Expert answer:Need help with a Finance assignment: Bond Valuatio
Answer & Explanation:Write a paper describing the below on a fictitious company of your choice. I have attached an example of what the final paper should look like. Finance Project.docx The final paper should include the below: Brief background information for both your shadow firm and fictitious firm, and why and how you picked them.· Problem statement, methods and approaches, experimental results, discussion of the results. Make sure to answer all the questions in the TO DO list in the syllabus.· Conclusions. What did you learn and what are the implications of what you learned from the project.All reports should be submitted in Times New Roman-12″ font, single-spaced with 1-inch margins. a.Name your firm, describe the business it is in.b. Choose a publicly traded corporation to act as a shadow firm. (1) Go tohttp://www.annualreports.com, and look up the most recent annual financial statements for your shadow firm.To Do (Bond Valuation Project):1. Retrieve current information on the most recent debt issuance by your shadow firm. Several sites are available, including Standard & Poor’s home page. Although you can use this site free of charge, you are required to register. Alternatively, you can find bond quote for your shadow firm at www.morningstar.com.2. Using the current rating on your shadow company’s most recent debt and a current quote on comparable Treasuries, estimate the risk premium inherent in the difference between the rates on the most recently issued debt and the risk-free Treasury.3. Let’s use the YTM on your shadow firm to determine the coupon rate offered by your fictitious firm.4. Beyond determining the coupon rate, your group must decide on an appropriate use for the funds. In other words, you must design an investment project that makes sense in the context of your fictitious firm. What is the purpose of the investment? What are the returns expected from the investment? Essentially, you should design and defend this investment.5. Show how this bond’s valuation will change given differing assumptions on required return. In other words, what is likely to happen to the bond’s valuation if market rates rise (or fall) following the issuance of this debt?
finance_project.docx
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SNOWMAN’S CAPITAL STRUCTURE
PROJECT
1
CAPITAL STRUCTURE
Capital structure is defined as the mix of the long term debt and equity maintained by the
firm. Broadly speaking, there are two forms of capital: equity capital and debt capital.
Equity Capital: This refers to money put up and owned by the shareholders. Equity capital
consists of two types:
1.) Contributed capital, which is the money that was originally invested in the business in
exchange for shares of stock or ownership and
2.) Retained earnings, which represents profits from past years that have been kept by the
company and used to strengthen the balance sheet or fund growth, acquisitions, or expansion.
Debt Capital: The debt capital in a company’s capital structure refers to borrowed money that is
at work in the business. The safest type is generally considered long-term bonds because the
company has years, if not decades, to come up with the principal, while paying interest only in
the meantime.
Cost of Capital: Most of the successful companies in the world base their capital structure on
one simple consideration: the cost of capital. Cost of capital represents the firm’s cost of
financing and is the minimum rate of return that a project must earn to increase firm value. It
forms a link between the firm’s long term investment decision and the wealth of the owner’s as
determined by investors in the market place. The managers must have a knack for consistently
lowering their weighted average cost of capital (WACC) by increasing productivity, seeking out
higher return products, and more.
Risk: As a broad rule, the riskier the strategy the more the business should rely on shareholder
equity as opposed to debt. This is because lenders must be paid back no matter what. Should the
business strategy fail to yield the expected profits and the company is unable to honor debt
obligations, lenders can take legal action. In extreme cases, these lawsuits can push the borrower
into bankruptcy. However, shareholders who are unhappy with the company’s performance
cannot take legal action except in the case of gross neglect of duties or fraud by management. If
the management in charge merely picked the wrong strategy and profits suffered as a result,
shareholders, at best, can vote the board members out of office in the annual shareholder
meeting.
2
Shadow Company: Mc DONALD’S
The McDonald’s Corporation is the world’s largest chain
of hamburger fast food restaurants, serving around 68
million customers daily in 119 countries across 35,000
outlets. Headquartered in the Illinois, United States, the
company began on May 15, 1940 as a barbecue restaurant
operated by Richard and Maurice McDonald. In this project we selected Mc Donalds as our
shadow firm because we slowly want to make our firm global and follow Mc Donald’s foot-steps.
FINANCES:
Market Capital
$93.08 Billion
P/E ratio
20.09
EPS
4.82
Dividend
3.48
Beta
0.76
Mc Donalds has raised capital for investment opportunity by a 3.8% yield, McDonald’s is one of
the highest paying dividend stocks. But that has more to do with a slumping share price than a
growing pay-out. Meanwhile, dividend increases have slowed to a crawl lately. After a 15%
boost in 2011, income investors’ raises are down in the single digits these days. Last year’s 4.9%
nudge was the smallest since before the financial crisis.
3
Following Earnings:
Investors can’t really fault the company for being stingy. After all, McDonald’s dividend policy is
just following the same path as its earnings growth. Profitability has taken a big hit since 2012 as
customer traffic levels dive and as comparable store sales fall. With earnings growth down,
McDonald’s dividend is actually climbing faster than its profits. In fiscal year 2013, for example,
per share earnings only grew by 4%, while the dividend increase was 5%. The company has kept
up its pay-out hikes even in the face of declining profit growth. But that can’t last forever.
Cash is King
McDonald’s has a few good options for raising capital to fund increasing returns to shareholders.
For one, the burger giant remains a cash generating machine. Operating cash flow was $5.2
billion through the first three quarters of 2014. That was a full $3.4 billion above the company’s
commitment to capital expenditures — things like store renovations and new restaurant launches.
The good news for investors is that while profitability is down, operating cash flow is right on
pace with the prior year and chugging along near all-time highs.
McDonald’s also has access to cheap bonds and can take as much new debt as it wants at low
rates. And the company can raise cash by refranchising its restaurants. McDonald’s expects to
sell more than 1,500 of its 7,000 company-owned locations to franchisees by the end of next year.
This strategy will pressure sales growth. Management last year set a target for cash returns to
shareholders through 2016 that amounts to almost $7 billion per year. In 2014 that spending was
almost evenly split between dividends and stock repurchases. Thanks to its many sources of
capital growth, McDonald’s should have no problem hiking its spending on both those categories
in the next few years. That would be true even assuming earnings don’t bounce back to strong
growth. Still, with an uncomfortably high pay-out ratio, dividend investors shouldn’t count on
anything like the hefty double-digit raises that we saw just a few years ago from McDonald’s.
SNOWMAN
COMPANY PROFILE
Our fictitious fast food company’s name is “Snowman”
which was established 5 years ago in January 2010 in Chicago. It
has 100 branches and is currently located in 5 states (20 each)
namely Chicago, NY, Texas, California and Florida serving 20,000
people per day. It is well known for burgers, fries, sandwiches,
salads, smoothies etc. and caters majority of population between
the age group 16 – 55 years. It is a partnership based firm planning
to go public soon. The names of the partners are Jesal Shah and
Gigi Hoang. Our present competitors are Mc Donalds, Subway and In N out Burgers.
4
In this project, we have selected McDonald’s as our shadow firm because we would want
to expand Snowman and make it global just like Mc Donald’s. Also we are in the same fast food
industry so we would want to be a market challenger to Mc Donalds who is one of the market
leaders. Snowman plans to open 20 new branches, 10 in Washington D.C. and 10 in Boston.
Clearly we have an expansion project wherein we need new machinery and new restaurant
furniture. And also capital to open the new branches across the locations.
FINANCIAL REPORTS OF SNOWMAN
Balance Sheet: 31st Dec, 2014
Cash and cash equivalents
Premiums and fees recievable
Other current assets
Total Current Assets
Fixed assets -net
Deferred income taxes
Goodwill – net
Amortizable intangible assets – net
$
$
$
$
$
$
$
$
Total Assets $
705,000,000
1,288,800,000
261,300,000
2,255,100,000
160,400,000
279,800,000
490,100,000
1,078,800,000
$
$
$
$
$
$
$
$
798,000,000
1,096,100,000
179,700,000
2,073,800,000
105,400,000
251,800,000
3,900,000
1,320,400,000
$
$
$
$
$
$
$
$
812,000,000
1,027,100,000
188,600,000
2,027,700,000
91,300,000
240,200,000
5,500,000
1,021,900,000
4,264,200,000 $ 3,755,300,000 $
3,386,600,000
Current Liabilities $
84,500,000 $
70,600,000 $
69,700,000
Total Current Liabilities $
84,500,000 $
70,600,000 $
69,700,000
Long-Term Debt $
Long Term Notes $
2,154,700,000 $
825,000,000 $
1,819,700,000 $
725,000,000 $
1,621,900,000
675,000,000
2,979,700,000 $ 2,544,700,000 $
3,064,200,000 $ 2,615,300,000 $
2,296,900,000
2,366,600,000
Total Long Term Liabilities $
Total Liabilities $
Private Equity
$
Total Liabilities and Stockholder Equity $
1,200,000,000 $
1,140,000,000 $
1,020,000,000
4,264,200,000 $ 3,755,300,000 $
3,386,600,000
Weighted average Cost of Capital (WACC):
A company has different sources of finance, namely common stock, retained earnings, preferred
stock and debt. Weighted average cost of capital (WACC) is the average after tax cost of all the
sources. It is calculated by multiplying the cost of each source of finance by the relevant weight
and summing the products up.
Uses of WACC
•
Weighted average cost of capital is used in discounting cash flows for calculation of NPV
and other valuations for investment analysis.
5
•
WACC represents the average risk faced by the organization. It would require an upward
adjustment if it has to be used to calculate NPV of project which are more risk than the
company’s average projects and a downward adjustment in case of less risky projects.
The weighted average cost of capital (WACC) for our firm can be calculated as
WACC = WiRi + WpRp + WsRs
Wi = % of Debt, Wp = % Preferred stock, Ws = % of Common stock
These weights are the target percentages of debt and equity that will minimize the firm’s overall
cost of raising funds.
•
Weight of Debt = Long term Liability / Long Term Liabilities + Total Equity
= 2979700000 / 4179700000 = 0.7128
= 71%
•
Weight of Equity = Total Equity / Long Term Liabilities + Total Equity
= 1200000000 / 4179700000 = 0.29
= 29 %
•
•
•
•
We do not have preferred stock in my company hence Rp = 0
Do = 3.48
D1 = D0 * (1 + g) = 3.48 * (1+.02) = 3.55
Rr = D1/P + g
= 3.55/96.85 + .02
= 0.0566
= 5.66%
Where; D = Dividend of MC Donalds = 3.48
on historical basis)
•
•
P = Price = 96.85
g = Growth = 2% (based
To calculate the cost of Debt Ri we assume the tax rate for Mc Donalds as 12.6% (Average
tax rate for US) and from historical data we know that the cost of debt before taxes for MC
Donalds is 3.98
Hence Ri = Rd * (1- T) = 3.98 * (1 – 0.126) = 3.98 * 0.874 = 3.478 = 3.5 %
WACC = WiRi + WpRp + WsRs
6
= 0.71 * 3.5 + 0 + 0.29 * 5.66 = 2.49 + 1.64
= 4.13%
We plan on an Expansion Project to introduce Snowman to Boston and Washington which will
have 10 branches each. Proposed Project expansion is mentioned below where the total capital
required for investment is $13,000,000.
Proposed Project Expenditure:
Expansion
Machinery
Restaurant Furniture
10,000,000
2,000,000
1,000,000
Total Investment for Expansion
13,000,000
The following tables show depreciation of machinery and for restaurant furniture. I have
calculated them by using Modified Average Cost Recovery System (MACRS)
Machinery
Year
Cost
1
2
3
4
5
6
Percentage
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
2,000,000
Depreciation
20%
32%
19%
12%
12%
5%
7
400000
640000
380000
240000
240000
100000
Restaurant Furniture
Year
Cost
1
2
3
4
5
6
7
8
Percentage
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
1,000,000
Depreciation
14%
25%
18%
12%
9%
9%
9%
4%
140000
250000
180000
120000
90000
90000
90000
40000 .
Summarize Cash Outflows and Inflows for Project:
Cash
Year
Flows
0
(13,000,000)
1
(10,000,000)
2
13,000,000
3
15,000,000
4
16,000,000
5
17,500,000
Required Rate of Return for the Project
0.10
21,716,953.0148835
38%
Net Present Value
IRR
The payback period is 3 years so we will be recovering the initial investment of $13,000,000
in 3 years.
Payback Period
Year
Cash
Flows
0
1
2
3
4
5
(13,000,000)
(10,000,000)
13,000,000
15,000,000
16,000,000
17,500,000
Discounted
Cumulative Discounted
Cash Flows
Cash Flows
($13,000,000)
(13,000,000)
($9,090,909)
(22,090,909)
$10,743,802
(11,347,107)
$11,269,722
(77,385)
$10,928,215
10,850,830
$10,866,123
21,716,953
Payback Period
3.01
8
DISCUSSION
After calculations, the NPV is positive and the IRR is 38%, given that the WACC is 4.13%
IRR has to be greater than WACC in order for us to accept this expansion project along with a
positive NPV. In general the project with the highest IRR would be considered the best and is
undertaken first. An investment whose IRR exceeds its cost of capital adds value for the
company (i.e., it is economically profitable).One of the uses of IRR is by corporations that wish
to compare capital projects. For example, a corporation will evaluate an investment in a new
plant versus an extension of an existing plant based on the IRR of each project. In such a case,
each new capital project must produce an IRR that is higher than the company’s cost of capital.
FINANCING DECISION
I would like to finance the expansion project using Debt. I would take a loan from bank
for 5 years at 0.71%. This is the amortization table for repayment of loan. The advantage of
loan is that a low rate of interest, interest is deductible from tax. Also I can invest my
retained earnings in other investments and earn a higher rate of return to pay the bank’s loan.
Financing
5 year loan
13,000,000
Present Value
Rate
0.071
5
($3,179,072.97)
No. of years
Annual Loan Payment
Year
1
2
3
4
5
Beg. of year
Loan
principal
payment
13,000,000
$10,743,927.03
$8,327,672.88
$5,739,864.68
$2,968,322.10
End of year
Interest
$3,179,072.97
$3,179,072.97
$3,179,072.97
$3,179,072.97
$3,179,072.97
Principal
923000
$762,818.82
591264.7743
407530.3923
210750.8692
$2,256,072.97
$2,416,254.15
$2,587,808.20
$2,771,542.58
$2,968,322.10
principal
$10,743,927.03
$8,327,672.88
$5,739,864.68
$2,968,322.10
$0.00
CONCLUSION
This project has taught us what capital structure is all about and how to calculate the cost of
capital and compare two business projects looking at their IRR. It has also helped us understand
the concepts and techniques of financial management in the business enterprise. We have
actually learnt a lot while doing this project in terms of research on the finances of a company,
detailed use of yahoo finance and also how to make a financial decision in terms of debt,
common stock or retained earnings.
9
10
…
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