This Mini Case incorporates the calculation of a weighted average cost of capital (WACC) to determine whether the Alpha One Software Corporation added economic value in 2010. The Appendix to Chapter 7 will need to be covered first in order to complete this Mini Case.
The Alpha One Software Corporation was organized to develop software products that would provide Internet-based firms with information about their customers. As a result of initial success, the venture's premier product allows firms with subscriber bases to predict customer profiles, retention, and satisfaction.
Arlene Io received an undergraduate degree in computer science and information systems from a major northeastern university four years ago. The Omega Subscriber Software Product was developed and test-marketed with the help of two of her classmates; Alpha One Software Corporation was up and running within one year. Venture capital was obtained to start up operations; a second round of venture financing helped Alpha One move through its survival stage. Product success in the marketplace has allowed the venture to achieve such rapid sales growth that it now is able to get bank loans and to issue long-term debt.
The interest rate on the bank loan is 10 percent. For long-term debt, the real interest rate is estimated to be 3 percent; the inflation premium is 4 percent; and Alpha One's default/liquidity risk premium over government bonds is estimated to be 7 percent. The cost of common equity was estimated using the risk-free long-term government bond rate and a stock investment risk premium of 13 percent.
Arlene Io has now reached the point of being able to consider whether Alpha One is adding economic value in terms of its net operating profit after taxes (NOPAT) and its weighted average cost of capital (WACC). Following are the financial statements for 2010.
ALPHA ONE SOFTWARE CORPORATION
INCOME STATEMENT 2010
Net sales ............. $1,500,000
Cost of goods sold ......... -850,000
Gross profit ............. 650,000
General and administrative expenses . -250,000
Marketing ............ -206,000
Depreciation .......... -50,000
Earnings before interest and taxes ... 144,000
Interest ............. -84,000
Earnings before taxes ........ 60,000
Income taxes (40% rate) ...... -24,000
Earnings after taxes ........ $ 36,000
BALANCE SHEET 2010
Cash ............. $ 20,000
Accounts receivable ....... 250,000
Inventories .......... 350,000
Total current assets ........ 620,000
Fixed assets, net ......... 480,000
Total assets .......... $1,100,000
Accounts payable ........ $ 125,000
Accrued liabilities ....... 125,000
Notes payable ......... 100,000
Total current liabilities ....... 350,000
Long-term debt .......... 500,000
Common stock (20,000 shares) ... 100,000
Retained earnings ......... 150,000
Total liabilities and equity ... $1,100,000
A. cD. Estimate the cost of common equity capital.
E. Determine the financial structure weights from Alpha One's 2010 financial statements for the two interest-bearing debt components and the common equity.
F. Calculate Alpha One's weighted average cost of capital (WACC).
G. Determine the dollar cost of financial capital used.
H. Estimate Alpha One's economic value added (EVA). Did Alpha One build or destroy economic value in 2010?