P5. Innovative Engineering was founded by two partners, Gale and Yeaton. Within five years, the partners had built a thriving business, primarily through the development of a product line of measuring instruments based on the laser principle. Success brought with it the need for new permanent capital. The partners placed the amount of this need at $1.2 million. This would replace a term loan that was about to mature and provide for plant expansion and related working capital.

They learned that Arbor Capital Corporation, a venture capital firm, might be interested in providing permanent financing. In thinking about what they should propose to Arbor, their first idea (Proposal A) was that Arbor would be asked to provide $1.2 million, of which $1.1 million would be LTD. For the other $100,000, Arbor would receive 10% of Innovative common stock as a sweetener. If Arbor would pay $100,000 for 10% of the stock, this would mean that the 90% that would be owned by Gale and Yeaton would have a value of $900,000. Although this was considerably higher than Innovatives net assets, they thought that this amount was appropriate in view of the profitability of the product line that they had successfully developed. They thought this might be too risky, so they considered a second (Proposal B) idea. Specifically, they thought of a package consisting of $200,000 of debt, $900,000 preferred stock, and $100,000 common stock. They learned that Arbor was probably not interested in preferred, even at a fairly high dividend rate. They approached Arbor with a proposal of $600,000 debt and $600,000 of equity (Proposal C). For the $600,000 of equity, Arbor would receive 40% of the common stock.

Arbor was more interested in owning at least 50% of the company. They countered with (Proposal D) $300,000 of debt and $900,000 for half of the equity in the company. Gale and Yeaton were not sure they wanted to share control of the company.

Before proceeding further, they decided to run the numbers on the four proposals. Assume an interest rate of 8% on debt and a dividend rate on preferred stock of 10%. They assumed that Innovative would earn $300,000 a year after income taxes on operating income but before interest costs and the tax savings thereon. They included their own common stock equity at $900,000.

They also believe a good year would be $500,000 (instead of $300,000) and a bad year would be $100,000. (but just run the numbers for $500,000 and $300,000). Innovatives tax rate is 34%. Assume Innovative pays out as a dividend its entire profit for the year.

For each proposal (A-D), calculate:

1. The return on common equity for Innovative Engineering

2. Arbor Capitals pre-tax earnings and return on its $1.2 million investment (Run the returns to both parties at $300,000; then repeat at $500,000).

Is this answer right or wrong? Please Answer ASAP!

Income Scenario Il Income Scenario ! 300000 500000 1100000 8% 8% 88000 88000 29920 241920 29920 441920 After Tax Operating Income Long Term Debt Interest on Long Term Debt Tax shield on Interest Paid Net After Tax Cash flows for Equity Holders Equity Arbor Equity Arbor Proposal A Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 24192) 44192 100000 10% 900000 90% 397728 44.19% 217728 24.19% 112192 9.35% 24.19% 132192 11.02% 44.19% 200000 8% 16000 16000 5440 5440 Debt Interest on Debt Tax shield on Interest Paid Preferred Stock Preferred Stock dividend rate Net After Tax Cash flows for Equity Holders 900000 10% 90000 90000 199440 399440 19944 39944 100000 10% 900000 90% B Equity Arbor Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 179496 19.94% 125944 10.50% 19.94% 359496 39.94% 145944 12.16% 39.94% 600000 8% 48000 48000 16320 268320 16320 468320 600000 40% 107328 187328 Proposal Debt Interest on Debt Tax shield on Interest Paid Net After Tax Cash flows for Equity Holders Equity Arbor Equity Arbor Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 900000 60% 280992 31.22% 160992 17.89% 155328 12.94% 17.89% 235328 19.61% 31.22% 300000 8% 24000 24000 8160 8160 284160 484160 142080 242080 Debt Interest on Debt Tax shield on Interest Paid Net After Tax Cash flows for Equity Holders Equity Arbor Equity Arbor Proposal D Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 900000 50% 900000 50% 142080 15.79% 166080 13.84% 15.79% 242080 26.90% 266080 22.17% 26.90% Income Scenario Il Income Scenario ! 300000 500000 1100000 8% 8% 88000 88000 29920 241920 29920 441920 After Tax Operating Income Long Term Debt Interest on Long Term Debt Tax shield on Interest Paid Net After Tax Cash flows for Equity Holders Equity Arbor Equity Arbor Proposal A Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 24192) 44192 100000 10% 900000 90% 397728 44.19% 217728 24.19% 112192 9.35% 24.19% 132192 11.02% 44.19% 200000 8% 16000 16000 5440 5440 Debt Interest on Debt Tax shield on Interest Paid Preferred Stock Preferred Stock dividend rate Net After Tax Cash flows for Equity Holders 900000 10% 90000 90000 199440 399440 19944 39944 100000 10% 900000 90% B Equity Arbor Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 179496 19.94% 125944 10.50% 19.94% 359496 39.94% 145944 12.16% 39.94% 600000 8% 48000 48000 16320 268320 16320 468320 600000 40% 107328 187328 Proposal Debt Interest on Debt Tax shield on Interest Paid Net After Tax Cash flows for Equity Holders Equity Arbor Equity Arbor Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 900000 60% 280992 31.22% 160992 17.89% 155328 12.94% 17.89% 235328 19.61% 31.22% 300000 8% 24000 24000 8160 8160 284160 484160 142080 242080 Debt Interest on Debt Tax shield on Interest Paid Net After Tax Cash flows for Equity Holders Equity Arbor Equity Arbor Proposal D Equity Partners Equity Partners ROE Company Arbor Pre Tax Earning Return Arbor on 1.2 million Partner Return 900000 50% 900000 50% 142080 15.79% 166080 13.84% 15.79% 242080 26.90% 266080 22.17% 26.90%