SUN COMPANY The Sun Co. was founded five years ago by three former Moon Company employees. The three founders own 100% of the Sun Company's stock which has a market value of $5 per share. Below is the Balance Sheet of the company. The boards of directors of Sun Company have asked Frank Norman, the financial officer of the company, to make the first major decision for the company's future financial planning. The board has asked Frank to evaluate the profitability of two new investments (Table 1) that the company considers acquiring for its future survival. #The two investments are different in their characteristics and descriptions. Table 1 Investment A Investment B Purchase Price $2,000,000 $4,000,000 Output 2,500 2,500 Growth in Output 5% 6% Variable Cost $400 $400 Growth in Costs 3% 3% Unit Price $1,000 $1,500 Price Increase 4% Beta 1.4 Tax Rate 40% 40% 4% 1 The investments would be depreciated on a straight-line basis over their five-year life to a zero- salvage value. Frank Norman, being a sophisticated financial analyst, obtained the following information in Table 2 for the analysis of various investment and financial proposals. Table 2 Risk-Free Rate Market Portfolio SUN CO. Expected Return Variance Covariance with Market Return 10% 20% 8% Part I What is the cost of capital for each investment? 2. Which of the two investments should be adopted? Why? 3. What would be the Sun's cost of capital if these two investments are adopted? 4. Based on the expected rate of return of each investment which investment should be accepted? Why? Part II The financial officer has long believed that Sun's capital structure is not optimal, and he believes by financing half of total investment of each investment by debt at the 10% and retires the debt over the life of the investment, the value of each investment will be maximized. If Frank Norman is correct with his assumptions and if his financial plan is adopted, what would the following be? 1. 2. What is the Adjusted Present Value (APV), for each investment? What would be the value of each investment based on the Weighted Average Cost of Capital (WACC)? What is the Cash Flow-to-Equity (FTE) for each investment? Explain the differences among the three methods for the level of debt financing. 3. 4. $150,000 Sun Company - Balance Sheet (in thousands) Cash $100,000 Accounts Payable Account Receivable $300,000 Notes Payable Inventory $250,000 Accrued Wages Current Assets $650,000 Current Liabilities $50,000 $75,000 $275,000 Gross Fixed Assets less: Accumulated Depreciation Net Fixed Assets Total Assets $1,850,000 Common Stocks (IM shares at par value of $1.5) ($300,000) Retained Earnings $1,500,000 $425,000 $1,550,000 Equity $2,200,000 Total Debt & Equity $1,925,000 $2,200,000