Reference no: EM133189768

Part 1: El Cap Climbing Company

El Cap Climbing Company (ECCC) is a small startup that manufactures and sells high-quality climbing gear in Fresno, California. The founder of the company, Leah, has been incredibly successful, but she hasn't kept the company's financial records as well as she might have.

The initial investment for El Cap was provided by her friends and family and was small. However, current operations can't meet the demand for the product, and Leah has plans to increase both production and the number of storefronts.

These plans require a large investment from both equity and debt financing. The new investors and creditors require detailed financial statements. Leah has hired you, a financial analyst, to prepare these statements and give insight into the financial position of the firm. Leah has provided information from her bank statements, bills, and receipts in an Excel spreadsheet, which is found in your downloaded project files. She explained to you that taxes are paid at a rate of 30 percent, and dividends are paid at a rate of 40 percent. (Note: You can create the statements in the same Excel spreadsheet that has the financial information.)

Prepare the following:

An income statement for 2018 and 2019

A balance sheet for 2018 and 2019

Operating cash flows for the two years

Cash flows from assets in 2019

Cash flows to creditors for 2019

Cash flows to stockholders for 2019

B. Answer the following:

How would you describe the financial position of the firm in 2019? I need to create brief overview.

What do you think about Leah's plans to expand?

Part 2: Mortgage Decision

To expand, El Cap Climbing Company (ECCC) is considering taking out a mortgage for a new store location, a nonresidential real property that includes land and a building. Leah is unsure if she has the cash flow to take on any more debt. She asked you to make loan amortization schedule for the proposed mortgage loan. Then, you'll form chart that represents the portion of each payment that goes toward principal and interest.

A. Prepare the following:

A loan amortization schedule

A chart showing the percentage of the payment applied to the principal and interest

Loan Amortization Schedule

First, you'll need to build loan amortization schedule in the downloaded Excel spreadsheet. Create the table on the tab named "Part 2 Loan Amortization Sched." The following table illustrates the payments and interest amounts for a fixed-rate, 30-year, $500,000 mortgage, at a five-percent interest rate. The monthly payment will be $2,684.11.

Payment Number Payment Amount 5% Interest Expense Principal Balance Annual Interest Expense

0 500,000.00 -

1 2,684.11 2,083.33 600.78 499,399.22  

2 2,684.11 2,080.83 603.28 498,795.94  

...break in the sequence...

Totals 466,278.03 500,000.00  

359 2,684.11 22.22 2,661.89 2,671.41  

360 2,682.54 11.13 2,671.41 - 855.56

The table serves as an example of what you'll create in Excel. Note that the table shows only the figures for the first and the last year of payments; you'll need to calculate the amounts for the remaining payments and fill them in.

Once you've determined how each amount in the table is obtained, you can use relative and absolute cell references to fill in the full 360 payments.

The following is an explanation of the columns in the table:

Payment number-The first column in the table shows the 360 payments required to pay off the mortgage loan (30 years, with 12 monthly payments per year).

Payment amount-The second column shows the monthly payment amount.

Interest-The third column shows the portion of the monthly payment that goes to interest.

Principal-The fourth column shows the portion paid toward the principal.

Balance-The fifth column shows the starting balance of $500,000, and the remaining balance each month after the principal is subtracted.

Annual interest expense-The last column provides a running total of the interest expense on the mortgage for the entire 12-month period. It's the amount that would be reported on the financial statements.

Totals-The "Totals" under the "5% Interest Expense" and "Principal" columns show the final totals for the 30-year life of the mortgage.

Mortgage Principal and Interest Chart

Next, you'll make chart following these steps. Create the table on the tab named "Part 2 Chart."

Start by selecting the Interest Expense and Principal columns. Make sure to select the column headers and values. Don't select the Totals row.

Click on the Insert tab and select a "Stacked Column." Make sure to label the x-axis (payment month) and y-axis (dollars), and include a legend for the two values (interest and principal).

Your final chart should be set up similar to the chart below, with the data populating the chart. (The increments don't need to be the same).

An image of a chart depicting mortgage principal and interest.

B. Answer the following:

How can you describe the relationship between time and the amount paid towards principal and interest?

Knowing what you know about ECCC's cash flow from Part 1, is it reasonable to believe that ECCC can take on this new debt?

Part 3: Can We Upgrade?

It's now 2020, and El Cap Climbing Company (ECCC) has continued to grow. One of ECCC's major revenue-producing products is a spring-loaded camming device called SLCD, or cams. It's a device with a small handle (called the "trigger") and two spring-loaded "cams" on an axle. When the trigger is pulled, the cams move together, decreasing the size of the cams. It's then inserted into a crack or pocket in the rock. When the trigger is released, the cams expand. These cams are used as anchors when "trad" rock climbing.

ECCC currently has one set of cams on the market, and sales have been excellent. The cams are lighter and perform better than their competitors'. However, as with any high-performance item, technology changes rapidly, and the cams are now falling behind the competition.

ECCC spent $200,000 to develop a prototype for a new line of cams that has all the features of the existing cams but are made from an even lighter and stronger 7075-T6 aluminum alloy. The company has spent a further $150,000 for a marketing study to determine the expected sales figures for the cam line.

ECCC can manufacture a set of the new cams for an average of $140 each in variable costs. Fixed costs for the operation are estimated to run an additional $2.1 million per year if the new project is undertaken. The estimated sales volume is 75,000, 85,000, 80,000, 70,000, and 65,000 per year for the next five years, respectively. The unit price of the new cam set will be $240. The necessary equipment can be purchased for $10.5 million and will be depreciated on a seven-year MACRS schedule. It's believed the value of the equipment in five years will be $1.1 million.

Production of the current cam line is expected to be terminated in two years. If ECCC doesn't introduce the new line of cams, sales will be 45,000 units and 25,000 units for the next two years, respectively. The price of the cam set is $150, with variable costs of $95 each, and fixed costs of $1.5 million per year. If ECCC does introduce the new cams, sales of the existing product will fall by 10,000 units per year, and the price of the existing sets should be lowered to $120 each. Net working capital for the cams will be 22 percent of sales and will occur with the timing of the cash flows for the year; for example, there's no initial outlay for NWC, but changes in NWC will occur in Year 1 with the first year's sales. ECCC has a 30-percent corporate tax rate and a required return of 10 percent. (Note: You can create the solutions in the same Excel spreadsheet that has the data report information. Be sure to let the instructor know if you choose to in a Word document.)

Leah has provided you with a data report in an Excel spreadsheet that contains information to answer the following questions:

What's the payback period of the project?

What's the profitability index of the project?

What's the IRR of the project?

What's the NPV of the project?

Should Leah accept the project?

If Leah needs to adjust the price of the product, what's the lowest Leah could make the price of the new cam set and still have a positive NPV project (keeping all other assumptions the same)?

Part 4: Risky Business

Lastly, just for fun, El Cap Climbing Company (ECCC) is looking at determining its sensitivity to market fluctuations.

Since ECCC isn't publically traded and can't look at its own stock history, it must evaluate its competitors. Black Diamond Equipment is its closest competitor, but the company doesn't have enough trading volume to make any sound conclusions. Leah identifies Callaway Golf Company (ELY) as ECCC's closest publicly-traded competitor. Even though ELY sells golf equipment, it too is a specialized company selling high-tech sports equipment.

Finding Beta with CAPM

Note: This information is also in your textbook.

CAPM is one of the most thoroughly researched models in financial economics. When beta is estimated in practice, a variation of CAPM, called the market model, is often used. To derive the market model, start with the CAPM:

E(Ri) = Rf + β[E(RM) - Rf]

Since CAPM is an equation, you can subtract the risk-free rate from both sides, which gives you:

E(Ri) - Rf = β[E(RM) - Rf]

This equation is deterministic-that is, exact. In a regression, you'll realize that there's some indeterminate error. You need to formally recognize this in the equation by adding epsilon, which represents this error:

E(Ri) - Rf = β [E(RM) - Rf] + ε

Finally, think of the above equation in a regression. Since there's no intercept in the equation, the intercept is zero. However, when you estimate the regression equation, you can add an intercept term, which is called alpha here:

E(Ri) - Rf = αi + β[E(RM) - Rf] + ε

The intercept term is known as Jensen's alpha, and it represents the "excess" return. If CAPM holds exactly, this intercept should be zero. Think of alpha in terms of the SML: If the alpha is positive, the stock plots above the SML; if the alpha is negative, the stock plots below the SML. You'll first make scatter- plot and then perform a regression analysis for ELY stock and the mutual fund. Then, use those results to compare and analyze the results.

A. Scatter Plotting and Regression Analysis

Use the following steps to create the scatter plot:

 

Go to the Part 4 Stock Data tab in your Excel spreadsheet. Highlight column K-M headings, then hold down the Ctrl button and select cells K-3 through M-62.

Go to the Insert tab, click on Scatter Chart, and select the first style.

An image of a dialogue box with five types of scatter charts and two types of bubble charts

Move the chart to the side of the data, and increase the size of the chart. Click on the Chart Title and change it to Risk Premium Analysis.

In the Design tab, click on Quick Layout. Select the layout that gives you the y formulas and the R2.

An image of a dialogue box of quick layout with 11 layouts.

Move the y formulas and the R2 to the bottom right-hand corner of the chart.

Now, use the following steps to show regression analysis for ELY and for the Mutual Fund:

First, check to see that you have the ability to run the analysis. Go to the Data tab in Excel, and look for the Data Analysis feature shown in the following image.

An image of the Excel sheet menu bar with the data analysis selection under data tab.

If you don't see Data Analysis, you might need to add Analysis Toolpak in Excel. For instructions on how to load the Analysis Toolpak into your version of Excel, visit https://support.office.com/en-us/article/Load-the-Analysis-ToolPak-6a63e598-cd6d-42e3-9317-6b40ba1a66b4. Contact Microsoft Support if you have any issues with this add-in. Once you've completed all these steps, you can continue with your project.

Click on Data Analysis. A dialog box with a list of analysis tools will open. Select Regression from the list and click OK.

An image of data analysis dialogue box with regression option selected in it.

Next, another dialog box opens for you to select your Inputs and Output for the regression. Select the input data ranges by highlighting S&P Risk Premium numbers (x-axes range) and the number for the asset you're comparing as the y-axes range. Output to a new worksheet (do not name in the text box). Select the checkboxes for Labels, Confidence Level, and Residuals. Click OK.

An image of Regression dialogue box.

Your regression analysis will open in a new worksheet. Rename the worksheet based on the premium being compared to the S&P premium, for example: "ELY Regression Analysis."

B. Answer the following questions:

In this regression, Rt is the return on the stock, and Rft is the risk-free rate for the same period. RMt is the return on a stock market index, such as the S&P 500 index. αi is the regression intercept, and βi is the slope (and the stock's estimated beta). εt represents the residuals for the regression. The intercept, αi, is often called Jensen's alpha. What does it measure? If an asset has a positive Jensen's alpha, where would it plot with respect to the SML?

Rt - Rft = αi + βi [RMt - Rft] + εt

Is the alpha of either ELY or the mutual fund significantly more or less than zero? (Hint: The alpha is the intercept.)

How do you interpret the beta for the stock and the mutual fund? (Hint: The beta is next to the coefficient.)

Which of the two regression estimates has the highest R-squared? Is this what you would have expected? Use the scatterplot to explain why.