3415 Corporate Finance

Dean Culligan

Assignment 2
Wanda Christenson 3171835 Leslie Hinton 3207461 Jennifer Connolly 3336912 7/29/2013

UNIVERSITY OF NEW BRUNSWICK Faculty of Administration ADM 3415

Dean Culligan Summer 2013 ASSIGNMENT #2 (due: July 29, 2013) QUESTION ONE (10 marks) You are the Capital Budgets Officer of Great Big Enterprises Inc. (GBEI), which is headquartered in Saint John, New Brunswick. The conglomerate company has three major divisions, a trucking division, an aquaculture division, and a lumber products division, as well as a number of projects in other areas. GBEI is financed with 30% debt and 70% equity. GWEIs average cost of debt is 9% and its corporate tax rate is 30%. You forecast that the rate of return from one-year Treasury bills will be 5% in the next period and the rate of return from the stock market will be 13%. You have been asked to conduct an evaluation of the following two investment projects: Alternative #1 This alternative involves the purchase of a lumber mill operation located in Nova Scotia. You have estimated the initial investment as $1,000,000 and the annual pre-tax cash flow over the next 10 years as $200,000 at which point the operation will be obsolete. If GBEI decides to invest in the lumber mill operation, it will be financed using the same proportions of debt and equity that GWEI currently uses. You have collected information on a publicly-traded lumber products company whose primary line of business is similar to GBEIs lumber mill operation. The information gathered implies systematic risk (beta) of 1.05. Assume straight line depreciation. Alternative #2 This alternative involves purchasing new aquaculture equipment for $500,000, with a forecasted useful life of 10 years, to replace old equipment that could be disposed of at an estimated salvage value of $60,000. If GBEI acquires the new equipment, it could take on a bigger service area that was not previously feasible, thus leading to an annual increase in sales of $200,000. With the improvements in technology built into the equipment, GBEIs annual operating expenses would be reduced by $100,000. Operation of the new equipment would require GBEI to maintain inventory levels $100,000 higher than usual over the life of the project. The new equipment could be sold at the end of its useful

life for $40,000. This project will be financed using 50% debt thus it warrants a project beta of 1.50 given its riskier profile. Assume straight line depreciation. Assume gross margin on incremental revenues is 60%.

A. Calculate the following to be used in evaluating the purchase of the lumber mill operation: Cost of equity Cost of equity = Risk free rate + (Rm-Rf) = .05 + 1.05(.13-.05) = .05 + .084 = .134 / 13.4 % Weighted average cost of capital

= (300000/1000000 x (1-.30) x.09) + (700000/1000000 x .134) = .0162 + .0938 = .11 / 11% B. Calculate the NPV, Payback Period, Discounted Payback Period and Profitability Index of the lumber mill operation.
t C0 AT Cash Flows DTS Total PV Total (11%) (1000000) 0 (1000000) 1 2 3 4 5 6 7 8 9 10 140000 30000 170000 59871

140000 140000 140000 140000 140000 140000 140000 140000 140000 30000 30000 30000 30000 30000 30000 30000 30000 30000 66457

170000 170000 170000 170000 170000 170000 170000 170000 170000 153153 137976 124303 111984 100888 90889 81882 73768

After Tax Cash Flows = Pretax cash flow x (1-T) = 200 000 x .7 = 140 000 DTS Annual Dep. Expense = 1 000 000 / 10 = 100 000 Tax Shield = 100 000 x .3 = 30 000 NPV = C0 + PV Inflows = -1 000 000 + 1 001 171 PI = NPV/C0 = 1171/1 000 000

= 1171 Payback period = 5.15 years Discounted payback period = 9.06 years PV cash flows after 9 years = 941300 1 000 000 941 300 = 58 700 58 700/1 000 000 = .06

= .001171

C. Calculate the NPV, Payback Period, Discounted Payback Period and Profitability Index of the purchase of the new aquaculture equipment.
T C0 0 (500000) 1 84000 2 84000 3 84000 4 84000 5 84000 6 84000 7 84000 8 84000 9 84000 10 84000 100000

AT Cash Flows Inventory Tax paid (18000) on Gain Disposal of Equip DTS Salv. Val. 60000 Old Equip. Salv. Val. New Equip. Operating Exp. Total (458000) PV Total (12%)

100000 100000 100000 100000 100000 100000 100000 100000 100000

13800 -

13800 -

13800 -

13800 -

13800 -

13800 -

13800 -

13800 -

13800 -

13800 40000 100000 337800

100000 100000 100000 100000 100000 100000 100000 100000 100000 297800 297800 297800 297800 297800 297800 297800 297800 297800 265893 237404 211968

189257 168980 150875 134710 120276 107390 108763

As there is no information to indicate otherwise it is assumed the old equipment is fully depreciated and the carrying value is $0 Cost of equity Cost of equity = Risk free rate + (Rm-Rf) = .05 + 1.50(.13-.05) = .05 + .12 = (.5x(1-.3)x.09) + (.5 x .17) = .0315 + .085 = .1165 / 12%

= .17 / 17 % AT increase in Revenue DTS = 200 000 / yr x .6 GM x (1-.3 Tax) Annual Dep. Expense = 500 000 40 000 / 10 = 46 000 = 84 000 Tax Shield = 46 000 x .3 = 13 800 Tax paid on Gain for disposal of old equipment =Disposition Carrying Cost =60000 x .3 =18 000 NPV = C0 + PV Inflows = -458 000 + 1 695 516 = 1 237 516 PI = NPV/C0 = 1 237 516/458 000 = 2.7

Payback period = 1.35 years 458 000 297 800 = 160 200 160 200 / 458000 = .35

Discounted payback period = 2.02 years PV cash flows after 2 years = 449372 458 000-449372 = 8 628 8 628/458 000 = .02

D.

If the projects were mutually exclusive, which would you choose and why? If the projects were mutually exclusive I would choose alternative # 2 as the potential profit is much more

QUESTION TWO (7 marks) Part A Calculate the funded (i.e., interest-bearing) debt/equity ratios of the following firms given this information: I. Accounts payable $100, Accounts receivable $200, Cash $700, Bank debt $400, Note payable $300, Total equity (2005) $700, Retained earnings (2005) $600, Net income (2006) $100
Debt/Equity = 100+400+300/700 + 100 = 800/800 =1

II.

Share price $30, Bond price $103.50, # of shares outstanding 100K, Face value of bonds $1.5m, Line of credit $1.2m, Preferred shares with market value of $800K
Debt/Equity = 1 500 000+1 200 000/3 000 000+800 000 = 2 700 000/3 800 000

= .71

III.

Dividend $2, $1m in face value of 3 year 8% bonds yielding 10%, Dividend yield 5%, 50K shares outstanding, Accounts payable $330K, Cash balance -$300K Debt/Equity = 330 000 + 950 263 / 2 000 000 + 300 000 = .56

Part B Calculate the Economic Profit earned by the Alpha Corporation in 2012 given the following information: EBITDA: million Depreciation Expense: million Interest Rate of Debt: Market Risk Premium: Corporate Tax Rate: million $850,000 $150,000 8% 6% 30% Market Value of Equity: Market (and Book) Value of Debt: Beta coefficient for Alpha Equity: T-bill rate: Other liabilities: 4% $1 $2 $1 0.8

EBITDA 850 000 Less Depreciation (150 000) EBIT 700 000 Less Interest Expense (1 m x .08) (80 000) Taxable Income 620 000 Less Income Tax Payable (620 000 x.3) (186 000) NOPAT 434000

Cost of equity = Risk free rate + (Rm-Rf) = .04 + .8(.06) = .088 / 8.8%

= (1m/3m x (1-.3)x.08) + (2m / 3m x .088) = .018 + .059 = .077 / 7.7% Economic Profit = NOPAT(net operating profit after taxes) opportunity cost of capital
taxe

= 434 000 (2 000 000 x .077) = 434 000 154 000 = 280 000 QUESTION THREE (12 marks) A.A firm is considering a $120,000 outlay for a new piece of equipment which is expected to increase employee productivity. Over its 4-year life, this equipment is expected to reduce current annual operating costs of $2.4M by 2%. The equipment is not expected to have any effect on revenue or other costs. The equipment will be depreciated on a straight line basis, with the first year one-half rule, and with no salvage value. The treasury bill rate is 4%, the market risk premium is 4% and the firms beta is 1.5. Assume corporate tax rate is 30%. I. Calculate the annual after-tax operating cash flows for each of the next five years associated with the purchase of this piece of equipment. 2.4 m x .02 = 48 000 (1-.3) = 33 600 II. Compute the NPV, profitability index, discounted payback period and payback period for this project. Do you think the company should pursue the project? Why or why not?
0 (120 000) 1 2 3 4

C0 AT Cash Flows due to Operating Cost DTS Total (120 000) PV Total (10%)

33 600
9 000 42 600 38 727 35207

33 600
9 000 42 600 32 006

33 600
9 000 42 600 29 096

33 600
9 000 42 600

Expected rate of return = Risk free rate + (Market risk premium) = .04 + 1.5(.04) = 10% DTS Annual Dep. Expense = 120 000 / 4 = 30 000 Tax Shield = 30 000 x .3 = 9 000 NPV = C0 + PV Inflows = -120 000 + 135 036 = 15 036 Payback period = 2.29 years 120 000 85 200 = 34 800 = 34 800 / 120 000 PI = NPV/C0 = 15 036/120 000 = .13 Discounted payback period = 3.12 years 120 000 105 940 = 14 060

III.

If the projects IRR was 13%, would it represent an attractive project? Why or why not? What about 7%? If the IRR was 13% than the project would be attractive as the NPV is positive when its discount rate is lower than the IRR. Therefore if the IRR is 7% than the NPV would be negative and not an attractive project.

B.Consider two mutually exclusive machines: A and B. Acquisition cost of A is $500 and that of B is $1,100. Assume that both machines produce identical revenue and, other than maintenance costs, incur identical costs over their lives. Both machines can be acquired repeatedly over time but the cost of capital associated with purchase of A is 10% and the cost of capital associated with purchase of B is 12%. Additionally, their maintenance costs over their useful lives (A - 3 years; B - 6 years) are as follows: Year Maintenance Costs A 1 80 2 80 3 80 4 5 40 6 40 EAC = PV costs / n-year annuity factor 0 -500 -1 100 1 -80
-40

B 40 40 40 40

Year Machine A Machine B

2 -80
-40

3 -80
-40

4 -40

5 -40

6 -40

EACA = = = = = EACB =

PVA/3-year annuity factor -500 - 80/(1.1) - 80/(1.1)2 - 80/(1.1)3)/2.487 -500 -72.72 66.12-60.12 / 2.487 698.92.487/2.487 281.05 PVA/6-year annuity factor

= = = =

-1100 40(1.2)-40(1.12)-40(1.12)-40(1.12)4 -40(1.12)5-40(1.12)6 /4.1114 -1100 35.71-31.89-28.47-25.42-22.70-20.27/4.1114 -1264.46/4.114 -307.55

Which of the two machines is economically more desirable? Why? Machine A would be more economical as the EAC is lower than for Machine B. A. PC Shopping Network may upgrade its modem pool. It last upgraded 3 years ago, when it spent $129 million on equipment with an assumed life of 6 years and an assumed salvage value of $12 million for tax purposes. The firm uses straight-line depreciation. The old equipment can be sold today for $71 million. A new modem pool can be installed today for $156 million. This will have a 3-year life, and will be depreciated to zero using straight-line depreciation. The new equipment will enable the firm to increase sales by $32 million per year and decrease operating costs by $11 million per year. At the end of 3 years, the new equipment will be worthless. Assume the firm's tax rate is 35 percent and the discount rate for projects of this sort is 10 percent. a. What is the net cash flow at time 0 if the old equipment is replaced? Net cash flow at time 0 = (156 000 000) + (175 000) + 71 000 000 = 85 175 000 b. What is the incremental cash flow in years 1-3? After tax incremental cash flow = 27 950 000 / year c. What is the NPV of the replacement project?

t C0
Tax paid on Gain Disposal of Equip

0 (156 000 000) (175 000)

Disp. Old Equip Salvage New Equip AT Cash Flows due to Operating Cost and revenue DTS Total PV Total (10%)

71 000 000 -

27 950 000

27 950 000

27 950 000

85 175 000 85 175 000

18 200 000 18 200 000 18 200 000 46 150 000 46 150 000 46 150 000 41 954 546 38 140 496 34 673 178

Tax paid on Gain for disposal of old equipment =Disposition Carrying Cost x tax rate =71 000 000- 70 500 000 x .35 =175 000 DTS Annual Dep. Expense = 156 000 000-0/3 = 52 000 000 Tax Shield = 52 000 000 x .35 = 18 200 000 After Tax Cash Flows = Increase in revenue + decrease in operating costs x (1-Tax) = 32 000 000 + 11 000 000 x .65 = 27 950 000 NPV = -85 175 000 + 114 768 220 = 29 593 220 QUESTION FOUR (6 marks) Calculate the WACC of these firms given the following information and an income tax rate of 40% and a risk free rate of 5%: I. Bank debt $400 @ interest rate of 6.5% Total equity $700 Price/book ratio of 2.5x Unsecured bonds $800 @ 12% Beta of 1.2 Market risk premium of 8%

Cost of equity = Risk free rate + (Market risk premium) = .05 + 1.2 x .08 = .146 / 14.6 %

= (400/1900 x (1-.4).065) + (700/1900 x .146) + (800/1900 x .12)

= .008 + .054 + .051 = .113 / 11.3%

II. Share price $30 # of shares outstanding 100K Face value of bonds $1.5mm (8%) Line of credit $1.2mm (6%) Preferred shares with dividend yield of 9% Equity required return of 13%

= (1.2/6.2x(1-.4).06) + (1.5/6.2 x .08) + (.5/6.2 x .09) + (3/5.2 x .13) = .007 + .019 + .007 + .063 = .096

QUESTION FIVE (5 marks) A. Provide detailed definitions for each of the following terms using a different (and credible) World Wide Web or written (e.g., textbook, journal, financial magazine, etc.) source for each one: I. Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is used to calculate the required rate of return for any risky asset. Your required rate of return is the increase in value you should expect to see based on the inherent risk level of the asset. (InvestingAnswers, 2013, para 1)

II.

Capital Budgeting
Capital Budgeting is the process by which the firm decides which long-term investments to make. Capital Budgeting projects, i.e., potential long-term investments, are expected to generate cash flows over several years. The decision to accept or reject a Capital Budgeting project depends on an analysis of the cash flows generated by the project and its cost. (Mathis, R., 2001, para 1)

III.

Internal Rate of Return (IRR)

(1) The rate of return that you can expect to earn on an investment, assuming that you have estimated the cash flows accurately. (2) The discount rate that will cause the present value of an investment's cash inflows to equal the present value of its cash outflows. (Murray State, n.d., para 1)

IV.

Market Portfolio

The market portfolio is a portfolio consisting of all securities where the proportion invested in each security corresponds to its relative market value. The relative market value of a security is simply equal to the aggregate market value of the security divided by the sum of the aggregate market values of all securities.(Bjornsson, Magnus, 1998, para 4) Note: Please provide the source used for each definition along with your answer. B. For each of the topics listed below and using either the Internet or a nontextbook financial publication (e.g., Wall Street Journal, Financial Post, Business Week, financial journals, etc.) as a source, please cite and briefly summarize a separate article or document dealing with the relevant subject I. Limitations of Net Present Value (NPV) technique Due to fluctuations in the market / economy it is difficult to accurately predict projected cash flows and future interest rates which can lead to inaccurate present values used in calculation. (Michel, G. page 30, para 6) . II. Limitations of Internal Rate of Return (IRR) technique IRR can give unrealistic rates of return due to or there may be multiple rates due to a mixture of negative and positive cash flows. There could also be issues if there is no large initial outflow of cash. (Awomewe, Alaba Femi, Ogundele, Oludele Olawale , page 31 para 2) III. Assumptions underlying the Capital Asset Pricing Model (CAPM) The CAPM assumes that there are many diversified investors who are concerned only with the market risk and that the expected rate of return is equal to the risk free rate plus the investments beta times the market risk premium. Investors will only invest in securities that offer the same expected rate of return as other risky investments (Brealey, page 347, para 5)

References Awomewe, A.laba Femi and Ogundele, Oludele Olawale. (2008). The Importance Of The Payback Method In Capital Budgeting Decision. Retrieved from
http://www.bth.se/fou/cuppsats.nsf/all/96459e3b71bce192c1257507003ae68f/$file/The%20Importance%20of %20the%20Payback%20Method%20in%20Capital%20Budgeting%20Decision.pdf

Bjornsson, Magnus(1998, May 12). The Market Portfolio. Retrieved from

http://www.cs.brandeis.edu/~magnus/stocks/node7.html

Brealey,R. Myers, S, Marcus, A. Maynes, E, Mitra, D. (2009) Fundamentals of Corporate Finance. 4th Canadian Edition. USA. McGraw-Hill Ryerson Investing Answers, (2001-2013), Capital Asset Pricing Model (CAPM). Retrieved from
http://www.investinganswers.com/financial-dictionary/stock-valuation/capital-asset-pricing-model-capm-1125

Mathis, Rock. (2001). Capital Budgeting. Retrieved from

http://www.prenhall.com/divisions/bp/app/cfl/CB/CapitalBudgeting.html

Michel, Gregory. (2001 February) Government Finance Review. Net Present Value Analysis:A Primer for Finance Officers Retrieved from
http://www.gfoa.org/services/dfl/budget/documents/NetPresentValueAnalysis.pdf

Murray State. (n.d.). Internal Rate of Return. Retrieved from

http://campus.murraystate.edu/academic/faculty/lguin/FIN330/CapBud-IRR.htm