Current Situation:

Stefano, Giuseppe’s third grandchild, was now running RomanManufacturing, while his cousin, Guido, was director ofmanufacturing operations. Guido presented to Stefano and the othermanagers his research into the costs of acquiring new machinery forthe athletic footwear and casual shoes lines. However, Lorenzobrought forth the possibility of setting up a subsidiary inSouthern Italy making a new line of men’s and women’s luxury shoes.Establishing a new manufacturing branch in Southern Italy caughtStefano totally off-guard, but when Lorenzo, another cousin and thecompany’s chief financial officer, heard that a long-establishedItalian family was looking to sell their company, House of NapoliShoes, at a fairly reasonable price, the opportunity presentedStefano with an intriguing possibility he could not ignore. Stefanoand Guido had come to the conclusion that Roman’s manufacturingplant needed ten new machines to make athletic shoes. The costwould be $1.25 million dollars just for the new machinery importedfrom abroad. Materials and supplies as well as worker’s salariesand benefits would come to be $1 million. The total cost would be$2.25 million. Roman Manufacturing had the floor-space for themachines and could transition to the new product line inapproximately six months. Guido also did research into themachinery needed for the casual footwear line. Roman would need tennew machines, imported from overseas, at a cost of $2 million. Thecost of materials and supplies and worker’s wages would be $1.25million for a total cost of $3.25 million. These machines wouldneed less floor space than the machines for the athletic footwearand would take approximately four months to start manufacturingoperations. The situation with the purchase of the Italian shoemanufacturing company, House of Napoli Shoes, was more complicated.First, the sale would have to be approved by the Italian governmentand the anti-trust division of the European Union (EU). Once thathurdle was cleared then the unions involved with the company wouldhave to be assured that no jobs would be lost after the sale tookplace. Stefano knew that the situation regarding the relationshipwith the unions could hurt Roman’s reputation in Italy and theUnited States if it was not handled correctly. Stefano always feltthat bad publicity will hurt a good company every time. Guido andLorenzo had been in negotiations with the Italian firm as well aswith the anti-trust division of the EU and the unions. Guido andLorenzo were able to work out a deal in which Roman would purchasethe Italian firm for $500 million. The deal would be all cash andfinanced by the sale of corporate bonds and common and preferredstock to new and

Financial Information:

Stefano, after consulting with Guido and Lorenzo as well as withRoman’s accounting firm, investment bankers, and financial advisorscame up with three different methods to finance each possibleventure. For the casual footwear line, the commercial bank RomanManufacturing has been working with since the business waspurchased by Giuseppe in 1933 could make a loan for $3.25 millionat a fixed rate of 5% for a term of 10 years with monthly loanpayments of $17,447.90. However, there was a prepayment penalty of2% of the remaining balance of the loan if it were paid off in thefirst five years. For financing the athletic shoes line, Stefano,based upon Lorenzo’s recommendation, was considering using afinance company from Chicago. The loan would be for $2.25 millionfor 10 years at a rate of 6.5% without any prepayment penalties andat a monthly payment of $14,222.43. The financing for the purchaseof the Italian footwear company would be the costliest, morecomplicated, and, Stefano felt, have the highest amount of risk.The financing would be done using a split of corporate bonds,preferred stock, and issuing a new class of common stockspecifically designated for the purchase. Fifty percent of the $500million purchase would be using callable bonds with a couponinterest rate of 5% at a par value of $1,000 per bond and a term of30 years. The 250,000 issued bonds would pay interest semi-annuallyand, with Roman’s corporate tax rate at 34%, the after-tax interestrate on the issue would be 3.3%. The would have a market price of103 as a percentage of par. Twenty-five percent of the purchaseprice would be financed using non-cumulative preferred stock issuedwith a par value of $100 per share and paying dividends quarterlyat a rate of 10%. The cost of capital for the preferred stock issuewould be 7%. The other 25% of the cash to be raised would come fromthe sale of a new class of common stock at a projected price of$25.00 per share, not paying dividends for the first five years ofthe issue, no voting rights, and 5 million shares authorized to beissued. The investment bankers hired by Roman Manufacturing haveprojected that its ? would be 1.25, higher than Stefano and Lorenzowanted it to be. Also, T-bills are currently at a rate of 3%, whilethe market return rate is 9%. Another piece of the puzzle, andperhaps the most important, are the cash flows each venture couldpotentially bring to Roman Manufacturing, assuming a 10% discountrate. Lorenzo’s staff have come up with the following cashflows:

Year Casual ShoesAthletic Shoes House of NapoliShoes

1 ?$500,000 $850,000 $1,000,000

2 ?$400,000 $850,000 $1,500,000

3 $300,000 $850,000 $2,000,000

4 $500,000 $850,000 $2,500,000

5 $800,000 $850,000 $3,500,000

6 $900,000 $850,000 $4,500,000

7 $1,250,000 $850,000 $5,000,000

8 $1,500,000 $850,000 $5,500,000

9 $1,750,000 $850,000 $6,000,000

10 $2,000,000 $850,000 $6,500,000

While Roman Manufacturing is largely a family-owned company,with the Romano family controlling 51% of the firm’s voting stock,Stefano knew he would have to present management’s final decisionto the board of directors. For Stefano, there were still questionsand concerns that needed to be addressed which he listed in a memoto Lorenzo and requested an answer in one week.

1. What is the net present value (NPV) for each venture? Andbased on the principle of mutually exclusivity, which venture(s)should be accepted or rejected?

2. What is the internal rate of return (IRR) for each venture?Given that the company’s cost of capital is 10%, which venture(s)should be accepted or rejected?

3. What are the Payback Periods for each venture? Whichventure(s) should we accept given the company’s cutoff period ofthree (3) years?

4. By using the Capital Asset Pricing Model (CAPM), find therequired return on equity for the purchase of House of NapoliShoes.

5. Examine the proposed bond issue to be used in the acquisitionof House of Napoli Shoes and find its cost of debt using the yieldto maturity.

6. Given the weights of the equity portion (both preferred andcommon stock) and debt in the capital structure for the House ofNapoli Shoes venture let me know what is Roman’s weighted averagecost of capital involving the deal.

7. What do you think are the best financial decision rules thatshould be used in order to make a correct decision for the threepossible ventures?

8. Are there any key questions that should be considered? 9. AsCFO, which of the three ventures do you think Roman Manufacturingshould