Introduction: You are part of an analysis group set up by the Controller of the firm XYZ. Your group has been tasked to respond to the following issues raised in a meeting with the CFO. You and your team must look over several prospective financial strategies to aid in the successful growth of the firm.
Over 10 weeks, you are to work on several projects, detail your work as you proceed on these projects, and assemble the report for the CFO to present to the board on the items listed below, while working in a team environment. Management will be looking at the team over this period on how well they self-organize and analyze the research areas which will include:
· Capital investment analysis
· CAPM – Capital Asset Pricing Model determination for the company
· WACC – Weighted Average Cost of Capital computations
· EVA – Economic Value Analysis
· MVA – Market Value Added
· The capital structure of the company
· Dividend policy
· Stock repurchase and option pricing strategy
· Bankruptcy risk analysis
· Decision Tree Creation
· Real options analysis of projects
The CFO wants to test your team out on a simple project in the first task before you get into preparing items for his board presentation in subsequent tasks and projects. He wants to see how well you perform tasks as a team as well as how accurate and thoughtful you are in your work. Details are important to him as well as good organization/presentation and communication.
Financial Statements for use on Tasks
Here are the financial statements you are to use in this exercise:
BEB Balance Sheet
Current assets: 2020 2021 change
Cash 1,500,000 1,800,000 300,000
Investments 1,000,000 1,025,000 25,000
Inventories 112,000,000 127,000,000 15,000,000
Accounts receivable 11,950,000 12,500,000 550,000
Pre-paid expenses 2,500,000 2,650,000 150,000
Other 0 0
Total current assets 128,950,000 144,975,000 16,025,000
Fixed assets: 2020 2021 change
Property and equipment 155,000,000 172,500,000 17,500,000
Leasehold improvements 0 0 0
Equity and other investments 48,000,000 57,000,000 9,000,000
Total fixed assets 203,000,000 229,500,000 26,500,000
Other assets: 2020 2021 change
Goodwill 85,000,000 70,000,000 -15,000,000
Total other assets 85,000,000 70,000,000 -15,000,000
Total assets 416,950,000 444,475,000 27,525,000
Liabilities and owner’s equity
Current liabilities: 2020 2021 change
Accounts payable 38,500,000 43,200,000 4,700,000
Accrued wages 75,000,000 80,500,000 5,500,000
Accrued compensation 10,000,000 10,255,000 255,000
Income taxes payable 4,024,000 4,697,000 673,000
current portion of LT debt 5,000,000 5,350,000 350,000
Other 0 0 0
Total current liabilities 132,524,000 144,002,000 11,478,000
Long-term liabilities: 2020 2021 change
Long term debt 115,000,000 130,000,000 15,000,000
Total long-term liabilities 115,000,000 130,000,000 15,000,000
Owner’s equity: 2020 2021 change
Common stock 122,000,000 122,000,000 0
Preferred stock 16,725,000 16,725,000 0
Accumulated retained earnings 30,701,000 31,748,000 1,047,000
Total owner’s equity 169,426,000 170,473,000 1,047,000
Total liabilities and owner’s equity 416,950,000 444,475,000 27,525,000
Financial Statements in ‘000s of U.S. Dollars
Less: Sales Returns and Allowances
Cost of Goods Sold
Freight-in Direct Labor
Inventory Available Less: Ending Inventory
Cost of Goods Sold Gross Profit (Loss)
Advertising Amortization Bad Debts Depreciation
Dues and Subscriptions Employee Benefit Programs Insurance
Legal and Professional Fees Licenses and Fees Miscellaneous
Office Expense Payroll Taxes Postage
Repairs and Maintenance Supplies
Telephone Travel Utilities
Vehicle Expenses Wages
Net Operating Income
Gain (Loss) on Sale of Assets Interest Income
Total Other Income
Net Income (Loss)
Calculate the following financial ratios:
Capital Asset Pricing Model (CAPM) :
Your team needs to investigate certain items to compute the required rate of return of your company. The expected market return for the coming year is 6%, and the risk-free rate is 2%. The beta for XYZ stock is 1.2. Calculate the rate of return according to CAPM for XYZ.
WORK 2 &3
Capital Structure and Weighted Average Cost of Capital: In this task, we will examine the current capital structure of XYZ and determine the WACC of the company. Assume that XYZ’s tax rate is 36%. To compute the WACC you must first find the after-tax cost of debt, the cost of equity, and the proportions of debt and equity in the firm. You can assume that the cost of debt before tax is 7.5% for the firm. Please clearly show how you derive each of these values: The after-tax cost of debt =
Cost of equity = (from your previous task)
Proportions of debt and equity in the firm (from the balance sheet) =
How do we compute the WACC in this circumstance?
Why do we need to be concerned with the WACC?
Any insights into the capital structure of BEB?
Concept Check: Capital structure for a public company consists of both debt and equity. We must consider the ability to write off interest payments in the calculation of our cost of debt which results in an after-tax cost of debt being used in our WACC calculation.
The weighted average cost of capital is the weighted average of the cost of equity and the after-tax cost of debt. Another way of looking at this is by computing the effect of the capital structure on expected returns by investors. WACC= (S/(B+S) x Rs) + (B/(B+S) x RB x (1 – tc))
Where S = value of equity B = value of debt Rs = cost of equity After tax cost of debt: RB x (1 – tc )
Helpful Hint: One thing to bring up here is WACC is needed to determine risk on several levels. To determine risk, we need to remember the following items: 1. Risk is a deviation from expectations. 2. We need to set expectations for our investments based on risk and return. Higher risk = higher return. 3. Capital is obtained from the marketplace in two forms: equity and debt. This is the capital structure of a corporation and impacts the profits of a company depending on how this is managed. 4. We use our cost of capital to discount any cash flows from new investments (NPV and IRR analysis). 5. If the cost of capital rises, then our risk rises and the projects we undertake to increase sales and return to our investors are reduced. 6. If debt rises, then our obligation to make payments on interest increases, and profits can decrease if sales do not increase rapidly enough. 7. If risk increases our beta will increase to show the increase in risk. This will increase our required rate of return to stockholders (CAPM) and thus increase our required rate of return we must use in discounting future cash flows.
To illustrate and further support our strategic financial planning systems we need to show the CFO and management team an example of the application of the previously constructed WACC. The CFO thinks that showing management how we can validate and choose projects based on expected returns developed from the WACC will help reduce the risk of our investor’s capital thus lowering the required rate of return we would have to provide to those investors. If we lower our expected return, we can then do more projects and grow at a faster rate. He has asked your team to evaluate the following project: Capital investment: XYZ is planning the construction of a new loading ramp for its single mill. The initial cost of the investment is $600,000, followed by an investment of $200,000 10 years later and another investment of $200,000 20 years later and finally an investment of $1,000,000 for environmental cleanup at the end of the project 30 years from now. Efficiencies from the new ramp are expected to reduce costs by $50,000 per year (at the end of every year) for the life of the plant, which is currently estimated at another 30 years. These savings can be assumed to be reinvested at a rate of 9% pa. What is the NPV of the project if XYZ has a required rate of return of 7%? What is the MIRR of the project if the cost of borrowing (with the loading ramp used as collateral) for a period of 10 years is 6% pa and the term structure of borrowing costs for Y years (Y > 15) is 6% + 0.0183*(1 – (1/(Y-9)) pa?
Concept Check: We need to adjust cash flows to account for things like inflation, our cost of capital, and opportunity costs. Simply looking at cash flow not adjusted for some of these costs will lead to taking on projects which are not adding to the value of the organization.
Helpful Hint: The first step in conducting an NPV analysis is to include all the relevant cash flows. This includes savings from taxes and any expenses directly related to the venture. We reject any project with a negative NPV.
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