Finance-O’Hagan Apparel Company was founded 30 years ago

Question1 (22marks)

O’Hagan Apparel Company was founded 30 years ago when Tipene O’Hagan, a descendant of an Irish immigrant who realised that fashionable clothing styled on indigenous lines could be a “winner” amongst both young fashion-conscious environmentalists andtourists.

Today, O’Hagan Apparel Company is a medium-sized manufacturer of fabrics and clothing based on indigenous Maori and Aboriginal designs. In 2014, the Pahiatua-based company experienced sharp increases in both domestic (Australasian) and European markets, resulting in record earnings. Sales rosefrom$7.7millionin2012to$9.2millionin2014,withearningspershare(EPS)of$0.33and

$0.38, respectively. In 2015, EPS is expected to rise to $0.44. (Selected income statement items are presented in Table1).

Because of recent growth, the Chief Financial Officer (CFO), is concerned that the projected

$650,000 of internally generated funds that would be available in 2015 would be insufficient to meet the company’s expansionneeds.

Management has set a policy to maintain the capital structure of O’Hagan Apparel Company at 65% equity capital, 25% interest bearing debt and 10% preference share capital for at least the next three years.

Table1 SELECTED INCOME STATEMENTITEMS

	2012	2013	2014	Projected2015
Netsales	$6 930000	$7 745000	$9 165000	$10 540 000
Net profits aftertax	760000	875000	1 010000	1 161000
Earnings per share (EPS)	0.29	0.33	0.38	0.44
Dividend PerShare	0.115	0.131	0.154	0.176

The CFO has been presented with several competing investment opportunities by division and product managers. However, because funds are limited, choices of which projects to accept must be made. The investment opportunities schedule (IOS) is shown in Table 2. To analyse the effect that the increase in financing requirements would have on the weighted average cost of capital, the CFO contacted a leading investment banking firm, which provided the financing cost data given in Table 3.O’Hagan is in the 30% taxbracket.

Table2 INVESTMENT OPPORTUNITIES SCHEDULE (IOS)

InvestmentOpportunity	Internal Rate of Return(IRR)	InitialInvestment
A	17.50%	$200000
B	15.5	100000
C	19	350000
D	20	250000
E	14	100000
F	18.5	350000
G	13.5	275000

Table 3: COST DATA FOR ADDITIONALFINANCE

Interest-bearingdebt

The firm can raise $250 000 of additional debt by selling ten-year, $1000, 9% annual interest rate bonds to net $980 after flotation costs. Any debt in excess of $250 000 will have a before-tax cost, (Rd), of12%.

PreferenceShares

Preference shares, regardless of the amount sold, can be issued for $10 with an 11% annual dividend rate, and will net $9.50 per share after flotationcost.

Ordinaryshares

The firm expects its dividends and earnings to continue to grow at a constant rate of 15% per year. The firm's shares are currently selling for $3.50 per share. The firm expects to have $650 000 of available retained earnings. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new ordinary shares, netting $2.8 per share after under-pricing and flotationcosts.

Required:

1. Over the relevant ranges noted in the following table, calculate the after-tax cost of each source of financing needed to complete thetable.

(8marks)

Source ofCapital	Range of newfinancing	After-tax cost(%)
Interest-bearingdebt	$0- $250000
	$250 000 andabove
Preferenceshares	$0 andabove
Ordinaryshares	$0- $650000
	$650 000 andabove

2. Calculate the Weighted Average Cost of Capital (WACC) if the CFO wishes to raise the funds needed to invest in investmentopportunities:

a. A toE

b. A to G, specified in table2.

(8marks)

3. Based on your computation above in 2 (a) and (b), which investment opportunities would you recommend that the CFO should consider investing in?Why?

(4marks)

4. Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term interest-bearing debt, 10% preference shares and 40% ordinary shares have on your previous findings? (Hints: rework questions 2 and 3 using these capital structureweights)

(6marks)

5. Which capital structure – the lowly leveraged or the highly leveraged one seems better?Why?

(4marks)