Reference no: EM133061687

Namib Mills, an established manufacturer of consumer goods, expects its sales to remain flat for the next three to five years due to both weak economic outlook and an expectation of little new industrial technology development over that period. Based on that scenario the firm's management has been instructed by the Board of directors to institute programs that will allow it to operate more efficiently, earn higher profits, and most importantly maximize shareholder wealth. In this regard, the firm's chief financial officer (CFO), Theo van Zyl, has been tasked to evaluate the firm's capital structure, dividend policy, inventory management strategy, and possible capital projects as well as measuring the corporation's cost of capital. Currently the firm has a fixed total capital of $10, 000,000, which is made up of 20 percent debt and 80 percent equity. The firm has 100,000 outstanding ordinary shares and no preference shares. Although Theo feels that the firm's current policy of paying out 60 percent of each year's earnings in dividends is appropriate, he believes that the current capital structure may lack adequate financial leverage. In order to evaluate the firm's capital structure, Theo is considering three alternative capital structures - A (30 percent debt ratio), B (50 percent debt ratio), and C (60 percent debt ratio). The interest rate on current debt is 10 percent and is believed to remain the same up to a borrowing limit of $1,000,000. Theo expects the firm's current earnings before interest and taxes (EBIT) to remain at $1,200,000. The firm expects to have $200,000 of retained earnings available in the coming year.

The firm has a tax rate of 40 percent. In assessing the cost of capital, Theo has the following information which has been compiled about the company's current costs of two sources of capital:

Exhibit 1

Source of capital	Range of new financing	Cost
Long-term debt	$0 to $1,000,000	10%
$1,000,001 and above		11%
Common stock equity	$0 to $2,000,000	13%
$2,000,001 and above		14%
Retained earnings		12%

Exhibit 2

NAMIB MILLS
Balance Sheet
Assets	2017	2018	2019
Cash	$20,000	$30,000	$20,000
Marketable securities	30,000	35,000	50,000
Accounts receivable	150,000	230,000	330,000
Inventory	250,000	285,000	325,000
Total Current Assets	450,000	580,000	725,000
Net Plant and equipment	550,000	720,000	1,169,000
Total Assets	$1,000,000	$1,300,000	$1,894,000
Liabilities & Equity
Accounts payable	$100,000	$225,000	$200,000
Notes payable (bank)	100,000	100,000	300,000
Total Current liabilities	200,000	325,000	500,000
Long-term liabilities	250,000	331,120	550,740
Total liabilities	450,000	656,120	1,050,740
Common stock ($10 par)	400,000	400,000	460,000
Capital paid in excess of par	50,000	50,000	80,000
Retained earnings	100,000	193,880	303,260
Total stockholders' equity	550,000	643,880	843,260
Total liabilities and stockholders' equity	$1,000,000	$1,300,000	$1,894,000

Exhibit 3

NAMIB MILLS
Income Statement
	2017	2018	2019
Sales (all on credit)	$1,500,000	$1,800,000	$2,160,000
Cost of goods sold	950,000	1,120,000	1,300,000
Gross profit	550,000	680,000	860,000
Selling and administrative expense	380,000	490,000	590,000
Operating profit	170,000	190,000	270,000
Interest expense	30,000	40,000	85,000
Net income before taxes	140,000	150,000	185,000
Taxes	46,120	48,720	64,850
Net Income	$93,880	$101,280	$120,150
Shares	40,000	40,000	46,000

Question 1 

(a) What is Namib Mills' Basic earning power

(b) What are the returns on assets (ROA) for current and proposed capital structures?

Question 2 

Exhibit 1

Namib Mills uses the weights based on the desired target capital structure proportions outlined above:

(a) Calculate the breakpoints associated with the firm's retained earnings for the three proposed capital structures.

(b) Calculate the breakpoints associated with the firm's financial situation for the current capital structure?

(c) Calculate the weighted cost of capital associated with the current and below the first breakpoint in (b).

(d) Calculate the breakpoints associated with the firm's 50 percent debt capital structure.

Question 3 

Exhibits 2 and 3

Using the Du Pont System, describe the changes in the return on equity from year to year.