ADMS 2510 Lecture Notes - Lecture 3: Current Asset, Current Liability, Investment

By this point in the semester, you have a pretty good idea of what drives a company's net income. You've also read about ethics in business and what kinds of conditions are typically present in fraud situations (opportunity, justification, and pressure).

In your introductions, several of you indicated career goals around business ownership. Well, let's say that you own a small restaurant. The restaurant business is very competitive because diners have a variety of choices. Therefore, you must be very careful to manage costs without sacrificing quality in order to generate a profit. Recently, one of your key food suppliers announced a large price increase across the board. You are reluctant to switch suppliers because you feel the quality of your meals would suffer. You are also reluctant to increase your menu prices because you feel that might result in decreased business. However, one area where you could cut costs is associated with your kitchen staff. You could hire kitchen employees who are not legally authorized to work in the U.S. Because these potential employees have not followed the appropriate legal process, they are willing to work for lower wages. You also know that these employees would feel fortunate to have a job and would be very hard workers who didn't mind long hours. You know that some of your competitors have already hired employees illegally, but nothing has happened as a result. If you were to do likewise, you could cut your expenses significantly while holding your menu prices constant. Your customers would be able to enjoy the same quality meals at reasonable prices.

This restaurant provides the only source of income for you and your family. It's been in your family for over 50 years. Your parents started the restaurant and you took it over 15 years ago when your dad's health started to decline. The profits from the restaurant not only provide an income for you and your family but they also provide retirement income for your parents. Your dad's health has caused him to be in and out of the hospital several times over the past few years and insurance has not always paid for all the related expenses. Therefore, it's important to both your family and your parents that the restaurant continues to do well.

Would you decide to hire employees who were not legally authorized to work in the U.S.? If your decision was challenged by the local news team, what would you say in your defense? How did the knowledge that you've gained in the course so far play into your decision? Do you think this might be a real situation that you might encounter or it might be similar to a real situation that you might encounter?

In order to earn the maximum points, you must address all the questions posed here (2 points per question), using proper grammar. You will lose a half point for each grammar error.

The following Balance Sheet extract relates to the Snapple Company:

Bonds payable $1,000,000

Common Stock $3,000,000

Preferred Stock $2,000,000

Additional Information:

The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 95% of par.

The company’s common shares which have a book value of $25 per share are currently selling at $20 per share.

The company has an equity beta of 1.5 and the current Treasury bill rate is 3.5%. The market risk premium is 1.5%

The preferred dividends are 5% preferred shares with a book value of $100 per share. These shares are currently selling at $80 per share.

The Company’s tax rate is 35%.

Required:

a) Calculate Snapple’s cost of debt. [5 marks]

b) Calculate Snapple’s cost of equity. [5 marks]

c) Calculate Snapple’s cost of preferred shares. [3 marks]

d) Calculate Snapple’s Weighted Average Cost of Capital [8 marks]

e) Explain why the cost of debt is cheaper than the cost of equity. [3 marks]

f) Explain why the cost of retained earnings is equivalent to the cost of an existing issue of common stock. [4 marks]

g) Outline two (2) reasons why a firm’s cost of capital is critically important. [2 marks]

2.

The Beacon Inc. is considering two mutually exclusive projects, each with an initial investment of $150,000. The company’s board of directors has set up a 4-year payback requirement and has set its cost of capital at 9%. The cash inflows associated with the two projects are as follows:

a) Calculate the payback period for each project. [2 marks]

b) Calculate the NPV for each project at 7% and 9%. [6 marks]

c) Based on b) above which project would you choose and why.[ 2 marks]

d) Briefly explain why firms engage in “capital rationing” [2 marks]

e) What are Real Options? What are some major types of real options? [3 marks]

3.

The Life’s Good Corporation 2012 income statement shows the following:

Life’s Good Corp. also issued $106,700 in new equity during the year and redeemed $65,300 in outstanding long-term debt.

i. Calculate the operating cash flow for the firm. (2 marks) $2,920,600

ii. Calculate the cash flow to creditors. (2 marks) $150,855

iii. Calculate the cash flow to stockholders. (2 marks) 62,300

iv. Define free cash flow (FCF) and state one of the equations for computing FCF. (3 marks)

4.

Clark’s Drug Store, a medium-size drugstore located in Bridgetown Barbados, is owned and operated by Robert Clark. Clark’s sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Clark’s most recent annual net income statement is as follows:

Clark’s sales and expenses have remained relatively constant over the past few years and are expected to continue unchanged in the near future. To increase sales, Clark’s is considering using some floor space for a small soda fountain. Clark’s would operate the soda fountain for an initial three-year period and then would reevaluate its profitability. The soda fountain would require an incremental investment of $85,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the three-year period. At the end of that time, additional capital would be required to continue operating the soda fountain, and no capital would be recovered if it were shut down.

The soda fountain is expected to have annual sales of $670,000 and food and materials expenses of $380,000 per year.

The soda fountain is also expected to increase wage and salary expenses by 6% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of non-soda fountain items are expected to decline by 10%.

Calculate net incremental cash flows for the soda fountain. (6 marks)

ii. Assume that Clark’s has the capital necessary to install the soda fountain and that he places a 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not? (4 marks)

5. “In order for a project to be acceptable, its required rate of return must exceed the cost of debt”. Do you agree? In light of the statement, define what is cost of capital and what role does it play in long-term investment decisions? (5 marks)

6. What do you understand by the term net proceeds in context with a bond sale? How do floatation costs affect the net proceeds? (3 marks)

7. Go-geta Corp. issued 10-year bonds 2 years ago at a coupon rate of 6 percent. The bonds make semiannual payments. If these bonds currently sell for 98 percent of par value, what is the YTM? (2 marks)

8. ABC Company has an unusual dividend policy. The company has just paid a dividend of $5 per share and has announced that it will increase the dividend by $2 per share for each of the next four years, and then never pay another dividend. If you required a 9 percent return on the company’s stock, how much will you pay for a share today? (5 marks)

9 “While contemplating to create a portfolio, it is imperative to study the correlation amongst the assets that constitute the portfolio”. Discuss the statement and explain how diversification helps in reducing the risk of the portfolio as compared to the individual risks of constituting assets. (5 marks)