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.
Include the following in your response:
- Clearly discuss 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.
