a) Provide a critical discussion, relating to the underlying assumptions of WACC, when companies decide to use their current weighted average cost of capital (WACC) when assessing the acceptability of new projects. (9 Marks)
b) Explain how a finance manager’s attitude of short termism negatively impacts his goal of shareholder wealth maximization. (6 Marks)
c) Artificial Intelligence (AI) is a technology that aims to build systems that can be beneficial to any sector of the economy. Discuss the potential risks and loses of AI technology to financial institutions and financial markets to generate better economic value to the economy. (10 Marks) (Total: 25 Marks)
Magpie plc is reviewing the capital structure of their company. The purpose of the review is to assess the WACC for application to new projects. The balance sheet is available for analysis:
|Financial position statement at January 2020
|Ordinary shares ($0.50)
|Reserves- retained earnings
|5% preference shares @$100 per share
|9% bonds (irredeemable)
|9% bank loan ( 5 years)
You are also given the following information:
|Yield on Treasury bills
|Wren plc equity beta
|Equity risk premium
|Current ex-div ordinary share price
|Current ex-div preference share price
|Current ex-in the interest bond price
( irredeemable bonds)
|Corporate tax rate
Calculate the weighted average cost of capital (WACC) for Wren plc. (22 Marks)
Comment on your result. (3 Marks)
As part of its planning for the coming Christmas season, Criswell Motorsports is considering whether to expand its product line that currently consists of skateboards to include gas-powered skateboards. The company feels it can sell 2,000 of these per year for 10 years (after which time this project is expected to shut down, with solar-powered skateboards taking over). Each gas-powered skateboard would have variable costs of $40 and sell for $200; annual fixed costs associated with production would be $160,000. In addition, there would be a $450,000 initial expenditure associated with the purchase of new production equipment. It is assumed that the simplified straight-line method would be used to depreciate this initial expenditure down to zero over 10 years. The project would also require a one-time initial investment of $50,000 in net working capital associated with inventory, and this working-capital investment would be recovered when the project is shut down. Finally, the firm’s marginal tax rate is 34 percent.
a. What is the initial cash outlay associated with this project? (2 Marks)
b. What are the annual net cash flows associated with this project for Years 1 through 9? (12 Marks)
c. What is the terminal cash flow in Year 10 (that is, what is the free cash flow in Year 10 plus any additional cash flows associated with termination of the project)?
d. What is the project’s NPV, given a 10 percent required rate of return? (4 Marks)
e) Explain why a positive net present value evaluation is acceptable to the company. (3 Marks) (Total: 25 Marks)
a) What is the principle of self-liquidating debt, and how can it be used to manage a firm’s working capital? A diagram is required to demonstrate the above principle. (10 Marks)
b) The Pumpkin Company has for many years cultivated and sold what are known as heritage plants and seeds. Pumpkin has recently been considering ways to reduce its investment in working capital in order to make itself more profitable. At present, it has an inventory conversion period of 90 days and offers credit terms of 30 days, which are taken full advantage of by the majority of its customers. The company purchases its inventory items on credit terms that allow it 45 days to pay, but it has always followed a policy of making cash payments for invoices as soon as they are received, so the accounts payable deferral period is typically only 5 days.
a. What are Pumpkin s operating and cash conversion cycles?
b. If Pumpkin decides to take full advantage of its credit terms and delay payment until the last possible date, how will this impact its cash conversion cycle?
c. What is your recommendation to the company with regard to its working-capital management practices and why? (15 Marks)
Answers to Above Questions on Financial Management
Answer 1: An assumption that a project’s risks are comparable to other investments or company risk is made. This assumes that an investment project’s risk is similar to the company’s risk for measuring the required return, or WACC, for evaluating a project. This assumption is flawed because each project’s risk is different than the risk associated with other projects or the overall company risk. It is not fair to use the WACC to determine the project’s performance. Each project should be assessed based on its risk. The WACC cannot be used to evaluate the performance of a project in order to make a decision about an investment.
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