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

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?

How much of the internal fund is available for investments?

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

Answer 1

DETAILS	BOOK VALUE	MARKET VALUE	Explanation
Long term debt	= $ 10 million	=$ 10 million + ( $ 10 million * (10% - 8%)*20) = $ 10 million + 0.20*20 = $ 14 million.	Given that it is a 30 year bond, that was purchased 10 years ago. And also, the new rate of interest will be 10%.
Preferred stock	$ 15 million	= 0.50million * $40 = $ 20 million	Given number of shares in preferred stock as per balance sheet is 0.50 million shares.
Common stock	$ 10 million	= market price e= D1 / (Ke - g) = 9.81 / (15% - 9%) = 163.50 So, market value = 163.50 * 1million = $163.50 million	Dividend per share as per given information = 8400000* 50% / 1 million = Dividend per share = $ 8.40; Growth % =9%; cost of capital = 15%; Post tax cost of capital = 15% *(1-0.40) = 9%
Common Equity	$ 25 miilion	= $ 25 million

WACC CALCULATION

PARTICULARS	BOOK VALUE (WACC)	MARKET VALUE (WACC)
Long term Debt	= 8% * 10/75 = 1.067%	= 10% * 14/222.50 = 0.629%
Preferred stock	=( 4.80 / 30) * 15/75 = 3.20%	= 16% * 20/222.50 = 1.438%
Commmon stock	= 15% * (10/75) = 2%	= 15% *163.50 / 222.50 = 11.022%
Common equity	= 15% * (25/75) = 5%	=15% * (25/222.50) = 1.685%
Total WACC	= 5+2+3.20+1.067 = 11.267%	= 0.629+1.438+11.022+1.685 = 14.774%

CALCULATION OF IRR AND NPV

PARTICULARS	Defence 1	Defence 2	Eng materials 1	Eng materials 2	Communication and Space 1	Communication and Space 2
Initial cash outflow	1000,000	2000,000	1000,000	2000,000	1000,000	1000,000
Annual cashflow	219,120	368,580	222,851	542,784	202,168	319,775
Life	7	10	8	6	9	5
Present value cumulative factor @ 15% for respectives lives	4.160	5.019	4.487	3.784	4.772	3.352
PV cumulative inflows	911,539	=360580 * 5.019 = 1,809,751	= 222,851 * 4.487 =999,932	= 542784 * 3.784 =2,053,895	= 202168 *4.772 = 964,746	= 319775 * 3.352 = 1,071,886
Net Present Value	=911539 - 1000000 =-88,461	=1809751 - 2000000 = -190249	=999,932 - 1000,000 = - 68	= 2053895 - 2000000 =53,895	=964746 - 1000000 = -35,254	=1071886 - 1000000 =71,886
NPV per year	=-88461 / 7 = 12,637	= -190249 / 10 = 19,025	= -68 / 8 = -8.50	= 53895 / 6 = 8,983	=-35254 / 9 = -3,917	=71886 / 5 = 14,377
IRR	12%	13%	15%	16%	14%	18%