Task 4
An aspect of investment analysis that you and your team had thought about was the different outcomes that may happen when managing projects and how to adjust management's expectations for return in light of the real options or probabilities that alternative scenarios may develop depending on available information.
You determine the best activity for your team to explain this to the CFO and management is to use a real example from a project you are currently evaluating.
The most recent example was the company decision whether to invest $50 Million in developing and implementing a new enterprise system to help manage resources and meet customer demand in the face of considerable technological and market uncertainty.
There can be a good and bad result for this investment.
Good Result: A good result has a probability of .5 of occurring. Here the planned cost reductions have been realized and better integration of the supply chain is possible. These benefits are leveraged by strong market demand for the firm's product. There have also been feedback benefits, the enterprise system has significantly improved perceived quality and service from the customer's point of view. Annual benefits under this scenario equal $15 million in after tax cash flow per year over the life of the system which has been estimated as 10 years.
Bad Result: The system proves to be more difficult to implement and improvements in management of the supply chain are less. In addition, the growth in market demand for the product is lower. Annual benefits under this scenario are $2 million in after tax cash flow per year for the 10 years.
Real Options: For these capital investments you must analyze the nature of risk in this capital investment and decide on how to adjust for that risk. You have decided to utilize an NPV analysis of the project. Now you must define project risks and utilize the concepts in real options to adjust or plan for that risk.
It will be best for you to provide an option tree graphic to show the options and then provide a table with the computations showing how you would compute the value of this project.
Scenario #1: Use 10% cost of capital in computations and compute the good result and poor result NPVs. Calculate the real option NPV using the results computed.
Scenario #2: Use a risk adjusted cost of capital against the good scenario above which can adjust for risk variables such as; experience with the focus of the project, chance of change to estimated variables (revenue, costs, timing, etc) and/or the potential change in cost of capital in the future.
Compute the new NPV using a variety of risk adjusted discount rates. Justify your computations in determining how you have adjusted discount rates for risk. Discuss the outcomes from your adjustments and how you would apply them in capital expenditure justification.
Concept Check: Risk in finance is deviation from expectation. We use this concept in computing beta by mathematically computing the Security Market Line (SML) for assets and then computing the deviation of the individual assets against the market. The utilization of real option analysis in project evaluation is similar to these concepts and the concept of weighted average cost of capital.
Helpful Hint: Risk adjustment in project management can be achieved in several manners. In the case of real options we first need to identify the different paths our investments can take and then the probability that each event may occur.
Task 5:
This leads the CFO to ask you team to look at how the market value of ACME is compared to the industry and research how you can show not only this value but come up with justification for the capital investments being made.
Your team discusses this and has determined EVA (Economic Value Added) as well as MVA (Market Value Added) concepts need to be established for the corporation.
Use the following table as a guide:
| |
Shares
Outstanding
|
Stock Price |
Market Capitalization |
Debt & Equity (2015) |
WACC |
EBIT |
Net Earnings |
|
Industry Average
|
25,000,000
|
$ 27.75
|
$ 693,750,000
|
675,000,000
|
13%
|
$ 17,975,000
|
$ 15,000.000
|
|
Competitor 1
|
20,000,000
|
$ 35.00
|
$ 700,000,000
|
$ 695,455,000
|
15%
|
$ 18,255,000
|
5 15,000,000
|
|
ACME Iron
|
15,000,000
|
$ 27.50
|
$ 412,500,000
|
$ 300,423,000
|
12*
|
$ 10,742,000
|
$ 7,045,000
|
*12% here is a plug number. This will be different than the number you calculated in Task 3.
•Compute the P/E ratio and market capitalization for everyone.
•Compute the MVA and EVA for all.
•Compare and contrast the ratios; what do the ratios convey to the investing public? How would you present these internally and externally? Make recommendations to management from your analysis.
Concept Check: Market value added focuses on the market price and relation to invested capital while economic value is based on operational profitability compared to invested capital. These measures help us evaluate our organization internally and externally to help identify gaps and opportunities.
Helpful Hint: Ratios, by themselves, tell us very little; it is only when they are placed in context of the market, industry or competition that they truly can be powerful.
Task 6
Leasing: You are to use your critical thinking skills, collaboration techniques, creative problem solving tools and communication skills under the following scenario:
Your company (Acme Iron) is considering leasing a new computer, you and your team need to perform analysis to support the decision making process. The lease lasts for 9 years. The lease calls for 10 payments of $10,000 per year with the first payment occurring immediately. The computer would cost $70,650 to buy and would be straight-line depreciated to a zero salvage over 9 years. The actual salvage value is negligible because of technological obsolescence. The firm can borrow at a rate of 8%. The corporate tax rate is 30%.
1. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in years 1-9?
2. What is the after-tax cash flow from leasing relative to the after-tax cash flow from purchasing in year 0?
3. What is the NPV of the lease relative to the purchase?
4. What would the after-tax cash flow in year 9 be if the asset had a residual value of $500 (ignoring any possible risk differences)?
5. Do you have a recommendation?
Concept Check: Understanding which cash flows are relevant is key to determining best financing methods or project acceptance. It helps to detail all you assumptions within the model since questions may arise years after the initial construction of the model.
Helpful Hint: Creating a time-line with corresponding cash flows is usually helpful. You should also do the NPV calculations showing your formula so if anyone wishes to change the variables they will know how to proceed.
Task 7
In your discussions with the CFO you have talked about the impact of a dividend on your company's market price and financial statements. He has asked that you and your team evaluate the impact of issuing a dividend.
Use the income statement and balance sheet provided to make recommendation for the amount of dividend (if any). How are retained earnings impacted and what does this mean for the organization?
•Compute the Internal Growth Rate and Sustainable Growth Rate using current (2015) financial information and then a second scenario; if we issue a dividend payment of $3 million.
•Explain your thought process and rationale for a recommended dividend strategy.
Concept Check: Dividends are distributions of profits to your investors who placed their capital at risk for you. Theoretically every company should eventually provide a dividend distribution to their investors.
Helpful Hint: Dividends are voted on every quarter by the Board of Directors for a company; the amount of the dividend or if any is paid can be decided at that time.
Task 8:
Share repurchase proposal: Currently, the firm has available capital (cash and net income) of approximately $5,000,000. There is a large block of stock available at $25 a share.
If the firm decides to spend this amount of excess cash on a share repurchase program, how many shares of stock will be outstanding after the stock repurchase is completed?
•What are the benefits of repurchasing shares? How will this affect the capital structure of the company? How can this be interpreted in the marketplace?
•Would a dividend be better? Please discuss the pros and cons of dividends and share buybacks. Make a recommendation to management.
Concept Check: There are tax ramifications which tend to get very complex; for the sake of this exercise let us disregard tax implications and effects.
Helpful Hint: Think about the impact on the ratios that companies usually are measured by in the marketplace. Look at these policies through the eyes of current and potential investors as well as management of ACME.
Task 9:
Evaluation of potential acquisition: Martin & Sons has $4.2 million in net working capital. The firm has total assets with a book value of $48.6 million and a market value of $53.4 million. They currently carry no debt on their balance sheet, sales are expected to be $45 million next year, and their tax rate is similar to ACME at 40%. Through a mixture of synergistic savings and increased market share this acquisition should add $2 million in net profit per year for the next 10 years. Acme Iron is considering buying the company for $60 million in cash. The acquisition will be recorded using the purchase accounting method.
• What is the amount of goodwill that Acme will record on its balance sheet as a result of this acquisition?
• How do you recommend the firm finance this transaction?
• Is there a danger that ACME could damage their finances to the point that bankruptcy is a potential?
Concept Check:
5-factor model of the Altman Z-score (a for private manufacturing firms):
Z-score = 0.717T1 + 0.847T2 + 3.107T3 + 0.42T4 + 0.998T5
where,
T1 = Working Capital / Total Assets T2 = Retained Earnings / Total Assets T3 = Earnings before Interest and Taxes / Total Assets T4 = Equity / Total Liabilities T5 = Sales / Total Assets
Zones of Discrimination:
- 23 or less - "Distress" Zone
- from 1.23 to 2.9 - "Grey" Zone
- 9 or more - "Safe" Zone
Interpretation of Altman Z-Score
The Z-Scores are helpful in predicting corporate defaults as well as an easy-to-calculate measure of control for financial distress status of companies in academic studies. A Z-Score above 2.6 (2.9) indicates a company to be healthy. Besides, such a company is also not likely to enter bankruptcy. However, Z-Scores ranging from 1.1-2.6 (1.23-2.9) are taken to lie in the grey area.
Attachment:- Task-.rar