Question

In: Finance

On January 2, 2006, in the strategic committee meeting of the company, Christine Carmen Chairman, President...

On January 2, 2006, in the strategic committee meeting of the company, Christine Carmen Chairman, President and Chief Executive Officer said, we are optimistic about 2006 and the years beyond. The proposed projects presently under consideration will enable us efficiently to expand our productivity in order to meet ever-increasing customers demand with high quality engineered products and systems for defense, aerospace and industrial applications.

Carmen Corporation is a supplier of sophisticated, highly engineered products and systems for defense, aerospace and industrial applications. The Company has three business segments.

The Company's Defense segment provides integrated front-line war-fighting systems and components, including electronic warfare systems, reconnaissance and surveillance systems, aircraft weapons suspension and release systems and airborne mine countermeasures systems.

The Company's Communications and Space Products segment supplies antenna products and ultra-miniature electronics and systems for the remote sensing, communications and electronic warfare industries.

The Company's Engineered Materials segment supplies piezoelectric ceramic products for commercial and military markets and advanced fiber composite structural products for the aircraft, communication, navigation, chemical, petrochemical, paper, and oil industries.

Carmen Corporation has the following financial statements:

Table 1                                 CARMEN COMPANY

Balance Sheet 12/31/2005

Assets

Liability & Equity

Cash

$6,000,000

Account Payable

$1,000,000

Account Receivable

$8,000,000

Notes Payable

$3,000,000

Inventory

$3,000,000

Accrued Taxes

$1,000,000

Current Asset

$17,000,000

Current Liabilities

$5,000,000

GFA

$40,000,000

Long-term debt

$10,000,000

Accumulated Depreciation

($2,000,000)

Preferred Stock (0.5 million shares)

$15,000,000

Net Fixed Assets

$38,000,000

Common Stock (1 million shares)

$10,000,000

Returned Earnings

$15,000,000

Common Equity

$25,000,000

Total Asst

$55,000,000

Total Liability & Equity

$55,000,000

Table 2 -Income Statement (12/31/2005)

Sales

$25,000,000

Cost of Sales

-8,500,000

Earnings Before Depreciation and Amortization (EBITDA)

$16,500,000

Depreciation

-1,550,000

Earnings Before Interest and taxes (EBIT)

$14,950,000

Interest Expense

($950,000)

Taxable Income

$14,000,000

Taxes (40%)

($5,600,000)

Net Income

$8,400,000

Its established common stock’s dividend payout ratio after the preferred stock dividends payment is 50 percent and it is expected to grow at a constant rate of 9 percent in the future. The tax rate is 40 percent and investors requiring a rate of return of 15% on the common stock.

Preferred stock is trading at a price of $40 per share, with a dividend of $4.8. The 30-year long-term debt with a par value of $1,000 was issued 10 years ago with a coupon rate of 8%. The bonds can be refinanced at the market interest rate of 10 percent today.

Carmen has the following investment opportunities:

Table 3

Project

Annual Net

Project

Cost

Cash Flow

Life

Defense 1

$1,000,000

$219,120

7

Defense 2

$2,000,000

368,580

10

Eng. Materials 1

$1,000,000

222,851

8

Eng. Materials 2

$2,000,000

542,784

6

Communication and Space 1

$1,000,000

202168

9

Communication and Space 2

$1,000,000

319,775

5

Although the average project in the Defense Segment was substantially riskier than communications and Space Products segment and Engineered Materials segment, the project evaluation process did not formally incorporate risk considerations. This lack of risk consideration was more evident in the Communications and Space Products segment and Engineered Materials segments, since their productions, earnings, and profits were highly correlated and fluctuated with the economy. As a result, these segments provided a very stable income to the company. On the other hand, the Defense segment provides military products and professional services to the United States and allied governments, and their prime defense contractors and as a result, the earnings and profits of the Defense segment tended to be tied to the world geo-political environment.

Carmen has gathered the following beta for each segment based on comparable companies:

Project             Defense           Com. Space     Eng. Materials                        

Beta                 1.50                 1.20                 0.80                

The risk-free rate is 5% and rate of the market risk premium 9.0%.

1) Calculate the required rate of return for each project?

2) Compare the required rate of return with expected rate of return, according to the risk characteristics of each project; which project is appropriate to take?

Solutions

Expert Solution

Required rate of Return of each project [Calculate IRR]

Project Cost Cash Flow Life IRR
Defence 1 1000000 219120 7 12%
Defence 2 2000000 368580 10 13%
Eng & Materials 1 1000000 222851 8 15%
Eng & Materials 2 1000000 542784 6 49%
Communicaion & Space1 1000000 202168 9 14%
Communication & Space 2 1000000 319775 5 18%

IRR calculated in Excel

Expected Rate of Return

ER= RF+Beta* Risk premium

Risk Premium=9%

RF=5%

Project Beta Exected rate of return
Defence 1.5 18.5%
Com Space 1.2 15.8%
Eng Mat 0.8 12.2%

According to the question, there are 2 proosals for each segment. Considering beta of each segment as measure of risk, expected return has been calculated. On comparision of expected and required return, following can be concluded-

1- Defence Segment- ER is 18.5%. Required return for P1 is 12% and P2 is 13%. In both cases, IRR is less that exected return and therefore none of the proosals are feasible.

2-Com Sace segment- ER-15.8%. Required rate for P1 is 14% and P2 is 18%. IRR is higher than expected return in P2. Therefore P2 should be selected

3-Eng Mat segment- ER- 12.2%. Required Return for P1 is 15% and P2 is 49%. IRR is higher that Exected return in both cases. Therefore both proosals can be selected.


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