CO222 Business Finance II Task brief & rubrics

Task: Midterm Assignment (40% of course grade)

You are asked to answer all the questions in the proposed four cases.

This task assesses the following learning outcomes:

· Develop sound analytical frameworks to grasp the process of decision making with respect to making investment in fixed assets and the methods used to evaluate new projects.

· Understand what free cash flow is and how to measure it.

· Understand a company’s capital structure and dividend policy.

LAUNCH: WEEK 1 / DELIVERY: WEEK 4 Sunday June 21st, 2020, 23:59hrs ON MOODLE

Submission file format: Word document with all the answers, clearly identifying each case separately.

CASE 1 (30 points)

The following information is available for Solley Corporation:

Debt: 5,000 bonds outstanding that are selling for 96 percent of par; bonds with similar characteristics are yielding 8.5 percent, pretax.

Common stock: 43,800 shares outstanding, selling for €51 per share; the beta is 1.54.

Preferred stock: 10,000 shares of 7 percent preferred stock outstanding with a stated value of €100 per share, currently selling for €83 per share.

Market: 7.5 percent market risk premium and 3.6 percent risk-free rate.

Assume the company’s tax rate is 21 percent.

Instructions:

1. Calculate the firm’s market value capital structure. (6 points)

2. Calculate the firm’s costs of common equity, preferred stock and debt. (6 points)

3. Calculate the weighted average cost of capital (WACC). (5 points)

4. What discount rate should the firm apply to a new project’s cash flows if the project has the same risk as the company’s typical project? Explain. (4 points)

5. What happens if we use the WACC as the discount rate for all projects? Explain. (3 points)

6. Which is more relevant, the pretax or the after-tax cost of debt? Explain. (3 points)

7. Which are more relevant, the book or market value weights? Explain. (3 points)

CASE 2 (25 points)

The treasurer of Arnaud Corporation has projected the cash flows of Projects A and B as follows:

The relevant discount rate is 12 percent. The company imposes a payback cut-off of two years for its investment projects.

Instructions:

1. If these two projects are independent, which project(s) should Arnaud accept based on:

a. The Payback rule? Explain. (5 points)

b. The Profitability Index rule? Explain. (5 points)

c. The IRR rule? Explain. (5 points)

d. The NPV rule? Explain. (5 points)

2. If these two projects are mutually exclusive, which project should Arnaud accept? Explain. (5 points)

CASE 3 (25 points)

You have been hired as a consultant for Medicals Inc., manufacturer of medical devices. The company projects unit sales for a new dental implant as follows:

Year Unit Sales

1 73,000

2 86,000

3 97,000

4 68,000

Additional information:

• Production of the implants will require €1,500,000 in net working capital immediately, all of which will be recovered at the end of the project.

• Total fixed costs are €4,200,000 per year, variable production costs are €255 per unit, and the units are priced at €375 each.

• The equipment needed to begin production has an installed cost of €8,500,000. This equipment qualifies as three-year MACRS property (depreciation rates are 33.33% for Year 1, 44.45% for Year 2, 14.81% for Year 3, and 7.41% for Year 4).

• In four years, this equipment can be sold for about 20 percent of its acquisition cost.

• The tax rate is 21 percent and the required return is 24 percent.

Instructions:

1. Complete the pro forma below and determine total cash flows for each year of project’s life. (20 points)

2. Would you recommend to accept or reject the project? Explain your decision. (5 points)

CASE 4 (20 points)

The owners’ equity accounts for Vera Corporation are shown here:

Common stock (€2 par value) €100,000

Capital surplus 860,000

Retained earnings 2,570,800

Total owners’ equity 3,530,800

Instructions:

1. If the company’s stock currently sells for €64 per share and a 20 percent stock dividend is declared, how many new shares will be distributed? Show how the equity accounts would change. (10 points)

2. Assume that instead of a stock dividend, the company declares a four-for-one stock split. How the equity accounts will change? How many shares are outstanding now? What is the new par value per share? (10 points)

Rubrics

Points are stated at the end of each question.