Reference no: EM133061687
Namib Mills, an established manufacturer of consumer goods, expects its sales to remain flat for the next three to five years due to both weak economic outlook and an expectation of little new industrial technology development over that period. Based on that scenario the firm's management has been instructed by the Board of directors to institute programs that will allow it to operate more efficiently, earn higher profits, and most importantly maximize shareholder wealth. In this regard, the firm's chief financial officer (CFO), Theo van Zyl, has been tasked to evaluate the firm's capital structure, dividend policy, inventory management strategy, and possible capital projects as well as measuring the corporation's cost of capital. Currently the firm has a fixed total capital of $10, 000,000, which is made up of 20 percent debt and 80 percent equity. The firm has 100,000 outstanding ordinary shares and no preference shares. Although Theo feels that the firm's current policy of paying out 60 percent of each year's earnings in dividends is appropriate, he believes that the current capital structure may lack adequate financial leverage. In order to evaluate the firm's capital structure, Theo is considering three alternative capital structures - A (30 percent debt ratio), B (50 percent debt ratio), and C (60 percent debt ratio). The interest rate on current debt is 10 percent and is believed to remain the same up to a borrowing limit of $1,000,000. Theo expects the firm's current earnings before interest and taxes (EBIT) to remain at $1,200,000. The firm expects to have $200,000 of retained earnings available in the coming year.
The firm has a tax rate of 40 percent. In assessing the cost of capital, Theo has the following information which has been compiled about the company's current costs of two sources of capital:
Exhibit 1
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Source of capital
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Range of new financing
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Cost
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Long-term debt
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$0 to $1,000,000
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10%
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$1,000,001 and above
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11%
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Common stock equity
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$0 to $2,000,000
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13%
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$2,000,001 and above
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14%
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Retained earnings
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12%
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Exhibit 2
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NAMIB MILLS
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Balance Sheet
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Assets
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2017
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2018
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2019
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Cash
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$20,000
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$30,000
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$20,000
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Marketable securities
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30,000
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35,000
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50,000
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Accounts receivable
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150,000
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230,000
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330,000
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Inventory
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250,000
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285,000
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325,000
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Total Current Assets
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450,000
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580,000
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725,000
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Net Plant and equipment
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550,000
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720,000
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1,169,000
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Total Assets
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$1,000,000
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$1,300,000
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$1,894,000
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Liabilities & Equity
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|
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Accounts payable
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$100,000
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$225,000
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$200,000
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Notes payable (bank)
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100,000
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100,000
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300,000
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Total Current liabilities
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200,000
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325,000
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500,000
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Long-term liabilities
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250,000
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331,120
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550,740
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Total liabilities
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450,000
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656,120
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1,050,740
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Common stock ($10 par)
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400,000
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400,000
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460,000
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Capital paid in excess of par
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50,000
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50,000
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80,000
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Retained earnings
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100,000
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193,880
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303,260
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Total stockholders' equity
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550,000
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643,880
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843,260
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Total liabilities and stockholders' equity
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$1,000,000
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$1,300,000
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$1,894,000
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Exhibit 3
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NAMIB MILLS
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Income Statement
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2017
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2018
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2019
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Sales (all on credit)
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$1,500,000
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$1,800,000
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$2,160,000
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Cost of goods sold
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950,000
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1,120,000
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1,300,000
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Gross profit
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550,000
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680,000
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860,000
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Selling and administrative expense
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380,000
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490,000
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590,000
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Operating profit
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170,000
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190,000
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270,000
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Interest expense
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30,000
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40,000
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85,000
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Net income before taxes
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140,000
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150,000
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185,000
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Taxes
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46,120
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48,720
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64,850
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Net Income
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$93,880
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$101,280
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$120,150
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Shares
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40,000
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40,000
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46,000
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Question 1
(a) What is Namib Mills' Basic earning power
(b) What are the returns on assets (ROA) for current and proposed capital structures?
Question 2
Exhibit 1
Namib Mills uses the weights based on the desired target capital structure proportions outlined above:
(a) Calculate the breakpoints associated with the firm's retained earnings for the three proposed capital structures.
(b) Calculate the breakpoints associated with the firm's financial situation for the current capital structure?
(c) Calculate the weighted cost of capital associated with the current and below the first breakpoint in (b).
(d) Calculate the breakpoints associated with the firm's 50 percent debt capital structure.
Question 3
Exhibits 2 and 3
Using the Du Pont System, describe the changes in the return on equity from year to year.
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