Financial Review of Southern Textiles - Essay Example

FINANCIAL REVIEW OF SOUTHERN TEXTILES

1. a) Based on the two sources of financing, what is the initial weighted average cost of Capital? (Use Kd and Ke).                                                                                                                                

Po= Div1/ (r-g)                                                                                                                               

Div1 = 1.5                                                                                                                

g=       9%                                                                                                               

Po=     30                                                                                                                 

Kd=     r=(Div1/ Po)+g=                   14.00%                                                                                            

We=    weightage of equity=                      0.6                                                                                        

Wd=    weightage of equity=                      0.4                                                                                        

Kd=     Cost of debt=                        11.00%                                                                                            

Ke=     Cost of equity=                    14.00%          (calculated above)                                                                         

T=       Tax rate=                   34%                                                                                     

The initial weighted average cost of Capital                                                                                                                       

=We Ke + Wd Kd (1-T)=                           11.304%                                                                                          

1. b) At what size capital structure will the firm run out of retained earnings?

Retained earnings=            $15     million                                                                                  

We=                                       0.6                                                                                                    

Total capital=                      $25     million           =15/0.6                                                                                

1. c) What will the marginal cost of capital be immediately after that point?

            Po= Div1/ (r-g)                                                                                                                   

            Div1 = 1.5                                                                                                    

            g=       9%                                                                                                    

            Po=     27        =30-3  since underwriting costs are $3                                                                                                                                                                                    

Kd=     r=(Div1/ Po)+g=                   14.56%                                                                                                                                                                                                                                                                                                                                      

            We=    weightage of equity=                      0.6                                                                            

            Wd=    weightage of equity=                      0.4                                                                            

            Kd=     Cost of debt=                        13.00%          since the first $20 million of bounds could be sold to yield 13%.                                                              

            Ke=     Cost of equity=                    14.56%          (calculated above)                                                             

            T=       Tax rate=                   34%                                                                          

            the initial weighted average cost of Capital                                                                                                            

            =We Ke + Wd Kd (1-T)=                           12.165%                                                                                                                                                                                                         

1. d) At what size capital structure will there be a change in the cost of debt?

First, $20 million of bounds could be sold to yield 13%.                                                                                                                               

Debt=                         20       million                                                                      

Wd=                           0.4                                                                                        

Total additional capital=                            $50     million =20/0.4                                                                    

After the size of capital reaches                                 $75     million there is a change in the cost of debt                                                                             

                                    =25+50 (25 with the retained earnings)                                                                                            

1. e) What will the marginal cost of capital be immediately after that point?

The cost of debt has not been given after $20 million in the problem                                                                                                                          

So exact marginal cost of capital cannot be calculated                                                                                                                               

However, for additional debt cost of debt would rise from 13%                                                                                                                                                       

Hence the marginal cost of capital would be more than 12.165% calculated in c                                                                                                                                                       

1. f) Based on the information about potential returns on investments in the first paragraph and information 0n marginal cost of capital ( in parts a, c, and e) how large a capital investment budget should the firm use?                                                                                   

Project A will increase the firm's processed yarn capacity and has an expected return of 15% after taxes. 

Project B will increase the capacity for woven fabrics and carries a return of 13.5%.                                                                                                                           

Project C, a venture into synthetic fibers, is expected to earn 11.2% and                                                                                                                        

Project D, an investment into dye and textile chemicals, is expected to show a 10.5 % return.                                                                                                                      

Project A                   15%    25       million                                                                      

Project B                   13.50%          25       million                                                                      

Project C                   11.20%          25       million                                                                      

Project D                   10.50%          25       million                                                                      

                                    100                                                                                       

Projects C and D yield lower rates of return than 11.304%. Hence they should not be taken up Investment budget should be for

Projects A and B= 25+25=50 million                                                                                                                                     

1. g) Graph the answer determined in part f.