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The Faculty of Business
BUACC3701: Financial Management
Semester 1-2014 ASSIGNMENT
This assignment is to be completed in groups of three and carries 30 per-cent of the marks in this unit.
Part A (15 marks)
You have been directed to develop a cost of capital for the firm to use in evaluating 2013 capital investment projects. You have obtained the projected December 31, 2012 Balance Sheet as well as information on sales and earnings for the past ten years.
Balance Sheet as at 31 December 2012
Notes
a) Accounts payable are exceptionally low because the firm follows the practice of paying cash on delivery in return for substantial purchase discounts.
b) The bonds outstanding have a par value of $1000, a remaining life of 15 years, and a coupon rate of 8 percent. The current rate of interest for bonds with the firm’s rating is 10 percent per year. The bonds pay annual interest.
c) The preferred stock currently sells at its par value of $100 per share.
d) There are 10 million shares outstanding and the stock currently sells at a price of $24 per share.
Sales and Earnings
Earnings Earnings
Sales after Taxes per Share
Year $m to of
Common Stock Common
$m Stock
2012 1152 31.25 3.13
2011 959 28.8 2.88
2010 848 25.4 2.54
2009 800 24.88 2.49
2008 716 21.46 2.15
2007 668 20.04 2
2006 608 18.24 1.82
2005 560 16.8 1.68
2004 524 15.77 1.58
2003 476 14.76 1.48
2002 413 12.1 1.21

Note: The firm’s marginal tax rate is 48 percent
You:
• believe the company's future growth to be only one half the rate experienced during the last decade.
• expect the firm to continue paying out about 60 percent of the earnings available to common in the form of cash dividends.
• Believe if expansion needs do not meet the required 40 percent retention rate, the payout ratio would be increased.
• believe that the mix of debt, common stock, and preferred stock that was optimum (that is, produced the lowest average cost-of-capital) was the one that the company presently employed. The proportions of this mix had been relatively stable over the past five years, and they were used to construct the projected December 31, 2012 Balance Sheet.
You have also asked the firm’s investment banks and commercial bankers what the firm's cost of various types of capital would be, assuming that the present capital structure is maintained. This information yielded the following conclusions.
DEBT
Up to and including $4 million of new debt, the company can use loans and commercial paper, both of which currently have an interest rate of 10 percent.
For additional funds above $4 million but less than $10 million, the company can issue mortgage bonds with an Aa rating and an interest cost to the company of 12 percent on this increment of debt.
From $10 million to less than $14 million of new debt, the company can issue subordinated debentures with a Baa rating that would carry an interest rate of 13percent on this increment of debt.
At and over $14 million of new debt would require the company to issue subordinated convertible debentures. The after tax cost of these convertibles to the company is estimated to be 9 percent on this increment of debt.
PREFERRED STOCK
The company's preferred stock, which has no maturity since it is a perpetual issue, pays a $9 annual dividend on its $100 par value and is currently selling at par. Additional preferred stock in the amount of $2 million can be sold to provide investors with the same yield as is available on the current preferred stock, but flotation costs would amount to $4 per share. If the company were to sell a preferred stock issue paying a $9 annual dividend, investors would pay $100 per share, the flotation costs would be $4 per share, and the company would net $96.
For additional raisings of preferred stock above $2 million but less than $3 million, the aftertax, after flotation cost would be 10.5 percent for this increment of preferred stock.
For $3 million and over, of preferred stock; the after-tax, after flotation cost would be 13 percent for this increment.
COMMON STOCK
Up to, and including, $2.5 million of new common stock can be sold at the current market price, $24 per share, less a $3 per share flotation cost. Over $2.5 million of new common stock can be sold at $24 per share, less a $5 share flotation cost.
Division managers have provided you with their proposed investment opportunities for 2007.
Note:
These projects are in divisible in the sense that each must be accepted or rejected in its entirety; that is, no partial projects may be taken on.
Required
You are asked to answer the following questions
1. Determine the firm’s existing market value capital structure. Disregard the minor amount of accounts payable. Also, lump notes payable in with long term debt. Round to the nearest whole percent.
2. Assuming that the firm maintains this optimum market value capital structure, calculate the breaking points in the Marginal Cost of Capital (MCC) schedule. Recall that the company is projecting $31.25 million of earnings available to common and a 60 percent dividend payout ratio.
3. Now calculate MCC in the interval between each of the breaking points and graph the MCC schedule in its step function form.
4. Estimate to the closest whole percentage point the missing internal rates of return in the investment schedule and then use the information developed thus far in the case to decide which projects should be accepted. Illustrate your solution technique with a graph and conclude your answer to this question with a discussion of the accept/reject decision on the marginal project.
Part B (10 marks)
You are considering the purchase of one of two large presses. The key financial characteristics of the existing press and the two proposed presses are summarised below.
Old press: Originally purchased three years ago at an installed cost of $400 000, it is being depreciated under prime cost (straight-line) using a 10-year recovery period. The old press has a remaining economic life of five years. It can be sold today to net $420 000 before taxes
Press A:
This highly automated press can be purchased for $830 000 and will require $40 000 in installation costs. It will be depreciated under prime cost (straight-line) using a five-year recovery period. At the end of the five years, the machine could be sold to net $400 000 before taxes. If this machine is acquired, it is anticipated that the following current account changes would result.
Cash +$25400
Accounts receivable + 120 000
Inventories —20000
Accounts payable + 35 000
Press B: This press is not as sophisticated as press A. It costs $640 000 and requires $20 000 in installation costs. It will be depreciated under prime cost (straight-line) using a five-year recovery period. At the end of five years, it can be sold to net $330 000 before taxes. Acquisition of this press will have no effect on the firm's net working capital investment.
The firm estimates that its earnings before depreciation and taxes with the old press and with press A or press B for each of the five years would be as shown in Table 1.
The firm is subject to a 33 per cent tax rate on both ordinary income and capital gains. The firm's cost of capital, k, applicable to the proposed replacement is 14 per cent.
EARNINGS BEFORE DEPRECIATION AND TAXES COMPANY'S PRESSES
Year
Old press Press A Press B
1 $120000 $250000 $210000
2 120000 270000 210000
3 120000 300000 210000
4 120000 330000 210000
5 120000 370000 210000
Required
1. For each of the two proposed replacement presses, determine:
a) Initial investment.
b) Net present value.
c) Internal rate of return.
2. Draw NPV profiles for the two replacement presses on the same set of axes, and discuss conflicting rankings of the two presses, if any, resulting from use of NPV and IRR decision techniques.
3. Recommend which, if either, of the presses the firm should acquire
PART C: (5 marks)
It is common for organisations which raise finance at the corporate level and then allocate that finance to projects throughout the organisation, to use the weighted average cost of capital as the required or hurdle rate in determining fund allocation. This approach is appropriate only in very specific circumstances. Particular frictions and issues may arise where an organisation is arranged into semi-autonomous divisions with each division being involved in activities with disparate levels of risk.
Examples of the issues include:
(a) The use of a firm wide cut off rate in which no explicit allowance is made for differential risk may well result in more capital being invested in the more risky division (and in riskier projects from all divisions), than otherwise would have occurred, because high-risk projects typically offer high returns. The question that arises here is whether hurdle rates be established for each division, for each product line within a division, or on an individual project basis. A related issue is how to measure the risk.
(b) Another issue that arises in this regard is that of differential debt capacity. This issue is important because some divisions need to use more debt so as to compete effectively with other firms that operate in the same industry. Some division managers may well argue that they could remain competitive only if their divisions could follow industry practice for capital structure when calculating hurdle rates. Thus the question arises as to whether
different divisions should be assigned different capital structures and debt costs or whether they should be assigned the corporate average. If different capital structures are to be used, how should they be derived? What interest rate should be used for debt? How should divisional equity costs be adjusted to reflect varying capital structures?
There are three types of protect risk that can be considered,
Required
a) What type of risk do we adjust for?
b) Which of these risks should we be interested in?
c) How do we measure the risk and incorporate it into the analysis.