QUESTION 1:
Vergas Enterprises wishes to determine the economic order quantity (EOQ) for a critical and expensive inventory item that it uses in large amounts at a relatively constant rate throughout the year. The firm uses 450 000 units of the item annually and has order costs of R375 per order; its carrying costs associated with this item are R28 per unit per year. The firm plans to hold safety stock of the item equal to five days of usage, and it estimates that it takes 12 days to receive an order of the item once placed. Assume a 365-day a year.
a. Calculate the firm's EOQ for the item of inventory described above.
b. What is the firm's total cost based upon the EOQ calculated in part?
c. How many units of safety stock should Vergas hold?
d. What is the firm's reorder point for the item of inventory being evaluated? (Hint: Be sure to include the safety stock)
QUESTION 2:
Cascade Water Company (CWC) currently has 30 000 shares of common stock outstanding, trading at a price of R42 per share. CWC also has 500 000 bonds outstanding that are currently trading at R923.38 per bond. CWC has no preferred stock outstanding and has an equity beta of 2.639. The risk-free rate is 3.5%, and the market is expected to return 12.52%.
CWC is considering adding ‘healthy' bottled water geared toward children to its product mix. The initial outlay for the project is expected to be R3 000 000, which will be depreciated using the straight-line method to a zero salvage value, and sales are expected to be 1 250 000 units per year at a price of R1.25 per unit. Variable costs are estimated to be R0.24 per unit, and fixed costs of the project are estimated at R200 000 per year. The project is expected to have a three year life and a terminal value (excluding the operating cash flows in year three) of R500 000. CWC operates in a 34% marginal tax rate. For the purposes of this project, working capital effects will be ignored. Bottled water with a focus toward children is expected to have different risk characteristics from the firm's current products. As such, CWC has decided to use the ‘pure play' approach to evaluate this project. After researching the market, CWC managed to find two ‘pure-play' firms. The specifics for those two firms are:
Firm Equity Beta D/E Tax Rate
Equity Water 1.75 0.43 34%
Ladybug Drinks 1.84 0.35 36%
a. Determine the current weighted average cost of capital for CWC.
b. Determine the appropriate discount rate for the healthy bottled water project.
c. Should the firm undertake the healthy bottled water project? As part of your analysis, include a sensitivity analysis for sales price, variable costs, fixed costs, and unit sales +-10%, 20%, and 30% from base case. Also perform a scenario analysis assuming: the best case is to sell 2 500 000 units at a price of R1.24 each, with variable costs of production of R0.22 per unit; and the worst case scenario of selling only 950 000 units at a price of R1.32 per unit, with variable costs of production of R0.27 per unit.
Additional information not included in the mini-case (Question 2 of Assignment 2): The firm's bonds have a 20-year life, a R1 000 par value, a 10% coupon rate and pay interest semi-annually.
QUESTION 3:
Seattle Manufacturing is considering the purchase of one of three mutually exclusive projects for improving its assembly line. The firm plans to use a 14 percent cost of capital to evaluate these equal-risk projects. The initial outlay and annual cash flows over the life of each project are shown in the following table.
Project X Project Y Project Z
Initial Outlay (CF0) R 156 000 R 104 000 R 132 000
Year Cash Inflows (CFt)
1 R 34 000 R 56 000 R 30 000
2 50 000 56 000 30 000
3 66 000 - 30 000
4 82 000 - 30 000
5 - - 30 000
6 - - 30 000
7 - - 30 000
8 - - 30 000
a. Calculate the NPV for each project over its life. Rank the projects in descending order based on NPV.
b. Use the equivalent annual cost (EAC) approach to evaluate and rank the projects in descending order based on the EAC.
c. Compare and contrast your findings in parts and (b). Which project would you recommend that the firm purchase? Why?
QUESTION 4:
You have a R10 million capital budget and must make the decision about which investments your firm should accept for the coming year. Use the following information on three mutually exclusive projects to determine which investment your firm should accept. The firm's cost of capital is 12 percent.
Project 1 Project 2 Project 3
Initial cash outflow -R 4 000 000 -R 5 000 000 -R 10 000 000
Year 1 cash inflow 1 000 000 2 000 000 4 000 000
Year 2 cash inflow 2 000 000 3 000 000 6 000 000
Year 3 cash inflow 3 000 000 3 000 000 5 000 000
a. Which project do you accept on the basis of NPV?
b. Which project do you accept on the basis of PI?
c. If these are the only investments available, which one do you select?
d. Now assume that another independent project is available to you. This new project has a cost of R5 million, with an NPV of R1.5 million. Given the availability of this new project, which of the mutually exclusive projects do you accept?
e. Is the NPV or PI the better technique in the situation described in part (d)? Why?
QUESTION 5:
Jo - Lo Ltd, a South African exporter, sells car parts to the value of €150 000 (Euro dollars) on 1 July 2013 to a company in Italy. Payment is made to Jo - Lo on 1 August 2013. The following information is available:
Price in € Exchange rate Price in R
I July 2013 €150 000 €1 = R14.25 R2 137 500
1 August 2013 €150 000 Unknown Unknown
The forward Rand to € rate is trading at a Rand discount of 20% per annum.
Required:
a. Jo - Lo wants to take out forward cover. Calculate the forward rate and the value of the transaction as at 1 August 2013. Round to four decimal places.
b. Describe the effect on the transaction if on 1 August 2013 the R/€ rate is € 1 = 14.70 and Jo - Lo never entered into any forward cover contract.
QUESTION 6:
a. In capital budgeting analysis, why do we focus on cash flow rather than accounting profit?
b. Should the costs of evaluating a project be included as a portion of the project's cost?
c. Is the ability to use money allocated to a project for another purpose an example of a sunk cost?
d. Explain how depreciation creates a cash inflow even though there is no cash inflow or outflow associated with the depreciation deductions themselves.
e. Is a negative change in net working capital a problem (assuming profitability and sales are maintained)?