maximize net worth

gobears99199

New member
Joined
Dec 5, 2007
Messages
1
I am very confused about this problem and do not know how to go about doing it. Thanks for your help

"You have decided to form a company to produce and market a new product, which you have developed. Your analysts tell you that equity could be raised through a stock sale of
$10/share. You may also borrow money for your project at a cost according to the following schedule:
Debt Schedule:
Amount Borrowed Interest Rate
On All Debt
Up to $ 3 million 11.00%
$ 3.1 to $ 5 million 11.50%
$ 5.1 to $ 7 million 12.00%
$ 7.1 to $ 9 million 12.50%
$ 9.1 to $11 million 14.00%
$11.1 to $13 million 16.00%
$13.1 to $15 million 22.00%

However, you know that you cannot raise the entire money you need through debt financing. Some equity will be required. Your analysts have come up with the following
cost of equity schedule, stated as a function of the amount of debt employed.

Cost of Equity Schedule
Debt
(Millions) Cost of Equity
$ 0.0 11.00%
$ 3.0 11.25%
$ 5.0 11.50%
$ 7.0 12.00%
$ 9.0 13.00%
$11.0 15.50%
$13.0 19.00%
$15.0 27.00%

You have decided that the par value of the shares (whatever # you issue) would be $.10. This is the price at which you issue shares to yourself. This means that you will issue
shares, sell to the public as many as needed (at a price of $10 per share) to finance the project and keep the rest for yourself (sell it to yourself at the par value but for
calculation purpose, consider it free of charge). Before the corporation charter can be filed, you must determine the # of shares that you can issue to yourselves at $.10 each;
and still be able to sell enough to outside investors at $10/share. You expect to be able to sell 70,000 units of this new product when company is formed at
a selling price $500 per unit. Variable costs are $275 per unit. The required fixed costs (excluding interest expenses) would be $l 2,000,000 per year. Total capital requirements
for the project is estimated to be $17.5 million.

Questions:
Your analysts have indicated that if no debt is used, and you finance only with
common stock, 1.75 million shares can be sold at the $10 price to raise the $17.5
million of capital required for the project. If debt financing is used, stock will be sold
at $10 per share, but fewer shares will have to be issued to raise the required $17.5
million.

You are interested in choosing the financing plan that will cause you to have the
greatest personal net worth, where net worth is defined as follows:

Net Worth = Value of Stock x Number of Shares for yourself.

Thus you need to find the maximum number of shares that you can issue to yourself
and still have investors who are willing to pay $10 per share while raising the
required equity. To simplify the calculations, assume that the capital requirements are
net of any cash received on the sale of the stock at $0.10 per share to yourself.
Assume a tax rate of 48 percent, and complete the following table. Show your work for at least one row.

Table 5: Value Calculations
Debt rB rS Firm Value Shares you issue to yourselves
$ 0 11.00% 11.00% $17,727,273 22,727
$ 3,000,000 11.00% 11.25% $18,808,000 130,800
$ 5,000,000 11.50% 11.50%
$ 7,000,000 12.00% 12.00%
$ 9,000,000 12.50% 13.00%
$11,000,000 14.00% 15.50%
$13,000,000 16.00% 19.00% $17,570,526 7,053
$15,000,000 22.00% 27.00% $15,866,667 Negative


Hints: (1) You should use the Net Income Approach (measuring the Firm Value on the
RHS of balance sheet) for this case. You can base your analysis on expected EBIT,
calculated at the expected level of sales. (2) If you use no debt, you will sell 1.75 million
shares to the public at a price of $10 each (disregarding the shares you yourself will
receive). 1f you use debt, you will sell fewer shares. The value of the firm, and the shares
that you can keep, will change at each debt level.
 

Denis

Senior Member
Joined
Feb 17, 2004
Messages
1,723
Youtch! Hire an accountant :)
 

Subhotosh Khan

Super Moderator
Staff member
Joined
Jun 18, 2007
Messages
24,744
gobears99199 said:
I am very confused about this problem and do not know how to go about doing it. Thanks for your help

"You have decided to form a company to produce and market a new product, which you have developed. Your analysts tell you that equity could be raised through a stock sale of
$10/share. You may also borrow money for your project at a cost according to the following schedule:
Debt Schedule:
Amount Borrowed Interest Rate
On All Debt
Up to $ 3 million 11.00%
$ 3.1 to $ 5 million 11.50%
$ 5.1 to $ 7 million 12.00%
$ 7.1 to $ 9 million 12.50%
$ 9.1 to $11 million 14.00%
$11.1 to $13 million 16.00%
$13.1 to $15 million 22.00%

However, you know that you cannot raise the entire money you need through debt financing. Some equity will be required. Your analysts have come up with the following
cost of equity schedule, stated as a function of the amount of debt employed.

Cost of Equity Schedule
Debt
(Millions) Cost of Equity
$ 0.0 11.00%
$ 3.0 11.25%
$ 5.0 11.50%
$ 7.0 12.00%
$ 9.0 13.00%
$11.0 15.50%
$13.0 19.00%
$15.0 27.00%

You have decided that the par value of the shares (whatever # you issue) would be $.10. This is the price at which you issue shares to yourself. This means that you will issue
shares, sell to the public as many as needed (at a price of $10 per share) to finance the project and keep the rest for yourself (sell it to yourself at the par value but for
calculation purpose, consider it free of charge). Before the corporation charter can be filed, you must determine the # of shares that you can issue to yourselves at $.10 each;
and still be able to sell enough to outside investors at $10/share. You expect to be able to sell 70,000 units of this new product when company is formed at
a selling price $500 per unit. Variable costs are $275 per unit. The required fixed costs (excluding interest expenses) would be $l 2,000,000 per year. Total capital requirements
for the project is estimated to be $17.5 million.

Questions:
Your analysts have indicated that if no debt is used, and you finance only with
common stock, 1.75 million shares can be sold at the $10 price to raise the $17.5
million of capital required for the project. If debt financing is used, stock will be sold
at $10 per share, but fewer shares will have to be issued to raise the required $17.5
million.

You are interested in choosing the financing plan that will cause you to have the
greatest personal net worth, where net worth is defined as follows:

Net Worth = Value of Stock x Number of Shares for yourself.

Thus you need to find the maximum number of shares that you can issue to yourself
and still have investors who are willing to pay $10 per share while raising the
required equity. To simplify the calculations, assume that the capital requirements are
net of any cash received on the sale of the stock at $0.10 per share to yourself.
Assume a tax rate of 48 percent, and complete the following table. Show your work for at least one row.

Table 5: Value Calculations
Debt rB rS Firm Value Shares you issue to yourselves
$ 0 11.00% 11.00% $17,727,273 22,727
$ 3,000,000 11.00% 11.25% $18,808,000 130,800
$ 5,000,000 11.50% 11.50%
$ 7,000,000 12.00% 12.00%
$ 9,000,000 12.50% 13.00%
$11,000,000 14.00% 15.50%
$13,000,000 16.00% 19.00% $17,570,526 7,053
$15,000,000 22.00% 27.00% $15,866,667 Negative


Hints: (1) You should use the Net Income Approach (measuring the Firm Value on the
RHS of balance sheet) for this case. You can base your analysis on expected EBIT,
calculated at the expected level of sales. (2) If you use no debt, you will sell 1.75 million
shares to the public at a price of $10 each (disregarding the shares you yourself will
receive). 1f you use debt, you will sell fewer shares. The value of the firm, and the shares
that you can keep, will change at each debt level.
This looks like a take-home project - are you supposed to be seeking help on these questions?

Please show us your work - using the hints supplied. Please state exactly where you are stuck - so that we know where to begin.

For example - what is the definition of Net Income approach - how is it used in producing balance sheet?
 
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