You work for the Berea Amalgamated Products Company that produces coloring books
ID: 2760011 • Letter: Y
Question
You work for the Berea Amalgamated Products Company that produces coloring books, velvet paintings and other fine arts.
You are proposing a new venture, to branch out into figurine animals and cartoon characters but this will require new equipment and a capital outlay.
You need to explore the financials before further researching unto a complete recommendation relative to this proposed venture. Therefore, you are not concerned with making "a complete recommendation relative to this proposed venture." Your task is to tender the mathematical solutions to the deliverables that will be used to find an optimal capital structure. You do not need to determine the optimal capital structure.
Pertinent financial information is below briefly stated:
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 Stock
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 (par value $1,000.; 30-year life) 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.
PROJECT DELIVERABLES: Steps to WACC for the Optimal Capital Structure
1. Find the costs (rate/percentage under current market conditions) of the following individual capital components:
Long-term debt, Bonds. [Hint: PV=-$874.78 (current selling price of Bonds), FV = $1000, PMT=$100, N=15 solve for I/Y].
This is a calculator (Texas Instruments BA II Plus Financial Calculator) problem and if you follow the hints you will find the effective rate (see textbook appendix 10B, page 338: Bond Valuation) CLICK Minor Project #1.a. Calculator Paradigm p. 338.pdf
New Preferred stock
This is a calculator (Texas Instruments BA II Plus Financial Calculator) problem
New common stock (CAPM required rate of return): see page 348 on Capital Asset Pricing Model. This common stock deliverable is Optional = Extra Credit
This is a calculator (Texas Instruments BA II Plus Financial Calculator) problem
2. Compute the current Total Value of the Firm depicting its long-term elements of the capital structure (balance sheet components).
3. Determine the target percentages for the capital structure: i.e. the weighted average cost of capital (WACC) using current values (see pages 351-352).
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 Stock
77,000,000
Total Assets
205,000,000
Total Claims
205,000,000
Explanation / Answer
Debt Financing:
Number of bonds issued=60,000
Par value of bond=$1,000
Time to maturity=15 years
Coupon rate on bond=10%
Current price of the bond=$874.78
Therefore,
Market value of bond = 60,000*$874.78 = $52,486,800
Cost of Debt before tax (YTM) = 11.82%
Preferred equity financing:
Number of shares=100,000
Par value of shares=$100
Dividend on perpetual preferred stock=9%
Current market price of preferred stock=$90
Flotation cost=$3.00 per share
Market value of preferred stock = 100,000 * $ 90 = $9,000,000
Cost of preferrd stock = ($100*9/100) / $90 - $3 = 10.34%
Common Equity financing:
Number of common stock outstanding=10,000,000
Current price of common stock=$14
Market value of Common stock = $14 * 10,000,000 = $140,000,000
Using dividend growth model:
Dividend growth rate=10%
Last dividend paid=$0.80
Flotation cost=15%
Cost of Common equity = $0.80 * (1+0.10) / $14 * (1+0.15) +0.10 = 0..1739 or 17.39%
Using CAPM:
Risk free rate of return=6%
Rate of return on stock market=14%
Stock beta=1.22
Cost of common equity = 6%+(14% - 6%) *1.22 = 15.76%
Using bond yield plus risk premium:
Bond yield=11.82%
Risk premium=5%
Cost of Common equity = 11.82% + 5% = 16.82%
2)
Current total value of the Firm depicting its long-term elements of the capital structure:
Current total value = $52,486,800+ $9,000,000+ $140,000,000 = $201,486,800
3)
Optimal Capital Structure
Weight of Debt = $52,486,800 / $201,486,800 = 26.05%
Weights of preferred stock = $9,000,000 / $201,486,800 = 4.47%
Weights of common equity = $140,000,000 / $201,486,800 = 69.48%
WACC = 26.05% * 11.82% * (1-0.40) + 4.47%*10.34% + 69.48% * 17.39% = 14.39%
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