The given case deals with a small company named Wheels for Rent Inc which has been founded by Jim. A peculiar feature of the company is that it is completely funded by equity owing to bad experience of the promoter Jim with debt in his previous company. Jim is currently evaluating an expansion project in Florida which would require an investment of $ 6 million and enhance the EBIT by $ 0.9 million annually till perpetuity. The objective is to provide recommendation to Jim with regards to whether investment should be made in this project. Additionally, the optimal financing mix for the project ought to be discussed with various proportion of debt and equity so as to highlight the mix which leads to maximisation of the firm value.
Analysis
The analysis of the various questions that Pauline has raised is carried out in this section in the same chronological order in which these queries have been raised.
1) It is known that the current capital structure of the firm is 100% equity funded since no debt is present. The WACC of the company currently (without the project) has been given as 7.5% and hence essentially this would represent the cost of equity owing to 100% weight of this means of financing only (Damodaran, 2015).
The total market value of equity for the firm would be essentially obtained by discounting the net income that the company would earn over the years to earn the present value of these. This is because all the net income would be available to the equity shareholders owing to absence of any preference shares (Petty et. al., 2015). The discount factor would be the cost of equity which is 7.5% as explained above.
Current EBIT for the company = $9,562,500
On the above EBIT, a tax of 40% would be applicable. Thus, net income (after tax) = 9562500*(1-0.4) = $5,737,500
Based on the information provided in the case, it is apparent that the above net income would continue to remain constant in the future years.
Hence, market value of equity of company = 5,737,500/(0.075) = $ 76,500,000
Total number of outstanding common shares = 3,000,000
Hence, market value of each common share = (76,500,000/3,000,000) = $ 25.5
2) The objective is to analyse the financial impact of the new project assuming that 100% funding is based on equity. In order to determine the net present value of the project, it is essential to compute the PV of the net cash inflows over the project life and subtract the PV of the net cash outflows over the project life (Brealey, Myers and Allen, 2014).
Expected incremental EBIT from the project from next year onwards = $0.9 million
Expected incremental net income (after tax) from the project from next year onwards == 0.9*(1-0.4) = $0.54 million
The cost of equity is 7.5% which would serve as the discount rate. Since the above cash inflows are expected to continue till perpetuity = (0.54/0.075) = $ 7.2 million
The cash outflow happens in the present and is expected to be $ 6 million
Hence, NPV associated with the project = $7.2 million – $6 million = $ 1.2 million
For funding the given project, additional money to the tune of $ 6 million is required which would be procured through equity issue. Considering that the current price per share is $ 25.5, hence incremental shares issued for financing the project = (6,000,000/25.5) = 235,294 shares
The price per share after the project needs to be determined which would be equal to the discounted value of the revised earnings after tax divided by the total number of outstanding shares (Parrino and Kidwell, 2014).
Revised earnings after tax after project implementation = ($9,562,500 + 900,000)*(1-0.4) = $6,277,500
The cost of equity is 7.5%, hence discounted value of revised earnings after tax = (6,277,500/0.075) = $83,700,000
Total number of shares outstanding after the project = 3,000,000 + 235,294 = 3,235,294
Hence, revised price per share = $83,700,000/3,235,294 = $25.87
Considering that after the implementation of the project also, only equity would exist, hence the value of equity is essentially the value of firm after project implementation. Thus, it can be concluded that the market value of the company after the project implementation is $ 83.7 million (Damodaran, 2015).
3) In the given case, the entire project funding is received through debt with no incremental equity based funding. Thus,$ 6,000,000 would be arranged through the issue of debt.
Incremental EBIT from the project per annum = $ 900,000
(-) Interest cost ($ 6 million*5%) = $ 300,000
Hence, incremental EBT from the project per annum = 900000-300000 = $ 600,000
Incremental earnings post tax = 600000*(1-0.4) = $ 360,000
PV of project = Incremental annual EAT/Cost of debt = 360000/0.05 = $ 7,200,000
NPV of project = PV of cash inflows – PV of cash outflows = 7,200,000 –6,000,000 = $ 1,200,000
The per share needs to be computed which is essentially the value of the firm after the project implementation using 100% debt funding divided by the outstanding shares. Since all funding is essentially through debt, hence no new equity would be raised which implies that the number of common shares would remain the same at 3,000,000
Revised earnings after tax after project implementation = ($9,562,500 + 600,000)*(1-0.4) = $6,097,500
The above earnings would continue, hence discounted value of revised earnings after tax = (6,097,500/0.075) = $81,300,000
Hence, revised price per share = $81,300,000 /3,000,000 = $27.1
The value of the firm in the given case would involve both the market value of equity as well as the debt. Hence, the firm value after the implementation of the project = 81,300,000+ 6,000,000 = $ 87.3 million
Thus, if the entire funding is through debt, then the value of the firm would increase primarily because of the tax shield and lower cost funding cost related to debt in comparison to equity.
4) In this scenario, the firm deploys a mixture of debt and equity based funding and does not rely solely on one particular means of funding. It is imperative to note that majority of the funding of the project is enabled through debt considering the fact that $ 5,000,000 would be equity funded while only $ 1,000,000 would be funded through debt. Hence, the computations need to be consider the above while deriving the PV, NPV of the project along with the value of the share of the share and the firm value. This is shown below.
Incremental EBIT from the project per annum = $ 900,000
(-) Interest cost ($ 1 million*5%) = $ 50,000
Hence, incremental EBT from the project per annum = 900000-50000 = $ 850,000
Incremental earnings post tax = 850000*(1-0.4) = $ 510,000
WACC for the project = (1/6)*5% + (5/6)*7.5% = 7.083%
PV of project = Incremental annual EAT/ = 510000/0.07083 = $ 7,200,000
NPV of project = PV of cash inflows – PV of cash outflows = 7,200,000 – 6,000,000 = $ 1,200,000
Since $ 5 million has to be raised using equity, hence, additional shares ought to be issued. Additional shares required = (5,000,000/25.5) = 196,078 shares
The price per share after the project needs to be determined which would be equal to the discounted value of the revised earnings after tax divided by the total number of outstanding shares.
Revised earnings after tax after project implementation = ($9,562,500 + 850,000)*(1-0.4) = $6,247,500
The cost of equity is 7.5%, hence discounted value of revised earnings after tax = (6,247,500/0.075) = $83,300,000
Total number of shares outstanding after the project = 3,000,000 + 196,078 = 3,196,078
Hence, revised price per share = $83,300,000/3,196,078 = $26.06
The value of the firm in the given case would involve both the market value of equity as well as the debt. Hence, the firm value after the implementation of the project = 83,300,000+ 1,000,000 = $ 84.3 million
5) Case 1: $ 4 million new equity and $ 2million debt
Hence, incremental EBT from the project per annum = 900000- (2,000,000*5%) = $ 800,000
Incremental earnings post tax = 800000*(1-0.4) = $ 480,000
WACC for the project = (2/6)*5% + (4/6)*7.5% = 6.67%
PV of project = Incremental annual EAT/ = 480000/0.0667 = $ 7,200,000
NPV of project = PV of cash inflows – PV of cash outflows = 7,200,000 – 6,000,000 = $ 1,200,000
Since $4 million has to be raised using equity, hence, additional shares ought to be issued. Additional shares required = (4,000,000/25.5) = 156,863 shares
Revised earnings after tax after project implementation = ($9,562,500 + 800,000)*(1-0.4) = $6,217,500
Discounted value of revised earnings after tax = (6,217,500/0.075) = $82,900,000
Hence, revised price per share = $82,900,000/(3,000,000 + 156,863) = $26.26
The firm value after the implementation of the project = 82,900,000+ 2,000,000 = $ 84.9 million
Case 2: $ 3 million new equity and $ 3 million debt
Hence, incremental EBT from the project per annum = 900000- (3,000,000*5%) = $ 750,000
Incremental earnings post tax = 750000*(1-0.4) = $ 450,000
WACC for the project = (3/6)*5% + (3/6)*7.5% = 6.25%
PV of project = Incremental annual EAT/ = 450000/0.0625 = $ 7,200,000
NPV of project = PV of cash inflows – PV of cash outflows = 7,200,000 – 6,000,000 = $ 1,200,000
Since $3 million has to be raised using equity, hence, additional shares ought to be issued. Additional shares required = (3,000,000/25.5) = 117,647 shares
Revised earnings after tax after project implementation = ($9,562,500 + 750,000)*(1-0.4) = $6,187,500
Discounted value of revised earnings after tax = (6,187,500/0.075) = $82,500,000
Hence, revised price per share = $82,500,000/(3,000,000 + 117,647) = $26.46
The firm value after the implementation of the project = 82,500,000+ 3,000,000 = $ 85.5 million
Case 3: $2 million new equity and $4 million debt
Hence, incremental EBT from the project per annum = 900000- (4,000,000*5%) = $ 700,000
Incremental earnings post tax = 700000*(1-0.4) = $ 420,000
WACC for the project = (4/6)*5% + (2/6)*7.5% = 5.83%
PV of project = Incremental annual EAT/ = 420000/0.0583 = $ 7,200,000
NPV of project = PV of cash inflows – PV of cash outflows = 7,200,000 – 6,000,000 = $ 1,200,000
Since $2 million has to be raised using equity, hence, additional shares ought to be issued. Additional shares required = (2,000,000/25.5) = 78,431 shares
Revised earnings after tax after project implementation = ($9,562,500 + 700,000)*(1-0.4) = $6,157,500
Discounted value of revised earnings after tax = (6,157,500/0.075) = $82,100,000
Hence, revised price per share = $82,100,000/(3,000,000 + 78431) = $26.67
The firm value after the implementation of the project = 82,100,000+ 4,000,000 = $ 86.1 million
Case 4: $1 million new equity and $5 million debt
Hence, incremental EBT from the project per annum = 900000- (5,000,000*5%) = $ 650,000
Incremental earnings post tax = 650000*(1-0.4) = $ 390,000
WACC for the project = (5/6)*5% + (1/6)*7.5% = 5.416%
PV of project = Incremental annual EAT/ = 390000/0.0416 = $ 7,200,000
NPV of project = PV of cash inflows – PV of cash outflows = 7,200,000 – 6,000,000 = $ 1,200,000
Since $2 million has to be raised using equity, hence, additional shares ought to be issued. Additional shares required = (1,000,000/25.5) = 39,216 shares
Revised earnings after tax after project implementation = ($9,562,500 + 650,000)*(1-0.4) = $6,127,500
Discounted value of revised earnings after tax = (6,127,500/0.075) = $81,700,000
Hence, revised price per share = $81,700,000/(3,000,000 + 39216) = $26.88
The firm value after the implementation of the project = 81,700,000+ 5,000,000 = $ 86.7 million
6) The requisite table is indicated below.
7) The firm should accept the project considering the fact that the NPV of the project is positive. The key decision rule with regards to NPV is that the project should be accepted if the underlying NPV is positive which is true in the given case. Also, with regards to the appropriate financing mix used to fund the project cost of $ 6 million, it is imperative to consider the financing option that leads to the maximisation of the firm value.
Based on the computations conducted above, it becomes evident that the value of the firm is maximised when the entire funding is through debt. Further, it is noteworthy that the company currently does not have any debt on the books and thereby 100% debt funding also would not result in any significant leveraging of the balance sheet so as to cause any concern or alter the cost of equity due to higher risk (Parrino and Kidwell, 2014).
8) Even in case of the incremental earnings from the project being $ 0.45 million annually, the above recommendation would be applicable. This is primarily because debt is a cheaper means of financing in comparison to debt besides offering tax shield. Further, currently the company is entirely funded with equity which is not an optimal capital structure and assumption of $ 6 million debt would push the capital structure for the firm towards a better financing mix (Petty et. al., 2015).
9) Before the project, the market value of equity was $ 76.5 million. However, after the project there is increase in the share price which leads to higher market value of equity nearing to about $ 80 million. It is apparent that if the debt equity of the firm cannot exceed 5%, then the entire $ 6 million cannot be funded through debt and some component of equity would be required. Thus, the recommendation of all debt based financing would need to be altered owing to the constraint on debt that can be assumed. However, even in this case, the maximum amount of possible funding should be debt based so as to maximise the firm value within the given constraint (Brealey, Myers and Allen, 2014).
Recommendations
Based on the above analysis, it would be fair to conclude that the given expansion project in Florida should be accepted by the company considering the fact that the NPV of this project is positive. Further, various combinations of financing have been tried for the given project and the one which leads to maximisation of the firm value would be funding through 100% debt i.e. $ 6 million. However, it is imperative to note that if there is a constraint with regards to 5% debt equity at firm level, then the above funding mechanism canoe apply but still maximum debt funding should be availed.
References
Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 6th ed. New York: McGraw-Hill Publications
Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.
Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications
Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed.. NSW: Pearson Education, French Forest Australia.
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