Concepts Learned to a Real-life Simulation Experience - Research Paper Example

?Task i) Air Jet Best Part is planning to purchase a factory in Mexico which amounts to $ 8 million. After careful deliberation, the company has decided to raise the funds required for the project through a combination of loan facility and by issuing corporate bonds. The finance department of the company has come up with two proposals, offered by two renowned commercial banks. The terms are as follows Bank APR Number of Times Compounded National First Prime Rate + 6.75% Semiannually Regions Best 13.17 Monthly In order to calculate EAR (Equivalent Annual Rate), the following formula is used In the above equation, ‘a’ is the annual equivalent rate of interest, ‘I’ is the annual periodic rate and ‘n’ is the annual period taken as one year. Now, on the right hand side of the equation, ‘e’ is taken as the number of times the interest is compounded. Now if we substitute the values in the equation we can get the following results. National First   Prime Rate 3.25% Floor Rate 6.75% Number of times compounded Semiannually i 0.1 e 2 a 10.25% Regions Best   Prime Rate 13.17% Number of times compounded Monthly i 13.17% e 12 a 13.99% (ii) Thus it is apparent from the above calculation that the company should borrow from National First Bank as it is charging interest at a lesser Equivalent rate which is 10.25%. If we suppose that the company acquires loan amounting to $ 8 million, then following will be the annual interest charge that the company will have to record in its income statement Loan Amount Bank Rate on interest Interest Charge $ 8,000,000 National First 10.25% $ 820,000.00 $ 8,000,000 Regions Best 13.99% $ 1,119,200.00 Thus it is apparent from the above calculation that in case of National First Bank, the company would have to pay lesser amount of interest as compared to that if the loan amount was obtained from Regions Best Bank. By adopting to obtain funds from National First, the company will save $299,200 on account of interest payments. (iii) Evaluating the proposal of Regions Best, the following formula is to be used (Figure a) The above mentioned formula is termed as the formula for ‘annuity’ in which “P” is the present value of the cumulative amount, “R” is the period payments, “I” is the period interest rate and “n” is the number of period for which the funds were borrowed. As per the terms decided with the Regions Best, the company will pay interest at 8.6% which shall be compounded monthly (that is why the ‘I’ in the formula of annuity has been divided by 12). Substituting the values we get P $ 6,950,000 i 8.60% n 5 years R $142,925 monthly Following is the loan schedule further explaining the computation Loan Schedule Months Opening Balance Annual Payments Interest Charged (8.6/12) Principal Paid Closing Balance 1 6,950,000 142,925 49,808 93,117 6,856,883 2 6,856,883 142,925 49,141 93,784 6,763,099 3 6,763,099 142,925 48,469 94,456 6,668,643 4 6,668,643 142,925 47,792 95,133 6,573,510 5 6,573,510 142,925 47,110 95,815 6,477,695 6 6,477,695 142,925 46,423 96,502 6,381,193 7 6,381,193 142,925 45,732 97,193 6,284,000 8 6,284,000 142,925 45,035 97,890 6,186,110 9 6,186,110 142,925 44,334 98,591 6,087,519 10 6,087,519 142,925 43,627 99,298 5,988,221 11 5,988,221 142,925 42,916 100,010 5,888,212 12 5,888,212 142,925 42,199 100,726 5,787,485 13 5,787,485 142,925 41,477 101,448 5,686,037 14 5,686,037 142,925 40,750 102,175 5,583,862 15 5,583,862 142,925 40,018 102,907 5,480,955 16 5,480,955 142,925 39,280 103,645 5,377,310 17 5,377,310 142,925 38,537 104,388 5,272,922 18 5,272,922 142,925 37,789 105,136 5,167,786 19 5,167,786 142,925 37,036 105,889 5,061,897 20 5,061,897 142,925 36,277 106,648 4,955,249 21 4,955,249 142,925 35,513 107,412 4,847,836 22 4,847,836 142,925 34,743 108,182 4,739,654 23 4,739,654 142,925 33,968 108,958 4,630,696 24 4,630,696 142,925 33,187 109,738 4,520,958 25 4,520,958 142,925 32,400 110,525 4,410,433 26 4,410,433 142,925 31,608 111,317 4,299,116 27 4,299,116 142,925 30,810 112,115 4,187,001 28 4,187,001 142,925 30,007 112,918 4,074,083 29 4,074,083 142,925 29,198 113,727 3,960,356 30 3,960,356 142,925 28,383 114,543 3,845,813 31 3,845,813 142,925 27,562 115,363 3,730,450 32 3,730,450 142,925 26,735 116,190 3,614,259 33 3,614,259 142,925 25,902 117,023 3,497,237 34 3,497,237 142,925 25,064 117,862 3,379,375 35 3,379,375 142,925 24,219 118,706 3,260,669 36 3,260,669 142,925 23,368 119,557 3,141,112 37 3,141,112 142,925 22,511 120,414 3,020,698 38 3,020,698 142,925 21,648 121,277 2,899,421 39 2,899,421 142,925 20,779 122,146 2,777,275 40 2,777,275 142,925 19,904 123,021 2,654,254 41 2,654,254 142,925 19,022 123,903 2,530,351 42 2,530,351 142,925 18,134 124,791 2,405,560 43 2,405,560 142,925 17,240 125,685 2,279,875 44 2,279,875 142,925 16,339 126,586 2,153,289 45 2,153,289 142,925 15,432 127,493 2,025,796 46 2,025,796 142,925 14,518 128,407 1,897,389 47 1,897,389 142,925 13,598 129,327 1,768,062 48 1,768,062 142,925 12,671 130,254 1,637,808 49 1,637,808 142,925 11,738 131,187 1,506,620 50 1,506,620 142,925 10,797 132,128 1,374,493 51 1,374,493 142,925 9,851 133,075 1,241,418 52 1,241,418 142,925 8,897 134,028 1,107,390 53 1,107,390 142,925 7,936 134,989 972,401 54 972,401 142,925 6,969 135,956 836,445 55 836,445 142,925 5,995 136,931 699,514 56 699,514 142,925 5,013 137,912 561,602 57 561,602 142,925 4,025 138,900 422,702 58 422,702 142,925 3,029 139,896 282,806 59 282,806 142,925 2,027 140,898 141,908 60 141,908 142,925 1,017 141,908 0 In order to analyze the financial viability of the two loan options offered by National First and Regions Best, we need to compare the interest payments that the company has to make in the two options. The base rate for National First Bank is 10%. By substituting the values in the formula given in Figure a, and assuming that the loan is for the tenure of 5 years, the semiannual payment is computed to be $ 900,057 (in this situation the ‘I’ will be divided by 2 as the payment is semiannually). Following is the comparison of the loan amortization schedule of the two banks. National First Months Opening Balance Annual Payments Interest Charged (10/2) Principal Paid Closing Balance 1 6,950,000 900,057 347,500 552,557 6,397,443 2 6,397,443 900,057 319,872 580,185 5,817,259 Total 667,372 Regions Best Years Opening Balance Annual Payments Interest Charged (8.6/12) Principal Paid Closing Balance 1 6,950,000 142,925 49,808 93,117 6,856,883 2 6,856,883 142,925 49,141 93,784 6,763,099 3 6,763,099 142,925 48,469 94,456 6,668,643 4 6,668,643 142,925 47,792 95,133 6,573,510 5 6,573,510 142,925 47,110 95,815 6,477,695 6 6,477,695 142,925 46,423 96,502 6,381,193 7 6,381,193 142,925 45,732 97,193 6,284,000 8 6,284,000 142,925 45,035 97,890 6,186,110 9 6,186,110 142,925 44,334 98,591 6,087,519 10 6,087,519 142,925 43,627 99,298 5,988,221 11 5,988,221 142,925 42,916 100,010 5,888,212 12 5,888,212 142,925 42,199 100,726 5,787,485 Total 552,586 As apparent from the above comparison, the loan option acquired from Regions Best is the better option as it results in interest charge of $114,786 in the first year. Task 2 (i) The Dividend growth model is a technique by utilizing which the market value of the share of a particular company or the required rate of return of the equity can be computed by substituting the other variables in the formula. (Figure b) In the above formula “E” is the market value of the company, “Do” is the latest dividend paid by the company, “g” is the dividend growth rate and “Ke” is the rate of return on equity. The competitor selected for the analysis of the share price is The Boeing Company. The Boeing has declared latest dividend which is $ 1.76 per share and its current market price is $74.50. Substituting all these values in the formula, the rate of return on the equity can be calculated. Do 1.76 per share g 5.00% E 74.50 Ke 2.48% Thus the rate of return for the Boeing Company is 2.48% (ii) Using the formula mentioned in Figure b, the current share price of Air Jet Best Parts can be computed as follows: Do 1.50 g 1.00% E 111.49 Ke 2.48% (iv) Increase in dividend creates a good signaling effect and is likely to increase the share price of the company. If the formula for the dividend growth model is analyzed it is actually the present value of the all the dividend that the shareholders of the company are likely to receive from the company assuming that the company pays constant dividend till perpetuity On the other hand, if the required rate of return increases, the share price of the company is likely to move downwards, this can also be analyzed from the formula in the Figure b. With the increase in the required rate of return for the shareholder, the maximum price that the share holder is willing to pay for the company will keep on decreasing. Task 3 (i) AirJet Best Parts have decided to raise the other half of the finances required for the factory in Mexico by raising funds through issuing a bond. Currently the company is offering coupon at the rate of 7.5% on the bonds currently in issue. In order to calculate the coupon rate at which the company should currently issue the bonds, the first step should be to calculate the required rate of return of the debt holders in the market. The required rate of return can be calculated by the following formula Where M is the market value of the bond currently on which it is being traded in the market. “i” is the interest payments and “kd” is the rate of return required by the debt holder. From the formula it can easily be deduced that the market value of any bond is the present value of the interest payments. But the above formula is only applicable in the case of debt having maturity till perpetuity. The following table further highlights the computation of the required rate of return of a debt having a fixed period maturity. Particulars Amount Factor (7.03%) PV MV (1,062.00) 1.00 (1,062.00) Interest 75.00 13.28 996.04 Redemption 1,000.00 0.07 65.96 Total 0.00 It is assumed in the above computation that the bond will be redeemed at par. The rate 7.03% is basically the Internal Rate of Return (IRR) at which the sum of the Market Value, Interest Payments and Redemption all becomes zero. Thus 7.03% is the required rate of return. If the company wants to issue a bond and sell them at the par value, then the coupon rate will be equal to the required rate of return in the marker which is 7.03%. (ii) Yield to maturity of a bond can be describe as the single discount rate applied to all future interest and principal payments. The rate will calculate the Present Value that is equal to the price of the bond. It is sometimes also referred as the redemption yield or the IRR of the bond. The rate is calculated assuming that the bond will be held till maturity and all the payments will be made on time. On the other hand, the coupon of the bond can be simply described as the amount of interest that is paid every year. It is normally denominated as the percentage of the face value. Basically, it is the rate of interest that a bond issuer, or debtor, will pay to the holder of the bond. Thus, the coupon rate determines the income that will be earned from the bond. (iv) A bond covenant is a condition that the issuer applied on the bond in order to restrict certain activities on the bond. Bond covenants are usually the restriction devised in order to protect the rights of both the issuer and the holder of the bond. There are two types of bond covenants: Negative and Positive. Negative bond covenants restrict the issuer from undertaking certain activities whereas the positive bond covenants saves the important rights and benefits of both the parties. Air jet Best parts can apply the following negative covenants at the time of the issue of the bond. The company can implement operational covenant based on which the borrowers will be required to maintain their assets to a certain percentage and will only be allowed to engage in permissible business only Other negative covenants that the company can implement is termed as the financial covenants according to which the borrower will be require to maintain specific debt to equity ratios, working capital ratio or interest coverage ratios etc. Other negative covenants include restriction on the payments of dividends or the issuance of new debts. Following is the example of certain positive bond covenants that the company can implement. Air Jet Best Part will maintain adequate levels of insurance The company will present its financial statements for auditing Task 4 (i) The IRR of the project is as follows Year Cash Inflow / (outflow) 0 (3,000,000) 1 1,100,000 2 1,450,000 3 1,300,000 4 950,000 IRR 22% (ii) Year Cash Inflow / (outflow) Present Value Factor Present Value 0 (3,000,000) 1.0000 (3,000,000) 1 1,100,000 0.8696 956,522 2 1,450,000 0.7561 1,096,408 3 1,300,000 0.6575 854,771 4 950,000 0.5718 543,166 NPV 450,867 (iii) The company should accept the project as the NPV of the project is positive i.e. $ 450,867 and the internal rate of return is also greater than the required rate of return. Based on these conditions the project is financial viable (iv) Depreciation is a non-cash item, but it is included in the cash flow forecasting because of the tax shield. Suppose that the useful life of the machines is 4 years and at the end of the useful life, the salvage value of the machines is nil. The effect of the depreciation on the NPV of the machines can be analyzed by going through the following calculation. It is assumed that the tax rate is 35% and tax is paid at the end of the year. Year Cash Inflow / (outflow) After tax (tax @ 35%) Present Value Factor Present Value 0 (3,000,000) (3,000,000) 1.00 (3,000,000) 1 1,100,000 715,000 0.87 621,764 2 1,450,000 942,500 0.76 712,624 3 1,300,000 845,000 0.66 555,588 4 950,000 617,500 0.57 353,087 NPV (756,938) Now if the tax is involved in the above computation, it is clear that the project is not financially viable. However, the depreciation provides tax shield and increases the present value of the project which is evident from the following example. Year Cash Inflow / (outflow) Depreciation Taxable Net Cash flow After tax cash flow (tax @ 35%) Add back Depreciation Cash flow for discounting Present Value Factor Present Value 0 (3,000,000) - (3,000,000) (3,000,000) - (3,000,000) 1.0000 (3,000,000) 1 1,100,000 (750,000) 350,000 227,500 750,000 977,500 0.8696 850,000 2 1,450,000 (750,000) 700,000 455,000 750,000 1,205,000 0.7561 911,153 3 1,300,000 (750,000) 550,000 357,500 750,000 1,107,500 0.6575 728,199 4 950,000 (750,000) 200,000 130,000 750,000 880,000 0.5718 503,143 NPV (7,505) (v) Sunk Cost Amount paid to the engineer for preparing the feasibility report of the machines Opportunity Cost In order to install the machine, labor will be diverted from other operations. Contribution margin lost due to the diversion of the labor is an example of opportunity cost Erosion The company taking out funds from its main operations, for example from the pool of funds kept for the repair and maintenance of the aircrafts primarily used in the business (vi) There are several principal risks that surround the project. Air Jet Best Parts operates in the aircraft industry, which is subject to rapid changes in many fields such as standard equipment, operating procedures, and laws and regulation. The project under consideration requires a careful estimation of all the relevant costs and revenues; a misjudgment in the forecast will cause an error in the project net present value, which might result in the acceptance of a project which is not financially viable. The initial capital expenditure must be carefully projected. In order to do so, it is of prime importance that the company obtains quotations from several companies in order to project the current market value of the machines. An artificially higher price will put a declining effect on the net present value of the project, and an artificially lower price will cause the opposite. Another risk that is present in the financial appraisal of the project is that the company might not have estimated the correct useful life of the equipment. The aircraft related hardware and equipment are subject to becoming obsolete at a greater pace as compared to the other kinds, so this risk is present. While making an investment appraisal decision, it is imperative to consider the impact of inflation in the future cash flow. The information provided does not include any relevant information about the price inflation over the three year period, which can significantly impact the expected NPV. The director of the company must also consider the sources from which the financing will be obtained for the investment. Financing decision is significant, as the company would have to pay finance charge to the bank or any other financial institution, and the company must have enough cash flow in the future for the payment of these finance charge. In order to commence any investment venture, the director must receive the approval of the shareholders. Although certain investments might appear to be rewarding and worthwhile to do, they do not receive shareholders’ attention that easily. Shareholders, who are often short-sighted and tend to ignore the long-term feasibility, disapprove the decision of the board based on the fact that the cost of the investment will weaken the financial outlook of the organization in the year of the investment. The directors, while making the investment decision, must consider whether it is of a capital nature or will be reflected in the profit and loss of the company as an expense. TASK 5 1 a) The company that is being chosen is the Boeing Company, and the bond that is being chosen offers coupon at the rate of 6.125% and maturity date is 02/14/2033 (21 years). The YTM of the bond is 4.06% b) After tax cost of debt is YTM multiplied by (1-tax rate). The after tax cost of debt of the company is 2.68% c) Cost of debt is actually the rate at which the present value of the interest payments and redemption amounts equals the current market value of the debt. The following formula further clarifies. Where M is the market value of the bond currently on which it is being traded in the market. “i” is the interest payments and “kd” is the rate of return required by the debt holder. From the formula it can easily be deduced that the market value of any bond is the present value of the interest payments. But the above formula is only applicable in the case of debt having maturity till perpetuity. In case tax is involved, the interest is taken after tax. Cost of debt is basically the internal rate of return. d) Coupon rate is the interest rate which is fixed and denotes the amount of interest being paid to the holder of the bond by the company. Whereas YTM is the internal rate of return of the bond which is actually the required return which the debt holder is looking for and thus it is prudent to take this as the cost of debt. 2) a) The CAPM formula for calculating the cost of equity is as follows Where ‘Ke’ is the cost of equity, ‘Rf’ is the risk free rate, ‘Rm’ is the market rate of return and B is the beta of the company. The average beta of the company is taken to be the average beta of three competitor companies which is illustrated as follows Company Beta Boeing 1.11 Northrop Grumman 1.06 Lockheed Martin 0.65     Average Beta 0.94 Thus Ke of the company is calculated to be 3.94% b) Following are the advantages of CAPM CAPM considers only systematic risk which is close to a real situation in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated. The model derives a relationship between required return and systematic return which has been proved through testing and empirical research It is better than Dividend Growth Model as it takes into account a company’s level of systematic risk It provides a more authentic discount rate to be used for investment appraisal With the above mentioned advantages, the model comes with the following disadvantages The risk free rate of return is not fixed and changes on daily basis which is cumbersome to determine and required a tedious process It is not an easy task to determine the market rate of return. The return on a stock market is the sum of the average capital gain and the average dividend yield. The value of beta is uncertain and changes over time One disadvantage in using the CAPM in investment appraisal is that the assumption of a single-period time horizon is at odds with the multi-period nature of investment appraisal. Dividend growth approach cannot be applied to those companies, which are not paying any dividends, or whose dividend per share is growing at a rate higher than Ke, or whose dividend policies are highly volatile. On the other hand, the CAPM has a wider application. The only condition for its use is that the company’s share is quoted on the stock exchange. In addition, all the variables in the CAPM model are derived from the market information. The value of beta, which is quite essential to the model, is calculated based on authentic statistical method. 3) a) The Cost of equity of the preferred debt can be calculated by using the constant dividend model. The cost of equity is 5.86% b) The cost of preferred equity cannot be computed other than the dividend valuation model 4) The weighted average cost of capital of the company is as follows Particular Cost Percentage Calculation Equity 3.94% 0.60 2.36% Preferred Equity 5.86% 0.10 0.59% Debt (After Tax) 2.68% 0.30 0.80%   WACC 3.75% 5) For investment appraisal decision, the company should use project specific beta. This can further be explained as the systematic risk associated with the project or the equity beta of a company involve in the similar project. The above calculated project of the company can only be applied on the projects which pertain to aircraft industry since it represents the systematic risk of that particular industry ( as the beta was calculated by averaging out the beta of three companies operating in the aircraft industry). However, for example if the company decides to diverse its operations and decides to start a project which involves designing operating system software for desktop computers, it would be required to recalculate its WACC as the project specific beta would be different. In this case, the company would have to take beta of companies such as Microsoft or Apple. 6) The revised NPV of the project based on the WACC of the company is as follows Year Cash Inflow / (outflow) Present Value Factor Present Value 0 (3,000,000) 1.00 (3,000,000) 1 1,100,000 0.96 1,060,241 2 1,450,000 0.93 1,347,075 3 1,300,000 0.90 1,164,070 4 950,000 0.86 819,919 NPV 1,391,305 In both cases the NPV is positive, thus the project is financially viable. References [1] Rosemary Peavler “Debt and Equity Financing.” Bizfinance.about.com” About.com – a part of the New York Times company, n.d. Web. 23 July 2012. [2] Linda Grayson “Internal rate of return: An inside Look” investopedia.com. Investopedia, n.d. Web. 23 July 2012. [3] “Net Present Value - NPV” investopedia.com. Investopedia, n.d. Web. 23 July 2012. [4] Elazar Berkovitch “Why the NPV Criterion does not maximize NPV” rfs.oxfordjournals.org Oxford Journals n.d. Web. 23 July 2012. Read More