The Following Data Applies To Crunch Cookie Company Income

The Following Data Applies To Crunch Cookie Companyincome Statementsa

The following data applies to Crunch Cookie Company: Income Statement Sales: $1,000,000 Operating Expenses: (626,000) EBIT: 374,000 Interest: (24,000) EBT: 350,000 Taxes @40%: (140,000) Net Income: 210,000 Year Net Income Per Share 1988 $210,000 3.,000 3.,000 3.,000 2.,000 2,500 2,500 2.20 Assets Current $300,000 Fixed $600,000 Total $900,000 Liabilities and Owners’ Equity Bonds ($1000 par) $300,000 Common Stock ($20par) $300,000 Retained Earnings $300,000 Total $900,000 Bond Price $687 Common Stock Price $54 Common Stock costs $5 per share to issue, floatation cost for bonds is 5% and the bonds have ten years to maturity. Assume the growth rate in earnings and dividends to be constant over time and the payout rate to be the same as in the previous year.

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The financial health and valuation strategies of a corporation are crucial to its growth, stability, and investor confidence. In analyzing the Crunch Cookie Company's financial data, we aim to project future earnings, evaluate the company's weighted average cost of capital (WACC), and understand how financing levels impact the company's cost structure. This analysis involves calculating expected earnings and retained earnings for 1989, determining the WACC with and without retained earnings, exploring financing levels that influence WACC, and identifying the assumptions necessary for accurate capital cost estimation.

Expected Earnings and Retained Earnings for 1989

Estimating future earnings requires understanding the company's growth prospects and dividend payout policies. Given that the earnings and dividends are assumed to grow at a constant rate, we can utilize the dividend discount model (DDM) and the retained earnings roll-forward approach to project 1989 figures. The net income in 1988 was $210,000, and the payout ratio can be inferred from the dividend payout, which, based on the data, appears to be approximately 40% (since the tax rate is 40%, and typically figures relate to the net income available for dividends). Assuming this payout ratio remains consistent, dividends paid in 1988 were approximately 40% of net income, equating to $84,000.

The payout ratio's constancy implies retained earnings in 1988 were 60% of net income, or $126,000. Using the assumption of a growth rate, g, which is vital for projecting earnings, we rely on the company's historical growth rates. Although not explicitly provided, typical economic analysis suggests a moderate growth rate. For illustration, we assume a 5% growth rate in earnings and dividends.

The expected earnings for 1989 are calculated as:

Expected Net Income (1989) = Net Income (1988) × (1 + g) = $210,000 × (1 + 0.05) = $220,500.

The retained earnings for 1989 will be:

Retained Earnings (1989) = Retained Earnings (1988) + (Net Income - Dividends). Since dividends are 40% of net income, dividends in 1988 were $84,000, and for 1989, expected dividends are:

Expected Dividends = 40% of $220,500 = $88,200.

Therefore, Retained Earnings (1989) = $126,000 + ($220,500 - $88,200) = $126,000 + $132,300 = $258,300.

Weighted Average Cost of Capital (WACC) With and Without Retained Earnings

WACC is a vital metric for assessing the cost of financing through both debt and equity. It reflects the average rate a company must pay to finance its assets. The calculation incorporates the cost of debt, cost of equity, and the proportions of each in the firm's capital structure.

Calculating the cost of debt involves considering the bond's market price, coupon rate, and time to maturity. Given the bond's par value of $1,000 and trading at $687, with a flotation cost of 5%, the after-tax cost of debt (k_d) is calculated using the yield to maturity (YTM). Using the approximation method for YTM:

YTM ≈ [(Face value / Present value)^(1/n)] - 1, where n=10 years.

YTM ≈ [($1,000 / $687)^(1/10)] - 1 ≈ [1.455^(0.1)] - 1 ≈ 1.037 - 1 = 0.037 or 3.7%. Adjusted for tax, the after-tax cost of debt is:

k_d(1 - tax rate) = 3.7% × (1 - 0.40) ≈ 2.22%.

Cost of Equity (k_e):

The cost of equity can be determined using the Capital Asset Pricing Model (CAPM):

k_e = Risk-free rate + β × Equity risk premium.

Assuming a risk-free rate of 3%, a beta of 1.2, and an equity risk premium of 6%,

k_e = 3% + 1.2 × 6% = 3% + 7.2% = 10.2%.

With these components, the WACC with retained earnings (equity directly financed) is:

WACC = (E / V) × k_e + (D / V) × k_d(1 - Tax rate),

where E = equity value, D = debt value, V = E + D.

The market value of equity is: {Number of shares} × {Share price} = 3,000 × $54 = $162,000.

The market value of debt is given by the bond price times the number of bonds: $687 × (Total bonds / bond par value). Since total bonds are $300,000 at par, and each bond is $1,000 par, the number of bonds is 300, so market value of bonds:

Market value of bonds = 300 × $687 = $206,100.

Total firm value V = $162,000 + $206,100 = $368,100.

Thus, WACC with retained earnings (funding through existing market values):

WACC = ($162,000 / $368,100) × 10.2% + ($206,100 / $368,100) × 2.22% ≈ 0.4402 × 10.2% + 0.5598 × 2.22% ≈ 4.49% + 1.25% ≈ 5.74%.

WACC without considering retained earnings (if the company issues new equity at the same cost), would involve adjusting the capital structure to include the new stock issuance at $5 per share with flotation costs, which would raise the equity cost slightly due to issuance costs. Including flotation costs effectively increases the cost of new equity, but in this context, since the question implies other financing means, the primary difference is the source of funds used to finance growth.

Level of Total Financing Where WACC Increases

As the company increases leverage (debt financing), the WACC initially decreases due to the tax shield benefit of debt (tax deductibility of interest). However, beyond an optimal point, additional debt increases financial risk, leading to higher costs of debt and equity, hence increasing WACC. This breakeven point occurs when the marginal cost of new debt exceeds the benefit of the tax shield. Estimating this point involves analyzing the firm's debt capacity and the trade-off theory, which balances tax savings against bankruptcy costs.

Assuming the current debt ratio and capital structure remain constant, an increase in total financing beyond the current levels would eventually cause WACC to increase when the increased cost of debt and equity outweighs the benefits of additional leverage. Quantitatively, this is identified where the cost of debt begins to rise sharply or equity becomes more expensive due to increased financial distress risk. Financier's models suggest that a debt-to-debt plus equity ratio exceeding 40-50% often leads to increased WACC for companies in similar industries.

Assumptions for Estimating WACC and Their Rationale

Estimating the weighted average cost of capital necessitates several assumptions. Firstly, it assumes that historical or estimated growth rates in earnings and dividends will persist constant over time. This is crucial because the projected WACC depends on future cash flows and capital structure stability. Secondly, it presumes market conditions and risk premiums remain unchanged, which simplifies the computation but ignores potential economic fluctuations.

Another key assumption involves the beta and risk-free rate, which are considered stable and reflective of the firm’s risk relative to the market. This assumption simplifies the CAPM calculation but could be inaccurate if market conditions change significantly. Additionally, the projections assume no significant changes in taxation policy, monetary policy, or industry dynamics that could alter the firm's financial risk profile. Lastly, the valuation model presumes market efficiency and that the firm’s existing capital structure is optimal or near-optimal, meaning the current ratio of debt to equity adequately balances risk and return.

Making these assumptions is essential for creating manageable, comparable financial models. They allow analysts to isolate the effect of specific variables on the company's valuation and decision-making processes. However, in practice, these assumptions must be revisited regularly, incorporating updated market data and company performance metrics to refine estimates and support strategic financial planning.

Conclusion

In summary, projecting the financial future of Crunch Cookie Company involves detailed calculations and assumptions. The expected earnings and retained earnings growth provide a basis for valuation and strategic planning. The WACC calculation, both with and without retained earnings, emphasizes the importance of capital structure in minimizing cost of capital. Recognizing the financing thresholds where WACC begins to increase informs optimal debt levels, balancing risk and growth. Finally, understanding the assumptions behind these models ensures that financial analyses are realistic and adaptable to changing market conditions, supporting sound managerial decisions and investor confidence.

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