Determine the financial consequences

Assignment Help Corporate Finance
Reference no: EM13957

Case 1

A friend of yours, employed as a Tier 2 field service representative for a telephony corporation, wants your help as a financial specialist to determine the financial consequences associated with investing in education. One alternative is to enroll in an MBA-program and the other alternative is to attain a certification in network design. Your friend has provided you the following information:

General

  • The current salary of $40 000 is paid once at the end of each year.
  • The salary is expected to grow at a rate of 3% per year and your friend is expected to work for another 35 years (until retirement)
  • Your friend's income tax level is expected to be 25% forever
  • Your friend's current discount rate is 10% and is expected to stay at this level forever unless no further education investment is made.
  • Today is the 1st of January 2013

The network design certification education

  • The education starts immediately and ends 31st of December 2013
  • The course fee is $5 000, to be paid today.
  • The certificate implies a promotion and a salary increase of $10 000. The new salary will be paid starting December 31st 2014 and onwards.
  • Due to that the education runs on evenings no salary loss is expected during the education
  • Upon completion of the education your friend's new discount rate will become 11%

The mba-program education

  • The education starts immediately and ends the 31st of December 2013
  • If enrolling your friend will earn no salary during 2013
  • The tuition fee is $20 000, to be paid today
  • An MBA degree implies a managerial position in the company and a salary increase of $20 000 . The new salary will be paid starting December 31st2014 and onwards.
  • Upon completion of the MBA-program your friend's new discount rate will be 13% (following higher risk of income decrease)

Create a spreadsheet model showing your friend which alternative is to prefer from a financial point of view. In particular your friend wants you to show her the following in the spreadsheet model:

a) Show by calculation the net present value for the three alternatives (no education, network design certification, mba). Also, according to NPV suggest which alternative you advise your friend to choose

b) Show by calculation (creating a formula) the discount rate (by replacing the 13% given above) at which your friend ought to be indifferent between not investing in education and investing in the MBA education (assuming she will complete it successfully).

c) Your friend is a bit uncertain about what her discount rate will be if completing an MBA. Therefore she wants you to show in a graph the NPV (with and without income tax) for different discount rates. Use the interval 0% to 100% with 5% subintervals. Set the y-axis as NPV and use the x-axis for the discount rates.

Finally, since your friend wants to be able to use this spreadsheet in the future as well you need to use cell references in the formulas (for tasks a, b and c above).

Case 2

A medical company has contracted you as a finance consultant to advise them on an investment opportunity of marketing their new drug "Memory" treating Alzheimer disease. More specifically, the company wants you to advise them on whether to make the investment or not and whether it is preferable to use equity or debt financing for the project. Information about the company and the investment opportunity follows:

General

  • The company is currently financed by 60% ($6 000 000) equity and 40% debt
  • The current after-tax WACC is 9%
  • The cost of company debt, Rd, is currently 5% and expected to be constant as long as D/E ≤ 0.8. Thereafter Rd increases with 1% per each ten-percentage-unit increase in D/E. For instance, 0.8< D/E ≤ 0.9 implies Rd= 6%
  • The corporate tax rate, Tc, is 25%
  • It is the 1st of January 2013

The investment opportunity

  • The initial cost of marketing the investment is $1 000 000
  • The project is expected to generate yearly cash flows of $400 000 at the end of each year for 5 years starting 31st of December 2013.
  • After the five years the investment has no scrap value
  • The company can either finance the project with 75% debt and 25% equity or with 60% equity and 40% debt. Further, assume that under the 75% debt-financing alternative, project debt is kept fixed during the project's lifetime.
  • Assume that the upfront cost per$1 equity issued is $0.07 and that the upfront cost per$1 debt issued is $0.01
  • Assume no cost for rebalancing debt

Create a spreadsheet model showing whether to undertake the investment or not and if so, what financing alternative that is to prefer. The client more specificallywants you to show the following in your spreadsheet model:

a) Would it be worthwhile to finance the investment with equity only? Show by calculation the investment's worth to the company

b) Show the interest tax shield value of each financing alternative. Hence, calculate PV (interest tax shield)

c) Use the APV-method (base-case NPV + sum of PV of financing side effects) to show which of the two financing alternatives that is to prefer given the information above.

Finally, since the company wants to be able to use this spreadsheet model in the future as well you need to use cell references in the formulas (for tasks a, b and c above).

Grading of the cases

We do not punish you for obvious minor mistakes in the grading. However, multiple and of each other independent minor mistakes will be counted as errors. The following applies for grading:

•For an A/VG: You have to complete both cases and provide fully correct solutions, only minor errors are accepted.
•For a B/VG: You have to complete correctly 5 out of 6 tasks, only minor errors are accepted.
•For a C/G: You have to complete correctly 4 out of 6 tasks, only minor errors are accepted.
•For a D/G: You have to complete correctly 3 out of 6 tasks, only minor errors are accepted.
•For an E/G: You have to complete correctly 3 out of 6 tasks, only minor mistakes are accepted.

Reference no: EM13957

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