Fairfield Office Supplies Case -- Spring 2018 Fairfield Office Supplies Inc. has a regional chain of office supply stores in the Midwest. Fairfield is trying to compete with the large nationwide office supply companies. It is January of 2018 and Fairfield needs to make some capital budgeting decisions this year. They need to decide whether to replace their computerized inventory system or upgrade the old one, whether to purchase two stores from a sole proprietor or not, whether to keep, abandon or modernize one of the stores, which new copiers to purchases and a few other small projects. The company is under some pressure and has a strict capital budget of $10 million, so they need to be careful as to which projects they choose. Examine the following book-value balance sheet for Fairfield Office supplies for the year 2017. What is the capital structure of the firm based on market values?
The preferred stock currently sells for $6.25 per share and the common stock for $15.50 per share. The preferred stock pays a dividend of $.60 per share, the Common Stock paid a dividend of $1.03 last year, and the firm is expected to continue to grow at the same rate as the net income for the past five years, The rate on 90 day treasuries is 2.00%, the beta of the stock is 1.4, the market risk premium is 9%, and the firm’s tax rate is 40%. The float costs are as follows: Debt: 10% of par only for the amount borrowed under $1 million (after that it is 0%), preferred: $0.5 per share and Common: $1.50 per share. The firm has paid out 20% of its net income as dividend in the past five years and is expected to continue. If the company borrows over $1.0 million then the cost of debt goes from 10.0% to 12% (including flotation) and if the company borrows over $2 million the cost goes to 13% (including flotation). Find the Marginal costs of capital for Fairfield. Fairfield tax rate is 40%. (For Required return of retained earnings use an average of the DCF method and the CAPM method). Book Value Balance Sheet for 12/31/17 (all values in millions) Assets Liabilities and Net Worth Cash and short-term securities $1.5 Bonds, coupon =9.5%, paid $14.0 Annually (maturity = 20 years, Current yield to maturity = 10.0%) Accounts Receivable 3.0 Preferred stock (par value $5 3.0 Per share) Inventories 6.0 Common Stock (par value $.5) 1.25 Plant and equipment 35 Additional paid in stockholders’ 8.75 Capital Retained Earnings 18.5 Total $45.5 Total $45.5 Years 2017 2016 2015 2014 2013 Net Income (in millions) 5.14 4.75 4.30 4.00 3.78 Projects: Replacement or upgrade of the computerized inventory system: The current system is 3 years old, originally cost $1,000,000, is being depreciated on a straight-line basis over its five year life and has an estimated salvage value of $100,000. Although the system is being depreciated over 5 years, it could last for 5 more years. If the machine was sold today, it would be for $300,000. The new system would cost $1,200,000, including installation costs, and would be depreciated on a straight-line basis over its five year life to a salvage value of $100,000. Fairfield spent $100,000 last year researching this new system. This new system would reduce cash operating costs by $300,000 per year. Inventory needs are expected to increase by $60,000 immediately due to the new system, but accounts payable will rise by $20,000. At the end of the life of this machine inventory and accounts payable will reverse. Both machines will be sold at their salvage value at the end of the five year project.
Should the company recommend replacement or upgrade the system?