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Finance Management
Note: Solve any 4 Case Studies:
Case
1:
Lewis Securities Inc. has decided to acquire a new market
data and quotation system for its Richmond home office. The system receives
current market prices and other information from several on-line data services,
then either displays the information on a screen or stores it for later
retrieval by the firm’s brokers. The system also permits customers to call up
current quotes on terminals in the lobby. The equipment costs $1,000,000, and,
if it were purchased, Lewis could obtain a term loan for the full purchase
price at a 10 percent interest rate. Although the equipment has a six-year
useful life, it is classified as a special-purpose computer, so it falls into
the MACRS 3-year class. If the system were purchased, a 4-year maintenance
contract could be obtained at a cost of $20,000 per year, payable at the
beginning of each year. The equipment would be sold after 4 years, and the best
estimate of its residual value at that time is $200,000. However, since
real-time display system technology is changing rapidly, the actual residual
value is uncertain. As an alternative to the borrow-and-buy plan, the equipment
manufacturer informed Lewis that Consolidated Leasing would be willing to write
a 4-year guideline lease on the equipment, including maintenance, for payments
of $260,000 at the beginning of each year. Lewis’s marginal federal-plus-state
tax rate is 40 percent. You have been asked to analyze the
lease-versus-purchase decision, and in the process to answer the following
questions:
Questions:
1. Who are the two parties to this potential lease transaction?
2. How will these alternative decisions impact the company's
Capital Structure and its balance sheet?
3. What discount
rate should be used in this Net Present Value analysis? Why?
4. In the Purchase Decision, what are the cash flow impacts of the
Bank Loan? (Please focus on the after tax cash flows.)
Case 2: McKenzie Corporations Capital Budgeting
Sam
McKenzie is the founder and CEO of McKenzie Restaurants, Inc., a regional
company. Sam is considering opening several new restaurants. Sally Thorton, the
company's CFO, has been put in charge of the capital budgeting analysis. She
has examined the potential for the company's expansion and determined that the
success of the new restaurants will depend critically on the state of the
economy next year and over the next few years.
McKenzie
currently has a bond issue outstanding with a face value of $34 million that is
due in one year. Covenants associated with this bond issue prohibit the
issuance of any additional debt. This restriction means that the expansion will
be entirely financed with equity, at a cost of $8.4 million. Sally has
summarized her analysis in the following table, which shows the value of the
company in each state of the economy next year, both with and without
expansion.
|
Economic
Growth
|
Probability
|
Without
Expansion
|
With
Expansion
|
|
Low
|
0.3
|
$30,000,000.00
|
$33,000,000.00
|
|
Normal
|
0.5
|
$35,000,000.00
|
$46,000,000.00
|
|
High
|
0.2
|
$51,000,000.00
|
$64,000,000.00
|
Questions:
1.
What is the expected value of
the company in one year, with and without expansion? Would the company’s
stockholders be better off with or without expansion? Why?
2.
What is the expected value of
the company’s debt in one year, with or without the expansion?
3.
One year from now, how much
value creation is expected from the expansion? How much value is expected for
stockholders? Bondholders?
4.
If the company announces that
it is not expanding, what do you think will happen to the price of its bonds?
What will happen the price of the bonds if the company does expand?
 |
| If the company announces that it is not expanding, what do you think will happen to the price of its bonds What will happen the price of the bonds |
Case 3: Bullock Gold Mining
Seth
Bullock, the owner of Bullock Gold Mining is evaluating a new gold mine in
South Dakota. Dan Dority, the company’s geologist, has just finished his
analysis of the mine site. He has estimated that the mine would be productive
for eight years, after which the gold would be completely mined. Dan has taken
an estimate of the gold deposits to Alma Garrett, the company’s financial
officer. Alma has been asked by Seth perform an analysis of the new mine and
present her recommendation on whether the company should open the new mine.
Alma
has used the estimates provided by Dan to determine the revenues that could be
expected from the mine. She has also projected the expense of opening the mine
and the annual operating expenses. If the company opens the mine, it will cost
$500 million today, and it will have a cash flow of $80 million nine years from
today costs associated with closing the mine and reclaiming the area
surrounding it. The expected cash flows each year from the mine are shown in
the table. Bullock Mining has a 12 percent required return on all of its gold
mines.
|
Year
|
Cash
Flow
|
|
0
1
2
3
4
5
6
7
8
9
|
─$500,000,000
60,000,000
90,000,000
170,000,000
230,000,000
205,000,000
140,000,000
110,000,000
70,000,000
─80,000,000
|
Questions:
1.
Construct a spreadsheet to calculate the payback
period, internal rate of return, modified internal rate of return, and net
present value of the proposed mine.
2.
Based on your analysis, should the company open
the mine?
Case 4: Choosing Between Projects in ABC
Company
ABC
Company, has three projects to choose from. The Finance Manager, the operations
manager are discussing and they are not able to come to a proper decision. Then
they are meeting a consultant to get proper advice. As a consultant, what
advice you will give?
The
cash flows are as follows. All amounts are in lakhs of Rupees.
Project
1:
Duration
5 Years
Beginning
cash outflow = Rs. 100
Cash
inflows (at the end of the year)
Yr. 1 –
Rs 30; Yr. 2 – Rs 30; Yr. 3 – Rs 30; Yr.4 – 10; Yr.5 – 10
Project
2:
Duration
5 Years
Beginning
Cash outflow Rs. 3763
Cash
inflows (at the end of the year)
Yr. 1 –
200; Yr. 2 – 600; Yr. 3 – 1000; Yr. 4 – 1000; Yr. 5 – 2000.
Project
3:
Duration
15 Years
Beginning
Cash Outflow – Rs. 100
Cash
Inflows (at the end of the year)
Yrs. 1
to 10 – Rs. 20 (for 10 continuous years)
Yrs. 11
to 15 – Rs. 10 (For the next 5 years)
Question:
1.
If the cost of capital is 8%, which of the 3
projects should the ABC Company accept?
Case 5: Eastern Machines Company
Raj,
who was in charge production felt that there are many problems to be attended
to. But Quality Control was the main problem, he thought, as he found there
were more complaints and litigations as compared to last year. With the demand
increasing, he does not want to take any chances.
So he
went down to assembly line, but was greeted by an unfamiliar face. He
introduced himself.
Raj: I am
in charge of checking the components, which we use, when we assemble the
machines for customers. For most of the components, suppliers are very reliable
and we assume that there will not be any problem. When we generally test the
end product, we don’t have failures.
Namdeo: I am
Namdeo. I was in another dept. and has been transferred recently to this dept.
Raj: Recently we have been having
problems, and there has been some complaint or other about the machines we have
supplied. I am worried and would like to check the components used. I would
like to avoid lot of expensive rework.
Namdeo: But
it would be very expensive to test every one of them. It will take at least
half an hour for each machine. I neither have the staff nor the time. It will
be rather pointless as majority of them will pass the test.
Raj: There
has been more demand than supply for these machines in last 2 years. We have
been buying many components from many suppliers. We have been producing more
with extra shifts. We are trying to capture the market and increase our market
share.
Namdeo: We
order for components from different places, and sometimes we do not have time
to check all. There is a time lag between order and supply of components, and
we cannot wait as production will stop. We use whatever comes soon as we want
to complete our orders.
Raj: Oh!
Obviously we need some kind of checking. Some sampling technique to check the
quality of the components. We need to get a sample from each shipment from our
component suppliers. But I do not know how many we should test.
Namdeo: We
should ask somebody from our statistics dept. to attend to this problem.
Question:
1.
As a Statistician, advice what kind of Sampling schemes
can we consider, and what factors will influence choice of scheme. What are the
questions we should ask Mr. Namdeo, who works in the assembly line?
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