Financial Management

Assignment
Arnold Athletic Supplies Case, Questions 11-19

GROUP 7
NEHA JATIYA 179
DEEPAK SONAWANE 177
ALIEU MANNEH 178
SHRUTI GARG 156
KUMAR RAVI 129
RUBY PAYAL 152
 Case study – Cost of capital

Arnold Athletic Supplies Case

Arnold Athletic Supplies, INC. is a stall, publicly held company located between Dallas and Fort
Worth. Arnold manufactures a variety of supplies and small equipment used by players and coaches
around the country. Over the past 15 years, Arnold has had particular success in the high school
and junior college markets; its products can be found in most dressing rooms of football, and
basketball teams throughout the Southwest and Midwest.

Arnold is considering expanding into product lines. Its well established sales force will be able to
handle supplies and equipment for sports such as swimming, golf and track through it’s a current
activities in high school and junior colleges. The marketing manager and the director of finance
have begun working on figures, related to the profitability of different athletic supplies and
equipment. At this time, five possible markets have been identified and the likely return on a cash
flow basis has been determined for each. Specific proposals have been drafted and will soon be
available for internal distribution in the company. In the meantime, the president has been given
the after tax internal rates of return for each proposal as follows:

1. Swimming Supplies, 10% return, medium risk

2. Golf Equipment, 14% return, medium-high risk
3. Golf Supplies, 7% return, medium-low risk
4. Track Equipment, 8% return, low risk
5. Track Supplies, 11% return, medium risk

At a meeting of the board of directors called to discuss the proposal, the director of finance
presented financial data, including the current year’s balance sheet and income statement. He
reported that the stock was selling for $30 per share and that the firm’s sale and earnings were
growing at a respectable 9% annually.

As the discussion shifted from the specific proposals to the need for financing, the director of
finance was asked to make a recommendation. He had been studying different possibilities and was
prepared to discuss specifics. “I recommend,” he began, “that we do not attempt to raise separate
funds for a series of small projects. Rather, I suggest that we prepare to raise $5 million to cover
whatever proposals are finally accepted by this board. If this seems logical, I have investigated
three alternatives that currently seem to be possible.
1. We can issue $4 million in bonds. Our investment banker believes that we would be able to
float a $5,400,000 offering with a 10% coupon to net us the $5 million. If this is done we will
have a debt equity ratio near 1/1, an acceptable ratio for our firm.
2. We can sell 51,177 shares of preferred stock. Our banker feels that a 6% offering would be
successful and would net us $5 million as $ 100 par. Most of the shares would probably be
purchased by our existing common shareholders, but a strong market seems to exist
generally and I would expect no problems with this alternative.
3. We could issue common stock. Our banker thinks that we can sell 2,40,000 shares at $22
per share. From this amount, we would have to deduct fees of approx $2,80,000, which
would leave us with $ 5 million net.”

After the presentation by the director of finance, the board began to discuss the different
possibilities. Finally the board began to discuss the cutoff point for the acceptance of the different
proposals. One board member inquired about the firm’s present required return, as basically a
medium risk investment. Dir of fin agreed to developed data on the required returns and how they
would affect the acceptance of each of the 5 proposals.

Questions:

1. What is the firm’s current required rate of return? What would it be with each of three
means of financing.
2. Which projects are acceptable under each financing method?

Arnold Athletic Supplies Inc. – Balance Sheet

Assets Amount($) Equity and Liabilities Amount($)
Cash 550000 Accounts Payable 480000
Accounts Receivable 1420000 Notes Payable, Current (15%) 630000
Inventories (at cost) 3220000 Bonds (13%) 1600000

Plant and Equip. (at cost) 12300000 Mortgage (14%) 1200000

(less) Acc. Depreciation 4500000 Common Stock ($1 par) 1100000
Land 2210000 Surplus 2300000
Retained Earning 7890000
Total 15200000 Total 15200000

Arnold Athletic Supplies Inc. – Income Statement

Particulars Amount($)
Sales 11550000
Cost of goods sold 6000000
Gross Margin 5550000
General and Administrative Expenses 1430000
Earnings before interest and taxes 4120000
Interest Charges 220000
Federal Income Taxes 1400000
Net Income After Taxes 2500000
Dividends Declared and Paid $.60 per share

Solution

Current Operations
Tax Rate 36%
Common Stock ($1 par) 1100000
Notes Payable, Current (15%) 630000 15% 94500

Bonds (13%) 1600000 13% 208000

Mortgage (14%) 1200000 14% 168000
Total Debt 3430000 Current Interest Paid 470500
Total Capital 4530000
Kd= Interest/ Market value of debt (1- tax rate) 8.79%
Dividends 0.60
Market price initial 30.00
Growth Rate 9%
Dividend/ Market price per share + Growth
Ke= rate 11.00%
WACC Current Operations 9.33%

Financing Option : 1
Kd(new)
Par value 5400000
Net Proceeds 5000000
Coupon Rate 10%
Tax Rate 0.36
No. of years (assumed) 10
Interest payable 540000
Kd(new)= Interest/Market value * (1-tax rate)
Irredeemable 6.92%
Redeemable 7.15% Interest+(Par- Net Proceeds)/n(1-t)/(Par+Net proceeds)/2

Financing Option : 2
Kp(new)
No. of shares issued 51177
Par value per share 100
Total book value 5117700
Total market value 5000000
Dividend rate 6%
Total Dividend 307062
Dividend/ Market value of
Kp(new)= Prefrence shares
6.14%

Financing Option : 3
Ke(new)
Dividends 0.60
Market price (new) 22.00
Growth Rate 9%
Flotation Cost 1.17
Ke(new)= (Dividend/(MP-Flotation cost))+Growth rate
11.88%

Initial Alternate 1 Alternate 2 Alternate 3

Equity (Existing) 11,00,000.00 11,00,000.00 11,00,000.00 11,00,000.00
Ke 11.00% 11.00% 11.00% 11.00%
Equity (New) 0.00 0.00 0.00 50,00,000.00
Ke(new) 0.00% 0.00% 0.00% 11.88%
Debt (existing) 34,30,000.00 34,30,000.00 34,30,000.00 34,30,000.00
Kd 8.79% 8.79% 8.79% 8.79%
Debt(new) 0.00 50,00,000.00 0.00 0.00
Kd(new) 0.00% 6.92% 0.00% 0.00%
Prefrence (existing) 0.00 0.00 0.00 0.00
Kp 0.00% 0.00% 0.00% 0.00%
Pref Capital (new) 0.00 0.00 50,00,000.00 0.00
Kp(new) 0.00% 0.00% 6.14% 0.00%
Total Finance 45,30,000.00 95,30,000.00 95,30,000.00 95,30,000.00
RRR 9.33% 8.07% 7.66% 10.67%

Alternate 1 Aternate 2 Alternate 3

8.07% 7.66% 10.67%
Swimming Supplies, 10% return, medium
Y Y N
risk
Golf Equipment, 14% return, medium-
Y Y Y
high risk
Golf Supplies, 7% return, medium-low
N N N
risk
Track Equipment, 8% return, low risk N Y N

Track Supplies, 11% return, medium risk Y Y Y

 QUESTIONS 11-19
11. (Cost of Debt) Belton is issuing a Rs 1,000 par value bond that pays 8 percent annual interest and
matures in 14 years. Investors are willing to pay Rs975 for the bond. Flotation costs will be 12
percent of market value. The company is in 30 percent tax bracket. What will be the firm’s after-tax
cost of debt on the bond?

Bond par value 1000 14 year bond

Coupon Rate 8%
Floatation 12% 117
Net Proceeds 883
Tax Rate 30% (1-t) 70%
Market Price 975
Interest+ [(Par value- net proceeds)/n]/(par value+net
kd (1-t) proceeds)/2
0.09379 0.065653 6.565287

12. (Cost of Preferred Stock) the preferred stock of Walter Industries sells for Rs52 and pays Rs5.80 in
dividends. The net price of the security after issuance costs is Rs40.00. What is the cost of capital for
the preferred stock?

Current Market
52
price
Dividends 5.8
Net Price 40

Kp Dividends/Market Price of Preferred stock

11%

13. (Cost of Debt) The Zephyr Corporation is contemplating a new investment to be financed with 40
percent from debt. The firm could sell new Rs1,000 par value bonds at a net price of Rs 935. The
coupon interest rate is 11 percent, and the bonds would mature in 12 years. If the company is in 40
percent tax bracket, what is the after tax cost of capital to Zephyr for bonds?

Par value 1000 12 years

Market Price 935
Coupon rate 11%
Tax 40%
After tax cost of capital 7.15%
WACC 3% cost of debt*proportion of debt in the capital structure
14. (Cost of Preferred Stock) Your firm is planning to issue preferred stock. The stock sells for Rs120;
however, if new stock is issued, the company would receive only Rs95. The par value of the stock is
Rs100 and the dividend rate is 12 percent. What is the cost of capital for the stock to your firm?

Par value 100

Dividend rate 12% 12
Current Market Price 120 If new stock issued 95
Kp 10%

15. (Cost of Internal Equity) Pathos Co.’s common stock is currently selling for Rs70.50. Dividends paid
last year were Rs.68. Flotation costs on issuing stock will be 11 percent of market price. The
dividends and earnings per share are projected to have an annual growth rate of 12 percent. What is
the cost of internal common equity for Pathos?

Current Market price 70.5

Dividends paid last year 68
Floatation Costs 11% of market price 7.755 62.745
Annual growth rate 12%

Cost of internal equity = [(next year's dividend per share/(current market price per share - flotation
costs)] + growth rate of dividends.

D(1+g)/MP- FC
Cost of internal common equity 76.16
62.745
Dividend Next year 76.16
Internal Common equity 15%

16.(Cost of Equity) The common stock for the Bestsold Corporation sells for Rs81. If a new issue is sold,
the flotation cost is estimated to be 7 percent. The company pays 45 percent of its earnings in
dividends, and a Rs5 dividend was recently paid. Earnings per share five years ago were Rs10.
Earnings are expected to continue to grow at the same annual rate in the future as during the past
five years. The firm’s marginal tax rate is 40 percent. Calculate the cost of (a) internal common and
(b) external common.

MP 81
FC 7%
Dividend 45% of MP
Dividend recently paid Rs.5
 floatation cost 7%
Earnings 5 years ago Rs10
Earnings now 11.11111111
R 2.10% Fv=pv(1+r)n
Cost of internal equity= 8.43%
cost of external equity= 8.90%

17. (Cost of Debt) Sincere Stationery Corporation needs to raise Rs600,000 to improve its manufacturing
plant. It has decided to issue a Rs1,000 par value bond with a 14 percent annual coupon rate and a
10-year maturity. If the investors require a 13 percent rate of return.

a. Compute the market value of the bonds.

b. What will the net price be if flotation costs are 11 percent of the market price?
c. How many bonds will the firm have to receive the needed funds?
d. What is the firm’s after-tax cost of debt if its marginal tax rate is 35 percent?

Par Value Rs1000

Coupon Rate 14%
Coupon interest Rs140
Required Rate YTM 13%
Maturity 10 years
a) Bond market value= Present value of the couponds +Present Value of the face
amount
Rs 140x6.417+ Rs 1000x 0.422
1320.88
b) Net Price= Market value of bond X (1-floatation cost)
Net Price = Rs 1320.88 X (1-0.11)
1175.26
C) Number of bonds to be issued = Required Fund / Net price
Rs 600,000/ Rs 1175.26
510.525 bonds
d) kd=11.02
kda= 11.02(1-0.35) 0.0716
7.16%

18. (Weighted cost of Capital) The capital structure for the Carrion Corporation is provided below. The
company plans to maintain its debt structure in the future. The firm has a 7.00 percent cost of debt,
a 15 percent cost of preferred stock, 6.5 percent cost of common stock, what is the firm’s weighted
cost of capital?
 Capital structure (Rs000)

Debt Rs. 7,000

Preferred stock 3500

Common stock

(4, 50,000 @ Rs. 10) 4,500

Weighted cost of capital: it is the rate the comp[any has to pay to the providers of capital to finance
the Assets of the company. It is also called as cost of Capital.

Weighted cost of Capital= We*Ke+Wp*Kp+Wd * (1-t)*Kd

Where We, =Percentage of equity in capital structure

Wp,= percentage of preference shares in Capital structure
Wd,= Percentage of debt in Capital structure
Ke,= Cost of equity
Kp= Cost of Preference Shares
Kd= Cost of dept

Weighted
Percentage cost of Cost of
Particulars Amount computation capital Capital
Debt 70,00,000 7000000/15000000 46.67% 7.00% (46.7%x7%) 3.27%
Prefered Stock 3500000 3500000/15000000 23.33% 15% (23.33%x15%) 3.50%
Common Stock 4500000 4500000/15000000 30.00% 6.50% (30%x6.50%) 1.95%
Total 15000000 8.72%
Weighted cost of
Capital = 8.72%

19. (Marginal Cost-of-Capital Curve) The Zenor Corporation is considering three investments. The costs
and expected returns of these projects are shown below:

Investment Internal Rate of

Investment Cost Return

 A Rs168,000 18%

B 250,000 13

C 120,000 10

The firm would finance the projects by 45 percent debt and 55 percent common equity. The after-
tax cost of debt is 7.5 percent. Internally generated common totaling Rs200,000 is available, and the
common stockholders’ required rate of return is 20 percent. If new stock is issued the cost will be 28
percent.

a. Construct a weighted marginal cost of capital curve.

b. Which projects should be accepted?

Cost of Debt 7.50%

Cost of equity
Up to Rs 200,000 20%
Above Rs 200,000 28%
Weightage of debt 45%
Wightage of equity 55%
Total Capital at Rs 200,000 equity= 200,000/0.55=363,636.36
Hence ,WACC will change at this level- aka Break Point
WACC
Up to Rs363,636 14.38%
Above Rs 363,636 18.78%

The firm has enough capital to invest and undertake any of the projects. We only have investment cost
given and not the Net present value.
Hence our Deceision is base on IRR. However only project A has IRR greather than the WACC