Financial Management
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 | ||||||
$ millions | ||||||
Cash and marketing securities | 19 | Accounts Payable (a) | 8 | |||
Accounts Receivable | 94 | Bank Notes Payable (9%) | 80 | |||
Inventories | 122 | Long Term Debt (b) | 120 | |||
Preferred Stock (c) | 47 | |||||
Net Fixed Assets | 172 | Common Stock (d) | 55 | |||
Retained Earnings | 97 | |||||
407 | 407 |
Notes
Sales and Earnings |
|||
Year |
Sales $m |
Earnings after Taxes to Common Stock $m |
Earnings per share of Common 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:
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 after- tax, 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 2013.
Investment Opportunities |
||||
$ millions |
||||
Project Identification |
Cost of |
Estimated Annual Cash Inflows |
Estimated Life |
Estimated Internal Rate of Return |
A |
7.00 |
1.03 |
15 |
12?p> |
B |
4.00 |
0.81 |
9 |
|
C |
5.00 |
1.05 |
6 |
7?p> |
D |
10.00 |
1.54 |
12 |
|
E |
9.00 |
2 |
10 |
18?p> |
F |
3.00 |
0.6 |
10 |
15?p> |
G |
4.00 |
0.95 |
5 |
6?p> |
H |
6.00 |
1.13 |
8 |
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