Question

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

Part II 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?

Answer 1

Preferred Stock
Annual Dividend	4.8
Current Stock Price	40
Based on Dividend Discount Model for a constant dividend
Current Price = Divdend / required rate of return		=> 40 = 4.80 / r1
That is    r1 = 4.80/40	=	0.12	or	12%
Common Stock
Dividend pay out ratio	50% after payment of Preference Dividend
Total Number of Preferred stock	500000
Preferred Dividend	4.8	per share
Common stock shares	1000000
Balance Sheet Value of common stock	10000000
Current Market Price = Balance sheet value / number of shares			= 10000000/1000000		=	10
Tax rate	40%
Net Income	8400000
Preferred dividend (500000*4.80)	2400000
Balance after Preferred Dividend	6000000
Common Stock Dividend (50% of balance)	3000000
Dividend Per share in 2005	= 3000000/1000000		3
Constant growth rate of dividend	9%
Required rate of return on common stock	15%
Dividend for 2006	= Dividend for 2005 * (1+ growth rate)				= 3 * (1+0.09)		=	3.27
Let r2 be the cost of equity capital, then r2 can be calculated using the formula
r2 =( Dividend for 2006/Current Market Price)+ constant growth rate of dividiends
r2 = 3.27/10 + 0.09	=	0.417	or	41.70%
current interest rate for refinancing the bonds		10%
After tax Cost of debt at current market rates		= current interest rate * (1- tax rate)				= 10% *(1-0.40)		0.06	or	6%
Calculation of cost of capital
			Weights f diffent components
Common Stock	10000000		Coomon stock		comoon stock/total			= 10000000/35000000			0.285714
Preferred stock	15000000		Preferred stock		Preferred stock / total			= 15000000/35000000			0.428571
Long Term Debt	10000000		Long Term Debt		Long Term Debt / Total			= 10000000/35000000			0.285714
Total	35000000
Cost of Capital	= Weight of Common stock * cost + Weight of preferred stock * cost + Weight of Long Term Debt * after tax cost of debt
	= 0.285714*41.70% + 0.428571*12% + 0.285714 * 6%
	0.187714	or	18.77%
Project	Defence	Com space	Eng Mat
Beta	1.5	1.2	0.80
Risk Free rate	5%
Market Risk Premium	9%
Expected rate of return	= risk free rate + beta * market risk premum
Expected rate of return for Defence	= 5% + 9%*1.5		18.50%
Expected rate of return for Comm Space	= 5% + 9% * 1.20		15.80%
Expected rate of return for Eng Materials	= 5+9%*0.80		12.20%
Details of Projects and cash flows
	Year
Project	0	1	2	3	4	5	6	7	8	9	10
Defence 1	-1000000	219120	219120	219120	219120	219120	219120	219120
Defence 2	-2000000	368580	368580	368580	368580	368580	368580	368580	368580	368580	368580
Eng Mateirals 1	-1000000	222851	222851	222851	222851	222851	222851	222851	222851
Eng Mateirals 2	-2000000	542784	542784	542784	542784	542784	542784
Coomunicaiton and Space 1	-1000000	202168	202168	202168	202168	202168	202168	202168	202168	202168
Coomunicaiton and Space 2	-1000000	319775	319775	319775	319775	319775
The formula for calculation of the required rate of return for constant flows (which is internal rate of return). Let ir be the internal rate of return and n is the number of years
Net Cash Flow * [ (1-(1+ir)^n)/ir] = 0
Here the IRR is calculated using the Excel Formula '= IRR(values, (rate to be calculated)), Accordingly the values are as follows
Project	required rate of return			Expected rate of return			Desirability
Defence 1	12.00%			18.50%			Desirable
Defence 2	13.00%			18.50%			Desirable
Eng Mateirals 1	15.00%			12.20%			Not Desirable
Eng Mateirals 2	16.00%			12.20%			Not Desirable
Coomunicaiton and Space 1	14.00%			15.80%			Desirable
Coomunicaiton and Space 2	18.00%			15.80%			Not Desirable