Integrated Case 6

O Grady Apparel Company was founded nearly 160 years about when an Irish merchant named O Grady landed in LA with an inventory of heavy canvas, which he hoped to sell for tents and wagon covers to miner headed for the California goldfields. Instead, he turned to the sale of harder-wearing clothing.

Today O Grady Apparel Company is a small manufacturer of fabrics and clothing whose stock is traded in the OTC market. In 2012, the LAS based company experienced sharp increase in both domestic and European markets resulting in record earnings. Sales from $15.9 million in 2008 to 18.3 million in 2012 with earnings per share of $3.28 and $3.84, respectively.

European sales represented 29% of total sales in 2012, up from 24% the year before and only 3% in 2007, 1 year after foreign operation were launched. Although foreign sales represent nearly one third of total sales, the growth in the domestic market is expected to affect the company mostly markedly. Management expect sales to surpass $21 million in 2013 and earnings per share are expected to rise $4.40. As seen in Table 1

Because of the recent forth, Margaret Jennings, the corporate treasurer is concerned that available funds are not being used to their fullest potential. The projected 1300000 of internally generated 2013 funds is expected to be insufficient to meet the companys expansion needs. Management has set a policy on maintaining the current capital structure proportion 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 earning as dividends. Total capital expenditures are yet to be determined.

Jennings has been presented with several competing investment opportunities by division and product manager. However because funds are limited, choices of which project to accept must be made. A list of investment opportunities is show 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. O Grady is in the 40% tax bracket.

Table 1

Selected Income Statements Items
	2010	2011	2012	2013
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	2.88	3.28	3.84	4.40
Dividends per share	1.15	1.31	1.54	1.76

Table 2

Investment Opportunities
Investment	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 floatation cost. Any debt in excess of $700,000 will have a before tax cost of 18%

Preferred Stock: Can be issued with a $60 par value and a 17% annual dividend rate. It will net $57 per share after floatation cost.

Common Stock: The firm expect 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 floatation cost.

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

Source of Capital	Range of New financing	After-tax cost (%)
Long term debt	<$700,000
Long term debt	$700,000+
Preferred Stock	$0+
Common Stock	<$1,300,000
Common Stock	$1,300,000+

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, O Grady plans to use 25% long-term debt in is its capital structure. That mean that 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 then desired 25%). From Table, 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 raise ($700,000 in debt plus $2.1 million in other sources to maintain the 25% proportion for debt). Therefore, $2.8 million is the break point for debt. If the firm wants to raise more than $2.8 million in total financing, then 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.

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.

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 raises on the horizontal axis and show how the firms WACC increases in steps as the amount of money raised increases.

Sort the investment opportunities described in Table 2 from highest to lowest return, and plot a line on the graph you drew in part c 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 ploy the relationship between IRR on the firms investments and the total financing required to undertake those investments.

Which, if any, of the available investments would your recommend that the firm accept?

Assuming that the specific financing cost do not change, what effect would a shift to more highly leveraged capital structure consisting of 50% long-term debt, 10% preferred stock and 40% common stock have on your previous findings?

What capital structure the original one or this one seems better? Why?

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?

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