Evaluating value of long-term elements of capital structure

Assignment:

You are interested in suggesting a new venture to the management of your company. Relevant financial information is given below.

BALANCE SHEET

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 Equity 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 with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10% semi-annual coupon, and are presently selling for $874.78.
• You also have 100,000 shares of $100 par, 9 percent dividend perpetual preferred stock outstanding. The present market price is $90.00. Any new issues of preferred stock will incur a $3.00 per share flotation cost.
• The company has 10 million shares of common stock outstanding with at present price of $14.00 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.80. New stock can be sold with flotation costs, including market pressure, of 15%.
• The risk-free rate is presently 6 percent, and rate of return on the stock market as a whole is 14 percent. Your stock's beta is 1.22.
• Stockholders need a risk premium of 5 percent above return on the firms bonds.
• The firm expects to have extra 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 present 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 at present 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.
• The firm has following investment opportunities presently available in addition to the venture that you are proposing:

Project   Cost             IRR
A         10,000,000    20%
B         20,000,000    18%
C         15,000,000    14%
D         30,000,000    12%
E         25,000,000     10%

Your venture will consist of a new product introduction (You must label your venture as Project I, for "introduction"). You estimate that your product would have a six-year life span, and the equipment used to manufacture the project falls into the MACRS 5-year class. Your venture will need a capital investment of $15,000,000 in equipment, plus $2,000,000 in installation costs. The venture will also result in an increase in accounts receivable and inventories of $4,000,000. At the end of the six-year life span of the venture, you estimate that the equipment can be sold at a $4,000,000 salvage value.

Your venture, that management considers fairly risky, will increase fixed costs by a constant $1,000,000 per year, while variable costs of the venture will equal 30 percent of revenues. You are projecting that revenues generated by project will equal $5,000,000 in year 1, $10,000,000 in year 2, $14,000,000 in year 3, $16,000,000 in year 4, $12,000,000 in year 5, and $8,000,000 in year 6.
The following list of steps provides a structure which you must use in analyzing your new venture.

Note: Carry all final calculations to two decimal places.

1. Evaluate the costs of the individual capital components:

a. long-term debt

b. preferred stock

c. retained earnings (avg. of CAPM, DCF, & bond yield + risk premium approaches)

d. new common stock

2. Determine the value of the long-term elements of the capital structure, and find out the target percentages for the optimal capital structure. Carry weights to 4 decimal places.

3. Evaluate the retained earnings break point.

4. Show the MCCF schedule, including depreciation-generated funds in the schedule.

5. Determine the Year 9 investment for Project I.

6. Determine the annual operating cash flows for years 1-6 of the project.

7. Compute the extra non-operating cash flow at the end of year 6.

8. Draw a timeline which summarizes all of the cash flows for your venture

9. Evaluate the IRR and payback period for Project I

10. Show IOS schedule including Project I along with Projects A-F

11. Evaluate your firm's cost of capital

12. Show which projects must be accepted based on your MCC and IOS schedules and why?

13. Determine the NPV for Project I at the risk-adjusted cost of capital for the project. Should management adopt this project based on your analysis? Describe.  Would your answer be different if the project were determined to be of average risk?