FI 311 Study Guide - Midterm Guide: Corporate Finance, Capital Budgeting, Capital Structure
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You are proposing a new venture, to branch out into animals and cartoon characters but this will require some new equipment and a capital outlay. Pertinent financial information is given below.
BALANCE SHEET
| Cash | 2,000,000 | Accounts Payable and Accruals | 18,000,000 |
| Accounts Receivable | 28,000,000 | Notes Payable | 40,000,000 |
| Inventories | 42,000,000 | Long-Term Debt | 60,000,000 |
| Preferred Stock | 10,000,000 | ||
| Net Fixed Assets | 133,000,000 | Common Equity | 77,000,000 |
| Total Assets | 205,000,000 | Total Claims | 205,000,000 |
� Last year�s sales were $225,000,000.
� The company has 60,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent annual coupon, and are currently selling for $874.78.
� You also have 100,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a $3.00 per share flotation cost.
� The company has 10 million shares of common stock outstanding with a currently price of $14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.80. New stock could be sold with 15% flotation costs.
� The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 14 percent. Your stock�s beta is 1.22.
� Stockholders require a risk premium of 5 percent above the return on the firms bonds.
� The firm expects to have additional retained earnings of $10 million in the coming year, and expects depreciation expenses of $35 million.
� Your firm does not use notes payable for long-term financing.
� The firm considers its current market value capital structure to be optimal, and wishes to maintain that structure. (Hint: Examine the market value of the firm�s capital structure, rather than its book value.)
� The firm is currently using its assets at capacity.
� The firm�s management requires a 2 percent adjustment to the cost of capital for risky projects.
� Your firm�s federal + state marginal tax rate is 40%.
� Your firm�s dividend payout ratio is 50 percent, and net profit margin was 8.89 percent.
� The firm has the following investment opportunities currently available in addition to the expansion you are proposing:
| Project | Cost | IRR |
| A | 10,000,000 | 20% |
| B | 20,000,000 | 18% |
| C | 15,000,000 | 14% |
| D | 30,000,000 | 12% |
| E | 25,000,000 | 10% |
Your expansion would consist of a new product introduction (You should label your venture as Project I, for �introduction�). You estimate that your product will have a six-year life span (after all how many people will really buy this stuff), and the equipment used to manufacture the project falls into the MACRS 5-year class. Your venture would require a capital investment of $15,000,000 in equipment, plus $2,000,000 in installation costs. The venture would also result in an increase in accounts receivable and inventories of $4,000,000. At the end of the six-year life span of the venture, you estimate that the equipment could be sold at a $4,000,000 salvage value.
Your venture, which management considers fairly risky, would increase fixed costs by a constant $1,000,000 per year, while the variable costs of the venture would equal 30 percent of revenues. You are projecting that revenues generated by the project would equal $5,000,000 in year 1, $10,000,000 in year 2, $14,000,000 in year 3, $16,000,000 in year 4, $12,000,000 in year 5, and $8,000,000 in year 6.
The following list of steps provides a structure that you should use in analyzing your new venture.
Note: Carry all final calculations to two decimal places.
Find the WACC:
1. Find the costs (rate of return under current market conditions) of the individual capital components:
a. long-term debt (Hint: PV=-$874.78, FV = $1000, PMT=$100, n=15 solve for i)
b. preferred stock
c. retained earnings (avg. of CAPM and bond yield + risk premium approaches)
d. new common stock
2. Compute the value of the long-term elements of the capital structure, and determine the target percentages for the optimal capital structure. (Carry weights to four decimal places. For example: 0.2973 or 29.73%)
Find the Cash Flow from the project:
3. Compute the Year 0 investment for Project I.
4. Compute the annual operating cash flows for years 1-6 of the project.
5. Compute the additional non-operating cash flow at the end of year 6.
Find alternative capital budgeting measures:
6. Compute the IRR and payback period for Project I.
7. Determine your firm�s cost of capital. (Hint this is the WACC plus an adjustment from the write up)
Make Some Decisions:
8. Compute the NPV for Project I. Should management adopt this project based on your analysis? Explain. Would your answer be different if the project were determined to be of average risk? Explain.
9. Indicate which of the other projects (A through E) should be accepted and why.
In March 2015 the management team of Londonderry Air (LA) met to discuss a proposal to purchase five short haul aircraft at a total cost of $25 million. There was general enthusiasm for the investment, and the new aircraft were expected to generate an annual cash flow of $4 million for 20 years.
The focus of the meeting was on how to finance the purchase. LA had $20 million in cash and marketable securities (see table), but Ed Johnson, the chief financial officer, pointed out that the company needed at least $10 million in cash to meet normal outflow and as a contingency reserve. This meant that there would be a cash deficiency of $15 million, which the firm would need to cover either by the sale of common stock or by additional borrowing. While admitting that the arguments were finely balanced, Mr. Johnson recommended an issue of stock. He pointed out that the airline industry was subject to wide swings in profits and the firm should be careful to avoid the risk of excessive borrowing. He estimated that in market value terms the long-term debt ratio was about 59% and that a further debt issue would raise the ratio to 62%.
Mr. Johnson's only doubt about making a stock issue was that investors might jump to the conclusion that management believed the stock was overpriced, in which case the announcement might prompt an unjustified selloff by investors. He stressed therefore that the company needed to explain carefully the reasons for the issue. Also, he suggested that demand for the issue would be enhanced if at the same time LA increased its dividend payment. This would provide a tangible indication of management's confidence in the future.
These arguments cut little ice with LA's chief executive. "Ed," she said, "I know that you're the expert on all this, but everything you say flies in the face of common sense. Why should we want to sell more equity when our stock has fallen over the past year by nearly a fifth? Our stock is currently offering a dividend yield of 6.5%, which makes equity an expensive source of capital. Increasing the dividend would simply make it more expensive. What's more, I don't see the point of paying out more money to the stockholders at the same time that we are asking them for cash. If we hike the dividend, we will need to increase the amount of the stock issue; so we will just be paying the higher dividend out of the shareholders' own pockets. You're also ignoring the question of dilution. Our equity currently has a book value of $12 a share; it's not playing fair by our existing shareholders if we now issue stock for around $10 a share.
"Look at the alternative. We can borrow today at 6%. We get a tax break on the interest, so the after-tax cost of borrowing is .65*6 = 3.9%. That's about half the cost of equity. We expect to earn a return of 15% on these new aircraft. If we can raise money at 3.9% and invest it at 15%, that's a good deal in my book.
"You finance guys are always talking about risk, but as long as we don't go bankrupt, borrowing doesn't add any risk at all. In any case my calculations show that the debt ratio is only 45%, which doesn't sound excessive to me.
"Ed, I don't want to push my views on this after all, you're the expert. We don't need to make a firm recommendation to the board until next month. In the meantime, why don't you get one of your new business graduates to look at the whole issue of how we should finance the deal and what return we need to earn on these planes?"
Evaluate Mr. Johnson's arguments about the stock issue and dividend payment as well as the reply of LA's chief executive. Who is correct? What is the required rate of return on the new planes?
| Balance sheet | |||
| bank Debt | 50 | cash | 20 |
| other current liabilities | 20 | other current assets | 20 |
| 10% bond, due 2032* | 100 | Fixed assets | 250 |
| Stockholders' equity** | 120 | ||
| Total liabilities | 290 | Total Assets | 290 |
| Income statement | |||
| Gross Profit | $57.5 | ||
| Depreciation | 20.0 | ||
| Interest | 7.5 | ||
| Pretax profit | 30.0 | ||
| Tax | 10.5 | ||
| Net profit | 19.5 | ||
| Dividend | 6.5 | ||
*the yield to maturity on LA debt is currently 6%
**LA has 10 million shares outstanding, with a market price of $10 a share. LA's equity beta s estimated at 1.25, the market risk premium is 8%, and the Treasury bill rate is 3%