Universal Parts Company is considering a bond issue instead of using its credit line to fund projects A and B. The following information was considered in deciding to change the source of capital:
-The new union bargaining agreement and increases in the cost of inputs will cause an increase in working capital needs.
-UPC's credit rating has improved because of a higher than expected profitability in the just-ended accounting period. Therefore, the chief financial officer (CFO) expects a successful bond issue at a lower cost than that of the credit line.
-UPC is planning to set up automobile repair centers (project C) in 10 major cities in the United States. Project C will require a capital outlay of $40 million. UPC's current credit line will be woefully inadequate to fund the new project.
Based on your knowledge of short- and long-term capital planning strategies and UPC's business and financing needs, defend the CFO's decision to issue bonds to fund project C.
Discuss the following:
-The weaknesses in the CFO's position. Under what circumstances will the CFO's proposal for capital expenditure financing result in an unfavorable capital project outcome? Suggest other sources of financing.
-Explain the impact of credit rating on cost of capital.
-Explain how you will calculate the new WACC.
The CFO's decision to raise bonds instead of using the line of credit for Project C is reasonable because the requirement for capital is $40 million. This is far larger than what is obtained with a line of credit. Further, the line of credit has a variable rate of interest. This means that the interest rate may increase leading to further burden on the company. On the other hand the interest rate of bonds is fixed and so the interest that has to be paid can be planned. Because of changes in the interest rate in case of line of credit often payments made for paying back the principal are payments that cover only the interest cost. The balloon payment at the end of the term can be a problem in a line of credit. If Universal Parts Company uses a line of credit it will have to give collateral. Also, when ...
The answer to this problem explains capital planning strategies. The references related to the answer are also included.