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Finance Revision – Interest rates + Capital budgeting Finance – Revision Exercise 2 (i) – Interest rates, bonds, forward rates & shares 1. How would you write the following expression: the two year forward rate starting in three years time? 2. If the one, two, three, four year spot rates are 5%, 6%, 7%, 8% respectively, what is the one year forward rate starting in two years time? 3. A bond is priced at £96.45 in the market. It’s coupon rate is 4%, the bond has four years to redemption. What is the yield to maturity? 4. If the one, two, three, and four year spot rates are 4%, 4.5%, 5% and 5.25%, what will be the price of a four year bond with a 7% coupon? 5. There are three zero coupon government bonds, maturing in one, two and three years time. The prices are £93.50, £86.90, and £80.10 respectively. What are the spot rates that can be derived from these prices, and if there is a three year 9% coupon bond available in the market what will be its price? Given that price, what is the yield to maturity? 6. A company has dividends of 5.8p, 6p, 6.3p, 6.7p, 7.1p, 7.7p, 8.5p in 2004 through to 2010 respectively. If the cost of equity for the company is 14%, what is the share price if you base the growth of dividends on (i) the entire period, (ii) the last two years (2008 – 2010)? 7. How useful is the price-earnings ratio as a measure of value? List the advantages and disadvantages of its use. 8. What are the problems with the dividend growth model as a means of valuing shares? 9. What features can a bond have that may help overcome the agency problems that bondholders have with managers and shareholders? 10. If you have a 4 year bond with a 7% coupon, and the term structure of interest rates for the next four years is 4%, 5%, 6% and 6.5% respectively, what is the price of the bond and what is its duration? What does duration tell us (in general)? src.doc - 1 -
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Finance Revision – Interest rates + Capital budgeting Finance – Revision Exercise 2 (ii) – Capital budgeting 1. An asset has a book value of £100,000 having cost £200,000 originally, the company faces a tax rate of 30%. Show the cash flow implications of the following: (a) The asset is sold for £130,000. (b) The asset is sold for £40,000. (c) The asset is sold for £100,000 2. NYS wants to buy new machinery for £550,000 which will be depreciated straight-line to zero over 5 years. It requires £100,000 set up, installation and shipping costs. Their will be a requirement for an additional £30,000 in inventory for the new machine. The new machine replaces an old machine bought and installed for £350,000 two years ago. It was being depreciated straight line to zero over its seven year life. The old equipment can be sold today for £200,000. The company faces a 30% tax rate. What is the initial investment? 3. Using the company NYS in Q.2, the new machine will generate revenues of £290,000 and have cash operating costs of £80,000 for years 1 through 5. The old machine has revenues of £170,000 and cash costs of £90,000. Assume the new machine will have zero value at the end of the project. What are the after tax cash flows? 4. Using the NYS example, layout all the relevant cash flows and calculate the NPV if the cost of capital is 9%. 5. A company is buying a new machine, it costs £230,000 plus £20,000 to install. Working capital will increase by £25,000 as a result of the new machine. Taking each of the examples in Q.1 (a), (b) and (c), as the machine it is replacing, work out the year 0 cash flow (net investment). 6. A company has sales of £80m and expenses (excluding depreciation) of £50m. The company’s assets have a book value of £60m and 5 years of life remaining – they are depreciated straight line to zero. The company faces a 30% tax rate. Assume no change in working capital. What is the annual cash flow of the company? 7. A company has the opportunity of buying one machine for £400,000 that will replace three older machines. The older machines can be sold for £10,000, £20,000 and £15,000, they have respective book values of £40,000, £40,000 and £35,000. src.doc - 2 -
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Finance Revision – Interest rates + Capital budgeting The new machine will reduce the need for so much stock so there will be a saving of £15,000 per annum on stock levels. The new machine will require shipping and installation charges of £30,000. Tax rate is 30%. What is the year 0 cash flow (net investment)? 8. Explain how you would treat each of the following for project capital budgeting cash flow analysis: - interest payments - project overheads - general company fixed costs - working capital 9. You own a large industrial site, part of which has been developed but isn’t used. To use up this extra space you decide to run a single five year project on it. Explain if there are any capital budgeting concerns regarding the use of this company owned land. 10. Two companies plan new product launches: Samsung plan to launch a new mobile phone to replace their current best seller; Sky decides to launch a new dedicated sports channel – this time offering ‘live chess’ on TV. What are the associated cash flow costs of these two ventures? Explain how you would decide on the relevant cash flows in decisions like this? 11. Taking two investment decisions from the last couple of years; Apple launching its ‘i-pad’, and Carphone Warehouse taking over AOL’s European operations. Carphone Warehouse already had an internet offering to the UK household market, then added AOL to it. Discuss what you think the associated cash flow considerations would be in these cases? What about Apple’s earlier products like the ipod and iphone? Can you think of other examples like this? 12. What are mutually exclusive projects and can you give some examples? 13. (a) What is the net impact of the following increases in the year 0 investment in a project: Inventory £50,000 Accounts payable £30,000 Accounts receivable £80,000 (b) What would be the working capital entry for the final year? 14. Why are cash flows used instead of accounting earnings in capital budgeting analysis? 15. What impact do the following have on project cash flows – describe the likely impact on either the initial investment cash flows, or the operating cash flows of the project. Assume a tax rate of 30%. src.doc - 3 -
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Finance Revision – Interest rates + Capital budgeting (a) An old machine is sold for £10,000 to be replaced by a new one, the old machine having a book value of £25,000. (b) A new machine producing cost savings of £50,000 per year from replacing an old machine (c) Ongoing marketing analysis into project’s product popularity. (d) Extension of credit to new customers i) at the start of the project ii) during the project (e) A fully depreciated asset is sold for £20,000 at the start of the project. (f) A new asset has an estimated salvage value of £40,000 (g) The firm has borrowed £200,000 at 8% interest. (h) As a result of introducing a new product, sales of the existing product fell by £15,000. (i) Between year 2 and 3, accounts payable increases by £20,000. (j) Marketing costs incurred before the project started are paid at the end of year 2. (k) There is a net increase in depreciation of £35,000 a year in years 1 to 5, and then a net increase of £55,000 a year from years 6- 10. 16. You are examining the viability of a capital investment project that your firm is interested in. The project will require an initial investment of £800,000 and the projected revenues are £640,000 a year for five years. The projected cost-of-goods- sold is 40% of revenues and the company faces a tax rate of 30%. The initial investment is primarily in plant and equipment which would be depreciated straight line over 5 years to zero salvage value. The project makes use of other resources that your firm already owns: Two employees of the firm, each with a salary of £64,000 a year, who are currently employed by another division will be transferred to work on this project. The other division has no alternative use for them, but they are covered by a union contract, which will prevent them from being fired for three years (during which time they would be paid their current salary). The project will use excess capacity in the current packaging plant. While this excess capacity has no alternative use now, it is estimated that the firm will have to invest £400,000 in a new packaging plant in year 4 as a consequence of this project using up excess capacity (instead of year 8 as originally planned). The project will use a van currently owned by the firm. While the van is not currently used, it can be rented out for £4,800 a year for the next five years. The book value of the van is £16,000 and it is being depreciated on a straight line basis to zero (with five years still to be depreciated). The discount rate for the project is 12%. What is the NPV of the project? src.doc - 4 -
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Finance Revision – Interest rates + Capital budgeting 17. A company has a dividend today of 10p. The share price is 220p, the rate of growth of the dividend is 4%. What is the cost of equity capital? 18. A company has a dividend in 2005 of 16p and a dividend of 23.5p in 2010 (just paid). The share price is 380p. What is the cost of equity? 19. If the risk free rate of interest is 4% and the beta of company X is 0.9 and the return on the stock market is 12%, what is the cost of equity for company X? 20. If the market risk premium is 7% and company Y has a beta of 1.2, what is the cost of equity for Y given a risk free rate of 4.5%? 21. If XYZ is made up of one part debt to three parts equity, and the required rate of return on debt is 6%, the cost of equity is 15%, tax is 30%, what is the weighted average cost of capital? 22. A company has just paid a dividend of 10p, this is up from 8.5p two years ago. The company has 70% equity in its capital structure. The risk free rate of interest is 4%, the equity risk premium is 6%. The company has a bond in issue with a coupon of 7%. The bond is priced at £106.25 in the market, the share price is 250p. The bond has three years to maturity. The tax rate is 30%. What is the WACC? 23. If a project has a different risk to the parent company how would you work out a WACC for the project? 24. You have been hired as a capital budgeting analyst by a sports goods firm. It manufactures running shoes and has gained 10% of the overall shoe market (total market worth £100 million a year). The fixed costs associated with manufacturing these shoes is £2 million a year and variable costs are 45% of revenues. The tax rate is 30%. The discount rate is 8%. The company believes that it can increase its market share to 20% (of the £100m market) by investing £15 million in a new distribution system (which will be depreciated straight line over its 10 year life to a scrap and salvage value of zero) and spending £1 million a year in additional advertising. The company proposes to continue to maintain working capital at 10% of annual revenues. (a) What is the initial investment for this project? (b) What is the annual operating cash flow from this project? (c) What is the NPV of the project? src.doc - 5 -
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Finance Revision – Interest rates + Capital budgeting 25. The Bigger Pizza Company is considering the purchase of a new pizza oven. The original cost of the old oven was £300,000. This oven is now 5 years old and has a current market value of £50,000, if the project is undertaken it will be sold for that amount. The oven is being depreciated straight line over a ten-year period down to zero book value. The new pizza oven costs £250,000, has a zero expected salvage value and will be depreciated on a straight-line basis over five years. Expected savings from the new oven are £30,000 per annum. Extra working capital will be needed for the new machine and will amount to £20,000. The new machine is expected to increase revenues by £50,000 per annum in the first two years, after which the increase in revenues will fall to £30,000, £20,000 and £10,000 for the last year. Bigger Pizza Company is part of a food, drink and leisure conglomerate which is traded on the stock market. The parent company has an ungeared (asset) beta of 1.2. There is another pure pizza company on the stock market whose equity beta is 1.5. This company has a debt: equity ratio of 25/75, and a debt beta of 0.2. The Bigger Pizza project will be financed purely by equity. The risk free rate is 5% and the market risk premium is 6%. The tax rate is 30%. Calculate the cost of capital for Bigger Pizza, layout the cash flows and calculate the NPV of the project. Should they proceed? 26. You can buy an asset for £2000 or you can lease it for 5 payments of £480 per year starting today. The tax rate is 30%, the asset will be depreciated straight line to zero over four years. If the cost of debt is 10%, should the asset be leased or bought? 27. A manager is trying to choose between 2 mutually exclusive projects using the IRR technique (they don’t use NPV). The cash flows to project A are (in £’000s); -£4000, £2100, £1800, £1300. The cash flows for project B are (in £’000s); -£4000, £1400, £1700, £2250. The hurdle rate for the company is 12%. How would you work this out and which project should be chosen? 28. Torres is considering two alternative machines for its expanded production line. The first is buying more of the existing machinery. This is a high quality machine that costs £25,000 has a useful life of 5 years. The alternative machine costs £17,000 and has a useful life of four years. The existing machine has annual operating costs of £6,500, while the alternative machine has annual costs of £8,000. The company’s cost of capital is 9%. Which machine should it select? 29. Discuss the strengths and weaknesses of the following capital budgeting evaluation techniques; IRR, EVA, PI, AROI. src.doc - 6 -
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