FACC 300 Lecture Notes - Lecture 5: Accounts Payable, Promissory Note, Preferred Stock
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The following Balance Sheet extract relates to the Snapple Company:
Bonds payable $1,000,000
Common Stock $3,000,000
Preferred Stock $2,000,000
Additional Information:
The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 95% of par.
The company’s common shares which have a book value of $25 per share are currently selling at $20 per share.
The company has an equity beta of 1.5 and the current Treasury bill rate is 3.5%. The market risk premium is 1.5%
The preferred dividends are 5% preferred shares with a book value of $100 per share. These shares are currently selling at $80 per share.
The Company’s tax rate is 35%.
Required:
a) Calculate Snapple’s cost of debt. [5 marks]
b) Calculate Snapple’s cost of equity. [5 marks]
c) Calculate Snapple’s cost of preferred shares. [3 marks]
d) Calculate Snapple’s Weighted Average Cost of Capital [8 marks]
e) Explain why the cost of debt is cheaper than the cost of equity. [3 marks]
f) Explain why the cost of retained earnings is equivalent to the cost of an existing issue of common stock. [4 marks]
g) Outline two (2) reasons why a firm’s cost of capital is critically important. [2 marks]
2.
The Beacon Inc. is considering two mutually exclusive projects, each with an initial investment of $150,000. The company’s board of directors has set up a 4-year payback requirement and has set its cost of capital at 9%. The cash inflows associated with the two projects are as follows:
| Year | Cash Inflows (CFt) | ||
| Project A | Project B | ||
| 1 | $45,000 | $75,000 | |
| 2 | $45,000 | $60,000 | |
| 3 | $45,000 | $30,000 | |
| 4 | $45,000 | $30,000 | |
| 5 | $45,000 | $30,000 | |
| 6 | $45,000 | $30,000 | |
a) Calculate the payback period for each project. [2 marks]
b) Calculate the NPV for each project at 7% and 9%. [6 marks]
c) Based on b) above which project would you choose and why.[ 2 marks]
d) Briefly explain why firms engage in “capital rationing” [2 marks]
e) What are Real Options? What are some major types of real options? [3 marks]
3.
The Life’s Good Corporation 2012 income statement shows the following:
|
Income Statement 2012 | |
| Sales | $ 5,250,000 |
| Costs | 2,173,000 |
| Other expenses | 67,400 |
| Depreciation expense | 179,000 |
| EBIT | $ 2,830,600 |
| Interest expense | 85,555 |
| EBT | $ 2,745,045 |
| Taxes | 89,000 |
| Net income | $ 2,656,045 |
| Dividends | $ 169,000 |
| Addition to retained earnings | $ 2,487,045 |
Life’s Good Corp. also issued $106,700 in new equity during the year and redeemed $65,300 in outstanding long-term debt.
i. Calculate the operating cash flow for the firm. (2 marks) $2,920,600
ii. Calculate the cash flow to creditors. (2 marks) $150,855
iii. Calculate the cash flow to stockholders. (2 marks) 62,300
iv. Define free cash flow (FCF) and state one of the equations for computing FCF. (3 marks)
4.
Clark’s Drug Store, a medium-size drugstore located in Bridgetown Barbados, is owned and operated by Robert Clark. Clark’s sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Clark’s most recent annual net income statement is as follows:
| Sales Revenue | $2,600,000 |
| COGS | 1,460,000 |
| Wages and Salaries | 250,000 |
| Rent | 190,000 |
| Depreciation | 70,000 |
| Utilities | 95,000 |
| Miscellaneous | 30,000 |
| Total Expenses | 2,095,000 |
| Net Profit before Tax | 505,000 |
Clark’s sales and expenses have remained relatively constant over the past few years and are expected to continue unchanged in the near future. To increase sales, Clark’s is considering using some floor space for a small soda fountain. Clark’s would operate the soda fountain for an initial three-year period and then would reevaluate its profitability. The soda fountain would require an incremental investment of $85,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the three-year period. At the end of that time, additional capital would be required to continue operating the soda fountain, and no capital would be recovered if it were shut down.
The soda fountain is expected to have annual sales of $670,000 and food and materials expenses of $380,000 per year.
The soda fountain is also expected to increase wage and salary expenses by 6% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of non-soda fountain items are expected to decline by 10%.
Calculate net incremental cash flows for the soda fountain. (6 marks)
ii. Assume that Clark’s has the capital necessary to install the soda fountain and that he places a 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not? (4 marks)
5. “In order for a project to be acceptable, its required rate of return must exceed the cost of debt”. Do you agree? In light of the statement, define what is cost of capital and what role does it play in long-term investment decisions? (5 marks)
6. What do you understand by the term net proceeds in context with a bond sale? How do floatation costs affect the net proceeds? (3 marks)
7. Go-geta Corp. issued 10-year bonds 2 years ago at a coupon rate of 6 percent. The bonds make semiannual payments. If these bonds currently sell for 98 percent of par value, what is the YTM? (2 marks)
| FV | $1000 |
| PV | $ (980.00) |
| Coupon | $ 30.00 |
8. ABC Company has an unusual dividend policy. The company has just paid a dividend of $5 per share and has announced that it will increase the dividend by $2 per share for each of the next four years, and then never pay another dividend. If you required a 9 percent return on the company’s stock, how much will you pay for a share today? (5 marks)
| Dividend D0 | 5.00 | ||
| Div increase yrly | 2.00 | ||
| Required return | 9.00% | ||
| Stock Price | |||
| Factor | Price | ||
| D (1) | 1.09 | 5.00 | 4.59 |
| D (2) | 1.1881 | 7.00 | 5.89 |
| D (3) | 1.295029 | 9.00 | 6.95 |
| D (4) | 1.411582 | 11.00 | 7.79 |
9 “While contemplating to create a portfolio, it is imperative to study the correlation amongst the assets that constitute the portfolio”. Discuss the statement and explain how diversification helps in reducing the risk of the portfolio as compared to the individual risks of constituting assets. (5 marks)
I need help find the Weighted Average Cost of Capital as well as the Weighted Average Flotation Costs
COST OF CAPITAL EXERCISE
The Stone Meat Corporation is a medium‑sized agricultural products company headquartered in Ogden, Utah. Its primary products are beef, pork and poultry and include packaged deli meats to half animals sold directly to in-store butcher markets in the retail grocery stores. They also supply their own butcher packs to various retail outlets including grocery stores, big box stores, and restaurants. In addition, they have their own factory store. The firm's products are well recognized within the markets in terms of quality and food safety.
During the 2000's and the early 2010's sales and earnings had grown rapidly. Sales in 2002 were approximately $60 million, but had reached $180 million by 2012. Per share earnings and dividends more than kept pace. The relevant figures are contained in Exhibit 1.
In order to support the firm's expansion, substantial expenditures on plant and equipment were required during the period indicated. The majority of funds came from retained earnings and the private placement of debentures with insurance companies. In 2004, however, the company was forced to sell additional common stock because it felt that the debt level, which would ensue from trying to borrow the money to keep up its expansion program, would be excessive. In particular, possible adverse effects in its stock price were feared since, at the time, the firm's ratio of debt to total capitalization was already somewhat above the industry average of 30 percent. The firm's balance sheet as of December 31, 2012 is shown in Exhibit 1.
Originally, the company's Board of Directors had established a policy of paying out half its annual earnings as dividends. The actual percentage varied from year to year because an attempt was made to stabilize the dividends despite fluctuating profit. By the late 2000's, this policy had been revised to set one‑third of earnings as the target pay‑out ratio due to the continuing need for capital. At their last annual meeting, the Directors announced that the 2012 dividend would be 60 cents per share, payable quarterly in 15 cent installments. The company's stock is listed on the AMEX and trades actively. The range of yearly stock prices is included in Exhibit 1. The closing price on June 30, 2012 was $24.
Market data indicated that Stone was somewhat less risky than the market as a whole with a beta of .80. Returns on the market were averaging approximately 12% and risk free borrowing was still low following the financial meltdown of 2008. These rates averaged 3.5%. Preferred stock, which had been issued many years ago as a part of a financial deal, was selling at $90 per share. Tax rates had averaged 30% over the last few years.
Early in 2012, the treasurer of Stone was reviewing its investment and financing strategies with an eye toward improving both. The question as to an appropriate cut‑off ratio of return on new investments was of special concern. The treasurer was of the opinion that many capital expenditures had been made in the past without proper analysis. He wanted a figure he could justify to the firm's managers as a cost of capital in order to achieve a more accurate capital budgeting procedure throughout the organization. He felt this was an especially timely move in view of an article he had just read in the WSJ and which is reproduced in Exhibit Ill. Stone's own long‑range planning group had earlier forecast a trend not unlike that indicated in the Journal.
The treasurer was well aware that financing did not come free and that the costs of issuance of preferred stock would cost 8%, bonds would cost 4% and equity 12%. He thought it important to determine how such costs would inflate the costs of any proposed projects the company might pursue in the futures. Thus he wanted to determine what the total cost of a $1,000,000 investment would be after considering any financing costs.
| Year | Sales in MillionsOf Dollars | EPS | DPS | Stock Price Range |
| 2002 | 60 | 0.560 | 0.30 | 6-10 |
| 2003 | 63 | 0.500 | 0.30 | 5-9 |
| 2004 | 68 | 0.710 | 0.35 | 5-10 |
| 2005 | 85 | 0.880 | 0.40 | 8-12 |
| 2006 | 97 | 0.820 | 0.45 | 9-14 |
| 2007 | 119 | 0.940 | 0.45 | 12-20 |
| 2008 | 130 | 1.110 | 0.45 | 11-18 |
| 2009 | 145 | 1.350 | 0.45 | 15-24 |
| 2010 | 164 | 1.300 | 0.50 | 17-27 |
| 2011 | 173 | 1.600 | 0.50 | 20-30 |
| 2012 | 180 | 1.750 | 0.60 | 24-32 |
| Exhibit II | |
| Balance Sheet As of 12/31/2012 (figures in millions) | |
| Cash | 20 |
| Accounts Receivable | 10 |
| Inventories | 30 |
| Plant and Equipment, net | 60 |
| Total Assets | 120 |
| Accounts Payable | 20 |
| Misc Accruals | 10 |
| Preferred Stock (5%) | 10 |
| Long term Debt | 24 |
| Common Stock (2.5 million shares) | 12 |
| Capital Surplus | 4 |
| Retained Earnings | 40 |
| Total Liabilities and Equity | 120 |
| The firm's bonds carried a 6% coupon, (paid semi- | |
| annually) a 12/31/2022 maturity and were selling for | |
| $960 as of 6/30/2012. | |
EXHIBIT III
Article taken form the February 7, 2012 issue of the Wall Street Journal.
Meat Processing Industry To Be Hurt by Increasing Prices?
Decimated Life stock Herds Also Contribute to Price Increases.
Kansas (AP) ‑ The ConAgra Corporation, in a recent annual meeting announcement, forecast a trailing off of sales in its meat processing division. That division, which had been growing at a rate equivalent to three times the CPI growth rate throughout the 2000's and early 2010's, may be hit by decreases in household expenditures as the effects of the most recent financial crisis are still lingering for the decimated middle class. Retail outlets such as restaurants and grocery stores are reporting that sales of beef and pork products are declining in response to price pressures. Disease that swept through beef and pork herds, are also having a telling effect. Other sources close to the industry confirm the ConAgra prognosis. They estimate the best forecasts that their economists can come up with indicate a decline of about five percent in the growth rate which had been experienced in the last 12 to 15 years. ConAgra is curtailing several plant expansions in its meat processing division which were on the drawing board for the mid‑2010's." We are moderately pessimistic," a company spokesman indicated, "and are going to adopt a wait and see attitude for the next year or so."
Hints
Create the Cost of Capital
Number of shares can be determined by taking the book value and dividing by the par value of the securities.
Market value is shares X price.
Average the two possible ways to calculate the cost of equity
Remember the tax rate.
Assume the bonds are semi - annual
The term to maturity is from 6/30/2012 to 12/31/2022 or 10.5 years. This info is in the footnote to Exhibit II
The growth rate should be determined from the EPS data and the adjustment to the growth rate is in Exhibit III
Create the Weighted Average Flotation Cost
What is the cost of equity using the dividend growth model? (Decimal answer to the fourth decimal place)
Given the $1,000,000 cost of the investment, what is the total cost of the investment including flotation costs? (Round to whole numbers)