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

Book Value = Asset – Liabilities = 55000000 – 25000000 = $30000000

Calculation of Common Stock Price:

Preferential dividend payment = 4.8 * 0.5 million = $2.4 million

Profit available to common shareholders = (8.4 – 2.4) million = $6 million

Dividend paid to common shareholders = Dividend payout ratio * Profit available to common shareholders = 0.5 * 6 million = $3 million

Per share dividend paid = 3 / 1 = $3

The dividend is expected to grow at 9% perpetually.

Hence the market price of common stock = 3 / 0.09 = $33.33

Market Value = Stock Price * No. of shares = 33.33 * 1000000 = $33330000

Weighted Average Cost of Capital = Weight of Debt * Cost of Debt + Weight of Equity * Cost of Equity + Weight of Preferential Shares * Cost of Preferential Shares

                                                 = 0.2 * 10% * (1 – 40%) + 0.5 * 15% + 0.3 * 12% = 12.3%

If we go by NPV, then Project: Engg. Materials 2 is lucrative but as per IRR, Project: Communication and Space 2 is the best choice.

To resolve the conflict, another measure known as Profitability Index (PI) should be used.

Hence as per PI, Project: Communication and Space 2 should be selected.

Total Internal fund available for investments = Retained earnings + Earnings after paying off dividends

                                                                                = (15 + 3) = $18 million

After doing the financial analysis, one should also do the non-financial risk analysis. Maybe project: Communication and Space 2 looks lucrative but there may be chances that the risk associated with this project is very high. Hence we would be better off with less risky and highly profitable projects.