Question

Please solve this case in Excel，Many thanks!

The Problem:

You are the technology controller for a mid-sized publicly traded company. You have been assigned to evaluate an investment in a new process that would cost $2.5 million. You have determined that the internal rate of return of the positive operating cash flows associated with the investment is 13.0%.

On a market value basis, the firm's capital structure is as follows:

Debt: 40%; Preferred Stock: 5%; Common equity: 55%;

This capital structure is in line with the peer group industry average, and management has no appetite for altering the existing ratios, which they consider to be optimal.

Your firm’s current stock prices are $95 per share for common equity and $60 per share for 9% $100 par value cumulative preferred stock. The 2018 common dividend was $10 per share, and the company has increased this dividend by 5% per year for the past ten years. The company also has $1,000 par value 10% coupon bonds outstanding, with a remaining maturity of ten years. The bonds are currently trading at 87.5% of par value. The capital markets are very receptive to the company's bonds and preferred common equity, all of which are actively traded both regionally and nationally.

In addition to this, you determine that the 20-year average yield on 10-year US Treasury obligations is 5% and that the market risk premium is 7%. Your firm's common equity has been given a beta of 1.65. The firm's effective rate of income tax is 25%.

In organizing financing for the proposed project, you have approached your firm's bank. The bank has agreed to a limited amount of long-term secured financing to a maximum of $ 600,000, at 6%. The bank would be willing to supply an additional $ 400,000 of long-term funds on an unsecured basis, at a rate of 15%, as an alternative to a bond issue. Based upon the company's conservative retention policy and healthy cash reserves, you are confident that it could fund up to $1.5 million of the proposed investment with internally generated retained earnings.

Based upon the information provided above, come up with a funding plan for the proposed investment and make a recommendation as to its suitability from a financial standpoint.

Answer 1

Hello

In this Question their is total fund requirement of $ 2.5 Million

Out of which $ 1.5 Million is arranged from internal sources or surplus cash wit company

and for the rest $ 1 Million company has two alternatives which are as below

1- Arrange fund from market in proportion to this Debt: 40%; Preferred Stock: 5%; Common equity: 55%

OR

2- From Banker 600,000 and 400,000

let analyse both of them

1)

Ke(cost of equity) = 5+1.65(7)= 16.55%

Kp(cost of Preferred Stock) = 9%

Effective cost of Bond = 10%(1-.25)= 7.5%

but here bonds are traded at value 87.5% of par so their will be 40% of bond of total $10,00,000

so value of bond comes to $ 400000

which will be from issue of 400000/87.5%= 457143 value bonds

WACC= 16.55*.55+9*.05+7.5*4.57= 12.98%

2)

Effective Cost from other option will be

Secured = 6(1-.25)=4.5%

Unsecured =15(1-.25)= 11.25%

WACC= 4.5*.6+11.25*.4=7.2%

It is viable to company for arrangement of funds from banker's option because it saves a lot in terms of cost and generate good return