Financial Management Assignment
Learning outcome: Students will apply capital budgeting techniques and evaluate investment decisions.
Key element -
(a) Capital budgeting techniques
- Time value of money
- Net present value
- Internal Rate of Return
- Payback period
(b) Critical factors influencing investment decisions
- Capital rationing or unlimited funds
- Independent and Mutually exclusive projects
- Expansion or replacement projects
(c) Accounting for risk investment decisions:
- Expected return
- Standard deviation
- Coefficient of variation
Question 1: Time Value of Money
Sandoz Ltd has $ 100,000 with the opportunity to invest in any viable project. There are two opportunities available for the company. These are Project A and Project B. The cost of capital is 12%. The expected cash flows for both projects are outlined below for years 1 to 5:
|
Year
|
Project A
|
Project B
|
|
1
|
$70,000
|
$45,000
|
|
2
|
$45,000
|
$45,000
|
|
3
|
$35,000
|
$45,000
|
|
4
|
$50,000
|
$45,000
|
|
5
|
$25,000
|
$45,000
|
|
Total
|
$225,000
|
$225,000
|
1. Calculate the present value of each cash flow stream of Projects A and B.
2. The CEO of the company realises the potential of both investment opportunities having total cash flows of $225,000 each. Explain to him which project is favourable for the company and explain why.
Question 2: Internal Rate of Return
Sandoz Ltd also want to calculate an alternative sophisticated capital budgeting technique; the Internal Rate of Return (IRR) for the two projects (Projects A and B) referred in Question 1 and they ask for your advice as they want to know about IRR.
1. Calculate the Internal Rate of Return (IRR) for the two projects manually.
2. On the basis of your IRR results, advices to the company which project is a better investment option for them and give suitable justification.
Question 3: Payback Period
Creative Solution Company is evaluating two mutually exclusive projects; project A or project B. The company uses payback criteria of three years or less. Project A involves an initial investment of $300,000 and Project B has an initial investment of $250,000. The following are the yearly net cash flows expected from each project:
|
Year
|
Project A
|
Project B
|
|
1
|
$90,000
|
$45,000
|
|
2
|
$90,000
|
$54,000
|
|
3
|
$90,000
|
$65,000
|
|
4
|
$90,000
|
$74,000
|
|
5
|
$90,000
|
$85,000
|
1. Calculate the payback period for project A and project B to two decimal places.
2. Which project meets the company's payback criteria?
Question 4: Capital rationing
The Financial Controller of Centro Infrastructure Limited is reviewing the investment have proposals for the coming year. Five proposals with a total investment of $460,000 have been received from several different branch offices. Given budget constraints, only $250,000 will be available for undertaking new investments Cost of capital is 10%. The following data relates to the different projects:
|
Project
|
Initial Investment
|
IRR
|
NPV k = 12%
|
|
A
|
$50,000
|
25%
|
$20,500
|
|
B
|
$80,000
|
20%
|
$35,000
|
|
C
|
$120,000
|
18%
|
$7,000
|
|
D
|
$80,000
|
12%
|
$18,000
|
|
E
|
$130,000
|
8%
|
$45,000
|
1. Determine which projects should be undertaken to ration $250,000.
2. Make your recommendation top Centro Infrastructure Limited the combination of projects with your justification.
Question 5: Net Present Value, Payback Period and Mutually Exclusive Projects
Calitrope Ltd is considering two mutually exclusive projects; Project A or Project B. Project A involves an initial investment of $150,000 and a terminal value of 0. Project B has an initial investment of $120,000 but has a terminal value of 30,000. The following are the yearly net cash flows expected from each machine:
|
Year
|
Project A
|
Project B
|
|
1
|
$45,000
|
$35,000
|
|
2
|
$45,000
|
$38,000
|
|
3
|
$45,000
|
$36,000
|
|
4
|
$45,000
|
$48,000
|
|
5
|
$45,000
|
$50,000
|
1. Calculate the payback period for project A and project B to two decimal places.
2. Using a 20% cost of capital, calculates the Net Present Value (NPV) for each of the projects and provide a recommendation to the Company as to which machine to purchase.
3. Would your recommendation to the Company change if the business had unlimited funds and the two machines were independent projects rather than mutually exclusive? Explain.
Question 6: Expansion or Replacement of Project
You are operating an old machine that is expected to produce a cash inflow of $8000 in each of the next two years before it fails. You can replace it now with a new machine that costs $30,000 but is much more efficient and will provide a cash flow of $18,000 each year for years. Should you replace your equipment now? The discount rate is 15%.
Question 7: Expected Returns, Standard Deviation and Coefficient of Variation
Steve Georgesis is considering an investment in one of two shares with following Probabilities of returns:
|
Share M
|
Share P
|
|
Probability
|
Return
|
Probability
|
Return
|
|
0.30
|
12%
|
0.10
|
5%
|
|
0.40
|
16%
|
0.30
|
7%
|
|
0.30
|
20%
|
0.40
|
11%
|
|
|
|
0.20
|
16%
|
1. Calculate the expected return for each of the two shares to two decimal places.
2 Calculate the standard deviation for the two shares manually.
3. Calculate the coefficient of variation for the two shares.
4. Which share would you consider more risky for Henry and why?
Learning Outcome - Students will examine capital structure and calculate the cost of capital.
Key element -
(a) Debt and Equity consideration: Financial/ Non-financial factors
(b) Cost of Capital: Cost of equity/debt
- Weighted average cost of capital (WACC)
- Capital Asset Pricing Model (CAPM)
(c) Capital Structure decisions: Determination of optimal capital structure
Question 8: Capital Asset Pricing Model (CAPM)
A mutual fund manager expects her portfolio to earn a rate of return of 12% this year. The beta of her portfolio is 0.6. If the rate of return available on risk free assets is 6% and you expect the rate of return on the market portfolio to be 12%, should you invest in this mutual fund?
Question 9: Cost of Capital
Mudvayne Company, a major woodcraft manufacturer, is contemplating selling one million worth of 20-year, 10% coupon bonds, each with a face value of $1,250. Since similar -risk bonds earn returns greater than 10%, the firm must sell the bonds for $965 to compensate for the lower coupon interest rate. The flotation costs paid to the investment banker are 2.5% of the face value of the bond. The company has a 35% tax rate.
Required:
a) Calculate the cost of debt before tax.
b) Calculate the cost of debt after tax.
Mudvayne is also considering a 10.5 % preference share issue. The shares sell at their par value or $3.00 per share and the issue cost per share is $ 0.20.
Required:
c) Determine the net proceeds of the sale of preference share.
d) Calculate the cost of preference capital.
Question 10: Weighted Average on Cost of Capital
Tasman Corporation has a target capital structure of 60 percent common stock, 5 percent preferred stock, and 35 percent debt. Its cost of equity is 12 percent, the cost of preferred stock is 5 percent, and the before-tax cost of debt is 7 percent. The relevant tax rate is 35 percent.
a. What is Tasman's WACC?
b. The company president has approached you about Tasman's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president?
Question 11: Optimal Capital structure
Tata Sky Limited has made the following forecast or sales with the associated probability of occurrence noted.
|
Sales
|
Probability
|
|
$300,000
|
.20
|
|
400,000
|
.60
|
|
500,000
|
.20
|
The company has fixed operating costs of $140,000 per year, variable operating cost represent 30 percent of sales. The existing capital structure consists of 30,000 ordinary shares that have a $ 10 per share book value. No other capital items are outstanding. The market place has assigned the following discount rates to risky EPS:
|
Coefficient of variation of EPS
|
Estimated required return, ks
|
|
.4743
|
16%
|
|
.5060
|
17%
|
|
.5581
|
18%
|
|
.6432
|
24%
|
The company is contemplating shifting its capital structure by substituting debt in the capital structure for ordinary shares. The three different debt ratios under consideration are shown in the following table, along with an estimate of the corresponding require interest rate all debt.
|
Debt ratio
|
Interest rate on all debt
|
|
20%
|
10%
|
|
40%
|
12%
|
|
60%
|
14%
|
The tax rate is 40 percent. The market value of the ordinary share equity for a leverage firm can be found by using the simplified method.
a) Using the highest probability of occurrence of forecasted sales; calculate three expected earnings per share (EPS) for three proposed capital structures.
b) Determined the optimal capital structure, assuming (1) maximization of earnings per share and (2) maximization of share value.