Needed help in Part B Case Study, question 1&2. Regards

ASSIGNMENT QUESTIONS Answer ALL questions Due date: Value: Monday 4 April, 2016 15% Rationale This assignment covers Weeks 1 - 10, and builds on previous work. Criteria Where necessary, state any assumptions you have made. Please note that assumptions have to be valid. Assignments should show all workings and students will be penalised for failing to do this. You will be assessed on: your understanding of the problem; choice of method for solving the problem; application of techniques. ANSWER ALL QUESTIONS Part A Question 1 (10 marks) a. Explain what is meant by the time value of money and why a bird in the hand is worth two or more in the bush. Which capital budgeting approach(es) ignores this concept? b. Why cannot the accounting rate of return be used as a reliable capital budgeting technique? What are its advantages? Question 2 (10 marks) a. Use the following information to calculate the cost of capital for TLC Ltd, on the assumption that investors can remove all unsystematic risk by diversification. The systematic risk of TLC Ltd's equity is 0.80; The risk free rate is 10%; The expected rate of return on the market portfolio is 15%; 8 The sources of funds used by TLC Ltd and their respective market values are as follows: Source of Funds Debt (par value $100) Equity Market Value ($m) 1 3 The interest rate on the debt is 11% paid annually. The debt, which is due to mature in eight years' time, has a current market price of $111. The company tax rate is 30%. b. Under what assumptions is the cost of capital you have calculated for TLC Ltd in (a) appropriate for a proposed project? Question 3 (10 marks) TLC Ltd at present only sells on a cash basis and it averages $50,000 of sales per month, with associated (variable) expenses of $40,000. It is thought that all customers would accept an offer of 90 day (three month) free credit terms and that the company's monthly sales would increase to $55,000 and its associated expenses to $44,000. TLC Ltd's required rate of return is 1% per month. a. Assuming that there are no costs associated with providing credit, will TLC Ltd benefit from offering such credit terms? b. If expenses remain at 80% of sales, what would the increase in sales need to be in order to justify the provision of these credit terms? Question 4(A) (5 marks) Currently Hambleton Ales dividends are growing by 10% pa and this is expected to continue for another two years. After that time they are expected to grow by 8% pa for $0.80, and the appropriate discount rate is 12%. If you have $20,700 to invest, how many shares can you buy in Hambleton Ales? Question 4(B) (5 marks) Two years ago Batlow Ltd. issued at par, bonds with a face value of $1,000 and a maturity of 8 years. The bonds have a coupon interest rate of 8%, paid semi-annually. a. If the current yield is 7.5%, what is the value of a Batlow bond today? b. If the expected yie bond at that time? 9 Question 5 (10 marks) Comment on the following statements: i. 'If after all your calculations you tell me that there is a high probability that the share's price will vary between $4.50 and $9.60, I can make a fortune by buying the share at $4.50 and selling when it reaches $9.60.' ii. 'I don't care how high the price may go, all that worries me is whether or not I will make a loss.' iii. 'Expected return and standard deviation are of no interest to me, all I want to know is what my investment will be worth one year from now.' Part B (50 marks) Case study This case is intended to be an introduction to the various methods used in capital budgeting and looks at some of the decisions that may have to be made when evaluating projects. It is also designed to develop skills in using spreadsheets. You should set up a spreadsheet at the start to help analyse the problems. When using a spreadsheet, any tables that you wish to present to the reader should be embedded into a Word document as an ordinary table. Note, however, that you must still show how an answer is obtained, for example, you must show in Q5 how the NPV was derived, not simply give the final answer. Archer Juices, Inc Archer Juices is a leading juice producer who distributes unfranked dividends to its shareholders. The firm was founded in 1968 by Charles Archer who had spent several years in Australia and who was convinced that his country could produce juices that were as good as or better than the best Australia had to offer. Originally, Archer sold his juice to wholesalers for distribution under their brand names, but in the early 1970s, when juice sales were expanding rapidly, he joined with several other producers to form Archer Juices, which then began an aggressive promotion campaign. Today, its juices are sold throughout the country. Archer's management is currently evaluating a potential new product; a light, fruity juice designed to appeal to the younger generation. The new product, Bulgong Gold, would be positioned between the various juice coolers and the traditional drinks. The new product would cost more than juice coolers, but less than premium table drinks, and in market research samplings at the company's Bulgong headquarters, it was judged superior to various competing products. Jan Armstrong, the Chief Financial Officer, must analyse this project, along with other potential investments, and then present her findings to the company's executive committee. Production facilities for the new juice product would be set up in an unused section of Archer's main plant. Relatively inexpensive, used machinery with an estimated cost of only $500,000 would be purchased, but shipping costs to move the machinery to 10 Archer's plant would total $40,000, and installation charges would add another $60,000 to the total equipment cost. Further, Archer's inventories would have to be increased by $20,000, and this cash flow is assumed to occur at the time of the initial investment. The machinery has a remaining economic life of 4 years and Tax Office ruling will allow Archer Juices to claim the following annual depreciation allowances: Year 1: Year 3: 33% 15% Year 2: Year 4: 45% 7% The machinery is expected to have a salvage value of $50,000 after 4 years of use. The section of the plant in which production would occur has not been used for several years, and consequently had suffered some deterioration. Last year, as part of a routine facilities improvement program, Archer spent $200,000 to rehabilitate that section of the main plant. Rufus Smith, the chief accountant, believes that this outlay, which has already been paid and expensed for tax purposes, should be charged to the juice project. His contention is that if the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make the site suitable for the juice project. Archer's management expects to sell 200,000 bottles of the new juice product in each of the next 4 years, at a wholesale price of $4 per bottle, but $3 per bottle would be needed to cover fixed and variable cash operating costs. In examining the sales figures, Armstrong noted a short memo from Archer's sales manager which expressed concern that the juice project would cut into the firm's sales of juice coolers - this type of effect is called an externality (or opportunity cost). Specifically, the sales manager estimated that juice cooler sales would fall by 5 percent if the new juice were introduced. Armstrong then talked to both the sales and production managers, and she concluded that the new project would probably lower the firm's juice cooler sales by $40,000 per year, but, at the same time, it would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis. Thus, the net externality effect would be $40,000 + $20,000 = -$20,000. Archer's effective tax rate is 40 percent, and its overall cost of capital is 10 percent, calculated as follows: WACC E D RE R D (1 TC ) V V 1 1 (0.152) (0.08)(1 0.40) 2 2 0.10 10% Now assume that you are Armstrong's assistant and she has asked you to analyse the project and then to present your findings in a 'tutorial' manner to Archer's executive committee. As Chief Financial Officer, Armstrong wants to educate some of the other executives, especially the marketing and sales managers, in the theory of capital budgeting so that these executives will have a better understanding of her capital budgeting decisions. Therefore, Armstrong wants you to ask and then answer a series of questions as set out below. Specifics on the other two projects that must be analysed are provided in Questions 4 and 5. Keep in mind that you will be questioned closely during your presentation, so you should understand every step of the analysis, including any assumptions and weaknesses that may be lurking in the background and that someone might spring on you in the meeting. 11 Depreciation Schedule Table 1 Depn. Allowance Depn. Expense End-of-Year Book Value $198,000 X X $600,000 $402,000 X X $ 0 Year 1 2 3 4 33% X X 7% 100% Cash Flow Statement Table 2 Year 0 Year 1 Year 2 Year 3 Year 4 Unit price Unit sales Net Investment Outlay Price Freight Installation Change in NWC Operating cash flows Revenues Operating Costs Depreciation Other project effects Before-tax income Tax Net income Plus depreciation Net operating cash flow Salvage value Salvage value tax Recovery of NWC Project net cash flow Note: The WACC (Weighted Average Cost of Capital) of 10% is the appropriate discount rate to use when evaluating this project Table 2 above is a suggested way of formatting your spreadsheet. Question 1 (10 marks) a. Define the term 'incremental cash flow'. Since the project will be financed in part by debt, should the cash flow statement include interest expenses? Explain. b. Should the $200,000 that was spent to rehabilitate the plant be included in the analysis? Explain. 12 c. Suppose another juice maker had expressed an interest in leasing the wine production site for $10,000 a year. If this were true (in fact it was not), how should that information be incorporated into the analysis? Question 2 (15 marks) Using Tables 1 and 2 to help identify relevant cash flows, what are the projects: Net Present Value (NPV) Internal Rate of Return (IRR) Payback Period Will you recommend that the project should be undertaken? Why or why not? Question 3 (5 marks) Now assume that the sales price will increase by the 5% inflation rate beginning after Year 0. However, assume also that operating costs will increase by only 2% annually from the initial cost estimate, because over half of the costs are fixed by long-term contracts. For simplicity, assume that no other cash flows (net externality costs, salvage value, or net working capital) are affected by inflation. What are the project's NPV, IRR and Payback Period now that inflation has been taken into account? Does change your recommendation in Q2 (d)? (Hint: the Year 1, and succeeding cash flows, must be adjusted for inflation because the estimates are in Year 0 dollars.) Question 4 (10 marks) The second capital budgeting decision which Armstrong and you were asked to analyse involves choosing between two mutually exclusive projects, S and L, whose cash flows are set forth below: Year 0 1 2 3 4 Expected Net Cash Flow Project S Project L -$200,000 120,000 120,000 -$200,000 67,000 67,000 67,000 67,000 Both of these projects are in Archer's main line of business, premium table juice, and the investment which is chosen is expected to be repeated indefinitely into the future. Also, each project is of average risk, and hence each is assigned the 10% required rate of return. What is each project's single cycle NPV? Can you make a decision on this information? Why or why not? If not, what should you do to be able to make a decision? Which project should be chosen? Why? 13 Question 5 (10 marks) The third decision to be considered involves a fleet of trucks with an engineering life of three years (that is, the trucks will be totally worn out after three years). However, if the trucks were taken out of service, or "abandoned" prior to the end of three years, they would have a positive salvage value. Here are the estimated net cash flows for each truck: Year Initial Investment and Operating Cash Flow End-of-Year Net Abandonment Cash Flow 0 1 2 3 ($20,000) $ 8,400 $ 8,000 $ 7,000 $20,000 $12,400 $8,000 $ 0 The relevant required rate of return is again 10%. What would the NPV be if the trucks were operated for the full three years? What if they were abandoned at the end of Year 2? What if they were abandoned at the end of Year 1? What is the economic life of the truck project? 14