Business Finance Issues - Assignment Example

Assignment (Practical Exercises & Discussion Questions) Business Finance 6392 Semester 1, 2014 Group member’s names, your tutorial class, and the date the assignment is due. Part-A: (Total marks = 20, 2 Marks each) Multiple Choices: Select the most appropriate solution from the alternatives provided. Note marks are only allocated for your selection – there is no need to include workings for the multiple choice questions. 1. You are thinking of adding one of two investments to an already well diversified portfolio. If you are a risk adverse investor, which one is the better choice? a. Security A b. Security B c. Either security would be acceptable. d. Cannot be determined with information given. 2. You are considering buying a machine which costs $1 200, has a 5-year life and would be depreciated straight-line to a salvage value of $200. The machine would start generating revenues one year from now. Annual revenues and operating costs would be $400 and $150 respectively. If your tax rate is 30 percent and your cost of capital is 10 percent, what is the NPV of this project, assuming that you should evaluate the project on a pre-tax basis? A. $250.00 b. $100.00 c. - $204.00 d. - $128.05 3. All else constant, the future value of an investment will increase if: a. the investment is compounded for more years. b. the investment is compounded at a higher interest rate. c. both a and b. d. the investment involves more risk. 4. You are considering buying some shares in Continental Grain Ltd. Which of the following are examples of non-diversifiable risks? I. Risk resulting from a general decline in the stock market. II. Risk resulting from a possible increase in income taxes. III. Risk resulting from an explosion in a grain elevator owned by Continental. IV. Risk resulting from an impending lawsuit against Continental. a. I and II b. III and IV c. I only d. II, III, and IV 5.You want to travel to Europe to visit relatives when you graduate two years from now. The trip is expected to cost a total of $10 000 at that time. Your parents have deposited $5 000 for you in an account paying 6% interest annually, maturing three years from now. Aunt Hilda has agreed to finance the balance. If you are going to put Aunt Hilda's gift in an investment earning 10% over the next three years, how much must she deposit now, so you can visit your relatives at the end of three years? a. $3 757 b. $3 039 c. $5 801 d. $3 345 6. Of all the capital-budgeting criteria, ______________ is the only one that provides a direct estimate of the addition to owner or shareholder wealth. a. internal rate of return b. payback period c. profitability index d. net present value 7. Your company is considering an investment in one of two mutually exclusive projects. Project 1 involves a labour-intensive production process. Initial outlay for Project 1 is $1 495 with expected cash flows of $500 per year in years 1-5. Project 2 involves a capital intensive process, requiring an initial outlay of $6 704. Cash flows for Project 2 are expected to be $2 000 per year for years 1-5. Your firm's discount rate is 10 percent. If your company is not subject to capital rationing, which project(s) should you accept based on the net present value? a. Project 1 b. Project 2 c. Projects 1 and 2 d. Neither project is acceptable. 8. You are going to pay $800 into an account at the beginning of each of 20 years. The account will then be left to compound for an additional 20 years. At the end of the 41st year you will begin receiving a perpetuity from the account. If the account pays 14% per annum, how much each year will you receive from the perpetuity (round to nearest $1 000)? a. $140 000 b. $150 000 c. $160 000 d. $170 000 9. Given the following information on Project X, compute the accounting rate of return and the payback period a. 12%, 3.03 years. b. 15%, 1 year. c. 12%, 4 years. d. 6%, 3.03 years. 10. XLNT Ltd. just paid a dividend of $2.15 per ordinary share. The dividends of XLNT are expected to grow at about 4 percent per year indefinitely. If the risk-free rate is 5 percent and investors' risk premium is 7.5 percent, estimate the value of XLNT shares 3 years from now. a. $71.71 b. $28.47 c. $37.23 d. $29.59 Part-B: (Total marks = 30) ‘Standard deviation and beta are the appropriate measures of risk of investment’- do you agree? Write an essay of 700 words on beta explaining the importance of beta of a company/ security and how the beta of a security is measured, referring to at least 5 most recent journal articles? Beta indicates the extent to which a stock correlates with the market while standard deviation measures individual stock’s risks (Downs 2010). Positive Beta implies that if the stock market goes up, the value of the stock would also go up and if it goes down, the value of the stock would also go down. Similarly, if it’s negative, it implies that when the stock market increases, the value of the stock market decreases and vice versa (Downs and Ingram 2000). Beta is important in investment decision because it helps the investor invest according to their risk appetite. A risk averse investor will look for stocks with a beta of 1 or less while risk takers will invest in stock that has more than 1 beta. Apart from using beta to identify a suitable investment alongside their risk appetite, investors can also use it to strategize on how to minimize long term volatility. Financial institutions rely on Beta to measure stock volatility. This helps them beat their competition (Savage, 2013). The competition’s average often ends up around the average. Individual investors will use beta to identify the attractiveness of a stock, while corporations and Financial Institutions will use it to gain competitive advantage against their respective industry. The attractiveness of beta as one of the measurement tools lies on its ease of interpretation (Stein, 1996). Sometimes beta also extrapolates on the expected return from potential stock. Stocks with a more than 1 stock are more likely to have greater returns, and the reverse is true. Beta stock is appropriate to measure risk investment but is not the only measurement tool. Increased stock volatility translates to increased risks (Stein, 1996). In order to calculate Beta, only two sets of data are required; a stock’s closing prices and Index’s closing prices. It is easy to identify calculated betas from stock reporting websites like Yahoo Finance, Google Finance and MSN Money. Similarly, it is easy to calculate it using straight forward linear regression on Microsoft Excel, Open Office Calculate spreadsheet applications. Mostly, it comprises of the Month-end stock price. Typically, Beta is Covariance of the stock versus the Market divided by the variance of the stock market (Hightower 2009). Most investors develop investment strategies based on beta. An example is the Swing strategy which fully relies on beta to benchmark individual stock against their industry. The Capital Asset Pricing Model (CAPM) relies on Beta to establish the required rate of returns which helps investors know whether a stock is undervalued or overvalued. However, one must take note of the stock price and volume action and the overall health of the market as primary indicators. Other problems with relying on beta alone include its tendency to rely on backward/ historical data which is seldom an accurate predictor of the future. Similarly, it fails to account for changes in the work such as industry shifts or a new business line. This explains why beta should not be the only signal (Savage, 2013). If a stock is outperforming the industry and the market is steadily advancing, beta may only be 1 and fail to advice an investor appropriately. This is because it looks for upward and downward movements. Given this information, beta may work best for short term decision making where volatility is important (Tofallis 2010). For long term decision making, investors should rely more on the company’s fundamentals (Downs and Ingram 2000). From regression analysis, (adjusted R2) will show the percentage of the relationship between the security’s total variance to the market. This reflects the reliability of the beta. Research shows that different industries are characterized by different betas. Staple stocks have lower beta because they are least affected by cycles, for instance the tobacco companies and Health and consumer goods. Similarly, utility stocks have lower beta because they are less cyclical, just like staple stocks. In contrast, Tech stocks have a high beta because of the superiority of tech companies in growth. Foreign betas also offer high betas because of diversification potential. Given these generalizations, beta may be the first signal to look at when thinking of the overall realm of investment, given the underlying investment objectives (Stein, 1996). Part-C: (Total marks = 50 marks) Question: Text Book (FM) Chapter-12, CASE STUDY (Page 438-439) Assume that the corporate tax rate is 30%, instead of 28% proposed tax mentioned in the textbook. NB: Need to show full workings of the Cash Flow calculation. ___________________________________________________________ TOTAL ASSIGNMENT MARKS = 100 MARKS MEMO: To: The Chief Executive Officer From: Financial Analyst Subject: Report on New Product Introduction Our objective of this report is to analyze the investment decision on the new diagnostic test for prostate cancer which is expected to last for five years. Samphore Pty Ltd is under the 30% corporate tax bracket with a discount rate of 22% p.a. Underlying Issues 1. Cash Flow over Accounting Profits The firm will use cash flows rather than accounting profits to measure the cost benefits of this project because they represent what is received and reinvested. Capital budgeting is specifically concerned with the actual amount actual dollars that are generated. Free cash flow does not include interests and adds back depreciation which accounting profits take out yet they are part of the inflows and outflows. Accounting allocates cash depending on the period that an asset provided economic benefit. However, in order to account for the time value of money, the company has to translate profit into cash flows. Moreover our concern is on the after-tax basis of the cash flow because that is what is available to shareholders. Additionally, we are concerned with incremental cash flows because that is the marginal benefits for the new project which determines our acceptance or rejection decision. 2. Role of Annual Profits Annual profits help in the cash flow computation. Incremental cash flow is defined as the company’s cash flow with the project minus company’s cash flow without the project. Interest is a cash expense, and so it is a common misconception that interest on any debt used to finance a project should be deducted when we estimate the project’s net cash flows. We discount a project’s cash flows by its risk-adjusted cost of capital, which is the weighted average (WACC) of the costs of debt, preferred stock and common equity, adjusted for the project’s risk and debt capacity. The project’s cost of capital is the rate of return necessary to satisfy all of the firm’s investors (stockholders and debt holders). The cost of debt is already embedded in the cost of capital, and subtracting interest payments from the project’s cash flows would account to double-counting interest costs. Therefore, we should not subtract interest expense when finding the project’s cash flow. Similarly, Depreciation needs to be added back to annual profits after taking out tax to arrive at the Cash flow amount. Sunk costs are also taken out of the annual profit because they are irrelevant for decision making. 3. Dealing with Depreciation Depreciation offers tax savings because it is added back during cash flow computation. Therefore, although it isn’t a cash flow item, it affects the amount of differential cash flows. Apart from depreciation, interests are also added back because they do not affect the cash flow but are instead treated on accrual basis by accounting, in the annual profits. 4. Australian Tax System Significance and the EBIT Taking into account the new plant and equipment, the new EBIT, and tax would be as follows: Year 0 1 2 3 4 5 Units Sold   70,000 120,000 140,000 80,000 60,000 Sale Price   $300 $300 $300 $300 $260               Sales Revenue   $21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000 Less: Variable Costs   12,600,000 21,600,000 25,200,000 14,400,000 10,800,000 Less: Fixed Costs   $200,000 $200,000 $200,000 $200,000 $200,000 Equals: EBDIT   $8,200,000 $14,200,000 $16,600,000 $9,400,000 $4,600,000 Less: Depreciation   $1,600,000 $16,000,000 $16,000,000 $16,000,000 $16,000,000 Equals: EBIT   $6,600,000 $12,600,000 $15,000,000 $7,800,000 $3,000,000 Taxes (@30%)   $1,980,000 $3,780,000 $4,500,000 $2,340,000 $900,000 5. Initial Outlay The initial outlay equals the total amount of of freight and installation costs and the cost of the new plant and equipment (7,900,000 + 100,000) = 8,100,000 Change In Net Working Capital: Revenue: $21,000,000 $36,000,000 $42,000,000 $24,000,000 $15,600,000 Initial Working Capital Requirement $100,000 Net Working Capital Needs: $2,100,000 $3,600,000 $4,200,000 $2,400,000 $1,560,000 Liquidation of Working Capital $1,560,000 Change in Working Capital: $100,000 $2,000,000 $1,500,000 $600,000 ($1,800,000) ($2,400,000) 6. Annual Cash Flows From the operating profits EBIT we can find the Cash Flows by deducting taxes, then adding back depreciation as shown below. Operating Cash Flow: 80 1 2 3 4 5 EBIT   $6,600,000 $12,600,000 $15,000,000 $7,800,000 $3,000,000 Minus: Taxes   $1,980,000 $3,780,000 $4,500,000 $2,340,000 $900,000 Plus: Depreciation   $1,600,000 $1,600,000 $1,600,000 $1,600,000 $1,600,000 Equals: Operating Cash Flow   $6,220,000 $10,420,000 $12,100,000 $7,060,000 $3,700,000 7. Terminal Cash Flow There is no terminal cash Flow because the project has zero salvage value Terminal CFs Salv-New Taxes-New Salv-Old Taxes-Old Rec NWC CFAT Year (0).30 5 0 0 0 0 0 0 NPV 0 8. Outlays and Future Benefits -Diagram $3,956,000 $8,416,000 $10,900,000 $8,548,000 $5,980,400 Years 1 2 3 4 5 ($8,100,000) 9. Finding NPV Discounted from the difference between the cash inflow and change in networking capital spending Free Cash Flow:             Operating Cash Flow   $6,220,000 $10,420,000 $12,100,000 $7,060,000 $3,700,000 Minus: Change in Net Working Capital $100,000 $2,000,000 $1,500,000 $600,000 ($1,800,000) ($2,400,000) Minus: Change in Capital Spending $8,000,000 0 $0 0 0 0 Free Cash Flow: ($8,100,000) $4,220,000 $8,920,000 $11,500,000 $8,860,000 $6,100,000               NPV =   $11,427,500         IRR = 81%           10. The IRR Equals 81% as shown above 11. Yes. The new test should be accepted since the NPV ≥ 0. and the IRR ≥ required rate of return Reference Downs T. and Ingram R. (2000), “Beta, Size, Risk and Return” The Journal of Finance Research, the University of Alabama Hightower, J. (2009) “Reformulating Beta – Is the normal calculation of this correlation coefficient correct?” Auburn University http://bama.ua.edu/~tdowns/jfr_risk_return.PDF Savage, M. (August 2013), “Beta Diversification: Using fundamental index strategies to enhance long term return potential,” Charles Schwab Investment Management. Stein, J. (1996). Rational capital budgeting in an irrational world. Journal of Business 69(4): 429-455 Tofallis, C. (2010), “Investment volatility: A critique of standard beta estimation and a simple way forward,” University of Hertfordshire Read More