5. Note that all of your calculations are done as of the summer of 2004; yet, actions such asselling securities and investing in assets will occur during 2005. What would happen if (a)more or fewer "good" projects are actually available than Miller now anticipated, or (b)conditions in the capital markets change so as to raise or lower your MCC curve? How shouldthe company react to such changes? That is, what instructions should corporate headquarters issue to the operating personnel charged with acquiring assets if and when actual conditions differ from those expected during the budgeting period?

*JUST NEED THE ANSWER TO PROBLEM #5*

Wyler's Cuisine Case - Team #_____ NAMES: _____________________________ 1. Determine Wyler's Cuisine's existing market value capital structure, disregarding the minor amount of accounts payable, which constitute "free" capital. Also, lump notes payable in with long-term debt. Round to the nearest percentage point. 2. Assuming that Wyler's Cuisine maintains this optimum market-value capital structure, calculate the breaking points in the MCC schedule. Recall that the company is projecting $31.25 million of earnings available to common and a 60 percent dividend payout ratio. 3. Now calculate MCC = Ka in the interval between each of the breaking points, and graph the MCC schedule in its step-function form. In your calculations, use 60 percent of estimated 2004 earnings per share as your value of D1, and use the current price as P0. To reduce calculations, you may take as given Ka = 9.4 percent in the first interval, K a = 9.9 percent in the second interval, and Ka = 13.2 percent in the last interval. Note: the marginal tax rate is 48 percent. 4, Estimate to the closest whole percentage point the missing internal rates of return in Exhibit 3, and then use the information developed thus far in the case to decide which projects should be accepted and which should be rejected. Illustrate your solution technique with a graph, and conclude your answer to this question with a discussion of the accept-reject decision on the marginal project. 5. Note that all of your calculations are done as of the summer of 2004; yet, actions such as selling securities and investing in assets will occur during 2005. What would happen if (a) more or fewer "good" projects are actually available than Miller now anticipated, or (b) conditions in the capital markets change so as to raise or lower your MCC curve? How should the company react to such changes? That is, what instructions should corporate headquarters issue to the operating personnel charged with acquiring assets if and when actual conditions differ from those expected during the budgeting period? 6. Do you think Miller is likely to be more confident about his ex ante (or estimated) MCC or his ex ante IOS schedule? Explain. 7. Are any assumptions implicit in your analysis to this point about the riskiness of the various projects with respect to:(a) each other; and (b) the firm's existing assets? If these assumptions are not valid, can you indicate how the analysis could be modified? WYLER'S CUISINE Wyler's Cuisine is a leading restaurant chain with outlets throughout the western coast of the United States. It serves low calorie food in cafeteria style, on either an eat-in or take-out basis. Fast service is maintained by having a limited menu, an efficient restaurant layout, and an assembly line "production" of each menu item. Wyler's Cuisine has captured a substantial percentage of the fast food market through its emphasis on the fact that food does not necessarily have to be fattening or unhealthy. Wyler's Cuisine was started as a small, family owned, stand-up lunch counter in an indoor shopping mall in Sacramento, California. Its popularity grew, and operations were soon expanded throughout Northern California. As the large potential market became apparent, Wyler's Cuisine acquired a professional corporate staff to fulfill increasingly sophisticated needs in the area of finance, operations, and general management. The success of Wyler's Cuisine was due in large part to the hard work and foresight of the founder, Kenneth Wyler, and his policy of hiring only competent employees, paying them well, and demanding first-rate performance. Wyler's Cuisine was operated as a closely held, family-owned corporation until 1995, when Kenneth Wyler sold approximately 20 percent of the outstanding stock to the public. Since this original public offering, members of the family have disposed of an additional 50 percent of the stock. In 2004, outsiders owned 70 percent of the shares, while 30 percent of the shares were still held by the Wyler family. Members of the Wyler family managed the firm until 2004, when Kenneth Wyler retired from active participation. Since no other member of the family was interested in or qualified to assume a dominant role in management, Karen Wilson, who was then a senior vice-president of another leading fast food chain, was brought in as president and chief executive officer. Wilson considered the Wyler management team--people in operations, marketing, personnel, and so on--excellent, so she did not institute any major personnel changes upon her takeover. But she did bring in Sam Miller, a 28-yearold M.B.A., who had been her assistant at her previous company. Miller's primary responsibility was to seek out weaknesses in Wyler's Cuisine's operations and then devise methods for correcting them. One of the first things Miller noticed was the rather haphazard manner in which capital investment decisions were reached. For the most part, capital budgeting decisions seemed to be made by David Campbell, financial vice-president, without any systematic analysis. Apparently, Campbell simply approved all requests for capital expenditures as the different district managers made them based on the district's return on investment (ROI). Campbell periodically reviewed the rate of return on investment in the different districts, and if the ROI for a given district was seriously below that of the firm as a whole, the district manager was notified that his/her results were below average. As a result of this procedure, managers with a below-standard ROI tended not to make substantial requests for expansion funds until their district's ROI was brought up to the average for the firm. It was apparent to Miller that this informal procedure tended to cause available funds to be allocated to districts with the highest return on investment. He also noted that during years when expansion had been more rapid than normal, such as 2000 and 2001, Campbell had requested information on the payback period for the larger capital expenditure proposals. He had rejected several proposals on the grounds that (1) the firm was short of funds for additional capital expenditures, and (2) the paybacks on the rejected projects were relatively long compared to those on certain other alternatives. In early 2004 Miller wrote a memorandum to president Wilson, sending copies to the other 1 major executives of the firm (the executive committee), in which he suggested that the capital budgeting process be formalized. Specifically, Miller recommended that the firm adopt the net present value approach, under which projects would first be ranked in accordance with their net present values, and then all projects with positive net present values would be accepted. Wilson enthusiastically endorsed the proposal, but Miller detected a certain amount of skepticism about it on the part of the other senior officers, especially Campbell. Although Campbell seemed to endorse the principle of using a net present value approach to making capital budgeting decisions, he was uncertain about the firm's ability to find an appropriate discount rate, or cost of capital, to use in the capital budgeting process. Nevertheless, in May 2004 Miller was directed by the executive committee to develop a cost of capital for the firm to use in evaluating 2005 capital investment projects. As a first step in this task, he obtained the projected December 31, 2004 balance sheet (Exhibit 1) as well as information on sales and earnings for the past ten years (Exhibit 2). In addition, Miller had discussions with several investment bankers and security analysts for major brokerage firms to learn something about investor expectations for the company and the costs that would be incurred by the firm if it attempted to obtain additional outside capital. Miller received the impression from the security analysts that investors do not expect Wyler's Cuisine to continue to enjoy the same rate of growth it has had for the past ten years. If fact, most of the analysts seem to be estimating the company's future growth to be only one half the rate experienced during the last decade. The analysts, however, do expect the firm to continue paying out about 60 percent of the earnings available to common in the form of cash dividends. At the last annual meeting, Wilson had in fact announced that the policy of paying out at least 60 percent of earnings would be maintained. Wilson also stated that if expansion needs did not meet the required 40 percent retention rate, the payout ratio would be increased. The current yield on the ten-year Treasury bond is 4.75% and analysts' expectations with respect to the equity market yielded a market risk premium (MRP) of 6.50. The beta for Wyler's Cuisine' stock is 1.25. After a careful analysis of the existing financial structure, Miller determined that the mix of debt, common stock, and preferred stock that was optimum (i.e., produced the lowest average cost of capital) was one that the company presently employed. The proportions of this mix had been relatively stable over the past five years, and they were used to construct the projected December 31, 2004 balance sheet. Miller also asked the investment banks and Wyler's Cuisine's commercial bankers what the firm's cost of various types of capital would be, assuming that the present capital structure is maintained. His study yielded the following conclusions: Debt Up to and including $4 million of new debt, the company can use loans and commercial paper, both of which currently have an interest rate of 10 percent. From $4.01 to $10.0 million of new debt, the company can issue mortgage bonds with an Aa rating and an interest cost to the company of 12 percent on this increment of debt. From $10.1 to $14.0 million of new debt, the company can issue subordinated debentures with a Baa rating that would carry an interest rate of 13 percent on this increment of debt. Over $14 million of new debt would require the company to issue subordinated convertible debentures. The after-tax cost of these convertibles to the company is estimated to be 11 percent on this increment of debt. 2 Preferred The company's preferred stock, which has no maturity since it is a perpetual issue, pays a $9 annual dividend on its $100 par value and is currently selling at par. Additional preferred stock in the amount of $2 million can be sold to provide investors with the same yield as is available on the current preferred stock, but flotation costs would amount to $4 per share. If the company were to sell a preferred stock issue paying a $9 annual dividend, investors would pay $100 per share, the flotation costs would be $4 per share, and the company would net $96 per share. From $2.1 to 3.0 million of preferred stock, the after-tax, after-flotation cost would be 10.5 percent for this increment of preferred stock. For over $3 million of preferred stock, the after-tax, after-flotation cost would be 13 percent for this increment. Common Up to $2.5 million of new common can be sold at the current price, $24 per share, less a $3 per share flotation cost. Over $2.5 million of new common stock can be sold at $24 per share, less a $5 per share flotation cost. ______________________________________________________________________________ EXHIBIT 1 Balance Sheet ______________________________________________________________________________ Projection for December 31, 2004 (Millions of Dollars) Cash & marketable securities Accounts receivable Inventories Total current assets $ 19 94 120 $ 233 1 Account payable Bank notes payable (9%) Total current liabilities $ 8 80 $ 88 2 Long-term debt $120 3 Preferred stock 45 4 Common stock 55 Net fixed assets $172 Retained earnings 97 Total assets $405 Total Liabil. & Equity $405 ______________________________________________________________________________ 1 Accounts payable are exceptionally low because the firm follows the practice of paying cash on delivery in return for substantial purchase discounts. 2 The bonds outstanding have a par value of $1,000, a remaining life of 15 years, and a coupon rate of 9 percent. The current rate of interest for bonds with Wyler's Cuisine's rating is 10 percent per year. The bonds pay annual interest. 3 The preferred stock currently sells at its par value of $100 per share. 4 There are 10 million shares out standing and the stock currently sells at a price of $24 per share. ______________________________________________________________________________ President Wilson asked Miller to estimate the company's investment opportunity schedule and to interface this schedule with the cost of capital schedule to give the board of directors an idea of the amount of funds likely to be required during the 2005 budget year. After thinking about how he would 3 develop the investment opportunity schedule, Miller concluded that the best approach would be to ask the operating officers to estimate the number of capital projects that would have positive net present values at various cost of capital hurdle rates. However, given the current state of knowledge in the company, Miller recognized that it would be impossible for the division heads and district managers to respond meaningfully to this request. Accordingly, he decided to investigate, on a case study basis, only major projects, and to do this on a face-to-face basis with each division and district manager. ______________________________________________________________________________ EXHIBIT 2 Sales and Earnings ______________________________________________________________________________ Earnings After Earnings Taxes Available to Per Share of Sales Common Stock Common Stock 1 Year (millions) (millions) ______________________________________________________________________________ 2004 (Est.) $1,152 $31.25 $ 3.13 2003 959 28.80 2.88 2002 848 25.40 2.54 2001 800 24.88 2.49 2000 716 21.46 2.15 1999 668 20.04 2.00 1998 608 18.24 1.82 1997 560 16.80 1.68 1996 524 15.77 1.58 1995 476 14.76 1.48 1994 413 12.00 1.20 ______________________________________________________________________________ 1 The firm's marginal tax rate is 48 percent. ______________________________________________________________________________ Miller, therefore, went to each operating manager and explained what he wanted to accomplish. Each manager indicated to Miller the major projects under consideration by the division or district and the estimated costs and cash flows that would result if these projects were implemented. Miller also requested information on minor projects (relatively small replacement decisions and the like) and concluded that their total was so small that they could be ignored without seriously affecting his results. The major projects, together with their costs and estimated annual cash flows, are shown in Exhibit 3. Note the projects are not divisible; each must be accepted or rejected in its entirety. To aid Miller in preparing his report, you are asked to answer the following questions. Questions: 1. Determine Wyler's Cuisine's existing market value capital structure, disregarding the minor amount of accounts payable, which constitute "free" capital. Also, lump notes payable in with long-term debt. Round to the nearest percentage point. 2. Assuming that Wyler's Cuisine maintains this optimum market-value capital structure, calculate the breaking points in the MCC schedule. Recall that the company is projecting $31.25 million of earnings available to common and a 60 percent dividend payout ratio. 4 3. Now calculate MCC = Ka in the interval between each of the breaking points, and graph the MCC schedule in its step-function form. In your calculations, use 60 percent of estimated 2004 earnings per share as your value of D1, and use the current price as P0. To reduce calculations, you may take as given Ka = 9.4 percent in the first interval, Ka = 9.9 percent in the second interval, and Ka = 13.2 percent in the last interval. Note: the marginal tax rate is 48 percent. ______________________________________________________________________________ EXHIBIT 3 Investment Opportunities (Millions of Dollars) ______________________________________________________________________________ Estimated Project Cost of Estimated Annual Estimated Internal Rate of Identification Project Cash Inflows Life (Years) Return on Project ______________________________________________________________________________ A $ 7.0 $1.03 15 12% B 4.0 0.81 9 ____ C 5.0 1.05 6 7% D 10.0 1.54 12 ____ E 9.0 2.00 10 18% F 3.0 0.60 10 15% G 4.0 0.95 5 6% H 6.0 1.13 8 ____ ______________________________________________________________________________ Note: These projects are indivisible in the sense that each must be accepted or rejected in its entirety; that is, no partial projects may be taken on. ______________________________________________________________________________ 4. 5. 6. 7. Estimate to the closest whole percentage point the missing internal rates of return in Exhibit 3, and then use the information developed thus far in the case to decide which projects should be accepted and which should be rejected. Illustrate your solution technique with a graph, and conclude your answer to this question with a discussion of the accept-reject decision on the marginal project. Note that all of your calculations are done as of the summer of 2004; yet, actions such as selling securities and investing in assets will occur during 2005. What would happen if (a) more or fewer "good" projects are actually available than Miller now anticipated, or (b) conditions in the capital markets change so as to raise or lower your MCC curve? How should the company react to such changes? That is, what instructions should corporate headquarters issue to the operating personnel charged with acquiring assets if and when actual conditions differ from those expected during the budgeting period? Do you think Miller is likely to be more confident about his ex ante (or estimated) MCC or his ex ante IOS schedule? Explain. Are any assumptions implicit in your analysis to this point about the riskiness of the various projects with respect to: (a) each other; and (b) the firm's existing assets? If these assumptions are not valid, can you indicate how the analysis could be modified? 5