MINI CASE: ALPHA ONE SOFTWARE CORPORATION
The Alpha One Software Corporation was organized to develop software products that would provide Internet-based firms with information about their customers. As a result of initial success, the venture’s premier product allows firms with subscriber bases to predict customer profiles, retention, and satisfaction.
Arlene Io received an undergraduate degree in computer sciences and information systems from a major northeastern university four years ago. The Omega Subscriber Software Product was developed, test marketed with the help of two of her classmates; Alpha One Software Corporation was up and running within one year. Venture capital was obtained to start up operations; a second round of venture financing helped Alpha One to move through its survival stage. Product success in the marketplace has allowed the venture to achieve such rapid sales growth that it now is able to get bank loans and issue long-term debt. The interest rate on the bank loan is 10 percent. An effective cost for the long-term debt will need to be determined; the cost of common equity was estimated using a risk-free rate of 7 percent and a risk premium of 13 percent.
Arlene Io has now reached the point of being able to consider whether Alpha One is adding economic value in terms of its net operating profit after taxes (NOPAT) and its weighted average cost of capital (WACC). Based on the most recent years’ financial statements (see end of mini case), Arlene was interested in answering the following:
A. What is Alpha One’s NOPAT? Why does NOPAT differ from the earnings after taxes?
NOPAT = 144,000 x (1 - .40) = 86,400
EAT = 36,000
NOPAT excludes interest financing costs on an after-tax basis (i.e., 84,000 x .60 = 50,400). Check: 86,400 – 36,000 = 50,400
B. Estimate the effective before-tax cost of the long-term debt.
% cost of bank loan = 10%
Interest on bank loan (notes payable) was: 10% x 100,000 = 10,000
% cost of long-term debt = interest/long-term debt
Interest paid on long-term debt: 84,000 (total interest) - 10,000 (interest on bank loan) = 74,000
74,000/500,000 = 14.8%
C. Estimate the effective after-tax cost of the bank loan and the long-term debt.
Bank loan: 10% x (1 - .40) = 6.0%
Long-term debt: 14.8% x (1 - .40) = 8.88% after-tax cost
D. Estimate the cost of common equity capital.
Using a risk-premium model: Cost of Equity = 7% + 13% = 20.0%
E. Determine the financial structure weights for the two interest-bearing debt components and the common equity.
$ Amount % Weight
Bank loan 100,000 11.8%
Long-term debt 500,000 58.8
Common equity 250,000 29.4
Total 850,000 100.0%
Note: common equity = common stock + retained earnings (100,000 + 150,000 =
250,000)
F. What is Alpha One’s WACC?
WACC = 6.0%(.118) + 8.88%(.588) + 20.0%(.294) = .71% + 5.22% + 5.88% = 11.81% or 11.8% rounded
G. Determine the dollar cost of financial capital used.
$ cost of financial capital used = amount of financial capital x WACC
850,000 x .118 = 100,300
H. Estimate Alpha One’s economic value added (EVA).
EVA = NOPAT - $ cost of financial capital used
EVA = 86,400 – 100,300 = -13,900
Alpha One Software Corporation
Income Statement 2007
|Net Sales | $1,500,000 |
|Cost of Goods Sold | -850,000 |
|Gross Profit | 650,000 |
|General & Administrative Expenses | -250,000 |
|Marketing | -206,000 |
|Depreciation | -50,000 |
|Earnings Before Interest and Taxes | 144,000 |
|Interest | -84,000 |
|Earnings Before Taxes | 60,000 |
|Income Taxes (40% rate) | -24,000 |
|Earnings After Taxes | $36,000 |
| | |
Alpha One Software Corporation
Balance Sheet 2007
|Cash | $20,000 |
|Accounts Receivable | 250,000 |
|Inventories | 350,000 |
| Total Current Assets | 620,000 |
|Fixed Assets, Net | 480,000 |
| Total Assets | $1,100,000 |
| | |
|Accounts Payable | 125,000 |
|Accrued Liabilities | 125,000 |
|Notes Payable | 100,000 |
| Total Current Liabilities | 350,000 |
|Long-Term Debt | 500,000 |
|Common Stock (20,000 shares) | 100,000 |
|Retained Earnings | 150,000 |
| Total Liabilities & Equity | $1,100,000 |
The Alpha One Software Corporation was organized to develop software products that would provide Internet-based firms with information about their customers. As a result of initial success, the venture’s premier product allows firms with subscriber bases to predict customer profiles, retention, and satisfaction.
Arlene Io received an undergraduate degree in computer sciences and information systems from a major northeastern university four years ago. The Omega Subscriber Software Product was developed, test marketed with the help of two of her classmates; Alpha One Software Corporation was up and running within one year. Venture capital was obtained to start up operations; a second round of venture financing helped Alpha One to move through its survival stage. Product success in the marketplace has allowed the venture to achieve such rapid sales growth that it now is able to get bank loans and issue long-term debt. The interest rate on the bank loan is 10 percent. An effective cost for the long-term debt will need to be determined; the cost of common equity was estimated using a risk-free rate of 7 percent and a risk premium of 13 percent.
Arlene Io has now reached the point of being able to consider whether Alpha One is adding economic value in terms of its net operating profit after taxes (NOPAT) and its weighted average cost of capital (WACC). Based on the most recent years’ financial statements (see end of mini case), Arlene was interested in answering the following:
A. What is Alpha One’s NOPAT? Why does NOPAT differ from the earnings after taxes?
NOPAT = 144,000 x (1 - .40) = 86,400
EAT = 36,000
NOPAT excludes interest financing costs on an after-tax basis (i.e., 84,000 x .60 = 50,400). Check: 86,400 – 36,000 = 50,400
B. Estimate the effective before-tax cost of the long-term debt.
% cost of bank loan = 10%
Interest on bank loan (notes payable) was: 10% x 100,000 = 10,000
% cost of long-term debt = interest/long-term debt
Interest paid on long-term debt: 84,000 (total interest) - 10,000 (interest on bank loan) = 74,000
74,000/500,000 = 14.8%
C. Estimate the effective after-tax cost of the bank loan and the long-term debt.
Bank loan: 10% x (1 - .40) = 6.0%
Long-term debt: 14.8% x (1 - .40) = 8.88% after-tax cost
D. Estimate the cost of common equity capital.
Using a risk-premium model: Cost of Equity = 7% + 13% = 20.0%
E. Determine the financial structure weights for the two interest-bearing debt components and the common equity.
$ Amount % Weight
Bank loan 100,000 11.8%
Long-term debt 500,000 58.8
Common equity 250,000 29.4
Total 850,000 100.0%
Note: common equity = common stock + retained earnings (100,000 + 150,000 =
250,000)
F. What is Alpha One’s WACC?
WACC = 6.0%(.118) + 8.88%(.588) + 20.0%(.294) = .71% + 5.22% + 5.88% = 11.81% or 11.8% rounded
G. Determine the dollar cost of financial capital used.
$ cost of financial capital used = amount of financial capital x WACC
850,000 x .118 = 100,300
H. Estimate Alpha One’s economic value added (EVA).
EVA = NOPAT - $ cost of financial capital used
EVA = 86,400 – 100,300 = -13,900
Alpha One Software Corporation
Income Statement 2007
|Net Sales | $1,500,000 |
|Cost of Goods Sold | -850,000 |
|Gross Profit | 650,000 |
|General & Administrative Expenses | -250,000 |
|Marketing | -206,000 |
|Depreciation | -50,000 |
|Earnings Before Interest and Taxes | 144,000 |
|Interest | -84,000 |
|Earnings Before Taxes | 60,000 |
|Income Taxes (40% rate) | -24,000 |
|Earnings After Taxes | $36,000 |
| | |
Alpha One Software Corporation
Balance Sheet 2007
|Cash | $20,000 |
|Accounts Receivable | 250,000 |
|Inventories | 350,000 |
| Total Current Assets | 620,000 |
|Fixed Assets, Net | 480,000 |
| Total Assets | $1,100,000 |
| | |
|Accounts Payable | 125,000 |
|Accrued Liabilities | 125,000 |
|Notes Payable | 100,000 |
| Total Current Liabilities | 350,000 |
|Long-Term Debt | 500,000 |
|Common Stock (20,000 shares) | 100,000 |
|Retained Earnings | 150,000 |
| Total Liabilities & Equity | $1,100,000 |
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