Assignment IY2541

Assignment IY2541, Aug-16

O’Grady Apparel company is a small manufacturer of fabrics and clothing whose stock is currently traded in the OTC market. Because of recent growth (see table 1 on p.2), the corporate treasurer at O’Grady is concerned that current funds are not used at their fullest potential. The firm expects to have $M1.3 of available retained earnings for 2013, being insufficient to meet the company’s expansion needs. Management has set a policy of maintaining the current capital structure proportions of 25% long-term debt, 10% preferred stock, and 65% common equity for at least the next 3 years. In addition, it plans to continue paying out 40% of its earnings as dividends. O’gradyhave several competing investment opportunities at the moment and since funds are limited choices must be made (see table 2 on p.2). To analyze the effect of the increased financing requirements on WACC, O’Grady has contacted an investment bank specialist who has provided financing cost data (see table 3 on p.3).  O’Grady is in the 40% tax bracket. Now O’Grady wants your help as a hired consultant to do the following using a spreadsheet program (using cell references):

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• Over the relevant ranges noted in the following table, calculate the after-tax cost of each source of financing needed to complete the table

• Determine the break point associated with common equity and debt. A peak point represents the total amount of financing that the firm can raise before it triggers an increase in the cost of a particular financing source. For instance, O’Grady plans to use 25% long-term debt in its capital structure. That means that for every $1 in debt that the firm uses, it will use $3 from other sources.
• Using the break points calculated, determine each of the ranges of total new financing over which the firm’s WACC is constant
• Calculate WACC for each range of total new financing. Draw a graph with the WACC on the vertical axis and money raised on the horizontal axis, and whos how the firm’s WACC increases in steps as the amount of money raised increases
• Sort the investment opportunities described in table 2 from highest to lowers return, and plot a line on the graph you have drawn, showing ho2w much money is required to fund the investments, starting with the highest return and going to the lowest. In other words, this line will plot the relationship between the IRR on the firm’s investments and the total financing required to undertake those investments.
• Which, if any, of the investments listed in table 2, do you recommend the firm to accept? Explain your answer.
• Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 40% common stock, and 10% preferred stock have on your previous findings (rework above parts)?
• Which capital- the original or the new one, seems better?
• What type of dividend policy does the firm appear to employ`Does it seem appropriate given the firm’s recent growth in sales and profits and given its current investment opportunities. Show by calculations and explain your answer.
• Would you recommend an alternative dividend policy? Show by calculation and explain. .

TABLE 1: SELECT INCOME STATEMENTS

TABLE 2: INVESTMENT OPPORTUNITIES

TABLE 3: FINANCING COST DATA