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1. Use the following information to answer questions a through d. Market Values Current cap. Structure Proposed cap. Structure Assets \$15 million \$15...

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1. Use the following information to answer questions a through d.

Market Values             Current cap. Structure       Proposed cap. Structure

Assets                          \$15 million                        \$15 million

Debt                            \$0                                      \$6 million

Equity                         \$15 million                        \$9 million

Share price                  \$25.00                                     \$22.50

Shares outstanding      600,000                                   ???

Bond Interest rate       N/A                                         8%

There are no taxes. EBIT is expected to be \$2.5 million, but could be as high as \$3.5 million if an economic expansion occurs, or as low as \$2 million if a recession occurs. All values are market values.

What is EPS under the current capital structure if there is a recession?

What is EPS during an expansion for the proposed capital structure?

What is ROE for the proposed capital structure if the expected state occurs?

How many shares are outstanding under the proposed capital structure?

Repeat questions a thru d with 40% tax rate. Explain the difference between no taxes and with taxes.

What is the levered cost of equity if the unlevered weighted average cost of capital is 12%?

What is the value of the equity if the EBIT is actually \$2.5 million?

What would be the stock price of the company if the EBIT is \$2.5 million?

• KARMAN CORPORATION

On January 2, 2006, in the strategic committee meeting of the company, Tina Kash Chairman, President and Chief Executive Officer said, we are optimistic about 2006 and the years beyond. The proposed projects presently under consideration will enable us efficiently to expand our productivity in order to meet ever-increasing customers demand with high quality engineered products and systems for defense, aerospace and industrial applications.

Karman Corporation is a supplier of sophisticated, highly engineered products and systems for defense, aerospace and industrial applications. The Company has three business segments.

The Company's Defense segment provides integrated front-line war-fighting systems and components, including electronic warfare systems, reconnaissance and surveillance systems, aircraft weapons suspension and release systems and airborne mine countermeasures systems.

The Company's Communications and Space Products segment supplies antenna products and ultra-miniature electronics and systems for the remote sensing, communications and electronic warfare industries.

The Company's Engineered Materials segment supplies piezoelectric ceramic products for commercial and military markets and advanced fiber composite structural products for the aircraft, communication, navigation, chemical, petrochemical, paper, and oil industries.

Karman Corporation has the following financial statements:

 EXHIBIT A                                 KARMAN COMPANY Balance Sheet 12/31/2005 Assets Liability & Equity Cash \$6,000,000 Account Payable \$1,000,000 Account Receivable \$8,000,000 Notes Payable \$3,000,000 Inventory \$3,000,000 Accrued Taxes \$1,000,000 Current Asset \$17,000,000 Current Liabilities \$5,000,000 GFA \$40,000,000 Long-term debt \$10,000,000 Accumulated Depreciation -\$2,000,000 Preferred Stock (0.5 million shares) \$15,000,000 Net Fixed Assets \$38,000,000 Common Stock (1 million shares) \$10,000,000 Returned Earnings \$15,000,000 Common Equity \$25,000,000 Total Asst \$55,000,000 Total  Liability & Equity \$55,000,000

 INCOME STATEMENT (12/31/2005) Sales \$25,000,000 Cost of Sales -8,500,000 EARNINGS BEFORE DEPRECIATION & TAXES \$16,500,000 Depreciation -1,550,000 EARNINGS BEFORE INTEREST & TAXES \$14,950,000 Interest Expense -\$950,000 EARNINGS BEFORE TAXES \$14,000,000 Taxes (40%) (\$5,600,000) EARNINGS AFTER TAXES \$8,400,000

Its established common stock’s dividend payout ratio after the preferred stock dividends payment is 50 percent and it is expected to grow at a constant rate of 9 percent in the future. The tax rate is 40 percent and investors requiring a rate of return of 15% on the common stock.

Preferred stock is trading at a price of \$40 per share, with a dividend of \$4.8. The 30-year long-term debt with a par value of \$1,000 was issued 10 years ago with a coupon rate of 8%.  The bonds can be refinanced at the market interest rate of 10 percent today.

Karman has the following investment opportunities:

Annual Net                Project

Project                                    Cost                            Cash Flow                  Life

Defense                                   1,000,000                    \$219,120                     7 years

Communication and Space     1,000,000                    319,775                      5

Eng. Materials                         1,000,000                    222,851                      8

Defense                                   2,000,000                    368,580                      10

Eng. Materials                         2,000,000                    542,784                      6

Comm. and Space                   1,000,000                    202168                        9

Part I

Determine the book value and market value of the capital structure.

Determine the weighted average cost of capital (WACC) for each of the capital structure.

Calculate the internal rate of return (IRR) of each project and compare them against the book value and market value weighted average cost of capital.

Which projects should Karman accept?

What is the total investment budget?

Part II

Although the average project in the Defense Segment was substantially riskier than communications and Space Products segment and Engineered Materials segment, the project evaluation process did not formally incorporate risk considerations. This lack of risk consideration was more evident in the Communications and Space Products segment and Engineered Materials segments, since their productions, earnings, and profits were highly correlated and fluctuated with the economy. As a result, these segments provided a very stable income to the company. On the other hand, the Defense segment provides military products and professional services to the United States and allied governments, and their prime defense contractors and as a result, the earnings and profits of the Defense segment tended to be tied to the world geo-political environment.

Karman has gathered the following beta for each segments based on comparable companies:

Project             Defense           Com. Space     Eng. Materials

Beta                 1.50                 1.20                 0.80

The risk-free rate is 5% and rate of the market risk premium 9.0%.

Calculate the required rate of return for each project?

Compare the required rate of return with expected rate of return, according to the risk characteristics of each projects; which project is appropriate to take?

1. Use the following information to answer questions a through d. Market Values Current cap. Structure Proposed cap. Structure Assets \$15 million \$15 million Debt \$0 \$6 million Equity \$15 million \$9 million Share price \$25.00 \$22.50 Shares outstanding 600,000 ??? Bond Interest rate N/A 8% There are no taxes. EBIT is expected to be \$2.5 million, but could be as high as \$3.5 million if an economic expansion occurs, or as low as \$2 million if a recession occurs. All values are market values. a. What is EPS under the current capital structure if there is a recession? b. What is EPS during an expansion for the proposed capital structure? c. What is ROE for the proposed capital structure if the expected state occurs? d. How many shares are outstanding under the proposed capital structure? e. Repeat questions a thru d with 40% tax rate. Explain the diference between no taxes and with taxes. F. What is the levered cost oF equity iF the unlevered weighted average cost oF capital is 12%? g. What is the value oF the equity iF the EBIT is actually \$2.5 million? h. What would be the stock price oF the company iF the EBIT is \$2.5 million? 2. KARMAN CORPORATION On January 2, 2006, in the strategic committee meeting of the company, Tina Kash Chairman, President and Chief Executive Officer said, we are optimistic about 2006 and the years beyond. The proposed projects presently under consideration will enable us efficiently to expand our productivity in order to meet ever-increasing customers demand with high quality engineered products and systems for defense, aerospace and industrial applications. Karman Corporation is a supplier of sophisticated, highly engineered products and systems for defense, aerospace and industrial applications. The Company has three business segments. The Company's Defense segment provides integrated front-line war-fighting systems and components, including electronic warfare systems, reconnaissance and surveillance systems, aircraft weapons suspension and release systems and airborne mine countermeasures systems. The Company's Communications and Space Products segment supplies antenna products and ultra-miniature electronics and systems for the remote sensing, communications and electronic warfare industries.
The Company's Engineered Materials segment supplies piezoelectric ceramic products for commercial and military markets and advanced fiber composite structural products for the aircraft, communication, navigation, chemical, petrochemical, paper, and oil industries. Karman Corporation has the following financial statements: EXHIBIT A KARMAN COMPANY Balance Sheet 12/31/2005 Assets Liability & Equity Cash \$6,000,000 Account Payable \$1,000,000 Account Receivable \$8,000,000 Notes Payable \$3,000,000 Inventory \$3,000,000 Accrued Taxes \$1,000,000 Current Asset \$17,000,000 Current Liabilities \$5,000,000 GFA \$40,000,000 Long-term debt \$10,000,000 Accumulated Depreciation -\$2,000,000 Preferred Stock (0.5 million shares) \$15,000,000 Net Fixed Assets \$38,000,000 Common Stock (1 million shares) \$10,000,000 Returned Earnings \$15,000,000 Common Equity \$25,000,000 Total Asst \$55,000,000 Total Liability & Equity \$55,000,000 INCOME STATEMENT (12/31/2005) Sales \$25,000,000 Cost of Sales -8,500,000 EARNINGS BEFORE DEPRECIATION & TAXES \$16,500,000 Depreciation -1,550,000 EARNINGS BEFORE INTEREST & TAXES \$14,950,000 Interest Expense -\$950,000 EARNINGS BEFORE TAXES \$14,000,000 Taxes (40%) (\$5,600,000) EARNINGS AFTER TAXES \$8,400,000 Its established common stock’s dividend payout ratio after the preferred stock dividends payment is 50 percent and it is expected to grow at a constant rate of 9 percent in the future. The tax rate is 40 percent and investors requiring a rate of return of 15% on the common stock. Preferred stock is trading at a price of \$40 per share, with a dividend of \$4.8. The 30-year long- term debt with a par value of \$1,000 was issued 10 years ago with a coupon rate of 8%. The bonds can be refinanced at the market interest rate of 10 percent today. Karman has the following investment opportunities: Annual Net Project Project Cost Cash Flow Life Defense 1,000,000 \$219,120 7 years Communication and Space 1,000,000 319,775 5 Eng. Materials 1,000,000 222,851 8 Defense 2,000,000 368,580 10 Eng. Materials 2,000,000 542,784 6 Comm. and Space 1,000,000 202168 9 Part I a. Determine the book value and market value of the capital structure.
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a. What is EPS under the current capital structure if there is a recession? EPS =
=
= b. What is EPS during an expansion for the proposed capital structure? EPS =
= c. EBIT/Numbers of shares...

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