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You want to make an investment in a small business. Describe the financial criteria, in terms of financial statements and ratios, which you will demand both before and after the infusion of funds. Also describe other non-financial criteria that you will use, such as industry trends or new technology. How might you evaluate risk?

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Jarrod Robel
Jarrod RobelLv2
28 Sep 2019
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Assume that you live in the United States and invest $60,000 to establish a language school called Escuela de Inglés in Mexico City, Mexico. You set up a small subsidiary in Mexico with an office and an attached classroom that you lease. You hire local individuals in Mexico who can speak English and teach it to others. Your school offers two types of courses: a 1-month structured course in English and a 1-week intensive course for individuals who already know English but want to improve their skills before visiting the United States. You advertise both types of teaching services in local newspapers. All revenue and expenses associated with your business are denominated in Mexican pesos. Your subsidiary sends most of the profits from the business in Mexico to you at the end of each month. Although your expenses are fairly stable, your revenue varies with the number of clients who sign up for the courses in Mexico. Answer the following questions as if you were serving on the board or as a manager of the business. The questions force you to assess the firm’s opportunities and exposure and to consider potential strategies that your business might pursue.

1. Explain how the theory of competitive advantage could justify the existence of your business in Mexico.

2. Assume that your business in Mexico grows. Explain how global financial markets could help to finance the growth of the business and which criteria could use to make the correct financing decisions.

3. Explain how your business could be adversely affected by economic, political, cultural, demographic and legal issues in Mexico.

4. Describe the type of economic or other conditions in Mexico that could cause the Mexican peso to weaken and thereby adversely affect your business.

5. Under this situation what is your recommendation about the appropriate financial tools that could apply by management to minimize the negative effect of peso depreciation.

6. Explain how the activities of your business are related to the Balance of payments of the USA and Mexico?

Position A: Financial Institutions' role as specialists in risk measurement and management is reduced.

Position B: Financial Institutions' role as specialists in risk measurement and management is increased.

Required:

Read the “background” below. After reading, select the position you agree with and write a position paragraph supporting either Position A or Position B.

Background: A major event that changed and reshaped the financial services industry was the financial crisis of the late 2000s. As Financial Institutions adjusted to regulatory changes brought about in the 1980s and 1990s, one result was a dramatic increase in systemic risk of the financial system, caused in large part by a shift in the banking model from that of “originate and hold” to “originate to distribute.” In the traditional model, banks take short-term deposits and other sources of funds and use them to fund longer term loans to businesses and consumers. Banks typically hold these loans to maturity, and thus have an incentive to screen and monitor borrower activities even after a loan is made. However, the traditional banking model exposes the institution to potential liquidity, interest rate, and credit risk. In attempts to avoid these risk exposures and generate improved return-risk trade-offs, banks shifted to an underwriting model in which they originated or warehoused loans, and then quickly sold them. Indeed, most large banks organized as financial services holding companies to facilitate these new activities. More recently activities of shadow banks, nonfinancial service firms that perform banking services, have facilitated the change from the originate-and-hold model of commercial banking to the originate-and-distribute banking model. In the shadow banking system, savers place their funds with money market mutuals and similar funds, which invest these funds in the liabilities of other shadow banks. Like the traditional banking system, the shadow banking system intermediates the flow of funds between net savers and borrowers. However, instead of the bank serving as the middleman, it is the non-bank financial service firm, or shadow bank, that intermediates. Further, unlike the traditional banking system where the complete credit intermediation is performed by a single bank, in the shadow banking system, it is performed through a series of steps involving many non-bank financial service firms. These innovations remove risk from the balance sheet of financial institutions and shift risk off the balance sheet and to other parts of the financial system. Thus, the financial institutions, acting as underwriters, are not exposed to the credit, liquidity, and interest rate risks of traditional banking.

In your own words, explain what is meant by business and financial risk. Suppose Firm A has greater business risk than Firm B. Is it true that Firm A also has a higher cost of equity capital? Why or Why not? Explain.

The two alternatives carry equal risk and should be evaluated at the company's cost of capital. The cost for the new smoker line will be $7,000,000. Also, the company has been guaranteed a buyer for the new line at the end of the fifth year. The buyer has agreed to purchase the new line for $7,900,000. The outdoor grill alternative will cost $3,987,000 and also has a guaranteed buyer, who has agreed to pay $4,000,000 at the end of the fifth year.

Investment B

Investment B involves two independent investment opportunities. The decisions on these two investment alternatives are also independent of Investment A. Investment B-1 involves a new packaging machine, which will eliminate the need for a local firm for packaging Vanda-Laye's products. The cost of this machine will be $24,000, and the expected revenues from this opportunity are given in the table and are considered to be of average risk. Investment B-2 is the purchase of a new computer system that will allow the company to sell its products on the Internet worldwide. The cost of this new system will be $29,000, with the expected cash flows after taxes given in the table.

For Investment B:

Using Microsoft Excel, calculate the NPV for each alternative.

Using the decision-making criteria for the NPV, specify which alternative you would select if the two alternatives were mutually exclusive. Explain your answer.

Given that the two alternatives are independent of each other, specify which investment you would select, if not both. Explain your answer.

Using Microsoft Excel, calculate the IRR for each investment.

Using the decision-making criteria for the IRR, specify which alternative you would prefer. Explain your answer.

If funding were available, specify whether you would select both investments. Why or why not?

Calculate the profitability index (PI) for the two investments. Which project is preferred?

Determine whether there is a ranking conflict present in terms of the IRR and the NPV. Explain your answer. If a conflict does exist, explain how you would resolve the situation.

Year

Cash Flows

Packaging Machine

Computer System

1

$8,400

$9,100

2

$4,800

$8,800

3

$7,800

$8,300

4

$6,200

$8,000

5

$5,500

$5,100

6

$4,600

$4,000

7

$3,000

$3,500

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