Reference no: EM132701966

Iconic Limited, a company established in the country 5 years ago, listed on stock exchange and engaged in the manufacturing of various electronic goods and home appliances. The company has seen rapid growth during the past 2 years due to high demand from various consumer groups.

During these years, the growing demand forced the company to opt for debt financing which has put pressure on cash flows of the company. Consider Share price as Rs 62/-

The following are extracts from the recent meeting held between the management/BoD.

Director # 1: There is a lot of demand for our products and consumers love us for the technology, quality & price we are offering. But we are growing company who needs funding but our cash flows are tight, very tight. We should opt for increase in our banking lines.
Director # 2: More banking lines? We are facing the cash flow crunch due to high level of interest and debt payments, banks are no longer willing to lend us. Those who are agreeing, only against high interest rates. I think we need to repay some of these loans back.
Director # 3: I don't get numbers and I can't say much. But all I know, we need a good financial advisor who can understand what is going on, suggest ways to manage our capital, find appropriate funding and establish our returns.
Director # 4: I attended a webinar on Corporate Finance lately, and I realized that as owners, our return is also the cost of the company. I thought our return is Return on Investment, but the webinar mentioned some equation Asset Pricing Model type, which measured the return, but I still didn't get the concept of Risk factor. I don't know, but we are doing things wrong financially this I can tell.

Data related to the company                                                                                   Data realted to the economy

Equity                              4,125,000,000                                                                     Yield on 5-year PIB 8%                                                                           Long-term Debt 1         5,500,000,000                                                                      Market-interest rates 12%  Long-term Debt 2        11,000,000,000

                                                               16,500,000,000                                                           Average return on KSE-100 index 18%

                                                                                                                 Inflation Rate 4%

Number of Shares outstanding 150,000,000

Cost of Equity 26%

Cost of Debt (Debt 1) 14%

Cost of Debt (Debt 2) 18%

Tax Rate 30%

It has been decided that the capital structure needs to be changed and in order to do this the company has decided to issue right shares. The funds received from these rights will be used to partially pay-off debt. The company will issue a 3 for 4 right issue at price of Rs. 55/- per share.

Required:
You have been hired by the Board of Directors to act in the capacity of company's financial advisor and report on the following matters:
a) As per understanding of BoD, when a company issue right shares the price goes down, but they are unclear.
Explain with calculations what is the Theoretical Ex-Right Price (TERP), why cum-right price is higher than TERP and what will be the actual market price of share after rights are issued.
b) What will be the company's revised capital structure once the rights are issued and the arrangement is made (i.e debt paid - you need to decide which debt shall be paid off, give reasons as to why you chose to pay off the chosen debt).
c) What will be the revised cost of equity for the company and why does the cost of equity actually change due to changes in the capital structure. Show all relevant calculation.
d) What will be overall revised cost of capital of the company and has the changes in capital structure really changed in the cost of capital from company's perspective (show comparison).

PART-B

The company is looking to expand its existing business which will require investment of Rs. 5,000,000,000 (and will last for 5 years), the breakup of which is given below:

Description Amount in Rs

Plant & Machinery 3,000,000,000

Land & Building 1,000,000,000

Research & Data 500,000,000

Other related assets (like vehicles, equipments etc) 500,000,000

Total Investment 5,000,000,000

The following are estimates related to the project

                                                                                 1                    2                        3                            4                        5

                   Sales (in Units)                            1,000,000      1,250,000        1,475,000        1,696,250           1,526,625

          Selling Price (Per Unit)                       Rs.50,000            6%                     6%                      3%                      3%                                                          Variabel Cost Component (Per Unit)        Rs. 35,000           0.08                   9%                    10%                     10%

Fixed Cost Component (Total)      Rs. 8,481,250,000             5%                   5%                      5%                       5%

It has been estimated that because of this expansion, the company will lose sales & after tax cash flows on two of its existing products (Product Z & Product W). As per estimates, Product Z will lose Rs. 500,000,000 annually in operating cash flows, while Rs. 250,000,000 annually will be lost from Product W
(however these cashflows are all in current terms and the will be subject to annual increments of 10% as per growth rates).

The project will result in annual working capital at 15% of Sales in Rupee terms, which shall be available at the start of each year. As per the current Tax Ordinance & Finance Bill, the company can claim capital allowance at 25% reducing balance on Plant & Machinery only (no capital allowance is allowed on any other form of asset)

The relevant risk adjusted discount rate for this project is 12.5%

Required:
Make a schedule for cash flow estimation and evaluate the project using investment appraisal technique.

Attachment:- Strategic Finance self practice.rar