Question 1
a. For evaluating the new equipment above, please explain whether the following cash flows should be included in the analysis:
i. Reduction in operating costs by 2,000 annually for the use of the new equipment; (4 marks)
Answer:
This cash flow is important for the analysis of the capabilities of the new equipment. This will indicate how much savings that the company will have if the new equipment was used compared to the current equipment. Basically, companies are looking for new equipment for production efficiency and most of all efficiency in terms of cost.
ii. ,000 research cost; (4 marks)
Answer:
The research cost is also vital for the evaluation of the new equipment. This will determine if the decision of the company to buy a new equipment is advantageous or a burden. In addition, this value should also be included since it is part of the transition of the old equipment to new equipment.
iii Annual cash operating costs total ,000,000 for the use of existing equipment; and (4 marks)
Answer:
This is also needed in the evaluation of the efficiency of the new equipment. Let say, the new equipment is efficient in production but the annual cash operating cost of it was still similar to the annual cash operating costs of the old equipment. Then we may say that buying the new equipment is worthless since the equipments are same in terms of annual cash operating cost. However, in our case the new equipment could possibly reduce the operating costs by 2,000 annually. Actually, the annual cash operating costs total ,000,000 can be use as gauge of determining how much savings that the company will have is they consider the new equipment i.e. ,000,000 - 2,000. This means that the savings could be around ,118,000.
iv ,000,000 loan for financing the new equipment. (4 marks)
The ,000,000 loan isn’t necessary for the evaluation of the new equipment but it is still important to consider at the end of evaluation. At the end of the evaluation, the company will be able to determine if the 3,000,000 loan is enough to buy the new equipment or they need to finance more.
b. If your company requests a required rate of return of 15%, please find out the maximum price that your company would be willing to pay for the new equipment? In your calculation, please ignore taxes. (14 marks)
Answers:
Existing Situation:
Cost of Old equipment = ,000,000.00
Cost of maintenance = ,000,000.00 per year
Cost of Repair = 8,000.00
Expected life = 13 years
Age = 5 years old
Expected salvage value in 8 years = 5,000.00
Current salvage value = ,528,000.00
Proposed Situation:
Research: ,000
Cost of New equipment = ?
Cost of Maintenance = ,118,000.00
Cost of Repair = 0,500.00
Expected life = 8 years
Expected salvage value in 8 years = ,646,000.00
Initial Outlay (at time t0):
Cost of old equipment: $ 5,000,000.00
Research: 80,000.00
Cost of new equipment: xx,xxx,xxx.xx
Less: Salvage Value of Old machine -3,528,000.00
Salvage Value of New machine -2,646,000.00
$ -1,094,000.00 + xx,xxx,xxx.xx
Differential cash flows over the project’s life (t1- t8)
Reduced repair: $ 220,500.00
Reduced maintenance: 2,118,000.00
$ 2,338,500.00
Terminal Cash Flow (at time t8) $ 2,338,500.00
Maximum Price = [$ 2,338,500.00/(1.15)8] – (-1,094,000.00) = ,858,759.80
Based on the computation and in order to respond on the request of the company to have a least 15% rate of return, the company was only willing to pay for up to ,858,759.80 for the new equipment. Actually, the financing value of ,000,000.00 from the OPEN Bank was too much since they only need ,858,759.80 for the new equipment.
Question 2
WINDAM Company is considering following independent projects. The initial outlays and the after-tax cash flows of two projects are shown as follows: Year
Project A
Project B
0 (initial outlays)
-,080,000
-,350,000
1
5,236
2
5,236
3
5,236
4
5,236
5
5,236
,359,232
WINDAM Company's required rate of return is 16%.
You are working in WINDAM Company and your boss only wants to select either Project A or Project B.
a. You boss asks you to calculate the IRR for these two projects, respectively. Please do it.
Answers:
Project A IRR:
Project B IRR:
b Please advise your boss which one of the projects should be chosen.
From the computed IRR values, it is advised to choose Project A.
Question 3
a Zala Company needs ,000,000 for a new acquisition. Zala finances new acquisitions with 66% debt and the rest in equity. Retained earnings available for Zala’s reinvestment are ,000,000. Based on the residual dividend approach, please calculate how much money will be available for dividends.
Answers:
b.) Zala Company has 150,000,000 shares of common stock outstanding. Net income is ,500,000 and the P/E ratio for the stock is 12. Zala’s top management is planning a 20% stock dividend.
i What will be the price of the stock before the stock dividend?
Answers:
Net income = ,500,000
Before the stock dividend, the price is .84
earnings per share is 10,500,000/150,000,000 = 0.07;
price is 0.07/12 = 0.84
new shares held = 2000 x 1.2 = 2400
ii If you have 2,000 shares before the stock dividend, does the total value of your shares change? Please explain.
Answers:
In theory, the total value of the shares does not change. The stock dividend will lower the price by the amount of the dividend, making the total value the same. However, one purpose of a stock dividend is to make the stock price more affordable to attract new investors, which could increase demand for the stock, driving up the price. When that happens, the value of the stock would increase.
Credit:ivythesis.typepad.com
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