BADM 605 Fundamentals of Finance

BADM 605 Fundamentals of Finance. Week Six; Cost of capital problems.

1. You need to raise $50,000 to finance the inventory in your retail widget store. You can borrow the money from your father at a straight 15%, from your bank at 12% with a 20% compensating balance, or from a commercial finance company at 14% with interest discounted in advance. How would you finance the inventory?

2. You need a loan of $30,000 for twelve months to finance the inventory of your seed and garden store. Your rich uncle offers you the loan for a straight 12% annual interest, your bank will lend you the money at 9 ¾% with a 20% compensating balance, and a commercial credit firm offers you the money at 11% with interest discounted in advance. Which offer would you accept (Show work)

3. Since you opened your business two years ago sales have doubled each year. You manufacture small boat accessories at costs considerably lower than your competition, and can easily sell all your present plant can produce. Although you are a cyclical industry with sharp turndowns when economic recessions threaten, you believe that sales will probably continue growing in the next few years. You want to double your manufacturing capacity and need $250,000 to do it. You presently value the net worth of the company at around $250,000, and so does a friend that has recently offered to put up the needed additional $250,000 from your bank at 14%. With the new production capacity, your earnings will be $100,000 before interest the first year after the expansion if the entire capacity were sold. However, if sales remain level with this year (1/2 the new capacity) there will be a $10,000 loss for the year. Would you take a partner or a loan?

4. You are a contractor that builds private homes, and you depend heavily on borrowed money. You normally make $1000 (before interest) on each home you build. In boom times you build 200 per year and in a bust you build 100. If your total capital is $1,000,000, what difference would it make on your return on equity if you had $300,000 equity and borrowed $700,000 at 15% OR had $600,000 equity and borrowed $400,000 at 12%?

5. You are planning to invest $100,000 in a process to produce gasoline from water, and you are trying to decide whether to borrow another $100,000 at 15% to build a one million gallon per year capacity plant or borrow an additional $300,000 at 18% to build a two million gallon per year capacity plant. What would the return on equity be for each of these debt positions if gasoline netted you, before interest, ten cents per gallon? Fifteen cents? Twenty cents?

6. After graduation you plan to start your own business, and you need a total of $500,000 to begin. You are undecided on whether to put up $100,000 yourself and borrow the rest from a rich uncle at 12%, or take on a partner and put up $100,000 equity each, borrowing the rest from a bank at 8%. What would be your return on equity in each case if you earned $25,000 before interest? $50,000 before interest? $75,000 before interest? Graph and show work.

7. As director of the London-Continental Shipping Co. in 1487, a strange Genoese approached you about a mad scheme at a coast of 100,000. To raise these funds, you plan to either borrow the money from the gold merchants on Threadneedle Street or to issue new shares of your joint stock company at 12 per share. The loan would be of indefinite term at 17%. Earnings per share now run 2, and the new venture is expected to increase earnings by 25,000 per year. If 80,000 shares of the joint stock company are presently outstanding, what would be the earnings per share with the new stock issue? With the new debt? What would be the earnings per share of the stock issue, and of the debt issue, if the oriental shipping scheme contributed nothing to earnings? Graph earnings per share vs. earnings before interest for both financing alternatives.

8. You purchased 1,000 shares of Disney Airlines last year for $30 per share on 50% margin with a broker loan rate of 10%. The commission was $35 plus ½% of the trade value. The company pays an annual dividend of $1.50 per share. What would be your return on equity if you sold one year later for $35 per share? For $25 per share? If you had not borrowed on margin for your purchase, what would have been return on equity if you had sold for $35 per share? $25 per share? Include a brief discussion on the risk induced by financial leverage.

9. Intergalactic Communications Inc. needs to raise $50,000,000 to build a time-warp hypersignaltron to respond to the increased traffic between the Solar System and Alpha Centauri B. Instead of the painfully slow 8-year turnaround time for signals at the speed of light, the hypersignaltron will be practically instantaneous. Intergalactic has 100 million shares outstanding and earns $4.16 per share. They are trying to decide whether to issue additional stock, or to issue a 25 year 12% bond. Assume there is no flotation cost for the equity. The hypersignaltron is expected to boost earnings by $12,000,000. What would be the earnings per share with the common stock issue? The bond issue? What would be the earnings per share for the stock issue, and for the bond issue, if the hypersignaltron contributed nothing to earnings? Graph earnings per share vs. earnings before interest for both financing alternatives.

10. Five years age your real estate development company arranged for a 5-year option to take out a 40 year $100,000 annual payment lease on a parcel of land in downtown Santiago, on which you planned to build a hotel costing $25,000,000. The hotel has been completed on time and within budget, and you need to decide whether or not to exercise your option ($25 million to purchase the hotel and $100,000 each year to lease the land). If you do not exercise the option, the land owner will own the hotel and will pay your for its construction. When the lease expires in 40 years, the ownership of the hotel defaults to the landowner. You have two financing alternatives available: either a $10 million or a $15 million 40 year 12% amortized loan. Since your company is a developer and not a hotel manager, you have arranged for an offer from a hotel management company to sublease the property from your company for $2,000,000 per year in which they assume responsibility for all costs of operating the hotel, and all capital maintenance and improvement. If you exercise your option and sublease to the hotel management company, which mortgage alternative would you choose? If you renegotiated with the hotel management company for a $2,500,000 annual lease, which mortgage alternative would you choose?

(All analysis before income tax, show your work, Graph IRR vs. sublease annual revenue for each mortgage alternative)

11. In April 1995 financier Kirk Kerkorian offered $55 per share for the 90% of Chrysler’s common stock that he did not already own. With 350 million shares outstanding, he could buy the remaining shares for a little over $17 ½ billion. At $55 per share the 35 million shares that he then owned would be valued at around $2 billion, and the entire company would be valued at around $2o billion. Value Line, an investment newsletter, predicted 1995 interest of $1.30 billion. At the time Chrysler had $7 ½ billion in cash, and the takeover play called for the company to use $2 ½ billion of this cash and the proceeds from a new $15 billion 9% bond issue to repay the $17 ½ billion that Mr. Kerkorian hoped to borrow from his bankers.

Without the takeover, what would be the total 1995 earnings of Mr. Kerkorian’s shares? What would be the total earnings of his shares if he took over the whole company as planned? If instead of the good year predicted by Value Line Chrysler earned only $1.925 billion before interest and taxes, what would be the total earnings of his shares without the takeover? With the takeover? Plot Chrysler’s earnings before interest and taxes vs. Mr. Kerkorian’s earnings, both with the takeover and without the takeover.