Financial Management (ACC-933 - Fall 2022)

Assignment # 2

(Due on or before 22 November2022)

Mini Case # 1 (Investment Decisions - Risk Adjusted Discount Rates) (10 Marks)

CBA company is considering two mutually exclusive projects, A and B. The following table shows the CAPM-type relationship between a risk index (Beta) and the required return (RADR) for the CBA company.

Risk Index () Required return (RADR)

1. 7.0% (Risk-free rate)

0.50 9.0%

1.0 12.0%

1.50 14.0%

1.80 16.0%

2.00 18.0%

Project Data are as follows: (assume a Cost of capital of 10%)

Project A Project B

Initial Investment $15,000 $20,000

Project Life 3 Years 3 Years

Expected cashflows: $7,000 $10,000

Risk Index () 0.50 1.80

Required:

1. Calculate the NPV for each project without risk considerations.
2. Calculate the NPV using the RADR to account for risk.
3. Compare, contrast, and explain your findings in A and B above.

Mini Case # 2 (Break-even Analysis, DOL, DFL and DTL) 14 Marks

Specialty Products Limited (SPL) is considering introducing a new product that will sell for $2.00 per unit. There are two ways to produce this product.

The first is capital intensive. With this method, the fixed costs would be $60,000, variable cost $0.80 per unit, and interest expense $12,000.

The second method is labour intensive. With this method, the fixed costs would be $12,000, variable costs $1.60 per unit, and interest expense $4,000. SPL has a tax rate of 40%. and they have 8,000 common shares outstanding.

Required: (3 + 3 + 3 + 3 + 2 = 14 Marks)

1. Calculate the break-even units for both production methods and prove the break-even calculated is correct!
2. Calculate the degree of operating leverage (DOL) at a production of 60,000 units. What does DOL indicate in terms of taking risk?
3. Which production method is a better option for SPL if they produced 60,000units?
4. Calculate the degree of financial leverage (DFL) at the production level of 60,000 units
5. At what production level would SPL be indifferent to the cost structure selected?

Mini Case # 3 (Individual Costs and WACC) (10 Marks)

Humble manufacturing is interested in measuring its overall cost of capital. The firm is in the 40% bracket. The financial manager compiled the following information:

Debt: The firm cab raise debt by selling $1,000 par value, 10% coupon interest rate on which annual interest payments are made. To sell the issue, an average discount of $30 per bond must be given. The firm must also pay a floatation cost of $20 pet bond. You may use the approximate formula for the cost of debt)

Preferred Stock:The firm can sell 11% preferred stock (annual payment) at its $100-per-share par value. The cost of issuing the preferred stock will be $4 per share.

Common Stock:The firm's common stock is currently selling at $80 per share. It expects to pay cash dividend 0f $6 per share next year. The dividend has been growing at the rate of 6% and expect to continue in the future. The stock will have to be underpriced by $4 per share, and floatation costs are expected to amount to another $4 per share.

Retained Earnings:

The firm expects to have $225,000 of retained earning available in the coming year. Once the retained earnings are exhausted, the firm will use new common stock as the form of common stock equity financing.

Required:

1. Calculate the individual cost of each source of financing. Round to the nearest 0.1%.
2. Calculate the Weighted Cost of Capital using the capital structure below:
   1. Debt: 40%; Preferred stock: 15%; Common Stock 45%

Mini Case # 4 (Portfolio Returns and Beta and the CAPM model) 10 Marks

You are considering an investment with a of 1.50. At this time, the risk-free rate of return R_fis 7%, and the return on the market R_mis 10%. You believe that the investment will earn an annual rate of return of 11%.

Required:

1. If the return on the market portfolio were to increase by 10%, what would you expect to happen to the investment's return? What if the market were to decline by 10%?
2. Use the CAPM to find the required return on this investment when R_mis 10%
3. On the basis of your calculation in (b), would you recommend this investment? Why or why not?
4. Assume that as a result of investors becoming less risk-averse, the market return drops to 8%. What effect would this change have on your responses in parts (b) and (c)?

Mini Case # 5 16 Marks

• (Marginal Cost of Capital (MCC), Investment Opportunity Schedule (IOS) and Break Points (BP) in Financing Projects)

Cambridge Products Limited (CPL) has compiled the following data for its three sources of capital for their various ranges of new financing:

Source of Capital Range of New Financing After-tax costs

Long-term Debt $1 to $320,000 6%

$320,001 and above 8%

Preferred Equity $1 and above 17%

Common Equity $1 to $200,000 20%

$200,001 and above 24%

The optimal capital structure for CPL, as compiled by its financial controller, is as follows:

Source of Capital Weight

• Long-term Debt 40%
• Preferred Equity 20%
• Common Equity 40%

SPL has also identified a number of the investment opportunities for consideration. These are listed below with respected to their expected internal rate of return (IRR):

Investment Opportunity Expected IRR Initial Investment

Project A 19% $200,000

B 15% 300,000

C 22% 100,000

D 14% 600,000

E 23% 200,000

F 13% 100,000

G 21% 300,000

H 17% 100,000

J 16% 400,000

Required: (2 + 4 + 4 + 3 + 3 = 16 Marks)

1. Determine the breakpoints of new financing associated with each source of capital?
2. Calculate the weighted average cost of capital for each of new financing found in (a)
3. Draw SPL's Marginal Cost of Capital (MCC) schedule and Investment Opportunity Schedule (IOS)
4. Which, if any, of the available investment do you recommend that SPL select? Why?
5. Calculate the overall cost of capital for SPL. Which projects SPL should select? Is it different from the previous question (d)? Explain.

End of 2^nd Assignment

ACC-933 Financial Management - Fall 2022

Marking scheme:

Min-Case 1 10 Marks

Mini-case 2 14

Mini-case 3 10

Mini-case 4 10

Mini-case 5 16

Total: 60 marks