The Case and Capital Structure Determinations. case study analysis. ( 5 pages )
1. Capital Asset Pricing Model: for the discount rate used in determining the present value for future cash flows for companies that have only common stock in their capital structure (right side of the Balance Sheet), discussed in chapter 10 in your current textbook (pg 338) but further defined
CAPM, RE = Rf + βE(E(RM) – Rf)
Where Rf is the lowest return on any market asset because of its lower risk, namely Treasury bills and notes qualify, since the federal government has never defaulted, it’s the lowest or risk-free rate. Betas are widely available (given in the problem as 1.15) it’s the risk of the market, and T-bill rates or the rate on long-term Treasury securities (120 day treasury bills from the problem) are often used for Rf. The expected market risk premium(Rm – Rf) is (12.5% – 9.75%) = 2.75% is the more difficult number to come up with – make sure that the market risk premium used is consistent with the risk-free rate chosen (as it is presented in the problem). That is 12.91%.
2. Next is the discount rate used for companies that have debt (bonds) in their capital structure or the right side of their balance sheet, which your assigned company does. This rate compensates for the fact the company, or any company you encounter after this point has bonds and therefore extra risk of default in their balance sheet and that rate looks like the following.
WACC = (E/V)RE + (D/V)RD(1-TC)
Where the weights of each item in the company’s balance sheet (liabilities and owners equity) are used to determine their impact on the company’s cost of capital or cost of equity.
The Capital Structure Weights
E = market value of the firm’s equity = # of outstanding shares times price per share
D = market value of the firm’s debt = # of bonds times price per bond or take bond quote as percent of par value and multiply by total par value
V = combined market value of the firm’s equity and debt = E + D (Assuming that there is no preferred stock and current liabilities are negligible. If this is not the case, then you need to include these components as well. This is really just the market value version of the balance sheet identity. The market value of the firm’s assets = market value of liabilities + market value of equity.)
In the EMBA problem you are given two different bond rates 12.7 (large stores) and 10% (small stores ) so the WACC must be calculated twice but the difference is simply the Rd factor of either 12.7% or 10%. Remember the value of equity in the problem is $23,168 (Owners Equity) and total value of the firm $54,416, thus the value of debt is $54,416 – $23,168. When calculating the WACC the weights remain the same for each store type and once you’ve calculated them then you are ready to move on to the Net Present Value (NPV) determination of which store is more profitable for selection (the one with the highest NPV.
Net Present Value is the difference between the market value of an investment and its cost. Estimating cost is usually straightforward; however, finding the market value of assets can be tricky. The principle is to find the market price of comparables. In other words, the value created accrued to the owners of the investment. This is the essence of the NPV approach: The NPV measures the increase in firm value, which is also the increase in the value of what the shareholders own. Thus, making decisions with the NPV rule facilitates the achievement of our goal in Chapter 1 – making decisions that will maximize shareholder wealth. Note from the problem case that the cost of each store is $3.7million for the large stores and $2.1 million for the small stores so the first stage of this NPV problem is the initial cost of the project.
NPV = – $(Cash out (how much you are spending for the project) + Cash flows IN
The large firm: negative or outgoing $3.7 PLUS inflows $740,000 for 5 years + Depreciation or in a straight-line depreciation of $740,000= $3,700,00/5years (tax rate of 34%). Stated in present value terms, the NPV problem will look like the following
NPV = -$3,700,000 + ($740,000 (PVFA10.31,5) + $251,600 (PVF10.31,5), and the Annuity present value factor (provided to those interested/needing it) is 3.761 The rest is simple addition, subtraction and multiplication to see which project has the highest value to the company. Also for the Smaller stores the PVFA = 3.861
By the end of Week Three, you will need to work with a group of your classmates and produce an analysis of a case. You are not expected to start working on the project until Week Three, but you may want to look ahead to understand the requirements and schedule your time. To read the group project instructions, go to the Week Three course content area and locate the page titled “Case Analysis: EMBACAP Corporation” You should begin communicating with your group members as soon as you can in Week Three.
Individually, download and review the following documents, which contain the information relevant to the EMBACAP Corporation case.
· EMBACAP Corporation case description (PDF document)
· EMBACAP Corporation income statement and balance sheet (Excel document)
Work with your group members and agree on an analysis, addressing all the questions posed in the case description document. The completed analysis should be 3 to 5 pages, double-spaced. Please add a cover sheet identifying the group number and group members.
Appoint one group member to submit a Word file with your group’s analysis of the case. In addition, submit an Excel file with the case numbers. Only one set of submissions is required from each group.
Your course content Week# 3 NPV and Project analysis content for the CAPM or Capital Asset Pricing Model or better known as the discount rate and cost of capital, which are interchangble names for the percentage This is the minimal return that you company can receive in order to meet its capital expenses (interest on debt and required return for the equity holders. ) Please take your time and compare the purchases of the cars considering the alternatives such as discounts, etc. Where the discount rate is 12% and you must decide which purchase to take advantage of. Please read Chapter # 6 carefully.
|Cash||$ 400,000||Short-term debt||$ 244,000|
|Accounts receivable||800,000||Accounts payable||560,000|
|Total current assets||$2,400,000||Total current liabilities||$ 804,000|
|Net fixed assets||$2,600,000||Long-term debt||$2,196,000|
|Total assets||$5,000,000||Total liabilities and owners’ equity||$5,000,000|
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