Which Capital Structure the Lowly Leveraged or the Highly Leveraged One Seems Better? Why?

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Should Farmer lease the IPM machine or purchase the more efficient BMC machine?

 

SKU: Fin1002942

Question 1

O’Hagan Apparel Company was founded 30 years ago when Tipene O’Hagan, a descendant of an Irish immigrant  who realised that fashionable clothing styled on indigenous lines could be a “winner”amongst both young fashion-conscious environmentalists and tourists.

 

Today, O’Hagan Apparel Company is a medium-sized manufacturer of fabrics and clothing based on indigenous Maori and Aboriginal designs. In 2014, the Pahiatua-based company experienced sharp increases in both domestic (Australasian) and European markets, resulting in record earnings. Sales rose from $7.7 million in 2012 to $9.2 million in 2014, with earnings per share (EPS) of $0.33 and $0.38, respectively. In 2015, EPS is expected to rise to $0.44. (Selected income statement items are presented in Table 1).

 

Because of recent growth, the Chief Financial Officer (CFO), is concerned that the projected $650,000 of internally generated funds that would be available in 2015 would be insufficient to meet the company’s expansion needs.

 

Management has set a policy to maintain the capital structure of O’Hagan Apparel Company at 65% equity capital, 25% interest-bearing debt and 10% preference share capital for at least the next three

 

Table 1                                SELECTED INCOME STATEMENT ITEMS

2012 2013 2014 Projected 2015
Net sales $6 930 000 $7 745 000 $9 165 000 $10 540 000
Net profits after tax 760 000 875 000 1 010 000 1 161 000
Earnings per share ( EPS) 0.29 0.33 0.38 0.44
Dividend Per Share 0.115 0.131 0.154 0.176

 

The CFO has been presented with several competing investment opportunities by division and product managers. However, because funds are limited, choices of which projects to accept must be made. The investment opportunities schedule (IOS) is shown in Table 2. To analyse the effect that the increase in financing requirements would have on the weighted average cost of capital, the CFO contacted a leading investment banking firm, which provided the financing cost data given in Table 3. O’Hagan is in the 30% tax bracket.

 

Table 2                     INVESTMENT OPPORTUNITIES SCHEDULE ( IOS)

Investment Opportunity Internal Rate of Return (IRR) Initial Investment
A 17.50% $200 000
B 15.5 100 000
C 19 350 000
D 20 250 000
E 14 100 000
F 18.5 350 000
G 13.5 275 000

 

Table 3: COST DATA FOR ADDITIONAL FINANCE

Interest-bearing debt

The firm can raise $250 000 of additional debt by selling ten-year, $1000, 9% annual interest rate bonds to net $980 after flotation costs. Any debt in excess of $250 000 will have a before-tax cost, (Rd), of 12%.

Preference Shares

Preference shares, regardless of the amount sold, can be issued for $10 with an 11% annual dividend rate, and will net $9.50 per share after flotation cost.

Ordinary shares

The firm expects its dividends and earnings to continue to grow at a constant rate of 15% per year. The firm’s shares are currently selling for $3.50 per share. The firm expects to have $650 000 of available retained earnings. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new ordinary shares, netting $2.8 per share after under-pricing and flotation costs.

 

Required:

1. Over the relevant ranges noted in the following table, calculate the after-tax cost of each source of financing needed to complete the table.

Source of Capital Range of new financing After-tax cost (%)
Interest-bearing debt $0- $250 000
$250 000 and above
Preference shares $0 and above
Ordinary shares $0- $650 000
$650 000 and above

 

2. Calculate the Weighted Average Cost of Capital (WACC) if the CFO wishes to raise the funds needed to invest in investment opportunities:

a. A to E

b. A to G, specified in table 2.

 

3. Based on your computation above in 2 (a) and (b), which investment opportunities would you recommend that the CFO should consider investing in? Why?

 

4. Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term interest-bearing debt, 10% preference shares and 40% ordinary shares have on your previous findings? (Hints: rework questions 2 and 3 using these capital structure weights)

 

5. Which capital structure – the lowly leveraged or the highly leveraged one seems better? Why?

 

Question 2

Tampa Ltd, an established producer of printing equipment, expects its sales to remain flat for the next three to five years due to both a weak economic outlook. On the basis of this scenario, the firm’s management has instituted programs that will allow it to operate more efficiently, earn higher profits and, most importantly, maximise share value. The firm’s chief executive officer (CEO), Jon Lawson, has been charged with evaluating the firm’s capital structure. Lawson believes that the current capital structure, which contains approximately 11% debt, may not be taking full advantage of the borrowing capacity of the firm. The firm’s bankers have indicated that the firm can borrow up to $ 5 million at the current interest rate of 7.5%. Lawson has gathered the following data on two possible capital structures that he would like to consider.

 

CAPITAL STRUCTURES

Source of Capital Current Alternative “A” Alternative “B”
Interest bearing debt $1,000 000 $3,000 000 $5,000 000
Coupon interest rate 7.5% 7.5% 7.5%
Number of ordinary shares 90,000 shares 70,000 shares 50,000 shares
Required return on equity (Rs) 8.47% 8.64% 8.88%

 

Lawson expects the firm’s earnings before interest and taxes (EBIT) to remain at its current level of $1.2 million. The firm pays tax at the rate of 30%.

 

Required:

1. Use the current level of EBIT to calculate the “Times Interest Earned (TIE)” ratio for each of the capital structures. Based on the TIE which capital structure would be preferred by the debt holders? Why?

 

2. Prepare a single EBIT-EPS graph showing the current and two alternative capital structures.

 

3. On the basis of the graph in question 2, which capital structure will maximise Tampa’s Earnings per Share (EPS) at the expected level of EBIT of $1.2 million? Why might this not be the best capital structure?

 

4. Using the zero growth share valuation model, find the market value of Tampa’s equity under each of the three capital structures at the expected level of EBIT of $1.2 million?

 

5. Compute the Weighted Average Cost of Capital (WACC) for each of the options and explain how your findings correspond with the Modigliani and Miller proposition on capital structure when taxes are present.

 

Question 3,

Stanley, a financial analyst for Chargers products, a manufacturer of stadium benches, must evaluate the risk and return of two assets – X and Y. the firm is considering adding these assets to its diversified asset portfolio. To assess the return and risk of each asset, Stanley gathered data on the annual cash flow and beginning and end – of –year values of each asset over the immediately preceding 10 years, 2001-2010. These data are summarised in the following table. Stanley’s investigation suggests that both assets, on average, will tend to perform in the future just as they have during the past 10 years. He therefore believes that the expected annual return can be estimated by finding the average annual return for each asset over the past 10 years.

 

Stanley believes that each asset’s risk can be assessed in two ways: (a) in isolation and (b) as part of the firm’s diversified portfolio of assets. The risk of the assets in isolation can be found by using the standard deviation and coefficient of variation of returns over the past 10 years. The capital asset pricing model (CAPM) can be used to assess the asset’s risk as part of the firm’s portfolio of assets. Applying some sophisticated quantitative techniques, he estimated betas for assets X and Y of 1.60 and 1.10, respectively. In addition, he found that the risk-free is currently 7% and the market return is 10%.

 

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Required:

1. Calculate the annual rate of return for each asset in each of the 10 preceding years, and using those values to find the average annual return for each asset the 10-year period.

 

2. Use the returns calculated in question 1, to find (a) standard deviation and (b) the coefficient of variation of the returns of reach asset over the 10-year period 2001-2010.

 

3. Use your findings in questions 1 and 2 to evaluate and discuss the return and risk associated with each asset. Which asset appears to be preferable? Explain.

 

4. Use Capital Asset Pricing Model (CAPM) to find the required return for each asset. Compare this value with the average annual returns calculated in question 1.

 

5. Compare and contrast your findings in questions 3 and 4, what recommendations would you give Stanley with regard to investing in either of the two assets? Explain to Stanley under what circumstances would he should use beta than the standard deviation and coefficient of variation to assess the risk of each asset.

 

6, Rework questions 4 and 5 under each of the following circumstances and advice Stanley whether he should invest in either asset:

  • 6a. A rise of 1% in inflationary expectations causes the risk-free rate to rise to 8% and the market return to rise to 11%

 

  • 6b. As a result of favourable political events, investors suddenly become less risk-averse, causing the market return to drop by 1% to 9%.

 

Question 4

High electricity costs have made Farmer Corporation’s chicken-plucking machine economically worthless. Farmer Corporation could choose any of the following to replace its ageing machine:

(a) The International Plucking Machine (IPM) model is available only on a lease basis. The lease payments will be $65,000 for five years, due at the beginning of each year. This machine will save Farmer $15,000 per year through reductions in electricity costs.

(b) As an alternative, Farmer can purchase a more energy-efficient machine from Basic machine Corporation (BMC) for $330,000. This machine will save $25 000 per year in electricity costs. A local bank has offered to finance the remaining balance and will require five annual principal payments of $66,000. Farmer has a target debt-to-asset ratio of 67 percent.

Farmer is in the 34 percent tax bracket. After five years, both machines will be worthless. The machines will be depreciated on a straight-line basis.

Required:

a. Should Farmer lease the IPM machine or purchase the more efficient BMC machine?

b. Does your answer depend on the form of financing for direct purchase?

c. How much debt is displaced by this lease?

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