Reference no: EM132596085
Maxlight is in the manufacturing industry. Maxlight's operating cycle is 91 days, accounts receivable day is 45 days and accounts payable days of 15 days. The company currently provides a 30 day credit term to its customers. Its suppliers offer credit terms of 2/10 net 30. The industry average cash conversion cycle is 65 days and the inventory days is 40 days.
Maxlight is considering whether to venture into the restaurant business. There is an opportunity to open a restaurant which the company hopes to eventually tum into a franchise. Maxlight's book value of equity is $100 million and its market value of equity is $200 million. The cost of equity (calculated using the company's beta) is 12%. The face value of its debt is $50 million and its market value of debt is $60 million. The outstanding debt with a coupon rate of 8%, currently trades with a yield to maturity of 9%.
The restaurant business's annual cash flow was forecast ed. In order to evaluate the investment, net present value (NPV) is to be used and this requires a discount rate to be estimated. Weighted average cost of capital (WACC) is commonly used as a discount rate in order to arrive at the NPV. WACC is the weight of debt times cost of debt plus weight of equity times cost of equity. The WACC for Maxlight was calculated as follows:
WACC = (100/150) x 12% + (50/150) x 8%= 0.1067 or 10.67%
Maxlight plans to use the company's WACC as the discount rate for the NPV calculation. Assume a perfect capital market. Assume that the Maxlight operates in a perfect capital market.
Required:
(a)Critically evaluate the whether WACC figure is correct. Is it appropriate to use the Maxlight's WACC to evaluate the new investment?
(b)Maxlight's management is considering whether to increase the level of debt of the company. How would this decision affect the firm value and WACC?
(c)Suppose the company was an all equity firm, what would be the cost of equity and WACC? Clearly show the workings to calculate the figure and explain.
(d)Analyze Maxlight's cash cycle to determine whether working capital is efficiently managed. Make specific recommendations for working capital management, if applicable.