Question

CARMEN CORPORATION

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

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

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

C) 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.

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

E) Which projects should Carmen accept?

F) How much of the internal fund is available for investments?

G) Are there any issues about the projects you should consider before your recommendation?

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%.

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

J) 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

(A) Let us first determine the market value of the different instruments

i. Equity

Market value of Equity with perpetual growth is given by the formula:

D₁/(K_e-g)

Where,

D₁ is the Expected Dividends next year

K_e is the cost of equity or the required rate of return i.e. 15%

g is the growth rate i.e. 9%

In the given example, we shall first need to calculate the expected dividends next year

Hence, D₁ = 3000000*(1+0.09) = 3270000

Hence, market value of equity = 54500000

ii. Market Value of preference shares = Price per share*No of shares = 40*500000 = 20000000

iii. Market Value of debt

We need to compute the present value of the cash flows discounted at 10% with 20 years to maturity and coupon rate of 8%

Thus, we can create the following table for the book values and market values of the instruments:

B) We determine the weighted average cost of capital for each project by the following table:

c) We compute IRR by Equating the present value of the cash outflows with the present value of the cash inflows. I suggest you do it using Excel IRR function since it is more convenient.

Lets compare the above IRRs with the book value WACC:

As we can clearly see, both the defense projects are rejected since they are lower than WACC. The company can accept all the other projects.

Comparing now with Market value WACC

Again, both the defense projects gets rejected and all others get accepted.

d) Let us now rank the projects on the basis of the IRR and market value WACC

Rankings on the basis of IRR and market value weights

As can be seen from the above, there are conflicts in ranking on the basis of IRR and NPV. The conflicts in ranking can be resolved by any of the two methods:

i. In case of no capital shortages, accept the projects with the maximum NPV since our aim is to maximise shareholder’s wealth

ii. In case of capital shortage, we calculate the Profitability Index i.e. Present value of cash inflows per rupee of cash outflows and then rank the projects accordingly. Accept the project with the highest PIs till your capital is exhausted.

Hope it answers your queries. Kindly get in touch and post your feedbacks/comments if any.