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Phoenix Corp. faltered in the recent recession but is recovering. Free cash flow has grown rapidly. Forecasts made at the beginning of 2016 are as follows:
($ millions)
2017 2018 2019 2020 2021
Net income 1 4 7.2 7.7 8
Investment 1 3 3.2 3.4 3.4
Free cash flow 0 1 4 4.3 4.6
Phoenix

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Irving Heathcote
Irving HeathcoteLv2
28 Sep 2019

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Modern Furnitures was established in 2000. Its products include household and office furniture. It has grown organically with new designs of furniture as well as through acquisition of other furniture companies. It has high cash balance in order to provide funds for these opportunities. Its financial statements are shown in Exhibit 1 and 2.


Exhibit 1 Income Statement for the year ending December 31, 2016


Sales Revenue
6,000,000


Cost of goods sold
-1,800,000


Gross Profit
4,200,000


Operating expenses
-2,000,000


Depreciation
-200,000


EBIT
2,000,000


Interest
-120,000


Earnings before tax
1,880,000


Tax (20%)
-376000


Net income
1,504,000


Dividend payment
-601600


Addition to retained earnings
902,400


Exhibit 2 Balance Sheet as at December 31, 2016
Assets
Cash and Cash Equivalents
1,200,000


Receivables
560,000


Inventory
500,000


Total current assets
2,260,000


Gross Fixed assets
1,350,000


Accumulated Depreciation
-550,000


Net fixed assets
800,000


Total assets
3,060,000


Liabilities and Shareholder equity
Payables
400,000


Short-term debt
150,000


Current Liabilities
550,000


Long-term debt
1,000,000


Total Liabilities
1,550,000


Paid up capital
1,000,000


Retained Earnings
510,000


Total equity
1,510,000


Equity + Liabilities
3,060,000


The number of shares outstanding is 1,000,000.


The company expects that its dividend will grow at 6% every year indefinitely. The long-term debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 9%


The beta of furniture industry is 1.2; the risk-free rate is 4% and the expected market risk premium is 7%. The market price per share is $9.50.


Modern Furnitures is planning to launch a new bedroom suite. They have been doing research for this product for the past 8 months and have spent $200,000 in research expenses. This project will last for 4 years.


The manufacture and sale of new bedroom suites will begin in January 2018 and the expected demand for the next 4 years will be:
Year


Demand in Units
2018
3,200


2019
4,000


2020
4,800


2021
5,600


The variable cost is estimated as 50% of sales. Other operating expenses are fixed costs which will be $600,000 a year. The unit price at which the suite can be sold is $1,800. The cost of the new machinery is $9,000,000. The machinery will be fully depreciated over its useful of 5 years. At the end of the project, the machinery has a salvage value of $2,500,000. The working capital needed for each year is 30% of the sales.


Question 2
Examine whether the new product should be introduced.


Modern Furnitures was established in 2000. Its products include household and office furniture. It has grown organically with new designs of furniture as well as through acquisition of other furniture companies. It has high cash balance in order to provide funds for these opportunities. Its financial statements are shown in Exhibit 1 and 2.


Exhibit 1 Income Statement for the year ending December 31, 2016


Sales Revenue
6,000,000


Cost of goods sold
-1,800,000


Gross Profit
4,200,000


Operating expenses
-2,000,000


Depreciation
-200,000


EBIT
2,000,000


Interest
-120,000


Earnings before tax
1,880,000


Tax (20%)
-376000


Net income
1,504,000


Dividend payment
-601600


Addition to retained earnings
902,400


Exhibit 2 Balance Sheet as at December 31, 2016
Assets
Cash and Cash Equivalents
1,200,000


Receivables
560,000


Inventory
500,000


Total current assets
2,260,000


Gross Fixed assets
1,350,000


Accumulated Depreciation
-550,000


Net fixed assets
800,000


Total assets
3,060,000


Liabilities and Shareholder equity
Payables
400,000


Short-term debt
150,000


Current Liabilities
550,000


Long-term debt
1,000,000


Total Liabilities
1,550,000


Paid up capital
1,000,000


Retained Earnings
510,000


Total equity
1,510,000


Equity + Liabilities
3,060,000


The number of shares outstanding is 1,000,000.


The company expects that its dividend will grow at 6% every year indefinitely. The long-term debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 9%


The beta of furniture industry is 1.2; the risk-free rate is 4% and the expected market risk premium is 7%. The market price per share is $9.50.


Modern Furnitures is planning to launch a new bedroom suite. They have been doing research for this product for the past 8 months and have spent $200,000 in research expenses. This project will last for 4 years.


The manufacture and sale of new bedroom suites will begin in January 2018 and the expected demand for the next 4 years will be:
Year


Demand in Units
2018
3,200


2019
4,000


2020
4,800


2021
5,600


The variable cost is estimated as 50% of sales. Other operating expenses are fixed costs which will be $600,000 a year. The unit price at which the suite can be sold is $1,800. The cost of the new machinery is $9,000,000. The machinery will be fully depreciated over its useful of 5 years. At the end of the project, the machinery has a salvage value of $2,500,000. The working capital needed for each year is 30% of the sales.


Question 1
(a) Calculate the weighted average cost of Modern Furnitures using market value weights.

(b) Explain the conditions under which WACC of Modern Furnitures can be used to appraise the new project?

Modern Furnitures was established in 2000. Its products include household and office furniture. It has grown organically with new designs of furniture as well as through acquisition of other furniture companies. It has high cash balance in order to provide funds for these opportunities. Its financial statements are shown in Exhibit 1 and 2.


Exhibit 1 Income Statement for the year ending December 31, 2016


Sales Revenue
6,000,000


Cost of goods sold
-1,800,000


Gross Profit
4,200,000


Operating expenses
-2,000,000


Depreciation
-200,000


EBIT
2,000,000


Interest
-120,000


Earnings before tax
1,880,000


Tax (20%)
-376000


Net income
1,504,000


Dividend payment
-601600


Addition to retained earnings
902,400


Exhibit 2 Balance Sheet as at December 31, 2016
Assets
Cash and Cash Equivalents
1,200,000


Receivables
560,000


Inventory
500,000


Total current assets
2,260,000


Gross Fixed assets
1,350,000


Accumulated Depreciation
-550,000


Net fixed assets
800,000


Total assets
3,060,000


Liabilities and Shareholder equity
Payables
400,000


Short-term debt
150,000


Current Liabilities
550,000


Long-term debt
1,000,000


Total Liabilities
1,550,000


Paid up capital
1,000,000


Retained Earnings
510,000


Total equity
1,510,000


Equity + Liabilities
3,060,000


The number of shares outstanding is 1,000,000.


The company expects that its dividend will grow at 6% every year indefinitely. The long-term debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 9%


The beta of furniture industry is 1.2; the risk-free rate is 4% and the expected market risk premium is 7%. The market price per share is $9.50.


Modern Furnitures is planning to launch a new bedroom suite. They have been doing research for this product for the past 8 months and have spent $200,000 in research expenses. This project will last for 4 years.


The manufacture and sale of new bedroom suites will begin in January 2018 and the expected demand for the next 4 years will be:
Year


Demand in Units
2018
3,200


2019
4,000


2020
4,800


2021
5,600


The variable cost is estimated as 50% of sales. Other operating expenses are fixed costs which will be $600,000 a year. The unit price at which the suite can be sold is $1,800. The cost of the new machinery is $9,000,000. The machinery will be fully depreciated over its useful of 5 years. At the end of the project, the machinery has a salvage value of $2,500,000. The working capital needed for each year is 30% of the sales.

Question 3
Compute the expected share price if sales are expected to increase by 10%. Assume that the operating expenses are fixed costs and P/E ratio based on the current market price per share.

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