Finance assignment

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timer Asked: Oct 8th, 2018

Question Description

Finance, Information Systems, & Management Science

FINANCE 3361 ASSIGNMENT #2

DUE FRIDAY, October 12, 2018 AT 12:00 noon.

Total Marks: 100

Problem 1 (69 marks):

GPS Inc. currently has $50,000,000 in bonds outstanding with a coupon rate of 6% paid semiannually and a maturity of 10 years. The bonds are currently selling at a quoted price of 90. The company also has 50,000 shares of 10% preferred stock outstanding ($100 par), currently selling for $95 per share.In addition, the company has 1,000,000 common shares outstanding, selling for $60 per share. The firm has a tax rate of 40%, a beta of 1.75, an ROE of 20%, and a dividend payout ratio of 40%. The firm just paid a dividend of $2 per common share. Flotation cost to issue new debt is 2%, new preferred share is 4%, and new common share is 6%. The firm has $5,000,000 in internally generated funds available.

a) Calculate the discount rate the firm should use to evaluate projects with the same level of risk as the firm. (23 marks)

b) Over the last two years, GPS Inc. incurred a cost of $100,000 for conducting a feasibility study on a new project. The project requires purchasing a new machine that will cost $2,200,000 plus an additional $300,000 in installation costs. Management estimates that the firm will obtain annual operating revenues before taxes of $1,000,000 and incur annual operating expenses before taxes of $400,000 over the economic life of the project. The specifications of this machine indicate an economic life of ten years and management estimates that at the end of the economic life, the machine will have a salvage value of $200,000. This machine is in asset class 8 which has a CCA rate of 20%. The asset class is expected to remain open at the end of the project. Finally, management expects to make an initial investment in working capital of $400,000, which will be recovered at the end of the economic life of the project.

Calculate the following: the weighted average flotation cost, initial investment (amount needed), amount raised, flotation costs (in $), annual tax shield associated with flotation costs, present value of annual tax shield associated with flotation costs, present value of the after tax operating cash flows, present value of salvage value, present value of net working capital, and present value of CCA tax shield.

Based on NPV analysis, should the project be undertaken? Assume this project will have the same level of risk as the firm. Show your work. (31 marks)

c) How would your answers to question (b) change if the firm had no internally generated funds? Explain. (15 marks)

Unformatted Attachment Preview

FINANCE, INFORMATION SYSTEMS, & MANAGEMENT SCIENCE FINANCE 3361 ASSIGNMENT #2 DUE FRIDAY, October 12, 2018 AT 12:00 noon. Total Marks: 100 Problem 1 (69 marks): GPS Inc. currently has $50,000,000 in bonds outstanding with a coupon rate of 6% paid semiannually and a maturity of 10 years. The bonds are currently selling at a quoted price of 90. The company also has 50,000 shares of 10% preferred stock outstanding ($100 par), currently selling for $95 per share. In addition, the company has 1,000,000 common shares outstanding, selling for $60 per share. The firm has a tax rate of 40%, a beta of 1.75, an ROE of 20%, and a dividend payout ratio of 40%. The firm just paid a dividend of $2 per common share. Flotation cost to issue new debt is 2%, new preferred share is 4%, and new common share is 6%. The firm has $5,000,000 in internally generated funds available. a) Calculate the discount rate the firm should use to evaluate projects with the same level of risk as the firm. (23 marks) b) Over the last two years, GPS Inc. incurred a cost of $100,000 for conducting a feasibility study on a new project. The project requires purchasing a new machine that will cost $2,200,000 plus an additional $300,000 in installation costs. Management estimates that the firm will obtain annual operating revenues before taxes of $1,000,000 and incur annual operating expenses before taxes of $400,000 over the economic life of the project. The specifications of this machine indicate an economic life of ten years and management estimates that at the end of the economic life, the machine will have a salvage value of $200,000. This machine is in asset class 8 which has a CCA rate of 20%. The asset class is expected to remain open at the end of the project. Finally, management expects to make an initial investment in working capital of $400,000, which will be recovered at the end of the economic life of the project. Calculate the following: the weighted average flotation cost, initial investment (amount needed), amount raised, flotation costs (in $), annual tax shield associated with flotation costs, present value of annual tax shield associated with flotation costs, present value of the after tax operating cash flows, present value of salvage 1 Fall 2018 Assignment #2 value, present value of net working capital, and present value of CCA tax shield. Based on NPV analysis, should the project be undertaken? Assume this project will have the same level of risk as the firm. Show your work. (31 marks) c) How would your answers to question (b) change if the firm had no internally generated funds? Explain. (15 marks) 2 Fall 2018 Assignment #2 Problem 2 (31 marks): NS Groceries, Inc. is specialized in the distribution of groceries. NS Groceries is considering expanding into a new line of business by adding coffee shops (the coffee venture) to its existing groceries retail locations. Currently, NS Groceries has a before tax cost of debt of 6% and an effective tax rate of 40%. Its stock has twice as much systematic risk as the market portfolio, and the firm’s debt to equity ratio is 0.5. The firm has identified a pure play company (NS Coffee, Inc.) whose only business is operating coffee shops. NS Coffee has a before tax cost of debt of 8%, a beta of 2.5, and a debt to equity ratio of 0.2. The effective tax rate of NS Coffee is 20%. The expected return on the market is 8%, and the risk free rate of interest is 2%. a) Determine the appropriate discount rate (WACC) NS Groceries should use for evaluating new projects within its business of groceries distribution. (11 marks) b) Determine the appropriate discount rate (WACC) NS Groceries should use for evaluating the new coffee venture if the new venture will have a debt to equity ratio similar to that of NS Groceries. (14 marks) c) What are the potential implications for the capital budgeting decision of the new venture if NS Groceries uses the WACC of its groceries distribution to evaluate this new venture? Briefly explain. (6 marks) 3 Fall 2018 Assignment #2
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