BUS2201 Financial Management- Cost Of Ordinary Shares
This Assessment is open-book. There is no time limit, and you may use your textbooks, other supporting material and and Excel financial formulae for your reference and assistance.
Please answer all questions.
1. Landcruisers Plus has operated an online retail shop selling off-road truck parts. As the name implies, the firm specialises in parts for the venerable Toyota FJ40 that is known throughout the world for its durability and off-road prowess. The fact that Toyota stopped building and exporting the FJ40 to the Australian market in 1982 meant that FJ40 owners depended more and more on re-manufactured parts to keep their beloved off-road vehicles running. More and more FJ40 owners are replacing the original inline six-cylinder engines with a modem Australian-built engine. The engine replacement requires mating the new engine with the Toyota drive train. Landcruisers’ owners had been offering engine adaptor kits for some time but have recently decided to begin building their own units. To make the adaptor kits, the firm would need to invest in a variety of machine tools costing a total of $70000.
Landcruisers’ management estimates they will be able to borrow $40000 from the firm’s bank at an annual interest rate of 8%. The remaining funds would have to be supplied by Landcruisers’ owners.
The firm estimates they will be able to sell 100 units a year for $1300 each. The units would cost $1000 each in cash expenses to produce (this does not include depreciation expense of $7000 per year or interest expense of $3200). After all expenses, the firm expects earnings before interest and tax of $23 000. The firm has a marginal tax rate of 30%, which results in net profit of $13 860 per year over the 10-year expected life of the equipment.
a) What is the annual free cash flow Landcruisers Plus should expect to receive from the investment in year 1, assuming it does not require any other investments in either capital equipment or working capital and the equipment is depreciated over a 10-year fife to a zero salvage and book value? How should the financing cost associated with the $40000 loan be incorporated into the analysis of cash flow?
b) If the firm’s required rate of return for its investments is 10% and the investment has a 10-year expected fife, what is the anticipated NPV of the investment?
2. Emily Dao, 27, just received a promotion at work that increased her annual salary to $74000. In addition to standard compulsory employer superannuation, she is eligible to participate in her employer’s retirement savings plan, workers’ contributions up to 5% of salary. However, Emily wants to buy a new $50000 car in three years, and she wants to have enough money to make a $14000 deposit on the car and finance the balance.
Fortunately, she expects a sizeable bonus this year that she hopes will cover that deposit in three years.
A wedding is also in her plans. Emily and her boyfriend, Paul, have set a wedding date two years in the future, after he finishes his medical degree. In addition, Emily and Paul want to buy a home of their own as soon as possible. This might be possible because at age 30, Emily will be eligible to access a $100000 trust fund left to her as an inheritance by her late grandfather. Her trust fund is invested in 7% government bonds.
a) Justify Emily’s participation in her employer’s retirement savings plan using the time- value-of-money concepts by explaining how much an investment of $20000 will grow to in 40 years if it earns 10% annual interest.
b) Calculate the amount of money that Emily needs to set aside from her bonus this year to cover the deposit on a new car, assuming she can earn 6% annual interest on her savings. What if she could earn 10% annual interest on her savings?
c) What will be the value of Emily’s trust fund at age 60, assuming she takes possession of half of the money ($50000 of the $100000 trust fund) at age 30 for a house deposit, and leaves the other half of the money untouched where it is currently invested?
3. You have just been hired to compute the cost of capital for debt, preference shares and ordinary shares for the Mindflex Corporation. Show all the steps how you find them.
a) Cost of debt: Because Mindflex’s bonds do not trade very frequently, you have decided to use 9% as your cost of debt, which is the yield to maturity on a portfolio of bonds with a similar credit rating and maturity as Mindflex’s outstanding debt. In addition, Mindflex faces a corporate tax rate of 30%.
b) Cost of debt: Now let us assume Mindflex’s bonds are frequently traded. A Mindflex bond has a $1000 face value (par value) and a coupon interest rate of 13% that is paid semi-annually. The bonds are currently selling for $1125 and will mature in 20 years. Mindflex’s corporate tax rate is 30%.
c) Cost of preference shares: Mindflex’s preference shares pay a 7% dividend on a $125 face value. However, the market price at which the preference shares could be sold is only $90.
d) Cost of ordinary shares: Mindflex’s ordinary shares paid a $ 1.25 dividend last year. In addition, Mindflex’s dividends are growing at a rate of 6% per year and this growth rate is expected to continue into the foreseeable future. The price of these shares is currently $30.
4. Green Gadgets Ltd is trying to decide whether to cut its expected dividends for next year from $8 per share to $5 per share in order to have more money to invest in new projects. If it does not cut the dividend, Green Gadgets’ expected rate of growth in dividends is 5% per year and the price of its ordinary shares will be $100 per share. However, if they cut their dividend, the dividend growth rate is expected to rise to 8% in the future.
Assuming the investor’s required rate of return for Green Gadgets’ shares does not change, what would you expect to happen to the price of its ordinary shares if Green Gadgets cuts the dividend to $5? Should Green Gadgets cut its dividend? Support your answer as best as you can.
5. Suppose Walker Company has this book value balance sheet:
Common stock (1 million shares)
Total liabilities and equity
The notes payable are to banks, and the interest rate on this debt is 10%, the same as the rate on new bank loans. These bank loans are not used for seasonal financing but instead are part of the company’s permanent capital structure. The long-term debt consists of 30,000 bonds, each with a par value of $1,000, an annual coupon interest rate of 6%, and a 20-year maturity. The going rate of interest on new long-term debt, rd, is 10%, and this is the present yield to maturity on the bonds. The common stock sells at a price of $60 per share. Calculate the firm’s market value capital structure.
6. For your job as the business reporter for a local newspaper, you are given the assignment of putting together a series of articles on multinational finance and the international currency markets for your readers. Much recent local press coverage has been given to losses in the foreign exchange markets by JGAR, a local firm that is the subsidiary of Daedlufetarg, a large German manufacturing firm. Your editor would like you to address several specific questions dealing with multinational finance. Prepare a response to the following memorandum from your editor:
To: Business Reporter
From: Perry White, Editor, Daily Planet
Re: Upcoming series on multinational finance
In your upcoming series on multinational finance, I would like to make sure you cover several specific points. In addition, before you begin this assignment, I want to make sure we are all on the same page, as accuracy has always been the cornerstone of the Daily Planet. I’d like a response to the following questions before we proceed:
a) What new problems and factors are encountered in international financial management as opposed to domestic financial management?
b) What does the term arbitrage profit mean?
c) What does interest rate parity refer to?
7. a) From the firm’s perspective, how are dividends different from interest payments?
b) When a firm’s accounts receivable balance increases from one period to the next, the firm has experienced a use of cash. How is it that an increase in an asset, such as accounts receivable, represents a use of cash?
c) The cash flow statement is one of the four basic financial statements. Define the objective in preparing this statement and discuss some of the types of questions that can be addressed using its content.