4. AppsAlot is a small company that develops a variety of apps for smart phones.

Question

4. AppsAlot is a small company that develops a variety of apps for smart phones. Management desires to raise $10 million in funds to initiate and continue various projects. With that funding, they project an earnings (net of all expenses except capital costs) stream of $800,000 per year.

(a) Management is considering borrowing the funds. Because AppsAlot is a relatively new and risky company, the interest on loans that lenders would charge is 12%. If it goes this route, what is its expected economic profit?

(b) Suppose instead that management decides to raise funds by issuing stock, which provides shareholders a claim on the net earnings of the company. Suppose that the market returns on stock for well-known, blue chip companies is 7%. Do you think investors would invest in a new company like AppsAlot with that same expected return? Suggest a return that they might require for such a new company and determine AppsAlot’s expected economic profit based on this.  

Explanation / Answer

(a)

Interest cost = 12% x $10 million = $1.2 million

Economic loss = $0.8 million - $1.2 million = $0.4 million

(b)

If equity financing is possible, cost of equity = 7% x $10 million = $0.7 million

Economic profit = $800,000 - $700,000 = $100,000

However, investors generally require higher return in a small and new project, due to risks involved. So cost of equity is expected to be higher than 7%.

We can expect an off-the-cuff estimated required return on equity of 10%, and if that is realized, free cash flow (earnings after paying off the equity holders) will be negative. This firm can break even if return on capital is a maximum of 8%.

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