Corporate finance assignment: Question Based on Financial Analysis
Question
Task: You are supposed to address the following question in this corporate finance assignment: Question1: You are the new CFO of Risk Surfing Ltd, which has current assets of $7,920, net fixed assets of $17,700, current liabilities of $4,580 and long-term debts of $5,890. Required:
a) What are the three important questions of corporate finance you will need to address? Please briefly explain them and indicate how they are related to the areas in the balance sheet of a company.
b) Calculate owners’ equity and build a balance sheet for the company?
c) How much is net working capital of the company? (1 mark)
d) Calculate the return on assets of the company given that Return on Equity is 30%?
e) What is the PE of the company total number of ordinary share outstanding of the companyare 2,000 and market price of each share is $12?
Question 2: You are a young personal financial adviser. Molly, one of your clients approached you for consultation about her plan to save aside $450,000 for her child’s higher education in United States 15 years from now. Molly has a saving of $120,000 and is considering different alternative options:
Investment 1: Investing that $120,000 in a saving account for 15 years. There are two banks for her choice. Bank A pays a rate of return of 8.5% annually, compounding semi-annually. Bank B pays a rate of return of 8.45 annually, compounding quarterly.
Investment 2: Putting exactly an equal amount of money into ANZ Investment Fund at the end of each month for 15 years to get 330 000 she still shorts of now. The fund is offering a rate of return 7% per year, compounding monthly.
Required:
a) Identify which Bank should Molly choose in Investment 1 by computing the effective annual interest rate (EAR)?
b) Calculate the amount of money Molly would accumulate in Investment 1 after 15 years if she chooses Bank B?
c) How much is the annual interest rate, assuming compounding annually Molly should aim at if she chooses to invest her $120 000 in a saving account to get the $450,000 ready in just 10 years from now?
d) Calculate the monthly payment Molly needs to contribute into ANZ Investment Fund to get $330,000 after 15 years in Investment 2?
e) In investment 2, if Molly changes to contribute $1200/month to that super fund at the beginning of each month, how much money she would have in ANZ Investment fund after 15 years?
f) Molly is offered an investment that will pay $12 000 each year forever. How much should she pay for this investment if the rate of return 12% applies?
Question 3: You are an active investor in the securities market and you have established an investment portfolio of two stocks A and B five years ago. Required:
a) If your portfolio has provided you with returns of 9.7%, -6.2%, 12.1%, 11.5% and 13.3% over the past five years, respectively. Calculate the geometric average return of the portfolio for this period?
b) Assume that expected return of the stock A in your portfolio is 14.6%. The risk premium on the stocks of the same industry is 5.8%, the risk-free rate of return is 5.9% and the inflation rate was 2.7. Calculate beta of this stock using Capital Asset Pricing Model (CAPM)
c) Assume that you bought 200 stocks B in your portfolio for total investment of $1200, now the market price of the stock is $75, the dividend paid for this stock is $2 each year. How much is the capital gain of this stock?
d) Assume that the following data available for the portfolio, calculate the expected return, variance and standard deviation of the portfolio given stock A accounts for 45% and stock B accounts for 55% of your portfolio?
Question 4: Blooming Ltd. currently has the following capital structure:
Debt: $2,500,000 par value of outstanding bond that pays annually 12% coupon rate with an annual before-tax yield to maturity of 10%. The bond issue has face value of $1,000 and will mature in 25 years.
Ordinary shares: 65,000 outstanding ordinary shares. The firm plans to pay a $7.50 dividend per share in the next financial year. The firm is maintaining 3% annual growth rate in dividend, which is expected to continue indefinitely.
Preferred shares: 40 000 outstanding preferred shares with face value of $100, paying fixed dividend rate of 14%. Company tax rate is 30%.
Required:
a) Calculate the current price of the corporate bond?
b) Calculate the current price of the ordinary share if the average return of the shares in the same industry is 9%?
c) Calculate the current value of the preferred share if the average return of the shares in the same industry is 12%
d) Calculate the current market value (rounded off to the nearest whole number) and capital structure of the firm (rounded off to two decimal places). Identify the total weights of equity funding
e) Compute the weighted average cost of capital (WACC) under the traditional tax system for the firm, using dividend constant growth model for calculation the cost of ordinary equity
Question 5: Bunnings Ltd is considering investing in one of the two following projects to buy new equipment. Each equipment will last 5 years and have no salvage value at the end. The company’s required rate of return for all investment projects is 8%. Required:
a) Identify which option of equipment should the company accept based on Profitability Index?
b) Identify which option of equipment should the company accept based on discounted pay back method if the payback criterion is maximum 2 years?
Question 6: Net profit of Lily Fashion House Ltd in the current year is $2,575, 000. The company is planning to launch a project that will require an investment of $745 000 next year. Today the company’s stock has market value of $22/share. Lily Fashion House has the current capital structure of 60% in equity and 40% in debt.
Required:
a) The Company is paying a cash dividend of $4.50/share plus an extra-cash dividend of $1.5/share. Tomorrow the stock will go ex-dividend. Explain why there is ex-dividend date and ex-dividend price? Calculate the ex-dividend price tomorrow morning. Assuming the tax on dividend is 25%?
b) How much dividend Lily Fashion House can pay its shareholders this year and what is dividend payout ratio of the company. Assume the Residual Dividend Payout Policy applies?
c) Floral Textile Ltd. is a daughter company of the Lily Fashion House Group and currently under a liquidation plan due to severe business contraction caused by the COVID 19 pandemic. The company plans to pay total dividend of $3.5 million now and $ 8.5 million one year from now as a liquidating dividend. The required rate of return for shareholders is 13.5%. Calculate the current value of the firm’s equity in total and per share if the firm has 2.5 million shares outstanding?
Answer
Question 1
a) Addressing three important questions of corporate finance
The three important questions for corporate finance are
What are long-term investments?
It takes into account of the capital structure decision of the business on what type of funding should the company use. It includes debt and equity where debt is associated with fixed obligations and equity deals with the total outstanding shares.
How to raise money to fund investment?
Fund can be raised from the invested capital in the form of equity, debt and preference share capital (Laktionovaet al., 2017). Depending upon the cost of each of the financial instruments, the company raises funds.
How to manage cash flow?
Cash flow management refers to the process of assessing and tracking the total amount of money that is coming in as well as going out from the business. The management of cash flow takes place in keeping a track of the total flow of cash and analyzing the changes derived from it.
b) Compute equity capital
Equity capital = Total assets- Total Liabilities
Total assets = Current assets+ Non-current assets = $7920+$17700 = $25,620
Total liabilities = Current liabilities+ Non-current liabilities = $4580+$5890 = $10,470
Equity capital = $25620-$10470 = $15,150
c) Compute net working capital
Net working capital = Current assets – Current liabilities
Current assets = $7920
Current liabilities = $4580
Net working capital = $7920-$4580 = $ 3,340
d) Compute ROA if ROE is 30%
ROE = Net profit/ Shareholders Fund = 30%
Or, 0.30 = Net income/ Shareholders equity
Or, 0.30*Shareholders equity = Net income
Or, 0.30*$24310 = Net income
Or, $7293 = Net Income
ROA = Net income/ Average total assets
ROA = 7293/ Average total assets
Average total assets = Current assets + Net fixed assets
Average total assets = 7920+17700 = $25620
ROA = 7293/ 25620
ROA = 28.4660%
e) Compute P/E ratio
P/E ratio = Share price/ Earnings per share
P/E ratio = 12/2000 = $0.006
Question 2
a) Calculation of Effective Annual Rate
EAR = (1+ i/n)n – 1.
EAR for Bank A = i=(1+r/n)n?1
i=(1+0.085/2)2?1
i=0.086806
I=i×100=8.6806%
EAR for Bank B = i=(1+r/n)n?1
i=(1+0.0845/4)4?1
i=0.087216
I=i×100=8.7216%
b) Derive amount of money for Molley in Bank B
Amount = Principal (1+r/n)n*t
A = 120000(1+0.087216/4)4*15
A = 120000(1+0.087216/4)60
A = $420645.06
c) Compute the annual interest rate for Molly assuming compounding annual rate
Annual rate of interest = n[(A/P)1/nt-1]
r = 1[(450000/120000)1/10*1-1]
r = 1[(450000/120000)1/10*1-1]
r= 1[(450000/120000)0.1-1]
r = 1[(3.75)1/10*1-1]
r= 14.131% p.a.
d) Compute monthly payment
Future value amount = $330000
Monthly rate of interest = 7%/12 = 0.00583
Number of period = 15*12 = 180 months
Present Value = PMT*(1-1/(1+i)n)/i
Monthly payment = $1041.13
e) Compute future value for Molley in case of Investment 2
Future Value = PV(a+r/m)mt
PV = $12894.56
No. of period = 15
Interest rate = 7%
PMT = $1200
FV = $35576.50
f) Compute the cost of investment
Cost = -x+12000+12000/0.12
X= 12000+100000
Cost of the investment= $112000
Question 3
a) Compute GAR
Geometric average return = ((1 + R1) × (1 + R2) × (1 + R3)×(1 + R4)× (1 +R5)) (1/5) – 1
GAR = ((1 + 9.7%) × (1 + -6.2%) × (1 + 12.1%) × (1 + 11.5%) × (1 +13.3)) (1/5) – 1
GAR = 7.82%
b) Compute beta under CAPM
Expected return = Risk dree rate + Beta*Market risk premium
14.6% = 5.9%+ Beta*5.8%
Beta = 1.5
c) Compute profit on stock
Costs = $1200
Proceeds = (200*$75)+(200*$2) = $15400
Capital gain = $15400-$1200 = $14,200
d) Calculate expected return, variance and standard deviation
Expected Return = 0.45*0.125+0.55*0.185 = 0.05625+0.10175 = 0.158 = 15.8%
Variance = 0.45(0.125-0.05625)^2 + 0.55 (0.185-0.10175)^2 = 0.0021269+0.003811 = 0.005938
Standard deviation = ? 0.005938 = 0.0770
Question 4
a) Compute current price of corporate bond
Face value 1000
Coupon Rate 12%
Market interest rate 10%
Years to Maturity 25
Payment per year 1
Corporate Bond price (Current) $1,181.54
b) Calculate current price of ordinary shares
Dividend paid = $7.50
Required rate of return = 9%
Annual growth rate = 3%
Price = Dividend paid*(1+g)/r-g
Price = $7.50*(1+3%)/ 9%-3%
Price = $128.75
c) Calculate current price of preferred stock
Price of preference shares = Preference dividend/ Required return
Price of preference shares = $100*14%/10%
Price of preference shares = 14/10%
Price of preference shares = $140
d) Calculate value of equity, preferred and capital structure of the business
Value of equity shares = 7.50/0.03= $250
Value of preference shares = 100*0.14 = 14/0.12 = $116.67
Capital structure = $250+$116.67 = $366.67
e) Calculate WACC
WACC = 14%
Question 5
a) Compute profitability index
Equipment 1
Initial investment |
186000 |
||
Cost of Capital |
8% |
||
Year |
Cash Flow |
Present Value @8% |
Present Value of Future Cash Flows |
1 |
86000 |
0.925926 |
79629.63 |
2 |
93000 |
0.857339 |
79732.51 |
3 |
83000 |
0.793832 |
65888.08 |
4 |
75000 |
0.73503 |
55127.24 |
5 |
55000 |
0.680583 |
37432.08 |
317809.5 |
|||
PI |
1.708653 |
||
Equipment 2 Initial investment |
195000 |
||
Cost of Capital |
8% |
||
Year |
Cash Flow |
Present Value @8% |
Present Value of Future Cash Flows |
1 |
97000 |
0.925926 |
89814.81 |
2 |
84000 |
0.857339 |
72016.46 |
3 |
86000 |
0.793832 |
68269.57 |
4 |
75000 |
0.73503 |
55127.24 |
5 |
63000 |
0.680583 |
42876.74 |
328104.8 |
|||
PI |
1.682589 |
Bunnings Limited should choose Equipment 1 over Equipment 2 as the PI for the former is higher 1.7086 than PI for the latter as 1.6825.
b) Compute discounted payback period
Equipment 1
Year |
CF |
PV @8% |
PV of FCF |
Cumulative FCF |
0 |
-186000 |
1 |
-186000 |
-186000 |
1 |
86000 |
0.925926 |
79629.63 |
-106370 |
2 |
93000 |
0.857339 |
79732.51 |
-26637.9 |
3 |
83000 |
0.793832 |
65888.08 |
39250.22 |
4 |
75000 |
0.73503 |
55127.24 |
94377.45 |
5 |
55000 |
0.680583 |
37432.08 |
131809.5 |
Discounted Payback Period = 26637.9/65888.08 = 2+0.40429 = 2.40429 years Equipment 2
Year |
Cash Flow |
PV @8% |
PV of FCF |
Cumulative FCF |
0 |
-195000 |
1 |
-195000 |
-195000 |
1 |
97000 |
0.925926 |
89814.81 |
-105185 |
2 |
84000 |
0.857339 |
72016.46 |
-33168.7 |
3 |
86000 |
0.793832 |
68269.57 |
35100.85 |
4 |
75000 |
0.73503 |
55127.24 |
90228.09 |
5 |
63000 |
0.680583 |
42876.74 |
133104.8 |
Discounted Payback Period = 33168.7/68269.57 = 2+0.48585 = 2.48585 years Bunnings Limited should accept Equipment 1 than Equipment 2 as according to DPB, the lower payback period must be selected. In this case, Equipment 1 has a lower DPB as 2.404 years than Equipment 2 of 2.4858 years.
Question 6
a. Compute ex-dividend price
The ex-dividend date is the future date which intends to the existing as well as potential shareholders of the business those dividends which was declared by the company against the stock shall be paid to the respective shareholders (Mortalet al., 2017). They are allowed to claim only on the ex-dividend date and after that the shareholders shall not be entitled to receive the said amount of dividend. Ex-dividend is one business date which is the day before the final declaration of dividend or the record date wherein the company counts the number of shareholders and their independent holdings based on company’s records. On the other hand, ex-dividend means the stock that is trading without knowing the value of the future dividend payment (Ngocand Cuong, 2016). The ex-dividend is the day when the stock starts its trading business without knowing the value of the future dividend payment. Prospective investors purchase new stock at a premium to avail the dividend before stock is declared as ex-dividend. Ex-dividend price is the price for tomorrow morning which is determined as ex-dividend price less after tax valuation of the declared dividend.
Ex-dividend price = Current market value – after tax value of dividends declared (both)
= 22-((4.5+1.5)*(1-0.25%)) = $17.5 per share
b. Compute dividend payout ratio
Net profit for the year = $2575000
Less: Equity shares of CAPEX = 74500*0.60 = $447000
Net income available to be distributed among the equity shareholders = $2128000
Dividend payout = $2128000/$2575000 = 82.64%
c. Compute current value in total and per share
Value of equity shares = 3.675/(13.5-5) = $43.235 per share
Value of equity shares = 2.5 million shares * $43.235 = $108.088 million
Expected dividend payment at the end of the year = 3.5*1+0.05 = 3.675
References
Laktionova, O.E., Tereshchenko, E.Y. and Desyatskii, S.P., 2017. Transformation of the organization and management of small and medium-sized business' finance. Finansovayaanalitika: problemy i resheniya= Financial Analytics: Science and Experience, 10(7), pp.767-789.
Mortal, S., Paudel, S. and Silveri, S., 2017.The impact of market structure on ex?dividend day stock price behavior. Financial Management, 46(4), pp.1053-1082.
Ngoc, D.B. and Cuong, N.C., 2016. Dividend announcement and ex-dividend effects on stock return. International Journal of Economics and Finance, 8(7), pp.207-215.