FINANCE-This assignment is to be completed in groups of three and carries 30 per-cent

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The Faculty of Business

BUACC3701: Financial Management
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Semester 1-2014

ASSIGNMENT

This
assignment is to be completed in groups of three and carries 30 per-cent of the
marks in this unit.

Part A(15 marks)

You
have been directed to develop a cost of capital for the firm to use in
evaluating 2013 capital investment projects. You have obtained the projected
December 31, 2012 Balance Sheet as well as information on sales and earnings
for the past ten years.

Balance Sheet
as at 31 December 2012
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Notes
a)
Accounts
payable are exceptionally low because the firm follows the practice of paying
cash on delivery in return for substantial purchase discounts.
b)
The
bonds outstanding have a par value of $1000, a remaining life of 15 years, and
a coupon rate of 8 percent. The current rate of interest for bonds with the
firm’s rating is 10 percent per year. The bonds pay annual interest.
c)
The
preferred stock currently sells at its par value of $100 per share.
d)
There are 10 million shares outstanding
and the stock currently sells at a price of $24 per share.

Sales and Earnings
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Earnings

Earnings

Sales

after
Taxes

per
Share

Year

$m

to

of

Common Stock

Common

$m

Stock

2012

1152

31.25

3.13

2011

959

28.8

2.88

2010

848

25.4

2.54

2009

800

24.88

2.49

2008

716

21.46

2.15

2007

668

20.04

2

2006

608

18.24

1.82

2005

560

16.8

1.68

2004

524

15.77

1.58

2003

476

14.76

1.48

2002

413

12.1

1.21

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Note: The firm’s marginal tax rate is 48 percent

You:
•
believe
the company’s future growth to be only one half the rate experienced during the
last decade.
•
expect
the firm to continue paying out about 60 percent of the earnings available to
common in the form of cash dividends.
•
Believe
if expansion needs do not meet the required 40 percent retention rate, the
payout ratio would be increased.
•
believe that the mix of debt, common
stock, and preferred stock that was optimum (that is, produced the lowest
average cost-of-capital) was the one that the company presently employed. The
proportions of this mix had been relatively stable over the past five years,
and they were used to construct the projected December 31, 2012 Balance Sheet.

You
have also asked the firm’s investment banks and commercial bankers what the
firm’s cost of various types of capital would be, assuming that the present
capital structure is maintained. This information yielded the following
conclusions.

DEBT

Up
to and including $4 million of new debt, the company can use loans and
commercial paper, both of which currently have an interest rate of 10 percent.

For
additional funds above $4 million but less than $10 million, the company can
issue mortgage bonds with an Aa rating and an interest cost to the company of
12 percent on this increment of debt.
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From
$10 million to less than $14 million of new debt, the company can issue
subordinated debentures with a Baa rating that would carry an interest rate of
13percent on this increment of debt.

At
and over $14 million of new debt would require the company to issue
subordinated convertible debentures. The after tax cost of these convertibles
to the company is estimated to be 9 percent on this increment of debt.

PREFERRED STOCK

The
company’s preferred stock, which has no maturity since it is a perpetual issue,
pays a $9 annual dividend on its $100 par value and is currently selling at
par. Additional preferred stock in the amount of $2 million can be sold to
provide investors with the same yield as is available on the current preferred
stock, but flotation costs would amount to $4 per share. If the company were to
sell a preferred stock issue paying a $9 annual dividend, investors would pay
$100 per share, the flotation costs would be $4 per share, and the company
would net $96.

For
additional raisings of preferred stock above $2 million but less than $3
million, the after-tax, after flotation cost would be 10.5 percent for this
increment of preferred stock.

For
$3 million and over, of preferred stock; the after-tax, after flotation cost
would be 13 percent for this increment.

COMMON STOCK

Up
to, and including, $2.5 million of new common stock can be sold at the current
market price, $24 per share, less a $3 per share flotation cost. Over $2.5
million of new common stock can be sold at $24 per share, less a $5 share
flotation cost.

Division
managers have provided you with their proposed investment opportunities for
2007.
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Note:
These projects are in divisible in the sense that
each must be accepted or rejected in its entirety; that is, no partial projects
may be taken on.

Required

You are asked to
answer the following questions

1.
Determine the firm’s existing market value capital
structure. Disregard the minor amount of accounts payable. Also, lump notes
payable in with long term debt. Round to the nearest whole percent.
2.
Assuming that the firm maintains this optimum market
value capital structure, calculate the breaking points in the Marginal Cost of
Capital (MCC) schedule. Recall that the company is projecting $31.25 million of
earnings available to common and a 60 percent dividend payout ratio.
3.
Now calculate MCC in the interval between each of
the breaking points and graph the MCC schedule in its step function form.
4.
Estimate to the closest whole
percentage point the missing internal rates of return in the investment
schedule and then use the information developed thus far in the case to decide
which projects should be accepted. Illustrate your solution technique with a
graph and conclude your answer to this question with a discussion of the
accept/reject decision on the marginal project.

Part B(10 marks)

You
are considering the purchase of one of two large presses. The key financial
characteristics of the existing press and the two proposed presses are
summarised below.

Old
press: Originally purchased three years ago at an installed cost of $400 000,
it is being depreciated under prime cost (straight-line) using a 10-year
recovery period. The old press has a remaining economic life of five years. It
can be sold today to net $420 000 before taxes

Press A:
This
highly automated press can be purchased for $830 000 and will require $40 000
in installation costs. It will be depreciated under prime cost (straight-line)
using a five- year recovery period. At the end of the five years, the machine
could be sold to net $400 000 before taxes. If this machine is acquired, it is
anticipated that the following current account changes would result.

Cash +$25400
Accounts
receivable + 120 000
Inventories —20000

Accounts
payable

+
35 000

Press
B: This press is not as sophisticated as press A. It costs $640 000 and
requires $20 000 in installation costs. It will be depreciated under prime cost
(straight-line) using a five-year recovery period. At the end of five years, it
can be sold to net $330 000 before taxes. Acquisition of this press will have
no effect on the firm’s net working capital investment.

The
firm estimates that its earnings before depreciation and taxes with the old
press and with press A or press B for each of the five years would be as shown
in Table 1.
The
firm is subject to a 33 per cent tax rate on both ordinary income and capital
gains. The firm’s cost of capital, k, applicable to the proposed replacement is
14 per cent.

EARNINGS BEFORE
DEPRECIATION AND TAXES COMPANY’S PRESSES

Year

Old
press

Press
A

Press
B

1

$120000

$250000

$210000

2

120000

270000

210000

3

120000

300000

210000

4

120000

330000

210000

5

120000

370000

210000

Required

1.
For each of the two proposed replacement presses,
determine: a) Initial investment.
b) Net present
value.
c) Internal rate of return.
2.
Draw NPV profiles for the two replacement presses on
the same set of axes, and discuss conflicting rankings of the two presses, if
any, resulting from use of NPV and IRR decision techniques.
3.
Recommend which, if either, of the presses the firm
should acquire

PART C:(5 marks)

It
is common for organisations which raise finance at the corporate level and then
allocate that finance to projects throughout the organisation, to use the
weighted average cost of capital as the required or hurdle rate in determining
fund allocation. This approach is appropriate only in very specific
circumstances. Particular frictions and issues may arise where an organisation
is arranged into semi-autonomous divisions with each division being involved in
activities with disparate levels of risk.

Examples of the
issues include:

(a) The
use of a firm wide cut off rate in which no explicit allowance is made for
differential risk may well result in more capital being invested in the more
risky division (and in riskier projects from all divisions), than otherwise
would have occurred, because high-risk projects typically offer high returns.
The question that arises here is whether hurdle rates be established for each division,
for each product line within a division, or on an individual project basis. A
related issue is how to measure the risk.

(b) Another
issue that arises in this regard is that of differential debt capacity. This
issue is important because some divisions need to use more debt so as to
compete effectively with other firms that operate in the same industry. Some
division managers may well argue that they could remain competitive only if
their divisions could follow industry practice for capital structure when
calculating hurdle rates. Thus the question arises as to whether

different divisions should be assigned different
capital structures and debt costs or whether they should be assigned the
corporate average. If different capital structures are to be used, how should
they be derived? What interest rate should be used for debt? How should
divisional equity costs be adjusted to reflect varying capital structures?

There are three
types of protect risk that can be considered,

Required

a)
What type of risk do we adjust for?
b)
Which of these risks should we be
interested in?
c)
How do we measure the risk and
incorporate it into the analysis.