Reference no: EM133775913

Corporate Finance

Introduction

Problem 1: Time value of money

You plan to start saving for a family vacation that you want to take in a few years. The vacation will cost $8,000 when you go. You plan to make an annual deposit into a savings account that earns 6% interest, compounded annually, with the first deposit at the end of this year. You will make identical deposits at the end of each year, with the final deposit made the year before the vacation. If an annual deposit of $2,500 will allow you to reach your goal, how many years from now will you take the vacation? Assume annually compounded 6% interest in your calculation.

Problem 2: Evaluating an investment decision
Alexa Nationwide Industries Ltd is a large company with interests in mining, shipbuilding, entertainment, food processing and interstate freight haulage. Its food processing division is investigating the possibility of adding mandarin-flavoured yoghurt to its current range of banana, strawberry and apple. Currently, all flavours are sold at a price of $1.5 per carton and sales are even throughout the year. Alexa recently hired Western Market Research Ltd to survey consumers to judge likely popularity of the new flavour. The report cost $40,000 and suggested that the company should be able to sell 400,000 cartons of the new flavour next year, and 800,000 in each of the following 2 years. After that time, the fad for mandarin flavour is expected to have run its course. Alexa's costing department has advised that the incremental cost of production is $1.20 per carton. Alexa's sales department has advised that it is essential that all flavours in the range should be sold at the same price. Alexa's engineers have advised that there is no spare production capacity although there is plenty of spare floor space in the factory. They have also advised that yoghurt processing machines have a production capacity of 400,000 cartons per annum and that the cost of one machine, fully installed, is $230,000. Alexa's finance division has advised that the company's nominal required rate of return is estimated to be 15 per cent per annum. The machines have a life of 3 years and at that point have only a scrap value, which is estimated to be only $10,000. However, this amount usually only just covers the cost of removing the machine from the factory.

Alexa's project analyst has recommended against proceeding with the new flavour, basing this recommendation on a net present value analysis. The next cash inflows were forecast to be $120,000 in the first year and $240,000 in the second year and the third year. The initial outlay was $500,000. The NPV was calculated as:
$120,000 $240,000 $240,000
NPV = $500,000 = -$24,264
1.15" 1.151.5 1.152.5
[1]
The project analyst's report contained the usual range of sensitivity analyses and supporting discussion and documentation but his calculation was the central result.

As a student of Corporate Finance, you have been asked to review the project analyst's work and report on any errors you detect. Provide reasons. Ignore tax. Note that it is not necessary to redo the analysis, or to suggest how the analysis might be extended. Your task is to identify the errors.

Problem 3: Assessing diversification benefits

The manager of SureGain Fund, located in Perth, came to know that you are an expert financial specialist. Before offering you a job as an financial analysts in his firm, he wanted you to do some analyses for one of his clients. He supplied you the following data:

Shares                                                        Expected return (%)                    Standard deviation (%)

Western Mining Ltd                                                  9                                            8

SmartHouse Ltd                                           13                                         48

Correlation coefficient between the returns of the two shares is 0.80.

A client currently has all her wealth invested in Western Mining shares. She wishes to diversify her portfolio by redistributing her wealth such that 30% is invested in Western Mining shares and 70% is invested in SmartHousu shares.

You constructed the portfolio and reported the results (expected return and standard deviation) to her. However, she seemed quite upset. She said, "I thought the whole purpose of diversification was to reduce risk; however, the results show that the variability of my6 portfolio has actually been increased from what it was when I invested only in Western Mining Ltd."

Provide a response to your client that demonstrates that the new portfolio does or does not reflect the benefits of diversification. Show all necessary calculations.

Problem 4: Investment flecision

Consider a scenario where you are evaluating an investment opportunity in a restaurant business with two years remaining on its lease. The required initial investment is $60, and the projected cash flow in the first year is $155. However, at the end of the second year, you plan to cease operations to return to university. Additionally, before vacating the premises, you are required to restore the property, incurring a significant expense. Consequently, the business will generate a negative cash flow of $100 in the second year.

Your task is to determine whether to proceed with this investment under two scenarios: Assuming a required rate of return of 5%.
Assuming a required rate of return of 10%.

(a) Would you accept the investment under these conditions using NPV?

(b) What problem, if there is any, do you confront in decision making using IRR? Explain.