Market Value Capital Structure, Initial Investment, Risk Associated with a Project - Assignment Example

Name: Lecturer: Course name: Course code: Date: Question One A) Market Value Capital structure The concept involves the determination of capital structure using existing market prices of components that form a capital structure. Capital structure is a combination of debt and equity in a firm. Thus, the concept uses current market prices of debt and equity. Solution Debt PB= Interest [PVIFAr%n] + FV [PVIFr%n] =$80 [PVIFA10%15] + $1000 [PVIF10%15] =$80(7.6061) + $1000 (0.2394) =$847.9 Market value= 200 million/$1000 x 847.9= $169.58 million Preferred Stock Currently trading at par, that is $100 Market value of preferred stock= $47 million Common Stock = $55 million/10 million shares outstanding x $24 Market value = $132 million Market Value Capital structure Market Value Capital structure Component Market Value in Millions Percentage Debt 168.58 37.92% Preferred Stock 47 10.6% Common Stock 132 29.69% Retained Earnings 97 21.82% Total Market Value 444.58 100.000% b) Calculation of break points in marginal cost curve The point where a the cost of one source of capital changes is known as the break point.it is calculated by the use of the following formula Break Point= Amount of capital where the source of capital changes Proportion of capital that is raised from the new source Amounts required to be raised= $48 million Capital structure that the company has in proportion of the market structure is Debt structure Analysis The company projects will be financed by various types of debt capital which have varying interest rates. The company has estimated it will borrow using the current market capital structure an amount not exceeding $18.20 million Details Amounts Accumulated Amounts Interest Loan Type Up to $4m $4 million $4 million 10% Loans & Commercial paper More than 4m but less than $10m $6 million $10 million 12% Mortgage Bonds From $10m but less than $14M $4million $14 million 13% Subordinated Debentures From $14m $4.20 million $18.2 million 9% Subordinated Conv. Debentures $18.20 million Retained Earnings The company has a policy of paying to the common stock holders a 60% dividend payout ratio and retain the remaining 40%. However if the expansion rate does not meet the required 40% retention rate, the payout can be increased[Str13]. The company will distribute $18.75million and retain $12.5 to finance the project under consideration. Using the market value capital structure, the company will finance the project with $10.47 million which falls below the 40% retention rate. Common stock The company will finance the project with additional stock amounting to $14.25 million. The company will finance the project with two common stock issues, the first is worth $2.5 million and the other the excess amounts on the $2.5million. Calculation of Breaks Breaks Retained Earnings= 10.47/0.52 $20.34m 3rd Break 1st Common stock=(10.47+2.5)/0.52 $25.18m 4th Break 2nd Common stock=10.47+14.25/0.52 $48.0m 9%Debt= 4.2/0.48 $8.66m 1st Break 10% Debt=8.2/0.48 $16.91m 2nd Break 12% Debt=14.2/0.48 $29.28m 5th Break 13% Debt=18.2/0.48 $37.53m 6th Break 1st Preferred Stock=(18.2+2)/0.48 $41.66m 7th Break 2nd Preferred Stock= (18.2+3)/0.48 $43.72m 8th Break 3rd Preferred Stock=(18.2+5.07)/0.48 $48.0m Calculation of MCC in the interval between each break points The process involves the determination of the component costs of each capital structure element used to finance the project of the company. Equity Component Costs The compamy equity comprises of three components that is, retained earnings, and two common stock worth $2.5million and $11.25million Where Ke is the cost of equity Do is the dividend paid in the current year Po is the market price of the share Fe is the floatatiom costs G is the growth rate Hence, to calculate the growth rate The company growth rate will thus be 5.5% as the company expects one half of the future growth rate experienced in the last decade of the company operation. Cost of retained earnings (Kr)= $1.88(1+0.055)/ $24 +0.055 =13.76% Notes; the retained earnings have no flotation costs as there are no costs incurred to raise it. The retained earnings are internal sources of finance generated by the company Cost of 1st Common stock issued Ks= $1.88(1+0.055)/ ($24-$3)+0.055= 14.94% Cost of 2nd Common stock issued Ks=$1.88(1+0.055)/ ($24-$5)+ 0.055=15.94% Debt Component Cost The company debt structure consists of debt and preferred stock. Each component has been further divided with the terms of issue being the separating factor Debt The cost of debt is usually the cost of debt after tax has been deducted. The formulae is given as Cost of Debt= Kd (1-T) And thus the cost of debt of each debt component is Cost of 9% Debt= 9% (1-0.48) = 4.68% Cost of 10% debt=10% (1-0.48)= 5.2% Cost of 12% Debt= 12% (1-0.48)= 6.24% Cost of 13% Debt= 13% (1-0.48)= 6.79% Preferred Stock The cost of preferred stock is the ratio of dividends received from the preferred stock net of the current market price and cost incurred during floatation. The formulae is given as Cost of Preferred Stock = Div/ (Po-Fe) Cost of 1st Preferred Stock=$9/ ($100-$4) = 9.4% Cost of 2nd Preferred Stock= $9/ ($100-$10.5) = 10.1 % Cost of 3rd Preferred Stock=$9/ ($100-$13)-= 10.3% Calculation of MCC the component costs and breakpoints MCC1 = 0.5151( 13.76%) + 0.4849(4.68%)=9.36% MCC2 =0.5151 (13.76%)+0.4849(5.2%)=9.61% MCC3 =0.5151(14.94%)+0.4849(4.68%)=9.96% MCC4 =0.5151 (14.94%)+0.4849(5.2%)=10.22% MCC5 =0.5151(15.94%)+0.4849(6.24%)=11.24% MCC6 =0.5151(15.94%)+0.4849(6.79%)=11.5% MCC7 =0.5151(15.94%)+0.4849(9.4%)=12.77% MCC8 =0.5151(15.94%)+0.4849(10.1%)=13.1% MCC9 =0.5151(15.94%)+0.4849(10.3%)=13.21% MCC GRAPH Estimates on the missing IRR C/ (1+IRR)T- Initial investment =0 Project B= 16.26% Project D=14.4% Project H= 18.84% Question Two Initial Investment Initial Investment is the installed cost of a machine net of after tax sale value of an asset that is currently being used in the company[Las13]. The company is faced with two scenarios of replacing the existing press with either Press A or Press B. A comprehensive approach in determination of the initial investments of presser A or B is given by the following workings; Determination of initial outlay (IO) Determination of Initial Investment of Presser A Purchase of New Presser $830,000 Add Installation Costs $40,000 Installed cost of new Presser $870,000 Less After Tax Proceeds on Sale of Old Press Proceeds from Sale of Old Press $420,000 Tax on Sale of Old Press(wk 1) $46,200 Total after tax proceeds $373,800 Working capital changes $90,400 Initial Investment $586,600 Determination of tax of old presser Installed Costs ( Book Value) $400,000 Less Depreciation of 3 years $120,000 Net Book Value (NBV) $280,000 Proceeds from Sale of Old Press $420,000 Profits from sale of press $140,000 Tax rate 33% Tax amounts $46,200 Calculation of depreciation Installed Costs $400,000 No. of Years of presser recovery 10 years Yearly Depreciation $40,000 Calculation of working capital changes Current Account Change In Balance Cash $25,400 Accounts Receivable $120,000 Inventories ($20,000) Current assets (1) $125,400 Accounts Payable $35,000 Current Liabilities(2) $35,000 Changes in working capital (1-2) $90,400 Determination of Initial Investment of Presser B Purchase of New Presser $640,000 Add Installation Costs $20,000 Installed Cost of new presser $660,000 Less After Tax Proceeds on Sale of Old Press Proceeds from Sale of Old Press 420000 Tax on Sale of Old Press(wk 1) 46200 Total after tax proceeds 373800 Initial Investment $286,200 Net Present Value The summation of present values of all incoming cash inflows and outgoing cashoutflows in a business set up is known as the Net Present Values (NPV) The following calculations provide the concepts in the calculation of NPV Incremental EBIT and Depreciation of current and proposed presses YEAR EBIT Press A(1) EBIT old Press(2) Incremental EBIT(1-2) 1 $250,000 $120,000 $130,000 2 $270,000 $120,000 $150,000 3 $300,000 $120,000 $180,000 4 $330,000 $120,000 $210,000 5 $370,000 $120,000 $250,000 YEAR EBIT Press B(1) EBIT old Press(2) 1 $210,000 $120,000 $90,000 2 $210,000 $120,000 $90,000 3 $210,000 $120,000 $90,000 4 $210,000 $120,000 $90,000 5 $210,000 $120,000 $90,000 Depreciation of New Press A Installed Cost of A $870,000 No. of years 5 $174,000 Depreciation of Old Installed Cost $400,000 No. of years 10 $40,000 Incremental Depreciation $134,000 Depreciation of New Press B Installed Cost of B $660,000 No. of years 5 $132,000 Depreciation of Old Installed Cost $400,000 No. of years 10 $40,000 Incremental Depreciation $92,000  Incremental Cash flows of A Years 1 2 3 4 5 EBDT $130,000 $150,000 $180,000 $210,000 $250,000 Depreciation $174,000 $174,000 $174,000 $174,000 $174,000 EBT ($44,000) ($24,000) $6,000 $36,000 $76,000 Tax @ 33% ($14,520) ($7,920) $1,980 $11,880 $25,080 EAT ($29,480) ($16,080) $4,020 $24,120 $50,920 Depreciation $174,000 $174,000 $174,000 $174,000 $174,000 Terminal Value $77,000 Net Cash flows $144,520 $157,920 $178,020 $198,120 $301,920 Terminal Value After-tax profit on sale of Press A Proceeds on sale of Press A $400,000 33% Tax on sale of Press A @ 33% $132,000 Total after-tax $268,000 Less After-tax profit on sale of Old Press Proceeds on sale of old press $420,000 33% Tax on sale of old press@ 33% $138,600 Total after-tax $281,400 Working capital recovery $90,400 Terminal value $77,000  Incremental Cash flows of B Years 1 2 3 4 5 EBDT $90,000 $90,000 $90,000 $90,000 $90,000 Depreciation ($92,000) ($92,000) ($92,000) ($92,000) ($92,000) EBT ($2,000) ($2,000) ($2,000) ($2,000) ($2,000) 0.33 Tax @ 33% ($660) ($660) ($660) ($660) ($660) EAT ($1,340) ($1,340) ($1,340) ($1,340) ($1,340) Add Depreciation $92,000 $92,000 $92,000 $92,000 $92,000 Terminal Value ($60,300) Net cash flows $92,000 $92,000 $92,000 $92,000 $31,700 Terminal Value of B After-tax profit on sale of Press B Proceeds on sale of Press B $330,000 0.33 Tax on sale of Press B@ 33% $108,900 Total after-tax $221,100 Less After-tax profit on sale of Old Press Proceeds on sale of old press $420,000 0.33 Tax on sale of old press@ 33% $138,600 Total after-tax $281,400 Terminal value ($60,300)  Discounted Cash flow For Press A Net Cash flows $144,520 $157,920 $178,020 $198,120 $301,920 Discounting Factor @14% 0.8772 0.7695 0.675 0.5921 0.5194 Present value of cash flows $126,772.94 $121,519.44 $120,163.50 $117,306.85 $156,817.25 Net Present Value for Press A Total Present Value of Cash flows $642,580 Less Initial Investment $586,600 NPV $55,980  Discounted Cash flow for Press B Net Cash flows 92000 92000 92000 92000 31700 Discounting Factor @14% 0.8772 0.7695 0.675 0.5921 0.5194 Present value of cash flows 80702.4 70794 62100 54473.2 16464.98 Net Present Value for Press B Total Present Value of Cash flows 284535 Less Initial Investment $286,200 NPV ($1,665.42) Internal Rate of Return The rate of interest in which the Net Present Value of all cashflow, that is ,it includes all the positive and negative cashflows from a project equals to zero[Cha11]. IRR evaluates the attractiveness of a given project. Its given by the following formulae C/ (1+IRR)t – Initial Outlay = 0 IRR is usually derived with the use of mathematical trial and error through the use of applicable rates. The company Internal Rate of Return on Presses A and B is given as follows Internal Rate of Return of Press A Try higher rate Net Cash flows 144520 157920 178020 198120 301920 Discounting Factor @25% 0.8 0.64 0.512 0.4096 0.3277 Present value of cash flows 115616 101068.8 91146.24 81149.952 98939.184 NPV at higher rate Total Present Value of Cash flows 487920.176 Initial Investment $586,600 Npv ($98,680) IRR of A= lower rate +[NPV of lower rate/ absolute sums of NPV]X (higher rate – lower rate) = 14% + [55980/ 55980+ 99680] x (25%-14%) =17.95% Internal Rate of return of Press B Try a lower rate Net Cash flows 92000 92000 92000 92000 31700 Discounting Factor @7% 0.9346 0.8734 0.8163 0.763 0.713 Present value of cash flows 85983.2 80352.8 75099.6 70196 22602.1 NPV at lower rate Total Present Value of Cash flows 334233.7 Less Initial Investment $286,200 Npv $48,034 IRR of B= lower rate +[NPV of lower rate/ absolute sums of NPV]X (higher rate – lower rate) =7% + [48034/44034+ 1665] x (14%-7%) =13,2% A graph repesenting the NPV the two replacement Presses Conflicting ranking between Net Present Value and Internal Rate of Return is brought about by differences in cash flow which is occasioned by two factors Magnitude of the cashflows Timing of the cashflows. The NPV in terms of opportunity cost assumes that it has a minimum opportunity cost. Returns in the NPV context hypothetically will cover just the cost of caital. From the perspective of IRR the assumption is based on maximum opportunity cost. The maximum cost of capital in this perspective will be able to sustain the project undertaken and still be acceptable. Press A computation proves that it is the best choice. The machine has recorded a positive NPV and the IRR is above the minimum required rate of return. In contrast press B has a negative NPV and the return which is calculated from IRR is below the minimum required rate which is described as the cost of capital. Question Three Risk to adjust for in the context is conceptualized from the perspective that the organization should be able to balance debt and equity. The risk which will be adjusted is the business risk. By the virtue of the firm having virtually no differential risk, it becomes ideal for the firm to invest in high risk projects that guarantee high returns in the event it comes into fruition[Cha11]. The risk adjustment should encompass the whole firm as funds are invested in other areas whereas it can be kept in form of retained earnings. The three main types of risk associated with a project are identified as a stand alone risk, corporate risk and market risk. Stand alone risk takes into account the firm will pursue a single project which is separate from the other projects[Str13]. Corporate risk is incorporated in the light that the firm project is incorporated with the other assets. Market risk is emphasized by the fact that the company project takes into account the stakeholder way of investimg through an overall portfolio The risk is measured by analysing how it will have an impact on the firm when it occurs. It becomes essential that the firm has mechanisms which will be used to caution the firm. Measurement on the risk can be taken into account through the application of the company beta. References Str13: , (Stretcher), Las13: , (Lasher), Cha11: , (Chau), Read More