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Paper 602: financial management

Assessment 2: Assignment

Total marks available: 80

Weighting: 40%

Learning outcome 2: students will apply capital budgeting technique and evaluate investment decision[15%]

Learning outcome 4: student will examine capital structure and will calculate cost of capital [15%]

Learning outcome 5: student will compare and contrast financing options and make recommendations for given business situations[10%]

Answer

Part A

Question 1: Time value of money

1.1 Present values of each cash flow

Year Cash in-flowExpenditureNet cash flowDiscounting factorPresent value of net cash   flows
00($7,000,000)($7,000,000)1($7,000,000)
10 $2,000,000.00  $(2,000,000.00)0.925925926 $                      (1,851,851.85)
2 $12,000,000.00 $2,000,000  $10,000,000.00 0.85733882 $                      10,288,065.84 
Present value of project $                       1,436,213.99 



1.2 Recommendation based on NPV

In the above calculation, it has been determined that the net present value of the project is $8436213.99. In this regard, it is to be stated that the manager is required to accept the project as the project has a positive cash inflows.


Question 2: Net Present Value and Internal Rate of Return

2.1 NPVs for both opinions


Calculation   of Net Present Value of Project A
YearCash   FlowDiscounting   factorPresent   value of Cash Flows
1$50,000.000.9090909091$45,454.55
2$30,000.000.826446281$24,793.39
3$20,000.000.7513148009$15,026.30
Present   value of cash inflows$85,274.23
Present   value of initial investment$60,000.00
Net   present value$25,274.23




Calculation   of Net Present Value of Project B
YearCash   FlowDiscounting   factorPresent   value of Cash Flows
1$10,000.000.9090909091$9,090.91
2$20,000.000.826446281$16,528.93
3$80,000.000.7513148009$60,105.18
Present   value of cash inflows$85,725.02
Present   value of initial investment$60,000.00
Net   present value$25,725.02


2.2 IRR provided for both opinions


Calculation   of IRR of Project A
YearCash   Flow
0-$60,000.00
1$50,000.00
2$30,000.00
3$20,000.00
Internal   Rate of Return37.39%



Calculation   of IRR of Project
YearCash   Flow
0-$60,000.00
1$10,000.00
2$20,000.00
3$80,000.00
Internal   Rate of Return26.44%

In order to verify the above results, the following crosschecks can be made:

Project A
Year Cash flowsDiscounting factor @   37.39%Present value of cash   inflows
1$50,000.000.728$36,392.8
2$30,000.000.530$15,893.2
3$20,000.000.386$7,712.0

Present value of cash   inflows$59,998


Project B
Year Cash flowsDiscounting factor @   26.44%Present value of cash inflows
1$10,000.000.791$7,908.9
2$20,000.000.626$12,510.1
3$80,000.000.495$39,576.4

Present value of cash   inflows$59,995


In this regard, it can be stated that the present values of both the projects have been calculated at $60000 approximately. Thus, it can be stated that the project A has the IRR of 37.39% and the project B has the IRR of 26.44%.

2.3 Recommendation provided with justification

As per the above calculation, of NPV and IRR regulates information on the effectiveness regarding both the calculations. In this context if Greg and Joan want to invest their $60,000, then project B seems to be suitable for the people. This is because the NPV of project B is calculated as $25,725.02 and is better than project A which had been calculated as $25,274.23. In relating both the aspect it can be said that project B is more effective for Greg and Joan to invest. However, on the other hand, the IRR of both the projects were calculated as 37% and 26% and this can be said that project A is more than project B. in this context, it can be said that Greg and Joan would need to invest their $60,000 in project B as in computing NPV with IRR, it can be said that NPV is considered more to calculate the profit of a company. In this context it can be said that Project B would need to be selected by Greg and Joan to invest. 

2.4 Recommendation provided with justification

As per the calculation of IRR provides an explanation that both the projects is above 10% and is investable. This makes it easy for Greg and Joan to invest in both the projects as because both the projects will be able to provide profit to the people. 

Question 3: Payback Period

3.1 Payback period of Project A & B



Calculation   of Payback period of Project A
YearCash   flowsCumulative   cash flows
0-$200,000.00-$200,000.00
1$76,000.00-$124,000.00
2$76,000.00-$48,000.00
3$76,000.00$28,000.00
4$76,000.00$104,000.00
5$76,000.00$180,000.00






Payback   period
=Initial   investment / Annual cash flows

2.63   years




Calculation   of Payback period of Project B
YearCash   flowsCumulative   cash flows
0-$180,000.00-$180,000.00
1$60,000.00-$120,000.00
2$64,000.00-$56,000.00
3$72,000.00$16,000.00
4$80,000.00$96,000.00
5$90,000.00$186,000.00






Payback   period
=Initial   investment / Average cash flows

2.46   years

3.2 Decision made based on results

As per the above calculation of the payback period it can be said that project B can be considered as the most suitable one as it will provide more time to the company to invest effectively and without any problem. The project B’s payback period is calculated at 2.23 years which means that the company has more time to invest in the process and gain the most out of it.

Question 4: Capital Rationing

Combination of projects provided along with recommended projects with justification

$50,000 had been inherited and it was decided to invest that money into different procedures that will help in providing effective feedback to the process. In this context give investment procedures had been initiated through which more effective feedback can be earned. In this context the following table will help in elaborating the effectiveness to work under the appropriate investment process which is as follows:


ProjectInvestment NPVPI
Buy   a new car for the business $20,000$10,0001.500
Start   a small moving business$25,000$10,0001.400
Buy   a collection of old comic books $5,000$1,0001.200

If the company invests $20,000 to buy a new car then the total NPV will be calculated as $10,000 and under this the PI had been calculated as 1.500. In this context it can be said that the company may invest under this project, however there are other projects that may help the company to invest and attain more NPV and PI will be elaborated in the following parts.


ProjectInvestment NPVPI
Buy   an apartment near campus$50,000$22,5001.450

In this context as per the second investment options it can be said that the total  investment money that is being worked out by the company will be fully invested under this project. This will provide the company with a total NPV of $22,500 which is more than buying a new car, however, the PI was calculated as 1.450 less than 1.500o the first project. In this context, it can be said that the company would need to invest in this project as the NPV under this is more than the other projects and the PI is relatively effective. In this regard, it is to be commented that the Profitability Index (PI) of the investment by buying the apartment near campus would be profitable. This investment would have a PI of 1.45, and the PI of adopting other investment options would be lower than 1.450. Thus, buying the apartment would be the best option for the investor. 


Question 5: Expansion or Replacement of project

Net Present value of both options provided along with recommendation with justification


Option 1: Old Machine
Year Cash inflowDiscounting factorPresent value of cash   inflows
1 $5,000.00 0.869565217 $                          4,347.83 
2 $5,000.00 0.756143667 $                          3,780.72 
Present value  $                          8,128.54


Option 2: New Machine
Year Cash inflowDiscounting factorPresent value of cash   inflows
1 $10,000.00 0.869565217 $                          8,695.65 
2 $10,000.00 0.756143667 $                          7,561.44 
3 $10,000.00 0.657516232 $                          6,575.16 
Present value of cash   inflows $                         22,832.25 
Less: Present value of   initial investment  $                         20,000.00 
Net present value  $                          2,832.25



The above table shows that the net present value of the old machine is $8128.54, whereas the present value of the new machine is $2832.25. From the above calculation, it has been evident that continuing the old machine would be more profitable for the company as the present value of that machine is the maximum between the two options.

Question 6: Expected Returns, Standard Deviation and Coefficient of variation

6.1 (a) Expected to return for both options provided


Expected   return of Share X=   (0.20 * 10%) + (0.40 * 15%) + (0.30 * 18%) +(0.10 * 20%)

15.40%



Expected   return of Share Y=   (0.10 * 8%) +(0.30* 12%) + (0.50 * 15%) + (0.10 * 19%)

13.80%


6.1 (b) Recommendation with justification

Antec Corporation would need to invest in X share as the expected return of share had been recorded as 15.40% which is providing a better return than share Y. In this context it can be said more the expected return then more will be the profit of the company. 

6.2 (i) One project recommended

In this context the project that Aeroflot Airlines would need to select projects X as the NPV was recorded as $122,000 and the standard deviation was recorded as $90,000. This will help the company to earn more profit and gain preferences to earn more in the future.

6.2 (ii) CV for both projects calculated and recommendation provided based on CV


ProjectNPVStandard DeviationCalculation of   coefficient of variation
X$122,000$90,0001.36
Y$225,000$120,0001.88

As per the above calculation under which it will be necessary to calculate the coefficient of variation under which it can be said that project X needs to be taken under consideration as this will help the company to incur more profit with fewer risk factors. The coefficient variation that had been calculated in this context resulted into 1.36 which is lower than project Y of 1.88. However, it can be said that project Y will incur more risk than project Y.

6.3 (iii) Measures to make decisions compared

As per the calculation it can be said that project Y can be considered as the more effective project for the company as through this the company would be able to earn more in the context of less risk involved.

Part B

Question 7: Capital Asset Pricing Model (CAPM)

CAPM calculations along with recommendation and justification


Computation   of expected rate of return on the portfolio
ParticularsDetails
The   market rate of return14%
The   risk-free rate of return4%
Beta0.8
The   expected rate of return=   Risk-free rate of return + Beta * (Market rate of return - the Risk-free rate   of return)

=   4%+0.8*(14%-4%)
12.00%

As per the above calculation which elaborates the expected rate of return was calculated as 12% whereas as per her portfolio expected at 11% per year. In this context it can be said as beneficial for the fund manager to invest into a mutual fund.

Question 8: Cost of Capital

8.1 Individual cost of each source of financing calculated


Computation   of cost of debt capital
Cost   of debt capital=   I + (RV - SV) / n /(RV + SV) /2 *(1-t)=   $100 + ($1000 - $950)/10 / ($1000-$950)/2 *(1-0.4)


6.5%
Where,


I=   Annual interest per bond=   $1000 * 10%$100.00
SV=   Sales value per bond deducted by flotation cost=   $1000-$30-$20$950.00
RVRedeemable   value per bond=   $1000
t=   Tax rate=   40%0.4



Computation   of cost of Preferred stock
Cost   of preferred stock=   D/ SV=   $11 / $96


11.5%
D=   Dividend on Preferred stock=   $100 * 11%$11.00
SV=   Selling value per Preferred stock=   $100-$4$96.00



Calculation of cost of common stock

Cost of common stock

 = D * (1+g) / P + g

 = $6 * (1+6%) / $80 + 0.06

13.95%

D

 = Dividend paid per share

 = $6

P

 = Current price per share

 =$80

g

 = Growth rate 

 = 6%


8.2 Calculation of WACC

Computation of weighted average cost of   capital
Source of capitalProportion Specific cost of capitalWeighted cost of capital
Long term debt 40.00%6.46%2.58%
Preferred stock15.00%13.95%2.09%
Common stock 45.00%13.95%6.28%
Weighted average cost of capital10.95%


8.3 Explanation about the new financing is required

In the above table, it has been seen that the weighted average cost of capital of the company is 11%, and therefore, an investment option with a higher rate of return than 11% would be beneficial for the company. In this regard, it is to be commented that the investment option A, C, D and E would be profitable for the company as these investment options have higher expected return than the weighted average cost of capital. However, investment option D would generate the highest profit for the company as it has the highest expected rate of return. On the basis of weighted average cost of capital which had been calculated as 10.95.

.


Question 9: Optimal Capital Structure

9.1 Financial and nonfinancial factors

Financial factors are considered to be the transactions and type of debtors under which a business sells its account receivable to the other party in discount. In this context the different types of financial factors are as follows:

Short-term Liquidity: It is being defined as the ability of a company to meet up with the financial obligations as it arrives. 

Return on investment: It is considered as the ratio between the net profit and the cost of investment resulting from any other investment process (Balazs, Liu-Barker, Foiles, Thomas & Lee, 2016).

Non-financial factors are considered to be the transactions which are not considered under financial terms and the works that are being done are apart from any financial aspect. 

Non-financial factors are as follows:

Meeting the current requirements: It is said to be necessary for a company to perform different working procedures, in the present time so that the future working procedures may become easy. This will effectively lead up the working procedures of the company to be done in an effective manner (Barr & McClellan, 2018).

Future legislation: Keeping in mind the different procedures that may change in the future would need to be the duty of the company. In this context it may be the case under which a company may need to connect with the different procedures and take up necessary working procedures to perform for the future of the company.           

9.2 (a) EPS for all options calculated


 20% debt40% debt60% debt
Sales$375,000.00   $375,000.00   $375,000.00   
Less: variable cost$150,000.00   $150,000.00   $150,000.00   
Total Contribution$225,000.00   $225,000.00   $225,000.00   
Less: operating cost$125,000.00   $125,000.00   $125,000.00   
Operating profit$100,000.00   $100,000.00   $100,000.00   
less: interest$6,000.00   $13,200.00   $21,600.00   
Total Profit$94,000.00   $86,800.00   $78,400.00   
Less: Tax$37,600.00   $34,720.00   $31,360.00   
Profit after tax$56,400.00   $52,080.00   $47,040.00   
Number of ordinary shares300003000030000
Earnings per share$1.88   $1.74   $1.57

9.2 (b) Optimal capital structure

As per the above calculation of EPS it can be said that the three capital structure was calculated as $2.35, $2.89 and $3.92. It can be said that the 60% debt can be considered as effective for Sea Shore Salt Limited. In this context, it can be said that $375,000 is producing the least profit after tax which is $78,400 and the number of ordinary shares was recorded as 12,000. In this context theEPS was recorded as $3.92 and is beneficial than the other two. 

The earnings per share is maximum if the company adopts the capital structure with 20% debt and 80% equity.

Part C

Question 11: Short-term Financing-Overdraft and Inventory

a. Cost of each plan calculated


Proposed Plan 1
Cost of financing= Administration fees + Interest for 1 month

= ($100000 * 0.25%) + ($75000 * 12%*1/12)

$1,000.00



Proposed Plan 2
Cost of financing= Interest for one month

= $100000 * 13%*1/12

$1,083.33


b. Recommendation with justification

As per the above calculation, proposed plan 1 is the most economic option as the cost of financing of this plan is the lowest. The interest rate of the Westpac Bank is the lowest and therefore, this option is required to be adopted by the company.  


Question 12: Short-term Financing-Factoring of Debtors

a. Cost of factoring calculated




Calculation of cost factoring method
ParticularsAmountAmount
Credit sales 
$2,550,000
Add: Annual administration fees$33,150.00
Add: interest charge$51,000.00
Add: Overdraft rates$41,917.81
Total cost
$126,067.81
Total cost factoring
$2,676,067.81


b. Cost of employing credit controller calculated


Controller's fees $47,000.00 
 Overdraft rate $27,945.21
 Just add the cost of credit controller’s fees and   the overdraft rate
 $      74,945.21 


c. Recommendation provided

As per the above calculation which provides an effective illustration of the cost factoring method under which the company suffered a loss of $69,950. In this context, it can be said that the company had been performing efficiently but then the cost that the company experiences made it a lot hard to incur profit and perform effectively. On the other hand the cost of employing the credit controller that provides an effective illustration of the different procedures through which the company had been making a profit of $2,503,000. 

Question 13: Lease vs Buy

i. Recommendation for lease vs buy

As per the given situation, the net present value on taking the car on lease is $5450. On the other hand, it has also been evident that the NPV of purchased car would be $5150. Thus, it can be stated that the courier firm is recommended to purchase the car as would be more economical for the company than take the car on lease.

ii. Motivational factor for leasing

If an organisation takes a property on lease, the organisation would not require to pay the price of such asset as it is mandatory in case of a purchase. Thus, organisations prefer taking properties on lease. On the other hand, the companies, who take properties on lease, could use the properties like the owners for a long term, and due to these reasons, leasing has become a motivational factor for the companies.


iii. One reason for conflict 

The different types of conflicts arise with the lease are as follows: 

  1. Companies cannot claim capital expenditure allowances if they take properties on lease.
  2. The owners can only use the leasehold properties, and this also creates conflict among the proprietors of a business. 
  3. In order to take a property on lease, the business firms are to pay a deposit, which could also become a conflicting factor. 


Question 14: Long-term financing

14.1 (a) Two reasons relating to the study

It is said to be necessary for the investment bankers to say that new security offerings need to be preferred under low pricing rate. As because the different investment working procedures under which the company invests would need to be lower which may make it profitable for the company to invest. The two reasons on why the investment bankers would need to purchase shares on low prices will be elaborated in the following points:

  1. If a company issues its shares in a low price then it would need to be the duty of the investment bankers to take up the responsibility and issue the shares in lower price. This will help the shares price of the company to boom in the initial stage (Finkler, Smith, Calabrese &Purtell, 2016). In this context, it will be easier for the company to effectively raise their share price without any problem.
  2. This will help the company to run for a longer period of time and make it effective for the company shareholders to perform as per the requirement. 

14.1 (b) various factors of cost of IPO provided

The different factors of cost of IPO are as follows:1. Demand and Supply: it is one of the most common factors that affect the IPO valuation under which strong demand is said to be as necessary which boosts up the sales of commercial products and services. 

2. The timing of the issue: it is considered to be one of the most important factors that affect the valuation of IPO. Every business consists of different favourable timings and helps in flourishing the optimum pace. It is eventually true that going for the listing of the company under the stock exchange (Renz, 2016). 

14.2 (a) Two reason relating to the study

Gaga enterprises would need to take a review of the financial institution under which it may need to take the production money from any financial institution which does not contain any risk but the cost that is being put into in massive. On the other hand, financial market performances need to be taken into consideration under which risk is massive but the cost of production is low. So in this context, it may need to be necessary for the company to take up the financial institution process that may lead the company to perform effectively and raise production money for itself. 

In this regard, it is to be stated that the issuance of share through financial institution would attract the brokerage cost. On the other hand, if the company issues the shares directly, the company would not require to pay any brokerage cost. Apart from that, it is also to be noted that the company could get advises regarding the issue of stock if it considers the financial institutions for such issuance. If the company issues the shares directly, the companies would not get any advises regarding the issue.

14.2 (b) Recommendation with at least two reasons

1. The interest from the promissory note is tax-free and therefore, Pruro Inc would not require paying tax and therefore the amount of after tax income. 

2. The debt would not have any risk factor and this would enhance the after tax profit of the company.

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