Posted: June 6th, 2023

O’Hagan Apparel Company was founded 30 years ago when Tipene O’Hagan

Question
1 (22marks)O’Hagan
Apparel Company was founded 30 years ago when Tipene O’Hagan, a descendant of an Irish
immigrant whorealised
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$7.7million
in2012to$9.2millionin2014,withearnings
pershare(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 meetthe company’s
expansionneeds.Management has set a policy to maintain the
capital structureof
O’Hagan Apparel Company at65% equity capital, 25%
interest bearing debt and 10% preference share capital for at least the next
three years.Table1 SELECTED INCOME
STATEMENTITEMS201220132014Projected
2015Netsales$6 930000$7 745000$9 165000$10 540 000Net
profits aftertax7600008750001 0100001 161000Earnings per share (EPS)0.290.330.380.44Dividend Per
Share0.1150.1310.1540.176The 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 Table3.O’Hagan is in the 30%
taxbracket.Table2 INVESTMENT
OPPORTUNITIES SCHEDULE (IOS)Investment
OpportunityInternal Rate of Return(IRR)InitialInvestmentA17.50%$200000B15.5100000C19350000D20250000E14100000F18.5350000G13.5275000Table 3: COST DATA FOR ADDITIONALFINANCEInterest-bearingdebtThe 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%.PreferenceSharesPreference 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.OrdinarysharesThe 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 ofCapitalRange of new
financingAfter-tax cost(%)Interest-bearingdebt$0- $250000$250 000 and
abovePreference
shares$0 andaboveOrdinaryshares$0- $650000$650 000 and
above2.
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)

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