Making Long Term FM Decisions - Integrative Case

Introduction: As a special analytical group set up by ACME Iron by the firms Controller, you have been tasked to respond to the following issues raised in a meeting with the CFO.

You must look over several prospective financial strategies to aid in the successful growth of ACME Iron: Capital investment analysis; CAPM Capital Asset Pricing Model determination for the company; WACC Weighted Average Cost of Capital computations; EVA Economic Value Analysis; MVA Market Value Added; Capital structure of the company; Dividend policy; Stock repurchase and option pricing strategy; Bankruptcy risk analysis; Decision Tree Creation; Real option analysis of projects

The CFO wants to test you out on a simple project in the first task before you get into preparing items for his board presentation in subsequent tasks and projects. He wants to see how well you perform tasks as well as how accurate and thoughtful you are in your work. Details are important to him as well as good organization/presentation and communication.

Financial Statements for use on Tasks

ACME Iron		Balance Sheet
Assets
Current assets:	2014	2015	change
Cash	500,000	600,000	100,000
Investments	1,000,000	1,025,000	25,000
Inventories	110,000,000	117,000,000	7,000,000
Accounts receivable	11,750,000	12,500,000	750,000
Pre-paid expenses	2,500,000	2,600,000	100,000
Other	0	0	-
Total current assets	125,750,000	133,725,000	7,975,000
Fixed assets:	2014	2015	change
Property and equipment	165,000,000	175,000,000	10,000,000
Leasehold improvements	0	0	-
Equity and other investments	55,000,000	65,000,000	10,000,000
Less accumulated depreciation	15,000,000	15,500,000	500,000
Total fixed assets	235,000,000	255,500,000	20,500,000
Other assets:	2014	2015	change
Goodwill	75,000,000	70,000,000	(5,000,000)
Total other assets	75,000,000	70,000,000	(5,000,000)
Total assets	435,750,000	459,225,000	23,475,000
Liabilities and owner's equity
Current liabilities:	2014	2015	change
Accounts payable	40,500,000	42,400,000	1,900,000
Accrued wages	85,000,000	90,500,000	5,500,000
Accrued compensation	10,000,000	10,855,000	855,000
Income taxes payable	4,024,000	4,697,000	673,000
current portion of LT debt	5,500,000	10,350,000	4,850,000
Other	0	0	-
Total current liabilities	145,024,000	158,802,000	13,778,000
Long-term liabilities:	2014	2015	change
Long term debt	125,000,000	130,000,000	5,000,000
Total long-term liabilities	125,000,000	130,000,000	5,000,000
Owner's equity:	2014	2015	change
Common stock	122,000,000	122,000,000	-
Preferred stock	16,725,000	16,725,000	-
Accumulated retained earnings	27,001,000	31,698,000	4,697,000
Total owner's equity	165,726,000	170,423,000	4,697,000
Total liabilities and owner's equity	435,750,000	459,225,000	23,475,000

Income Statement

ACME Iron

December 2015

Financial Statements in '000s of U.S. Dollars

REVENUE
Gross Sales	250,000
Less: Sales Returns & Allowances	2,500
Net Sales		247,500
COST OF GOODS SOLD
Beginning Inventory	7,500
Add: Purchases	4,500
Freight-in	0
Direct Labor	75,000
Indirect Expenses	15,000
Inventory Available	102,000
Less: Ending Inventory
Cost of Goods Sold		102,000
Gross Profit (Loss)		145,500
EXPENSES
Advertising	7,500
Amortization	0
Bad Debts	5,000
Depreciation	500
Dues and Subscriptions	0
Employee Benefit Programs	18,750
Insurance	2,500
Interest	10,350
Legal & Professional Fees	100
Licenses & Fees	0
Miscellaneous	10
Office Expenses	100
Payroll Taxes	5,625
Postage	3
Rent	0
Repairs & Maintenance	5,000
Supplies	2,000
Telephone	120
Travel	1,750
Utilities	50,000
Vehicle Expenses	450
Wages	25,000
Total Expenses		134,758
Net Operating Income		10,742
OTHER INCOME
Gain (Loss) on Sale of Assets	0
Interest Income	1,000
Total Other Income		1,000
TAXES		4,697
Net Income (Loss)		7,045

TASK 2

In this task we are examining the current capital structure of ACME Iron and determining the WACC of the company. Assume that ACMEs tax rate is 40%.

To compute the WACC you must first find the after-tax cost of debt, the cost of equity and the proportions of debt and equity in the firm. You can assume that the cost of debt before tax is 8% for the firm. Please clearly show how you derive each of these values:

After-tax cost of debt =

Cost of equity =

Proportions of debt and equity in the firm =

How do we compute the WACC in this circumstance? Why do we need to be concerned with the WACC?

Any insights into the capital structure of ACME Iron?

The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is computing the effect of the capital structure on expected returns by investors.

WACC= S/B+S x Rs + B/B+S x RB x (1 tc )

Where

S = value of equity

B = value of debt

Rs = cost of equity

After tax cost of debt: RB x (1 tc )

Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk we need to remember the following items:

1. Risk is deviation from expectations.

2. We need to set expectations for our investments in relation to risk and return. Higher risk = higher return.

3. Capital is obtained from the marketplace in two forms; equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed.

4. We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis).

5. If cost of capital rises then our risk rises and the projects we undertake to increase sales and return to our investors is reduced.

6. If debt rises then our obligation to make payments on interest increases and profits can decrease if sales do not increase rapidly enough.

7. If risk increases our beta will increase to show the increase in risk. This will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return we must use in discounting future cash flows.

TASK 3

Acme is planning construction of a new loading ramp for its single iron mill. The initial cost of the investment is $1 million. Efficiencies from the new ramp are expected to reduce costs by $100,000 for the life of the plant which is currently estimated at another 30 years.

When will this project break-even on a simple cash basis and a discounted cash basis.

What is the NPV of the project if Acme has an after tax cost of debt of 8% and a cost equity of 12% (they are currently funded equally by debt and equity)?

Helpful Hint: The first step in conducting an NPV analysis is to include all the relevant cash flows. This includes savings from taxes and any expenses directly related to the venture. We reject any project with a negative NPV.