Problem #1
Radical Co.
Balance Sheet
Cash $ 50 Accounts payable $100
Inventory $150 Notes payable 100
Fixed assets $600 Long-term debt 350
Equity 250
Total assets $800 Total liabilities & equity $800
Radical Co.
Income statement
Sales $800
Costs 600
EBT $200
Taxes (34%) 68
Net income $132
a. Suppose that current assets, costs, and accounts payable maintain a constant ratio to sales. The firm retains 40% of earnings.
i. If the firm is producing at full capacity, what is the total external financing needed if sales increase 25%, assuming fixed assets increase proportionately with sales ?
ii. If the firm is producing at only 90% capacity, describe how this would impact your answer. You don't need to do a calculation, but it may help you to explain your reasoning.
b.. Suppose the firm wishes to maintain a constant debt-equity ratio, retains 60% of net income, and raises no new equity. Assets and costs maintain a constant ratio to sales. What is the maximum increase in sales the firm can achieve?
Problem #2
The managers of Magma International, Inc. plan to manufacture engine blocks for classic cars from the 1960s era. They expect to sell 250 blocks annually for the next five years. The necessary foundry and machining equipment will cost a total of $800,000 and belongs in a 30% CCA class for tax purposes. The firm expects to be able to dispose of the manufacturing equipment for $150,000 at the end of the project. Labour and materials costs total $500 per engine block, fixed costs are $125,000 per year. Assume a 35% tax rate and a 12% discount rate.
a. What is the depreciation tax shield in the third year for this project?
b. What is the present value of the CCA tax shield?
c. What is the minimum bid price the firm should set as a sale price for the blocks if the firm were in a bidding situation?
d.. Assume that management believes that auto restorers will pay $3,000 retail per engine block. What is the NPV of this project?
Problem #3
King's Mfg. Inc. has 12,000 bonds outstanding that have a 6% coupon rate. The bonds are selling at 98% of face value, pay interest semi-annually, and mature in 28 years. There are 400,000 shares of 9% $100 preferred stock outstanding with a current market price of $83 a share. In addition, there are 1.40 million shares of common stock outstanding with a market price of $54 a share and a beta of 1.2. The common stock paid a total of $1.80 in dividends last year and expects to increase those dividends by 4% annually. The firm's marginal tax rate is 34%. The overall stock market is yielding 12% and the Treasury bill rate is 4.0%.
a. What is the cost of equity based on the dividend growth model?
b. What is the cost of equity based on the security market line?
c. What is the cost of financing using preferred stock?
d. What is the pre-tax cost of debt financing?
e. What weight should be given to equity in the weighted average cost of capital computation?
f. What would be the cost of new financing (including the impact of each of 28-year bonds, preferred shares and common shares), assuming that flotation costs would be 5% of the proceeds of the issue?
g. If net income in the next year is expected to be $8,000,000, what would be the common equity breakpoint for new financing, assuming the current capital structure is considered optimal?