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Adam Co. is a listed company operating in the textile industry. Adam Co’s board of directors met recently to discuss a new strategy for the business. The proposal put forward was to sell all the old plant and machinery and use this fund as well as borrow from market to purchase new plant and equipment. The new plant and machinery are more productive and meet the current standard quality required by the international buyers. It is also argued that new plant is more energy efficient and environment friendly that gives more advantage when facing international competitors.

 

The proposal stated that the funds raised from the sale of the old plant and machinery would be used to buy the new plant and machinery.

 

New borrowing for the balance amount will be made from local bank which offered lowest rate. Since inflation is on higher side compared to last few years so cost of borrowing is on higher side which will increase firm cost of capital.

 

The board of directors are of the opinion that increasing the level of debt in ADAM Co. will increase the company’s risk and therefore it can increase its cost of equity capital. It is assumed that due to change in plant and equipment current local sales of the product will not be affected.

 

 

New Plant price                                  Rs.5.32 million

 

Sales of old plant                                 Rs.1.32 million

 

 

Firm existing capital structure i.e. debt to assets ratio is 40:60.

At this level firm interest rate on all debt is 9.5%.

 

 

 

After borrowing firm capital structure will shift to 60:40 and at this level firm beta will shift from earlier 1.2 to 1.4. Risk free rate of return is 7% and market risk premium is 6%. New loan is negotiated with Citi bank and it is agreed that this loan will be for five years at 11% mark up.

 

 

 

Instructions:

 

  1. How much borrowing required by firm?
  2. Why risk factor will increase if firm is changing its capital structure?
  3. What is the current weighted average cost of capital?
  4. What the new cost of equity capital?
  5. What would be new Weighted Average Cost of Capital?

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The CEO of Dynamic Manufacturing was at a conference and talked to a supplier about a new piece of equipment for its production process that she believes will produce ongoing cost savings. As the Operations Manager, your CEO has asked for your perspective on whether or not to purchase the machinery.

After talking to the supplier and meeting with your Engineers and Financial Analysts, you’ve gathered the following pieces of data: • Cost of Machine: $150,000 • Estimated Annual After Tax Cash Flow Savings: $65,000 (which may or may not grow) • Estimated machinery life: 3-5 years (after which there will be zero value for the equipment and no further cost savings) • You seem to recall that Dynamic’s Finance organization recommends either a 10% or a 15% discount rate for all Cost Savings Projects. , you understand that you need to understand the project financials to ensure that this investment will be economically attractive to Dynamic Manufacturing’s shareholders.

Calculate the Nominal Payback, the Discounted Payback, the Net Present Value and the IRR (so 4 answers for each scenario) assuming: •

Alice (A) recommends using the base assumptions above: 3 year project life, flat annual savings, 10% discount rate

Bill (B) recommends savings that grow each year: 3 year project life, 10% discount rate and a 10% compounded annual savings growth in years 2 & 3. In other words, instead of assuming savings stay flat, assume that they will grow by 10% in year 2, and then grow another 10% over year 3 in year •

Carla (C) believes we use a higher Discount Rate because of the risk of this type of project: 3 year project life, flat annual savings, 15% discount rate. •

Danny (D) is convinced the machine will last longer than 3 years. He recommends using a 5 Year Equipment Life: 5 year project and savings life, flat annual savings, 10% discount rate. In other words, assume that the machine will last 2 more years and deliver 2 more years of savings.

Discussion – in a Word Document in paragraph form, respond to the following:

1) Which person’s scenario would you present to management and why? From a strictly financial (numbers) perspective, would you recommend this purchase to management?

2) In your opinion, which person’s scenario is the most aggressive (i.e., is based on the most aggressive assumptions)? If you were to select this scenario as the basis for your proposal, how would you justify the more aggressive assumptions?

3) In SIMPLE English (as in talking to a non-Finance and non-MBA person), explain why there is value to management in running all 4 of these scenarios.

4) Beyond financial measures, what other considerations would you want to consider, before making a recommendation to management?

5) If you were the CEO, would you approve this proposal? Why or why not? How would you show work through excel?

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%

Lampkin Manufacturing Company has two projects. The first, Project A, involves the construction of an addition to the firm's primary manufacturing facility. The plant expansion will add fixed operating costs equal to $200,000 per year and variable costs equal to 20% of sales. Project B, on the other hand, involves outsourcing the added manufacturing to a specialty manufacturing firm in Silicon Valley. Project B has lower fixed costs of only $50,000 per year, and thus lower operating leverage than Project A, while its variable costs are much higher, at 40% of sales. Project A has an initial cost of $3.2 million, while Project B will cost $3.4 million.

When the question arose as to what discount rates the firm should use to evaluate the two projects, Lampkin's CFO, Paul Keown, called his old friend Arthur Laux, who works for Lampkin's investment banker.

Art, we're trying to decide which of two major investments we should understake, and I need your assessment of our firm's capital costs and the debt capacities of both projects. I've asked my assistant to email you descriptions of each. We need to expand the capacity of our manufacturing facility, and these two projects represent very different approaches to accomplishing that task. Project A involves a traditional plant expansion totaling $3.2 million, while Project B relies heavily on outsourcing arrangements and will cost us a little more up front, $3.4 million, but will have much lower fixed operating costs each year. What I want to know is, How much debt can we use to finance each project without putting our credit rating in jeopardy? I realize that this is a very subjective thing, but I also know that you have some very bright analysts who can provide us with valuable insight.

Art replied:

Paul, I've got suggestions for you regarding the debt-carrying capacity of your projects and current capital costs for Lampkin. Our guys think that you've probably got room for about $1,200,000 in new borrowing if you do the traditional plant expansion project (Project A). If you decide on Project B, we estimate that you could borrow up to $2,400,000 without realizing serious pressure from the credit rating angencies. If the credit angencies cooperate as expected, we can place that debt for you with a yeild of 5%. Our analysts also did a study of your firm's cost of equity and estimate that it is about 10% right now. SHOW ALL WORK, ANSWER BOTH A AND B

A) Assuming that Lampkin's investment banker is correct, use book value weights to estimate the project-specific cost of capital for the two projects. (Hint: The only difference in the WACC calculations relates to the debt capacities for the two projects. Also, the firm's tax rate is 35%).

B) How would your analysis of project-specific WACCs be affected if Lamkin's CEO decided that he wanted to delever the firm by using equity to finance the better of the two alternatives (Project A or Project B)?

Cost of equity 10%
Cost of debt 5%
Tax rate

35%
Project A (expand)
Up-front initial investment $3,200,000
Annual fixed costs $200,000
Variable costs 20%
Contribution margin 80%
Degree of Operating Leverage high
Debt capacity $1,200,000
Debt to value ratio at capacity ?
Project WACC ?
Project B (outsource)
Up-front intitial investment $3,400,000
Annual fixed costs $50,000
Variable costs 40%
Contribution margin 60%
Degree of Operating Leverage low
Debt capacity $2,400,000
Debt to value ratio at capacity ?
Project WACC ?

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