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Clarisse, after consulting with Michael and Hana as well as with FORM’S accounting firm, investment bankers,...

Clarisse, after consulting with Michael and Hana as well as with FORM’S accounting firm, investment bankers, and financial advisors came up with three different methods to finance each possible venture.

For the casual footwear line, the commercial bank FORM Manufacturing has been working with since the business was purchased by Giuseppe in 1933 could make a loan for $3.25 million at a fixed rate of 5% for a term of 10 years with monthly loan payments of $17,447.90. However, there was a prepayment penalty of 2% of the remaining balance of the loan if it were paid off in the first five years.

For financing the athletic shoes line, Clarisse, based upon Hana’s recommendation, was considering using a finance company from Chicago. The loan would be for $2.25 million for 10 years at a rate of 6.5% without any prepayment penalties and at a monthly payment of $14,222.43.

The financing for the purchase of the Italian footwear company would be the costliest, more complicated, and, Clarisse felt, have the highest amount of risk. The financing would be done using a split of corporate bonds, preferred stock, and issuing a new class of common stock specifically designated for the purchase.

Fifty percent of the $500 million purchase would be using callable bonds with a coupon interest rate of 5% at a par value of $1,000 per bond and a term of 30 years. The 250,000 issued bonds would pay interest semi-annually and, with FORM’s corporate tax rate at 34%, the after-tax interest rate on the issue would be 3.3%. The would have a market price of 103 as a percentage of par.

Twenty-five percent of the purchase price would be financed using non-cumulative preferred stock issued with a par value of $100 per share and paying dividends quarterly at a rate of 10%. The cost of capital for the preferred stock issue would be 7%.

The other 25% of the cash to be raised would come from the sale of a new class of common stock at a projected price of $25.00 per share, not paying dividends for the first five years of the issue, no voting rights, and 5 million shares authorized to be issued. The investment bankers hired by FORM Manufacturing have projected that its ? would be 1.25, higher than Clarisse and Hana wanted it to be. Also, T-bills are currently at a rate of 3%, while the market return rate is 9%. Another piece of the puzzle, and perhaps the most important, are the cash flows each venture could potentially bring to FORM Manufacturing, assuming a 10% discount rate. Hana’s staff has come up with the following projected cash flows:

Year Casual Shoes Loafers Eva Union Shoes
1 - $500,000 $850,000 $1,000,000
2 - $400,000 850,000 1,500,000
3 300,000 850,000 2,000,000
4 500,000 850,000 2,500,000
5 800,000 850,000 3,500,000
6 900,000 850,000 4,500,000
7 1,250,000 850,000 5,000,000
8 1,500,000 850,000 5,500,000
9 1,750,000 850,000 6,000,000
10 2,000,000 850,000 6,500,000

While FORM Manufacturing is largely a family-owned company, with the Formo family controlling 51% of the firm’s voting stock, Clarisse knew he would have to present management’s final decision to the board of directors. For Clarisse, there were still questions and concerns that needed to be addressed which he listed in a memo to Hana and requested an answer in one week.

1. What is the net present value (NPV) for each venture? And based on the principle of mutually exclusivity, which venture(s) should be accepted or rejected?

2. What is the internal rate of return (IRR) for each venture? Given that the company’s cost of capital is 10%, which venture(s) should be accepted or rejected?

3. What are the Payback Periods for each venture? Which venture(s) should we accept given the company’s cutoff period of three (3) years?

4. By using the Capital Asset Pricing Model (CAPM), find the required return on equity for the purchase of Eva Union Shoes.

5. Examine the proposed bond issue to be used in the acquisition of Eva Union Shoes and find its cost of debt using the yield to maturity.

6. Given the weights of the equity portion (both preferred and common stock) and debt in the capital structure for the Eva Union Shoes venture let me know what is FORM's weighted average cost of capital involving the deal.

7. What do you think are the best financial decision rules that should be used in order to make a correct decision for the three possible ventures?

8. Are there any key questions that should be considered?

9. As CFO, which of the three ventures do you think FORM Manufacturing should pursue and why?

Solutions

Expert Solution

1. NPV Casual wear shoe line : We will use the after tax borrowing cost as the discount rate for NPV. After tax borrowing cost = 5% * (1-34%) = 3.3%.

Now we will calculate NPV for aethletic line which will be financed at debt cost of 6.5% or after tax cost of 6.5% * (1-34%) = 4.29%.

Now we will calculate NPV for the Italian company:

Total funding required = $ 500 million

Bonds : 50% or 250 million at 5% coupon or after tax cost of 3.3%. SInce they will be issued at premium of 103%, the YTM will be as below:

1030 = 25/(1+r) + 25/(1+r)2 + ..... + (25+1000)/(1+r)50 (semi annual coupons)

where r is the YTM and solving for r, we get r = 2.40% semi annually or annualised 4.8%. This shall be the cost of bonds for the company and after tax cost will be 3.17%

Preferred Stock is 25% at 7% cost of capital (given to us).

Common equity is also 25%; beta = 1.25, risk free rate is 3% and market return is 9%. Hence as per CAPM the cost of equity issuance shall be = 3% + 1.25 * (9%-3%) = 10.50%

Thus WACC for this project = 50% * 3.17% + 25% * 7% + 25% * 10.50% = 5.96% and this what we use for calculating the NPV. We have also used terminal value for NPV calculation and since we were not given the growth rate. we have assumed constant cash flows from Year 10 onwards .

Now we see that as per NPV the first 2 projects should be executed and third one should not be.

2. As per the IRR rule , we see that the IRR of casual and aethletic line is above 10% (calculated above along with NPV) and they should be considered.

3. Payback period is simply the time period required to earn back the initial investment from cumulative cash flows .

Casual wear : 8 years

Aethletic wear : 3 years

Italian aquisition : Not applicable

As per the 3 year cut off only aethletic line investment should be considered

4. We already calculated above - as per CAPM the rate should be 10.50%

5. YTM calculated above = 4.8%

6. WACC = 5.96% calculated above

7. NPV and IRR in conjunction should be used since the financin choice will impact the NPV but at the company level if the opportunity cost is given at 10%, then IRR should also be used to sieve out the projects like in this case the casual wear and aethletic line both meet the NPV and IRR rule.

8. Yes - the cash flow assumptions for Italian company and growth rate for terminal value.

9. Project 2 - since it meets the NPV, IRR and payback rule of the company.


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