Applied Manufacturing, Inc. (AM) is a custom metal fabrication corporation providing a wide range of goods and

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Question:

Applied Manufacturing, Inc. (AM) is a custom metal fabrication corporation providing a wide range of goods and services to its customers. For decades, AM has been a parts manufacturer and supplier to the aerospace and naval industries. They service both major manufacturers such as Nordam, Boeing, and Airbus, as well as the United States Government in contracts for both military aircraft and naval vessels. While the existing lines of business are profitable, senior leadership of the corporation is pushing for the creation of new lines of business that will generate new revenue streams that are not dependent on their existing clients. As part of its budgeting process for the next year, the senior leadership team has identified three mutually-exclusive projects which meet the strategic goals mentioned above. As a member of the senior leadership team, you have been assigned the task of performing a financial analysis of these projects to determine the appropriate valuation of each one. However, before you can determine the appropriate valuations of these projects, you need to determine the weighted average cost of capital for the firm. Senior management has a preference in using the market values of the firm’s capital structure and believes it current structure is optimal.

Balance Sheet

Cash 1,789,298 Accounts Payable and Accruals 28,204,824

Accounts Receivable 52,740,911 Notes Payable 48,240,305

Inventories 70,670,223 Long Term Debt 77,260,000

Net Fixed Assets 179,040,000 Preferred Stock 15,000,000

Common Equity 135,535,303

Total Assets 304,240,432 Total liabilities and Equity 304,240,432

Market Values of Capital:

The company has 81,000 bonds with a 30-year life outstanding, with 15 years until maturity. The bonds carry a 10 percent semi-annual coupon, and are currently selling for $899.24.  You also have 150,000 shares of $100 par, 9% dividend perpetual preferred stock outstanding. The current market price is $90.00. Any new issues of preferred stock would incur a 3.6% per share flotation cost.  The company has 5 million shares of common stock outstanding with a currently price of $29.84 per share. The stock exhibits a constant growth rate of 10 percent. The last dividend (D0) was $.80. New stock could be sold with flotation costs of 6.7% per share. The risk-free rate is currently 6 percent, and the rate of return on the stock market as a whole is 13 percent. Your stock’s beta is 1.18.  Your firm does not use notes payable for long-term financing.  Your firm’s federal + state marginal tax rate is 28%.  For all projects, the reinvestment rate shall be 9.5%

Project A:

This project requires an initial investment of $30,000,000 in equipment which will cost an additional $4,000,000 to install. The firm will use the attached MACRS depreciation schedule to expense this equipment. Once the equipment is installed, the company will need to increase raw goods inventory by $6,000,000, but it will also see an increase in accounts payable for $2,500,000. With this investment, the project will last 6 years at which time the market value for the equipment will be $1,000,000. The project will produce a product with a sales price of $20.00 per unit and the variable cost per unit will be $10.00. It is estimated the sales volume for this project will be 700,000 in year 1, 1,000,000 in year 2, 650,000 in year 3, 700,000 in year 4, 650,000 in year 5 and 650,000 in year 6. The fixed costs would be $3,000,000 per year. Because this project could use some existing company infrastructure, management has expressed some favoritism towards this project and as allowed for a reduced rate of return of 2 percentage point below its current WACC as the valuation hurdle it must meet or surpass.

Required

4) Find the average cost of retained earnings (average of both values below) for Project A:

a) Capital Asset Pricing Model method

b) Dividend Discount Model method