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Modern Furnitures was established in 2000. Its products include household and office furniture. It has grown organically with new designs of furniture as well as through acquisition of other furniture companies. It has high cash balance in order to provide funds for these opportunities. Its financial statements are shown in Exhibit 1 and 2.

Exhibit 1 Income Statement for the year ending December 31, 2016

Sales Revenue

6,000,000

Cost of goods sold

-1,800,000

Gross Profit

4,200,000

Operating expenses

-2,000,000

Depreciation

-200,000

EBIT

2,000,000

Interest

-120,000

Earnings before tax

1,880,000

Tax (20%)

-376000

Net income

1,504,000

Dividend payment

-601600

Addition to retained earnings

902,400

Exhibit 2 Balance Sheet as at December 31, 2016

Assets

Cash and Cash Equivalents

1,200,000

Receivables

560,000

Inventory

500,000

Total current assets

2,260,000

Gross Fixed assets

1,350,000

Accumulated Depreciation

-550,000

Net fixed assets

800,000

Total assets

3,060,000

Liabilities and Shareholder equity Payables 400,000 Short-term debt 150,000 Current Liabilities 550,000 Long-term debt 1,000,000 Total Liabilities 1,550,000 Paid up capital 1,000,000 Retained Earnings 510,000 Total equity 1,510,000 Equity + Liabilities 3,060,000 The number of shares outstanding is 1,000,000. The company expects that its dividend will grow at 6% every year indefinitely. The long-term debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 9% The beta of furniture industry is 1.2; the risk-free rate is 4% and the expected market risk premium is 7%. The market price per share is $9.50. Modern Furnitures is planning to launch a new bedroom suite. They have been doing research for this product for the past 8 months and have spent $200,000 in research expenses. This project will last for 4 years. The manufacture and sale of new bedroom suites will begin in January 2018 and the expected demand for the next 4 years will be: Year / Demand in Units 2018 / 3,200 2019 / 4,000 2020 / 4,800 2021 / 5,600 The variable cost is estimated as 50% of sales. Other operating expenses are fixed costs which will be $600,000 a year. The unit price at which the suite can be sold is $1,800. The cost of the new machinery is $9,000,000. The machinery will be fully depreciated over its useful of 5 years. At the end of the project, the machinery has a salvage value of $2,500,000. The working capital needed for each year is 30% of the sales. Question 1 (a) Calculate the weighted average cost of Modern Furnitures using market value weights. (20 marks) (b) Explain the conditions under which WACC of Modern Furnitures can be used to appraise the new project? (5 marks)

Question 2 Examine whether the new product should be introduced. (25 marks) Question 3 Compute the expected share price if sales are expected to increase by 10%. Assume that the operating expenses are fixed costs and P/E ratio based on the current market price per share. (20 marks) Question 4 Modern Furnitures is considering three options to raise the needed funds for the investment. Modern Furnitures feels that the true value of their shares is $9.94. Modern Furnitures also would like to keep the debt ratio at a maximum of 50% of total capital. The three options are: 1. Issue convertible bond for $9 million with a coupon rate of 3% at a par value of $100. The YTM on this bond is 4%. The maturity of the bond is 5 years. Coupon will be paid at the end of every year. The bond can be converted with a conversion price of $10.2 after 1 year. The management believes that the price of shares will increase causing all convertible bond to be converted. 2. Issue a bond with no convertible provision. The coupon rate will be 3% at a par value of $100. Coupon will be paid at the end of every year. The YTM of this bond is 4.3%. These bonds will also mature after 5 years. 3. Issue equity at a discount of 10% to the current market price. (a) Discuss why the YTM on convertible bond is lower than that of a bond with no convertible provision when coupon rate and maturity are the same. (5 marks) (b) Assess the funds needed to be raised from outside sources to take up the project using the values from your answer to Question 2 and the information in financial statements. (5 marks) (c) Explain why Modern Furnitures should not go with debt issue for the whole amount needed. (5 marks) (d) If the company wants to issue addition shares to finance the need, calculate the issue price and the number of new shares to issue. (5 marks)

(e) Calculate the number of bonds that the company needs to issue to finance the needs. (4 marks) (f) Explain why issue of convertible is a better choice as compared to issue of new stock. (6 marks)