Establishing the Optimal Capital Budget

HARRIS PUBLISHING, INC.

Directed

Harris Publishing, Inc. is a regional printing house specializing in the production of historical texts

and procedural manuals for offices and software manufacturers. The company currently operates in

the North East United States with offices in Boston and New York City, as well as an office and

headquarters in Hartford, Connecticut. Harris Publishing offers high quality printing that is easily

adapted to the changing needs of its customers. The company maintains its customer base through

competitive pricing and attention to detail. Many customers have been with the company since the

late 1930s. They appreciate the quality of service and the personal attention given to their projects.

In addition, new customers are drawn to the company?s ability to rapidly incorporate changes

through the flexible manuscript system perfected by the company.

Harris Publishing was started by Edward Harris and his son Andrew as a small family-owned

printer in Hartford, Connecticut. Edward received his degree in American history and spent his

career as a historian with the National Park Service. Early retirement allowed him to implemented

a lifelong dream of writing and publishing historical accounts of the development of the Eastern

United States. His writing was well received and won numerous literary awards. Andrew apprenticed

in a Boston print shop while attending college, and upon graduation went to work for a large

publishing house in New York City. He was eager to return to his native Connecticut and join with

his father in starting a new company.

Harris Publishing began by printing the writings of Edward and other prominent historians

on a one color letter press with cast metal plates applied to paper. The products were recognized

for their high quality of content and production. However, sales volume was insufficient to maintain

the business. Andrew recognized the demand for printed material from Hartford?s prominent

insurance industry and negotiated long term contracts to produce materials required by several of the

larger insurers. The high standards and business acumen of Andrew Harris was responsible for the

rapid growth of the business as the company quickly identified and responded to the printing needs

of other industrial customers. The development of word processing and modern printing techniques

contributed to another major jump in business. Noting the rapidly changing environment of

some of their customers, Harris Publishing developed a system of accurately tracking and providing

custom revisions of selected portions of existing manuals.

Even with phenomenal growth, Harris Publishing remained private until the early 1980?s. At

this time, Andrew sold 75 percent of the outstanding stock in a public offering to raise funds for

Copyright 1994. The Dryden Press. All rights reserved.

1

expansion into the Boston and New York markets. The Harris family continued to manage the

company, and in 1990 the Board of Directors unanimously elected Andrew?s grandson Jacob to the

post of Chief Executive Officer. Andrew maintained the office of Chair of the Board. Increasing

competition and economic conditions made Jacob realize that in order to survive and thrive the company

must strengthen its financial position. He felt that the company must diversify. Some of the

company industrial accounts indicated an interest in contracting with Harris to produce high quality

color annual reports and sales brochures. In addition, Jacob wanted to investigate the feasibility

of expanding to other geographic areas with high demand and more limited competition.

Although Jacob was raised in the printing business, he did not possess strong financial analysis

skills. Therefore, he hired Ellen Adams as a special assistant to the president to help strengthen

the company?s financial position. She had a finance degree and had experience in the finance operations

of a major paper supplier. She was responsible for assisting with evaluating current and proposed

projects and recommending appropriate corporate actions.

As she began to familiarize herself with the activities of the various departments and the

company?s operations, Ellen became aware of the haphazard way in which capital-investment

decisions were made. Al Erickson, the company?s financial vice president for 25 years, is responsible

for capital budgeting at Harris Publishing. He generally approves capital investment requests as

they are presented by local project managers. He recently started calculating ROIs for each project

and notified managers if their operations? ROIs were below the company average. He reported that

this procedure resulted in a jump in the company?s return. Adams noticed that with this procedure,

managers of operations with low returns on investment typically avoided requesting money for

substantial capital investment until they were able to pull their operations? ROI up to that of the overall

company. Thus, funds are typically allocated to those operations that had above-average ROIs

in the past. In addition, in years when funds for capital expenditures were severely limited, Erickson

had the finance department calculate the payback period on larger investments. Several potential

high return capital investments whose payback periods exceeded the 3 year standard had been

rejected in favor of lower return projects with faster payback.

Ellen sent a memorandum to Jacob Harris in which she recommended that a formal process

be used to make capital budgeting decisions. Ellen met with Jacob about her ideas and explained

why a net present value approach would be best for the company. Jacob felt that the process would

move the company in the right direction and was eager to put a new procedure into effect. Therefore,

he asked Adams to address this topic at the board of directors? meeting scheduled for the following

month.

Ellen?s presentation to the board went smoothly, and the members seemed to agree that the

company should implement a formal capital budgeting process. Erickson, however, was skeptical

about Ellen?s plan. He noted that his current system improved returns. He also argued that the net

present value approach would change allocations depending on the rate used to discount cash flows.

He questioned her about the appropriate cost of capital for evaluating the company?s projects.

Other board members then asked Ellen to broaden her study and include an estimate of the appropriate

discount rate for use in generating Harris Publishing?s 1996 capital budget. Also, Chair

Andrew Harris was uncomfortable with the concept of a net present value dollar amount; he felt

that rates of return should form the basis for project evaluation.

The board also indicated an interest in expanding operations to Chicago, Los Angeles, and

Houston. A consultant had been hired to estimate cost and returns for these projects, and the results

are presented in Table 1. The report indicated that the costs were based on the minimum acceptable

levels of expansion. Therefore, none of the projects are divisible, and each project must be accepted

or rejected in its entirety.

Case: 17A Establishing the Optimal Capital Budget

2

TABLE 1

Expansion Opportunities

(Millions of Dollars)

Project Group Total Cost Average IRR

Chicago $26 13.8%

Los Angeles $34 12.8%

Houston $28 16.0%

Jacob also expressed an interest in acquiring a new 4-color offset lithography system. The

acquisition would produce sufficient quality to permit an expansion into the annual report and sales

brochure market that exists within the company?s customer base. He found two systems that would

be appropriate, each costing $2 million. System A is faster and is expected to produce annual net

cash flows of $450,000 over its estimated 10 year life. System B is expected to produce annual

cash flows of only $390,000, but it has an expected life of 15 years. The systems are mutually exclusive.

The board members agreed that either system would give the company a major competitive

advantage, and the market demand from existing customers was already documented.

The board asked Ellen to determine the acceptability of the company?s potential projects and

to estimate the level of funding that would be required for capital projects during 1996. She also was

asked to analyze the company?s cost of capital and to determine an appropriate rate for use in project

evaluation. Finally, she was charged with making a full report, including support for her recommendations,

at the next quarterly board meeting.

Adams decided that the best way to present her findings would be to calculate the company?s

investment opportunity schedule (IOS) and the firm?s marginal cost of capital (MCC) schedule.

She also felt that she must be prepared to field questions relating to risk and how to deal with the possibility

of new projects that may surface during the year.

The first step was to find out what other projects were under consideration and, therefore, she

interviewed each project manager. From these conversations she discovered that she must consider

a large number of relatively routine projects (replacement decisions and the like) in addition to the

expansions presented in Table 1 and the offset lithography system. These routine projects could be

grouped into three broad categories based on expected profitability?high, average or low. The risks

of these projects were average for the company. The total costs and expected average internal rates

of return (IRR) for each group are shown in Table 2.

TABLE 2

Investment Project Groups

(Millions of Dollars)

Project Group Total Cost Average IRR

Group 1 (high profitability) $34 18.0%

Group 2 (medium profitability) $36 15.0

Group 3 (low profitability) $43 13.5

She then obtained the projected December 1995 balance sheet (Table 3) and information on

sales and earnings for each year from 1985 to 1995 (Tables 4). Next, she met with several security

analysts and investment bankers to determine investor expectations for the firm and the cost to

Harris Publications of raising outside debt and equity capital. The analysts said that investors do

not expect the company to experience the same high growth rates that it has enjoyed over the previous

decade. The consensus of these experts was that the rate would be only three-fourths of that

realized from 1985 to 1995.

Case: 17A Establishing the Optimal Capital Budget

3

TABLE 3

Harris Publishing, Inc.

Pro forma Balance sheet for December 31, 1995

(Millions of Dollars)

Cash & marketable securities $ 14 Accounts payablea $ 3

Accounts Receivable 56 Short-term debt (6%)b 36

Inventories 90 Total current liabilities $ 39

Total current assets $160 Mortgage bondsc 75

Preferred stockd 40

Net fixed assets 240 Common equitye 165

Retained earnings 81

Total liabilities and

Total assets $400 shareholders equity $400

aAccounts payable are exceptionally small because the firm follows the practices of paying cash on delivery in

return for substantial purchase discounts from suppliers.

bHarris Publishing uses short-term debt as part of its permanent capital structure.

cThe bonds outstanding have a par value of $1,000, a remaining life of 10 years and an annual (one payment per

year) coupon rate of 8.0%. The current annual required rate of return for 10-year bonds with Harris? bond rating

is 9%.

dThe preferred stock currently sells at its par value of $100 per share.

eFour million shares are outstanding, and the stock currently sells at a price of $45 per share.

Ellen Adams also made an analysis of the firms market value capital structure, and she noted

that the capital structure reflected in the balance sheet has been stable over the past decade. She

then concluded that Harris? current mix of debt, preferred stock, and common stock was probably

close to optimal. She also noted the company uses short term debt as a source of permanent financing.

The company?s accounting department estimates depreciation for 1995 to be $25 million, and

since depreciation is not a cash charge, this amount will be available to finance new projects. The

company has a 40 percent marginal tax rate.

To obtain more information Ellen held discussions with the firm?s investment and commercial

bankers. From these meeting she learned that costs, as specified in the following sections, would be

incurred as the company sought to obtain additional capital.

Case: 17A Establishing the Optimal Capital Budget

4

TABLE 4

Harris Publication, Inc.

Sales and Earnings

Earnings After Tax Available Earnings per Share

Sales to Common Stock of Common

Year ($ million) ($ million) Stock

1996 (est.) $456 $ 44.0 $11.00

1995 433 41.8 10.44

1994 410 40.0 10.00

1993 427 40.8 10.25

1992 364 34.4 8.60

1991 333 33.2 8.30

1990 309 30.0 7.52

1989 278 25.6 6.40

1988 259 20.8 5.20

1987 221 19.2 4.80

1986 175 16.0 4.00

1985 160 15.2 3.80

SHORT-TERM DEBT

New short-term debt, which currently has an interest rate of 6 percent, could be issued as bank

notes payable and commercial paper.

LONG-TERM DEBT

The company could obtain an additional long-term loans of up to $20 million under current covenant

restrictions. Analysts believe that the company can issue senior debt at a rate of 10.5 percent. If the

company needs debt beyond this amount, it must issue subordinated debentures with a lower rating.

These lower rated bonds would carry an interest rate of 13 percent.

PREFERRED STOCK

The company?s non voting perpetual preferred stock pays an $8 annual dividend, has a $100 par

value, and is currently selling at par. The company can sell additional preferred stock to private

investors. However, the market for new issues is weak, and the flotation costs on new issues are

expected to be $20 per share.

COMMON STOCK

Harris Publishing?s investment bankers have estimated that they could sell new common stock at the

current market price of $45 per share. The underwriting commission would be $9 per share. Because

of difficulties in determining the exact effect of capital requirements on the costs of capital, Ellen

assumed that Harris could sell any amount of new common stock at the net price.

Finally, the analysts noted that investors expect Harris? 35 percent dividend payout ratio to

hold steady for some time into the future. Indeed, in his last annual report to shareholders, Andrew

Harris had emphasized that the company would continue the current dividend payout policy. Ellen

was told to investigate the cost of equity based on a growth rate from historical earnings as well as

the analyst?s expectations. Adams was uncomfortable with the growth estimates and wanted to see

if costs were sensitive to the method of estimation. She found that Treasury Bonds were selling at

6 percent. The expected market risk premium, based on the historical level of the Standard & Poor?s

Case: 17A Establishing the Optimal Capital Budget

5

over Treasuries, was 6.2%. Further, the company was somewhat more risky than the market. ValueLine

indicated that Harris Publishing has a beta of 1.4.

Conversations with several board members indicated a lack of consensus about the riskiness

of the expansion projects in Houston, Chicago, and Los Angeles. Some board members felt that

the projects mirrored existing projects, while others felt that they were riskier than the existing company

activities. After reviewing the consultant report, Ellen concluded that the projects should be

evaluated both as having average risk as well as with a 2% risk premium added to the company

cost of capital. Due to board disagreement, she felt that she must present both high and normal

risk scenarios. Ellen knew that Jacob was curious about how the Harris? high tax bracket may

impact the capital budgeting analysis. She believed that this review provided a nice opportunity to

investigate this issue.

Your task is to help Ellen prepare a report that addresses the concerns mentioned above. In

addition you must make and explain recommendations concerning the funding of projects for the

coming year. Ellen has asked that you answer the following questions and use this information to

help you structure your report.

QUESTIONS

1. Explain why Al Erickson?s method of monitoring project manager?s ROI may have contributed

to an increase in the company?s ROI. Then explain why this procedure may not

maximize the company?s value. Also explain the benefits and detriments of using simple

payback to allocate funds.

2. Explain the appropriate use of sort term debt (such as notes payable funds) and of spontaneously

generated capital (such as accruals and accounts payable) for determining the company?s

capital structure.

3. Adams believes that Harris Publication?s present market capital structure is optimal, that is,

it minimizes the firm?s weighted average cost of capital and maximizes the stock price. Calculate

Harris Publication?s market value capital structure. Round your numbers to the nearest

whole percentage.

4. Determine the break points in the marginal cost of capital curve. Assume that the current

capital structure is maintained, the dividend payout ratio remains at 35 percent, depreciation

charges are $25 million, and 1995 earnings of $44 million are available to common shareholders

in 1996.

5. Find the weighted average cost of capital (WACC) for each interval of the marginal cost of

capital curve (MCC) and graph the curve. Recall that Harris Publishing?s marginal tax rate is

40 percent, and the current price of the stock (P0 ) is based on the expected dividend (D1 )

from 1995 EPS and the 35 percent payout ratio.

6. Consider the costs and annual revenues of the 4-color offset lithography in answering the

following questions.

a. Determine the internal rate of return for projects A and B.

b. Graph the investment opportunity schedule and the marginal cost of capital schedule.

c. Based on this information, what is the company?s marginal cost of capital, and which

project should be accepted?

Case: 17A Establishing the Optimal Capital Budget

6

7. Adams believes the modified internal rate of return (MIRR) is superior to the traditional IRR

as an evaluation criterion for capital investment projects.

a. Compute the MIRR for projects A and B.

b. Explain the shift in the IOS when using the MIRR rather than the ?traditional? IRR, and

then discuss the impact of the change on the accept/reject decision. (Hint: Answer this

part of this question conceptually; no calculations are necessary.)

8. Discuss the choice between the mutually exclusively projects of A and B that will maximize

the value of the company.

9. Capital budgeting decisions reflect the best estimate of projects at the time the decisions are

made. However, activities such as issuing securities and investing in capital assets will occur

over the entire year.

a. How would the IOS change if more ?good? projects (projects with higher returns)

become available, and how should the company respond?

b. How does the MCC change if the cost of capital increases or decreases, and how should

the company respond?

10. Is Adams more likely to be more confident about the estimated MCC or IOS? Explain.

11. Discuss how the analysis will change if a 2% risk premium is included for the expansion

project.

12. Compute the cost of internal equity based on the Security Market Line. Compare this to the

cost of equity found using the discounted cash flow model. Which, if either, do you think is

more correct? Explain.

13. Assume Andrew and Jacob Harris control the dividend decisions made for the company, and

they are in the highest personal tax bracket. How and why might the Harris? high tax status

change the capital budgeting analysis? Discuss how a change in dividend payout ratio may

affect the analysis.

Case: 17A Establishing the Optimal Capital Budget

7

Establishing the Optimal Capital Budget HARRIS PUBLISHING, INC. Directed Harris Publishing, Inc. is a regional printing house specializing in the production of historical texts and procedural manuals for offices and software manufacturers. The company currently operates in the North East United States with offices in Boston and New York City, as well as an office and headquarters in Hartford, Connecticut. Harris Publishing offers high quality printing that is easily adapted to the changing needs of its customers. The company maintains its customer base through competitive pricing and attention to detail. Many customers have been with the company since the late 1930s. They appreciate the quality of service and the personal attention given to their projects. In addition, new customers are drawn to the company's ability to rapidly incorporate changes through the flexible manuscript system perfected by the company. Harris Publishing was started by Edward Harris and his son Andrew as a small family-owned printer in Hartford, Connecticut. Edward received his degree in American history and spent his career as a historian with the National Park Service. Early retirement allowed him to implemented a lifelong dream of writing and publishing historical accounts of the development of the Eastern United States. His writing was well received and won numerous literary awards. Andrew apprenticed in a Boston print shop while attending college, and upon graduation went to work for a large publishing house in New York City. He was eager to return to his native Connecticut and join with his father in starting a new company. Harris Publishing began by printing the writings of Edward and other prominent historians on a one color letter press with cast metal plates applied to paper. The products were recognized for their high quality of content and production. However, sales volume was insufficient to maintain the business. Andrew recognized the demand for printed material from Hartford's prominent insurance industry and negotiated long term contracts to produce materials required by several of the larger insurers. The high standards and business acumen of Andrew Harris was responsible for the rapid growth of the business as the company quickly identified and responded to the printing needs of other industrial customers. The development of word processing and modern printing techniques contributed to another major jump in business. Noting the rapidly changing environment of some of their customers, Harris Publishing developed a system of accurately tracking and providing custom revisions of selected portions of existing manuals. Even with phenomenal growth, Harris Publishing remained private until the early 1980's. At this time, Andrew sold 75 percent of the outstanding stock in a public offering to raise funds for Copyright 1994. The Dryden Press. All rights reserved. 1 Case: 17A Establishing the Optimal Capital Budget expansion into the Boston and New York markets. The Harris family continued to manage the company, and in 1990 the Board of Directors unanimously elected Andrew's grandson Jacob to the post of Chief Executive Officer. Andrew maintained the office of Chair of the Board. Increasing competition and economic conditions made Jacob realize that in order to survive and thrive the company must strengthen its financial position. He felt that the company must diversify. Some of the company industrial accounts indicated an interest in contracting with Harris to produce high quality color annual reports and sales brochures. In addition, Jacob wanted to investigate the feasibility of expanding to other geographic areas with high demand and more limited competition. Although Jacob was raised in the printing business, he did not possess strong financial analysis skills. Therefore, he hired Ellen Adams as a special assistant to the president to help strengthen the company's financial position. She had a finance degree and had experience in the finance operations of a major paper supplier. She was responsible for assisting with evaluating current and proposed projects and recommending appropriate corporate actions. As she began to familiarize herself with the activities of the various departments and the company's operations, Ellen became aware of the haphazard way in which capital-investment decisions were made. Al Erickson, the company's financial vice president for 25 years, is responsible for capital budgeting at Harris Publishing. He generally approves capital investment requests as they are presented by local project managers. He recently started calculating ROIs for each project and notified managers if their operations' ROIs were below the company average. He reported that this procedure resulted in a jump in the company's return. Adams noticed that with this procedure, managers of operations with low returns on investment typically avoided requesting money for substantial capital investment until they were able to pull their operations' ROI up to that of the overall company. Thus, funds are typically allocated to those operations that had above-average ROIs in the past. In addition, in years when funds for capital expenditures were severely limited, Erickson had the finance department calculate the payback period on larger investments. Several potential high return capital investments whose payback periods exceeded the 3 year standard had been rejected in favor of lower return projects with faster payback. Ellen sent a memorandum to Jacob Harris in which she recommended that a formal process be used to make capital budgeting decisions. Ellen met with Jacob about her ideas and explained why a net present value approach would be best for the company. Jacob felt that the process would move the company in the right direction and was eager to put a new procedure into effect. Therefore, he asked Adams to address this topic at the board of directors' meeting scheduled for the following month. Ellen's presentation to the board went smoothly, and the members seemed to agree that the company should implement a formal capital budgeting process. Erickson, however, was skeptical about Ellen's plan. He noted that his current system improved returns. He also argued that the net present value approach would change allocations depending on the rate used to discount cash flows. He questioned her about the appropriate cost of capital for evaluating the company's projects. Other board members then asked Ellen to broaden her study and include an estimate of the appropriate discount rate for use in generating Harris Publishing's 1996 capital budget. Also, Chair Andrew Harris was uncomfortable with the concept of a net present value dollar amount; he felt that rates of return should form the basis for project evaluation. The board also indicated an interest in expanding operations to Chicago, Los Angeles, and Houston. A consultant had been hired to estimate cost and returns for these projects, and the results are presented in Table 1. The report indicated that the costs were based on the minimum acceptable levels of expansion. Therefore, none of the projects are divisible, and each project must be accepted or rejected in its entirety. 2 Case: 17A Establishing the Optimal Capital Budget TABLE 1 Expansion Opportunities (Millions of Dollars) Project Group Chicago Los Angeles Houston Total Cost $26 $34 $28 Average IRR 13.8% 12.8% 16.0% Jacob also expressed an interest in acquiring a new 4-color offset lithography system. The acquisition would produce sufficient quality to permit an expansion into the annual report and sales brochure market that exists within the company's customer base. He found two systems that would be appropriate, each costing $2 million. System A is faster and is expected to produce annual net cash flows of $450,000 over its estimated 10 year life. System B is expected to produce annual cash flows of only $390,000, but it has an expected life of 15 years. The systems are mutually exclusive. The board members agreed that either system would give the company a major competitive advantage, and the market demand from existing customers was already documented. The board asked Ellen to determine the acceptability of the company's potential projects and to estimate the level of funding that would be required for capital projects during 1996. She also was asked to analyze the company's cost of capital and to determine an appropriate rate for use in project evaluation. Finally, she was charged with making a full report, including support for her recommendations, at the next quarterly board meeting. Adams decided that the best way to present her findings would be to calculate the company's investment opportunity schedule (IOS) and the firm's marginal cost of capital (MCC) schedule. She also felt that she must be prepared to field questions relating to risk and how to deal with the possibility of new projects that may surface during the year. The first step was to find out what other projects were under consideration and, therefore, she interviewed each project manager. From these conversations she discovered that she must consider a large number of relatively routine projects (replacement decisions and the like) in addition to the expansions presented in Table 1 and the offset lithography system. These routine projects could be grouped into three broad categories based on expected profitabilityhigh, average or low. The risks of these projects were average for the company. The total costs and expected average internal rates of return (IRR) for each group are shown in Table 2. TABLE 2 Investment Project Groups (Millions of Dollars) Project Group Group 1 (high profitability) Group 2 (medium profitability) Group 3 (low profitability) Total Cost $34 $36 $43 Average IRR 18.0% 15.0 13.5 She then obtained the projected December 1995 balance sheet (Table 3) and information on sales and earnings for each year from 1985 to 1995 (Tables 4). Next, she met with several security analysts and investment bankers to determine investor expectations for the firm and the cost to Harris Publications of raising outside debt and equity capital. The analysts said that investors do not expect the company to experience the same high growth rates that it has enjoyed over the previous decade. The consensus of these experts was that the rate would be only three-fourths of that realized from 1985 to 1995. 3 Case: 17A Establishing the Optimal Capital Budget TABLE 3 Harris Publishing, Inc. Pro forma Balance sheet for December 31, 1995 (Millions of Dollars) Cash & marketable securities Accounts Receivable Inventories Total current assets Net fixed assets Total assets $ 14 56 90 $160 240 $400 Accounts payablea Short-term debt (6%)b Total current liabilities Mortgage bondsc Preferred stockd Common equitye Retained earnings Total liabilities and shareholders equity $ 3 36 $ 39 75 40 165 81 $400 aAccounts payable are exceptionally small because the firm follows the practices of paying cash on delivery in return for substantial purchase discounts from suppliers. bHarris Publishing uses short-term debt as part of its permanent capital structure. cThe bonds outstanding have a par value of $1,000, a remaining life of 10 years and an annual (one payment per year) coupon rate of 8.0%. The current annual required rate of return for 10-year bonds with Harris' bond rating is 9%. dThe preferred stock currently sells at its par value of $100 per share. eFour million shares are outstanding, and the stock currently sells at a price of $45 per share. Ellen Adams also made an analysis of the firms market value capital structure, and she noted that the capital structure reflected in the balance sheet has been stable over the past decade. She then concluded that Harris' current mix of debt, preferred stock, and common stock was probably close to optimal. She also noted the company uses short term debt as a source of permanent financing. The company's accounting department estimates depreciation for 1995 to be $25 million, and since depreciation is not a cash charge, this amount will be available to finance new projects. The company has a 40 percent marginal tax rate. To obtain more information Ellen held discussions with the firm's investment and commercial bankers. From these meeting she learned that costs, as specified in the following sections, would be incurred as the company sought to obtain additional capital. 4 Case: 17A Establishing the Optimal Capital Budget TABLE 4 Harris Publication, Inc. Sales and Earnings Year 1996 (est.) 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 Sales ($ million) $456 433 410 427 364 333 309 278 259 221 175 160 Earnings After Tax Available to Common Stock ($ million) $ 44.0 41.8 40.0 40.8 34.4 33.2 30.0 25.6 20.8 19.2 16.0 15.2 Earnings per Share of Common Stock $11.00 10.44 10.00 10.25 8.60 8.30 7.52 6.40 5.20 4.80 4.00 3.80 SHORT-TERM DEBT New short-term debt, which currently has an interest rate of 6 percent, could be issued as bank notes payable and commercial paper. LONG-TERM DEBT The company could obtain an additional long-term loans of up to $20 million under current covenant restrictions. Analysts believe that the company can issue senior debt at a rate of 10.5 percent. If the company needs debt beyond this amount, it must issue subordinated debentures with a lower rating. These lower rated bonds would carry an interest rate of 13 percent. PREFERRED STOCK The company's non voting perpetual preferred stock pays an $8 annual dividend, has a $100 par value, and is currently selling at par. The company can sell additional preferred stock to private investors. However, the market for new issues is weak, and the flotation costs on new issues are expected to be $20 per share. COMMON STOCK Harris Publishing's investment bankers have estimated that they could sell new common stock at the current market price of $45 per share. The underwriting commission would be $9 per share. Because of difficulties in determining the exact effect of capital requirements on the costs of capital, Ellen assumed that Harris could sell any amount of new common stock at the net price. Finally, the analysts noted that investors expect Harris' 35 percent dividend payout ratio to hold steady for some time into the future. Indeed, in his last annual report to shareholders, Andrew Harris had emphasized that the company would continue the current dividend payout policy. Ellen was told to investigate the cost of equity based on a growth rate from historical earnings as well as the analyst's expectations. Adams was uncomfortable with the growth estimates and wanted to see if costs were sensitive to the method of estimation. She found that Treasury Bonds were selling at 6 percent. The expected market risk premium, based on the historical level of the Standard & Poor's 5 Case: 17A Establishing the Optimal Capital Budget over Treasuries, was 6.2%. Further, the company was somewhat more risky than the market. ValueLine indicated that Harris Publishing has a beta of 1.4. Conversations with several board members indicated a lack of consensus about the riskiness of the expansion projects in Houston, Chicago, and Los Angeles. Some board members felt that the projects mirrored existing projects, while others felt that they were riskier than the existing company activities. After reviewing the consultant report, Ellen concluded that the projects should be evaluated both as having average risk as well as with a 2% risk premium added to the company cost of capital. Due to board disagreement, she felt that she must present both high and normal risk scenarios. Ellen knew that Jacob was curious about how the Harris' high tax bracket may impact the capital budgeting analysis. She believed that this review provided a nice opportunity to investigate this issue. Your task is to help Ellen prepare a report that addresses the concerns mentioned above. In addition you must make and explain recommendations concerning the funding of projects for the coming year. Ellen has asked that you answer the following questions and use this information to help you structure your report. QUESTIONS 1. Explain why Al Erickson's method of monitoring project manager's ROI may have contributed to an increase in the company's ROI. Then explain why this procedure may not maximize the company's value. Also explain the benefits and detriments of using simple payback to allocate funds. 2. Explain the appropriate use of sort term debt (such as notes payable funds) and of spontaneously generated capital (such as accruals and accounts payable) for determining the company's capital structure. 3. Adams believes that Harris Publication's present market capital structure is optimal, that is, it minimizes the firm's weighted average cost of capital and maximizes the stock price. Calculate Harris Publication's market value capital structure. Round your numbers to the nearest whole percentage. 4. Determine the break points in the marginal cost of capital curve. Assume that the current capital structure is maintained, the dividend payout ratio remains at 35 percent, depreciation charges are $25 million, and 1995 earnings of $44 million are available to common shareholders in 1996. 5. Find the weighted average cost of capital (WACC) for each interval of the marginal cost of capital curve (MCC) and graph the curve. Recall that Harris Publishing's marginal tax rate is 40 percent, and the current price of the stock (P0 ) is based on the expected dividend (D1 ) from 1995 EPS and the 35 percent payout ratio. 6. Consider the costs and annual revenues of the 4-color offset lithography in answering the following questions. a. Determine the internal rate of return for projects A and B. b. Graph the investment opportunity schedule and the marginal cost of capital schedule. c. Based on this information, what is the company's marginal cost of capital, and which project should be accepted? 6 Case: 17A Establishing the Optimal Capital Budget 7. Adams believes the modified internal rate of return (MIRR) is superior to the traditional IRR as an evaluation criterion for capital investment projects. a. Compute the MIRR for projects A and B. b. Explain the shift in the IOS when using the MIRR rather than the \"traditional\" IRR, and then discuss the impact of the change on the accept/reject decision. (Hint: Answer this part of this question conceptually; no calculations are necessary.) 8. Discuss the choice between the mutually exclusively projects of A and B that will maximize the value of the company. 9. Capital budgeting decisions reflect the best estimate of projects at the time the decisions are made. However, activities such as issuing securities and investing in capital assets will occur over the entire year. a. How would the IOS change if more \"good\" projects (projects with higher returns) become available, and how should the company respond? b. How does the MCC change if the cost of capital increases or decreases, and how should the company respond? 10. Is Adams more likely to be more confident about the estimated MCC or IOS? Explain. 11. Discuss how the analysis will change if a 2% risk premium is included for the expansion project. 12. Compute the cost of internal equity based on the Security Market Line. Compare this to the cost of equity found using the discounted cash flow model. Which, if either, do you think is more correct? Explain. 13. Assume Andrew and Jacob Harris control the dividend decisions made for the company, and they are in the highest personal tax bracket. How and why might the Harris' high tax status change the capital budgeting analysis? Discuss how a change in dividend payout ratio may affect the analysis. 7