From Principles of Managerial Finance 14th Edition, Chapter 14, Interactive Case

OGrady Apparel Company was founded nearly 160 years ago when an Irish merchant named Garrett OGrady landed in Los Angeles with an inventory of heavy canvas, which he hoped to sell for tents and wagon covers to miners headed for the California goldfields. Instead, he turned to the sale of harder-wearing clothing.

Today, OGrady Apparel Company is a small manufacturer of fabrics and clothing whose stock is traded in the OTC market. In 2015, the Los Angelesbased company experienced sharp increases in both domestic and European markets resulting in record earnings. Sales rose from $15.9 million in 2014 to $18.3 million in 2015 with earnings per share of $3.28 and $3.84, respectively.

European sales represented 29% of total sales in 2015, up from 24% the year before and only 3% in 2010, 1 year after foreign operations were launched. Although foreign sales represent nearly one-third of total sales, the growth in the domestic market is expected to affect the company most markedly. Management expects sales to surpass $21 million in 2016, and earnings per share are expected to rise to $4.40. (Selected income statement items are presented in Table 1.)

Because of the recent growth, Margaret Jennings, the corporate treasurer, is concerned that available funds are not being used to their fullest potential. The projected $1,300,000 of internally generated 2016 funds is expected to be insufficient to meet the companys expansion needs. Management has set a policy of maintaining the current capital structure proportions of 25% long-term debt, 10% preferred stock, and 65% common stock equity for at least the next 3 years. In addition, it plans to continue paying out 40% of its earnings as dividends. Total capital expenditures are yet to be determined.

Jennings has been presented with several competing investment opportunities by division and product managers. However, because funds are limited, choices of which projects to accept must be made. A list of investment opportunities is shown in Table 2. To analyze the effect of the increased financing requirements on the weighted average cost of capital (WACC), Jennings contacted a leading investment banking firm that provided the financing cost data given in Table 3. OGrady is in the 40% tax bracket.

TABLE 1

Selected Income Statement Items
	2013	2014	2015	Projected 2016
Net sales	$13,860,000	$15,940,000	$18,330,000	$21,080,000
Net profits after taxes	$1,520,000	$1,750,000	$2,020,000	$2,323,000
Earnings per share (EPS)	2.88	3.28	3.84	4.40
Dividends per share	1.15	1.31	1.54	1.76

TABLE 2

Investment Opportunities
Investment opportunity	Internal rate of return (IRR)	Initial investment
A	21%	$400,000
B	19	200,000
C	24	700,000
D	27	500,000
E	18	300,000
F	22	600,000
G	17	500,000

TABLE 3

Financing Cost Data

Long-term debt: The firm can raise $700,000 of additional debt by selling 10-year, $1,000, 12% annual interest rate bonds to net $970 after flotation costs. Any debt in excess of $700,000 will have a before-tax cost, rd, of 18%.

Preferred stock: Preferred stock, regardless of the amount sold, can be issued with a $60 par value and a 17% annual dividend rate. It will net $57 per share after flotation costs.

Common stock equity: The firm expects its dividends and earnings to continue to grow at a constant rate of 15% per year. The firms stock is currently selling for $20 per share. The firm expects to have $1,300,000 of available retained earnings. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new common stock, netting $16 per share after underpricing and flotation costs.

TO DO

a. Over the relevant ranges noted in the following table, calculate the after-tax cost of each source of financing needed to complete the table.

Source of capital	Range of new financing	After-tax cost (%)
Long-term debt	$0$700,000	_________
	$700,000 and above	_________
Preferred stock	$0 and above	_________
Common stock equity	$0$1,300,000	_________
	$1,300,000 and above	_________

b.

(1) Determine the break point associated with common equity. A break point represents the total amount of financing that the firm can raise before it triggers an increase in the cost of a particular financing source. For example, OGrady plans to use 25% long-term debt in its capital structure. So, for every $1 in debt that the firm uses, it will use $3 from other financing sources (total financing is then $4, and because $1 comes from long-term debt, its share in the total is the desired 25%). From Table 3, we see that after the firm raises $700,000 in long-term debt, the cost of this financing source begins to rise. Therefore, the firm can raise total capital of $2.8 million before the cost of debt will rise ($700,000 in debt plus $2.1 million in other sources to maintain the 25% proportion for debt), and $2.8 million is the break point for debt. If the firms wants to maintain a capital structure with 25% long-term debt and it also wants to raise more than $2.8 million in total financing, it will require more than $700,000 in long-term debt, and it will trigger the higher cost of the additional debt it issues beyond $700,000.

(2) Using the break points developed in part (1), determine each of the ranges of total new financing over which the firms weighted average cost of capital (WACC) remains constant.

(3) Calculate the weighted average cost of capital for each range of total new financing. Draw a graph with the WACC on the vertical axis and total money raised on the horizontal axis, and show how the firms WACC increases in steps as the amount of money raised increases.

c.

(1) Sort the investment opportunities described in Table 2 from highest to lowest return, and plot a line on the graph you drew in part (3) above showing how much money is required to fund the investments, starting with the highest return and going to the lowest. In other words, this line will plot the relationship between the IRR on the firms investments and the total financing required to undertake those investments.

(2) Which, if any, of the available investments would you recommend that the firm accept? Explain your answer.

d.

(1) Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 10% preferred stock, and 40% common stock have on your previous findings? (Note: Rework parts b and c using these capital structure weights.)

(2) Which capital structurethe original one or this oneseems better? Why?

e.

(1) What type of dividend policy does the firm appear to employ? Does it seem appropriate given the firms recent growth in sales and profits and given its current investment opportunities?

(2) Would you recommend an alternative dividend policy? Explain. How would this policy affect the investments recommended in part c(2)?