FIN 6130
Graduate School of Management (GSM)
Case 1 - Due on July 19, 2011
Cost of Capital and Capital Budgeting
Perry Shoes, Inc. is considering two alternative investment proposals. The first proposal calls for investment in plant and equipment to produce a new line of footwear. The second proposal calls for investment in plant and equipment to expand a current, successful line of footwear. The company will choose one project or the other this year, but it will not invest in both.
Year | New Line | Expand Line | |
0 1 2 3 4 5 | ($18,000,000) $5,500,000 $5,500,000 $5,500,000 $5,500,000 $5,500,000 | ($10,000,000) $5,500,000 $5,000,000 $4,000,000 $0 $0 | |
Use the information provided below to calculate Perry Shoes’ weighted average cost of capital (WACC) to evaluate these two proposals. The following questions are asked to provide a guide for your analysis.
The WACC can be estimated based on Perry Shoes’ long-term (capital) financing sources, including the use of retained earnings, and the use of proceeds from new issues of corporate bonds, preferred stock, and common stock. Issuance costs (flotation costs) for new issues are 2% for new issues of corporate bonds, 4% for new issues of preferred stock, and 20% for new issue of common stock. Perry Shoes’ target capital structure is 25% debt, 15% preferred stock, and 60% equity. Perry Shoes’ marginal tax rate is 28%. Perry Shoes has $12,600,000 million in retained earnings.
Corporate Bonds
Perry Shoes can sell 9½% coupon, 30- year bonds (coupons are paid semi-annually) for $934.84. Perry Shoes can issue an unlimited amount of new bonds at the same rate.
The risk premium for Perry Shoes’ common stock is estimated to be 4% above its bond yield and is based on other companies in Perry Shoes’ risk category.
Preferred Stock
Perry Shoes’ preferred stock sells for $30.50 per share, the dividend rate is 7%, and the par value of this preferred stock is $50.
Common Stock
Perry Shoes' common stock sells for $22.43 per share, the growth rate is 6%, and Perry Shoes just paid a dividend for last year in the amount of $1.56 (D0 = $1.56).
Perry Shoes’ common stock has a beta of 1.35. For the general marketplace the risk-free rate is 4 percent (Rf = 4%) and the average rate of return on the market is expected to be 12 percent per year (Rm = 12%).
1. What is Perry Shoes’ after-tax cost of a new issue of debt?
PV - F = -$934.84 - 2%*934.34= -$916.1432
Pmt = 9.5 % * $1,000 = $47.5
2
n = 30 * 2 = 60
FV = $1000
$916.1432 = 47.5/rd(1-(1/(1+rd)60)+1,000/(1+rd)60
rdBT = 5.2086 % * 2 = 10.4171 %
rdAT = rdBT * (1-Tax)
= 10.4171 % (1- 28 %)
= 7.5003 %
2. What is Perry Shoes’ cost of a new issue of preferred stock?
rps = D = 7 % * 50 = 3.5 = 11.95 %
P0-F 30.50-(4%*30.50) 29.28
3. What is Perry Shoes’ cost of retained earnings [using the Discounted Cash Flow (DCF) Method]?
rs = D1 + g = D0 (1 + g ) + g = 1.56 (1+ 6 %) + 6 % = 7.37 % + 6 % = 13.37 %
P0 P0 22.43
4. What is Perry Shoes’ cost of retained earnings [based on the Capital Asset Pricing Model (CAPM)]?
r s = rRf + b(rM- rRf) = 4 % + 1.35 (12 % - 4 %) = 14.8 %
5. What is Perry Shoes’ cost of retained earnings [based on its bond yield plus risk premium]?
rs = rdBT + RP = 10.4171 % + 4 % = 14.4171 %
6. What is Perry Shoes’ cost of a new issue of common stock [using the Discounted Cash Flow (DCF) Method]?
rs = D1 + g = 1.56 (1+6 %) + 6 % = 1.6536 + 6 % = 15.22 %
P0- F 22.43- (20% x 22.43) 17.944
7. What is Perry Shoes’ weighted average cost of capital based on the cheapest combination of sources of capital (WACC1) (i.e. corporate bonds, preferred stock, and retained earnings)?
WACC1 = Wd * rdAT + Wps * rps + We * re
= 25 % * 7.50 % + 15 % *11.95 % + 60 % * 13.37 %
= 0.116
= 11.6095 %
8. How much will Perry Shoes have to invest at this rate (what is the breakpoint)?
BP = Retained earning/Weight of common stock = $12,600,000/0.6 = $21,000,000
9. What is Perry Shoes’ weighted average cost of capital based on the more expensive combination of sources of capital (WACC2) (i.e. corporate bonds, preferred stock, and a new issue of common stock)? For the cost of a new issue of common stock use the estimate from the Discounted Cash Flow (DCF) model.
WACC2 = Wd* rdAT+ Wps * rps + We * re
= 25 % * 7.05 % + 15 % *11.95 % + 60 % * 15.22 %
= 12.7996 %
10. Calculate the payback period (PB) of each project and based on this criteria for which project would you recommend acceptance?
Year | New Line | Accumulated Cash flows | Expand Line | Accumulated Cash flows |
0 1 2 3 4 5 | ($18,000,000) $5,500,000 $5,500,000 $5,500,000 $5,500,000 $5,500,000 | ($18,000,000) ($12,500,000) ($7,000,000) ($1,500,000) $4,000,000 $9,500,000 | ($10,000,000) $5,500,000 $5,000,000 $4,000,000 $0 $0 | ($10,000,000) ($4,500,000) $500,000 $4,500,000 $4,500,000 $4,500,000 |
The payback period for new line = 3 + ($1,500,000) = 3 + 0.27 = 3.27 years
$5,500,000
The payback period for expand line = 1+ ($4,500,000) = 1 + 0.9 = 1.9 years
$5,000,000
We select expand line because it’s shorter payback period
11. Calculate the discounted payback period (DPB) of each project and based on this criteria for which project would you recommend acceptance (use WACC1 as the discount rate)?
Year | New Line | Accumulated Cash flows | Expand Line | Accumulated Cash flows |
0 1 2 3 4 5 | ($18,000,000) $5,500,000 (1+11.6896 %)1 $5,500,000 (1+11.6896 %)2 $5,500,000 (1+11.6896 %)3 $5,500,000 (1+11.6896 %)4 $5,500,000 (1+11.6896 %)5 | ($18,000,000) $4,924,361.803 $4,408,970.757 $3,947,521.306 $3,534,367.843 $3,164,455.637 | ($10,000,000) $5,500,000 (1+11.6896 %)1 $5,000,000 (1+11.6896 %)2 $4,000,000 (1+11.6896 %)3 $0 $0 | ($10,000,000) $4,924,361.803 $4,008,155.234 $2,870,924.587 0 0 |
For the new line the discounted payback period = 4 + ($1,184,778.291) = 4 + 0.37 = 4.37 years
$3,164,455.637
For the expand line the discounted payback period = 2 + ($1,067,482.963) =2 + 0.37 = 2.37 years
$2,870,924.587
We select expand line because it is shorter return DPB
12. Calculate the net present value (NPV) of each project and based on this criteria for which project would you recommend acceptance (use WACC1 as the discount rate)?
Net present value (NPV) of each project
New Line | Expand Line | ||
Year 0 | ($18,000,000.00) | ($10,000,000.00) | |
PV Year 1 | $4,924,361.80 | $4,924,361.80 | |
PV Year 2 | $4,408,970.76 | $4,008,155.23 | |
PV Year 3 | $3,947,521.31 | $2,870,924.59 | |
PV Year 4 | $3,534,367.84 | $0.00 | |
PV Year 5 | $3,164,455.64 | $0.00 | |
NPV | $1,979,677.35 | $1,803,441.62 | |
Therefore, we select new line because it is higher NPV
13. Calculate the profitability index (PI) of each project and based on this criteria for which project would you recommend acceptance (use WACC1 as the discount rate)?
New Line | Expand Line | |
PV Year 1 | $4,924,361.80 | $4,924,361.80 |
PV Year 2 | $4,408,970.76 | $4,008,155.23 |
PV Year 3 | $3,947,521.31 | $2,870,924.59 |
PV Year 4 | $3,534,367.84 | $0.00 |
PV Year 5 | $3,164,455.64 | $0.00 |
PV in flow | $19,979,677.35 | $11,803,441.62 |
PV out flow | $18,000,000.00 | $10,000,000.00 |
PI | 1.11 | 1.18 |
14. Calculate the internal rate of return (IRR) of each project and based on this criteria for which project would you recommend acceptance?
New Line 0= -18,000,000+5,500,000/(1+IRR)1+ 5,500,000/(1+IRR)2+5,500,000/(1+IRR)3+5,500,000/(1+IRR)4+5,500,000/(1+IRR)5
IRR=16.0205%
Expand Line 0= -10,000,000+5,500,000/(1+IRR)1+ 5,000,000/(1+IRR)2+4,000,000/(1+IRR)3+0/(1+IRR)4+0/(1+IRR)5
IRR=22.4841%
Therefore, we select expand line because it is higher IRR
15. Calculate the modified internal rate of return (MIRR) of each project and based on this criteria for which project would you recommend acceptance (use WACC1 as the discount rate)?
New Line | Expand Line | |
FV Year 1 | $8,558,814.86 | $8,558,814.86 |
FV Year 2 | $7,663,036.54 | $6,966,396.85 |
FV Year 3 | $6,861,011.71 | $4,989,826.70 |
FV Year 4 | $6,142,928.00 | $0.00 |
FV Year 5 | $5,500,000.00 | $0.00 |
Total FV | $34,725,791.10 | $20,515,038.41 |
PV(YR0) | $18,000,000.00 | $10,000,000.00 |
MIRR | 14.0449% | 15.4555% |
16. Overall, you should find conflicting recommendations based on the various criteria. Why is this occurring?
Projects | PB | DPB | NPV | PI | IRR | MIRR |
New Line | 3.27 | 4.37 | $1,979,677.35 | 1.11 | 16.0205% | 14.0449% |
Expand Line | 1.90 | 2.37 | $1,803,441.62 | 1.18 | 22.4841% | 15.4555% |
We select the shaded figures because the PB and DPB lower, the better (return sooner). On the other hand, NPV, PI, IRR, MIRR are higher which are better.
17. Chart the NPV profiles of these projects. Label the intersection points on the X and Y axis and the crossover point.
Find for X-intersection
NPV = 0 | WACC |
New Line | 16.02% |
Expand Line | 22.48% |
Find for Y-intersection
WACC | NPV New Line | NPV Expand Line |
0% | $9,500,000 | $4,500,000 |
Select New Line when WACC is less than 12.28%
Select Expand Line when WACC is greater than 12.28%
18. Based on this NPV profile analysis and assuming the WACC based on the cheapest combination of capital sources (WACC1), which project is recommended? Why?
WACC1 = 11.6896 % which is less than 12.28% we can accept both but the company will choose only one project. Hence, project New Line is higher NPV than Expand Line so we can select New Line.
19. Based on this NPV profile analysis and assuming the WACC based on the more expensive combination of capital sources (WACC2) , which project is recommended? Why?
WACC2 = 12.7996 % which is more than 12.28% we can accept both but the company will choose only one project. Hence, project Expand Line has higher NPV, we select it.
Question 1
How does Bill’s Hardware compare to other firms in its industry?
Bill’s Hardware has much superiority as compare to other firms which is also running the same business. Strategy location is one of many advantages that Bill’s Hardware has. It located in Needles, California that it was a true value hardware store. This location has given many benefits for that company like there was the national advertising, which provided the store with name recognition for both in town and out of town hardware purchases. I t also got an offering from an affiliation to take the opportunity to purchase merchandise at “ National buying power” as well as the chance to find counsel from the hardware business experts at True Value. These conditions have been influenced Bill’s company to growth rapidly and make it being the major hardware store in town.
Other than that, Bill is cunning to graph the chance of business by making the building center, serving as a small lumberyard and source for all kinds of hardware items; a yard and garden store; and a variety store. Therefore, no wonder if Bill’s Hardware Company never seemed to be any money left at the end of the month.
Question 2
Why does Bill need to borrow in order to support this profitable business? You will probably find a statement of cash flows (Direct Method, starting with cash from customers not net income) useful in completing this analysis.
The cash flow of Bill’s Hardware is showing in positive amount. It indicates that the company is in well operation and it will be giving information to the investor about the operation of the company whether it runs well or not. It also shows where the money from and for what the money being spent. From this cash flow we can see clearly that cash flow for the year 1998 was $ 1,407,655. The bulk of the positive cash flow stems from cash earned from operations, which is a good sign for investors. It means that core operations are generating business. However, this amount of money is not enough to support the projected sales of Bill’s company in 1999. Whereas, the company need to borrow some money in order to support that profitable business.
Question 3
What amount of money will Bill need to grow his business to hardware sales of $ 1.4 million in 1999? Consider using a percent of sales growth using 1998 as a baseline.
Based on the explanation above, the projected sales growth is (sales 1999- sales 1998) which is $ 1,400,000 - $ 1,160,567 = $ 239,433. Through the forecasting of sales in 1998, which is the increasing sales from 1997 to 1998 is 4.96%. This percentage will be using in calculating the forecasting of sales in 2009. Hence, the sales in 1999 normally will be $ 1,160,567 + ($ 1,160,567 x 4.96%) = $1,218,131. However, the company wish to reach $1.400.000 in sales so in order to make the dreams come true the company has to add sum of money in fulfilling it. Bill needs $1.400.000 - $ 1,218,131= $ 181,869. This is the amount of money that Bill needs to grow his business to hardware sales of $ 1.4 Million in 1999.
Question 4
The bank office suggested some operating items that Bill might not be taking advantage of. Should Bill consider these operations? How much new financing will they require? How profitable will they be?
Before making the decision, Bill should be analyzing many possibilities below
a. In getting new loan : Bill must be finishing its obligation to the California National Bank in year 1998 which is $ 15,527.
Bill’s current payable period = 
= Account payables + Not Payable
Cost of goods sold + increasing in inventory
Cost of goods sold + increasing in inventory
= 
= 111.57 days
b. Let say Bill does not take the advantage of some operating items, the expected payables at the end of 2009 will be.
Expected payable 2009 = 
= 
= $ 254, 121
c. If Bill’s is taking the discount which is 2%/10 net 30 days.
If Bill is taking the discount, Bill has to pay down its payable. It has to pay down its payable within 10 days; it means it has to be settling the 101.58 days worth of payables. Below is the amount should be settled by Bill.
= 
= $ 231,502
Actually, how worth is the discount for the Bill’s hardware company. Percentage of the discount is 7.33%. It is getting from this formula.
Percentage =
x 
x = (2/98) X (365/111.58-10)
= 7.33%
Based on the analysis above, Bill should reject the options that Bank has given to him by not taking the bank option which is not taking the discount. Taking the discount itself will give more beneficial for the company. The discount can lead the cost of goods sold being lower while the capacity and the cost is constant. Hence, it will be turning to increase the profit of the Bill’s hardware. Bill should not be worry of losing the bank which is willing to finance the company because Bill has a good reputation or goodwill so others bank will be coming to him which both side can take the benefit fairly.
Question 5
What else might Bill consider in the event he is unable to raise all the money he needs from the bank?Bill’s Hardware unable to get money from the bank he has to follow some strategy
Sort-term
1. Make it delay payment to account payable.
2. As soon as possible collect the money from account receivable
by giving cash discount.3. Getting delay to pay account payable balance.
Long-term1. Issue ordinary common shares.
2. Issue preference shares.
3. Issue bond.
If you follow either one you can get money and continue your business.
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