Reference no: EM131159041

1. In January 2015, Teresa Leal was named treasurer of Casa de Diseño. She decided that she could best orient herself by systematically examining each area of the company's financial operations. She began by studying the firm's short-term financial activities.

Casa de Diseño, located in southern California, specializes in a furniture line called "Ligne Moderna." Of high quality and contemporary design, the furniture appeals to the customer who wants something unique for his or her home or apartment. Most Ligne Moderna furniture is built by special order because a wide variety of upholstery, accent trimming, and colors is available. The product line is distributed through exclusive dealership arrangements with well-established retail stores. Casa de Diseño's manufacturing process virtually eliminates the use of wood. Plastic and metal provide the basic framework, and wood is used only for decorative purposes.

Casa de Diseño entered the plastic-furniture market in late 2007. The company markets its plastic-furniture products as indoor-outdoor items under the brand name "Futuro." Futuro plastic furniture emphasizes comfort, durability, and practicality and is distributed through wholesalers. The Futuro line has been very successful, accounting for nearly 40 percent of the firm's sales and profits in 2014. Casa de Diseño anticipates some additions to the Futuro line and also some limited change of direction in its promotion in an effort to expand the applications of the plastic furniture.

Leal has decided to study the firm's cash management practices. To determine the effects of these practices, she must first determine the current operating and cash conversion cycles. In her investigations, she found that Casa de Diseño purchases all its raw materials and production supplies on open account. The company is operating at production levels that preclude volume discounts. Most suppliers do not offer cash discounts, and Casa de Diseño usually receives credit terms of net 30. An analysis of Casa de Diseño's accounts payable showed that its average payment period is 30 days. Leal consulted industry data and found that the industry average payment period was 39 days. Investigation of six California furniture manufacturers revealed that their average payment period was also 39 days.

Next, Leal studied the production cycle and inventory policies. Casa de Diseño tries not to hold any more inventory than necessary in either raw materials or finished goods. The average inventory age was 110 days. Leal determined that the industry standard, as reported in a survey done by Furniture Age, the trade association journal, was 83 days.

Casa de Diseño sells to all its customers on a net-60 basis, in line with the industry trend to grant such credit terms on specialty furniture. Leal discovered, by aging the accounts receivable, that the average collection period for the firm was 75 days. Investigation of the trade association's and California manufacturers' averages showed that the same collection period existed where net-60 credit terms were given. Where cash discounts were offered, the collection period was significantly shortened. Leal believed that if Casa de Diseño were to offer credit terms of 3/10 net 60, the average collection period could be reduced by 40 percent.

Casa de Diseño was spending an estimated $26,500,000 per year on operating-cycle investments. Leal considered this expenditure level to be the minimum she could expect the firm to disburse during 2015. Her concern was whether the firm's cash management was as efficient as it could be. She knew that the company paid 15 percent annual interest for its resource investment. For this reason, she was concerned about the financing cost resulting from any inefficiencies in the management of Casa de Diseño's cash conversion cycle. (Note: Assume a 365-day year, and assume that the operating-cycle investment per dollar of payables, inventory, and receivables is the same.)

TO DO:

a. Assuming a constant rate for purchases, production, and sales throughout the year, what are Casa de Diseño's existing operating cycle (OC), cash conversion cycle (CCC), and resource investment need?

b. If Leal can optimize Casa de Diseño's operations according to industry standards, what will Casa de Diseño's operating cycle (OC), cash conversion cycle (CCC), and resource investment need to be under these more efficient conditions?

2. P12-1 Recognizing risk Caradine Corp., a media services firm with net earnings of $3,200,000 in the last year, is considering the following projects.

Project    Initial investment       Details

A            -$ 35,000                  Replace existing office furnishings.

B            -500,000                   Purchase digital video editing equipment for use with several existing accounts.

C            -450,000                     Develop proposal to bid for a $2,000,000 per year 10-year contract with the U.S. Navy, not now an account.

D            -685,000                     Purchase the exclusive rights to market a quality educational television program in syndication to local markets in the European Union, a part of the firm's existing business activities.

The media services business is cyclical and highly competitive. The board of directors has asked you, as chief financial officer, to do the following:
a. Evaluate the risk of each proposed project and rank it "low," "medium," or "high."
b. Comment on why you chose each ranking.

3. P12-3 Breakeven cash inflows and risk Blair Gasses and Chemicals is a supplier of highly purified gases to semiconductor manufacturers. A large chip producer has asked Blair to build a new gas production facility close to an existing semiconductor plant. Once the new gas plant is in place, Blair will be the exclusive supplier for that semiconductor fabrication plant for the subsequent 5 years. Blair is considering one of two plant designs. The first is Blair's "standard" plant, which will cost $30 million to build. The second is for a "custom" plant, which will cost $40 million to build. The custom plant will allow Blair to produce the highly specialized gases that are required for an emerging semiconductor manufacturing process. Blair estimates that its client will order $10 million of product per year if the traditional plant is constructed, but if the customized design is put in place, Blair expects to sell $15 million worth of product annually to its client. Blair has enough money to build either type of plant, and, in the absence of risk differences, accepts the project with the highest NPV. The cost of capital is 12%.

a. Find the NPV for each project. Are the projects acceptable?
b. Find the breakeven cash inflow for each project.
c. The firm has estimated the probabilities of achieving various ranges of cash inflows for the two projects as shown in the following table.

What is the probability that each project will achieve at least the breakeven cash inflow found in part b?

Probability of achieving cash inflow in given range

Range of cash inflow ($ millions)   Standard Plant    Custom Plant

$0 to $5                                       0%                      5%

$5 to $8                                       10                       10

$8 to $11                                      60                       15

$11 to $14                                    25                        25

$14 to $17                                     5                        20

$17 to $20                                      0                        15

Above $20                                      0                         10

d. Which project is more risky? Which project has the potentially higher NPV? Discuss the risk-return trade-offs of the two projects.

e. If the firm wished to minimize losses (that is, NPV < $0), which project would you recommend? Which would you recommend if the goal were to achieve a higher NPV?

4. P12-6 Impact of inflation on investments You are interested in an investment project that costs $40,000 initially. The investment has a 5-year horizon and promises future end-of-year cash inflows of $12,000, $12,500, $11,500, $9,000, and $8,500, respectively. Your current opportunity cost is 6.5% per year. However, the Fed has stated that inflation may rise by 1.5% or may fall by the same amount over the next 5 years.

Assume a direct positive impact of inflation on the prevailing rates (Fisher effect) and answer the following questions. (Assume that inflation has an impact on the opportunity cost, but that the cash flows are contractually fixed and are not affected by inflation).

a. What is the net present value (NPV) of the investment under the current required rate of return?
b. What is the net present value (NPV) of the investment under a period of rising inflation?
c. What is the net present value (NPV) of the investment under a period of falling inflation?

d. From your answers in a, b, and c, what relationship do you see emerge between changes in inflation and asset valuation?

5. P12-17 Real options and the strategic NPV Jenny Rene, the CFO of Asor Products, Inc., has just completed an evaluation of a proposed capital expenditure for equipment that would expand the firm's manufacturing capacity. Using the traditional NPV methodology, she found the project unacceptable because

NPV traditional = -$1,700 < $0

Before recommending rejection of the proposed project, she has decided to assess whether there might be real options embedded in the firm's cash flows. Her evaluation uncovered three options:

Option 1: Abandonment. The project could be abandoned at the end of 3 years, resulting in an addition to NPV of $1,200.

Option 2: Growth. If the projected outcomes occurred, an opportunity to expand the firm's product offerings further would become available at the end of 4 years. Exercise of this option is estimated to add $3,000 to the project's NPV.

Option 3: Timing. Certain phases of the proposed project could be delayed if market and competitive conditions caused the firm's forecast revenues to develop more slowly than planned. Such a delay in implementation at that point has an NPV of $10,000.

Jenny estimated that there was a 25% chance that the abandonment option would need to be exercised, a 30% chance that the growth option would be exercised, and only a 10% chance that the implementation of certain phases of the project would affect timing.

a. Use the information provided to calculate the strategic NPV, NPVstrategic, for Asor Products' proposed equipment expenditure.

b. Judging on the basis of your findings in part a, what action should Jenny recommend to management with regard to the proposed equipment expenditure?

c. In general, how does this problem demonstrate the importance of considering real options when making capital budgeting decisions?

6. P12-19 Capital rationing: NPV approach A firm with a 13% cost of capital must select the optimal group of projects from those shown in the following table, given its capital budget of $1 million.

Project         Initial investment       NPV at 13% cost of capital

A                -$300,000                  $ 84,000

B                -200,000                    10,000

C                -100,000                    25,000

D                -900,000                    90,000

E                -500,000                    70,000

F               -100,000                     50,000

G               -800,000                    160,000

a. Calculate the present value of cash inflows associated with each project.

b. Select the optimal group of projects, keeping in mind that unused funds are costly.