Norwich Industries, an established manufacturer of printing equipment, expects its sales to remain flat for the next
Question:
Norwich Industries, an established manufacturer of printing equipment, expects its sales to remain flat for the next three to five years due to both weak economic outlook and an expectation of little new printing technology development over that period. Base on that scenario the firm’s management has been instructed by the Board of directors to institute that will allow it to operate more efficiently, earn higher profits, and most important maximize shareholder wealth. In this regard, the firm’s chief financial officer (CFO), Ron Lewis, has been tasked to evaluate the firm’s capital structure, dividend policy, and possible capital projects. Currently the firm has a fixed total capital of $10, 000,000, which is made up of 10 percent debt and 90 percent equity. The firm has 100,000 outstanding ordinary shares and no preference shares. Although Lewis feels that the firm’s current policy of paying out 60 percent of each year’s earnings in dividends is appropriate, he believes that the current capital structure may lack adequate financial leverage. In order to evaluate the firm/s capital structure, Lewis is considering two alternative capital structures – A (30 percent debt ratio) and B (50 percent debt ratio). The interest rate on current debt is 10 percent and is believed to remain the same. Lewis expects the firm’s current earnings before interest and taxes (EBIT) to remain at $1,200,000. The firm has a tax rate of 40 percent.
Norwich is considering replacing one of its printers with either of two printers – printer A or printer B. Printer A is highly automated, computer controlled; printer B is less expensive and uses standard technology. In order to analyze these alternatives, Lewis prepared estimates of the initial investment and the relevant incremental cash inflows associated with each printer. These are summarized in the following table:
Printer A | Printer B | |||
Initial investments | $660,000 | $360,000 | ||
Year | Profits after tax | Cash inflows | Profits after tax | Cash Inflows |
1 | $5,000 | $128,000 | $5,000 | $88,000 |
2 | 10,000 | 182,000 | 15,000 | 120,000 |
3 | 20,000 | 166,000 | 10,000 | 96,000 |
4 | 65,000 | 168,000 | 20,000 | 86,000 |
5 | 210,000 | 450,000 | 100,000 | 207,000 |
Note that Lewis planned to analyze both printers over a five -year period. At the end of that time
the printer will be sold, thus accounting for the large fifth-year cash inflow. Lewis decided to
apply the firm’s 13 percent cost of capital when analyzing the printers. Norwich required a
maximum payback period of 4.0 years.
Suppose the following table summarizes the net present values and associated probabilities for
the various outcomes for the two printer alternatives.
Net present value | |||
Market outcome | Probability | Printer A | Printer B |
Very poor | 5% | -$6,000 | $500 |
Poor | 15% | 2,000 | 4,500 |
Average | 60% | 8,500 | 8,000 |
Good | 15% | 15,000 | 12,500 |
Excellent | 5% | 23,000 | 16,500 |
(a) How much debt is used in the current and proposed capital structures? | |||||
(c) Assuming that the share price stays the same, calculate the earnings per share for the | |||||
three financing alternatives. (f)Use the payback period to access the acceptability and relative ranking of each printer.
(k)Summarize the preferences indicated by the techniques used in (a) and (b) and indicate
(n) Calculate the standard deviations of NPV for each printer. |
Expert Answer:
Total Capital 10000000 Currently the capital comprises of 10 Debt and 90 Equity So the value of current Debt 10 of 10000000 1000000 Calculation of Val... View the full answer
Introduction to Finance Markets Investments and Financial Management
ISBN: 978-1118492673
15th edition
Authors: Melicher Ronald, Norton Edgar
