QUESTION 1 - CASH BUDGET
Keith Brothers had sales of R87 000 in May and R83 000 in June. Sales for July, August and September are expected to be R74 000; R67 000 and R56 000 respectively. The company has a cash balance of R20 000 on 1 July and wishes to maintain a minimum cash balance of R20 000.
(a) Sales are: 15% for cash; 70% collected in the month following sales and 15% collected two months after sales. (No bad debt is experienced.)
(b) The company expects to receive other income of R4 000; R5 000 and R7 000 respectively in July, August and September.
(c) Expected cash purchases by the company are R70 000; R80 000 and R75 000 respectively in July, August and September.
(d) Rent paid amounts to R3 500 per month.
(e) Salaries and wages are 9% of the previous month's sales.
(f) A cash dividend of R3 300 will be paid in August.
(g) Interest of R5 400 will be paid in July.
(h) Equipment of R6 000 will be bought and paid for in September.
(i) Tax of R4 100 is to be paid in August.
(a) Given the information above, draw up a cash budget for the months of July, August and September.
(b) What is the maximum overdraft facility that must be arranged in order to maintain a good relationship with the bank?
QUESTION 2 - CAPITAL BUDGETING
Fast Corporation has the opportunity to replace a five year old machine with a brand new one costing R1 000 000. The new machine is expected to last for 10 years. The new machine will require R50 000 in freight and installation charges. Inventory is expected to increase by R40 000; accounts receivable by R20 000, cash by R15 000, accounts payable by R15 000, and accruals by R10 000. The old machine was originally purchased for R800 000 (5 years ago) and can be sold today for R600 000. The original plan was to depreciate the old machine over its expected economic useful life of 10 years, but through good maintenance the machine is expected to last for 5 more years (10 years' useful life remain). The company uses straight-line depreciation and its tax rate is 30%. The new machine is not expected to increase revenues, but it will decrease operating costs from R300 000 to R180 000 per year. The estimated market value of the new machine after 10 years is R100 000.
Do a complete capital budgeting analysis of the incremental cash flows resulting from the renewal. Assume cost of capital = 10%. What is your recommendation? (Hint: use Payback, NPV and IRR and comment on your answers.)
QUESTION 3 - CAPITAL STRUCTURE
Fine Chemicals is considering two possible capital structures, A and B, shown in the following table. Assume a 40% tax rate.
Source of capital Structure A Structure B
Long-term debt R75 000 at 16% coupon rate R50 000 at 15% coupon rate
Preferred stock R10 000 with an 18% annual dividend R15 000 with an 18% annual dividend
Common stock 8 000 shares 10 000 shares
(a) Calculate two EBIT-EPS coordinates for each proposed capital structure by selecting any two appropriate EBIT values and finding their associated EPS values. (7)
(b) Plot these on a set of EBIT-EPS axes. (3)
(c) Discuss the leverage and risk associated with each of the structures. (3)
(d) Determine the "cross-over" EBIT value, where the two capital structures would give identical EPS values. (3)
(e) Over what range of EBIT is each structure preferred? (2)
(f) Which structure do you recommend if the firm expects its EBIT to be, on average, more than R35 000? Explain. (2)
QUESTION 4 - COST OF CAPITAL
Anthony Shoe Co. is financed by R80 million long-term debt, R20 million preferred shares and R100 million common equity. The firm can raise debt by selling R1000 par value, 12% coupon rate (coupons paid annually), 10 year bonds at a discount of R30 and has to pay R30 in flotation cost. The firm can also sell 10% preferred shares with a par value of R100 at R80, and has to pay R5 per share in flotation cost. Anthony's common shares are selling at R50 each. A dividend of R5 per share has just been paid, and the annual growth rate of 8% per year is expected to continue in the near future. The company's tax rate is 30%.
Calculate Anthony's Weighted Average Cost of Capital (WACC).
Answers to 4 Questions on Cash budget, Capital Budgeting (Payback, NPV and IRR) , Capital Structure (EBIT-EPS analysis) , and Cost of Capital
12 questions on Capital Budgeting, Capital Structure, WACC
1. Billick Brothers is estimating its WACC. The company has collected the following information:
? Its capital structure consists of 40 percent debt and 60 percent common equity.
? The company has 20-year bonds outstanding with a 9 percent annual coupon that are trading at par.
? The company's tax rate is 40 percent.
? The risk-free rate is 5.5 percent.
? The market risk premium is 5 percent.
? The stock's beta is 1.4.
What is the company's WACC?
2. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an expected return of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk. Which of the following statements is most correct?
A. The project should be accepted since its expected return (before risk adjustment) is greater than its required return.
B. The project should be rejected since its expected return (before risk adjustment) is less than its required return.
C. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm's policy were to reduce a riskier-than-average project's expected return by 1 percentage point, then the project should be accepted.
D. Riskier-than-average projects should have their expected returns increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
E. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the problem to make an accept/reject decision.
3. Heller Airlines is considering two mutually exclusive projects, A and B. The projects have the same risk. Below are the cash flows from each project:
Project A Project B
Year Cash Flow Cash Flow
0 -$2,000 -$1,500
1 700 300
2 700 500
3 1,000 800
4 1,000 1,100
At what cost of capital would the two projects have the same NPV?
4. Tyrell Corporation is considering a project with the following cash flows (in millions of dollars):
Year Cash Flow
The project has a simple payback period of exactly two years. The project's cost of capital is 12 percent. What is the project's modified internal rate of return (MIRR)?
5. Oak Furnishings is considering a project that has an up-front cost and a series of positive cash flows. The project's estimated cash flows are summarized below:
Year Cash Flow
1 $500 million
2 300 million
3 400 million
4 600 million
The project has a payback of 2.25 years. What is the project's internal rate of return (IRR)?
6. Calculate the incremental operating cash flow for year 2 for a new proposed project given the following information:
Machine cost: $ 90000; Installation & delivery: $ 10000; Depreciation expense in year 2: $ 44,500; Tax rate: 40 %; New revenues: $ 145,000 per year; Old revenues: $ 90,000 per year
a. $ 104,800
b. $ 60,300
c. $ 50,800
d. $ 6,300
e. $ 145,000
7. St. John's Paper is considering purchasing equipment today that has a depreciable cost of $1 million. The equipment will be depreciated on a MACRS 5-year basis, which implies the following depreciation schedule:
8. Which of the following statements is most correct?
a. Underlying the MIRR is the assumption that cash flows can be reinvested at the firm's cost of capital
b. Underlying the IRR is the assumption that cash flows can be reinvested at the firm's cost of capital
c. Underlying the NPV is the assumption that cash flows can be reinvested at the firm's cost of capital
d. The discounted payback method always leads to the same accept/reject decisions as the NPV method
e. Statements a and c are correct.
9. Maple Media is considering a proposal to enter a new line of business. In reviewing the proposal, the company's CFO is considering the following facts:
? The new business will require the company to purchase additional fixed assets that will cost $600,000 at t = 0. For tax and accounting purposes, these costs will be depreciated on a straight-line basis over three years. (Annual depreciation will be $200,000 per year at t = 1, 2, and 3.)
? At the end of three years, the company will get out of the business and will sell the fixed assets at a salvage value of $100,000.
? The project will require a $50,000 increase in net operating working capital at t = 0, which will be recovered at t = 3.
? The company's marginal tax rate is 35 percent.
? The new business is expected to generate $2 million in sales each year (at t = 1, 2, and 3). The operating costs excluding deprecia-tion are expected to be $1.4 million per year.
? The project's cost of capital is 12 percent.
What is the project's net present value (NPV)?
B. $ 86,885
C. $ 81,243
D. $ 56,331
10. Klott Company encounters significant uncertainty with its sales volume and price in its primary product. The firm uses scenario analysis in order to determine an expected NPV, which it then uses in its budget. The base-case, best-case, and worst-case scenarios and probabilities are provided in the table below. What is Klott's expected NPV, standard deviation of NPV, and coefficient of variation of NPV?
Probability Unit Sales Sales NPV
of Outcome Volume Price (In Thousands)
Worst case 0.30 6,000 $3,600 -$6,000
Base case 0.50 10,000 4,200 +13,000
Best case 0.20 13,000 4,400 +28,000
A. Expected NPV = $35,000; óNPV = 17,500; CVNPV = 2.00
B. Expected NPV = $35,000; óNPV = 11,667; CVNPV = 0.33
C. Expected NPV = $10,300; óNPV = 12,083; CVNPV = 1.17
D. Expected NPV = $13,900; óNPV = 8,476; CVNPV = 0.61
E. Expected NPV = $10,300; óNPV = 13,900; CVNPV = 1.35
11. A company estimates that an average-risk project has a WACC of 10 percent, a below-average risk project has a WACC of 8 percent, and an above-average risk project has a WACC of 12 percent. Which of the following independent projects should the company accept?
A. Project A has average risk and an IRR = 9 percent.
B. Project B has below-average risk and an IRR = 8.5 percent.
C. Project C has above-average risk and an IRR = 11 percent.
D. All of the projects above should be accepted.
E. None of the projects above should be accepted
12. The costs of a stock-out do not include
a. Disruption of production schedules
b. Loss of customer goodwill
c. Depreciation and obsolescence
d. Loss of Sales
e. Answers c and d above.
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