Tukar Inc., a manufacturer of portable air conditioning units in Phoenix, is planning to expand its operations due to increasing market demand. Using the EFN Model (External Funds Needed), Tukar will need $6.0 million to expand and decide whether to use debt or equity financing. Debit can be sold at a cost of 10 percent while new equity can be sold at $32 per share. As a consequence of an earlier IPO, the company has one million shares of common stock outstanding and is within the 40 percent tax bracket. The information below has been gathered for analysis and recommendation. Air Conditioning Industry Rations Current Ratio 2.0X Sales to Total Assets 2.1X Current Debt to Total Assets 36% Long-Term Debt to Net Worth (Equity) 32% Total Debt to Total Assets 52% Fixed Coverage Ratio 6.0X Net Income to Sales 4% Return on Total Assets (ROA) 9% Net Income to Net Worth (Equity) 18% Tukar Inc., Balance Sheet December 31, 2006 (thousands of dollars) ASSETS LIABILITIES Cash $2,520 Current Liabilities $10,000 A/R $10,520 Long-term debt (10%) $3,600 Inventories $15,200 Total Debt $13,600 TCA $28,240 Net Worth $26,400 Net Fixed Assets $11,760 Total Assets $40,000 Total Liabilities $40,000 Tukar Inc., Income Statement December 31, 2006 Revenues $80,000 Net Operating Income (EBIT) $8,360 Interest Expense $360 Earnings before taxes $8,000 Less: taxes (40%) $3,200 Earnings after taxes (EAT) $4,800 Required: Given the above information a. Estimate Tukar's cost of Equity Capital using the CAPM, assuming that the risk-free rate is 7%, the expected return on the market is 12% with an attendant beta of 1.66 b. Determine and explain the market value of Tukar's equity, price per share as well as its market value, i.e., the market value of Tukar. c. What is Tukar's current weighted average cost of capital (WACC), using the 10% cost of debt given earlier and the cost of equity calculated in part (a). Assume no short-term interest bearing debt. d. Calculate the new financial structure and coverage relationships for expansion with debt and equity assuming that the percentage of net operating income to total assets remains the same. e. If debt financing is used, the cost of equity will rise to reflect the higher and hence a beta of 1.72. With equity financing, the beta will drop to 1.60 to reflect lower risk. Given this, calculate and discuss the cost of equity under both the debt and equity financing alternatives. f. Calculate the market value of equity and price per share under each financing method. g. Calculate and discuss the market value of Tukar under each financing option. h. Calculate and discuss the WACC under each method of financing. i. Based upon your activities above, which form of financing would you recommend for Tukar? Why?
j. Discuss pros and cons of debt and equity financing.
