers for the company’s credit cards, following up on past-due receivables, and determining when customer accounts should be written off. The credit department has two employees: a credit manager and an AR clerk.

Customers’ credit card requests are initiated by the customer completing an online application in any of Jannie’s 23 retail locations. The online application requests the customer’s name, address, current monthly income, and Social Security number, among other information. Once the credit application is completed, the IT system automatically interfaces with an independent credit bureau. If the information included in the customer’s application matches the information in the credit bureau’s database, and if the customer has a credit score of in excess of a predetermined minimum score, the customer is extended a credit limit equal to 10 percent of his/her current monthly income. Higher credit limits require the approval of the credit manager.

The AR IT system interfaces with the company’s point-of-sale system, automatically posting sales transactions that occur at the company’s stores to the AR trial balance. Customers’ payments are received at a lockbox, posted to the company’s bank accounts daily by the bank. Copies of customer checks and remittance advices are received by the Credit Department, where the AR clerk posts them to customers’ accounts. Monthly customer statements are automatically generated by the IT system. Each month-end, a report of all customers with past-due balances is generated by the IT system. The credit manager reviews the report and instructs the AR clerk to follow-up on specific customer accounts.

Based on the results of the AR clerk’s follow-up activities, the credit manager determines which accounts should be written off, and processes any necessary adjustments through the IT system. The credit manager meets quarterly with Jannie’s CFO to discuss any particularly problematic accounts or unusual write-offs of customer accounts.

The Fraud

Before accepting a position with Jannie’s Jewelry, the credit manager was employed by Fred’s Fashions in a similar position. Fred’s owner decided to discontinue Fred’s credit card program and eliminated the credit manager’s position. The credit manager purchased a new home just prior to being laid off. The night prior to being laid off, the credit manager got engaged, promising that he and his new fiance´e would soon shop for an engagement ring. Even though the position at Jannie’s paid $20,000 less than the position at Fred’s, the credit manager was assured by Jannie’s president that as long as the company’s credit card program went well, the credit manager was sure to receive raises that would soon make the salary comparable to his former salary. In addition, the credit manager was looking forward to taking advantage of Jannie’s employee discount program when purchasing his fiance´e’s engagement ring.

The credit manager selected a $3,500 ring for his fiancee´, which with his employee discount cost $2,900. The purchase was financed on a Jannie’s credit card, by the credit manager overriding the company policy of granting a credit limit of 10 percent of a customer’s current monthly salary. The credit manager quickly fell behind in his required credit card payments. Although his account began to show up on the AR past-due report, the credit manager avoided directing the AR clerk to perform follow-up procedures for several months. When he learned that the company’s auditors would be visiting his department soon, he wrote his remaining account balance off using the IT system, fully intending to repay the balance when he receives his promised raise.

Question:

What are the red flags present that suggest the possibility of fraud? Are there conditions present suggested by the fraud triangle that may facilitate fraud? Are there IT-related issues that could facilitate fraud?

How would the fraud impact the financial statements? What accounts would be misstated?

Problem 1-04A Skysong Inc., a provider of consulting services, was founded on October 1, 2022. At the end of the first month of operations, the company decided to prepare an income statement, retained earnings statement, and balance sheet using the following information. Accounts payable $ 3,700 Supplies $ 2,650 Interest expense 350 Supplies expense 360 Equipment (net) 48,000 Depreciation expense 260 Salaries and wages expense 2,800 Service revenue 19,540 Bonds payable 21,800 Salaries and wages payable 590 Unearned service revenue 4,190 Common stock 9,900 Accounts receivable 1,450 Interest payable 150 Cash 4,000 Using the information, answer the following questions. Prepare an income statement for the month of October 2022. SKYSONG INC. Income Statement choose the accounting period select an opening name for section one enter an income statement item $ enter a dollar amount select an opening name for section two enter an income statement item $ enter a dollar amount enter an income statement item enter a dollar amount enter an income statement item enter a dollar amount enter an income statement item enter a dollar amount select a closing name for section two enter a subtotal amount for section two select a closing name for this statement $ enter a total net income or loss amount Show List of Accounts Link to Text Prepare a retained earnings statement for the month of October 2022. SKYSONG INC. Retained Earnings Statement choose the accounting period select an opening name $ enter a dollar amount select between addition and deduction : select an item enter a dollar amount select a closing name $ enter a total amount Show List of Accounts Link to Text Prepare a balance sheet as of October 31, 2022. (List assets in order of liquidity.) SKYSONG INC. Balance Sheet enter an accounting period Assets enter a balance sheet item $ enter a dollar amount enter a balance sheet item enter a dollar amount enter a balance sheet item enter a dollar amount enter a balance sheet item enter a dollar amount select a closing name for the first part of the balance sheet $ enter a total amount for the first part of the balance sheet Liabilities and Stockholders' Equity select an opening name for section one enter a balance sheet item $ enter a dollar amount enter a balance sheet item enter a dollar amount enter a balance sheet item enter a dollar amount enter a balance sheet item enter a dollar amount enter a balance sheet item enter a dollar amount select a closing name for section one $ enter a subtotal of the two previous amounts select an opening name for section two enter a balance sheet item enter a dollar amount enter a balance sheet item enter a dollar amount select a closing name for section two enter a subtotal of the two previous amounts select a closing name for the second part of the balance sheet $ enter a total amount for the second part of balance sheet Click if you would like to Show Work for this question: Open Show Work Show List of Accounts Link to Text

CUSTOM FABRICATIONS Inc. is a bicycle manufacturing firm founded in 2000 that currently employs 126 people. The company produces custom bicycles in its factory located near Los Angeles, CA. Each bicycle is tailored to a rider based on a number of different measurements, including height, weight, inseam, and arm length. These measurements are taken at 30 professional bicycle shops around Southern California, which are certified to size CUSTOM FABRICATIONS cycles. By accepting orders only through licensed dealers, CUSTOM FABRICATIONS ensures that each bike matches its rider precisely. CUSTOM FABRICATIONS’ custom bikes are considered extremely high quality and the company takes pride in using only the best components sourced from around the world. Accordingly, CUSTOM FABRICATIONS purchases from a cast of hundreds of suppliers, chosen for their commitment to quality and reliability. Demand for CUSTOM FABRICATIONS’ cycles has grown exponentially in recent years. The surge in demand was somewhat unexpected and the company’s factory has been operating at capacity for over a year. As a result, current orders face a production backlog of approximately 5–6 weeks. The company’s operations have been further hampered by severe inefficiencies and control weaknesses attributed to its legacy accounting system. Your firm has been hired as an outside consultant to suggest improvements in the company’s accounting procedures. The following paragraphs describe the company’s expenditure cycle. Purchases System All purchases of raw materials are initiated in the CUSTOMFABRICATIONS’ purchasing department. A clerk in the department monitors inventory levels from his PC, which is linked to the inventory subsidiary ledger. Once a part needs to be replenished, he creates a hard-copy purchase order. One copy is mailed to the vendor, a blind copy of the purchase order is sent to the warehouse, and the third copy is filed in the purchasing department. Typically within 3–5 business days, the warehouse receives the ordered parts and the packing slip from the vendor, which the warehouse clerk reconciles with the blind copy of the purchase order. Once the reconciliation is complete, the warehouse clerk prepares a three-part hard-copy receiving report stating the quantity and condition of the items received. One copy of the receiving report is sent to the general ledger department to update the digital inventory control account. The second copy is sent to the accounts payable department, and the third is sent to the purchasing department to update the inventory subsidiary ledger. Within a week, the mail room receives the supplier’s invoice, which is immediately sent to the accounts payable department. The AP clerk reconciles the invoice with the receiving report and then records a liability in the AP subsidiary ledger from the department PC. Finally, the clerk prints an AP summary from the terminal and sends it to the general ledger clerk. Cash Disbursements System The accounts payable clerk regularly checks the accounts payable subsidiary account at his terminal to ensure timely payment to vendors. For those items due for payment, he sends approval in the form of a payment voucher to the cash disbursements department. For control purposes, cash disbursements are processed manually. The details of the check are recorded in the hard-copy cash disbursements journal, and the check is mailed to the vendor. The clerk then prepares a journal voucher and sends it to the general ledger. Once the general ledger clerk receives the journal voucher, the AP summary, and the receiving report, she updates the affected general ledger accounts from the department PC. Required a. Create a data flow diagram of the current system. b. Create a system flowchart of the existing system. c. Analyze the physical internal control weaknesses in the system. d. Describe the risks associated with these control weaknesses. e. (Optional) Prepare a system flowchart of a redesigned computer-based system that resolves the control weaknesses that you identified. Explain your solution.

Backyard Bulldog Barbecue Sauces, Inc., founded by Jefe Allen, produces a variety of barbecue sauces for use in outdoor grilling. Jefe is having difficulty understanding the relationship between different types of costs, revenue and profit. Jefe has asked you to clarify this issue for him by answering the following questions.

1. Define the different types of costs that Backyard Bulldog Barbecue Sauces, Inc. will incur along with several examples of each.

2. How could overly optimistic sales estimates potentially harm Jefe's business?

3. Explain how cost-volume-profit analysis can help Jefe make good managerial decisions regarding Backyard Bulldog Barbecue Sauces, Inc.?

Illinois Bio Technologies

Illinois Bio Technologies (IBTECH) was founded in Rosemont, Illinois, in 1992 by Kelly O'Brien, David Roberts, and Barbara Smalley. O'Brien and Roberts, both MDs, were on the research faculty at the Chicago Medical School at the time; O'Brien specialized in biochemistry and molecular biology, and Roberts specialized in immunology and medical microbiology. Smalley, who has a PhD, served a department chair of the Microbiology Department at the same school.

The company started as a research and development firm, which performed its own basic research, obtained patents on promising technologies, and then either sold or licensed the technologies to other firms which marketed the products. In recent years, however, the firm has also contracted to perform research and testing for larger genetic engineering and biotechnology firm, and for the U.S. government. Since its inception, the company has enjoyed enormous success - even its founders were surprised at the scientific breakthrough made and the demand for its services. One event that contributed significantly to the firm's rapid growth had been the AIDS research. Both the U.S. government and private foundations have spent billions of dollars in AIDS research, and IBTECH had the right combination of skills to garner significant grant funds, as well as perform as a subcontractor to other firm receiving AIDS research grant.

The founders were relatively wealthy individuals when they started the company, and they had enough confidence in the business to commit most of their own funds to the new venture. Still, the capital requirement brought on by extremely rapid growth soon exhausted their personal funds, so they were forced to raise capital from outside sources. First, in 2001, the firm borrowed heavily, and then in 2003, when it used up its conventional debt capacity, it issued $15 million of preferred stock. Finally, in 2006, the firm had an initial public offering (lPO) which raised $50 million of common equity. Currently, the stock trades in the over-the-counter market, and it has been selling at about $25 per share.

IBTECH is widely recognized as the leader in an emerging growth industry, and it won an award in 2008 for being one of the 100 best-managed small companies in the United States. The company is organized into two divisions: (1) the Clinical Research Division and (2) the Genetic Engineering Division. Although the two divisions are housed in the same buildings, the equipment they use and their personnel are quite different. Indeed, there are few synergies between the two divisions. The most important synergies lay in the general overhead and marketing areas. Personnel, payroll, and similar functions are all done at the corporate level, while technical operations at the divisions are completely separate.

The Clinical Research Division conduct most of the firm' AIDS research. Since most of the grant and contracts associated with AIDS research are long-term in nature, and since billion of new dollars will likely be spent in this area, the business risk of this division is low. Conversely, the Genetic Engineering Division works mostly on in-house research and short-term contracts where the funding, duration, and payoff are very uncertain. A line of research may look good initially, but it is not unusual to hit some snag, which preclude further exploration. Because of the uncertainties inherent in genetic research, the Genetic Engineering Division is judged to have high business risk.

The founders are still active in the business, but they no longer work 70-hour week. Increasingly, they are enjoying the fruits of their past labor, and they have let professional managers take over day-to-day operations. They are all on the board of director, though, and David Roberts is chairman.

Although the firm's growth has been phenomenal, it has been more random than planned. The founders would simply decide on new avenue of research, and then count on the skills of the research teams-and good luck-to produce commercial successes. Formal decision structures were almost nonexistent, but the company's head start and its bright, energetic founder easily overcame any deficiencies in its managerial decision processes. Recently, however, competition has become stiffer, and such large biotechnology firms such as Genentech, Amgen, and even Bristol-Myers Squibb have begun to recognize the opportunities in IBTECH's research line. Because of this increasing competition, IBTECH's founders and board of directors have concluded that the firm must apply state-of-the-art technique in its managerial processes as well as in its technological processes. As a first step, the board directed the financial vice president, Gary Hayes, to develop an estimate for the firm's cost of capital and to use this number in capital budgeting decisions. Hayes, in turn, directed IBTECH's treasurer, Julie Owens, to have a cost of capital estimate on his desk in one week. Owens has an accounting background, and her primary task since taking over as treasurer has been to deal with the banks. Thus, she is somewhat apprehensive about this new assignment especially since one of the board members is her former Kean University finance professor.

Table 1

Illinois Bio Technologies, Inc.

Balance Sheet for the Year Ended December 31, 2019

(In Millions of Dollars)

To begin, Owen reviewed IBTECH's 2019 balance sheet, which is shown in Table 1. Next, she assembled the following data:

• IBTECH's long-term debt consists of 9.5 percent coupon, semiannual payment bonds with fifteen year remaining to maturity. The bonds last traded at a price of $891 per $1,000 par value bond. The bonds are not callable and they are rated BBB.
• The founders have an aversion to short-term debt, so the firm uses such debt only to fund cyclical working capital needs.
• IBTECH' federal-plus-state tax rate is 40 percent.
• The company’s preferred stock pays a dividend of $2.50 per quarter and has a par value of $100. It is non-callable and perpetual, and it is traded in over-the-counter market at a current price of $104 per share. A flotation cost of $2 per share would be required on a new issue of preferred stock.
• The firm's last dividend (D₀) was $1.09, and dividends are expected to grow at about a 10 percent rate in the foreseeable future. Some analyst expect the company' recent growth rate to continue, other expect it to go to zero as new competition enter the market, but the majority anticipate that a growth rate of about 10 percent will continue indefinitely.
• An important minority of analyst have noted that over the last few years, the company has had a 14 percent average return on equity (ROE) and has paid out about 25 percent of its net income as dividends. They believe the firm' expected future growth rate, g should be based on this information and used to estimate the cost of capital.
• The firm's per share dividend payment over the past five year has been a follow

• IBTECH’s common stock now sells at a price of about $25 per share. The company has 5 million common shares outstanding.
• The current yield on long-term T-bonds is 8 percent, and a prominent investment-banking firm has recently estimated that the market risk premium is six percentage points over Treasury bond. The firm' historical beta, as measured by several analysts who follow the stock, is 1.2.
• The required rate of return on an average (A-rated) company's long-term debt is 10 percent.
• IBTECH is forecasting reinvested earnings of $1,800,000 and depreciation of 4,500,000 for the coming year.
• IBTECH's investment banker believes that a new common tack issue would involve total flotation costs - including underwriting costs, market pressure from increased supply, and market pressure from negative signaling effect- of 30 percent.
• The market value target capital structure call for 30 percent long-term debt, 10 percent preferred stock, and 60 percent common stock.

Now assume that you were recently hired as Julie Owen’s assistant, and she has given you the task of helping her develop the firm's cost of capital. You will also have to meet with Gary Hayes and, possibly, with the president and the full board of directors (including the Kean University Professor) to answer any question they might have. With this in mind, Owens wrote up the following questions to get you started with your analysis. Answer them, but keep in mind that you could be asked further questions about your answer, so be sure you understand the logic behind any formula or calculation you use. In particular, be aware of potential conceptual or empirical problems that might exist.

9. What is your estimate of IBTECH's cost of new common stock, r_e? What are some potential