Finance Business

Short Answer questions (4 points each) Show your numerical answer(s) and the Excel function(s) and inputs you used to get the answer.  You may use up to 25 words (50 words for #4) to supplement your numbers and Excel functions.

1. Retirement Planning Error (4 points – Numbers, Functions and 25 words)

A friend of yours is 40 years old.  She currently has $200,000 in her retirement account.  She is currently contributing (with her company’s match) $25,000 per year.  She plans to continue to contribute this amount every year until she is 65, when she will retire.  She goes to a financial planner, who does two calculations.

• The FV of 25 payments of $25,000 per year, starting 1 year from today at a 6% rate of return will become $2,229,986.94 =FV(6%,25,25000,200000,0)
• Assuming a 30-year retirement, the balance earning 6% and leaving $500,000 to heirs, with the first withdrawal on her 65^th birthday, she will have annual pre-tax income of $146,869.50 =PMT(6%,30,-2229986.94,500000,1)

All of these calculations are correct, however, suppose the 6% rate of return is too optimistic.  Suppose that the actual return over the entire period – up to and through retirement – is only 4%.  (i) How much income will she have at this 4% rate and

 (ii) how much more would she have to save each year to have the desired annual income of $146.869.50 and an inheritance of $500,000?

2. Yield-to-Call (4 points – Numbers, Functions and 25 words)

A company issues a callable bond with the falling features:

• 7% coupon rate
• Semi-annual coupon payments
• $1,000 face value
• Matures in 15 years
• The bond may be called after 3 years.
• Call premium: If the bond is called anytime during the 2-years period beginning 3 years from today and ending 5 years from today, the company will pay a face value of $1,250 instead of $1,000.

Compute the yield an investor will earn buying the bond today for $1,233.10 if it is called in exactly 3 years and one day from today (the first day is it eligible to be called).

3. Dividend Growth Model & CAPM (4 points – Numbers, Functions and 25 words)

A company’s stock has the following attributes:

• Current Market price of $25.00
• Current annual dividend of $1.50
• Constant dividend growth rate of 4%
• A beta of 1.14

The risk-free rate is currently 3.4% and the market risk premium is 6.0%. If the risk-free rate suddenly jumps to 4.25% what happens to this company’s stock price (Give the price to 2 decimal places)?

4. NPV (4 points – Numbers and 50 words – no Excel function needed)

A new financial analyst at Company X does the following NPV analysis.

He reports an NPV of $38,679.69, an IRR of 10.93% and a payback period of 5.02 years.

Check these results, if necessary, correct his analysis and explain his errors.

5. After-tax Cash Flows (4 points – 3 numbers and 25 words – no Excel function needed)

A new financial analyst at Company X was asked to compute the after-tax cash flows for a new product with the following characteristics:

• The product will increase EbDT by $20,000 for 10 years.
• The associated equipment will be depreciated $15,000 per year for years 1 through 4 to zero Book Value.
• At the end of the product’s life the equipment will be sold for scrap for $10,000
• The Company’s tax rate is 30%

Compute the cash flows for this project.  You only need the following three:

Cash flow for years 1 through 4 ____

Cash flow for years 5 through 9 _________

Cash flow for year 10 _________

6. Effects of a leveraged restructuring (10 points – one page)

You have an aged relative who is terrified of debt.  She runs a company that has zero debt.  The company is in steady state.  Its annual revenue is fixed at $1,000 and all income is distributed as dividends.  There are 40 shares outstanding.  The dividends are $6.00 per share.  Its required rate of return (or cost of equity) is 12%.  With zero dividend growth this results in a current share price of $50.00.  Currently the risk-free rate is 5% and the market risk premium is 7%.  So the company’s stock beta is 1.00.  This is also the asset beta.

Your aged relative retires and a new CEO is hired.  The new CEO sells $1,000 of 7% 100-year bonds and repurchases 20 shares of stock.  Nothing else changes in the company.  The company’s tax rate is 40%.  Construct new financial statements that reflect this change and estimate how much the market price of the stock will change, if at all.  There will be no change in revenue and all income will be distributed as dividends.

7. Debt Financing (10 points – one page)
8. You have an aged relative who grew up during the depression and saw her family lose everything.  To this day she avoids all forms of debt.  She contends that companies should not use debt and says she would never invest in a company that had any debt.  Explain to her why debt can benefit companies.  She is very bright and would quickly understand a well-designed and annotated numerical example.

1. You have an acquaintance who is in the first term of the MBA program.  He brags about sailing through the program with almost no outside studying and attending most but not all lectures.  For each topic he reads the first few pages of a chapter, the summary at the end, does 3 or 4 practice problems then moves on.  He has just used his system to ‘study’ capital structure and WACC, but missed the lectures – he had more important things to do.  He sees you working on finance problems and says the following:

“Capital structure is easy: Use the maximum amount of debt.  Look at the WACC formula.  The more low-cost debt you have, the lower the WACC.  At 90% or 95% debt the WACC is about the cost of debt and that cheap financing lets the company accept more positive NPV projects.

Explain what is wrong with his interpretation and why we don’t see most companies with capital structures that are overwhelming debt, with WACCs at about the cost of debt.

8. NPV analysis of wind energy (10 points – one page)

A large wind farm is being proposed for eastern Colorado.  As designed it will produce 6.0 billion kWh of electricity per year, which is contracted to be sold for $0.12 per kWh.  The Federal Production Tax Credit (PTC) will add $0.021 per kWh of revenue, and selling Renewable Energy Certificates (RECs) will add another $0.01 per kWh.  The initial investment for the wind turbines, site preparation, linking to the grid, etc. will be $4.2 billion.  The project is expected to last for 25 years.  Any salvage value from the turbines will exactly offset site rehabilitation costs.

Annual operating costs will be $90 million per year (maintenance, land leases, insurance, GA&S).  These costs do NOT include depreciation expense or taxes.

The project qualifies for accelerated depreciation.  The entire $4,200,000,000 will be depreciated evenly over 7 years ($600 million per year) to zero book value.

1. Using a 30% tax rate and a 10% discount rate compute the NPV, IRR and payback of this investment.  Show in detail the Year 1 and Year 8 calculation of your after-tax cash flows.

1. The PTC is scheduled to expire before the wind farm becomes operational if Congress doesn’t renew it.  If the PTC is NOT renewed, what will the NPV be?  The company will still be able to sell RECs for $0.01 per kWh.   Use a 30% tax rate, a 25-year life and a 10% discount rate.  Show in detail the Year 1 and Year 8 calculation of your after-tax cash flow.

1. Suppose that lobbyists from the fossil fuel industry are putting pressure on politicians to not renew the PTC and to eliminate the accelerated depreciation provision.  Advocates for renewable energy can probably salvage one or the other (the PTC or the 7-year depreciation benefit).  If the accelerated depreciation benefit is eliminated, depreciation would be spread evenly over 14 years.  The sale of RECs would continue in either case.  As an advocate for renewable energy if only one benefit is politically feasible (the PTC or accelerated depreciation) which would you argue for?  Support your decision with numbers.

9. Mergers (10 points – Maximum of one page)

               You have just been promoted to be the assistant to the VP in charge of corporate strategy at Rawlins Oil, a NASDAQ listed company with annual revenues of about $250 million.  This is a high-profile position working with a person known for her intelligence, integrity and concern about creating shareholder value.   In addition to the promotion and its accompanying raise, like all other managerial level employees, you have just received your recent bonus and a special grant of stock.  Because oil prices have been reached new highs the bonuses were equal to your annual salary and you received restricted shares equal to twice your annual salary!

               Your first assignment is to accompany your boss to a presentation by the company’s CEO, Rob ‘Red’ Rawlins, and Executive VP, Rick ‘Rock’ Rawlins, brothers and sons of the founder of the company, the late Rollo Rawlins.  The brothers have been trying come out from under their father’s shadow and leave their own mark on the company.  Red and Rock have announced they have a great acquisition idea that they want to present to the management team.  Your boss (who admired Rollo but has some doubts about Red and Rock) wants you to take notes then put together a short (one-page maximum) critique of the plan.  This memo will be for her eyes only, so you may state things strongly if need be (though still maintaining standard business protocol, since things do leak sometimes).  Later in the day she will take part in a discussion of the acquisition and wants you to identify benefits, pitfalls and questions regarding the acquisition that need to be discussed.

               After the meeting you are in your office and begin to organize your thoughts about the memo for your boss.  At the meeting you were nervous, so your notes are a little sketchy.

Red:  We are preparing our proposal for the upcoming board meeting.  The company is doing great.  Our stock is at a new high.  This is our best year and we want to capitalize on it with one or two key acquisitions.  Rock and I have been doing a lot of reading and thinking, and we think we need to diversify.  Computers.  Oil is good but computers not oil will run the 21st century.  Rock is a visionary, and he and I agree that we need to diversify, and computers are where it is at and where it is going to be for a long time.

               Obviously, our results prove that we have a skilled management team that is driving our success.  We want to exploit this skill set into new areas and develop some new core competencies.  Everybody does well if we grow.  We’ll need new VPs in the acquired units.

               We’ve identified a computer game company in California, Dega, which is ripe for the picking.  It stock price is down some, but Rock says that the company makes great games.  He has been doing a lot of research.

               We can add a lot of value to the operation of that company.  It would do well to have some of our discipline.  We can get those software geeks to work at 8 in the morning and really increase production.  Just moving the headquarters from California to Texas will save about million bucks a year.

Rock:  Integration will be easy.  We are an easy-going bunch here and we’ll make those folks feel at home.  This acquisition could be pretty cheap for us because we can use some of our stock.  There is talk that some other company is interested Dega, but we can out bid them.  We have plenty of cash.  Since we don’t pay dividends the company’s cash is growing fast with these high oil prices.

A resource on this titled ‘The Merger Hangover’ from the October 14, 2002 issue of Business Week magazine is in Week 16 course module as: BWWhyMergerDontPayoff.pdf

The URL for the article is:

http://www.businessweek.com/magazine/content/02_41/b3803001.htm

10. WACC (10 points – one page)

Assume it is January 1, 2018.  Zelus Sport Shoe Company has three debt issues outstanding.

6.5% Notes December 31, 2024 ($200 million face value) Market price $972.70.

7.0% Bonds, maturing December 31, 2027 ($100 million face value) Market price $992.05.

7.5% Bonds, maturing December 31, 2034 ($200 million face value) Market price $1,009.58.

All bonds have a $1,000 face value and pay interest semi-annually at the end of June and December.

Use a 5.0% risk-free rate and a 7.0% market risk premium to compute Zelus’s cost of equity.  The table shows the weekly closing prices for Zelus and the S&P 500 Index.  Last week Zelus’s stock closed at $99.75 per share.  There are 16 million shares of common stock outstanding.

The company also has 8 million shares of preferred stock outstanding.  The preferred stock pays an annual $5.00 dividend and current sells for $50 per share.  The tax rate is 30%.

Assume you are doing the WACC calculation on January 1, 2018, and that the semi-annual interest payments of the notes and bonds were paid on December 31, 2017.  Show your beta and the costs and weights of all of the WACC components in the table provided.  Show costs to 3 decimal places.

Beta (3 decimal places) = __________

11. Capital Structure (10 points –one-half page per essay: one page total)

You are a new associate at a well-known financial consulting firm. As part of the firm’s in-house training program you have just visited two client companies.  Next week you will present your recommendations for the financial strategy that will best enhance shareholder value for each client.  Recommend a financing plan for each firm and then explain why your plan is the best way to enhance shareholder value.

1. Company A is a multi-divisional company in a mature industry.The company generates fairly large cash flows each year but has limited growth prospects.  The long-time CEO is a very charismatic individual, but has a tendency to treat the company as his own rather than shareholders’. One example of this is an acquisition he pushed the company to make that was later sold at a loss.  A second example is a company plane that internal auditors complain is not used often enough to justify its cost.  The CEO is 63 years old, but has not named a successor yet.  He owns about 1% of the company’s stock.  The CEO has hired some very talented younger executives.  Although this group of managers has been rewarded well with stock, they are a little frustrated that stock price has not risen very much over the past few years.  As a group they own (or have in-the-money options on) about 4% of the company’s shares.

The company, largely because of the personal experiences of the CEO during the depression, has almost no debt.  Despite having a large and growing cash and marketable securities account, the company has never distributed dividends.

Employee wages are competitive within the industry, but the company gives generous benefits so total labor costs are slightly above average.  Employee turnover is very low and morale is very high.  Since many jobs in the company are technical in nature (e.g., machinists, etc.) low turnover is considered of high value.

The board of directors, which includes two new directors, has asked your consulting firm for suggestions on how the company’ can create more value for shareholders through financial decisions.

____________________________________________________________

1. Company B is a small, publicly-traded technology company.  Company B is close to completing development of a new software/hardware product for schools that uses voice recognition to quickly translate a lecture into written notes that are projected onto a screen.  The lecturer can then annotate the notes with a drawing pad linked to the computer projection system.

The company needs about $12 million to complete development and begin production and marketing of this product.  The company is profitable with one other product that generates about $500,000 in cash flow annually.  For many reasons the company has been very secretive about its new product so its stock price is quite low, being based on the modest cash flows of its existing product.  Company officials and outside consultants agree that it is too early to reveal the new product’s details given what they know of competing products.

The company is reluctant to issue more stock at this low price because management is certain that the new product will be successful and stock price will rise dramatically once the product is introduced.  They feel that selling stock now would be giving away the unrealized value of current shareholders, including themselves.

Current interest rates on bonds or notes for companies of this type are in the range of 8% to 10%, which would very likely exceed the company’s debt service capabilities.  Convertible debt would probably have a coupon rate of 3% to 5% depending on the conversion price.  The higher the conversion price the higher the coupon rate.  The company’s tax rate is about 28%.

12. Cash Budget (10 points – one page plus cash budget form)

It is July 2017.  You are a budget analyst for ACME Manufacturing Inc.  ACME makes a variety of large metal seasonal decorations, such as snowflakes, reindeer, snowmen etc., used in shopping malls and municipal parks.  Create a cash budget for the months July through December using the sales estimates and other information about the company given below.  All numbers are in thousands. A form is provided for your cash budget.

1. Complete the cash budget for the remainder of 2017 (July through December) on the form provided.
2. What will the Accounts Receivable balance be at the end of 2017?
3. Assume everything occurs exactly as the cash budget predicts, and ACME gets the loans forecast on the cash budget.  Given the minimum cash balance of $50 is ACME assured that there will never be a cash shortfall at any time during the forecast period of July through December?  Explain why or why not.
4. Why must this profitable company borrow money for a few months each year?

ACME Sales Forecasts

                                               Month                          Sales ($ 000s)

May 2017                             100

June 2017                             200

July 2017                              500

August 2017                        900

September 2017                   900

October 2017                       700

November 2017                   400

December 2017                    300

January 2018                        200

Notes on collection and payments patterns for ACME Manufacturing.

• The Company offers customers a 5% discount if they pay at the time of sale.  About 20% of the customers take advantage of this discount. This means that for every $100 of merchandise sold ACME collects $19.00 in the sale month.  This represents 20% of the sales being sold at a 5% discount or at 95% of full price ($100*0.20*0.95 = $19.00).
• Credit sales: 50% of each month’s sales are collected one month after the sale and 30% are collected two months after the sale.
• Raw materials are 60% of sales.  Materials are ordered two months in advance and paid for the following month.  So, materials for July are ordered in May and paid for in June.
• Manufacturing labor is 20% of sales and wages are paid for in the month of the sales.  Thus, labor in July will be 20% of July sales (0.20*$400 = $80) and is paid for in July.
• Managerial salaries are $30 per month.
• Rent and lease payments total $20 per month.
• Tax payments of $25 will be made in September and December.
• The company will spend $100 for a new fabricating machine in August.
• The beginning cash balance in July is $100 and the minimum cash balance the company needs is $50.  At the beginning of July there is no loan outstanding.

Please use the form on the next page for your cash budget.

13. Pro forma Analysis: (10 points – one page plus pro forma)

It is April 1, 2018.  Two Season Sports is a specialty backcountry skiing and mountaineering store in southwestern Colorado.  The shop ended 2017 in good shape, but the 2018 winter season was slow to take off because of a persistent La Nina weather pattern.  No snow, no sales.  By the end of March ski sales were 20% below expectations.  The summer season still looked promising, and with aggressive sales events, the owners thought that total sales for the year would be down just 10% from last year.  However, because of discounting the ski inventory the cost of goods sold as a percent of sales would increase from its historic 64% to 68%.  GA&S expense would increase to $150,000 for 2018 with some additional marketing costs and higher health insurance premiums for employees.  Depreciation Expense in 2018 will be $30,000.  A new ski base prep machine is the only new fixed asset purchased during 2018.  It costs $14,000.  No assets will be sold.

The owners plan to reduce Inventory to $450,000 by the end of 2018.  This reduction in inventory will require deep discounts on some items.  These discounts are included in the estimate of Sales and COGS.  Other accounts (Cash, A/R and A/P) will be the same percent of sales in 2018 as in 2017.

1. Develop pro forma financial statements for 2018 on the form provided.  Compute interest as if the Bank Loan and the LT Debt were reduced on January 1, 2018, so interest is based on your new year-end loan amounts for the entire year. (8 points)

1. Will the Bank Loan increase or decrease by the end of 2018? What changes contribute to the change in the bank loan; that is, what were the primary uses and sources of cash that caused the bank loan to change? (2 points)

Assumptions (all numbers in thousands)

• Sales will decrease 10% in 2018
• COGS will increase to 68% of Sales in 2018.
• GA&S will increase to $150,000 in 2018.
• In 2018, depreciation expense will be $30,000, no assets will be sold and $14,000 of new assets will be purchased.
• The bank loan has an interest rate of 5.6% and the Long-term Debt (LTD) has an interest rate of 7.2%.  LTD will be reduced by $90,000 during 2018. Another $90,000 payment will be due in 2019.
• The tax rate is 30%.
• Inventory will be reduced to $450,000 during 2018.
• Cash, A/Receivable and A/Payable will be the same % of sales in 2018 as they were in 2017.  The minimum cash balance is 2% of Sales.
• All earnings are retained to finance growth (No dividends are paid).
• Assume Cash is kept at its minimum level as long as there is a loan outstanding.

Two Season Mountain Sports

December 31

2017 Actual and 2018 Pro Forma