Question.3275 - Problem 1: Weighted average cost of capital: Crypton Electronics has a capital structure consisting of 42% common stock and 58% debt. A debt issue of $1000 par value, 5.8% bonds that mature in 15 years and pay annual interest will sell for $976. Common stock of the firm is currently selling for $29.68 per share and the firm expects to pay a $2.18 dividend next year. Dividends have grown at the rate of 4.7% per year and are expected to continue to do so for the foreseeable future. What is Crytpon’s cost of capital where the firms tax rate is 30%? Cryptons cost of capital is ____% (round to three decimal places) Problem 2: Weighted average cost of capital: The target capital structure for Jowers Manufacturing is 47% common stock, 15% preferred stock, and 38% debt. If the cost of common equity for the firm is 19.5%, the cost of preferred stock is 11.6%, and the beforetax cost of debt is 9.3%, what is Jower’s cost of capital? The firms tax rate is 34%. Jower’s WACC is _____% (round to three decimal places) Problem 3: Prepare a response to the following problem – Firm A has $10,000 in assets entirely financed with equity. Firm B also has $10,000 in assets, but these assets are financed by $5,000 in debt (with a 10% rate of interest) and $5,000 in equity. Both firms sell 10,000 units of output at $2.50 per unit. The variable cost of production are $1, and fixed production costs are $12,000. (To ease the calculation, assume no income tax). Make sure to show all calculations and clearly mark them. a) What is the operating income (EBIT) for both firms b) What are the earnings after interest? c) If sales increase by 10% to 11,000 units, by what percentage will each firm’s earnings after interest increase? To answer the question, determine the earnings after taxes and compute the percentage increase in these earnings from the answers derived in part (b) above. d) Why are the percentage changes different? Problem 4: Assume you have an organization that is privately held but wants to expand operations. They have 3 options to choose from: Option 1: Go public through an IPO Option 2: Acquiring another organization in the same industry Option 3: Merging with another organization - Compare and contrast the options above -Make recommendations on the strengths and weaknesses of each approach -Make recommendations on the opportunities and threats of each approach -What are the effects of globalization on financial decisions for each option -What are the factors that contribute to exchange rate risks with each option -What are the mitigating exchange rate risks with each option
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Problem 1: Weighted average cost of capital: Crypton Electronics has a capital structure consisting of 42% common stock and 58% debt. A debt issue of $1000 par value, 5.8% bonds that mature in 15 years and pay annual interest will sell for $976. Common stock of the firm is currently selling for $29.68 per share and the firm expects to pay a $2.18 dividend next year. Dividends have grown at the rate of 4.7% per year and are expected to continue to do so for the foreseeable future. What is Crytpon’s cost of capital where the firms tax rate is 30%? Crypton cost of capital is 7.514% (round to three decimal places) Pre tax cost of debt is YTM (IRR) of the bond cash outflow = -976 face value 1000 maturity 15 Coupon 5.80% PMT 58 IRR(YTM) Rate(nper,PMT,PV,FV )= 6.05%% After Tax cost of debt 4.23% (6.05*.30) Cost of equity Dividend in one year/Price today +growth 0.12 Cost of equity 12.05% Source of capital Proportion of capital (a) Cost of capital (b) Total cost ( a x b) Common stock 42% 12.05% 5.059% Debt 58% 4.23% 2.455% 100% 16.279% 7.514% Crypton cost of capital 7.514% Problem 2: Weighted average cost of capital: The target capital structure for Jowers Manufacturing is 47% common stock, 15% preferred stock, and 38% debt. If the cost of common equity for the firm is 19.5%, the cost of preferred stock is 11.6%, and the beforetax cost of debt is 9.3%, what is Jower’s cost of capital? The firms tax rate is 34%. Jower’s WACC is _13.237% (round to three decimal places) Source of capital Proportion of capital (a) Cost of capital (b) Total cost ( a x b) Common stock 47% 19.50% 9.165% Preferred stock 15% 11.60% 1.740% Debt 38% 6.14% 2.332% 100% 37.24% 13.237 % Jowers WACC 13.237% Note: Before-tax cost of debt 9.30 Tax rate 34% After-tax cost of debt = 6.138% Problem 3: Prepare a response to the following problem – Firm A has $10,000 in assets entirely financed with equity. Firm B also has $10,000 in assets, but these assets are financed by $5,000 in debt (with a 10% rate of interest) and $5,000 in equity. Both firms sell 10,000 units of output at $2.50 per unit. The variable cost of production are $1, and fixed production costs are $12,000. (To ease the calculation, assume no income tax). Make sure to show all calculations and clearly mark them. a) What is the operating income (EBIT) for both firms b) What are the earnings after interest? c) If sales increase by 10% to 11,000 units, by what percentage will each firm’s earnings after interest increase? To answer the question, determine the earnings after taxes and compute the percentage increase in these earnings from the answers derived in part (b) above. d) Why are the percentage changes different? Firm A Firm B Sales 25000 25000 Variable cost 10000 10000 Fixed cost 12000 12000 Operating Ebit 3000 3000 Interest 0 500 Proft before tax 3000 2500 Sales increases by 10% Firm A Firm B Sales 27500 27500 Varibale cost 11000 11000 Fixed cost 12000 12000 Operating Ebit 4500 4500 Interest 500 Proft before tax 4500 4000 Increase 1500 1500 % increase 50% 60% The percentage changes are different because of the interest Firm B is paying on their debt interest. The debt interest is $500, regardless of the sales. This data proves which firm has a more favorable financial advantage. Problem 4: Assume you have an organization that is privately held but wants to expand operations. They have 3 options to choose from: Option 1: Go public through an IPO Option 2: Acquiring another organization in the same industry Option 3: Merging with another organization - Compare and contrast the options above -Make recommendations on the strengths and weaknesses of each approach -Make recommendations on the opportunities and threats of each approach -What are the effects of globalization on financial decisions for each option -What are the factors that contribute to exchange rate risks with each option -What are the mitigating exchange rate risks with each option Option 1: Go public through an IPO Opportunities: 1. If the Company goes public, then it can get huge amount of money as the capital. The money can be utilized for the expansion of the industrial undertaking by establishing additional industrial units to produce more quantum of finished goods which ultimately increase the sales and the profit of the Company will become high. 2.When the sales are more, the Company can achieve more share in the market and it can soon become the market leader and can dictate the price in the long run. 3. Further, because of the expansion of the unit, it can produce more goods and can achieve the economies of scale. Threats.: 1. Once the Company is listed in the stock exchange and there are numerous shareholders in the market and the directors will become accountable to those shareholders. 2.The value of the share is dependent upon the general economic condition of the country , position of financial market and the financial performance of the Company. Therefore, the external considerations influence the market value of the share. 3.The decision to go public through an IPO is a risk because the company is not known on the market and investors may be hesitant to invest their money in unknown companies. Strength In an initial public offering (IPO) the company would allow to build new business space, purchase new high-tech equipment, and hire more employees to work with more of the complex jobs. The IPO would also allow owners to gain more liquidity because public shares are more easily bought and sold. Weaknesses Access to significant capital is required to complete the IPO process The financial obligations of going public can leave less money for other business initiatives, leaving the company vulnerable until the IPO is completed Going public requires a large amount of disclosure due to SEC requirements. The outlay of information becomes a competitive disadvantage because the company can no longer make rapid changes or take competitors off guard as easily. Once the corporation goes public, there may be global effects on financial decisions because an IPO will attract investors from around the world and common stockholders would have some influence on financial decisions made within the company. Because the stock market is volatile, global economic issues can affect market prices that in turn affect stock rates by increasing or dropping without warning, thus affecting the stability of investor’s funds in a corporation. The company should also consider the instability and differences in currency and market exchange rates with other countries when considering an IPO because the stock market is open to investors globally. b. They can acquire another company in the same industry. - The Company can acquire another company in the same industry provided the company has sound financial base. Opportunities: 1.The Company can acquire the another Company in order to eliminate the competition in the market. For example, the company X is posing strict competition, then the company can acquire the firm to eliminate the competition and to become the major player in the market 2 .If the Company goes for expansion of existing manufacturing facility instead of acquisition, then all the facilities needed for manufacturing operation like plant and machinery, land and building, work force to do the job , manpower to manage the unit need to be acquired afresh. However, here all the facilities are already there and the company just paying the purchase consideration to the company can acquire those facilities. 3. It will definitely expand the share of the company in the market and there is opportunity to become market leader. 4. Further, the company can use the existing distribution facility of the company which is being acquired. Threats; 1. Because of the acquisition, the resulting company will report the financial loss in the year in which acquisition took place and the loss might continue for some years. Afterwards some years, the company can show the positive financial result. 2. The Company which is being acquired might have obsolete machinery or old machinery which might increase the cost of production by frequent repairs or the Company might be facing labor unrest. These internal problems will affect the acquiring company. 3. After acquisition, the market value of the share will decrease. Strength The strengths and weaknesses of each company get displayed for the new owners to view and grow as a greater power in the market. The get other channels of distribution and as a larger distributor they have more power with suppliers and pricing bargaining. They are able to keep smaller companies out of their marketing areas as they have a larger economic scale. They build synergies between the companies and are able to pay for acquisitions of new properties or companies with its shares and it has little or no liquidity problems. Weaknesses There may be duplication of efforts between the management and departments. When or if these departments and management positions are merged they possibility of layoffs is high and that will affect the moral of the employees. The conflicts of culture between the two cultures may be high due to the fact that they may use to be competing companies. And finally the acquiring company may have to pay a larger price to acquire the new company. The company should avoid considering pursuit of an international location due to the legal and financial risk associated with globalization. While globalization might have some financial advantages such as saving money and lowering production cost, it also runs legal risks that can jeopardize company finances such as violating child labor and other laws. c. They can merge with another organization. – Here the company can merge with another organization. Here the company will lose its identity. Opportunities: 1. The overall competition in the market will be eliminated and the combined firm will become the market leader and will dictate the price which will benefit the firms combining. 2. Both companies can reap the benefit of large production resulting in high level of economies of scale and the profitability and growth rate will be high. 3. All the existing distribution facility used by both the firms can be combined to achieve the greater result in the market. 4. By merger, the company can also explore the foreign market. 5. Merger will lead to high financial liquidity which will result in allocation of more funds for research and development which will ultimately result in high quality finished product available to the customer. Threats; 1. In the merger, the company will lose its identity. 2. All the weakness /problems of the Company will be carried over to the merged companies. 3. Since the combined firm will become the market leader, it can dictate high price which will be prejudicial to the customer. 4. Combinations of firm will result in monopoly. That is few persons will control the entire market. Strength The strength of this option is that the cost is low and legally simple. Merging the two companies bring more bargaining power with suppliers, customers and distributors. The larger the two companies become the more money they have to invest in other ventures the owners feel may be profitable. They can improve the profitability and culture of the stores by restructuring and using the strengths of each of the two stores to gain more assets and customers. Weakness The companies may be affected by anit-trust laws and become too large and monopolize the current market. The goals of each company may clash as the co-owners may differ in their approach to business scenarios, which may cause dissatisfaction between employees and they may leave the company in search of other.More Articles From Finance
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