AFM131 Chapter Notes - Chapter 17: Commercial Bank, Dbrs, Revolving Credit

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OC2146671

13 Nov 2017

School

University of Waterloo

Department

Accounting & Financial Management

Course

AFM131

Professor

David H A

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AFM131 Full Course Notes

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Financial management the job of managing a firm"s resources to meet its goals and objectives. Financing a small business is important for surviving its first five years. The value of understanding finance: common reasons a firm fails financially, undercapitalization (insufficient funds to run a business, poor control over cash flow. Inadequate expense control: be able to understand costs and cash flow to make a profit. Financial managers are responsible for paying a company"s bills at the appropriate time and collecting overdue payments, not losing too much money to bad debts. Finance functions such as buying on credit and collecting payments from customers: pay attention to changes and opportunities in finance, e. g. tax laws, since taxes represent cash outflow from a company. Internal auditor checks journals, ledgers, and financial statements that the accounting department prepares: make sure transactions are in accordance with ifrs, objective and critical of any improprieties or deficiencies in their evaluations.

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Please show all calculations, on paper preferably. Have posted this before and all calculations weren't there. Need for them explaination process and to get a better understanding!

Tucker Inc. makes home kitchen and bathroom faucets. The company was founded 50 years ago by Joseph Tucker and his granddaughter Jill is now chief financial officer. Senior management is contemplating starting a new line of faucets designed specifically for restaurants. Tuckerâs marketing department has spent $225,000 on research in this area and is convinced this will be a viable product line for the company. The equipment, facilities, and departments for the new line must be financed and Jill is working on computing the appropriate cost of capital to be used in computing the present value of the lineâs future cash flows. Here are the facts facing the firm:

1) Tucker, Inc. has a history of maintaining its target capital structure over the long run.

2) The firmâs outstanding semiannual noncallable bonds carry a 4% coupon rate, mature in 12 years, and are trading in the market today at a price of $975 for each $1,000 face value. The firm has 1,000 bonds outstanding.

3) Tuckerâs beta is 1.20 and its last dividend, just paid yesterday, was $4.00. The company expects its earnings to grow at 4% per year into the foreseeable future. The market risk premium is 5%. The risk free rate is 2%. The stock is fairly valued. The firm has 28,125 shares of common stock outstanding. The firm is going to have to issue new shares of common stock to finance the new product line. Common stock flotation costs are 4%.

4) The new product line is slightly riskier than Tuckerâs existing business and will require an addition 1.25% required return over the firmâs weighted average cost of capital.

5) The firmâs tax rate 35%.

Assume you are the financial manager working for the CFO. The CFO wants you to recommend an appropriate weighted average cost of capital for Tucker, Inc. and the new product line. As a financial manager, write a letter to Jill, the CFO, discussing your recommendations and the issues surrounding your estimates. Attach your supporting calculations, appropriately labeled so that the CFO can verify your computations. State any relevant assumptions you made. The letter must be typed with 12-point font and should be one page or less. The calculations do not have to be typed, but need to be legible.

Intermediate Financial Management 11th Edition

Chapter 15: Capital Structure Decisions Part 1 Mini Case

Assume you have just been hired as a business manager of PizzaPalace, a regional pizze restaurant chain. The company EBIT was $50 million last year and is not expected to grow. The firm is currently financed with all equity, and it has 10 million shares outstanding. When you took your corporate finance course, your instructor stated that most firms' owners would be financially better off if the firms used some debt. When you suggested this to your new boss, he encouraged you to pursue the idea. As a first step, assume that you obtained from the firm's investment banker the following estimated costs of debt for the firm at different capital structures:

PERCENT FINANCED WITH DEBT, Wd	rd
0%	-
20	8.0%
30	8.5
40	10.0
50	12.0

If the company were to recapitalize, then debt would be issued and the funds received would be used to repurchase stock. PizzaPalace is in the 40% state-plus-federal corprate tax bracket, its beta is 1.0, the risk free rate is 6%, and the market risk premium is 6%.

Please answer All Parts:

Part A: Provide a brief overview of capital structure effects. Be sure to identify the ways in which capital structure can affect the WACC and free cash flows.

Part B: 1) What is business risk? What factors influence a firm's business risk? 2) What is operating leverage, and how does it affect a firm's business risk? Show the operating breakeven point if a company has fixed costs of $200, a sales price of $15, and variable costs of $10.

Part C: Now, to develop an example that can be presented to PizzaPalace's management to illustrate the effects of financial leverage, consider two hypothetical firms: Firm U, which uses no debt financing, and Firm L, which uses $10,000 of 12% debt. Both firms have $20,000 in assets, a 40% tax rate, and an expected EBIT of $3,000. 1) Construct partial income statements, which start with EBIT, for the two firms. 2) Now calculate ROE for both firms. 3) What does this example illustrate about the impact of financial leverage on ROE?

Part D: Explain the difference between financial risk and business risk.

Part E: What happens to ROE for Firms U and L if EBIT falls to $2,000? What does this imply about the impact of leverage on risk and return?

Part F: What does capital structure theory attempt to do? What lessons can be learned from capital structure theory? Be sure to address the MM models.

Part G: What does the empirical evidence say about capital structure theory? What are the implications for managers?

Part H: With the preceding points in mind, now consider the optimal capital structure for PizzaPalace. 1) For each capital structure under consideration, calculate the levered beta, the cost of equity, and the WACC. 2) Now calculate the corporate value for each capital structure.

Part I: Describe the recapitalization process and apply it to PizzaPalace. Calculate the resulting value of the debt that will be issued, the resulting market value of equity, the price per share, the number of shares repurchased, and the remaining shares. Considering only the capital structures under analysis, what is PizzaPalace's optimal capital structure?

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Read the Background Information about FirstRate Company, below. Then, explain what the companyâs treasurer should do about the draft versions of the projected financial statements and short-term cash flow forecast (prepared by him) in response to comments made by the companyâs chief financial officer (CFO) in their meeting. Do not recommend specific treasury management steps, such as selling investment securities, factoring accounts receivable, reducing operating costs, or seeking alternative financing arrangements. (The background information is not sufficient to formulate such steps, nor is there enough time to implement such steps before the CFO meets with FirstRateâs banks to discuss the financial projections and cash flow forecast). It is most important that you clearly provide the reasons for your recommendations. Background Information about FirstRate Company For nearly two decades, FirstRate has been the second largest firm in its industry, maintaining market share approaching 25 percent and generating stable, if modest, sales and net income growth. Beginning in 20X1, FirstRate began to experience intensified competition from several recent entrants into its industry, including a well-capitalized firm that expanded into FirstRateâs industry by exploiting a distribution channel it developed over many years in its original line of business. FirstRate responded to this increased crowding by "competing on price." In contrast, under its historical strategy, the company positioned itself based on brand recognition, product leadership, and personalized customer service. Along with its revised pricing strategy, FirstRate liberalized its customer credit and product return policies. In response to the effects of its revised pricing strategy on the companyâs operating performance, management immediately scaled back the companyâs product development plans, but was initially slow to critically re-examine its cost structure. FirstRate eventually reduced staff and closed some facilities as it outsourced certain production and fulfillment activities. However, the transitional costs of implementing these changes were significant. In addition, to support its revised pricing strategy, the company expanded its advertising and promotion. While FirstRateâs new strategy yielded greater-than-historical sales growth for the company, its reported net income suffered, along with its stock price. In response to the effects of these changes on FirstRateâs financial performance and condition, its lending banks increased the collateral requirements and interest rates on their loans to the company. The CFO of FirstRate Company is preparing for a meeting at one of the banks where the company been a long-time borrower. The companyâs $40 million working capital line of credit (LOC) will expire shortly. The company currently has $33.5 million in borrowings outstanding under the LOC and this balance will become due and payable in 30 days, unless the bank renews the LOC. The companyâs treasurer has just completed projected financial statements and a short-term cash flow forecast for the company. In anticipation of her bank meeting, the CFO met with the treasurer to discuss the financial projection and forecast. The CFO expressed her concern that "these will fail to make a favorable impression" on the bank. She continued, "Our recent results have already brought pressure from all of our banks. Itâs important that we have the banks in our corner while we implement our revised strategy." The treasurer responded, "Iâve prepared these [projections and forecasts] using our "best case" assumptions and estimates." The CFO replied cryptically, "Well, âsharpen your pencilâ because these are probably not going to get the job done." As the treasurer left her office, the CFO reminded him that, "We have more than a thousand employees, even more stockholders, not to mention dozens of suppliers, and our customers to take care of."

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AFM131 Chapter Notes - Chapter 17: Commercial Bank, Dbrs, Revolving Credit

AFM131 Full Course Notes

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