Question
Its amazing how much difference there is in the way proposals are presented at two different firms, said Art Monk to his assistant, Russell Jacobs,
Its amazing how much difference there is in the way proposals are presented at two different firms, said Art Monk to his assistant, Russell Jacobs, as he pointed to the stack of capital investment proposals piled on his desk. We sure have our work cut out for us, Russ. I need you to collect some data for me as soon as possible. Monk had recently been hired as assistant vice president of finance for American Structural Products. His past experience included a seven-year stint with another large consumer-products firm. His career had been very successful thus far, as he had gone from being a financial analyst to assistant VP of finance in a little over seven years. Art, who held an undergraduate degree in accounting and an MBA in finance from nationally recognized business schools, preferred to follow a conservative policy when analyzing capital investment projects. Most of the projects that he had analyzed and got approved had turned out to be profitable for his former employers. At a recent meeting of the Capital Investment Committeethe primary group responsible for approving proposals at American Structural Productsthe five divisional managers had presented proposals that had cost estimates ranging from $250,000 to $750,000. All five proposals were shown to have positive net present values (NPVs) and fairly high internal rates of return (IRRs). Moreover, the cost and revenue figures seemed to be conservatively arrived at, and all five proposals seemed to have good overall strategic value. However, upon careful deliberation and reflection, it was revealed that the divisional managers had used the cost of debt as the minimum acceptable rate of return whilst evaluating their respective projects. The company had issued 20-year, 8% bonds, at par, last year and that rate was used as the hurdle rate under the assumption that additional funds could be raised at the same rate. There was considerable argument, confusion, and dissent at the meeting when Art brought up the issue of the firms target capital structure and raised concerns that the hurdle rate for each project could vary depending on the total capital raised by the firm. It was clear that there was a lack of full understanding and consensus about cost of capital issues among the divisional managers, most of whom did not have a finance background. Sensing that the meeting was going nowhere, the chief financial officer, Tony Bowker, said, Art, why dont you take these proposals, re-evaluate them based on appropriate discount rates, and present your recommendations at our next weeks committee meeting? Im sure you all will agree with me that it is better to be safe than sorry! Art started his analysis by listing the estimated cost, economic life, and IRR of each proposal, as shown in Table 1. He then collected data regarding the current prices, preferred dividend rate, retention ratio, and number of issues outstanding of the firms bonds, preferred stock, and common stock (Table 2). For this purpose, Art referred to the latest income statement (Table 3), balance sheet (Table 4), and the Internet. A call to the firms investment banker helped him obtain estimates of flotation costs that would apply based on the type of issue (Table 5). As he crunched the numbers, Art realized that he would need the following estimates:
1.The firms expected growth rate of sales, earnings and dividends.
2.The expected return on the market index.
3.The Treasury bill rate.
4.The firms beta.
This is the list he passed on to his assistant, Russ.
Table 1
Project Information
Project | Cost | IRR | Estimated Life | NPV @ 8% |
A | $500,000 | 20% | 5 Years | $346,754.39 |
B | $750,000 | 12% | 4 Years | $117,437.77 |
C | $250,000 | 16% | 3 Years | $59,772.39 |
D | $600,000 | 25% | 4 Years | $476,703.89 |
E | $400,000 | 15% | 3 Years | $82,927.84 |
Table 2
Market Data Regarding Outstanding Securities
Type | Par Value | Current Price | Number Outstanding |
10%, 20-Year Bonds | $1,000 | $900 | 10,000 |
6% Preferred Stock | $10 | $12 | 500,000 |
Common Stock | $1 | $25 | 1,000,000 |
Table 3
American Structural Products Last Years Income Statement (000s)
Revenues | 37500 |
Cost of Goods Sold | 31875 |
Gross Profit | 5625 |
Selling & Administration Expenses | 1125 |
Depreciation | 1000 |
Earnings Before Interest and Taxes | 3500 |
Interest Expenses | 887 |
Earnings Before Taxes | 2613 |
Taxes (40%) | 1045 |
Net Income | 1,568 |
Preferred Dividends | 300 |
Income Available for Common | 1,268 |
Common Stock Dividends | 508 |
Addition to Retained Earnings | 760 |
Table 4
American Structural Products Balance Sheet (000s)
Current Assets | 10,000 | Current Liabilities | 3,000 |
Net Fixed Assets | 75,000 | Notes Payable | 2,000 |
| Long-Term Debt (10,000 Outstanding, Coupon Rate = 8%, Face Value = $1,000) | 10,000 | |
| Preferred Stock (500,000 Outstanding, Dividend Rate = 6%, Par Value = $10) | 50,000 | |
| Common Stock (1,000,000 Outstanding) | 20,000 | |
Total Assets | 85,000 | Total Liabilities & Shareholders Equity | 85,000 |
Table 5
Flotation Cost Schedule
Type of Security | Issuance Cost |
Bonds | 5% |
Preferred Stock | 10% |
Common Stock | 15% |
Table 6
Expected Growth Rate of Sales | 25% |
Expected Growth Rate of Earnings and Dividends | 12% |
Expected Return on the Market | 15% |
Treasury Bill Rate | 6% |
Expected Retention Rate | 60% |
Firms Equity Beta | 1.2 |
QUESTION (ANSWER ALL OF THE QUESTION PLEASE! )
1) Develop and graph the marginal cost of capital for the intended capital investments. Explain how the values are arrived at.
2) Using the same graph as in #5, develop an investment opportunity schedule using the data for the five proposals, and indicate which combination of projects would be acceptable.
3) Recalculate the NPVs of the five projects using the appropriate hurdle rate. Are the projects still acceptable? Explain.
4) Assume that the cash flows of Project B were 40% less risky than those of the other four projects, which were estimated to be of average risk. How would the evaluation process be affected? What would Art have to do to make the appropriate recommendations
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started