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
2018 Demand in units 3,200
2019 Demand in units 4,000
2020 Demand in units 4,800
2021 Demand in Units 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.
Modern Furnitures is considering three options to raise the needed funds for the investment.
Modern Furnitures feels that the true value of their shares is $9.94. Modern Furnitures also
would like to keep the debt ratio at a maximum of 50% of total capital. The three options are:
1. Issue convertible bond for $9 million with a coupon rate of 3% at a par value of $100.
The YTM on this bond is 4%. The maturity of the bond is 5 years. Coupon will be
paid at the end of every year. The bond can be converted with a conversion price of
$10.2 after 1 year. The management believes that the price of shares will increase
causing all convertible bond to be converted.
2. Issue a bond with no convertible provision. The coupon rate will be 3% at a par value
of $100. Coupon will be paid at the end of every year. The YTM of this bond is 4.3%.
These bonds will also mature after 5 years.
3. Issue equity at a discount of 10% to the current market price.
(a) Discuss why the YTM on convertible bond is lower than that of a bond with no
convertible provision when coupon rate and maturity are the same.
(5 marks)
(b) Assess the funds needed to be raised from outside sources to take up the project using
the values from your answer to Question 2 and the information in financial
statements.
(5 marks)
(c) Explain why Modern Furnitures should not go with debt issue for the whole amount
needed.
(5 marks)
(d) If the company wants to issue addition shares to finance the need, calculate the issue
price and the number of new shares to issue.
(5 marks)
(e) Calculate the number of bonds that the company needs to issue to finance the needs.
(f) Explain why issue of convertible is a better choice as compared to issue of new stock.
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
Exhibit 2 Balance Sheet as at December 31, 2016
The number of shares outstanding is 1,000,000.
The company expects that its dividend will grow at 6% every year indefinitely. The longterm 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:
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.
Modern Furnitures is considering three options to raise the needed funds for the investment. Modern Furnitures feels that the true value of their shares is $9.94. Modern Furnitures also would like to keep the debt ratio at a maximum of 50% of total capital. The three options are:
1. Issue convertible bond for $9 million with a coupon rate of 3% at a par value of $100. The YTM on this bond is 4%. The maturity of the bond is 5 years. Coupon will be paid at the end of every year. The bond can be converted with a conversion price of $10.2 after 1 year. The management believes that the price of shares will increase causing all convertible bond to be converted.
2. Issue a bond with no convertible provision. The coupon rate will be 3% at a par value of $100. Coupon will be paid at the end of every year. The YTM of this bond is 4.3%. These bonds will also mature after 5 years.
3. Issue equity at a discount of 10% to the current market price.
(a) Discuss why the YTM on convertible bond is lower than that of a bond with no convertible provision when coupon rate and maturity are the same. (5 marks)
(b) Assess the funds needed to be raised from outside sources to take up the project using the values from your answer to Question 2 and the information in financial statements. (5 marks)
(c) Explain why Modern Furnitures should not go with debt issue for the whole amount needed. (5 marks)
(d) If the company wants to issue addition shares to finance the need, calculate the issue price and the number of new shares to issue. (5 marks)
(e) Calculate the number of bonds that the company needs to issue to finance the needs. (4 marks)
(f) Explain why issue of convertible is a better choice as compared to issue of new stock. (6 marks)
Kindly assist with the calculations. TIA
