The Sun Co. was founded five years ago by three former Moon Company employees. The three founders own 100% of the Sun Company’s stock which has a market value of $5 per share. Below is the Balance Sheet of the company.

The boards of directors of Sun Company have asked Frank Norman, the financial officer of the company, to make the first major decision for the company's future financial planning.

The board has asked Frank to evaluate the profitability of two new investments (Table 1) that the company considers acquiring for its future survival.

The two investments are different in their characteristics and descriptions.

Table 1	Investment A	Investment B
Purchase Price	$1,000,000	$4,000,000
Output	2,500	2,500
Growth in Output	5%	6%
Variable Cost	$800	$600
Growth in Costs	3%	3%
Unit Price	$1,000	$1,500
Price Increase	4%	4%
Beta	1	1.4
Tax Rate	40%	40%

The investments would be depreciated on a straight-line basis over their five-year life to a zero-salvage value.

Frank Norman, being a sophisticated financial analyst, obtained the following information in Table 2 for the analysis of various investment and financial proposals.

Table 2	Expected Return	Variance	Covariance with Market Return
Risk-Free Rate	10%
Market Portfolio		20%
SUN CO.			8%

Part I

1. What is the cost of capital for each investment?

2.   Which of the two investments should be adopted? Why?

3. What would be the Sun’s cost of capital if these two investments are adopted?

4.   Based on the expected rate of return of each investment which investment should be accepted? Why?

Part 2

The financial officer has long believed that Sun's capital structure is not optimal, and he believes by financing half of total investment of each investment by debt at the 10% and retires the debt over the life of the investment, the value of each investment will be maximized. If Frank Norman is correct with his assumptions and if his financial plan is adopted, what would the following be?

1. What is the Adjusted Present Value (APV), for each investment?

What would be the value of each investment based on the Weighted Average Cost of Capital (WACC)?

3. What is the Cash Flow-to-Equity (FTE) for each investment?

4. Explain the differences among the three methods for the level of debt financing.

Sun Company -Balance Sheet (in thousands)
Cash	$100,000	Accounts Payable	$150,000
Account Receivable	$300,000	Notes Payable	$50,000
Inventory	$250,000	Accrued Wages	$75,000
Current Assets	$650,000	Current Liabilities	$275,000
Gross Fixed Assets	$1,850,000	Common Stocks (1M shares at par value of $1.5)	$1,500,000
less: Accumulated
Depreciation	($300,000)	Retained Earnings	$425,000
Net Fixed Assets	$1,550,000	Equity	$1,925,000
Total Assets	$2,200,000	Total Debt & Equity	$2,200,000

Answer rating: 100% (QA)

Cash flows from both the investments are given below These annual cash flows have to be discount... View the full answer