AM 6226 – Introduction to Finance Assignment Answers

Assessment 1: Individual Assignment

Learning Outcomes: 1, 2 and 3

Marks:            175 marks 

  1. The Role and Environment of Managerial Finance 14 marks
  1. What are the two primary activities of the finance manager, and how does each activity relate to the firm’s balance sheet?     4 marks
  1. b. Firms invest in real assets and finance them by selling financial assets. Give one example of a real asset and one example of a financial asset.              2 marks
  1. Define ethics, outline two benefits of having an ethics program, and explain how having these benefits may positively impact a firm’s share price. 4 marks
  1. Explain the meaning of “agency problem”, and give an example of how boards of directors attempt to manage this problem. 2 marks
  1. Explain the meaning of “capital market”, and give one example of a marketable security that would be exchanged on this market. 2 marks 
  1. Time Value of Money (theory) 7 marks
  1. How is a perpetuity different from an annuity? 1 mark
  1. Define each of stated interest rates and effective interest rates. 2 marks
  2. Use an example (calculation) to show why the effective interest rate is greater than the stated interest rate.        1 mark
  3. In finance what are the three key factors that we consider when making financing investment decisions? 3 marks
  4. Time Value of Money & Capital Budgeting 97 marks

You should can use either scientific or financial calculators or excel to carry out the necessary computations. You are required to:

  1. Decide what formula is appropriate and show this.
  2. Show your workings/calculations as appropriate to support your answers.
  3. Draw timelines, where appropriate, to demonstrate the cash flows.
  4. Answers without support of calculations will not receive any marks.

3.1   To purchase a new piece of equipment for your company, you found two machines that will do the job you require. The purchase price of machine A is $6000 and the purchase price of machine B is $8000. The expected economic life of each model is 5 years and there will be no resale value for either model at the end of this period.

 However, the projected additional cash inflows resulting for each machine differ, as shown below:

Year Model A Model B
1 $2,500 $7,500
2 $3,500 $6,500
3 $5,300 $5,400
4 $7,000 $4,000
5 $10,000 $3,500
  • Assuming a discount rate of 9%, which machine would you choose and why? 4 marks
  • If the discount rate increased to 11%, does this change your decision on which machine you would choose in part (a)? 1 mark

 3.2     You have just won first prize in Super Lotto. However, you have two options of receiving the prize money: – you can either receive 30 payments of $240,000 paid every year, starting today or you can receive $1,600,000 now and future annual payments of $130,000 for 30 years, starting in one year from now.

  • If you were to maximize your wealth, which option would you choose if the interest rate is 6%?

        (Show your calculations for each option)                                                     7 marks

3.3     Your friend Kelly has $280,000 to invest. She does not want to take any high risks in the current economic climate. She comes to you, because she has heard you are studying business finance, and wants your financial advice on two investment options she has discovered that she thinks are equally safe:

  BNZ Bank TSB Bank
Interest rate

 

4.3 % 4.00%
Compound interval Annual

(every 12 months)

Quarterly

(every 3 months)

To show Kelly which is the best investment, calculate the final amount under each scenario over 3 years if she invested with

(a)     the BNZ Bank (show formulae/calculations)                                            2 marks

(b)     the TSB Bank (show formulae/calculations)                                            2 marks

(c)      Which investment is better at the end of the 3 years, and by what amount? 1 mark
3.4     You are planning to retire in 30 years’ time. You estimate that to live at your desired standard of living at that time, you need to accumulate $1,500,000 in your retirement fund. To do so, you plan to make equal end-of-month deposits into an account paying 3.5 % annual interest.
(a)   What will your end of monthly deposits have to be to accumulate the $1,500,000 by the end of 30 years?                                                   3 marks

(b)   At retirement time you have decided that you will be happy that your fund ($1,500,000) provides an income in perpetuity. This assures you of an acceptable income on top of your national pension from the NZ government.
i) What is this annual amount in perpetuity if the interest rate is 4%? Assume that this is paid in annual amounts, starting at the end of the first year of your retirement. Ignore income taxes.                                                        1 mark
ii) If your national pension is $450 per week (before tax), what will be your total annual income of pension and perpetuity payment (before taxes)? 2 marks

3.5     Assuming an annual interest rate of five percent (5%), calculate the present value of the following streams of yearly (annual) payments:

(a)   $22500 per year forever, with the first payment one year from today.        1 mark

(b)   $25000 per year forever, with the first payment three years from today.  3 marks

(c)    $50000 per year, for ten years, the first payment starting at the end of two years.          3 marks

3.6 Your company has entered a contract to purchase a warehouse. The purchase price is $7,750,000. This purchase is to be financed by a short term (4-year) loan from your bank. What monthly repayment is required, with an annual interest rate, fixed at 10% over the period of the loan?                                                                         3 marks
3.7 Peach Paving invests $1.0m today on a new construction project. The project will generate annual cash-flows of $150,000 in perpetuity. The appropriate discount rate is 10%.
a) Calculate the payback period.                                                        3 marks
b) If Peach Paving’s cutoff is 10 years, should the project be accepted? 1 mark

  1. c) Calculate the discounted payback period. 5 marksd) Calculate the NPV of this construction project.                               2 marks3.8 Victory Inc. has the following additional cash-flows (in thousands) for a small project. Assume the investment would be made today and the additional cash is all received at the end of each year:
Year Cash-flows
0 -5000
1 1800
2 2000
3 1800
  1. Calculate the internal rate of return, IRR, on the project. 2 marks
  2. If the appropriate discount rate for this type of project is 10%, should the project be accepted? Prove this by calculating the NPV.                           2 marks
    3.9. You must decide whether to purchase new capital equipment. The cost of the equipment is $50,000. This equipment will produce incremental cash flows as below over the expected life of this equipment. At the end of the 8 years you can expect to sell the equipment for $3000. The appropriate discount rate is 10%. Should you proceed with this project?                                                                                  7 marks
Year Cash-flow
1 7000
2 9000
3 10000
4 10000
5 10000
6 10000
7 12500
8 13750

                                                                                                                                                           3.10 The Big Burrito is planning to purchase a touch screen order system for its drive-through window that would allow customers to select their order as soon as they arrive. This would reduce customer wait times and increase order accuracy. The touch screen and software would cost Big Burrito $180,000 and last five years. System maintenance and licensing costs would be $5000 in year one, increasing by 6% year-on-year. The touchscreen and software has no resale value at the end of the five years. In addition to the improved customer service, the Big Burrito would gain two benefits. Firstly, they could reduce their workforce by one person to save $32000 per year. Secondly, they expect drive through sales to increase by $20000 for year one, $25000 for year two, $35000 for year 3, $45000 for year 4 and $60000 for year 5 due to improved customer perception and increased through-put. The cost of goods sold is 35 % of the incremental sales. Ignoring working capital, depreciation and taxes, should Big Burrito make this touchscreen investment? The appropriate discount rate is 16%.
Marks awarded: set up spreadsheet to show incremental sales income (2), annual maintenance costs (2), labour savings (2), cost of goods sold (3), for each year to get an annual  net cash-flow (total 9 marks) and calculate the PV of the net cash-flow (5 marks), calculate the NPV (I mark) and advise decision on the investment project (1 mark).                                                                                                              Total =16 marks

3.11 Evaluate the following three projects, using the profitability index (PI) rule. Assume the cost of capital is 15%.

Cash Flows Liquidate Recondition Replace
Initial cash outflow -$100,000 -$500,000 -$1,000,000
Year 1 cash inflow 50,000 100,000 500,000
Year 2 cash inflow 60,000 200,000 500,000
Year 3 cash inflow 75,000 250,000 500,000

a)    Rank these projects by their PIs.                                                       7 marks

b)    If these projects are independent, which one would you accept according to the PI criterion?                                                                        1 mark

c)    If these projects are mutually exclusive, which would you accept according to PI criterion?                                                                            1 mark

d)    Apply the NPV criterion to the projects, rank them according to their NPVs, and indicate which you would accept if they are independent and mutually exclusive.       5 marks

e)    Compare and contrast your answer from part (c) with your answer to part (d) for the mutually exclusive case. Explain this result                                                   2 marks

3.12 Reynard Enterprises is attempting to evaluate the feasibility of investing $85,000 in a machine having a five-year life. The cost of capital is 12%.The firm has estimated the incremental cash inflows associated with the new machine (shown in the table below):

Year Cash Inflow
           1 $18,000
2 22,500
3 27,000
4 31,500
5 36,000

a)    Calculate the payback period for the proposed investment   (3 marks)

  1. Calculate the NPV for the proposed investment (3 marks)
  2. Calculate the IRR for the proposed investment (2 marks)
  3. Evaluate the acceptability of the proposed investment using NPV and IRR. What recommendation would you make relative to implementation of the project? Why?                                                          (3 marks)
  1. Working Capital Management 57 marks

Firms set policies on (investments, financing, inventory, payables and accounts receivable) to manage the cash available in the operations. The objective is to always have cash on hand to meet its obligations in a manner that is acceptable to all its stakeholders.
The following problems will demonstrate your learning to be able to calculate various ratios that give a measure to the policies that are in effect.

  • PC has $15m of sales, $2m of inventories, $3m of receivables and $1m of payables. Its cost of goods sold is 80% of sales and it finances working capital with bank loans at an 8% annual interest rate.a) What is PC’s cash conversion cycle (CCC)? 7 marksb) If PC could lower its inventories and receivables by 10% each and increase payables by 10%, all without affecting sales or cost of goods sold, what would be the new CCC?                                                                        2 marksc) How much cash would be freed up?                                       3 marks
  • McFadden Industries sell on terms 3/10, net 30 (3% discount for payment in 10 days, otherwise payment due in 30 days). Total sales are $9,125,000 per year. Customers pay their invoices – 40% pay on the 10th day and take discounts, while the other 60% pay, on average, 40 days after their purchases.
    a) What is the days’ sales outstanding? 2 marks

    b) What is the average amount of receivables? 3 marks

c) What is the nominal annual cost (%) of trade credit to customers who take the discount?                                                                                           3 marks

d) What is the nominal annual cost of trade credit to customers who do not take the discount and pay in 40 days?                                                        3 marks

5)What would happen to accounts receivable if the collection policy was enforced so that all non-discount customers paid on the 30th day?          2 marks

  • Zenith Incorporated produces car batteries. It makes 2000 batteries per day at a cost of $12 per battery for materials and labour. It takes the firm 25 days to convert raw materials into a battery. Zenith allows its customers 40 days in which to pay for the batteries. The firm generally pays its supplier of raw materials in 30 days.a) What is the length of Zenith’s cash conversion cycle? 2 marksb) At a steady state in which Zenith produces 2000 batteries a day, what amount of working capital must it finance?                                 3 marksc) By what amount could Zenith reduce its working capital financing needs if it was able to stretch its payables deferral period to 35 days?     2 marksd) Zenith is investigating the impact of a new production process on its working capital investment. The new process would allow the inventory conversion period to reduce to 22 days and increase its daily production output to 2300 batteries, however, the new process would cause an increase in materials and labour to a total of $13 per battery. Assuming that the changes do not affect ACP (40 days) or PDP (30 days) and the new process is implemented:

    i) What will be the length of the new CCC?                                     2 marks

    ii) What will be the new capital financing requirement?                            3 marks

  • Chill Corporation is trying to determine the effect of its inventory turnover ratio and days sales outstanding (DSO) on its cash conversion cycle. Chill’s 2015 sales (all on credit) were $15m; its cost of goods sold is 80% of sales and it earned a net profit of 6% of sales. It turned over its inventory 6 times during the year and its DSO was 36.5 days. The firm had fixed assets totalling $350,000. Chill’s payables deferral period (PDP) is 40 days.a) Calculate Chill’s CCC            5 marksb) Assuming Chill holds negligible amounts of cash and marketable securities, calculate its total assets turnover and ROA                                     6 marks

    c) Suppose Chill’s managers believe that the inventory turnover can be raised to 9.0 times, calculate the following if inventory turnover was 9.0 for 2015:i) CCC                                                                                                                     4 marks
    ii) Total assets turnover                                                                            3 marks
    iii) ROA                                                                                                       2 marks