Exhibit 2 Under these circumstances, answer the following questions: 1. Should NEC change its capital structure? (Compare the characteristics of NEC and KGroup in Exhibit 1. What similarities do you see? What differences? Consider cash balances, receivables, inventory, property, plant & equipment, bond ratings, common stock betas, and leverage ratios among other features. Can you draw any inferences from these observations?) 2. Suppose NEC uses the proceeds of a debt issue as shown in Exhibit 2 to buy back shares. What will happen to the total market value of common stock when the share repurchase is announced? What will happen to the price per share of stock when the buyback is announced? At what price should the shares be repurchased? How many shares will be repurchased? What will happen to total shareholder wealth? 3. Now, suppose management decides to undertake a recapitalization by means of a fixed price tender offer at $35 per share. How many shares will be repurchased? What will happen to stock price when the transaction is announced? What will happen to shareholder wealth? What will happen to shareholder wealth after the transaction is completed? 4. What leverage policy do you recommend? (Consider leverage ratio, coverage ratio, and bond rating.) Should the leverage policy be determined by book values or market values? 5. What is the firm's weighted average costs of capital under alternative capital structures? What is the company's weighted average cost of capital under your proposed optimal/target capital structure? 6. Which WACC should NEC use to make a decision regarding the new project. Should NEC undertake the new investment if you used the firm-wide WACC? 7. Can there be a more accurate estimate of the WACC of the internal electronics division? If so, calculate the WACC for the internal electronics division. Should NEC undertake the project using the new WACC? (Make note of all the assumptions you are making while doing the analysis.) Exhibit 3 Detailed Assumptions for Pro Forma Recapitalizations Presented in Exhibit 2 1. Debt is assumed to be added to the capital structure by issuing debt and using the proceeds to repurchase common stock. All repurchases are assumed to be executed in December 2023. The "status quo" pro forma capital structure assumes that NEC will begin in 2024 with its 2023 capital structure strategy unchanged and NEC did not undertake the project. 2. The interest rate on debt in all recapitalizations is assumed to be 7% before tax. 3. A tax rate of 34% is used. 4. The dividend payout ratio is 60%. 5. Stock is assumed to be repurchased at a price of $30 per share, which was the prevailing stock price in December 2023. 6. Details of recapitalization are in $ millions. Exhibit 1 Comparison Data for NEC and KGroup, 2023 ( $ in millions except per share and ratio data) =a Other liabilities include trade credit (i.e., accounts payable), accrued taxes and other miscellaneous non interest bearing liabilities. b Debt-to-total capital is calculated as interest bearing debt divided by interest bearing debt plus net worth. c Moody's rates the GGroun debt as AAA and S\&P rates KGroun debt as AA. Networth(bookvalue)CommonstockpriceTotalmarketvalueofcommonstock$1,472.8$30$4,665.0$1,040.7 * See footnotes on following page for explanations. Mr. Wilner Talbot Wizner is CEO of National Electronics Corp. (NEC) and has held that position since 2002. Mr. Wizner has never felt comfortable with having debt in the company's capital structure. During the 15 years of his tenure as CEO, NEC has experienced impressive growth in sales, earnings, and dividends. The date is now December 2023. At the end of 2023, NEC would essentially have no debt on its balance sheet and had cash equal to 25% of its net worth. Mr. Wizner is expected to retire in the near future and Wall Street analysts have the view that NEC will likely adjust its capital structure to include more debt after his departure. The Company NEC's 2023 sales of nearly $4 billion have been generated by over 40 brands in four lines of business divisions. Majority of the revenues are generated by the entertainment electronics (such as handheld games), cell phones, and internal electronics (such as electronics for automobiles). NEC's largest and most profitable business - cell phones - has a major market share against wellknown competitors. NEC's success has been built on marketing expertise. Whether the product is a game console or a new cell phone, NEC makes a practice of "out-marketing" the competition. A fourth division, the Scrap division, reduces the electronic waste produced by the other divisions to reusable scrap. Although it is not as profitable, it appeals to the NEC's mission to minimize electronic waste. NEC has a distinctive corporate culture that reflects the personal traits of its CEO. This culture has several features. The company is known for its tight financial controls and frugality. Any expenditure greater than $100,000 must be personally approved by Mr. Wizner, even if it has been previously allocated in the corporate budget. NEC's culture can also be described as highly risk averse. NEC consistently avoids much of the risk of new-product development in the volatile electronics industry. Historically, most of its new products either were acquired or licensed after their development by other firms, or they were copies of new products introduced by competitors. Further, many of NEC's new products are modest extensions of existing products. NEC thus avoids taking chances on R\&D and newproduct introductions and uses its marketing skills to promote purchased products and product extensions. When innovative products are introduced by competitors, NEC responds with similar products and relies on its marketing expertise to catch up with the competition. NEC's Performance Under Mr. Wizer's oversight, NEC has generated impressive financial results. NEC has experienced consistent growth in sales, earnings, and dividends over the past two decades. NEC has used internally generated capital to finance its growth while still maintaining a dividend payout ratio of nearly 60% of earnings. Further, NEC's six-fold growth in earnings per share has been accompanied by a tripling of its stock price. The likely retirement of Mr. Wizner in the near term has generated speculation about a recapitalization and the impact of such a change in policy on the company's stock price and equity market value. Further speculation arose regarding the new-product development within NEC and what kind of projects should be undertaken. NEC's Capital Structure Policy Many technology firms use relatively little debt financing, but few match NEC's low leverage ratio. Because of NEC's breadth of activities, it is difficult to find a truly similar company for comparison. The closest is K Group, Inc. (KGroup). KGroup has a debt-to-total capital ratio of 32% and its bond rating is AAA/AA (see Exhibit 1). The effect of a more aggressive capital structure that is likely to come about with a change in CEO has been evaluated by analysts who follow NEC's stock. Exhibits 1 and 2 show actual 2023 performance and pro-forma statements for 2024 under two capital structures. As presented in Exhibit 3, these projections assume that NEC issues debt and uses the proceeds to repurchase stock at a price of $30 per share. NEC's new investment Ms. Kathy McKita the chief budgeting analyst of NEC is preparing the capital budget for 2024 . She is negotiating to purchase a new piece of equipment for its current operations in the internal electronics division. It is deciding on whether to invest in a highly experimental technology that would propel further electrification of the automotive industry. This project is expected to have no impact on sales revenue but is expected to reduce manufacturing costs in the internal electronics division. The capital investment for equipment required for the project in question is $2,000,000. Setup costs associated with the new equipment are expected to add another 15 percent to the initial investment amount. Ms. McKita believes that the investment and setup costs associated with buying and setting up the equipment will be written off to zero using the 3-year Recovery Period Class (Use the MACRS schedule). The equipment is expected to have a five-year operating life. At the end of that period, the machinery is expected to be sold to the scrap division for $150,000. It is expected that the Scrap Division will process the machine for scrap at an incremental cost of $100,000 and sell the scrap for $300,000 at that time. Ms. McKita expects that total projected sales revenue in the internal electronics division in 2024 will be $10,000,000 and expects revenues to grow by 5 percent per year for the next four years. The expected benefits of the new equipment are threefold. First, Ms. McKita expects to reduce direct labor costs by 8% of total sales revenue each year for five years. Second, Ms. McKita expects that the new machine will reduce scrap created in the manufacturing process by 2000 pounds per year. Each pound of scrap reduction results in a net savings of $50 per pound. The price per pound is not expected to change. 1 Finally, the new equipment is expected to enhance working capital productivity. Specifically, the firm's expected required investment in work-inprogress inventory will decline from 20 percent of sales to 15 percent of sales. The new machinery is very sensitive to the intensity with which it will be used and might require extensive annual maintenance. Ms. McKita expects maintenance costs to be $280,000 per year, is not exactly sure how to estimate the maintenance cost, but is sure that whatever they are, they will be a tax-deductible expense in the period in which they are incurred. The Chief Financial Officer (CFO), Mr. Thomas Tedrow, has indicated that regardless of the source of financing used, the after-tax cost of capital for all projects considered by the internal electronics division should not change and should be equal to the cost of capital of NEC as a whole. Mr. McKita disagrees, she believes that the capital structure used by the firm will affect the cost of capital. Furthermore, even if the effect of debt is the same for each division, the cost of equity should be separate for the internal electronics division. 1 The net savings of $50 per pound takes into account the price at which the scrap is resold by the Scrap Division. Exhibit 2 Under these circumstances, answer the following questions: 1. Should NEC change its capital structure? (Compare the characteristics of NEC and KGroup in Exhibit 1. What similarities do you see? What differences? Consider cash balances, receivables, inventory, property, plant & equipment, bond ratings, common stock betas, and leverage ratios among other features. Can you draw any inferences from these observations?) 2. Suppose NEC uses the proceeds of a debt issue as shown in Exhibit 2 to buy back shares. What will happen to the total market value of common stock when the share repurchase is announced? What will happen to the price per share of stock when the buyback is announced? At what price should the shares be repurchased? How many shares will be repurchased? What will happen to total shareholder wealth? 3. Now, suppose management decides to undertake a recapitalization by means of a fixed price tender offer at $35 per share. How many shares will be repurchased? What will happen to stock price when the transaction is announced? What will happen to shareholder wealth? What will happen to shareholder wealth after the transaction is completed? 4. What leverage policy do you recommend? (Consider leverage ratio, coverage ratio, and bond rating.) Should the leverage policy be determined by book values or market values? 5. What is the firm's weighted average costs of capital under alternative capital structures? What is the company's weighted average cost of capital under your proposed optimal/target capital structure? 6. Which WACC should NEC use to make a decision regarding the new project. Should NEC undertake the new investment if you used the firm-wide WACC? 7. Can there be a more accurate estimate of the WACC of the internal electronics division? If so, calculate the WACC for the internal electronics division. Should NEC undertake the project using the new WACC? (Make note of all the assumptions you are making while doing the analysis.) Exhibit 3 Detailed Assumptions for Pro Forma Recapitalizations Presented in Exhibit 2 1. Debt is assumed to be added to the capital structure by issuing debt and using the proceeds to repurchase common stock. All repurchases are assumed to be executed in December 2023. The "status quo" pro forma capital structure assumes that NEC will begin in 2024 with its 2023 capital structure strategy unchanged and NEC did not undertake the project. 2. The interest rate on debt in all recapitalizations is assumed to be 7% before tax. 3. A tax rate of 34% is used. 4. The dividend payout ratio is 60%. 5. Stock is assumed to be repurchased at a price of $30 per share, which was the prevailing stock price in December 2023. 6. Details of recapitalization are in $ millions. Exhibit 1 Comparison Data for NEC and KGroup, 2023 ( $ in millions except per share and ratio data) =a Other liabilities include trade credit (i.e., accounts payable), accrued taxes and other miscellaneous non interest bearing liabilities. b Debt-to-total capital is calculated as interest bearing debt divided by interest bearing debt plus net worth. c Moody's rates the GGroun debt as AAA and S\&P rates KGroun debt as AA. Networth(bookvalue)CommonstockpriceTotalmarketvalueofcommonstock$1,472.8$30$4,665.0$1,040.7 * See footnotes on following page for explanations. Mr. Wilner Talbot Wizner is CEO of National Electronics Corp. (NEC) and has held that position since 2002. Mr. Wizner has never felt comfortable with having debt in the company's capital structure. During the 15 years of his tenure as CEO, NEC has experienced impressive growth in sales, earnings, and dividends. The date is now December 2023. At the end of 2023, NEC would essentially have no debt on its balance sheet and had cash equal to 25% of its net worth. Mr. Wizner is expected to retire in the near future and Wall Street analysts have the view that NEC will likely adjust its capital structure to include more debt after his departure. The Company NEC's 2023 sales of nearly $4 billion have been generated by over 40 brands in four lines of business divisions. Majority of the revenues are generated by the entertainment electronics (such as handheld games), cell phones, and internal electronics (such as electronics for automobiles). NEC's largest and most profitable business - cell phones - has a major market share against wellknown competitors. NEC's success has been built on marketing expertise. Whether the product is a game console or a new cell phone, NEC makes a practice of "out-marketing" the competition. A fourth division, the Scrap division, reduces the electronic waste produced by the other divisions to reusable scrap. Although it is not as profitable, it appeals to the NEC's mission to minimize electronic waste. NEC has a distinctive corporate culture that reflects the personal traits of its CEO. This culture has several features. The company is known for its tight financial controls and frugality. Any expenditure greater than $100,000 must be personally approved by Mr. Wizner, even if it has been previously allocated in the corporate budget. NEC's culture can also be described as highly risk averse. NEC consistently avoids much of the risk of new-product development in the volatile electronics industry. Historically, most of its new products either were acquired or licensed after their development by other firms, or they were copies of new products introduced by competitors. Further, many of NEC's new products are modest extensions of existing products. NEC thus avoids taking chances on R\&D and newproduct introductions and uses its marketing skills to promote purchased products and product extensions. When innovative products are introduced by competitors, NEC responds with similar products and relies on its marketing expertise to catch up with the competition. NEC's Performance Under Mr. Wizer's oversight, NEC has generated impressive financial results. NEC has experienced consistent growth in sales, earnings, and dividends over the past two decades. NEC has used internally generated capital to finance its growth while still maintaining a dividend payout ratio of nearly 60% of earnings. Further, NEC's six-fold growth in earnings per share has been accompanied by a tripling of its stock price. The likely retirement of Mr. Wizner in the near term has generated speculation about a recapitalization and the impact of such a change in policy on the company's stock price and equity market value. Further speculation arose regarding the new-product development within NEC and what kind of projects should be undertaken. NEC's Capital Structure Policy Many technology firms use relatively little debt financing, but few match NEC's low leverage ratio. Because of NEC's breadth of activities, it is difficult to find a truly similar company for comparison. The closest is K Group, Inc. (KGroup). KGroup has a debt-to-total capital ratio of 32% and its bond rating is AAA/AA (see Exhibit 1). The effect of a more aggressive capital structure that is likely to come about with a change in CEO has been evaluated by analysts who follow NEC's stock. Exhibits 1 and 2 show actual 2023 performance and pro-forma statements for 2024 under two capital structures. As presented in Exhibit 3, these projections assume that NEC issues debt and uses the proceeds to repurchase stock at a price of $30 per share. NEC's new investment Ms. Kathy McKita the chief budgeting analyst of NEC is preparing the capital budget for 2024 . She is negotiating to purchase a new piece of equipment for its current operations in the internal electronics division. It is deciding on whether to invest in a highly experimental technology that would propel further electrification of the automotive industry. This project is expected to have no impact on sales revenue but is expected to reduce manufacturing costs in the internal electronics division. The capital investment for equipment required for the project in question is $2,000,000. Setup costs associated with the new equipment are expected to add another 15 percent to the initial investment amount. Ms. McKita believes that the investment and setup costs associated with buying and setting up the equipment will be written off to zero using the 3-year Recovery Period Class (Use the MACRS schedule). The equipment is expected to have a five-year operating life. At the end of that period, the machinery is expected to be sold to the scrap division for $150,000. It is expected that the Scrap Division will process the machine for scrap at an incremental cost of $100,000 and sell the scrap for $300,000 at that time. Ms. McKita expects that total projected sales revenue in the internal electronics division in 2024 will be $10,000,000 and expects revenues to grow by 5 percent per year for the next four years. The expected benefits of the new equipment are threefold. First, Ms. McKita expects to reduce direct labor costs by 8% of total sales revenue each year for five years. Second, Ms. McKita expects that the new machine will reduce scrap created in the manufacturing process by 2000 pounds per year. Each pound of scrap reduction results in a net savings of $50 per pound. The price per pound is not expected to change. 1 Finally, the new equipment is expected to enhance working capital productivity. Specifically, the firm's expected required investment in work-inprogress inventory will decline from 20 percent of sales to 15 percent of sales. The new machinery is very sensitive to the intensity with which it will be used and might require extensive annual maintenance. Ms. McKita expects maintenance costs to be $280,000 per year, is not exactly sure how to estimate the maintenance cost, but is sure that whatever they are, they will be a tax-deductible expense in the period in which they are incurred. The Chief Financial Officer (CFO), Mr. Thomas Tedrow, has indicated that regardless of the source of financing used, the after-tax cost of capital for all projects considered by the internal electronics division should not change and should be equal to the cost of capital of NEC as a whole. Mr. McKita disagrees, she believes that the capital structure used by the firm will affect the cost of capital. Furthermore, even if the effect of debt is the same for each division, the cost of equity should be separate for the internal electronics division. 1 The net savings of $50 per pound takes into account the price at which the scrap is resold by the Scrap Division