Below is the current Balance Sheet for Fleury’s Flower Shop Limited

Fleury’s Flower Shop Balance Sheet

$millions

Assets Liabilities & Shareholders’ Equity

Cash & short-term securities $1 Bonds, coupon =9%, paid semi-annually
(maturity 15 years, $1,000 face value)  $10

Accounts Receivable 3 Preferred Stock (Par value $20 per share) 2

Inventories 7 Common Stock (1,000,000 shares outstanding) 10

Plant & Equipment 21 Retained Earnings 10

Total                          $32 Total $32

The financial manager of Fleury’s is evaluating equipment purchases with a total capital cost of $480,000and shipping costs for equipment of $20,000. The purchases will not alter the risk of the firm. The financial manager has gathered the following information for the firm:

Debt: The bonds are currently selling at a quoted price of 95. New debt would be issued at par ($1,000) with flotation costs of 2%
Preferred Shares: The preferred shares are currently selling for $15 per share. The firm can sell new $100 par value preferred shares with a $12 annual dividend. The market price is expected to be $95 per share. Flotation costs for new preferred shares are estimated at 3%.

Common Equity: The firm’s common shares currently sell for $30 per share. The firm does not have enough cash on hand to finance the equity portion of the projects. Fleury’s has a tax rate of 40% and a beta of 1.79. You have observed the following from the market: an 8% market risk premium and a 2% risk free rate. Flotation costs for new common shares are estimated at 4%.

Management is forecasting the new equipment will generate operating cash flows (before tax) of $150,000 per year for 10 years beginning at the end of year 1. The equipment (CCA class 9 with a CCA rate of 15%) has a useful life of 10 years after which time it is estimated to be worth $25,000.

a) Calculate the discount rate the firm should use to evaluate projects with the same level of risk as the firm.

b) Would this expansion create value for Fleury Flower Shop? Perform a NPV analysis. Assume the asset class will remain open.

    • 7 years ago
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