Handout #6 FINANCE 5813

Spring 2017

Capital, Inc., had the following Income Statement for 2016:

Income Statement

Revenues $100,000

Expenses

Cost of Goods Sold 62,000

Gen & Adm 22,500

Depreciation 4,000

88,500

EBIT 11,500

Interest Expense 2,240

Taxable Income 9,260

Income Tax (40%) 3,704

Net Income $ 5,556

The Balance Sheet as of December 31, 2016, was as follows:

Balance Sheet

Cash $ -0- A/P $ 7,600

A/R 17,000 Notes Payable (8%) 8,400

Inventory 62,000 Total CL 16,000

Total CA 79,000

L-T Debt (8%) 19,600

Net Plant & Equip. 50,000 Common Stock ($1 par) 1,000

Retained Earnings 92,400

Total Assets $129,000 Total Liab. & Equity $129,000

The owner of Capital has asked if you would be interested in buying the firm. While the firm actually has some cash balances as of the end of 2016, they have been removed from the 2016 financials to reflect the fact that the cash is a non-operating asset and the owner intends to take it out as a distribution upon sale. Being familiar with the industry, you expect sales to increase at a 5% rate indefinitely. However, you feel that you can accomplish several improvements. First, you feel that cost of goods sold can be trimmed to 55% of sales this year (2017) and finally to 50% next year (2018). You also expect to trim the fat in G&A expense to 20% of sales this year, a level which you can maintain. Also, you feel that tighter control of credit policy can cut the average collection period to 45 days. The inventory turnover rate (based on COGS) of 1.0 currently can be increased to 1.25 in 2017 and 1.5 times in future years. The level of cash and plant & equipment (as a percentage of sales) and debt (as a percentage of total assets) all seem appropriate. If you require a 15% rate of return, what is the value you would place on the equity of Capital, Inc.?

Note:

Since there is no beginning balance sheet for 2016 (i.e., no 2015 ending balance sheet), you need to calculate the interest rate based on the 2016 interest expense relative to the ending 2016 interest-bearing debt.

You must use the direct method of calculating the value of the equity since no WACC is given. If you try to use the sequential method or traditional method for enterprise value to verify your solution, you will get a different answer. Brownie points if you can explain why there will be a different answer in calculating the enterprise value after determining the value of the equity and then calculating the WACC for enterprise value.

More brownie points: Why is the value of the equity today greater than the terminal value at the end of 2018?

Needed in Excel.