Ed Mettway was concerned about his firm''s ability to acquire the necessary property, plant, and equipment to take advantage of steadily increasing sales. Touring Enterprises, established in 1970 began as a mail-order house for motorcycle parts and accessories. In the early years, growth was slow and the business, though profitable, plodded along. ED Mettway was the chief financial officer and treasurer. In the last 10 years, compound average annual sales and earnings growth had been 18 percent and 15 percent, respectively, a dramatic change from the earlier years.
Motorcycle parts and accessories sales in the early 1970s consisted primarily of parts sales to do-it-yourself repairpersons. In addition, sales of outerwear- jackets, pants, rain suits, and boots- were also offered by most mail-order houses in this business.
As the decade of the 1980s progressed, the nature of motorcycle sales, and consequently the accessories purchased, began to change. The elements of that change were as follows: (1) motorcycle ridership began rapidly lose its "radical" image; and (2) the market for motorcycles began to noticeably segment among touring riders, around-town riders, and others. In addition, more motorcycle dealerships began to emerge. As a result, motorcycles became more widely advertised and more accessible to consumers. Also, the European practice of riding "sport bikes," the faster more powerful type of motorcycle preferred by younger riders, started to catch on in the United States. This group of riders preferred more stylish and protective riding apparel.
These developments were a boon to the manufacturers and merchandisers of riding apparel, parts, and other accessories. Touring Enterprises was ideally situated to serve this growing market. Mail-order parts and accessories companies were successful if the goods were carried in wide variety and were of high quality, and if shipments and return were handled quickly and with minimum inconvenience to ther customer. The emergence of small package delivery companies was a definite complement to the industry. Touring Enterprises revenue and earnings grew along with these positive developments in the industry.
As the company''s sales and earnings increased, so did the demand for capital. The firm''s needs included inventory as well as additional space to house the inventory, computer facilities, and order processing areas. In the late 1980s the firm decided to include in its business some light fabrication of certain parts. The purpose of this was to handle customers'' needs for specialty items. Such items were generally those made of fiberglass or aluminum. On-premises fabrication of such items gave the firm the ability to purchase parts from a wid er array of suppliers without the constraints imposed by concerns for fit, style, color, and the like.
The recent growth, however, had placed severe demands on the firm''s ability to manage all aspects of its finances. Mettway had formed solid relationships with banks and other lenders, and the firm''s stock had been traded on a regional stock exchange since the initial public offering in 1978. As the firm''s strategic plan indicated the desirability of a new facility on the East Coast, Mettway''s attention turned increasingly to a careful articulation of an internal financial policy. The policy would serve as a guideline for acquiring capital in the short-term as well as during and after the establishment of a new business location.
Of specific concern to the company''s treasurer was the matter of how to communicate to the firm''s financial analysts and accountants the proper manner in which to calculate the weighted average cost of capital. The desire was to not only have the concept widely understood by all financial staff members, but to understand how the current liabilities and depreciation fit into the calculations, if at all. The firm''s balance sheet is shown in Table 1.
Table 1
Touring Enterprises
Balance Sheet
December 31, 1995
($000s)
Month
1993
Forecasted
for 1994
Cash
$810
Bank loans
$1,830
Marketable securities
2,647
Accounts payable
1,070
Account receivable
2,500
Accrued expenses
1,763
Inventory
8,519
Current maturities of long-term debt
460
Re-Paid expenses
500
Total current assets
$14,976
Total current liabilities
$5,123
Long-term debt
4,600
Total liabilities
$9,723
Gross fixed assets
$13,343
Less: Accumulated
Depreciation*
(5,499)
Common stock
$2,024
Net fixed assets
7,844
Paid-in capital
3,952
Other assets
677
Retained earnings
7,798
Total assets
$23,497
Common equity
$13,774
Total liabilities and equity
$23,497
*Annual accumulated depreciation, approximately $400,000 for the past 3 years.
What concerned Mettway was the unspecific nature of certain aspects of the cost of capital calculation in practice - that is, how best to present the general rules of cost of capital in a manner that the finance staff would see as logical and widely applicable. The firm''s cost of funds obtained through a stock issuance or offering of long-term debt was relatively easy to assess. At present the firm''s stock price was $22 and the annual dividend was $1.10. Further, the yield on debt of the type that Touring Enterprises had recently issued was 7.5 percent. The firm was in the 35 percent tax bracket. (This included federal, state, and local taxes.)
The bank loans shown Table 1 were revolving lines of credit, which the firm maintained at a relatively constant level of draw-down year to year. The same was true for accrued wages and taxes, and accounts payable. Mettway recognized that textbook expositions of the weighted average cost of capital exhibited a (necessarily ) simplistic approach, which showed the interrelationship among equity, long-term debt, and the total of those two as the basis for the weighted average capital cost calculation. However, the operating practices of firms differed across industries and among firms within the same industry. Such differences often influenced capital cost calculation. The primary causes of such differences were capital structure, composition and level of current liabilities and depreciation, and the firm''s effective tax rate. Mettway believed that developing a clear policy on the firm''s cost of capital calculation would require careful consideration of the specific operating characteristics of Touring Enterprises.
The company''s treasurer understood that the inclusion of current liabilities in the firm''s financial planning affected the capital budget. Mettway knew that in any period the amount of external funds at a given cost would be influenced by the inclusion or exclusion of cu rrent liabilities. For example, if Touring Enterprise used accelerated depreciation for its tax reporting, and straight line depreciation for reporting income to stockholders, a deferred tax (a current liability) charge would appear on the report to stockholders. Deferred taxes are a noncash charge; therefore, net income, but not net cash flow, would be altered due to the difference in depreciation.
QUESTIONS:
1. What is the major value of the weighted cost of capital calculation for the firm?
2. Describe *capital structure*
3. How is the firm''s weighted cost of capital influence by the firm''s capital structure?
4. Describe the role of the firm''s tax rate in cost of capital calculations?
5. Calculate the cost of long term debt and common equity for Touring Enterprises. Calculate the weighted average cost of capital.
6. Provide an argument for including or not including current liabilities in the cost of capital calculation.
7. Touring Enterprises'' capital structure is believed to be optimal. What is the meaning and importance of an optimal capital structure to the cost of capital calculation?
8. What economic circumstances will likely cause a change in the firm''s optimal capital structure?
9. Explain the effect of accelerated depreciation versus straight-line upon net income. How does this create "deferred taxes" on the firm''s balance sheet?
10. Should Touring Enterprises consider liabilities as a part of its permanent financing? Why or why not?