You, CPA, work as an associate with Campbell and Associates LLP, a financial and business advisory...
Fantastic news! We've Found the answer you've been seeking!
Question:
Transcribed Image Text:
You, CPA, work as an associate with Campbell and Associates LLP, a financial and business advisory firm. The board of directors of Pembroke Pulp and Paper Inc. (PPPI) has engaged your firm once again to provide some guidance and assistance. You have been asked by your boss, Heather Larimer, to assist on this engagement for PPPI. Heather recently met with the board of directors of PPPI, who expressed concern about the pulp and newsprint industry. For the newsprint industry, sale volumes and selling prices have been falling, while costs have been increasing. After waiting many years for an improvement in market conditions, it has now become clear that the company cannot continue losing money. PPPI's ongoing poor performance has reached a point where it is now undermining the company's viability. The board is fully committed to maintaining operations but emphasizes that the company needs to become profitable and self- sufficient. The directors have concluded that the newsprint industry will continue to decline. One suggestion is to use the excess capacity in the plant to serve a different market. allowing PPPI to diversify and become less reliant on newsprint. PPPI's CFO and his staff have been exploring other uses of pulp, including the production of diapers. The diaper market is a growing segment, and products include infant diapers as well as incontinence products for the elderly and injured. Diaper prices are increasing with this increased demand, while costs to manufacture are declining, and there are only a few key competitors in the market. The directors believe that diapers represent a good opportunity for the company to participate in a growing global market and is the best way to leverage its existing infrastructure. However, before the analysis of the capital spending required to move into the diaper business can be completed, the directors want to understand how the cost of capital differs between the two businesses and the implications of any differences. The board has provided Heather with information on its assumptions on the diaper business's cost of capital (Appendix I) and PPPI's current cost of capital (Appendix II). Task #1 Calculate the cost of debt and the levered and unlevered cost of equity for the diaper business. Because PPPI is a private company, use the modified capital asset pricing model formula when calculating the cost of equity. Explain what the different costs of equity represent, why they are different, and how the injection of debt impacts financial risk Your response should be no longer than one page, excluding any Excel files. Task #2 Calculate the weighted average cost of capital (WACC) for the diaper business. Explain how this rate can be used in assessing the expansion opportunity into the diaper industry. Compare and discuss the differences between the diaper business and PPP! for the following: 1. WACC 2. beta 3. cost of debt Your response should be no longer than one page, excluding any Excel files. Task #3 Discuss financial leverage and why it differs between industries. Discuss the three primary factors that are considered in determining the optimal proportion of debt versus equity for an industry, and compare these factors to both the pulp and newsprint industry and the diaper industry. Discuss what optimal capital structure means, the trade-offs between the benefits and risks of adding debt, and how increasing or decreasing debt affects the cost of equity. Calculate and explain the impact on PPPI's capital structure if it decides to go ahead with the expansion into the diaper industry. For your analysis, assume that the diaper business would represent 50% of the value of the combined business. Appendix I Diaper business cost of capital assumptions Relevant financial benchmarks for the diaper business: Bank of Canada 10-year bond yield Peer beta for the diaper industry Market risk premium Small company size premium (Note 1) Specific company premium (Note 2) Prime rate Debt risk premium (based on trading value of the public bonds) Target debt to equity for the diaper industry Income tax rate 3.50% 0.70 5.00% 9.81% 4.00% Notes: 1. PPPI is considered a small company with a market capitalization of less than $250 million. Summarized by the CFO: 4.50% 2.18% 2. This premium is determined based on the nature of the business, the location of the business, the quality of the management team, the product life cycle, and other specific considerations relevant to the company. Peer beta Cost of debt before tax 1.22 25.00% Appendix II Pembroke Pulp and Paper Inc.'s cost of capital assumptions 1.50 7.7% Proportion of debt 40% Proportion of equity 60% WACC 13.5% Income tax rate 25% Note that PPPI's current debt-to-equity ratio is in line with industry standards. You, CPA, work as an associate with Campbell and Associates LLP, a financial and business advisory firm. The board of directors of Pembroke Pulp and Paper Inc. (PPPI) has engaged your firm once again to provide some guidance and assistance. You have been asked by your boss, Heather Larimer, to assist on this engagement for PPPI. Heather recently met with the board of directors of PPPI, who expressed concern about the pulp and newsprint industry. For the newsprint industry, sale volumes and selling prices have been falling, while costs have been increasing. After waiting many years for an improvement in market conditions, it has now become clear that the company cannot continue losing money. PPPI's ongoing poor performance has reached a point where it is now undermining the company's viability. The board is fully committed to maintaining operations but emphasizes that the company needs to become profitable and self- sufficient. The directors have concluded that the newsprint industry will continue to decline. One suggestion is to use the excess capacity in the plant to serve a different market. allowing PPPI to diversify and become less reliant on newsprint. PPPI's CFO and his staff have been exploring other uses of pulp, including the production of diapers. The diaper market is a growing segment, and products include infant diapers as well as incontinence products for the elderly and injured. Diaper prices are increasing with this increased demand, while costs to manufacture are declining, and there are only a few key competitors in the market. The directors believe that diapers represent a good opportunity for the company to participate in a growing global market and is the best way to leverage its existing infrastructure. However, before the analysis of the capital spending required to move into the diaper business can be completed, the directors want to understand how the cost of capital differs between the two businesses and the implications of any differences. The board has provided Heather with information on its assumptions on the diaper business's cost of capital (Appendix I) and PPPI's current cost of capital (Appendix II). Task #1 Calculate the cost of debt and the levered and unlevered cost of equity for the diaper business. Because PPPI is a private company, use the modified capital asset pricing model formula when calculating the cost of equity. Explain what the different costs of equity represent, why they are different, and how the injection of debt impacts financial risk Your response should be no longer than one page, excluding any Excel files. Task #2 Calculate the weighted average cost of capital (WACC) for the diaper business. Explain how this rate can be used in assessing the expansion opportunity into the diaper industry. Compare and discuss the differences between the diaper business and PPP! for the following: 1. WACC 2. beta 3. cost of debt Your response should be no longer than one page, excluding any Excel files. Task #3 Discuss financial leverage and why it differs between industries. Discuss the three primary factors that are considered in determining the optimal proportion of debt versus equity for an industry, and compare these factors to both the pulp and newsprint industry and the diaper industry. Discuss what optimal capital structure means, the trade-offs between the benefits and risks of adding debt, and how increasing or decreasing debt affects the cost of equity. Calculate and explain the impact on PPPI's capital structure if it decides to go ahead with the expansion into the diaper industry. For your analysis, assume that the diaper business would represent 50% of the value of the combined business. Appendix I Diaper business cost of capital assumptions Relevant financial benchmarks for the diaper business: Bank of Canada 10-year bond yield Peer beta for the diaper industry Market risk premium Small company size premium (Note 1) Specific company premium (Note 2) Prime rate Debt risk premium (based on trading value of the public bonds) Target debt to equity for the diaper industry Income tax rate 3.50% 0.70 5.00% 9.81% 4.00% Notes: 1. PPPI is considered a small company with a market capitalization of less than $250 million. Summarized by the CFO: 4.50% 2.18% 2. This premium is determined based on the nature of the business, the location of the business, the quality of the management team, the product life cycle, and other specific considerations relevant to the company. Peer beta Cost of debt before tax 1.22 25.00% Appendix II Pembroke Pulp and Paper Inc.'s cost of capital assumptions 1.50 7.7% Proportion of debt 40% Proportion of equity 60% WACC 13.5% Income tax rate 25% Note that PPPI's current debt-to-equity ratio is in line with industry standards.
Expert Answer:
Answer rating: 100% (QA)
Task 1 Calculate the cost of debt and the levered and unlevered cost of equity for the diaper business Step 1 Calculate the Cost of Debt Given information Cost of debt before tax 77 Assuming the tax r... View the full answer
Related Book For
Auditing and Assurance services an integrated approach
ISBN: 978-0132575959
14th Edition
Authors: Alvin a. arens, Randal j. elder, Mark s. Beasley
Posted Date:
Students also viewed these finance questions
-
As the company Treasurer, the Board of Directors has asked you to comment upon a proposal to initiate dividend payments to the company's common shareholders. The Board wants you to address: What...
-
The board of directors of a city- owned electric power plant in a large urban city wants to assess the increase in electricity demands due to sources such as hybrid cars, big- screen TVs, and other...
-
On April 15 of this year, the board of directors for Jedi Company declared a cash dividnd of 65 cents per share payable to stockholders of record on May 20. The dividends will be paid on June14. The...
-
Why do we use the absolute value of x or of g(x) in the derivative formulas for the natural logarithm?
-
George Wilson dies on March 1, 2011, leaving a valid will. The will reads as follows: I leave my home, furnishings, remaining bank account balances and personal possessions to my wife Helen. I leave...
-
x + 1 + - 3 x 2 + 4 ( x - 1 ) ( x 2 + 4 ) d x
-
Ratliff Corporation produces lawn fertilizer spreaders. Ratliffs income statement shown has been prepared for August of the current year. Instructions: 1. Prepare Ratliffs August income statement...
-
Flowers Corporation reported net cash provided by operating activities of $412,000, net cash used by investing activities of $250,000, and net cash provided by financing activities of $70,000. In...
-
6. Refer to problem 5 above. You transfer your balance to a card charging 5.95% interest. How much should each payment be to retire your debt after 3 years? How much total interest do you pay? How...
-
Air is compressed steadily by a 5-kW compressor from 100 kPa and 17°C to 600 kPa and 167°C at a rate of 1.6 kg/min. During this process, some heat transfer takes place between the compressor...
-
RedCord Company's earnings per share of common stock for Year 1 is $2.50 and market price is $40.50. At the end of the year, total assets is $36,000 and total stockholders' equity is $15,200....
-
How do the predictions of the replacement model for modern human origins differ from those of the multiregional model?
-
Critics of DSGE models argue that despite their complexity and sophistication, they failed to provide indications of the shock that was the Financial Crisis. Apart from the lack of a financial...
-
What behavioral and anatomical characters signal the origin of Homo sapiens?
-
Match the following common risks with the appropriate mitigation strategy: Country risks A. Detailed tracking, alternate suppliers Regulatory risk B. Careful selection and monitoring of suppliers...
-
Given the limitations of using GDP as a measure of well-being, should calculation of GDP be scrapped in favour of wider reporting of well-being such as objective and subjective well-being?
-
Consider the matrix k-k 0 A = 1 -2 1 0 1 k 1 where k is a real parameter. 1. Discuss the rank of the matrix according to the parameter k. 2. Find a basis of the space Lhom, where Lhom is the space of...
-
r = 0.18 Find the coefficients of determination and non-determination and explain the meaning of each.
-
Describe the role of International Standards on Auditing. What is the relationship between International Standards on Auditing and U.S. Generally Accepted Auditing Standards?
-
Explain what is meant by acceptable risk of incorrect acceptance. What are the major audit factors affecting ARIA?
-
The following are selected transaction-related audit objectives and audit procedures for sales transactions: Transaction-Related Audit Objectives 1. Recorded sales exist. 2. Existing sales are...
-
Eliminating nearly all pollution would be economically _________ because the marginal _________ would exceed the marginal _________.
-
Transferable pollution rights _________ work when the EPA does not know the cheapest way for polluters to reduce their emissions because they make it in polluters interests to reduce pollution the...
-
The imposition of per-unit pollution taxes would likely be _________ costly than compliance standards for the same degree of pollution abatement.
Study smarter with the SolutionInn App