Assignment:
Smiths and sons is a company selling car springs. The new owner needs to be educated in corporate finance. The areas under construction are:
• Portfolio theory
• Capital budgeting
• Financing
• Dividend policy and risk.
Problem 1:
Part A:
Mr smith is considering whether to established a new subsidiary in Cyprus. The estimated cost of fixed asset investment would be £2,000,000 in total, with £1,500,000 payable at once and the remainder payable after one year. A further investment of £600,000 in working capital would be required.
Mr. Smith expects all the company investments to justify themselves financially within a four year planning horizon. The net disposal value of the fixed assests after four years is expected to be 0.
The operation would incur fixed costs of £950,000 a year in the first year, including depreciation of £300,000. These costs, excluding depreciation, are expected to increase by 5% each year because of inflation. The operation would involve the manufacturer and sale of standard unit, with a unit selling price and unit variable cost of £12 and £6 respectively in the first year and expected annual increases because of inflation of 4% and 7% respectively. Annual sales are expected to be £125,000 units. Inflation is ignored from the calculations.
The company’s money cost of capital is 15%.
Is the project viable?
Part B:
a) What are the characteristics of a good proposal?
b) List the key variables which are important when estimating the cash flows for the discounting purposes
c) How do you account for uncertainty and risk relating to such variables?
d) Identify reasons for the degree of interdependency between the projects and its importance when evaluating the projects.
e) How much reliance can we place on the decision arrived at using the investment appraisal?
Problem 2:
Smith has surplus cash and is keen to diversify into other businesses as he learnt recently that “putting all your eggs in one basket” is not a good idea. He has identified two companies, whose shares are quoted on the London stock market, which he believes will exhibit negative correlation in their possible returns over the next year, as follows:
|
State
|
Probability
|
Expected rate of return A
|
Expected rate of return B
|
|
1
|
0.28
|
25%
|
14%
|
|
2
|
0.47
|
20%
|
18%
|
|
3
|
0.25
|
22%
|
12%
|
Required:
a) Comment on the strategy Mr Smith has identified to reduce risk and over reliance in his own business.
b) Calculate the expected return, variance and standard deviation of each security.
c) Define correlation the correlation coefficient, p, and explain its uses; Mr smith has been informed by his contact that the correlation coefficient between the two companies is +0.5, explain its significance.
d) Construct Portfolios consisting of:
i. 70% in A shares and 30% in B shares
ii. 50% in A shares and 50% in B shares,
iii. 20% in A shares and 80% in B shares.
Comment on the results obtained.
Problem 3:
a) Mr smith never believed in borrowing external sources and when his newly appointed young accountant informed him that it is better for the company to introduce debt into firm’s capital structure, Mr Smith was rather confused. Therefore, you are required to explain the capital structure debate and summarise reasons to why debt leads to reductions in firms cost and how come cost of equity is higher than cost of debt?
Problem 4:
Smith and son is not a listed company; it is owned by small number of shareholders, mostly family and friends. In the past Mr Smith normally decided how much profit should be distributed amongst the shareholders. However, the more younger shareholders, who have attended university, have become much more vociferous and have demanded greater share of profit to be distributed in forms of dividends. Mr. Smith believes whatever is owned by the business belongs to all the shareholders so it does not matter whether money is held in reserves or re-invested or given out to shareholders. At annual general meeting, the phrases such as “one in hand is better than two in bushes, risk is greater if dividends are not received”, etc were heard. Therefore, Mr. Smith has invited you to write a brief summary of the key debate relating to dividend policy.
Problem 5:
“Managers personal objectives are as important as those of other stakeholders”.
Discuss.