Question

You are the technology controller for a mid-sized publicly traded company. You have been assigned to evaluate an investment in a new process that would cost $2.5 million. You have determined that the internal rate of return of the positive operating cash flows associated with the investment is 13.0%.

On a market value basis, the firm's capital structure is as follows:

Debt: 40%; Preferred Stock: 5%; Common equity: 55%;

This capital structure is in line with the peer group industry average, and management has no appetite for altering the existing ratios, which they consider to be optimal.

Your firm’s current stock prices are $95 per share for common equity and $60 per share for 9% $100 par value cumulative preferred stock. The 2018 common dividend was $10 per share, and the company has increased this dividend by 5% per year for the past ten years. The company also has $1,000 par value 10% coupon bonds outstanding, with a remaining maturity of ten years. The bonds are currently trading at 87.5% of par value. The capital markets are very receptive to the company's bonds and preferred common equity, all of which are actively traded both regionally and nationally.

In addition to this, you determine that the 20-year average yield on 10-year US Treasury obligations is 5% and that the market risk premium is 7%. Your firm's common equity has been given a beta of 1.65. The firm's effective rate of income tax is 25%.

In organizing financing for the proposed project, you have approached your firm's bank. The bank has agreed to a limited amount of long-term secured financing to a maximum of $ 600,000, at 6%. The bank would be willing to supply an additional $ 400,000 of long-term funds on an unsecured basis, at a rate of 15%, as an alternative to a bond issue. Based upon the company's conservative retention policy and healthy cash reserves, you are confident that it could fund up to $1.5 million of the proposed investment with internally generated retained earnings.

Based upon the information provided above, come up with a funding plan for the proposed investment and make a recommendation as to its suitability from a financial standpoint.

Answer 1

Total funds required for investment in new process= $2.5 million

Requirement fulfilled internally ie from cash reserves= $1.5million

Remaining fund required= $1 million

The company has two option:

1. Increase Capital in accordance with capital structure

2. Borrow from Bank

Option 1: Analysis

Cost of Equity( Ke)= Rish free return+Beta of company(market risk premium)

=5+1.65(7)= 16.55%

Kp(cost of Preferred Stock) = 9%

cost of Bond = Rate of interest*(1-tax rate%)

=10%(1-.25)= 7.5%

Bonds are trading at 87.5% of its par value. Hence the effective rate of interest

ie. Equivalent Cost of bond= 7.5%/87.5%=4.57%

Capital structure= 55% equity, 5% prefered stock, 40% bond

Weighted Cost of capital = Ke*weight+Kp*Weight+Kd*weight

WACC= 16.55*.55+9*.05+7.5*4.57= 12.98%

Option 2: Analysis

Cost of secured borrowing=Interest(1-tax rate %)

=6(1-.25)=4.5%

Cost of unsecured borrowing=Interest(1-tax rate %)

=15(1-.25)= 11.25%

Secured borrowing available = $600000 @6% and unsecured= $400000 @15% interest.

WACC= 4.5*.6+11.25*.4=7.2%

Hence WACC is less in option 2 ie 7.2% as compares to 12.98% in option 1, company should go for Bank ie option 2.