QUESTIONS ANSWERS [Document subtitle] FALL 2023 NAME: -------ID| 000000000000000 Question (1): At the end of 2015, Uma Corporation is considering undertaking a major long-term project in an effort to remain competitive in its industry. The production and sales departments have determined the potential annual cash flow savings that could accrue to the firm if it acts soon. Specifically, they estimate that a mixed stream of future cash flow savings will occur at the end of the years 2016 through 2021. The years each year. The firm estimates that its discount rate over the first 6 years will be 7%. The expected discount rate over the years 2022 through 2026 will be 11%. The project managers will find the project acceptable if it results in present cash flow savings of at least $860,000. The following cash flow savings data are supplied to the finance department for analysis. End of year Cash flow savings 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 $ 110,000.00 120,000.00 130,000.00 150,000.00 160,000.00 150,000.00 90,000.00 90,000.00 90,000.00 90,000.00 90,000,00 To Do Create spreadsheets similar to Table 5.2, and then answer the following questions. a. Determine the value (at the beginning of 2016) of the future cash flow savings expected to be generated by this project. b. Based solely on one criterion set by management, should the firm undertake this specific project? Explain. c. What is the “interest rate risk,” and how might it influence the recommendation made in part b? Explain. 1|Page Answer: End of year 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 Year (n) 1 2 3 4 5 6 7 8 9 10 11 Cash flow $ 110,000.00 120,000.00 130,000.00 150,000.00 160,000.00 150,000.00 90,000.00 90,000.00 90,000.00 90,000.00 90,000,00 Present value End of year 2021 81,081.08 73,046.02 65,807.22 59,285.79 53,410.62 Present value Beginning of 2016 $ 102,803.74 104,812.65 106,118.72 114,434.28 114,077.79 99,951.33 54,027.75 48,673.65 43,850.13 39,504.62 35,589.75 $ 863,844.42 (a) First, we will discount the cash flows at the end of years 2022 through 2026 at 11% back to the end of year 2021. Next, we will discount the cash flows at the end of years 2016 through 2021 (don't forget the present values found in the first step are now at the end of year 2021) at 7% back to the end of year 2015. The end of year 2015 is the beginning of year 2016, which is when we want the present value of the cash flow savings. By discounting cash flows for at the end of years 2016 through 2021 at 7%, we get PV of $863,844.42. (b) Based solely on the criteria set by management, the firm should undertake this project as the present value of the expected future saving total $863,844.42 which exceeds the $860,000 hurdle. (c) The concept of interest-rate risk states that changes in the interest rates will affect the present value of future cash flows. For this problem, if the the interest rates were to rise just 1 percentage point, the present value of the expected savings would fall below the required $860,000 limit set by management. 2|Page Question (2) Jane is considering investing in three different stocks or creating three distinct two stock portfolios. Jane considers herself to be a rather conservative investor. She is able to obtain forecasted returns for the three securities for the years 2015 through 2021. The data are given in the following table. In any of the possible two-stock portfolios, the weight of each stock in the portfolio will be 50%. The three possible portfolio combinations are AB, AC, and BC. Answer: a. Calculate the expected return for each individual stock. Year 2015 2016 2017 2018 2019 2020 2021 Expected return 3|Page Stock A 0.1 0.13 0.15 0.14 0.16 0.14 0.12 13.43% Stock B 0.1 0.11 0.08 0.12 0.1 0.15 0.15 11.57% Stock C 0.12 0.14 0.1 0.11 0.09 0.09 0.1 10.71% b. Calculate the standard deviation for each individual stock. Stock A Year Return Expected return Deviation Deviation^2 2015 2016 2017 2018 2019 2020 2021 10% 13% 15% 14% 16% 14% 12% 13.43% 13.43% 13.43% 13.43% 13.43% 13.43% 13.43% -3.43% -0.43% 1.57% 0.57% 2.57% 0.57% -1.43% 0.00117551 0.00001837 0.00024694 0.00003265 0.00066122 0.000032 0.00020408 0.00237143 Standard deviation = 1.99% Stock B Year Return Expected return Deviation Deviation^2 2015 2016 2017 2018 2019 2020 2021 10% 11% 8% 12% 10% 15% 15% 11.57% 11.57% 11.57% 11.57% 11.57% 11.57% 11.57% -1.57% -0.57% -3.57% 0.43% -1.57% 3.43% 3.43% 0.00024694 0.00003265 0.00127551 0.00001837 0.00024694 0.00117551 0.00117551 0.00417143 Standard deviation = 2.64% Stock C Year Return Expected return Deviation Deviation^2 2015 2016 2017 2018 2019 2020 2021 12% 14% 10% 11% 9% 9% 10% 10.71% 10.71% 10.71% 10.71% 10.71% 10.71% 10.71% 1.29% 3.29% -0.71% 0.29% -1.71% -1.71% -0.71% 0.00016531 0.00107959 0.00005102 0.00000816 0.00029388 0.00029388 0.00005102 0.00194286 Standard deviation = 1.80% 4|Page c. Calculate the expected returns for portfolios AB, AC, and BC. d. Calculate the standard deviations for portfolios AB, AC, and BC Portfolio AB Return Weight Year 2015 2016 2017 2018 2019 2020 2021 Stock A Stock B Stock A Stock B Expected Return 10.00% 13.00% 10.00% 11.00% 0.5 0.5 0.5 0.5 10.0% 12.0% 15.00% 14.00% 16.00% 8.00% 12.00% 10.00% 0.5 0.5 0.5 0.5 0.5 0.5 11.5% 13.0% 13.0% 14.00% 12.00% 15.00% 15.00% 0.5 0.5 0.5 0.5 14.5% 13.5% 87.5% Expected Return = 12.58% Year Return Expected return Deviation Deviation^2 2015 2016 2017 2018 2019 2020 2021 10% 12% 12% 13% 13% 15% 14% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% 12.5% -2.500% -0.500% -1.000% 0.500% 0.500% 2.000% 1.000% 0.062500% 0.002500% 0.010000% 0.002500% 0.002500% 0.040000% 0.010000% 0.130000% Standard deviation = 1.47% 5|Page Portfolio AC Return Weight Year 2015 2016 2017 2018 2019 2020 2021 Stock A Stock C Stock A Stock C Expected Return 10.00% 13.00% 12% 14% 0.5 0.5 0.5 0.5 11.0% 13.5% 15.00% 14.00% 16.00% 10% 11% 9% 0.5 0.5 0.5 0.5 0.5 0.5 12.5% 12.5% 12.5% 14.00% 12.00% 9% 10% 0.5 0.5 0.5 0.5 11.5% 11.0% 84.5% Expected Return = 12.07% Year Return Expected return Deviation Deviation^2 2015 2016 2017 2018 2019 2020 2021 11% 14% 13% 13% 13% 12% 11% 12.1% 12.1% 12.1% 12.1% 12.1% 12.1% 12.1% -1.071% 1.429% 0.429% 0.429% 0.429% -0.571% -1.071% 0.011480% 0.020408% 0.001837% 0.001837% 0.001837% 0.003265% 0.011480% 0.052143% Standard deviation = 0.93% 6|Page Portfolio BC Return Weight Year 2015 2016 2017 2018 2019 2020 2021 Stock B Stock C Stock B Stock C Expected Return 10.00% 11.00% 12% 14% 0.5 0.5 0.5 0.5 11.0% 12.5% 8.00% 12.00% 10.00% 10% 11% 9% 0.5 0.5 0.5 0.5 0.5 0.5 9.0% 11.5% 9.5% 15.00% 15.00% 9% 10% 0.5 0.5 0.5 0.5 12.0% 12.5% 78.0% Expected Return = 11.14% Year Return Expected return Deviation Deviation^2 2015 2016 2017 2018 2019 2020 2021 11% 13% 9% 12% 10% 12% 13% 11.1% 11.1% 11.1% 11.1% 11.1% 11.1% 11.1% -0.143% 1.357% -2.143% 0.357% -1.643% 0.857% 1.357% 0.000204% 0.018418% 0.045918% 0.001276% 0.026990% 0.007347% 0.018418% 0.118571% Standard deviation = 1.41% 7|Page e. Would you recommend that Jane invest in the single stock A or the portfolio consisting of stocks A and B? Explain your answer from a risk–return viewpoint. Stock A Portfolio B Return Risk CV 13.43% 12.50% 1.99% 1.47% 14.80% 11.78% Stock A, by itself, has an expected return of 13.43% with a standard deviation of 1.99%. Investing in the portfolio with a standard deviation 1.47%. So there is both a lower amount of risk and return in the portfolio, she needs to find the coefficient of variation (CV). Here we can see the CV of variation of the portfolio is less than stock A alone so the portfolio of AB should be recommended. f. Would you recommend that Jane invest in the single stock B or the portfolio consisting of stocks B and C? Explain your answer from a risk–return viewpoint. Stock B Portfolio BC Return Risk CV 11.57% 11.14% 2.64% 1.41% 22.79% 12.62% Stock B, by itself, has an expected return of 11.57% with a standard deviation of 2.64%. Investing in the portfolio comprised of stocks B and C delivers a lower return of 11.14% and is associated with a standard deviation of 1.41%. So once again both the return and risk of the portfolio are lower. Considering the CV, however, Jane, can determine that the portfolio BC is preferable to stock B alone because the CV of is lower for the portfolio. 8|Page Question 3 Integrative case 2 Tuck : a. (1) On what financial goal does Stanley seem to be focusing? Is it the correct goal? Why or why not? Increase in net profits over the period from 2009 to 2015 indicates that Stanely is focus on maximizing profits. The way in which he is deciding on employing a software designer also reflects the financial goals. Wealth maximization needs a long-term prospective, along with risk and cash flows whereas profit maximization does not integrate the factors in the management decision process. Hence, Stanley is using the correct financial goal. (2) Could a potential agency problem exist in this firm? Explain. Stanley owns 40% of the outstanding equity, there is no potential for problems at Track Software. An agency problem exists when managers place personal goals instead of corporate goals. b. Calculate the firm’s earnings per share (EPS) for each year, recognizing that the number of shares of common stock outstanding has remained unchanged since the firm’s inception. Comment on the EPS performance in view of your response in part a. Year Net profit after taxes EPS (NPAT/100,000 shares) 2009 (50,000) 0 2010 (20,000) 0 2011 15,000 0.15 2012 35,000 0.35 2013 40,000 0.40 2014 43,000 0.43 2015 48,000 0.48 Earnings per share have steadily increased. This verifies that Stanley is focusing on the goal of profit maximization. c. Use the financial data presented to determine Track’s operating cash flow (OCF) and free cash flow (FCF) in 2015. Evaluate your findings in light of Track’s current cash flow difficulties. OCF = EBIT- Taxes + Depreciation OCF=$89 - 12 + 11 = $88 FCF=OCF-Net fixed asset investment - Net current asset investment FCF=$88 - 15 - 47 = 26 NFAI = Change in net fixed assets + depreciation NFAI = (132 - 128) + 11 = 15 NCAI = Change in current assets - change in (accounts payable + accruals) 9|Page NCAI = 59 - (10+2) = 47 The OCF is large enough to provide the cash needed for the needed investment in both fixed assets and the increase in networking capital. The firm still has $26,000 available to pay investors. d. Analyze the firm’s financial condition in 2015 as it relates to (1) liquidity, (2) activity, (3) debt, (4) profitability, and (5) market, using the financial statements provided in Tables 2 and 3 and the ratio data included in Table 5. Be sure to evaluate the firm on both a cross-sectional and a time-series basis. e. What recommendation would you make to Stanley regarding hiring a new software developer? Relate your recommendation here to your responses in part a. Actual Industry average 1- liquidity Ratio Net Working capital 2014 $21.000 2015 $58.000 2015 $96.000 Current ratio 1.06 1.16 1.82 Actual Industry average 2- Activity Ratio 2014 2015 2015 Inventory turnover 10.40 5.39 12.45 Average collection period Total asset turnover 29.6 days 35.3 days 20.2 days 2.66 2.80 3.92 Actual Industry average 3- Debt Ratio Debt ratio 2014 0.78 2015 0.73 2015 0.55 Times interest earned 3.0 3.1 5.6 Gross profit margin 32.1% 33.5% 42.3% Net profit margin 3.0% 3.1% 4.0% 10 | P a g e TS: Time Series CS: Cross sectional TS: improving. CS: Poor TS: improving. CS: Poor TS: Time Series CS: Cross sectional TS: Deteriorating CS: Poor TS: Deteriorating CS: Poor TS: improving. CS: Poor TS: Time Series CS: Cross sectional TS: Decreasing. CS: Poor TS: stable. CS: Poor TS: Improving CS: Poor TS: stable CS: fair Actual Industry average 4- Profitability Ratio Return on total assets (ROA) Return on Equity (ROE) 2014 80% 2015 8.7% 2015 15.6% 36.4% 31.6% 34.7% Actual Industry average 5- Market Ratio Price /Earning (P/E) 2014 5.2 2015 11.0 2015 7.1 Market /Book (M/B) 2.1 1.74 2.2 TS: Time Series CS: Cross sectional TS: improving. CS: Poor TS: Deteriorating. CS: fair TS: Time Series CS: Cross sectional TS: improving. CS: poor TS: Deteriorating. CS: fair Analysis of Track Software based on ratio data: 1. Liquidity – Track software liquidity is shown by the current ratio, net working capital and acid-test ratio has slightly improved or stable but overall it is below the industry average. 2. Activity – Inventory turnover has decreased considerably and much worse than the industry average. The average collection period has also decreased and worse than the industry average. Total asset turnover has improved slightly but it is below the industry norm. 3. Debt – It has improved slightly from 2014 but greater than the industry average. The times interest earned ratio is stable and provides reasonable cushion for the company and is below the industry average. 4. Profitability – the firm’s gross, operating and net margins have slightly improved in 2014 but remain low compared to industry. Return on total assets has improved but half the industry average. 5- Market- Overall, the company's financial ratios have shown some mixed trends. The P/E ratio has improved, while the M/B ratio has deteriorated. The company is still undervalued compared to the industry average based on its P/E ratio. e. What recommendation would you make to Stanley regarding hiring a new software developer? Relate your recommendation here to your responses in part a. Since Stanley focused on profit maximization, the ability of a new product would increase Track Software's sales and results in greater profits over the long-term. Hence, Stanley should make all the effort possible to find the cash in hiring a new software developer. 11 | P a g e f. Track Software paid $5,000 in dividends in 2015. Suppose that an investor approached Stanley about buying 100% of his firm. If this investor believed that by owning the company, he could extract $5,000 per year in cash from the company in perpetuity, what do you think the investor would be willing to pay for the firm if the required return on this investment is 10%? If the investor believes they can extract $5,000 per year in cash from the company in perpetuity, the value of the firm can be calculated using the perpetuity formula: Value of the firm = Cash flow per year / Required return Value of the firm = $5,000 / 0.10 Value of the firm = $50,000 g. Suppose that you believed that the FCF generated by Track Software in 2015 could continue forever. You are willing to buy the company in order to receive this perpetual stream of free cash flow. What are you willing to pay if you require a 10% return on your investment? FCF = OCF – Net fixed asset investment (NFAI) – Net current asset investment OCF = [EBIT * (1 – T)] +Depreciation NFAI = Change in net fixed assets + Depreciation NCAI = Change in current assets – Change in (accounts payable + accruals) OCF = [89,000 * (1-20%)] + 11,000 OCF = 82,200 NFAI = 4,000 + 11,000 = 15,000 NCAI = 59,000 – (2,000 + 10,000) NCAI = 59.000 – 12,000 = 47,000 FCF = 82, 200 – 15,000 – 47,000 FCF = 20,200 12 | P a g e Question 4: Integrative Case 3 / Encore International In the world of trendsetting fashion, instinct and marketing savvy are prerequisites to success. Jordan Ellis had both. During 2015, his international casual-wear company, Encore, rocketed to $300 million in sales after 10 years in business. His fashion line covered the young woman from head to toe with hats, sweaters, dresses, blouses, skirts, pants, sweatshirts, socks, and shoes. In Manhattan, there was an Encore shop every five or six blocks, each featuring a different color. Some shops showed the entire line in mauve, and others featured it in canary yellow. Encore had made it. The company’s historical growth was so spectacular that no one could have predicted it. However, securities analysts speculated that Encore could not keep up the pace. They warned that competition is fierce in the fashion industry and that the firm might encounter little or no growth in the future. They estimated that stockholders also should expect no growth in future dividends. Contrary to the conservative securities analysts, Jordan Ellis believed that the company could maintain a constant annual growth rate in dividends per share of 6% in the future, or possibly 8% for the next 2 years and 6% thereafter. Ellis based his estimates on an established long-term expansion plan into European and Latin American markets. Venturing into these markets was expected to cause the risk of the firm, as measured by the risk premium on its stock, to increase immediately from 8.8% to 10%. Currently, the risk-free rate is 6%. In preparing the long-term financial plan, Encore’s chief financial officer has assigned a junior financial analyst, Marc Scott, to evaluate the firm’s current stock price. He has asked Marc to consider the conservative predictions of the securities analysts and the aggressive predictions of the company founder, Jordan Ellis. Marc has compiled the following 2015 financial data to aid his analysis. Data item 2015 Earnings per share (EPS) Price per share of common stock Book value of common stock equity Total common shares outstanding Common stock dividend per share value $6.25 $40.00 $60,000,000 2,500,000 $4.00 TO do a. What is the firm’s current book value per share? b. What is the firm’s current P/E ratio? c. (1) What is the current required return for Encore stock? (2) What will be the new required return for Encore stock assuming that the firm expands into European and Latin American markets as planned? d. If the securities analysts are correct and there is no growth in future dividends, what will be the value per share of the Encore stock? (Note: Use the new required return on the company’s stock here.) e. (1) If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firm maintains a constant annual 6% growth rate in future dividends? (Note: Continue to use the new required return here.) 13 | P a g e (2) f. If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firm maintains a constant annual 8% growth rate in dividends per share over the next 2 years and 6% thereafter? Compare the current (2015) price of the stock and the stock values found in parts a, d, and e. Discuss why these values may differ. Which valuation method do you believe most clearly represents the true value of the Encore stock? Answer: a. What is the firm’s current book value per share? = $ 24 The Current book value per share = b. What is the firm’s current P/E ratio? The Current P/E ratio = c. (1) What is the current required return for Encore stock? Givens: • • The Current risk premium is 8.8% the risk-free rate is 6% Then The Current Required Rate of Return (RRR) = Current Risk-Free rate + Current Risk Premium = 6% + 8.8 = 14.8% (2) What will be the new required return for Encore stock assuming that the firm expands into European and Latin American markets as planned? Given (With the assumption of expand): • • The Risk Premium is 10% The Risk – Free is 6% Then: The New Required Rate of Return (RRR) = Risk- Free rate + The New Risk Premium = 6% + 10% = 16% d. If the securities analysts are correct and there is no growth in future dividends, what will be the value per share of the Encore stock? (Note: Use the new required return on the company’s stock here.) Given: 14 | P a g e • Form (2C) - The New Required Rate of Return (RRR) = 16% • Common stock dividend per share $4.00 then Using Zero Growth Dividends The Present Value Per Share = = $25 e. (1) If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firm maintains a constant annual 6% growth rate in future dividends? (Note: Continue to use the new required return here.) Given: • Constant annual growth (g) = 6% • a constant annual growth rate in dividends per share of 6% • Form (2C) - The New Required Rate of Return (RRR) = 16% • Common stock dividend per share $4.00 then Using Constant Growth The Present Value Per Share P0 (2) If Jordan Ellis’s predictions are correct, what will be the value per share of Encore stock if the firm maintains a constant annual 8% growth rate in dividends per share over the next 2 years and 6% thereafter? Given: • • • • Constant annual growth next 2 Year (g) = 8% Constant annual growth thereafter (g) = 6% Form (2C) - The New Required Rate of Return (RRR) = 16% 2015 Common stock dividend per share (D0) $4.00 Then Using Variable Growth 𝐷�1�=�𝐷�0(1�+�8%)1�=�4(1.08)1 = 4.32 𝐷�2�=�𝐷�0(1�+�8%)2�=�4(1.08)2= 4.67 𝐷�3�=�𝐷�2(1�+�6%)1�=�4.67(1.06)1= 4.95 15 | P a g e PV = 3.72+3.47+36.77 = $43.96 f. Compare the current (2015) price of the stock and the stock values found in parts a, d, and e. Discuss why these values may differ. Which valuation method do you believe most clearly represents the true value of the Encore stock? Valuation Method Per Share Price per share of common stock $40 The Current book value $24 Using Zero Growth Dividends $25 Using Constant Growth $42.4 Using Variable Growth $43.96 The Values Different Because: It has differences on dividends growth. • BV per share: Can’t be used as stock valuation, except comparing it with peers and using it as P/B multiples. • Zero Growth: the most conservative method, but lacks of reality sense therefore not good method. • Constant and variable Growth: Both methods have similar stock price target, but variable is more realistic since it measures shift up or down due to the changing expectations. valuation method I believe most clearly represents the true value of the Encore stock Based on the computation, the book value has no relevance to the true value of the firm. Of the remaining methods, the most conservative estimate of value is given by the zero-growth model. Wary the analyst should advise paying no more than $25 per share. 16 | P a g e