On January 2, 2006, in the strategic committee meeting of the company, Christine Carmen Chairman, President and Chief Executive Officer said, we are optimistic about 2006 and the years beyond. The proposed projects presently under consideration will enable us efficiently to expand our productivity in order to meet ever-increasing customers demand with high quality engineered products and systems for defense, aerospace and industrial applications.
Carmen Corporation is a supplier of sophisticated, highly engineered products and systems for defense, aerospace and industrial applications. The Company has three business segments.
The Company’s Defense segment provides integrated front-line war-fighting systems and components, including electronic warfare systems, reconnaissance and surveillance systems, aircraft weapons suspension and release systems and airborne mine countermeasures systems.
The Company’s Communications and Space Products segment supplies antenna products and ultra-miniature electronics and systems for the remote sensing, communications and electronic warfare industries.
The Company’s Engineered Materials segment supplies piezoelectric ceramic products for commercial and military markets and advanced fiber composite structural products for the aircraft, communication, navigation, chemical, petrochemical, paper, and oil industries.
Carmen Corporation has the following financial statements:
|Table 1 CARMEN COMPANY|
|Balance Sheet 12/31/2005|
|Assets||Liability & Equity|
|Account Receivable||$8,000,000||Notes Payable||$3,000,000|
|Current Asset||$17,000,000||Current Liabilities||$5,000,000|
|Accumulated Depreciation||($2,000,000)||Preferred Stock (0.5 million shares)||$15,000,000|
|Net Fixed Assets||$38,000,000||Common Stock (1 million shares)||$10,000,000|
|Total Asst||$55,000,000||Total Liability & Equity||$55,000,000|
|Table 2 -Income Statement (12/31/2005)|
|Cost of Sales||-8,500,000|
|Earnings Before Depreciation and Amortization (EBITDA)||$16,500,000|
|Earnings Before Interest and taxes (EBIT)||$14,950,000|
Its established common stock’s dividend payout ratio after the preferred stock dividends payment is 50 percent and it is expected to grow at a constant rate of 9 percent in the future. The tax rate is 40 percent and investors requiring a rate of return of 15% on the common stock.
Preferred stock is trading at a price of $40 per share, with a dividend of $4.8. The 30-year long-term debt with a par value of $1,000 was issued 10 years ago with a coupon rate of 8%. The bonds can be refinanced at the market interest rate of 10 percent today.
Carmen has the following investment opportunities:
|Table 3||Project||Annual Net|
|Eng. Materials 1||$1,000,000||222,851||8|
|Eng. Materials 2||$2,000,000||542,784||6|
|Communication and Space 1||$1,000,000||202168||9|
|Communication and Space 2||$1,000,000||319,775||5|
- Determine the book value and market value of the capital structure.
- Determine the weighted average cost of capital (WACC) for each of the capital structure.
- Calculate the internal rate of return (IRR) and Net Present Value of each project and compare them against the book value and market value weighted average cost of capital.
- Are there any conflict between NPV and IRR? How do you resolve the conflict in ranking?
- Which projects should Carmen accept?
- How much of the internal fund is available for investments?
- Are there any issues about the projects you should consider before your recommendation?
Although the average project in the Defense Segment was substantially riskier than communications and Space Products segment and Engineered Materials segment, the project evaluation process did not formally incorporate risk considerations. This lack of risk consideration was more evident in the Communications and Space Products segment and Engineered Materials segments, since their productions, earnings, and profits were highly correlated and fluctuated with the economy. As a result, these segments provided a very stable income to the company. On the other hand, the Defense segment provides military products and professional services to the United States and allied governments, and their prime defense contractors and as a result, the earnings and profits of the Defense segment tended to be tied to the world geo-political environment.
Carmen has gathered the following beta for each segment based on comparable companies:
Project Defense Com. Space Eng. Materials
Beta 1.50 1.20 0.80
The risk-free rate is 5% and rate of the market risk premium 9.0%.
- Calculate the required rate of return for each project?
- Compare the required rate of return with expected rate of return, according to the risk characteristics of each project; which project is appropriate to take?