Financing Decisions
Be comprehensive in your written analysis, discussion, and choice of this critical capital budgeting case below by answering the following questions:
1. Determine the capital asset pricing model rate for the firm in case below.
2. Combine that rate with the specific debt rates for each store model, using a tax rate of 34%.
Overview
The primary subject matter of this case concerns the current effect of the financing decision to expand sales of African art to new sales locations and markets. It addresses the various types of opportunities available to the firm’s management and the determination of financing sources, and the ultimate decisions on strategic choices of outlet size and inventories that the firm must make in order to execute their new capital budgeting plans for the upcoming accounting period.
Your Finance for Executives: Managing for Value Creation textbook and relevant outside resources necessary to complete the analysis and assist EMBACAP managers in the expansion plans must be employed. The case has a difficulty level of four, appropriate for the first year graduate level. It serves as a pedagogically sound tool for applied market strategy in capital budgeting, financing and strategic acquisition financing in line with those theories that utilize and optimize these practices to produce more financially aware business managers. It is presented from the perspective of the corporate manager, who must determine both the size and number of new art stores faced with both capital and property constraints.
Case Synopsis
This case affords students an opportunity—from strategic and analytical points of view—to evaluate the plight of corporate managers in their daily or periodical decision-making tasks. Their tasks include selecting from alternative investments for the firm, based on the needs of the firm for organic and economic growth. Financial managers need to evaluate projects and optimize the use of scarce corporate funding to literally obtain the largest return for the company’s dollars.
Mr. Akim Smith is the project officer for the potential strategic acquisition plan known as MoShops2012. He has been with the firm for 10 years, joining it following an intensive MBA program at Howard University’s School of Business. As operations officer, this project has thus far taken more than two years, but his staff has assisted him greatly in arriving at the point of the case where he must prepare the project, present it to the firm’s board of directors, and ensure that if the project is accepted by the board, sufficient funding resources are present to make the project a success.
Typically, loans for projects of this sort are obtained by issues to capital markets in the form of debt or equity issues. In terms of handling all financing needs and operations, officers are assisted by financial managers in the process. Thus, we will not focus on the financing of the project but on the preparation of the capital budgeting plans assuming the financing will be available if the plan is accepted. The analysts for this case will become intimately familiar with the roles of corporate financial and operational managers in preparing capital budgeting plans for purchases of items for corporate use. Your task is to assist Akim in analyzing the elements of this budgeting decision by employing the financing tools acquired in XFIN-500 to resolve Akim’s capital budgeting problem.
Case Description
The EMBACAP Corporation has operated and licensed others to operate sales and distribution centers for African art, pictures, figures, and other collector items manufactured in the United States or acquired from various sources in the African continent, and to sell them under the name of EMBACAP Art. The items are sold under the major categories of figurines, picture art, and other tribal articles from shields of various tribes to full dress for all ceremonial and customary occasions. The first store was opened in Washington, D.C. on September 29, 1989 by Mr. Smith and two of his fellow students attending the business school at the University of Maryland, College Park
Twenty-one years later, the firm has 20 stores throughout 7 east coast states, of which 10 are operated by the company and 10 by franchisees. Each store was built to the same specifications for both interior and exterior design. Locations were chosen in heavily African-American populated areas since their success depended greatly upon serving a target market of customers with the resources to purchase the firm’s art products. Inventory items were standardized into the three categories, and advertising focused on one of the three product themes. Prospective franchisees signed a document that was designed to keep sales of items, locations and other details standard irrespective to their geographical location, and each new location required an initial payment of $10,000. In addition, franchisees were obligated to a royalty of 5% of gross sales, and each franchisee had to spend at least 2% of gross receipts on local advertising. The firm believed that properly trained employees were the key to success; therefore, managers and company trainees were required to attend a two-week program covering all aspects of the company’s operations.
This case begins in June 2010 when Mr. Smith started preparing to complete his analysis for the construction of five new company-owned stores where the sizes have not yet been determined. Mr. Smith and his management team believe that a larger capacity store with capacity to handle $100,000 in product inventory would be more profitable than the present stores where inventory capacity is $70,000.
The company faces two choices that Mr. Smith must evaluate with your assistance: continue with the current smaller sized stores, or select larger stores for the firm’s strategic growth or construction plan. The initial cost will be $2,100,000 for each of the smaller sized stores and $3,700,000 for each of the five larger ones. Projected present value of cash flows for the smaller units projected for the firm’s five-year strategic plans are $450,000 for each year while the projected cash flows for the larger units are projected to be $740,000 per year. Because the projects must be financed from different sources, unfortunately, financing costs will be different. Mr. Smith’s data indicates that the current and projected 120-day Treasury bill rate is 9.75% and the firm’s expected market return is 12.5% for the plan period. The beta for the African art industry and the planned new stores is 1.15. However, the bond rates for the projects are 10% for the smaller stores and 12.7% for the larger store funds. Thus, the details have been provided for the analysts, namely you, to:
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