Posted: May 30th, 2015

Topic: Entrepreneurial Finance Week 4

4. Why is it usually easier to forecast sales for seasoned firms in contrast with early-stage ventures?

It is usually easier to forecasts sale for seasoned firms because they have a sales history from which an analyst can base their future sales projections while early stage ventures lack a basis on which to make sales projections

1. MINI CASE: Pharma Biotech Corporatio
2. Calculate the following financial ratios (as covered in Chapter 5) for Pharma Biotech for 2010: (a) net profit margin, (b) sales-to-total-assets ratio, (c) equity multiplier, and (d) total-debt-to-total-assets. Apply the return on assets and return on equity models. Discuss your observations.

 

• Net Profit Margin

 

• Sales-to-Total-Assets Ratio

 

• Equity Multiplier

 

• Total-Debt-to-Total-Assets

 

1. Estimate Pharma’s sustainable sales growth rate based on its 2010 financial statements. [Hint: You need to estimate the beginning of period stockholders’ equity based on the information provided.] What financial policy change might Pharma Biotech make to improve its sustainable growth rate? Show your calculations.

 

The cash dividends, which should be paid at a rate of 40% of net inco will restrict Pharma Biotech from expanding its operations more rapidly without having to issue more equity capital. For instance, a policy of no cash dividends payout (i.e., a 100% retention rate) would result in a sustainable sales growth rate of:

 

 

1. Estimate the additional funds needed (AFN) for 2011, using the formula or equation method presented in the chapter.

 

 

2. Also, estimate the AFN using the equation method for Pharma Biotech for 2012. What will be the cumulative AFN for the two-year period?

 

9. Expected Rate of Return and Hubris Premiums
10. Calculate the expected rate of return before considering premiums for illiquidity, advisory activities, and hubris projections.
11. Estimate the hubris projections premium for this FirstVenture investment.
12. VentureBanc investors’ target rate of return:
    2. VentureBanc uses a systematic risk measure of 2.0. Based on the information shown, estimate VentureBanc’s investment risk premium. Then estimate the cost of equity capital for VentureBanc.

 

1. Determine the rate components and their returns that a venture investor like VentureBanc would require to be covered beyond a traditional cost-of-equity estimate.
2. What overall venture investment discount rate would be used by VentureBanc?

 

1. Kareem Construction Company
   1. Calculate the after-tax WACC for Kareem.

 

2. Show how Kareem’s WACC would change if the tax rate dropped to 25 percent and the estimated cost of equity capital were based on a risk-free rate of 7 percent, a market risk premium of 8 percent, and a systematic risk measure or beta of 2.0.

 

2. Voice River, Inc.
   1. Determine the historical average annual market risk premium for small-firm common stocks

1. Use CAPM to estimate the cost of common equity capital for Voice River

 

1. Calculate the net profit margin, total-sales-to-total-assets ratio, the equity multiplier, and the return on equity for both 2009 and 2010 for the Castillo Products Corporation. Describe what happened in terms of financial performance between the two years.

 

The company overall profitability generally increased between 2009 and 2010 as evidenced by the net profit margin in went from negative to positive. Moreover, there was an increase in assets turnover, which is indication that the company was utilizing assets more effectively and efficiently to generate sales. Additionally, the equity multiplier increased indicating greater usage of debt funds. Cumulatively, these changes resulted in a slight increase in return on equity, which reiterates the increase in the company’s profitability.

1. Estimate the cost of short-term bank loans, long-term debt, and common equity capital for the Castillo Products Corporation.

Cost of Short Term Bank Loans

Cost of Default Risk Free Long-Term Government Bonds:

Cost of Risky Long-Term Debt

 

Costillo Products Common Equity Capital

1. Although, Castillo Products paid a low effective tax rate in 2010, a 30 percent income tax rate is considered more appropriate when looking to the future. Estimate the after-tax cost of short-term bank loans, long-term debt, and the venture’s common equity.

 

1. Estimate the weighted average cost of capital (WACC) for the Castillo Products Corporation using the book values of interest-bearing debt and stockholders’ equity capital at the end of 2010.

Bank Values	Amount ($)	Percentage Weight	Cost	After-Tax Cost Component Cost
Bank Loan	100,000	10.31%	5.60%	0.58%
Long-term Debt	400,000	41.24%	11.20%	4.62%
Common Equity	470,000	48.45%	19.0%	4.62%
Total	970,000	100%		14.41%

1. Cindy and Rob estimate that the market value of the common equity in the venture is $900,000 at the end of 2010. The market values of interest-bearing debt are judged to be the same as the recorded book values at the end of 2010. Estimate the market value-based weighted average cost of capital for Castillo Products.

Market Values	Amount ($)	Percentage Weight	Cost	After-Tax Cost Component Cost
Bank Loan	100,000	7.14%	5.60%	0.40%
Long-term Debt	400,000	28.57%	11.20%	3.20%
Common Equity	900,000	64.29%	19.0%	12.22%
Total	1,400,000	100%		15.82%

 

 

1. Would you recommend to Cindy and Rob that they use the book value–based WACC estimate or the market value–based WACC estimate for planning purposes? Why?

I would advise Cindy and Bob to use the book value based WACC. Market value-based WACC is superior to book value-based WACC because it represents the true cost of capital in an efficient market (i.e. a market where the current price of a security reflects all the information currently available about that security) (Baker & Powell, 2005). Market value weights provide current estimates for required rates of return of the firm’s suppliers of capital (Brigham & Ehrhardt, 2008). If the firm is operating at its target or optimal capital structure, then it is advisable to use the market values of debt and equity. The main shortcoming of using market value based WACC is the fact that market value weights change very frequently (Pratt & Grabowski, 2010). An average market price can however be used to solve this challenge (Lasher, 2014).

 

 

References

Baker, H. K. & Powell, G. E., 2005. Understanding Financial Management : a Practical Guide.. 1 ed. Blackwell Publishers: Oxford.

Brigham, E. F. & Ehrhardt, M. C., 2008. Financial management : theory & practice. 12 ed. Mason, Ohio : Thomson Business and Economics,.

Lasher, W., 2014. Practical financial management. 12 ed. Mason, OH: South-Western Cengage Learning.

Leach, J. & Melicher, R., 2012. Entrepreneurial Finance. 5 ed. Mason, OH: Cengage Learning.

Pratt, S. P. & Grabowski, R. J., 2010. Cost of capital : applications and examples. 4 ed. Hoboken, N.J. : John Wiley & Sons.