This is a typical case of capital budgeting in which purchasing the new
asset has to be evaluated for Friendly Cards. In order to determine if
they should purchase the envelope machine, the Weighted Average
Cost of Capital (WACC) needs to be calculated. This is very important
as all the cash flows related to the purchase of the machine will be
evaluated using this rate. The WACC acts as the hurdle rate in knowing
the present values of the cash flows. This is also important as it is
compared with the Internal Rate of Return (IRR) of the project for
decision making purposes.
Calculation of WACC:
Re = weight of debt x after tax cost of debt + weight of equity x Cost of
equity (Brigham & Ehrhardt, 2009, pp. 337-338).
The cost of debt has been determined to be 11.5% which is provided in
Exhibit 5 (Harvard Business School, 1993, p. 8), and is similar to the
bonds of the Friendly cards. After tax, the cost of debt is 7.13%. To
determine the cost of equity, the dividend model is used. The dividends
calculations and the other calculations in respect of the cost of equity
are given in the Excel spreadsheet attached.
The WACC comes out to be 17.51% and after all the calculations, the
net present value (NPV) comes out to be $516,326.10, and therefore
the project should be accepted. This is also acceptable because the
IRR of the project is 37.82% and is way ahead of the cost of capital of
17.51%.
Should Friendly Cards acquire Creative
Designs?
It would be in Friendly Cards best interest to acquire Creative Designs
as the benefits are enormous for the company in the near future. This
conclusion was determined after making the two major changes as
suggested in the case study. The cost of goods sold and other costs as
suggested were decreased and then the net profits were calculated
based on these changes. Next, the present value of the future cash
flows at the company’s WACC was calculated to be 17.51% and it was
determined that the total projected cash flows could be up to $6.8
million. This is $4.8 million more than the offer price of $1.88 million
(Harvard Business School, 1993, pp. 4-5). The detailed calculations are
in the Excel spreadsheet attached.
Should Friendly Cards accept the "West Coast"
investors and issue new equity?
Raising the new capital or getting the new finance is really a challenging
position for any firm. Looking at the balance sheets of Friendly Cards, it
is easy to see that they are not as robust as the balance sheets of a
successful company. In the present scenario, the company has 580,000
shares outstanding and the share of Ms. Beaumont is 55%, which
comes out to be 319,000 (Harvard Business School, 1993, p. 8). There
are several issues that need to be addressed when addressing the sale
of new equity to West Coast.
Expensive Option
In comparison to the debt and other external funding, the cost of equity
is the highest. This is because there are tax savings with the debt which
are not available with the equity. Also the floating charges and the other
accounting and ancillary costs make it a very expensive option to go for.
Loss of Control
Under the present scenario, Ms. Beaumont holds 55% of the total
shares (Harvard Business School, 1993, p. 5). After the issue of an
additional 200,000 shares, the total number of shares would be 780,000
and Ms. Beaumont’s control would be reduced to approximately 41%.
This would mean that she will have to share the Board Room with some
new faces who may influence the decision making of the company.
Leverage
Issuing the new shares would definitely bring down the leverage of the
company. At present, the debt ratio of the company is approximately
82%, which means that the 82% of the total assets are financed by the
borrowed funds (Harvard Business School, 1993, p. 5-8). This is
certainly not a good sign as it would mean that the company might face
problems in servicing the debt. The interest coverage ratio in the
present circumstances is 2.33, a figure which might not serve the
company well in the coming years. Also, the current ratio is merely 1.18
which indicates that the growing debt might put strain on the short term
paying capacity of the firm. From this point of view, the issue of the new
share capital is justified.
Under the present circumstances, the company is poised to see a
growth of 20% increase in sales and in the growing sales. If the interest
payment is contained by issuing new equity, the company might be
benefited by the issue of the equity shares to West Coast. Looking at
the competition, Gibson has an interest coverage ratio of 9 (Exhibit 5)
which is far more than Friendly Cards (Harvard Business School, 1993,
p. 8).
Moreover, the company is not in the commanding position and might
face problems in raising the funds. Currently, the company’s shares are
being traded at $9.50, but the investors are not ready to pay beyond $8.
If the company wants any hope of staying afloat and keeping the
business running, the smart option would be to accept the $8 trade and
keep the investors they currently have and possibly attract new ones.
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