Which method do you think is the most accurate way to assign costs?

You have been asked to look at production options for the Android01, since production methods and allocation of costs have implications for cost per unit. Two alternative methods of production are being considered. Begin by gathering data (using financial information in decision making), then determine the suitability of the project.

The production of Android01 will share some production facilities and service divisions with Processor01. Fixed costs are $5 million per year, and will be assigned at the rate of 30 percent to Android01 and 70 percent to Processor01.

The variable cost of the production facilities and service divisions is $25 million per year. The square footage of factory space and labor needed for the production of 500 units of Processor01 and 300 units of Android01 are listed below.

Square Feet Labor
Processor01 (500 units) 70,000 120
Android01 (300 units) 30,000 80

The remaining cost for the production of Android01 is for components, at $25,000 per unit.

Question 1: In Method B, what would be the cost per unit of producing Android01 using factory space as the allocation basis? What would be the cost per unit using labor as the allocation basis?

Question 2: What would be the cost per unit of producing Android01 using activity-based costing?

Note that in addition to the setup costs and assemblies costs there are two more costs to add: (1) fixed costs of $5 million, which are still distributed at a rate of 30 percent to Android01 and 70 percent to Processor01, and (2) the cost of Android01 components at $25,000 per unit.

Discuss the differences in the cost per unit of Android01 using space as an allocation basis, using labor as an allocation basis, and using activity-based costing. Which method do you think is the most accurate way to assign costs?

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The firm decides to raise $30 million by selling equity and debt. The investment bankers hired by your firm contact potential investors and come back with the following numbers:

  • Debt that pays $1 million coupons a year and $18 million maturity value after 10 years will sell for $20 million.
  • Equity that pays expected dividends of $1.2 million starting next year and growing at a rate of 3 percent per year thereafter sells for $10 million.

Question 12: Calculate the cost of debt, equity, and the WACC.

Finally, your firm has decided to spin off Android01 and Processor01 as a separate firm. The owners of the new firm will be equity holders and debt holders. After speaking with potential investors, investment banks have identified two possible capital structures (structure of equity and debt ownership):

  • Debt buyers receive debt that pays them coupons of $2 million a year, and $30 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 4 percent. Equity buyers receive expected dividends of $3 million starting from year 5, and growing at a rate of 4 percent per year (a growing perpetuity). They price the equity using a discount rate of 7.5 percent.
  • Debt buyers receive debt that pays them coupons of $1 million a year, and $12 million after 20 years (these are expected values as the coupons and principal payments are not riskless, the debt buyers realize the firms could default). They price the debt using a discount rate of 3.5 percent. Equity buyers receive expected dividends of $3.9 million starting from year 5, and growing at a rate of 4.5 percent per year (a growing perpetuity). They price the equity using a discount rate of 7 percent.

Your firm receives all the proceeds from the sale debt and equity. Since the firm is selling debt and equity, it wants to sell using the capital structure that provides them with the most money (sum of whatever debt and equity sells for).

Prepare a Capital Budgeting and Cost of Capital report that answers the following Question 13.

Question 13: Which particular capital structure should be chosen for the spin-off?

Here. the firm is the seller of a physical asset for which it gets all the money today. Therefore you do not have to calculate NPV etc. It is not making an investment it is receiving money by selling the subsidiary. You have to calculate the price at which debt sells and the price at which equity sells. You have to calculate the price of debt using the annuity formula and the price of equity using the growing perpetuity formula. Then add the two to get total money raised by selling subsidiary. Whichever financing gives more total money should be the preferred financing.