STEP 5 – Financing Options

STEP 5 – Financing Options

Your firm has decided to spin off Android01 and Processor01 as a separate firm. The owners of the new firm will be equity holders and debt holders. After speaking with potential investors, investment banks have identified two possible capital structures (structure of equity and debt ownership):

• Debt holders receive debt that pays them      coupons of $2 million a year, and $30 million after 20 years (these are      expected values as the coupons and principal payments are not riskless, the      debt buyers realize the firms could default). They price the debt using a      discount rate of 4 percent. Equity holders receive expected dividends of      $3 million starting from year 5, and growing at a rate of 4 percent per      year (a growing perpetuity). They price the equity using a discount rate      of 7.5 percent. 
• Debt holders receive debt that pays them      coupons of $1 million a year, and $12 million after 20 years (these are      expected values as the coupons and principal payments are not riskless,      the debt buyers realize the firms could default). They price the debt      using a discount rate of 3.5 percent. Equity holders receive expected      dividends of $3.9 million starting from year 5, and growing at a rate of      4.5 percent per year (a growing perpetuity). They price the equity using a      discount rate of 7 percent.

Your firm receives all the proceeds from the sale debt and equity. Since the firm is selling debt and equity, it wants to sell using the capital structure that provides them with the most money (sum of whatever debt and equity sells for).

Prepare a Capital Budgeting and Cost of Capital report that answers the following Question 13.

Question 13: Which particular capital structure should be chosen for the spin-off?

Here the firm is the seller of a physical asset for which it gets all the money today. Therefore, you do not have to calculate NPV etc.  It is not making an investment it is receiving money by selling the subsidiary.  You have to calculate the price at which debt sells and the price at which equity sells.  You have to calculate the price of debt using the annuity formula and the price of equity using the growing perpetuity formula.  Then add the two to get total money raised by selling subsidiary.  Whichever financing gives more total money should be the preferred financing.

Before you submit your assignment, review the competencies below, which your instructor will use to evaluate your work.  A good practice would be to use each competency as a self-check to confirm you have incorporated all of them in your work.

• 3.1 Identify numerical or mathematical      information that is relevant in a problem or situation.
• 3.2 Employ mathematical or statistical      operations and data analysis techniques to arrive at a correct or optimal      solution.
• 3.3 Analyze mathematical or statistical      information, or the results of quantitative inquiry and manipulation of      data.
• 3.4 Employ software applications and analytic      tools to analyze, visualize, and present data to inform decision-making.
• 10.3 Determine optimal financial decisions in      pursuit of an organization's goals.
• 10.4 Make strategic managerial decisions for      obtaining capital required for achieving organizational goals.

Additional Guidance on Project 4

Ques 13.  Note that this question asks for the price of debt (not the cost of debt) -- similar calculation, except this approach suggest that debt instruments are being sold to raise capital.  Select the price of financing that produces the larger sum of money.