All rational investors want to invest in securities (or projects) that are expected to yield a return greater than their cost of capital. For the chief financial officer (CFO) of a company, the procedure for determining where to invest is a three-step process. The first step is finding the expected return on the securities or projects in which the firm may be interested. The second step is the determination of the firm's cost of capital. The final step is selecting those securities or projects whose expected return is greater than the firm's cost of capital. In reality neither of the first two steps precedes the other as the CFO may calculate the firm's cost of capital on an annual, a semi-annual, or even a quarterly basis, depending on changes in the capital markets. The calculated cost of capital may then be compared to the expected returns of the various securities and capital projects available.

History of Green Candy

Green Candy (GC) was founded in 1978 by John as a manufacturer of quality chocolate candy. As with most food companies established in the United Kingdom in that period, GC started as a modest manufacturer of a single product that was sold locally. Later, if successful, those firms expanded their sales efforts to regional, national, and sometimes even to international areas.

Green Candy was one of the successful companies. John's first product was a chocolate bar that sold for twenty pence. The bar, known as the Green Bar, soon became famous for its quality and fine taste. John expanded production to meet the rising demand for the Green Bar, but growth never exceeded cash available to pay for the expansion. Two of the basic tenets on which John founded and ran GC were to make a quality chocolate bar and not to go into debt. These tenets were considered almost sacrosanct, and John believed they were the reasons for his success while many other food companies failed.

By 1998, when John turned the reins of his company over to his son, William, GC had grown into a respected and well-known 40-million regional chocolate firm. It had survived intense competition, according to John, because the firm still produced a quality product and, above all, had no debt. William followed the principles laid down by his father, and in the next 10 years GC grew to a national firm with 700 million in sales. Although GC had purchased a confectionery candy firm, over 90 percent of the sales were from chocolate candy. Significantly only 5 percent of the firm's capital structure was in longterm debt, the debt needed to purchase the confectionery candy firm.

In 2012, when William's son Alex became president of GC, the family still owned all the shares of the firm and the board of directors was made up entirely of family members. However, in 2014 the company was forced into going public because of two circumstances. The first was the need to raise cash to pay estate taxes following the death of William. The second came from the increasing awareness that the firm needed to modernise its plants to compete with other food companies, which were slowly taking market share from GC with better quality candy products and higher profits from their automated, modern equipment.

By the early 2020 the firm had completed its modernisation, improving the quality of its products and reducing operating expenses. However, the firm was totally dependent on the chocolate and confectionery business and its managers were beginning to realise that diversification into other lines of the food business might be necessary for GC to survive in the increasingly competitive business environment. In addition, some family members were beginning to question the financial practices of the firm and the effects those practices had on the share price. They noticed that throughout the 1990s, many of the oldline family food businesses were purchased by larger publicly held firms run by managers who were not majority shareholders of the firm. More importantly they noticed that the returns on the shares sold seemed much higher than the returns they were receiving from their shares.

During the early 2010s, GC did expand into the pasta business through the purchase of three familyowned firms and by 2020 had a 20 percent market share of the 1.4 billion UK pasta business. The purchase of these businesses was financed through two bond issues. Long-term debt, however, was never more than 20 percent of total assets.

Jones Wilson

Jones Wilson, the chief financial officer (CFO) of GC, was hired in 2016 with specific instructions to improve the return on the financial resources of the firm. Jones's background included four years as the cash manager of a large corporation with sales in excess of 10 billion. He was a graduate of an MBA programme that is nationally known for its emphasis on financial management. Jones saw the job as CFO of GC as an outstanding opportunity to affect the financial decision making of a firm in transition from family ownership to one that was becoming a multibillion pound, publicly held firm.

This Monday morning, Jones had just walked into his office at 7:30 am to find a note stuck on his computer's monitor to call Alex, the CEO of Green Candy. Alex, however, was making a real effort to bring GC into the modern era, insisting that many of the top executives attend financial seminars sponsored by the Top Business School. Jones had suggested the seminars to Alex as a vehicle to help these executives understand some of the changes he thought were necessary to improve Green Candy' financial performance.

Jones called Alex, who asked him to come up to his office. In the next 30 minutes Jones learned that GC was considering the purchase of Country Foods, a pasta producer with annual sales in excess of 800 million, for 400 million. Before a decision could be made, Alex wanted the answers to three financial questions from Jones. First, what was the expected return from this proposed purchase? Second, what was Green Candy' cost of capital? Finally, what was Jones's recommendation on how the purchase could be financed?

Financial Information

Jones reviewed the GC financial data. (See Exhibits 1 and 2.) The average outstanding balance of shortterm, interest-bearing debt in 2021 was 200 million and the weighted average interest rate was 5.0 percent. Domestic borrowing under lines of credit and commercial paper was used to fund seasonal working capital requirements and provide interim financing for business acquisitions. Maximum shortterm borrowings at any month were 250 million.

GC had two long-term, AA+ rated bonds outstanding. The first was a 6.00 percent sinking fund debenture due in 12 years. This debenture is traded on the London Stock Exchange priced at 105.0 which results in yield to maturity of 5.43 percent per annum. Of the original 550 million issue, 200 million is still outstanding. The second issue was for 400 million and had a coupon interest rate of 5.5 percent. The entire issue was sold in 2019 in a private placement to two life insurance companies, and the issue will mature in 2049. Jones then called GC's investment banker and learned that the banker was highly confident that Green Candy could issue up to 400 million of new debt at the current return on GC's outstanding long-term debt.

Like many other family-controlled but publicly held businesses, GC has two classes of ordinary shares: Ordinary Shares and Class B shares. The Ordinary Shares have one vote per share and the Class B shares (held or controlled by family members) have 10 votes per share. However, the Ordinary Shares, voting separately as a class, are entitled to elect one-sixth of the board of directors. With respect to dividend rights, the ordinary shares are entitled to cash dividends that are 10 percent higher than those declared and paid on the Class B Shares. There are a total of 170 million shares of ordinary shares and 30 million of Class B Shares outstanding. The current price of both the ordinary shares and Class B Shares is 4500 pence and their beta is 1.1. The ordinary shares and Class B Shares generally vote together without regard to class on matters submitted to shareholders.

The growth rate of net income, earnings per share, dividends, and ordinary share prices are given in Exhibit 3. The increase in the stock price have averaged about 9.95 percent a year over the last five years. Some of this growth rate is the result of an aggressive repurchase of the firm's ordinary shares. Over the past three years the firm has repurchased over 10 million ordinary shares. Finally, Jones looked up the capitalisation ratio for other firms in the food industry. (See Exhibit 4.) As he expected, Green Bar had a much lower debt ratio than almost all other companies in the industry group.

Jones wrote down the additional information that he thought he needed before starting to work. The current Treasury bill rate was 3.0 percent and the return on the FT all share index has averaged 11 percent over the past 5 years. The current corporate tax rate is 20 percent. The beta for Country Food was 1.4 with debt accounting for 30 percent of the market value of the firms capital. The yield to maturity for the debt was 5.9 percent per annum, slightly higher than that for the Green Candy.

Questions requiring answers:

How can the firm raise 400 million for the acquisition without changing the present capital structure?