534_5_2_Joe-1: Hello, everyone. It has been awhile since we have seen each other! Long time no see everyone. My job has me out of the office more than usual, but I wanted to stop by and congratulate you on some fabulous work so far. You have been asked to do a lot of calculating as part of our financial analysis regarding our current state at TFC and the expansion project. I can see that your Strayer University education is paying off. They are really preparing you for making informed business decisions. FIN534_5_2_Joe-2: I brought some snacks and refreshments; help yourself. They are in the break-room. At TFC we encourage our employees to work out but that does not mean you cannot have some snacks. It just means you will have to work out a little more at the gym later. (laughter) FIN534_5_2_Joe-3: Well, I have to go. I have a busy day - full of meetings, but before I leave I would like you to continue your financial analysis. First, I would like you to do some research on financial options as we may be interested in using some of our cash to invest in those financial vehicles. Secondly, I would like you to determine our WACC, or weighted average cost of capital. Good luck and Im excited to see the reports on my desk. FIN534_5_2_Joe-4: Have a great day! You are the best financial team in the world! FIN534_5_3_Don-1: Joe is the most energetic and positive-minded CEO on the planet. He gave us some tall orders but, I am confident you and Linda will complete them with the highest standards. FIN534_5_3_Linda-1: Yes Don, we will. Our first task is to review what our financial options are in case we want to go down that investment road in the future. I have always learned that the more you are prepared ahead of time, the better the decision making is. FIN534_5_3_Don-2: I agree, Linda. That is why we have you and your Intern on this highly visible project. We want to make sure we are going to make the best practical decision for TFC. I will leave you two now so you can start preparing. FIN534_5_3_Linda-2: Let us meet in the conference room. I will meet you there. I want to pick up some of my textbooks dealing with financial options. FIN534_5_4_Linda-1: Here we are back in what I am now calling the Financial Management Room. I was able to find some text books on financial options. They are the part of investing that I like to call The Great Unknown.; because you are taking a chance on how stock will react in the future. An option is basically an investors choice to buy or sell a particular security at a predetermined price in the future and within the certain time period. For example, you may only have ninety days to have the option of buying a share of stock at an already agreed upon price. Also, options are traded on an options exchange market just like stocks are traded on a stock exchange market. FIN534_5_5_Linda-1: The two types of options that we are going to look at are the Call Option and Put Option. FIN534_5_5_Linda-2: With a Call Option, the holder of the option is given the right to buy a share of stock at a predetermined price within a certain period. If the owner decides to buy the share, then it is exercised. The predetermined price is called the strike or exercised price, because that is the agreed upon price and it is only carried out if the owner strikes a deal. FIN534_5_5_Linda-3: Let us look at an example. If someone buys a call option for two dollars and it comes with the terms of a strike price of thirty dollars a share with an expiration date of six months, the owner has six months to buy a share of stock at thirty dollars. If the stock is currently selling for twenty dollars, the owner would not exercise that option as the strike price is greater than the trading price. However, if the trading price goes over thirty dollars, actually thirty two since the owner paid two dollars for the option, then the owner has to decide if the option should be exercised. In our example, if the trading price is forty dollars then the owner should exercise the option as the share can be bought for thirty dollars. Whenever there is a profit involved, meaning that the stock price is greater than the exercised price, the option is said to be in-the-money. In our example, the owner would be in-the money. When the owner is out-of-the-money, that is when the exercised price is greater than the current price; the owner would not want to go through with the transaction. Of course for either transaction, you need to also consider the price you paid for such an option. FIN534_5_5_Linda-4: Personally, I like to think of the Call Option as the High Rise option, as the higher the share price goes the better as the owner is locked into a price. Keep in mind that most options come with an expiration date, meaning that if the owner does not exercise it within a certain period of time, the option is no good. FIN534_5_6_Linda-1: The second type of option can be thought of as the exact opposite of the Call Option. It is the Put Option. This option gives the owner the right to sell a share of stock at a predetermined price. An owner would most likely execute this when the price of a share of stock falls below the exercised price, and of course the price paid for the put option. FIN534_5_6_Linda-2: Let us look at another example but this time with put options. If an investor buys a put option for one dollar at an exercised price of forty dollars and the stock is currently selling for fifty dollars, the investor would not exercise the option as the selling price is higher than the exercised price. In that case it would be better for the investor to sell a share of the company at fifty dollars if the owner has shares of it. FIN534_5_6_Linda-3: Now, lets go back to our example. If the share price of the stock drops to ten dollars a share, the investor can exercise the put option at the price of forty dollars. Even though the share price is only ten dollars the investor would get forty dollars. Like the Call Option, the Put Option usually comes with an expiration date. FIN534_5_6_Linda-4: The difference with the Put Option is the owner is taking a risk that the price of the stock will go down. FIN534_5_6_Linda-5: As you can see, futures trading has risk involved. The owner of the option is taking a chance on what the price will be in the future, whether higher or lower than when the option was purchased. If the stock does not move in the direction you are hoping, then you stand the chance of losing money. FIN534_5_6_Linda-6: Hello. Okay I will be right over. FIN34_5_6_Linda-7: That was Don. He wants me to come by and pick up the information he has for our second task, calculating TFCs weighted average cost of capital or WACC. In the meantime, can you do some decision making on options so we can put it in our report to Joe? I will see you later. FIN534_5_8_Linda-1: Great work! While we are not too familiar with options at TFC, it is always good to increase your knowledge base. This may be an investment choice for us later. FIN534_5_8_Linda-2: Now for our second task. The company wants us to calculate TFCs Weighted Cost of Capital, more commonly known as the WACC. FIN534_5_8_Linda-3: The WACC includes many of the rates we have calculated earlier. It is like bringing the pieces together in a puzzle. FIN534_5_8_Linda-4: The formula to calculate the WACC is: Weight of debt times coupon rate of debt times one minus the tax rate plus weight of short term debt times interest rate on short term debt times one minus the tax rate plus weight of preferred stock times required return on preferred stock plus weight of common stock times required return on common stock. FIN534_5_9_Linda-1: As we have done before, let us look at each component of the WACC. FIN534_5_9_Linda-2: The first component is the r sub d, which is the Before-Tax Cost of Long Term Debt. While there can be many different ways to determine this debt, we will consider it to be the coupon rate that we plan on issuing for long term bonds. Previously, we determined that rate to be eight percent. FIN534_5_9_Linda-3: As the WACC suggests, we have to make an adjustment for the tax rate. This is because interest paid is deductible on the income statement for TFC, so in essence we are saving on taxes being paid. Think of it this way, since interest expense is deductible, TFC is already saving the tax rate on its bonds, so the rate being paid is really one minus the tax rate. For us, we are paying eight percent on our bonds and our tax rate is forty percent. FIN534_5_9_Linda-4: And the short term component of cost of debt is handled the same way. Lets move back to the conference room to meet up with Don. FIN534_5_10_Don-1: Another component of the WACC is the required rate of return on preferred stock. While TFC has never issued preferred stock, it is important to note should we ever decide. Preferred Stock is different than Common Stock, as it usually pays a better dividend than Common Stock and it is higher up on the order of being paid should a company decide to liquidate assets. To determine the required rate on preferred stock, the dividend divided by the price per share times one minus the flotation cost would be used. Flotation costs are those costs that are paid by the company who issues stock, like TFC, to an investment banking company, the company who would handle all of the transactions for the new offering. These costs need to be included in the calculation as the WACC is used to help determine the cost of raising new capital. Any new stock would have floatation costs included. For example, if we want to issue new shares of stock at one hundred dollars a share, and investment banking firm would handle the new issue for us. They would charge a fee. If they charge five percent of the offering price, in this case one hundred dollars, we would only get ninety-five dollars for each share sold and the five dollars would go to the investment banking company for taking care of the new issue. Bottom line is it costs money to issue new shares, FIN534_5_11_Linda-1: The last component is the required rate of return on common stock or r sub s. For this component we use the CAPM as our required rate of return for common stock. Typically, when doing a project that involves an equity contribution, a company would first look at using their retained earnings. After they are used up, they would look at selling stock. The main reason is retained earnings do not have flotation costs which will result in a lower overall cost of equity for a company. Previously we calculated our CAPM to be fifteen percent. FIN534_5_12_Linda-1: Now that we have all the components to the WACC, we are still missing one critical piece. And that is, how are we going to raise the capital? We know it will be through issuing bonds and selling stock, but what percentage of each. Or better yet, what weighted percentages will be assigned to each component? These are the Ws on our WACC formula. FIN534_5_12_Don-1: Linda that is an excellent point. We have the components but the weights come from what we at TFC feels is our optional capital structure and then keep that in mind when we are trying to raise new capital. While it is a work in progress, we feel that our optimal capital structure is sixty percent equity and forty percent debt. We also do not plan on issuing any preferred stock and all of our debt will be long term debt. FIN534_5_12_Linda-2: Well, now it is time to put all the pieces together.

* From the scenario, create a unique hypothetical weighted average cost of capital (WACC) and rate of return. Recommend whether or not the company should expand, and defend your position.