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# This is a typical case of capital budgeting in which purchasing the new asset has to be evaluated for Friendly Cards.

In order to determine if they should purchase the envelope machine, the Weighted Average Cost of Capital (WACC) needs to be calculated. This is very important as all the cash flows related to the purchase of the machine will be evaluated using this rate. The WACC acts as the hurdle rate in knowing the present values of the cash flows. This is also important as it is compared with the Internal Rate of Return (IRR) of the project for decision making purposes. Calculation of WACC: Re = weight of debt x after tax cost of debt + weight of equity x Cost of equity (Brigham & Ehrhardt, 2009, pp. 337-338). The cost of debt has been determined to be 11.5% which is provided in Exhibit 5 (Harvard Business School, 1993, p. 8), and is similar to the bonds of the Friendly cards. After tax, the cost of debt is 7.13%. To determine the cost of equity, the dividend model is used. The dividends calculations and the other calculations in respect of the cost of equity are given in the Excel spreadsheet attached. The WACC comes out to be 17.51% and after all the calculations, the net present value (NPV) comes out to be \$516,326.10, and therefore the project should be accepted. This is also acceptable because the IRR of the project is 37.82% and is way ahead of the cost of capital of 17.51%.

## Should Friendly Cards acquire Creative Designs?

It would be in Friendly Cards best interest to acquire Creative Designs as the benefits are enormous for the company in the near future. This conclusion was determined after making the two major changes as suggested in the case study. The cost of goods sold and other costs as suggested were decreased and then the net profits were calculated based on these changes. Next, the present value of the future cash flows at the companys WACC was calculated to be 17.51% and it was determined that the total projected cash flows could be up to \$6.8 million. This is \$4.8 million more than the offer price of \$1.88 million (Harvard Business School, 1993, pp. 4-5). The detailed calculations are in the Excel spreadsheet attached.

Should Friendly Cards accept the "West Coast" investors and issue new equity?
Raising the new capital or getting the new finance is really a challenging position for any firm. Looking at the balance sheets of Friendly Cards, it

is easy to see that they are not as robust as the balance sheets of a successful company. In the present scenario, the company has 580,000 shares outstanding and the share of Ms. Beaumont is 55%, which comes out to be 319,000 (Harvard Business School, 1993, p. 8). There are several issues that need to be addressed when addressing the sale of new equity to West Coast. Expensive Option In comparison to the debt and other external funding, the cost of equity is the highest. This is because there are tax savings with the debt which are not available with the equity. Also the floating charges and the other accounting and ancillary costs make it a very expensive option to go for. Loss of Control Under the present scenario, Ms. Beaumont holds 55% of the total shares (Harvard Business School, 1993, p. 5). After the issue of an additional 200,000 shares, the total number of shares would be 780,000 and Ms. Beaumonts control would be reduced to approximately 41%. This would mean that she will have to share the Board Room with some new faces who may influence the decision making of the company. Leverage Issuing the new shares would definitely bring down the leverage of the company. At present, the debt ratio of the company is approximately 82%, which means that the 82% of the total assets are financed by the borrowed funds (Harvard Business School, 1993, p. 5-8). This is certainly not a good sign as it would mean that the company might face problems in servicing the debt. The interest coverage ratio in the present circumstances is 2.33, a figure which might not serve the company well in the coming years. Also, the current ratio is merely 1.18 which indicates that the growing debt might put strain on the short term paying capacity of the firm. From this point of view, the issue of the new share capital is justified. Under the present circumstances, the company is poised to see a growth of 20% increase in sales and in the growing sales. If the interest payment is contained by issuing new equity, the company might be benefited by the issue of the equity shares to West Coast. Looking at the competition, Gibson has an interest coverage ratio of 9 (Exhibit 5) which is far more than Friendly Cards (Harvard Business School, 1993, p. 8). Moreover, the company is not in the commanding position and might face problems in raising the funds. Currently, the companys shares are being traded at \$9.50, but the investors are not ready to pay beyond \$8. If the company wants any hope of staying afloat and keeping the

business running, the smart option would be to accept the \$8 trade and keep the investors they currently have and possibly attract new ones. Read more: http://www.ukessays.com/essays/finance/case-study-andanalysis-on-friendly-cards-finance-essay.php#ixzz2R27Y19oy