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 I

Determine the book value and market value of the capital structure.

Determine the weighted average cost of capital (WACC) for each of the capital structure.

Calculate the internal rate of return (IRR) and Net Present Value of each project and compare them against the book value and market value weighted average cost of capital.

Are there any conflict between NPV and IRR? How do you resolve the conflict in ranking?

e.

How much of the internal fund is available for investments?

Are there any issues about the projects you should consider before yourrecommendation?

Answer 1

1. Book value of equity = Common stock + Retained earnings

= 10,000,000 + 15,000,000 = $25,000,000

Book value of Debt = Notes payable + LTD = 3,000,000 + 10,000,000

= 13,000,000

Book value of preferred stock = 15,000,000

1. Preferred stock dividend = $4.8 * 500,000 = $2,400,000

Net profit after preferred dividend = 6,000,000

Common stock dividend per share = $3,000,000 / 1,000,000 = $3.0 per share

Market price of stock = Dividend/ cost of equity – growth rate

= $3.0 / 0.15 – 0.09

= $50 per share

Market value of equity = $50 * 1,000,000 = $50,000,000

Market value of debt can be calculated using bond pricing formula,

              Price = [PMT(T1) / (1 + r)^1] + [PMT(T2) / (1 + r)^2] … [(PMT(Tn) + FV) / (1 + r)^n]

• PMT(Tn) = Coupon Payment at Time N
• FV = Future Value, Par Value, Principal Value
• R = Yield to Maturity, Market Interest Rates
• N = Number of Periods

Market value of bond = 829.73 (per $1000 dollar value)

Total market value of debt = 8,297,300 + 3,000,000 = $11,297,300

Market value of preffered stock = $40 * 500,000 = $20,000,000

1. Cost of equity, Ke = 15%

Cost of debt, Kd = 10% (1-0.4) = 6%

Cost of preferred = 4.8 / 40 = 12%

Weight of equity = $50,000,000 / (50,000,000 + 11,297,300 + 20,000,000)

= $50,000,000 / $81,297,300 = 61.5%

Weight of debt = $11,297,300 / $81,297,300 = 13.9%

Weight of preferred= (100 – 61.5 – 13.9) = 24.6%

WACC = (0.615*15%) + (0.139 *6%) + (0.246 * 12%)

= 13.01%

Above WACC is at market value rates. For calcululating the WACC with book value weights, take the books value of preferred, equity, and debt as calculated above for calculating weights.

Weight of equity = 47.2%, weight of debt = 25.5%, preferred = 27.3%

WACC = 11.88%

( c) Lets do for project 1,

Initial investment = $1,000,000

Cash flow = $219,120 (for all 7 years)

R = 13.01%

T = 7 years

Put these values in NPV formula.

With market WACC , NPV = -$31,179.36

With Book value WACC, NPV = $3,868.28

We see that through market value WACC NPV is negative and with book value WACC its positive.

You can do this for each of the project separately and compare them.

( D) For project 1 IRR = 12%

IRR is calculated usind excel or hit and trial method such that PVCF is equal to its initial investment.

With market based WACC NPV and IRR gives same result i.e project is not worth taking as NPV is negative and IRR is less than WACC.

Same is with book value WACC they both give same result that project is worth taking.

At time IRR and NPV can give conflict result. In such case, the result of NPV method is taken into consideration.