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Wacky Wine owns over 100 retail wine stores specializing in hard to find premium wines. The company, which opened its first store in 2009, experienced rapid growth, and went public with its initial public offering (IPO) in 2012. Since then, Wacky Wines as limited its use of debt and is currently financed using only equity. You will take on the role of a hedge fund analyst, Susan (or Sean) Goldsmith, at Kropp Capital. Your job is to prepare a report for Michael Silver, the managing partner. Kropp Capital pursues an activeinvestor strategy. Kropp Capital seeks to purchase a significant number of outstanding shares of Wacky Wines' common stock, apply pressure to Wacky Wines to change its capital structure with the hopes that this will increase the firm's value (and stock price) and then Kropp Capital would sell its shares at a profit. Michael Silver has requested your assistance with the analysis of this plan. As previously stated, Wacky Wines is currently financed using only equity. Currently, Wacky Wines has one million shares outstanding, the current stock price is $10 per share, and Wacky Wines' is 1.2. The proposed change in capital structure would be accomplished by convincing Wacky Wines to borrow money (take on debt) and use this debt to repurchase stock. Please evaluate each of these two possible proposals: 1) issuing $3 million of new debt and using the proceeds to repurchase shares; or 2) issuing $1.50 million of new debt and using the proceeds to repurchase shares. Assume that if Wacky Wines takes on $3million dollars in debt it will have a B credit rating, and will be able to borrow $3million via a 10 year loan at an interest rate of 9%. However, if Wacky Wines borrows $1.5million dollars in debt it will have an A credit rating, and will be able to borrow at an interest rate of 4.5% for 10 years. Assume further that the market risk premium is 7%. Wacky Wines' faces a corporate tax rate of 40%. Your job is to determine whether or not Kropp Capital should pursue the active investor strategy discussed above, and, if so, what capital structure should Kropp Capital encourage Wacky Wines to pursue. Your analysis should address the following: 1. For each of the proposed capital structures ($3million and $1.5 million dollars in debt), examine the effects of issuing new debt and using the proceeds to repurchase shares on: a. Wacky Wines financial statements? (Please construct pro forma financial statements for each proposed capital structure). b. Value of the firm after restructuring? c. The number of outstanding shares? d. The price per share of Wacky Wines' common stock? e. Earnings per share and ROE? f. Interest coverage and cash coverage ratios? g. D/E (using the accounting values from the balance sheet to constructed these ratio) h. Financial flexibility? i. Wacky Wines' WACC? (Compute the WACC for both proposed capital structures and compare to the WACC prior to recapitalization. Remember to use market values for debt and equity in the calculation of WACC.) 2. What is the expected cost of financial distress (both prerecapitalization and after recapitalization)? 3. Should Kropp Capital try to convince Wacky Wines' directors to undertake the recapitalization? If so, which of the two proposed capital structures should be pursued? You should write a memo to Michael Silver. He is extremely well versed in finance. Michael Silver is also looking for advanced analysis with evidence of critical thinking, particularly as it relates to optimal capital structure. He always appreciates well written memos that make appropriate use of correct grammar and spelling. Income Statement (Unaudited) (for years ending Nov 1) Net Sales Cost of Goods Sold Gross Profit $ $ $ Operating expenses Advertising and promotion Depreciation Insurance Legal and accounting Office expenses Repairs and Maintenance Rent Telephone Utilities Wages and benefits Total operating profit Income taxes Net Income $ $ $ $ $ $ $ $ $ $ $ $ $ 2015 2016 2017F 2,459,000.00 $ 2,550,800.00 $ 3,088,500.00 737,700.00 $ 765,240.00 $ 926,550.00 1,721,300.00 $ 1,785,560.00 $ 2,161,950.00 221,310.00 121,009.00 75,000.00 100,000.00 9,000.00 73,770.00 60,000.00 9,180.00 23,770.00 245,900.00 782,361.00 312,944.40 469,416.60 $ $ $ $ $ $ $ $ $ $ $ $ 229,572.00 104,431.20 80,000.00 130,000.00 10,000.00 89,278.00 ### 12,668.40 26,524.00 255,080.00 788,006.40 315,202.56 472,803.84 $ 277,965.00 $ 95,530.98 $ 85,000.00 $ 135,000.00 $ 10,500.00 $ 123,540.00 $ 60,000.00 $ 17,212.50 $ 30,655.00 $ 308,850.00 $ 1,017,696.52 $ 407,078.61 $ 610,617.91 Statement of Retained Earnings (Unaudited) (for years ending Nov 1) Beginning retained earnings Add: Net Income $ 2015 39,506.00 $ 469,416.60 2016 508,922.60 $ 472,803.84 2017F 981,726.44 610,617.91 Ending retained earnings $ 508,922.60 $ 981,726.44 $ 1,592,344.35 Balance Sheet (Unaudited) (for years ending Nov 1) 2015 ASSETS Current Assets: Cash Accounts Receivable Inventory Prepaid expenses Total Current Assets Fixed Assets: $ $ $ $ $ 83,908.08 737,700.00 368,850.00 12,341.00 1,202,799.08 2016 2017F $ 659,741.12 $ 765,240.00 $ 331,604.00 $ 13,528.00 $ 1,770,113.12 $ 693,166.01 $ 926,550.00 $ 370,620.00 $ 13,459.00 $ 2,003,795.01 Computer hardware & software Furniture & fixtures Signage Real Estate Total Fixed Assets (cost) Less: Accumulated depreciation Net fixed assets $ $ $ $ $ $ $ 17,190.00 11,688.00 9,545.00 1,225,296.00 1,263,719.00 219,407.00 1,044,312.00 TOTAL ASSETS $ 2,247,111.08 $ 2,725,422.92 $ 3,368,302.83 LIABILITIES Current Liabilities: Wages Payable Accounts Payable Total Current Liabilities $ $ $ Long Term Liabilities: Deferred Income Taxes Total Long Term Liabilities $ $ TOTAL LIABILITIES $ Shareholder's Equity Share Capital Retained Earnings Total Shareholder's Equity $ $ $ 1,577,261.48 ### $ 1,577,261.48 508,922.60 $ 981,726.44 $ 1,592,344.35 2,086,184.08 $ 2,558,987.92 $ 3,169,605.83 TOTAL LIABILITIES AND SHAREHOLDER'S EQUIT $ 2,247,111.08 $ 2,725,422.92 $ 3,368,302.83 $ $ $ $ $ 24,590.00 $ 122,950.00 $ 147,540.00 $ ### 26,662.00 10,000.00 ### 1,279,148.00 323,838.20 955,309.80 25,508.00 $ 127,540.00 $ 153,048.00 $ 30,885.00 154,425.00 185,310.00 ### $ ### $ 13,387.00 13,387.00 166,435.00 $ 198,697.00 13,387.00 13,387.00 160,927.00 $ $ 18,060.00 $ 30,521.00 $ 10,000.00 $ 1,725,296.00 $ 1,783,877.00 $ 419,369.18 $ 1,364,507.82 Statement of Cash Flows (for years ending Nov 1) OPERATIONS: Net Income Adjustments to Cash Basis: Depreciation Accounts Receivable Inventory Prepaid Expenses Accounts Payable Wages payable Deferred Income taxes Net Cash Flow From Operations 2016 2017F $ 472,803.84 $ 610,617.91 $ $ $ $ $ $ $ $ 104,431.20 (27,540.00) 37,246.00 (1,187.00) 4,590.00 918.00 118,458.20 $ $ $ $ $ $ $ $ 95,530.98 (161,310.00) (39,016.00) 69.00 26,885.00 5,377.00 (72,464.02) $ 591,262.04 $ 538,153.89 FINANCING ACTIVITIES Net Cash Flow From Financing Activities $ INVESTING ACTIVITIES Fixed Assets $ (15,429.00) $ (504,729.00) Net Cash Flow Beginning Cash Ending Cash $ $ $ 575,833.04 $ 83,908.08 $ 659,741.12 $ 33,424.89 659,741.12 693,166.01 - $