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Discuss why the return paid to the debt holders is not the same as the cost to the firm.

Moon Chemicals and Minerals (Pvt) Limited is a small-scale industry. The company purchased and constructed building in the year 1993. It started production in the year 1996. Its main product is lubricants for automobile. It is a private company situated in the Industrial estate, Ambewadi, which is enjoying all the required facilities like water, power, transport, labours and good environment and materials. Moon Chemicals and Minerals (Pvt) Limited, invest nearly 20% of its total asset in net working capital. This number is quite high compared to other company such Delhi Airlines, regional airline because Moon Chemicals and Minerals (Pvt) Limited requires a large investment in inventory compared to other company whose profitability relies more on investment in long term asset. The level of net working capital reflects the length of time between when cash goes out of a firm at the beginning of production process and when it comes back in. Moon Chemicals and Minerals (Pvt) Limited has traced the path of $15,000 worth of inventory and raw materials as follows;

I)Moon Chemicals and Minerals (Pvt) Limited buys $15,000 of raw materials and inventory from its suppliers, purchasing them on credit, which means that the firm does not have to pay cash immediately at the time of purchased.

II) About 14 days later, Moon Chemicals and Minerals (Pvt) Limited pays for the materials and inventory, so two weeks have passed between when Moon Chemicals and Minerals (Pvt) Limited purchased the materials and when the cash outflow occurred.

III) After another 10 days, Moon Chemicals and Minerals (Pvt) Limited sells the materials (now in the form of finished lubricants) to an automotive manufacturer, but the sale is on credit, meaning that the automotive manufacturer does not pay cash immediately.

IV) A total of 24 days have passed between when Moon Chemicals and Minerals (Pvt) Limited purchased the materials and when it sold them as part of the fmished product.

V) About 24 days later, the automotive manufacturer pays for the lubricant, producing a cash inflow for Moon Chemicals and Minerals (Pvt) Limited.

A firm’s sources of financing, which usually consist of debt and equity, represent its capital. The typical firm raises funds to invest by selling shares to stockholders (its equity) and borrowing from lenders. Like other company Moon Chemicals and Minerals (Pvt) Limited raise funds from debt and equity. Moon Chemicals and Minerals (Pvt) Limited uses the following securities to fund its operation:

VI) Moon Chemicals and Minerals (Pvt) Limited has $100,000 bonds due in 2019 that were originally issued in 2009; these bonds have a coupon rate of 10%. With the collapse of the U.S. real estate market in 2010, Moon Chemicals and Minerals (Pvt) Limited performance suffered and the risk that it might not be able to meet all of its debt obligations increased. By mid-2015, those 10% coupon bonds were rated BB (below investment grade) and trading at a yield to maturity of about 12.6%. Thus, to be willing to take a creditor position in Moon Chemicals and Minerals (Pvt) Limited, investors demanded a yield to maturity of 12.6%. Taking into account the probability of default and the expected loss in default, BB rated bonds had an average expected loss of 1.3%. Thus, the true expected return was closer to 11.3% (12.6% promised minus 1.3% expected loss).

VII) Suppose the equity beta of Moon Chemicals and Minerals (Pvt) Limited is 1.60, the yield on 10-year Treasury notes is 3%, and market risk premium is estimated to be 6%. Moon’s cost of equity using CAPM is 3% + 1.60 * 6%= 12.60%.

VIII) If Moon Chemicals and Minerals (Pvt) Limited keeps its dividend payout rate constant, then the long-run growth in dividends will equal the long-run growth in earnings. The average forecast for long-run earnings growth rate was 7.9%. Thus, with an expected dividend in one year of $1.80, a price of $57.66, and long-run dividend growth of 7.9%, the CDGM estimates cost of equity as 11%.

Required:

(a) Compute the operating cycle and cash cycle of Moon Chemicals and Minerals (Pvt) Limited. Discuss the difference between these two. (6 marks)

(b)Discuss how Moon Chemicals and Minerals (Pvt) Limited may have negative CCC? (4 marks)

(c) Discuss how the working capital needs are different between Moon Chemicals and Minerals (Pvt) Limited and Delhi Airlines (assume Delhi Airlines has negative CCC)? (5 marks)

(d) Discuss how working capital management can increase Moon’s value? (6 marks)

(e) Based on the company’s cost of capital information, which is a better estimate of the cost of debt capital for Moon in 2015, the 10% coupon or something based on the 12.6% yield to maturity? (4 marks)

(f)Discuss why the return paid to the debt holders is not the same as the cost to the firm. Provide calculation to justify, and assume borrowed amount is $100,000 at 10% of interest and tax rate is 35%. (2 marks)

(g) Discuss why the two estimates of cost of equity in (VII) and (VIII) do not match.

Solution:

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