Reference no: EM132409346
Financial Management
Mini Case # 1 (Book Value and market Valuation)
Webster Company has compiled the following information as shown below: (All in $1,000)
Source of Capital Book Value Market Value After-tax cost
Long-term Debt $ 4,000 $ 3,800 6.0 %
Preferred Equity 100 100 13.0 %
Common Equity $ 1,060 $ 3,000 18.0%
Total Value $ 5,100 $ 6,900
Required
a. Calculate the average cost of capital using book value weights
b. Calculate the weighted average cost of capital using market value weights
c. Compare the answers obtained in a and b, Explain the differences
Mini Case # 2(Break-even Analysis, DOL and DFL)
Evans Products Limited (EPL) is considering introducing a new product that will sell for $2.00 per unit. There are two ways to produce this product.
The first is capital intensive. With this method, the fixed costs would be $60,000, variable cost $0.80 per unit, and interest expense $12,000.
The second method is labour intensive. With this method, the fixed costs would be $12,000, variable costs $1.60 per unit, and interest expense $4,000. EPL has a tax rate of 40%. and they have 8,000 common shares outstanding.
Required:
1. Calculate the break-even units for both production methods and prove the break-even calculated is correct!
2. Calculate the degree of operating leverage (DOL) for EPL’s two cost structures at a production of 60,000 units. Discuss the implication of your answers. When using DOL, what assumptions must you make?
3. Which production method is a better option for EPL if they produced 60,000units?
4. Calculate the degree of financial leverage (DFL) at the production level of 60,000 units. Discuss the implication of your answers.
5. Assume that the basic cost structure will apply if the production increase to 80,000 units. Calculate the degree of operating leverage (DOL), Degree of Financial Leverage (DFL) and degree of Total leverage (DTL). Which cost structure would you recommend they select? Explain.
6. At what production level would EPL be indifferent to the cost structure selected?
Mini-Case # 3 (Determining NPV)
Lombard Company Limited (LCL) is contemplating the purchase high-speed grinder to replace the existing grinder. The existing grinder was purchased 2 years back at an installed cost of $60,000. The existing grinder can be used for another 5 years. The existing grinder can be sold for $70,000 removal and clean up costs will total $42,000.
The new grinder costs $105,000 and requires $5,000 to install and has a life of 5 years. To support the increased business resulting from the purchase of a new grinder, the controller for LCL gathered the following information:
Accounts receivable would increase by $40,000.
Inventories would increase by 30,000
Accounts payable by 58,000
Salvage value of existing grinder 0
New grinder - net value 29,000
CCA rate for class 8 Asset 20%
Tax rate for LCL 40%
Cost of Capital for LCL 12%
The estimated operating income for both grinders are shown below:
Year Operating Income before taxes
New Grinder Existing Grinder
1 $ 43,000 $ 26,000
2 43,000 24,000
3 43,000 22,000
4 43,000 20,000
5 43,000 18,000
Required:
a. Should LCL go with the purchase of new grinder?
b. Determine the approximate Internal Rate of Return for this proposal.
Mini Case #4 (Portfolio Returns and Beta and the CAPM model)
John Peters invested $100,000 to set up the following portfolio last year:
Common Share Investment Beta at purchase Income Value today
A $20,000 0.80 $1,600 $20,000
B 35,000 0.95 1,400 36,000
C 30,000 1.50 Nil 34,500
D 15,000 1.25 375 16,500
Required:
a) Calculate the portfolio Beta based on the original amount invested.
b) Calculate percentage return for each common share in the portfolio for the year.
c) Calculate the percentage return earned on the portfolio for the year.
d) At the time John made the investment, the analysts estimated the market return for the coming year would be at 10 percent and the risk-free rate at 4 percent. Calculate the required return for each stock based on its beta. Use the CAPM model for evaluations.
e) Based on your answers above, part c) and d) explain how each stock performed relative to the required return. What factors would explain the differences?
f) Calculate the arithmetic and geometric mean return for the portfolio.
(Marginal Cost of Capital (MCC), Investment Opportunity Schedule (IOS) and Financing Break points (BPs)
Caldwell Products Limited (CPL) has compiled the following data for its three sources of capital for their various ranges of new financing:
Source of Capital Range of New Financing After-tax costs
Long-term Debt $1 to $320,000 6%
$320,001 and above 8%
Preferred Equity $1 and above 17%
Common Equity $1 to $200,000 20%
$200,001 and above 24%
The optimal capital structure for CPL, as compiled by its financial controller, is as follows:
Source of Capital Weight
Long-term Debt 40%
Preferred Equity 20%
Common Equity 40%
CPL has also identified severalinvestment opportunities for consideration. These are listed below with respected to their expected internal rate of return (IRR):
Investment Opportunity Expected IRR Initial Investment
Project A 19% $200,000
B 15% 300,000
C 22% 100,000
D 14% 600,000
E 23% 200,000
F 13% 100,000
G 21% 300,000
H 17% 100,000
J 16% 400,000
Required:
a) Determine the break-points of new financing associated with each source of capital?
b) Calculate the weighted average cost of capital for each of new financing found in (a) Hint: There are three ranges
c) Using the result in b) and available investment opportunities shown above, draw CPL's Marginal Cost of Capital (MCC) schedule and Investment Opportunity Schedule (IOS)
d) Which, if any, of the available investment do you recommend that CPL select? Why?
e) Calculate the overall cost of capital for CPL. Which projects CPL should select? Is it different from the previous question (d)? If so, explain why.