Financial Policies and Analysis of Adheron Inc.


Case study:

Critique the analysis and proposals made by the Vice President for Finance of Adheron, Inc., as described in the attached case. Specific assignment questions to guide that critique are listed on page 5. Feel free, however, both to integrate your responses to those various questions and to go beyond the particular issues they raise, in order to develop a coherent capital structure, cost of capital, and investment decision framework for the firm, according to what you consider to be the correct conceptual approach to such matters. Thus, do not be reluctant to display the full range of your talents, even if they do not fit neatly into the guidelines provided. Assume that the reader of your critique will be knowledgeable in the relevant areas, but is interested in finding out whether you are. Limit your written response to 6 pages (one side), including any exhibits you may wish to provide; this is a firm limit, not merely a suggestion. You have four hours in which to complete your analysis.


In early 2008, the Vice President-Finance of Adheron, Inc., completed a study of the company's existing capital budgeting and financing procedures and was preparing to recommend major policy changes to management and the Board of Directors. Prior to presenting his ideas formally, however, he planned to review them with several of his colleagues who would be most affected by the changes he had in mind.

Adheron was a leading manufacturer of adhesives, pressure-sensitive papers, and packaging and household tapes. It had been founded in the late 1950's on the basis of several proprietary adhesives innovations, and had grown steadily--and profitably--since. By 2008, it had plant locations in 12 states and 4 foreign countries, and employed nearly 15,000 individuals. Annual revenues were comprised approximately 75 percent of sales to other manufacturers and 25 percent to the consumer marketplace. Some 20 percent of sales were made outside the US.

The company's reputation and competitive position were founded primarily on high product quality; price was not a major competitive concern in most of its markets. For that reason, the company emphasized the latest technology in its production processes, and was a relatively fixed-asset-intensive firm. Profit margins on sales had consistently been above average and, indeed, had improved in recent years. While Adheron's businesses had some cyclical elements, the company had been able to prosper over a broad range of economic conditions, and it anticipated continued strong growth.

Adheron's financial policies had evolved over time in response to the needs of the company's capital investment programs. Earlier, company policy had dictated a relatively high dividend payout of earnings and heavy reliance on borrowed funds. By the late 1990's, however, the company had adopted a target long-term book debt ratio of 50% and a reduced dividend payout also averaging about 50%. As an important corollary policy, management and the Board of Directors generally opposed the sale of additional common stock, out of a desire to avoid earnings dilution. This policy had been put aside only once in recent years when the company, in 2001, had found it necessary to issue shares to finance large capital expenditures and to retire some debt. The net effect of these policies had been to limit the aggregate amount of the firm's capital expenditures over the years primarily to funds provided by depreciation, retained earnings, and the additional long-term debt permitted by its target debt ratio.

Thus, in evaluating capital expenditure proposals, a critical determinant of each decision was the availability of sufficient funds from internal sources and new debt issues. Tactical, strategic, and intangible factors inevitably associated with major expansion projects were also given due consideration, and many of the company's most important investment decisions had been based heavily on such grounds. In most of those decisions, at least to the extent project economics had been analyzed in quantitative terms, estimates generally had been framed in terms of a project's net impact on reported profits. This emphasis on contribution to profits arose from the fact that outsiders seemed to evaluate the performance of both management and the company on that basis. It seemed only reasonable to apply the same standard internally and therefore--other things being equal--projects had been looked on favorably if they promised to contribute something to accounting profits, after allowing for estimated financing costs.

In his review of these procedures and investment criteria, the Vice President-Finance concluded that the company should change its approach to investment decisions in some respects. He summarized his ideas in the memorandum included in the following Appendix. While he continued to think that the potential impact of a project on reported earnings was an important consideration, he thought that more than this was involved. The alternative procedure outlined in his memorandum was a variant of the cost-of-capital/internal-rate-of-return method that was presently widely used throughout industry. Unlike Adheron's past practice, his proposal took the cost of retained earnings into account.

While he was reasonably confident of the merits of his policy recommendations, he planned to review them informally with several of his colleagues before trying to push them any further. In particular, he was aware of the fact that his memorandum implicitly made the assumption that the company should still limit the amount of its capital expenditures to the funds supplied by retained earnings, depreciation, and new debt at the target ratio, and he wondered how, if at all, he should change his thinking on that aspect of the proposal. He also wondered whether the cost of capital calculation he envisioned would require any modification if Adheron were to contemplate investments in businesses other than just its current ones.


Appraise the logic of the Finance Vice President's proposals and analysis. In doing so, you should address somewhere along the way the following issues, in specific terms:

1. His assessment of the respective "costs" of each of the various individual sources of capital available to the firm--i.e., debt, retained earnings, common stock.

2. The appropriate procedure for weighting those individual costs, to come up with an over-all cost of capital for the firm.

3. The determination of the degree of leverage which the firm should have in its capital structure, and the criteria which would bear on that decision.

4. Whether the firm's cost of capital should be expressed as a before-tax or an after-tax figure.

5. How the firm should decide whether to restrict its expansion capital expenditures to the amount which can be accommodated solely by retained earnings and the additional borrowing capacity created by retentions.

6. The criteria that bear on the establishment of a proper dividend policy for the firm to adopt.

7. The company's sustainable long run growth rate under its present financial policies.

8. Whether the procedure proposed on page 11 for appraising the desirability of new investment projects is appropriate.

9. What modifications should be made to any of the foregoing recommendations, if the firm should decide to undertake investments in areas outside its current line of business.


This question is related to a case study on Adheron, Inc. Company and discusses about company finance vice presidents proposals and analysis regarding financial position of the company.

Total word count: 1949



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