Poly Alchemia, Inc. Tom Hanks, President of Poly, Inc. pondered the executive summary of the consultants report on the financing of the proposed Elixir project. Poly, Inc. is a producer of chemicals used in the production of synthetic fibers and various chemical compounds. Once a small, privately-owned firm producing bottled gas, the discovery of a new economical exotic gas, Elixir, by cousin Jaber had caused Poly sales to mushroom. Jaber met a sudden death in the 1986 lab explosion, when Tom took over. In 1978, capital needs necessitated the first public offering of common stock, soon followed by the public sale of debentures. Poly common was listed for trading on the Midwest Stock Exchange this year on the initiative of Tom. The Bonds had a fairly active over-the-counter (OTC) market. Jaber, the inventor and former President, had paid scant attention to financial affairs of the firm. He had relied heavily on the advice of his banker and more recently, the investment banker who had assisted in Poly going public. Tom had asked for the consultants report last year because of this uncertainty, and in anticipation of additional financing needs for Elixir production. A portion of the executive summary read, The 1986 capital structure, plus my recommendation to borrow an additional 1 million to finance the Elixir project, will result in an estimated cost of capital, WACC, for Poly of 7.53%. Tom opened his Wall Street Journal, noting that Poly had closed at $66 a share yesterday, trading 17,000 shares (out of the total 1 million shares outstanding), up a half for the day. He noted that 10-year U.S. Treasury bonds were trading to yield 7% and 90-day T-bills sold to yield 4%. The Heard on the Street column reported that many market analysts were projecting the market risk-premium of 5.5%. Later on in this column he also noted that the industrial gas industry has received an enthusiastic report by one influential analyst saying that, long-run prospects for earnings and dividend growth of 6% coupled with 4 to 6 percent current dividend yields should make industrial gas shares warrant serious consideration for the aggressive investor portfolio. Poly stock return data and the Russell 1000 stock index return data for the past five years are shown below: 2 Poly had a long-term debenture with a face value of $8 million and a short-term note with a face value of $1 million. A total of 9,000 bonds (both long and short-term) were outstanding with par value of $1,000 for both issues. Tom telephoned his broker to find the prices of both debt issues as of yesterday, December 30, 1986. He noted the details as below: Poly Debenture: 6.75% coupon, semiannual bond due 12/30/1996 (10-years from today) Price: 824.9 Poly Note: 7.50% coupon, semiannual Note due 12/30/1987 (1 year from today) Price: 1,000 The main portion of the consultants report is included below

Q1 What mistake(s), if any, did the consultant make in computing the firms cost of capital? Briefly explain each mistake and necessary correction with its rationale.

2. What is your estimate of annualized cost of debt (before-tax) _________ and after tax __________?

3. If you disagree with the beta used by the consultant in estimating the cost of equity, what is your estimated beta coefficient _____________? R-Square _________?

4. What is your estimated cost of equity __________ and the weight of debt ________ and equity in the firms capital structure __________?

5. What is the appropriate cost of capital (WACC) to evaluate the Elixir project ___________?

Poly Russell 1000 Year Return Retum % 1982 16 14 1983 1984 13 12 1985 13 10 1986 12 Poly had a long-term debenture with a face value of S8 million and a short-term note with a face value of SI million. A total of 9,000 bonds (both long and short-term) were outstanding with par value of $1,000 for both issues. Tom telephoned his broker to find the prices of both debt issues as of yesterday, December 30, 1986. He noted the details as below: Poly Debenture: 6.75% coupon, semiannual bond due 12/30/1996 (10 years from today) Price: $24.9 Poly Note: 7.50% coupon, semiannual Note due 12/30/1987 (1 year from today) Price: 1.000 The main portion of the consultant's report is included below. "The 1986 year-end capital structure as indicated on the financial statements is (000.000): Short-term Note S1.O Long-term Debentures SR.O 9.0 (60%) Common Stock (Sl par) SI. Paid-In Capital 1.0 Retained Famings 4.0 6.0 (40%) SI5.0 The current market valued capital structure proportions are near the industry average. The recent carnings-dividend per share record is as follows 1979 1980 1981 1982 1983 1984 1985 1986 Earnings 4.86 2.91 4.07 5.27 4.10 5.20 7.00 8.00 Dividends 40 .40 The before-tax cost of debt of 8% was arrived at by taking the total interest expense for the year 1986 and dividing it by the company average debt balance. Allowing for the corporate income tax rate of 40%, the after-tax cost of debt is: K (I.T.) -0.08)*(1-40) - 4.80% The cost of equity, Ke, would be about 16.9% based on after tax-carnings of S& per share divided by the market price of 566, times the chemical industry beta of 14 - obtained from Value Line Investment Survey. Given the proportions of capital structure above, the WACC ork can be calculated as: K.-ke(-Tc)-DVD+E) + K.HED+E)* Beta - 4.8 (60) + 12.1 (.40X1.4) However, if the Elixir proposal is undertaken and financed by debt as I recommend, the cost needs to be adjusted to that effect. New debt can be obtained from a bank at an annual cost of about 9.5% for an after- tax cost of 9.5*(1-40) - 5.7%. Thus, the total debt outstanding would increase to 10 million at an average cost of 4.8% (9.0) +5.7% (1.0) -4.89% (10) The new capital structure weights for 10 debt + 6.0 equity - 16 million total capital. The new weights of debt and equity can be recomputed as 62.5% and 37.5%, respectively. The new cost of capital will then be K. - 4.89% (0.625) +16.94% (375) - 7.53% less than the current cost of capital." (10) Poly Russell 1000 Year Return Retum % 1982 16 14 1983 1984 13 12 1985 13 10 1986 12 Poly had a long-term debenture with a face value of S8 million and a short-term note with a face value of SI million. A total of 9,000 bonds (both long and short-term) were outstanding with par value of $1,000 for both issues. Tom telephoned his broker to find the prices of both debt issues as of yesterday, December 30, 1986. He noted the details as below: Poly Debenture: 6.75% coupon, semiannual bond due 12/30/1996 (10 years from today) Price: $24.9 Poly Note: 7.50% coupon, semiannual Note due 12/30/1987 (1 year from today) Price: 1.000 The main portion of the consultant's report is included below. "The 1986 year-end capital structure as indicated on the financial statements is (000.000): Short-term Note S1.O Long-term Debentures SR.O 9.0 (60%) Common Stock (Sl par) SI. Paid-In Capital 1.0 Retained Famings 4.0 6.0 (40%) SI5.0 The current market valued capital structure proportions are near the industry average. The recent carnings-dividend per share record is as follows 1979 1980 1981 1982 1983 1984 1985 1986 Earnings 4.86 2.91 4.07 5.27 4.10 5.20 7.00 8.00 Dividends 40 .40 The before-tax cost of debt of 8% was arrived at by taking the total interest expense for the year 1986 and dividing it by the company average debt balance. Allowing for the corporate income tax rate of 40%, the after-tax cost of debt is: K (I.T.) -0.08)*(1-40) - 4.80% The cost of equity, Ke, would be about 16.9% based on after tax-carnings of S& per share divided by the market price of 566, times the chemical industry beta of 14 - obtained from Value Line Investment Survey. Given the proportions of capital structure above, the WACC ork can be calculated as: K.-ke(-Tc)-DVD+E) + K.HED+E)* Beta - 4.8 (60) + 12.1 (.40X1.4) However, if the Elixir proposal is undertaken and financed by debt as I recommend, the cost needs to be adjusted to that effect. New debt can be obtained from a bank at an annual cost of about 9.5% for an after- tax cost of 9.5*(1-40) - 5.7%. Thus, the total debt outstanding would increase to 10 million at an average cost of 4.8% (9.0) +5.7% (1.0) -4.89% (10) The new capital structure weights for 10 debt + 6.0 equity - 16 million total capital. The new weights of debt and equity can be recomputed as 62.5% and 37.5%, respectively. The new cost of capital will then be K. - 4.89% (0.625) +16.94% (375) - 7.53% less than the current cost of capital