Task 1 -
Your company is considering two mutually exclusive capital projects. The details of the projects are set out below:
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Project A
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Project B
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Initial capital investment
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$600,000
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$800,000
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Annual net cash inflow (before tax)
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$260,000
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$360,000
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Depreciation method and rate
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20% straight line
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20% straight line
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Effective life of the asset
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5 years
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5 years
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Residual value after 5 years (for depreciation)
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0
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0
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Company tax rate
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30%
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Weighted average cost of capital
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16%
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Board's internal rate of return required
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25%
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Residual / Salvage Value
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Nil
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Calculate for each project:
(a) The annual Net Profit after Tax
(b) The annual Cash Flow after Tax
Task 2 -
Your company is considering two mutually exclusive capital projects. The details of the projects are set out below:
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Project C
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Project D
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Initial capital investment
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$350,000
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$400,000
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Annual net cash inflow (after tax)
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$120,000
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$155,000
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Annual net profit (after tax)
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$50,000
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$75,000
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Effective life of the asset
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5 years
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5 years
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Weighted average cost of capital
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16%
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Board's internal rate of return required
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23%
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Residual / Salvage Value
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Nil
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1. Calculate for each project:
a) Payback period
b) Accounting rate of return (ARR) based on original investment only
c) Net present value (NPV) of the discounted cash flows
d) Internal rate of return (IRR)
2. Since they are mutually exclusive projects, which alternative would be selected for each evaluation method?
3. The board of directors have specified that any capital project must achieve a payback period of no longer than 3 years and an accounting rate of return no less than 16%. Based on each board criterion, would you accept or reject either project? Consider each criterion separately in your answer.
4. Using both the NPV and the IRR results, determined in part 1, would you accept or reject either of the projects? Give your reasons in your answer.
5. When making capital budgeting decisions, businesses may also need to consider non-financial and ethical information before making a decision. List one of these non-financial or ethical considerations.
Task 3 -
Moving Freight Limited purchased a locomotive four years ago.
Information relating to the existing locomotive:
- It was purchased 4 years ago for $4,050,000
- It had an expected life of 9 years
- There was no expected residual for depreciation calculations
- The expected disposal value at the end of 9 years was estimated at $1,000,000
- The current disposal value is estimated at $2,500,000
They have received a proposal for a new locomotive to replace the current one now. The proposal consists of:
- $5,000,000 for the new locomotive (including all delivery costs)
- The new locomotive is considered to be more fuel efficient and is expected to save $600,000 per year in fuel and maintenance costs
- The new locomotive has an estimated life of 5 year
- There is no residual value used for depreciation calculations
- At the end of 5 years, the estimated disposal value is $1,500,000
Other information relevant to the decision:
- Depreciation method is straight line
- Company tax rate is 30%
- The Weighted Average Cost of Capital (WACC) is 10%
- Tax effects occur in the same year as the income/expense
Required:
(i) Calculate the NPV of the cash flows for the existing locomotive
(ii) Calculate the NPV of the cash flows of the new locomotive proposal
(iii) Recommend which option should be adopted based on the results of the NPV calculations.
Task 4 -
Part A - For each of the following movements in ratios, provide at least two (2) possible reasons for the movement in each ratio (1 to 5) for one year to the next:
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Year 20X1
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Year 20X2
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1.
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Current ratio
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2.0 : 1
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2.5 : 1
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2.
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Gross profit ratio
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45%
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40%
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3.
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Inventory turnover rate
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6 times per year
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5 times per year
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4.
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Debtor turnover rate
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40 days
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45 days
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5.
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PE ratio
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12times
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13times
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Part B - In each of the following examples the ratio has deteriorated from one year to the next. For each case, provide at least one (1) recommendation that you would make to management to correct the trend in the ratio:
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Year 20X1
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Year 20X2
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(a)
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Debtor turnover rate
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30 days
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45 days
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(b)
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Net profit ratio
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25%
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20%
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(c)
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Debt to equity ratio
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40%
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50%
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(d)
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Time interest coverage
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5 times
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4 times
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(e)
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Return on equity
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20%
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17%
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Part C - For the following actions taken by the management of the company, indicate how it would affect the identified ratio (unless specified assume that all other aspects of the financial
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Action taken
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How is this ratio affected
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(a)
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Gross profit ratio improved by reducing cost of sales
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Earnings yield
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(b)
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Debt repaid by issuing new ordinary shares
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Times interest coverage
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(c)
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Reduced debtor turnover rate by improved debt recovery procedures
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Current ratio
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(d)
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Borrowed funds to use for redevelopment of the business in the future (i.e. funds acquired but not yet spent)
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Liquid ratio
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(e)
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Instead of paying a dividend, the funds were retained for expansion of the business
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PE ratio
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Part D - Your Manager has asked you what the Net Profit is for the period, calculate the Net Profit ratio. What Accounting Software would you use and what report did you print to calculate this ratio. To complete this question you must include in your submission a copy of the report you used.
Task 5 -
Cozy Coaches needs to acquire a new coach. They have the option of leasing the new coach or buying it outright.
The lease proposal involves:
- A five year lease
- Payments of $100,000 at the beginning of each year
- A final residual payment at the end of the 5th year of $500,000
- No residual value for depreciation calculations
- A possible resale value, if sold after 5 years, of $200,000
If the company chooses to buy the coach, it involves:
- An initial cost of $800,000
- Depreciation, on a straight line basis over 5 years
- No residual for depreciation calculations
- A possible resale value after 5 years of $200,000
- The cost of the coach will be finance with a deposit of 20% by the company and the balance financed with an interest only loan at 10%
- Interest is payable at the end of each year
- The loan principal is repaid at the end of 5 years
Other information relevant to the decision:
- Company tax of 30% is payable at the end of each year
- Cost of capital is 10% per annum
- The coach will be sold at the end of 5 years, regardless of which option is chosen.
Required:
(i) Calculate the NPV of the lease proposal.
(ii) Calculate the NPV of the purchase proposal.
Recommend, based on the NPV, which option should be chosen.
Task 6 -
Hale & Pace Ltd have raised funds from the following sources:
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9.5% debentures
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$80,000
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8% preference shares
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$10,000
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Ordinary shares fully paid to $1
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$ 5,000
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Earnings before interest and taxes are currently $16,000. The company is required to raise $20,000 for expansion and is considering either issuing more ordinary shares at a market value of $1.60 or offering 11.5% debentures. The following estimates of earnings before interest and taxes have been calculated if the expansion proceeds.
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EBIT ($000s)
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Probability of occurrence
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15
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0.10
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18
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0.25
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20
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0.45
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25
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0.20
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Tax is 30% on profits.
(i) What are the earnings per share under each estimated level of EBIT if shares are issued?
(ii) What are the earnings per share under each estimated level of EBIT if debt is used?
(iii) What are the expected earnings per share under each alternative?
(iv) What is the coefficient of variation of EPS under each alternative?
(v) Which alternative would you choose?
(vi) Which alternative is more risky?
(vii) Calculate the indifference point (IP) between the Share option and the Debenture option.
(viii) Demonstrate by calculating the EPS for the Share option and the Debenture option that the indifference point is correct (it doesn't matter what level of EBIT you choose).
Task 7 -
Part A - Possible returns on shares in two companies Bowden and Moore are listed as follows:
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State
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Probability of occurrences
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Possible Returns
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Bowden
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Moore
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Boom
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0.40
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0.28
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0.20
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Normal
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0.40
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0.18
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0.16
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Recession
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0.20
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0.16
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-0.04
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(c) Calculate the following:
The weighted average of the standard deviations of the expected returns for Bowden and Moore.
The standard deviation of expected return of a portfolio comprised of half Bowden shares and half Moore shares.
(d) Compare you answer to part (a) (i) with your answer to part (a) (ii). What does the difference suggest to you?
Part B -
(i) List 3 assumptions made by the Capital Asset Pricing Model
(ii) Define the risk free rate
(iii) Explain Beta in relation to both the risk free rate and the market portfolio
Part C - From the following diagram, identify the points or areas on the diagram indicated from A to G.
Part D -
(i) Calculate the expected return of the following companies based on their beta coefficient and risk free rate of 5% and an expected return on a market portfolio of 15%:
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Company
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Beta Coefficient
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(i)
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Red
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1.15
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(ii)
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Blue
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0.99
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(iii)
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Yellow
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0.75
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(ii) Briefly explain the relationship between the company returns calculated in (i) and the expected return of the market portfolio.
Task 8 - Investment Options
Debt and Equity (ordinary shares) have certain distinguishing characteristics. In the table below, mark which characteristics are debt, which are equity and which are both (tick each column)
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Characteristic
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Debt ?
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Equity ?
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1
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Capital growth a component
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2
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Defined return
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3
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Dilutes ownership
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4
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Direct investment giving part ownership in a company
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5
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Does not involve giving up part of ownership in issuer
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6
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Earnings paid to holders are not tax deductible by the issuing
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company
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7
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Earnings paid to holders are tax deductible by the issuing
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company
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8
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Either short or long term
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9
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Face value has little relevance
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10
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Face value paid on maturity
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11
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Fixed maturity date
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12
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Indirect investment in the form of a loan
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13
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Negotiable (ownership may be transferred)
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14
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Return depends upon risk factor of issuing company
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15
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Return not fixed
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16
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Secured (usually)
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17
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Unlimited life
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18
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Unsecured
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19
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Usually a secondary market exists
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20
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Usually preferential treatment if issuing company become less
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profitable
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21
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Voting rights may be attached
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Task 9 - Risk and Ethics
Please comment on how the following ethical dilemmas could be resolved (if any exist):
I. You are a business manager assessing applications for a position vacant in your organisation. One of the applicants is your nephew who you have mentored for many years and would like to give him a start in your company.
II. Your business (established thirty years ago) has been struggling financially and may have to close down with twenty long-term employees losing their jobs.
Now, a product from an offshore supplier has been sourced for exclusive distribution domestically that will give the business huge profit margins and save it from closure. Sales and distribution will commence as soon as practical.
A friend returning from overseas mentioned rumours he heard about serious consumer health issues with the product in its home country.
So far, locally, there have been no comments regarding these overseas issues and the sale of this type of product domestically currently has no restrictions.
Summarise all the risks you are able to identify in the above in the form of a simple Risk Register
Keys - Likelihood: 4 Very likely ... 1 Very unlikely
Consequence - 5 Critical ... 1 Insignificant
Level of Risk: likelihood x consequence
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Risk identified
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Likelihood
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Consequences
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Level of Risk
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Task 10 - Types of Risk
For each of the following multiple choice questions, select the answer that is most appropriate. Deduct 2 marks for each incorrect answer.
Compliance with the Australian Standard for risk management is mandatory
The "risk appetite" of a business is set by its customers
Liquidity Risk is the risk that a business will not be able to pay its debts as and when they fall due
All assets in the form of listed securities are liquid
Keeping large amount of cash on hand may assist in avoiding liquidity risk
A policy to maintain large cash balances to avoid liquidity risk may increase the risk that the business fails to take advantage of market opportunities
Risk is something a business must always avoid
When choosing an option in your risk strategy, the one with the best financial outcome is the best
A system of internal controls removes all risks to the business
The reputation of a business is a critical factor in determining and maintaining its value
If a perceived credit risk is taken by a business, it should expect a higher return to compensate
A business considers a customer to be a high credit risk. It should sell more to that customer because the additional profit would compensate for the increased risk