TSL: A Supplier Of High-End Fitness Equipment Investment

Tsl A Supplier Of High End Fitness Equipment Has Some Investment Op

TSL, a supplier of high-end fitness equipment, has some investment opportunities. Due to capital rationing, TSL can spend only up to $2,000,000 on new investment opportunities. TSL has the following information to consider:

- Opportunity Cost IRR and Cost of Projects:

- Project A: IRR 16%, Cost $300,000

- Project B: IRR 14%, Cost $500,000

- Project C: IRR 12%, Cost $500,000

- Project D: IRR 11%, Cost $600,000

- Project E: IRR 15%, Cost $700,000

- Project F: IRR 18%, Cost $500,000

- Capital Structure:

- Debt: 50%

- Preferred Shares: 10%

- Equity: 40%

- Financial Position:

- Available retained earnings: $120,000

- Additional debt capacity: $250,000 (without additional financing costs)

- Costs of Capital:

- Cost of debt: 6% (net of taxes)

- Cost of preferred shares: 10%

- Cost of equity: 18%

- Financing cost ranges beyond certain break points:

- First break point:

- Debt: increases from 6% to 8%

- Preferred: remains at 10%

- Equity: remains at 18%

- Second break point:

- Debt: increases from 8% to 10%

- Preferred: remains at 10%

- Equity: increases to 20%

Compute the Weighted Average Cost of Capital (WACC) and complete the Marginal Cost of Capital (MCC) for the various ranges of financing.

Draw the firm's marginal cost of capital (MCC) and the Investment Opportunity Schedule (IOS).

Determine which projects should be selected and why.

Calculate the overall cost of capital for TSL.

Paper For Above instruction

The evaluation of investment opportunities in a capital-constrained environment requires a detailed understanding of a company's cost of capital, its financing structure, and the nature of potential investments. For TSL, a provider of high-end fitness equipment, careful financial analysis is vital to optimize the utilization of its limited funds amidst various project options and financing constraints. This paper provides a comprehensive calculation of TSL's Weighted Average Cost of Capital (WACC), sketches out its Marginal Cost of Capital (MCC) and Investment Opportunity Schedule (IOS), and discusses project selection criteria aligned with the company's strategic and financial goals. Ultimately, these decisions inform TSL's optimal investment and financing strategies to maximize value creation.

Calculating the WACC and MCC

The core of the analysis begins with computing the Weighted Average Cost of Capital (WACC) under existing financial conditions. WACC integrates the costs of debt, preferred stock, and equity, weighted by their proportions in the firm's capital structure. Given TSL's preferred structure of 50% debt, 10% preferred, and 40% equity, initial WACC calculation assumes current costs—6% for debt, 10% for preferred shares, and 18% for equity—assuming no breaches in the capital structure or financing costs beyond breakpoints. The formula for WACC is:

WACC = (D/V) r_d (1 - T) + (P/V) r_p + (E/V) r_e

Where:

• D = Market value of debt
• P = Market value of preferred stock
• E = Market value of equity
• V = Total value = D + P + E
• r_d = Cost of debt
• r_p = Cost of preferred stock
• r_e = Cost of equity
• T = Tax rate (assuming 0 for simplicity, as net of taxes are given)

Using the given capital structure, the WACC initially calculates as:

WACC = 0.50 6% + 0.10 10% + 0.40 * 18% = 3% + 1% + 7.2% = 11.2%

Given the financing cost ranges and breakpoints, the MCC curve is stepwise, increasing at each breakpoint. Starting with the initial WACC, as TSL increases debt or preferred stock beyond certain thresholds, the cost of debt rises from 6% to 8%, and then to 10%. The MCC thus shifts accordingly, impacting investment evaluation.

Constructing Marginal Cost of Capital and Investment Opportunity Schedule

The MCC curve plots the incremental cost of new capital as the firm raises additional funds. The initial MCC matches the WACC calculated above. When TSL reaches the first financing breakpoint, the marginal cost of debt increases from 6% to 8%, raising the overall MCC. At the second breakpoint, with debt costs rising to 10% and equity to 20%, TSL's MCC further increases.

The Investment Opportunity Schedule (IOS) plots available profitable investments at various costs of capital. TSL has several projects with IRRs ranging from 11% to 18%. By overlaying these IRRs against the MCC curve, TSL can identify which projects are acceptable: only those with IRRs exceeding the firm’s MCC at the corresponding funds’ marginal cost.

Project Selection Criteria

Given the capital constraint of $2 million, TSL should prioritize projects with IRRs exceeding its current MCC, provided funds are sufficient. Starting with projects with the highest IRRs (Project F at 18%, Project A at 16%, Project E at 15%, etc.), TSL can select projects until the $2 million limit is reached. This approach ensures value maximization while adhering to capital constraints.

In this scenario, the firm would typically select Projects F, A, and E, totaling $1.9 million, given their high IRRs and affordability within the cap. Proceeding with projects D, B, or C would not be optimal unless additional funds become available or the MCC drops due to financing options.

Overall Cost of Capital for TSL

The overall cost of capital is the weighted average of actual and incremental funding costs based on the selected projects and their financing structure. With the initial WACC at 11.2% and the project's IRRs surpassing this rate, TSL’s valuation augments. Adjustments for the specific costs of financing at increased levels would modify the overall cost, but for simplicity, the initial WACC serves as a baseline.

Conclusion

TSL’s investment decision hinges on the interplay of its cost of capital, available funds, and project IRRs. Accurate computation of MCC and WACC guides optimal project selection, ensuring that only projects offering returns exceeding the firm's marginal costs are undertaken. Adjusting the financing strategy to manage costs within the set breakpoints can further enhance valuation prospects. Overall, the firm's approach exemplifies prudent financial management in capital rationing environments, aligning investment choices with strategic financial parameters.

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