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Integrative Case: 4

OGrady Apparel Company


OGrady Apparel Company was founded nearly 160 years ago when an Irish merchant
named Garrett OGrady landed in Los Angeles with an inventory of heavy canvas, which he
hoped to sell for tents and wagon covers to miners headed for the California goldfields. Instead,
he turned to the sale of harder-wearing clothing.
Today, OGrady Apparel Company is a small manufacturer of fabrics and clothing whose
stock is traded in the OTC market. In 2006, the Los Angelesbased company experienced sharp
increases in both domestic and European markets resulting in record earnings. Sales rose from
$15.9 million in 2005 to $18.3 million in 2006 with earnings per share of $3.28 and $3.84,
respectively.
European sales represented 29% of total sales in 2006, up from 24% the year before and
only 3% in 2001, 1 year after foreign operations were launched. Although foreign sales represent
nearly one-third of total sales, the growth in the domestic market is expected to affect the
company most markedly. Management expects sales to surpass $21 million in 2007, and earnings
per share are expected to rise to $4.40. (Selected income statement items are presented in Table
1.)
Because of the recent growth, Margaret Jennings, the corporate treasurer, is concerned
that available funds are not being used to their fullest potential. The projected $1,300,000 of
internally generated 2007 funds is expected to be insufficient to meet the companys expansion
needs. Management has set a policy of maintaining the current capital structure proportions of
25% long-term debt, 10% preferred stock, and 65% common stock equity for at least the next 3
years. In addition, it plans to continue paying out 40% of its earnings as dividends. Total capital
expenditures are yet to be determined.
Jennings has been presented with several competing investment opportunities by division
and product managers. However, because funds are limited, choices of which projects to accept
must be made. A list of investment opportunities is shown in Table 2. To analyze the effect of the
increased financing requirements on the weighted average cost of capital (WACC), Jennings
contacted a leading investment banking firm that provided the financing cost data given in Table
3. OGrady is in the 40% tax bracket.
Table 1

Table 3
Financing Cost Data
Long-term debt: the firm can raise $700,000 of additional debt by selling 10-year, $1,000, 12%
annual interest rate bonds to net $970 after flotation costs. Any debt in excess of $700,000 will
have a before tax cost of 18%
Preferred Stock: regardless of the amount sold, can be issued with a $60 par value and a 17%
annual dividend rate. It will net $57 per share after flotation costs.
Common Stock Equity: the firm expects its dividends and earnings to continue to grow at a
constant rate of 15% per year. The firms stock is currently selling for $20 per share. The firm
expects to have $1,300,000 of available retained earnings. Once the retained earnings have been
exhausted, the firm can raise additional funds by selling new common stock, netting $16 per
share after underpricing and flotation costs.
TO DO:
a. Over the relevant ranges noted in the following table, calculate the after-tax-cost of each
source of financing needed to complete the table
Source of Capital
Long-Term Debt
Preferred Stock
Common Stock Equity

Range of New Financing


$0 - $700,000
$700,000 and above
$0 and above
$0 - $1,300,000
$1,300,000 and above

After-Tax Cost (%)

b.
(1) Determine the breaking points using the following capital structure weights. LongTerm Debt 25%
(2) Using the break point in (1), determine each of the ranges of total new financing over
which the firms weighted average cost of capital (WACC) remains constant.

(3) Calculate the WACC for each range of total new financing. Draw a graph with the
WACC on the vertical axis and total money raised on the horizontal axis, and show how the
firms WACC increases in steps as the amount of money raised increases.
c.
(1) Prepare the investment opportunity schedule and plot on the same axes as on b(3).
(2) Which if any, of the available investment would you recommend that the firm accept?
Explain your answer.
d.
(1) Assuming that the specific financing costs do not change, what effect would a shift to
a more highly leveraged capital structure consisting of 50% long term debt, 10% preferred stock
and 40% common stock have on your previous findings. (Note: rework b and c using these
capital structures)
(2) Which capital structure the original one or this one seems better? Why?
e.
(1) What type of dividend policy does the firm appear to employ? Does it seem
appropriate given the firms recent growth in sales and profits and given its current investment
opportunities?
(2) Would you recommend an alternative dividend policy? Explain. How would this
policy affect the investments recommended in part c (2)?

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