In order to calculate Friendly’s WACC the beta must first be obtained. Of the three methods available the bottom up method is most appropriate in this situation. Friendly’s stock is very lightly traded therefore regressing their common stock returns against market returns (top down beta) is unlikely to give a true figure. However using data from comparable firms it is possible to find an industry unlevered beta. American Greetings has sales of $1. 174 billion dollars and Gibson Greetings has sales of $359 million dollars. Both of these figures are much larger than Friendly’s sales of 16 million dollars.
Due to the disproportionately large sales of American Greetings weighting the firms by firm value rather than their sales gives a more accurate figure. To find the industry unlevered beta it is necessary to take the individual levered betas of American Greetings and Gibson Greetings, and unlever them using the firms’ actual debt/ equity ratios. These values are then weighted by firm value to end up with an unlevered industry beta of 0. 73. Now that the industry unlevered beta has been calculated it must now be levered up using Friendly’s target debt/equity ratio. The target ratio is given as 2:1, however this is based on book values.
This gives a capital structure of 67% debt and 33% equity, which is arguably unsustainable for a small company such as Friendly Cards. It is important to note that the market value of Friendly’s equity is approximately twice that of its book value. Therefore it is not realistic to aim for a target D/E ratio of 2:1. As the average maturities of Friendly’s debt are not given it is assumed that the market value of debt is equal to the book value. Given that Friendly’s market value of equity is 1. 96 times its book value of equity, an effective and more realistic target debt/equity ratio can be calculated based on market values.
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To find this new target ratio, the old debt/equity ratio of 2:1 must be multiplied by the ratio of book value of equity/market value of equity. This gives a new target ratio of 1. 0171. This ratio can then be used when levering up the industry unlevered beta to get Friendly’s levered beta of 1. 2. From this Friendly’s cost of equity is calculated as 14. 99. Friendly currently borrows at 2. 5% above the prime rate of 8. 5%, giving a cost of debt of 11%. With an after tax cost of debt of 6. 82%, Friendly’s WACC is then calculated to be 10. 87%. The cost of envelopes makes up a very large portion of Friendly’s cost of goods sold.
In 1987 the cost of purchasing 100 million envelopes amounted to $1. 5 million. The equipment needed to manufacture these envelopes is available to buy for $500,000 and the machine is estimated to have an economic life of 8 years. The machine will be depreciated using the straight-line method over the 8 years to a zero salvage value. The machine will operate at capacity, producing 100 million envelopes, with total expenses equalling $1,149,500 annually. The cost of any excess envelopes needed is not included in the discounted cash flow analysis, as Friendly will have to incur this cost even if the envelope machine is not purchased.
The profitability of this project will be analysed using discounted cash flow techniques. The project will increase Friendly’s net profit by $217,310 annually. As only incremental cash flows are considered, depreciation is added back to this figure. Net working capital will immediately increase by $200,000, which will be reclaimable at the end of the project. The incremental cash flows to the firm are then obtained, which are discounted back using Friendly Card’s WACC.
This results in a positive net present value of $853,915.07 for the project . Therefore the machine should be purchased. This decision is independent of any financing costs as these are accounted for in the WACC. Having determined that the machine purchase should be undertaken financing methods need to be considered. As things stand, Friendly Card’s has neither the sufficient cash nor the borrowing capacity to finance the purchase, however if the acquisition of CD goes ahead then Friendly will have sufficient debt capacity to purchase the machine .
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