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Case 18: It’s Better To Be Safe Than Sorry!

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Case 18: It’s Better To Be Safe Than Sorry!

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  1. This presentation will probably involve audience discussion, which will create action items. Use PowerPoint to keep track of these action items during your presentation • In Slide Show, click on the right mouse button • Select “Meeting Minder” • Select the “Action Items” tab • Type in action items as they come up • Click OK to dismiss this box • This will automatically create an Action Item slide at the end of your presentation with your points entered. Case 18: It’s Better To Be Safe Than Sorry! Case Discussion

  2. Objectives • Develop a firm’s marginal cost of capital schedule. • Develop an investment opportunity schedule. • Decide between competing projects using an MCC-IOS graph.

  3. Background • John Woods, the Asst. VP of Finance at Mid-West Home Products Inc. has been asked to re-evaluate the investment proposals presented by the 5 divisional managers. • All 5 proposals were shown to have positive NPVs (using 8% cost of debt as the hurdle rate) and fairly high IRRs. • John prefers to follow a conservative policy when analyzing capital investment proposals. • He knows that he has his work cut out for him. • John asks his assistant Pete Madsen to collect some information for him.

  4. Question 1 • What seems to be wrong with the way the NPV of each project has been calculated? • Indicate without any calculations, how Pete and John should go about recalculating the projects’ NPVs.

  5. Answer 1 • The NPV of each project has been calculated by discounting the cash flows at the 8% before-tax cost of debt. • This is incorrect. • Since the company has debt, preferred stock and common stock in its capital structure the weighted average cost of capital must be calculated and used to discount the projects’ cash flows.

  6. Answer 1 (Continued) • The weight of each component of the target capital structure (based on market values of outstanding securities) should be calculated and used along with their respective component costs to calculate the weighted average cost of capital. • Next, the present values of the projects’ cash flows should be used to compute the equivalent annuity that had been used by the managers when discounting at 8%. • These annual cash flows should then be discounted at the weighted average cost of capital to recalculate the projects’ NPVs.

  7. Question 2 • Why does John need to know the retention rate of the firm? • What impact will retained earnings have on the calculations?

  8. Answer 2 • The retention rate multiplied by the return on equity can be used to estimate the sustainable growth rate of the firm. • The growth rate can be then used to determine the cost of retained earnings and of new equity. • Retained earnings are also considered internal equity. • The retained earnings available for growth can help reduce the need for outside financing. • Accordingly, the level of retained earnings will affect the marginal cost of capital.

  9. Question 3 • Why is the target capital structure of concern to John? • How should it be determined?

  10. Answer 3 • The target capital structure determines the weights that are used when calculating a firm’s average cost of capital. • Although a firm can generally raise all the money it needs for a particular project from just one source, i.e. debt or equity, by doing so, it would be reducing its capacity to use that source for future projects. • Thus, in corporate finance, it is typically assumed that firms have a target capital structure, which will be adhered to over the long run.

  11. Answer 3 (Continued) The target capital structure can be determined by dividing the market value of each type of security issued by the firm (i.e. bonds, preferred stock, common stock) by the total value of all the components. Only long-term sources of capital should be used.

  12. Question 4 • Pete collects the necessary data and prepares Table 6 . • Accordingly, calculate the component costs of debt, preferred stock, and common stock. • Will these costs be constant irrespective of the amount of capital raised? • Please explain.

  13. Answer 4 TABLE 6   Expected Growth Rate of Sales… 25% • Expected Growth Rate of Earnings and Dividends… 12% Expected Return on the Market….. 15% Treasury bill rate…………………………………. 6% Expected retention rate……………………….. 60% Firm’s Equity Beta………………………….. 1.2 AFTER-TAX COST OF DEBT (Without floatation costs)  Calculate the Yield to maturity on the firm’s outstanding 8%, 20-year bonds which are currently selling at $900.  PMT = 80; FV = 1000; N=20; PV = -900; CPT I% = 9.10%  After-tax cost of debt = YTM*(1-Tax rate) = 9.1*(1-.4) = 5.46%

  14. Answer 4 (Continued) COST OF PREFERRED STOCK (without floatation costs) = Dividend/Price of Preferred Stock = $0.6/$12 = 5% COST OF EQUITY (without floatation costs) Based on CAPM = Risk-free rate + Beta(Expected Market Return – Risk-free rate)  = 6% + 1.2 (15% - 6%) = 6% + 10.8% = 16.8% Based on Dividend Discount Model  = [D0(1+g)/P0] + g = .51(1.12) / $25 + .12 = 14.28% Average of two estimates = (16.8 + 14.8)/2 = 15.54%

  15. Answer 4 (Continued) • These costs can and most likely will change as the firm’s overall level of debt increases. • These changes will be caused by increased issue costs and increased risk premiums. For example: Once the firm uses up all of its available retained earnings, its cost of equity will have to be adjusted for floatation costs associated with issuing new equity…

  16. Answer 4 (Continued) The firm’s expected retained earnings for the coming year can be determined as follows… Current Sales = $ 37,500,000 Expected Growth Rate of Sales = 25% Expected Sales Next Year = $37,500,000 (1.25) = $46,875,000 Estimated Net Profit = Net Profit Margin * Expected Sales = .0418*4,687,5000 = $1,960,000 Estimated Retained Earnings = $1,960,000*Retention Rate = 1,960,000* .6 = $1,176,000 For example: Once the firm uses up all of its available retained earnings… its cost of equity will have to be adjusted for floatation costs associated for issuing new equity.

  17. Answer 4 (Continued) Now, since equity is expected to be 62.5% of the total capital base (see #3 above)…. the firm can raise up to $1,881,600 i.e. ($1,176,000/.625), without having to issue new equity, and still maintain its target capital structure. Beyond a capital requirement of $1,881,600, the marginal cost of capital will increase primarily due to the higher cost of new equity.

  18. Question 5 • Develop the Marginal Cost of Capital for the intended capital investments. • Explain how the values are arrived at.

  19. Answer 5 Cost of New Equity Under DDM…..  Cost of Equity = [D0(1+g)/(P0 – Floatation Cost)] + g  = [.51(1.12) / ($25 - .15*$25)+ .12 = .57/(25-3.75) + .12 = 14.68% Floatation Cost Adjustment = Cost of New Equity under DDM (with floatation cost) – Cost of Retained Earnings under DDM (without floatation cost) = 14.68% – 14.28% = 0.4% Average Cost of New Equity = Average Cost of Retained Earnings + Floatation Cost Adjustment  =15.54%+0.4% = 15.94%

  20. Answer 5 (Continued) Marginal Cost of Capital $0 - $1,881,600 Component Proportion After-tax Cost Weighted Cost Debt 0.225 5.46% 1.23% Preferred Stock 0.150 5.00% 0.75% Retained Earnings 0.625 15.54% 9.71% WACC 11.925% Beyond $1,881,600 Debt 0.225 5.46% 1.23% Preferred Stock 0.150 5.00% 0.75% New Common Stock 0.625 15.94% 9.96% WACC 11.943%

  21. Question 6 • Develop an Investment Opportunity Schedule using the data for the 5 proposals and…. • accordingly indicate which combination of projects would be acceptable.

  22. Answer 6 First, rank order the 5 projects based on their IRRs as follows:

  23. Answer 6 (Continued) Next, plot the cumulative projects and their respective IRRs on a graph as shown below. Based on the graph, all projects are acceptable since their IRRs lie above the marginal cost of capital schedule. If the IOS line were to cut the MCC schedule from above, the projects that had returns below the MCC would be rejected. MCC-IOS Graph (click here)

  24. Question 7 • Recalculate the NPVs of the 5 projects using the appropriate hurdle rate. • Are the projects still acceptable? Please explain.

  25. Answer 7 Yes, all projects are still acceptable since they all have positive NPVs and their IRRs are greater than the WACC at that level of investment.

  26. Question 8 Let’s assume that the cash flows of Project B were 40% less risky than those of the other 4 projects –which were estimated to be of average risk. How would the evaluation process be affected and what would John have to do to make the appropriate recommendations?

  27. Answer 8 If project B were 40% less risky than the other 4 projects, its discount rate would have to be adjusted as follows: Firm’s WACC*.6 = Project B’s WACC = .6*11.94 = 7.2% Project B’s NPV = Annual Cash Flow(PVIFA, 4, 7.2%) - $750,000 = $$261,897.51(3.371)- $750,000 = $883,111.58 -$750,000 = $133,111.58 Thus, the NPV rankings would be affected. However, all 5 projects would still be acceptable, unless the firm had budget limitations.

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