Answer the following questions:
Q1: Suppose you have your grandfather died and left you $1 million to do with as you please. You are not an inventor, and you do not have a trade skill that you can market; however, you have decided that you would like to purchase at least one established franchise in the fast-foods area, maybe two (if profitable). The problem is that you have never been one to stay with any project for too long, so you figure that your time frame is 3 years. After 3 years you will go on to something else. You have narrowed your selection down to two choices: (1) Franchise L, Lisa’s Soups, Salads, & Stuff, and (2) Franchise S, Sam’s Fabulous Fried Chicken. The net cash flows shown below include the price you would receive for selling the franchise in Year 3 and the forecast of how each franchise will do over the 3-year period. Franchise L’s cash flows will start off slowly but will increase rather quickly as people become more health-conscious, while Franchise S’s cash flows will start off high but will trail off as other chicken competitors enter the marketplace and as people become more health-conscious and avoid fried foods. Franchise L serves breakfast and lunch whereas Franchise S serves only dinner, so it is possible for you to invest in both franchises. You see these franchises as perfect complements to one another: You could attract both the lunch and dinner crowds and the health-conscious and not-so- health- conscious crowds without the franchises directly competing against one another.
Here are the net cash flows (in thousands of dollars):
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|
Expected Net Cash Flows
|
Year
|
Franchise L
|
Franchise S
|
0
|
-100
|
-100
|
1
|
10
|
70
|
2
|
60
|
50
|
3
|
80
|
20
|
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows.
You also have made subjective risk assessments of each franchise and concluded that both franchises have risk characteristics that require a return of 10%. You must now determine whether one or both of the franchises should be accepted.
Required:
a) What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive? (3 marks)
b) WouldtheNPVschangeifthecostofcapitalchanges?(2mark)
c) How is the IRR on a project related to the NPV? (1 mark)
Q2: Suppose Tom O’Bedlam, president of Bedlam Products, Inc., has hired you to determine the firm’s cost of debt and cost of equity capital.
Required:
a. The stock currently sells for $50 per share, and the dividend per share will probably be about $5. Tom argues, “It will cost us $5 per share to use the stockholders’ money this year, so the cost of equity is equal to 10 percent ($5/50).” What’s wrong with this conclusion? (3 marks)
b. Based on the most recent financial statements, Bedlam Products’ total liabilities are $8 million. Total interest expense for the coming year will be about $1 million. Tom therefore reasons, “We owe $8 million, and we will pay $1 million interest. Therefore, our cost of debt is obviously $1 million/8 million= 12.5%.” What’s wrong with this conclusion? (3 Marks)
Q3: Download the annual reports of Clover Pakistan Ltd and Fauji foods Ltd from the below mentioned links and answer the questions:
Clover Pakistan Ltd
https://www.clover.com.pk/wp-content/uploads/2019/10/Annual-Accounts-2019.pdf
Fauji Foods Ltd
https://www.faujifoods.com/wp-content/uploads/2020/03/Annual-Report-2019-Fauji-Foods- Ltd.pdf
Required:
a) What is the capital structure of the two companies during 2018 and 2019? (2 marks)
b) IncalculatingtheWACC,ifyouhadtousebookvaluesforeitherdebtorequity,which
would you choose? Why? (2 mark)
c) Why do we use an after tax figure for cost of debt but not for cost of equity? (1 mark)
d) Suppose the company president has approached you about company’s capital structure.
He wants to know why the company doesn’t use more preferred stock financing, since it costs less than debt. What would you tell the president? (1 mark)
Q4: Pamela Rock (PR), Inc., predicts that earnings in the coming year will be $45 million. There are 12 million shares, and PR maintains a debt-equity ratio of 2.
Required:
a) Calculate the maximum investment funds available without issuing new equity and the increase in borrowing that goes along with it. (1 mark)
b) Supposethefirmusesaresidualdividendpolicy.Plannedcapitalexpenditurestotal$60 million. Based on this information, what will the dividend per share be? (2 mark)
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c) In part (b), how much borrowing will take place? What is the addition to retained earnings? (1 mark)
d) Suppose PR plans no capital outlays for the coming year. What will the dividend be under a residual policy? What will new borrowing be? (1 mark)
Q5: You have been hired as a consultant to Kulpa Fishing Supplies (KFS), a company that is seeking to increase its value. The company’s CEO and founder, Mia Kulpa, has asked you to estimate the value of two privately held companies that KFS is considering acquiring. But first, the senior management of KFS would like for you to explain how to value companies that don’t pay any dividends. You have structured your presentation around the following items.
The first acquisition target is a privately held company in a mature industry owned by two brothers, each with 5 million shares of stock. The company currently has free cash flow of $20 million. Its WACC is 11%, and the FCF is expected to grow at a constant rate of 5%. The company owns marketable securities of $100 million. It is financed with $200 million of debt, $50 million of preferred stock, and $210 million of book equity.
Required:
a) What is its value of operations? (1 mark)
b) Whatisitstotalcorporatevalue?(1mark)
c) What is its intrinsic value of equity? (1 mark)
d) Whatisitsintrinsicstockpricepershare?(1mark)
e) What is its intrinsic MVA? (1 mark)
f) Explain how it is possible for sales growth to decrease the value of a profitable company.
(2 mark)