Problem 1 - Your firm, Southern Comfort Corp. (SCC) has $1 billion of capital invested in several telecommunication projects, which are expected to generate a pre-tax operating profit of $170 million next year. SCC has an estimated pre-tax cost of capital of 15 percent.
Show your calculations for the scenarios.
a. What is the pre-tax economic value added (EVA) that SCC is expected to generate next year? Calculate EVA first based on pre-tax operating profit and then based on expected return on invested capital.
b. SCC is considering five possible actions, which should improve its expected pre-tax EVA. These are as follows:
1. A $10 million reduction in operating expenses that should not affect revenue.
2. A $60 million reduction in invested capital that should not affect operating profit.
3. A re-examination of its capital structure (debt-to-equity ratio) that could lower its pre-tax cost of capital to 14 percent.
4. The sale of assets at their book value of $100 million. These assets are expected to generate a pre-tax operating profit of $10 million next year.
5. The acquisition of assets of $100 million. These assets are expected to generate a pre-tax operating profit of $10 million next year.
Problem 2 - Your firm is considering a proposed project, which lasts three years and has an initial investment of $200,000. The after-tax operating cash flows (OCFs) are estimated at $60,000 for year one, $120,000 for year two, and $135,000 for year three. The firm has a target debt/equity ratio of 1.2. The firm's cost of equity is 14 percent and its cost of debt is 9 percent. The tax rate is 34 percent. Please answer the following:
a. Calculate the net present value. Should the firm accept the project?
b. Calculate the profitability index. Should the firm accept the project?
c. Calculate the payback method. Should the firm accept the project?
Problem 3 - Charles-Baker, International, Inc. expects sales to increase to $36 million next year from $27 million this year. Its current assets are $9 million, accounts payable is $2.7 million, fixed assets are $9 million, long-term debt is $3.6 million, owners' equity is $11 million, and the earnings after tax-to-sales ratio is 5 percent. Current assets and accounts payable can be assumed to increase in the same proportion as sales. Other current liabilities are expected to stay at the same level. Net fixed assets will increase by $1 million and the firm plans to pay $800,000 as dividends.
a. What are Charles-Baker, International, Inc.'s total financing needs for next year?
b. How much money would the firm have to borrow to finance its needs?