1.

Several biking enthusiasts recently left their defense industry jobs and grou ped together to form a corporation, Freedom Cycle, Inc. (FCI), which will produc e a new type of bicycle. These new bicycles are to be constructed using space-ag e technologies and materials so they will never need repairs or maintenance. The ir CFO, Mabra Jordan, has convinced a local venture capital partnership to provi de funding for FCI. Two alternatives have been proposed by the venture capitalis ts: a high leverage plan primarily using junk bonds (HLP), and a low leverage plan (LL P) primarily using equity. HLP consists of $6 million of bonds carrying a 14 percent interest rate and $4 m illion of common stock. LLP, on the other hand, consists of $2 million of bonds with an interest rate of 11 percent and $8 million of common stock. Under either alternative, FCI is required to use a sinking fund to retire 10 percent of the bonds each year. FCI s tax rate is expected to be 32 percent. a. If an analysis of FCI s long-term prospects indicates that long-term EBIT will be $1.6 million annually, which financing alternative will generate the higher ROE ? How much tax shield is provided by debt in each financing alternative in Year 1? b. Find the EBIT indifference level associated with the two financing alternativ es. Briefly explain the significance of this EBIT indifference level. A concern of the venture capitalists, of course, is whether FCI would be able to survive its first year in business if for some reason - such as an economic rec ession or just an overly optimistic sales projection - the cash flow targets wer e not met. To allay such fears, Mabra included in the FCI business plan a worstcase scenario based on the following pessimistic projections. The pessimistic sales forecast indicates cash receipts would be $4.2 million. Mi scellaneous cash receipts (for example, from the sale of scrap titanium and othe r materials) would be $200,000. Cash payments on raw material purchases would be $1 million; wage and salary cash outlays would be $1.5 million; non-discretiona ry cash costs (not including tax payments) would be $700,000; and estimated tax payments would be $441,600 under LLP and $243,200 under HLP (note that the diffe rence in estimated tax payments is attributable to the variation in taxable inco me, which reflects the difference in deductible interest expense). Starting initially with zero cash, the company would obtain cash of $10 million from either of the two financing alternatives described above. $9.5 million of s uch financing would be used for capital acquisitions; the balance is intended to partially fund initial working capital needs indicated above. c. A significant issue is whether FCI will have a sufficient cash balance at the end of the possible recessionary year. Mabra believes FCI should maintain a min imum $500,000 cash balance. Will this target be met in both plans? If not, what change in the loan terms would allow FCI to meet its desired cash balance in a p essimistic scenario? 2. Consider a financial institution with a P100 million asset base. Determine th e ROE under three (3) debt-equity and interest rate scenarios, and two (2) preta x return on asset scenarios as follows: ROIC of 13.5% and 11%, and D:E ratios of 10:1, 20:1 and 30:1. Interest rates on borrowings are 11% for the 10:1 debt-toequity ratio, 11.3% for 20:1 and 11.7% for 30:1 (approximately the spreads betwe en AAA-rated 10-year bonds and BBB+ bonds). The tax rate is 30%.