8006FMGT Financial Management

Background: Case Study

SoCal is a manufacturer of suitcases that operates in Los Angeles since 1984. The company has been facing a few issues that you - the chief financial officer - will have to act on as requested by the Board of Directors (BoD). Most prominently, SoCal's revenues have substantially decreased, with the demand for its suitcases at levels not seen since 2010. To overcome the obstacles entailed by such situation, the marketing department has suggested to launch an aggressive campaign whereby the payment period to wholesale customers is extended from 20 to 40 days, leading to (forecasted) sales of 12,500 suitcases per year (based on a unitary price of $90 per suitcase). Regardless of prolonging its accounts receivable period, the company would still be liable to pay its suppliers in 15 days, with production levels of 50 suitcases per day.

To accommodate the increase in demand (and considering that suitcases stay in stock for a period of 30 days), SoCal would need to buy new machines costing $1,200,000, with a lifetime of 6 years.

Moreover, the marketing campaign will involve a cash cost of $400,000 per year. Variable costs associated with the production of suitcases would remain the same ($50 per suitcase paid to suppliers). During their lifetime, the new machines will be able to generate free cash flows in the amount of $675,000 per year, having 'zero' salvage value by the time they need to be replaced.

To implement the strategy suggested by its marketing department, SoCal can dispose of assets in its balance-sheet, or else borrow money in the financial markets. Particularly, the company has (i) 1,500 units of Australian government bonds ($1,000 face value, 10 years to maturity, annual coupons of

$40 and yield to maturity of 5% per year), and (ii) 130,000 ordinary shares of XYZ (a public listed company whose last paid dividend was $0.50 per share, with growth prospects of 5% per year and exposure to market risk i.e. beta of 1.2). Based on its balance-sheet (80% debt, 20% equity), SoCal can borrow funds paying an interest rate of 20% per annum (the tax-shield in the U.S. is 30%), whereas its cost of equity is equal to that of XYZ (assume an annual rate return on the market portfolio of 9%, and a risk-free rate of 2% per year).