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 / Demand in Units
2018 / 3,200
2019 / 4,000
2020 / 4,800
2021 / 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.
Question 1
(a) Calculate the weighted average cost of Modern Furnitures using market value weights.
(20 marks)
(b) Explain the conditions under which WACC of Modern Furnitures can be used to appraise the new project?
(5 marks)

Question 2
Examine whether the new product should be introduced.
(25 marks)
Question 3
Compute the expected share price if sales are expected to increase by 10%. Assume that the operating expenses are fixed costs and P/E ratio based on the current market price per share.
(20 marks)
Question 4
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)

Answer rating: 100% (QA)

Question 1 Weighted Average Cost of Capital WACC a Calculate the weighted average cost of Modern Furnitures using market value weights 20 marks Data M... View the full answer