Below (Table 1) you will find information about the financial instruments that SigurLtd have used to raise capital as well as details outlining their current status in the market.
Table 1 - Outstanding Instruments
Instrument Details Proportion in
Structure
Debentures x Issued at par value ($1,000)
x Coupon rate - 9% (Annual Coupons)
x Maturity - 15 years
x Market Price - $1,090
35%
Preferred
Stock
x Class A
x Current Dividend - $2
x Market Price - $22
15
Common
Stock
x Market Price - $43
x Current Dividend (D0) - $4
50%
SigurLtd expects to raise future capital in the proportions currently indicated in Table 1. Any future investment projects they may want to fund will have to be done by issuing new instruments (new stocks and bonds) as the capital raised from the sale of the existing instruments has already been allocated.
If new debentures were sold the issuance cost would be $20 per bond and they would have a time to maturity of 15 years. If new preferred stocks were sold (Class B) they would be sold at a par value of $25 and would incur an issuance cost of $1 per share. If new common stocks were sold the issuance costs would be $2.50 per share. Current common stock dividends are expected to grow at an annual rate of 5%, and this growth rate is expected to continue into the foreseeable future.
SigurLtd has a 35% marginal tax rate.
a. If SigurLtd wanted to issue new debentures, and wanted to sell them at par value ($1,000) and pay annual coupon payments, what coupon rate would they have to pay on the new debentures?
b. What is the current required rate of return for preferred stock (Class A) investors? What dividend would you have to pay to new preferred stock (Class B) investors if new preferred shares were issued at a par value of $25 (NOT $28...Typo. It should match up with the value given in the description)?
c. What is the current required rate of return for common stock holders? What is SigurLtd's cost of capital for the new funds if they were to issue new instruments in the same proportion as their current capital structure? (i.e. what is the cost of capital resulting from the issue of new instruments...not the old ones that have already been issued in the market?)
e. What if you found out that SigurLtd could only raise $100m of debt at the coupon rate from Part A. And debt that they raise above $100m will have to be issued at a coupon rate that is 2% higher than the rate from part A. (e.g. If the old bonds had a coupon rate of 5%...the new ones will have a coupon rate of 7% Æ OldCouponRate + 2%. All Bonds are sold at PAR value)
Determine SigurLtd's new cost of capital structure including all relevant breakpoints. (Hint: You will have 2 costs of capital in this question).
Question 2 - Project Cash Flows
You work for FizzyPop, a soft drink manufacturer, and are considering replacing an old bottling machine. The old machine was purchased 10 years ago for $600,000 and has a useful life of 15 years. The old machine was being depreciated to a salvage value of $0 using straight line depreciation. As the old machine is quiet obsolete based on today's standards you would only be able to sell it for $50,000 today.
The new bottling machine would cost $1million and would have a useful life of 20 years (depreciated on a straight line basis to a salvage value of $100,000 as this is what you anticipate that you can sell the machine for after its 20 years of useful life i.e. market value after 20 years = $100,000). It will also cost you $15,000 to ship the equipment to your plant and an additional $45,000 to train employees to use the machine on top of the $30,000 you already spent on hiring an outside consultant to do a feasibility study on the new machine. You will also have to initially invest an additional $75,000 in working capital as the new machine requires slightly more expensive production materials. The production materials are also in demand and historically have increased in price by 5% each year and you expect this trend to continue into the foreseeable future.
The new machine will do nothing to increase sales but will bring with it significant cost savings as it uses energy more efficiently, makes less mistakes leading to less wastage (both time and production resources) and requires fewer employees to operate. You anticipate that the new machine will decrease operating expenses annually by $115,000 (excluding depreciation). Unfortunately the new machine is being purchased from a company, BLMetals, who has a poor reputation in the market due to their labour policies. You anticipate that some of your customers will find out about this purchase and as a result they will stop buying FizzyPop products resulting in annual losses in revenue of $10,000. (They don't like that you are supporting BLMetals and giving them business)
Your corporate marginal tax rate is 35%. a. Place all of the relevant cashflows for this project on a timeline (As always show all of your work so that we can see what you included in each cashflow). You can use a table to represent the timeline (It doesn't have to the horizontal drawing that we always do in class).
b. What is the highest cost of capital that you can pay and still accept this project? (The most that you can pay for the capital used to fund the project)
c. Would your answers to parts A and B change if you found out that you had to perform maintenance on the new bottling machine every 5 years in order for it to maintain functionality? Maintenance would cost $50,000 each time and you would have to perform the maintenance on the machine prior to selling it if you want to be able to sell it for $100,000 after its useful life).
If your answer changes make sure to include new solutions for parts A and B.
Question 3 - Project Selection
You are a manager for a telecommunications company, TalkCo. Below is a table (Table 2) outlining a series of possible projects that your company can invest in including information on the investment required for each project as well as the annual after tax net cash flows that they generate and the number of employees needed for each project. You can assume that the termination cash flow for each project is $0 and that all projects have a life of 20 years.
You company currently has 100million shares outstanding.