Accounting solution based on balance sheet.

Tukar Inc, a manufacturer of portable air conditioning units in phoenix, is planning to expand its operations due to increasing market demand. Using the EFN Model, Tukar will need 6.0 million to expand and decide whether to use debt or equity fiancing. Debt can be sold at a cost of 10% while new equity can be sold at $32.00 per share. As a consequence of an earlier IPO, the company has one million shares of below has been gathered for analysis and recommendation.

Air Conditioning Industry Ratios Current Ratio 2.0x 2.1x 36% 32%

Sales to total assets

Current Debt to total assets Long-term debt to net worth Total debt to total assets 52% Fixed Coverage Ratio Net income to sales Return on total assets Net income to net worth 18%

6.0x 4% 9%

Balance Sheet Tukar Inc 12-31-2006

Assets: Cash A/R 2,520 10,520 15,200

Liabilities: Current liabilities 10,000 Long term debt (10%) Total Debt Net Worth Total liabilities $40,000 3,600 13,600 26,400

Inventories TCA 28,240

Net Fixed Assets 11,760 Total assets: $40,000

Revenues Net operating income Interest expense Earning before taxes Less: taxes (40%) Earning after taxes

80,000 8,360 360 8,000 3,200 4,800

a. estimate Turkar's cost of equity capital using the CAPM, assuming that the risk free is 7%, the expected return on the market is 12% with an attendant beta of 1.66

b. Determine and explain the market value of Turkar's equity, price per share as well as its market value.

c. What is Turkar's current weighted average cost of capital (WACC), using the 10% cost of debt given earlier and the cost of equity calculated in part (a) assume no short term interest bearing debt.

d. calculate the new financial structure and coverage relationships for expansion with debt and equity assuming that the percentage of net operating income to total assets remains the same.

e. if debt financing is used, the cost of equity will rise to reflect the higher and hence a beta of 1.72. With equity financing, the beta will drop to 1.60 to reflect low risk. Given this, calculate and discuss the cost if equity under both the debt and equity financing alternatives.

f. calculate the market value of equity and price per share under each financing method

g. calculate and discuss the market value of Tukar under each financing option

h. calculate and discuss the WACC under each method of financing

1.

based upon your activities above, which form of financing would you recommend for Tukar? Why?

j. In a 2 or 3 paragraphs, discuss several major pros and cons associated with debt and equity financing. Current Ratio Sales to Total Assets Current Debt to Total Assets Long-Term Debt to Net Worth (Equity) Total Debt to Total Assets Fixed Coverage Ratio Net Income to Sales Return on Total Assets (ROA) Net Income to Net Worth (Equity) 2 2.1 0.36

0.32 0.52 6 0.04 0.09 0.18

Tukar Inc., Balance Sheet December 31, 2006 (thousands of dollars) ASSETS Cash A/R Inventories TCA Net Fixed Assets Total Assets 2520 10520 15200 28240 11760 40000

LIABILITIES Current Liabilities Long-term debt (10%) Total Debt 10000 3600 13600

Shares outstanding Net Worth Total Liabilities

1000000 26400 40000

Tukar Inc., Income Statement December 31, 2006 (thousands of dollars) Revenues Net Operating Income (EBIT) Interest Expense Earnings before taxes Less: taxes (40%) Earnings after taxes (EAT) 80000 8360 360 8000 3200 4800

Needed

6000 per share

Equity financing Tax rate Risk-free rate Expected Return on the Market a) b) Cost of capital Market value of Equity Price Per Share

32 40% 7% 12%

26.92% 26400 0.0264 It's given on the balance sheet - the total of equity section It's Total of Equity divided by total outstanding shares

The sum of market values of all the elements of capital structu Market value of Tukar c) d) WACC Debt expansion Long-term debt (10%) Total assets Net Operating income 9600 46000 9614 40000 19.81% i.e. equity + debt in our case

Interest expense Earnings before taxes Less:Taxes Earnings after taxes

960 8654 3461.6 5192.4

Equity expansion Net Worth Shares outstanding Total assets Net Operating income Interest expense Earnings before taxes Less:Taxes Earnings after taxes 32400 1187500 46000 9614 360 9254 3701.6 5552.4

e)

Debt beta Equity beta

1.72 1.6 Reflects the higher risk of Debt financing and therefore higher

Cost of equity with new Debt

27.64%

than Cost of equity

Cost of equity with new Equity f) Market value of equity Price per share Debt

26.20%

with New Equity financing of expansion Equity

26400 0.0264

32400 0.027284211 It will be the same since in both cases the

g)

Market value of Tukar

46000

46000

amount of financing is 6000

hence it would increase the total market va by the same amount

The difference would be through which channel - equity or debt Debt Equity

We can see from this calculations that over

cost of financing with debt is lower than tha h) WACC 18.42% 20.23% of with Equity.

That could be explained by the tax advanta of issuing new debt. The overall conclusion here is that the company should go with debt financing

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