Reference no: EM132179418

Assignment

Question 1

You are the Chief Operating Officer (COO) of an electrical appliances company, Sung-Sam. Currently you are considering replacing the existing old assembly line with a new one in order to boost the production capacity and product variety.

The old assembly line was purchased seven years ago at a total cost of $2.4 million. It has a 12-year economic life with five years remaining and zero salvage value. If this assembly line was to be sold today, it would be worth $1 million.

The new assembly line is proposed by Pro-M, a consulting firm with expertise in manufacturing consultancy. The proposed assembly line is currently selling at $1.4 million. In addition, Sung-Sam would have to incur $120,000 shipping and installation expenses and HK$80,000 investment in net working capital. The economic life of the new assembly line is five years with zero scrap value. It is expected that the new assembly line can reduce before- tax operating expenses by $220,000 every year. The company has paid $20,000 to Pro-M to obtain an evaluation report on the new assembly line.

Sung-Sam uses the straight line depreciation method on all its production machinery and sets the cost of capital to be 18%. Assume that the marginal tax rate is 25%.

Answer the following questions:

a What is a sunk cost in capital budgeting? Do you agree that the $20,000 to Pro-M is a sunk cost? Why?

b What is the initial outlay associated with this proposed purchase?

c What are the annual after-tax cash flows associated with this proposed purchase for years one through to four? What is the after- tax cash flow in terminal year (year 5)?

d Calculate the net present value (NPV) of this replacement decision. Would you accept the purchase of the new assembly line? Explain your reason with concept of the goal of the firm.

Question 2

Green Capital is a private equity investment firm focusing on environmental projects in China. The company requires a 12% p.a. return for its projects. Green Capital is now considering choosing one environmental project from two candidates: Project Demeter, an agricultural production company in the Gobi Desert and Project Hephaestus, a wind farm in Shangri-La. Although the two projects are mutually exclusive, Green Capital believes that the two projects can be repeated indefinitely. The after-tax cash flows for the two projects are as follows:

After-tax cash flows (000)

Year	Project Demeter	Project Hephaestus
0	-120,000	-120,000
1	28,000	15,000
2	28,000	35,000
3	28,000	45,000
4	23,000	75,000
5	23,000
6	23,000
7	17,000
8	17,000

Answer the following questions:

a With the application of the equivalent annual annuity (EAA) method, advise Green Capital on which project it should choose. Explain.

b Explain the difference between the time disparity problem and unequal lifespan problem in project selection. Which problem appears in this case and why can the EAA method solve such a problem?

Question 3

Your company is considering the five independent projects below. The initial outlay and the after-tax cash flows for each project are as follows:

Year	Project A ($)	Project B ($)	Project C ($)	Project D ($)	Project E ($)
0	-1,431,819.88	-1,430,000	-800,000	-600,000	-400,000
1	500,000	-	100,000	420,000	140,000
2	500,000	-	250,000	220,000	160,000
3	500,000	-	350,000	120,000	180,000
4	500,000	-	450,000	80,000	210,000
5	500,000	3,558,297.60	600,000	10,000	220,000

Your company's required rate of return is 15%.

Answer the following questions:

a You are asked to evaluate Project A and Project B only because your boss wants to select either Project A or Project B.

i Use the NPV method to make your recommendation. Also, what is your choice with the IRR method?

ii Based on your results in part (i), your boss observes a conflict in your results. Explain to him/her why such a conflict exists and justify which project should be chosen.

b Now you are asked to consider all five projects (Projects A, B, C, D and E). In addition, you are told that the fund available for the company to invest this year is limited to $2.5 million. Under strict capital rationing, please advise your boss on the best combination of projects which the company should select.

Question 4
Solidstone is a rubber tyre manufacturer producing high performance tyres for sports cars and heavy vehicles. The business of Solidstone has been flourishing in recent years and the board of directors intends to expand the business by acquiring companies in other industries.

One of the acquisition targets is a car manufacturer in Malaysia. The management of Solidstone believes this car manufacturer will bring huge revenue to the company in the future.

As a business analyst for Solidstone, you have been asked to determine the weighted average cost of capital (WACC) of your company. The senior management would like to use the WACC to benchmark potential targets for acquisition. The following is the current financial information on Solidstone:

i 800,000 shares of common stock with a current price of $60 per share

ii 600,000 shares of preferred stock currently trading at $30 per share in the market. The fixed annual dividend of this preferred stock is $3.

iii 24,000 units of 10-years, 14% p.a. coupon bonds with semi-annual interest payment. The bond has exactly four years to maturity with a par value of $1,000. The current quotation for this bond is 125, which means 125% of its par value. Bonds with a similar risk, interest term and maturity are currently selling at 6.7622% p.a. yield to maturity.

iv A $24 million long-term bullet payment loan with the Bank of Kowloon. The loan was borrowed two months ago with an 8% p.a. borrowing rate. The market value of this bank loan is not available.

v The expected market return is 11%; the risk-free rate is 3%; and beta of Solidstone's common stock is 1.8 respectively. The marginal tax rate is 15%.

Answer the following questions:

a What is the capital structure of Solidstone on a market value basis? Please make assumptions in your calculation if necessary.

b Evaluate the weighted average cost of capital (WACC) of the company.

c Discuss whether Solidstone should rely on its WACC only to accept or reject its acquisition targets?