Weekly tutorial solutions Full Year PDF

Preview

Summary

Topic 1 Solutions1. What are the advantages and disadvantages of organising a business as acorporation?​Advantages: ​ ​Limited liability, liquidity, infinite life, unlimited numberof owners.Disadvantages: ​Separation of ownership and control, more complicated andexpensive to set ​ ​ ​up.2. What is t...

Description

Topic 1 Solutions 1. What are the advantages and disadvantages of organising a business as a corporation? !Advantages: ! !Limited liability, liquidity, infinite life, unlimited number of owners. Disadvantages: !Separation of ownership and control, more complicated and expensive to set ! ! !up. 2. What is the most important difference between a corporation and all other organizational forms? A corporation is a legal entity separate from its owners. Owners’ liability is limited to the amount they invested in the firm. Stockholders are not responsible for any encumbrances of the firm; in particular, they cannot be required to pay back any debts incurred by the firm.

3. What are the main types of decisions that a financial manager makes? The financial manager has three main tasks: • Make investment decisions • Make financing decisions • Manage cash flow for operating activities.

4. What is the goal of the financial manager? The goal of the financial manager is to maximise the wealth of the owners of the firm.

5. What are agency costs and are these costs more or less likely to be present in (1) a sole proprietorship or (2) a company? Please discuss An agency cost occurs when a conflict arises between parties within a company. The primary agency conflicts arise between managers and shareholders and shareholders and bondholders. Agency costs are (1) the costs of monitoring the company to make sure that managers act in shareholders’ interests, bonding or the efforts that managers take to assure shareholders that they are acting in their best interest, and (2) residual loss, losses because managers did not make decisions in the best interests of shareholders. These costs tend to increase as a company grows larger because there is a larger, more diverse body of shareholders to satisfy. When there is one owner/manager, by definition – whatever choices he/she makes will maximise shareholder wealth. This becomes more difficult as the number of shareholders’ increases (i.e. when a business is structured as a company).

6. Corporate managers work for the owners of the corporation. Consequently, they should make decisions that are in the interests of the owners, rather than in their own interests. What strategies are available to shareholders to help ensure that managers are motivated to act this way? Shareholders can: E th t

l

id ith

h

d/

h

ti

a. Ensure that employees are paid with company shares and/or share options. b. Ensure that underperforming managers are fired. c. Write contracts that ensure that the interests of the managers and shareholders are closely aligned. d. Mount hostile takeovers. Supplementary notes: It is important that a company has a well-functioning corporate governance system. This requires a strong board of directors and other measures, such as performance linked compensation packages, to align the interest of managers with that of its shareholders. The market for corporate control and monitoring by institutional investors/block holders can also help mitigate agency problems.

7. You are a financial manager in a public corporation. One of your engineers says that they can increase the profit margin on your flagship product by using a lower quality vendor. However, the product is likely to fail more often and will generally not last as long. Will taking your engineer’s suggestion necessarily make shareholders better off? Why or why not? No—it will not necessarily make the shareholders better off. Even though you are reducing costs, which could increase cash flows in the short-term, you will deal with more costly warranty issues and with lost reputation with your customers, potentially leading them to buy from your competitors, which would reduce cash flows in the longrun. Making a less expensive, but lower quality product is NOT the same as maximizing the value of the shares (making your shareholders better off).

8. Ladders, Inc. has a net profit margin of 5.2% on sales of $51.2 million. It has book value of equity of $38.6 million and total liabilities with a book value of $30.5 million. What is Ladders’ ROE? ROA? Plan: First, we must compute Ladders’ net income using the fact that net profit margin is net income/sales. Then we can compute the ROE as net income/book equity and the ROA as net income/book assets. Execute: First, compute Ladders’ net income: 0.052 ´ $51.2 million = $2.66 million. ROE = Net Income/Book Equity = $2.66 million / $38.6 million = 6.90% ROA = Net Income/Book Assets = $2.66 million / ($30.5 million = $38.6 million) = 3.85% Evaluate: ROE measures the net income (to shareholders) as a percentage of the book value of their investment. ROA measures the net income (to shareholders) as a percentage of the book value of all the assets used to generate the income. A firm with positive book equity and some debt will always have a lower ROA than ROE. ROA and ROE will be the same for a firm with no liabilities.

9. From the following items produce an income statement and balance sheet. $ Accounts receivable 650,000 Accounts payable 480,000 Bonds outstanding 1,300,000 Cash 140,000 Cost of goods sold 4,200,000 Depreciation expense 235,000 Fixed assets 3,780,000 Interest expense 85 000

Interest expense Inventory Notes payable Retained earnings Sales Taxes Share capital

85,000 800,000 500,000 600,000 4,800,000 81,000 ?

Net Income (NI) = $199,000 Total liabilities and owners’ equity = $5,370,000 Balance Sheet Current assets Current liabilities Cash 140,000 Accounts payable Accounts receivable 650,000 Notes payable Inventory 800,000 1,590,000 Non-current assets Non-current liabilities Fixed assets 3,780,000 Bonds outstanding Owners’ equity Share capital Retained earnings Total assets

$5,370,000 Total liabilities and owners’ equity Income Statement

Sales Cost of goods sold Gross profit Depreciation expense Earnings before interest (EBIT) Interest expense Taxable income Taxes Net income

and

4,800,000 4,200,000 600,000 235,000 tax 365,000 85,000 280,000 81,000 $199,000

480,000 500,000 980,000

1,300,000

2,490,000 600,000 $5,370,000

Topic 10 Solutions Question 1 Why does a firm’s capital have a cost? To attract potential investors, the firm must offer them an expected return equal to what they could expect to earn elsewhere for assuming the same level of risk. This return is the cost a company bears to obtain capital from its investors.

Question 2 What does the WACC measure? The WACC measures the average return required on the assets of the firm to satisfy the investor base of the firm. It shows how much managers must earn on the assets of the firm in order for investors to earn their required rates of return on their investment.

Question 3 Why are market-based weights important? Market weights are used because market values are forward-looking while book values are historical and backwards-looking. Since investors use market values to make investment decisions, managers should use market weights in order to accurately estimate the return on asset required to satisfy investors.

Question 4 Why is the coupon rate of existing debt irrelevant for finding the cost of debt capital? The coupon rate sets the level of coupon payments over the life of the bond. This rate is locked in when the bond is issued; thus, this is a historical rate of return. Market conditions change, and for the cost of debt the firm should use the rate of return that bond investors currently demand on the debt. This is the yield to maturity.

Question 5 Explain when companies should discount projects using the cost of equity. When should they use the WACC instead? When should they use neither? Only companies with no debt in their capital structure should use the cost of equity to discount project cash flows, and only those projects that are very similar to a company’s existing assets should be discounted using that rate. Companies with both debt and equity should use the WACC as long as they are evaluating a project that is similar to their existing assets. When a company is making an investment that is very different from its existing investments, then it shouldn’t use the company’s cost of equity or its WACC. ! Question 6 XL CorporatBion has debt with market value of $100 million, ordinary equity with a book value of $100 million and preference shares worth $20 million outstanding. Its ordinary shares trade at $50 each and the firm has six million shares outstanding. What weights should XL Corporation use in its WACC?

!Compute the weights for the WACC.

Plan: E

t

Vl

f d bt

$100

illi

Execute:

! alue of debt = $100 million V !Value of preference shares = $20 million ! !Market value of ordinary shares = $50 × 6 million shares = $300 million !Total market value of firm = 100 + 20 + 300 = $420 million Weights for WACC calculation:

!

!

Evaluate: !The total market value of the firm is $420 million. Debt is 23.81% of the total value, preference !shares are 4.76%, and ordinary shares are 71.43%.

Question 7 Hardy Limited has debt outstanding with a coupon rate of 6% and a yield to maturity of 7%. Its tax rate is 30%. What is Hardy’s effective (after-tax) cost of debt? Plan: Compute Hardy’s after-tax cost of debt. Execute: The pretax cost of debt is the yield to maturity on the existing debt, or 7%. Thus, the effective after-tax cost of debt is Evaluate: Hardy’s before-tax cost of debt is 7%; its after-tax cost of debt is 4.9%.

Question 8 Truman Limited has preference shares trading at $50 each. The next preference dividend of $4 is due in one year. What is Truman’s cost of capital for preference shares? Plan: Compute the cost of preference shares for Truman Limited. Execute: The price of the preferred stock is $50, and this price should be the present value of the perpetuity of preference dividends. Therefore, the cost of capital for preference shares is:

Evaluate: Truman’s cost of preference shares is 8%.

! Question 9 Steady Company’s shares have a beta of 0.20. If the risk-free rate is 6% and the market risk premium is 7%, what is an estimate of Steady Company’s cost of equity? Plan: Compute Steady Company’s cost of equity. Execute: Evaluate: Steady Company’s cost of equity is 7.4%.

Question 10 HighGrowth Company has a share price of $20. The firm will pay a dividend next year of $1 and its dividend is expected to grow at a rate of 4% per year thereafter. What is your estimate of HighGrowth’s cost of equity capital?

Plan: Compute HighGrowth’s cost of equity capital. Execute: The price of the share is $20, and this price should be the present value of the growing perpetuity of dividends. Therefore, the cost of equity capital for HighGrowth Company is:

Evaluate: HighGrowth’s cost of equity capital is 9%.

Question 11 Company A’s capital structure contains 10% debt and 90% equity. Company B’s capital structure contains 50% debt and 50% equity. Both companies pay 8% annual interest on their debt. The shares of Company A have a beta of 1.1, and the shares of Company B have a beta of 1.45. The risk-free rate of interest equals 5%, and the expected return on the market portfolio equals 12%. Required: a. Calculate the WACC for each company, assuming there are no taxes. b. Recalculate the WACC for each company, assuming that they face a tax rate of 34%. c. Explain how taking taxes into account in part (b) changes your answer from part (a).

a. Company A has a cost of equity of 5% + 1.1(12% – 5%), or 12.7%, and Company B has a

cost of equity of 5% + 1.45(12% – 5%), or 15.15%. Given these figures and the fact that both companies have a cost of debt of 8%, the WACC for Company A is (0.10 ´ 8%) + (0.90 ´ 12%), or 12.230%, and for Company B it is (0.50 ´ 8%) + (0.50 ´ 15.15%), 11.575%. b. Recalculating, assuming a 34% tax rate: WACC for A: (0.1 ´ 8% ´ (1–0.34)) + (0.9 ´ 12.70%) = 0.11958, or 11.958% WACC for B: (0.5 ´ 8% ´ (1–0.34)) + (0.5 ´ 15.15%) = 0.10215, or 10.215% c. When there are taxes, there is a bigger advantage to debt financing. Company B that uses a

greater percentage of debt financing, has a lower weighted average cost of capital.

Additional Practise Exercises Mackenzie Company has a share price of $36 and will issue a dividend of $2 next year. It has a beta of 1.2, the risk-free rate is 5.5% and it estimates the market risk premium to be 5%. Required: a. Estimate the equity cost of capital for Mackenzie. b. Under the CDGM, at what rate do you need to expect Mackenzie’s dividends to grow to get the same equity cost of capital as in part (a)? Plan: Compute the cost of equity capital for Mackenzie and the dividend growth rate that would yield the same cost of equity capital. Execute: a.

!Using the Capital Asset Pricing Model,

b.

!

Evaluate: Mackenzie’s cost of equity using the CAPM is 11.5%, which would require a dividend growth rate of 5.94% to result in the same cost of equity using CDGM.

Topic 9 Solutions

1. Why do we focus only on incremental revenue and costs, rather than all revenue and costs of the firm? In capital budgeting, we want to determine how a particular project impacts the firm. Therefore, we want to focus on the changes in revenues and the changes in costs that will occur if the project is accepted. 2. If depreciation expense is not a cash flow, why do we have to subtract it and add it back when calculating OCF? Why not just ignore it? Although depreciation is not a cash outflow, it is considered an expense when calculating taxable income. Therefore, there is a depreciation tax shield that impacts the earnings of a project. 3. Should we include sunk costs in the cash flows of a project? Why or why not? No, we should not include sunk costs in the cash flows of a project because sunk costs must be paid regardless of the decision to proceed or not with the project. Sunk costs are not incremental with respect to the current decision. 4. Planet Enterprises is purchasing a $10 million machine. It will cost $50 000 to transport and install the machine. The machine has a depreciable life of five years and will have no salvage value. If Planet uses straight-line depreciation, what are the depreciation expenses associated with this machine? Plan: We can compute the total capitalization of the machine by adding the total cost of transporting and installing the machine to the initial cost of purchasing the machine, and this will provide us with the total cost of the machine that we must appreciate over the 5 years of the machine’s life. In order to compute the annual depreciation expense of the machine we can then take the total capitalization of the machine and divide it by the depreciable life of the machine. Execute: Capitalization of machine: $10,050,000 Annual depreciation expense: 10,050,000/5 = $2,010,000 Evaluate: Rather than expensing the $10,050,000 it costs to buy, ship and install the machine in the year it was bought, accounting principles require you to depreciate the $10,050,000 over the depreciable life of the equipment. Assuming the equipment has a 5-year depreciable life and that we use the straight-line method, we would expense $10,050,000/5 = $2,010,000 per year for five years. The idea is to match the cost of acquiring the machine to the timing of the revenues it generates.

5. Home Builder Supply, a retailer in the home improvement industry, currently operates seven retail outlets in New South Wales. Management is contemplating building an eighth retail store across town from its most successful retail outlet. The company already owns the land for this store, which currently has an abandoned warehouse located on it. Last month, the marketing department spent $10 000 on market research to determine the extent of customer demand for the new store. Now Home Builder Supply must decide whether to build and open the new store. Which of the following should be included as part of the incremental earnings for the proposed new retail store? a. the original purchase price of the land where the store will be located; b. the cost of demolishing the abandoned warehouse and clearing the land; c. the loss of sales in the existing retail outlet, if customers who previously drove across

c. the loss of sales in the existing retail outlet, if customers who previously drove across town to shop at the existing outlet become customers of the new store instead; d. the $10 000 in market research spent to evaluate customer demand; e. construction costs for the new store; f. the value of the land if sold; g. interest expense on the debt borrowed to pay the construction costs.

! a.

!Yes, this is a cost of opening the new store.

b. c.

! No, this is a sunk cost and will not be included directly. (But see part (f) below.)

!Yes, this loss of sales at the existing store should be deducted from the sales at the new store to determine the incremental increase in sales that opening the new store will generate for HBS. !No, this is a sunk cost.

d. e.

!This is a capital expenditure associated with opening the new store. These costs will therefore increase HBS’s depreciation expenses.

f.

!Yes, this is an opportunity cost of opening the new store. (By opening the new store, HBS forgoes the after-tax proceeds it could have earned by selling the property. This loss is equal to the sale price less the tax owed on the capital gain from the sale, which is the difference between the sale price and the book value of the property. The book value equals the initial cost of the property less accumulated depreciation.)

g.

!While these financing costs will affect HBS’s actual earnings, for capital budgeting purposes we calculate the incremental earnings without including financing costs to determine the project’s unlevered net profit.

6. Your projected income statement shows sales of $1 million, cost of goods sold as $500 000, depreciation expense of $100 000, and taxes of $120 000 due to a tax rate of 30%. What are your projected earnings? What is your projected operating cash flow? Plan: Set-up the pro-forma income statement to calculate your pro forma earnings. Then make adjustments to earnings to forecast free cash flows. In this case, your only adjustment is to add back the depreciation (not a real cash outflow) that was deducted from earnings. Execute: Sales COGS Depreciation

1,000,000 –500,000 –100,000

EBIT Taxes (30%)

400,000 –120,000

Earnings Add depreciation OCF

280,000 back 100,000 380,000

7. One year ago, your company purchased a machine used in manufacturing for $110 000. You have learned that a new machine is available that offers many advantages; you can purchase it for $150 000 today. It will be depreciated on a straight-line basis over 10 years and has no salvage value. You expect that the new machine will reduce costs by $20,000 per annum. The current machine is being depreciated on a straight-line basis over a useful life of 11 years, and has no salvage value, so depreciation expense for the current machine is $10 000 per year. The market value today of the current machine is $50 000. Your company’s tax rate is 30%, and the opportunity cost of capital for this type of equipment is 10%. Should

rate is 30%, and the opportunity cost of capital for this type of equipment is 10%. Should your company replace its year-old machine?

Replacing the machine reduces costs by $20,000; increasing EBIT by $20,000. Depreciation expenses rise by $15,000 – $10,000 = $5,000; decreasing EBIT by $5,000. Therefore, OCF will increase by (15,000) ´ (1 – 0.30) + (5000) = $15,500 in years 1 to 10. In year 0, the initial cost of the mach...