Institute of Art, Design & Management – (IADM)

Unit: Business Finance

Assessor: Munazza Ghafoor Assessment: Case Study

Assessment Title: “Case Study”

1. Monsters, Inc. have been involved in creating Art and crafts for kids and adults. The company
estimates to have following distribution of returns and probabilities in accordance to different
economic states in the Industry:

State Return Probability

Boom 0.3 0.25
Normal 0.4 0.15
Bust 0.3 0.30

Assuming that these returns are normally distributed, what is the probability that Monsters, Inc. will
return less than 7.25%?

Show all work, and clearly explain and state your answer.

Solution:

Mean = u = E(R) = (0.25 * 0.3) + (0.15 * 0.4) + (0.3 * 0.3)

= 0.225 = 22.5%

Variance = 0.3 * (0.25 – 0.225)^2 + 0.4 * (0.15 – 0.225)^2 + 0.3 * (0.3 – 0.225)^2
= 0.004125

Standard deviation = √ vari ance = √ 0.004125= 0.06423

Hence, the probability that Monsters, Inc. will return less than 7.25%:
P(x<7.25%) = P(x<0.0725) = z

Z = (0.0725 – u)/standard deviation

= (0.0725 – 0.225)/0.004125
= -2.374

P (z<-a) = 1 – P (z<a)
= 1 – P (z<2.374)

By looking value of (z<2.374) through the “z-table”, we get:

Q = 1 – P = 1 – [(0.9911+0.9913)/2] = 1 – 0.9912 = 0.0088

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2. Bankers Corp has a very conservative Beta of .7, while Biotech Corp has a Beta of 2.1. Given that the T-
bill rate is 5%, and the market is expected to return 15%, what is the expected return of Bankers Corp,
Biotech Corp, and a portfolio composed of 60% of Bankers Corp and 40% Biotech Corp?

Solution:

Beta of Bankers Corp = B1= 0.7

Beta of Biotech Corp = B2 = 2.1
T-bill rate = Risk-free rate = Rf = 5% = 0.05
E (R) = 15%
E (R) of Bankers Corp =?
E (R) of Biotech Corp =?
Portfolio of 60% of Bankers Corp =?
Portfolio of 40% of Biotech Corp =?

Market risk premium = E (Rm) = 15% - 5% = 10%

E (R) of Bankers Corp = Rf + [E (Rm) – Rf] * B1

= 0.05 + [0.1 – 0.05] * 0.7 = 0.085

E (R) of Biotech Corp = 0.05 = [0.1 – 0.05] * 2.1 = 0.155

Now,

Portfolio of 60% of Bankers Corp = 0.60 * 0.085 = 0.051

Portfolio of 40% of Biotech Corp = 0.40 * 0.155 = 0.062

3. You are currently 25 years of age. You have developed a lifetime budget that includes $50,000 at age
40 for a college fund for your kids and $25,000 per year for 20 years to supplement your retirement,
the first payment on your 60 th birthday and the last payment on your 79 th birthday. You open an
investment account on your 25th birthday that promises to pay 9% interest compounded annually.
You want to deposit equal annual amounts into the account every year on your birthday, starting
today (your 25th birthday) and continuing until you are 40 years old (i.e., the last deposit is made on
your 40th birthday). How much will each deposit have to be if you want to meet your financial goals?

Solution:

Current age = 25 years

Required budget at 40 age = $50,000
Required budget for 20 years per year = $25,000
Total required budget = A = $50,000 + ($25,000 * 20 years) = $5, 50, 000
Number of years to achieve goals = from 25 th to 40th birthday = n = 16 years
Compound interest rate = r = 9% = 0.09

Using formula,
Future value interest factor of annuity = FVIFA = {[(1+r)^n] – 1 } /r
= {[(1+0.09)^16]-1}/0.09 = 33.0034
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Hence,
Required payment of each year = PMT = A/FVIFA = $5, 50, 000/33.0034 = $16,665

4. Due to a number of lawsuits related to toxic wastes, a major chemical company has recently
experienced a market revaluation. The firm has bonds outstanding that were issued 10 years ago at
their par value of $1,000. These bonds have 15 years to maturity and a coupon rate of 8 percent, with
interest paid semiannually. The required return on these bonds has increased to 16 percent. What is
the current value of one of these bonds?

Solution:

Par (face) value = $1000

Coupon rate = 8% = 0.08
Annual interest = 1000 * 0.08 = $80
Semiannual interest = I = 80/2 = $40

Annual return arte = 16%

Semiannual return rate = k = 16/2 = 8%

Interest period = n = number of years till maturity * number of times interest is paid
n = 15 * 2 = 30

PVA = I [1 – (1+k)^-n] / k
= 40 [1-(1+0.08)^-30]/0.08 = $450.311

PV = $1000 / (1+0.08)^30 = $99.38

Therefore,
Present bond value = PVA + PV = $450.311 + $99.38 = $549.691

5. Spandra, Inc. has never paid a dividend. Frank, a stock analyst, decides to use the company’s
free cash flow to estimate the value of a share of Spandra's common stock. The company
provides financial statements for the company's competitive advantage period of the next two
years, and Frank calculates expected free cash flow to be $8 million in year one and $12 million
in year two. Frank expects the free cash flow to remain constant at $15 million per year for
years three and beyond. Spandra, Inc.’s weighted average cost of capital is 14% and its
standard deviation of returns is 21%. The market value of Spandra, Inc.’s debt is $17 million
and there are 10 million shares of common stock outstanding. Estimate the value of a share of
Spandra, Inc. common stock.

Solution:

Expected cash flow in year 1 = $15 million

Expected cash flow in year 2 = $12 million
Expected cash flow in year 3 and beyond = $15 million
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Weighted average cost of capital = WACC = 14%

Standard deviation of returns = r = 21% = 0.21
Market value of debt = $17 million
Common stock Outstanding = $10 million
Value of a share of stock = P =?

First year dividend = D1 = $15 / $10 = $1.5 million

Second year dividend = D2 = $12/ $10 = $1.2 million
Third and onward year dividend = D3 = $15 / $10 = $1.5 million

Hence,
Value of a share of stock = P = [D1/ (1+r)] + [D2/ (1+r)^2] + [D3/ (1+r)^3] + …..
= (1.5/1.21) + (1.2/1.4641) + (1.5/1.772)
= $2.9 million

6. The price of Geeslin Corporation stock is expected to be $68 in 5 years. Dividends are anticipated to
increase at an annual rate of 20 percent from the most recent dividend of $2.00. If your required rate
of return is 16 percent, how much are you willing to pay for Geeslin stock?

Solution:

Number of years = 5
Recent dividend = D =$2
Annual expected rate = ks = 20% = 0.2
Required rate of return = g = 16% = 0.16

Hence,
P = D(1+g) / ks – g
= 2(1+0.16) / 0.2 – 0.16 = 2.32/0.04 = $58

7. Consider the following two projects:

Initial Outlay Net Cash Flow Each Period

1 2 3 4
Project A $4,000,000 $2,003,000 $2,003,000 $2,003,000 $2,003,000
Project B $4, 000,000 0 0 0 $11,000,000

a. Calculate the net present value of each of the above projects, assuming a 14 percent discount
rate.

Solution:

Discount rate = r = 14% = 0.14

So,
NPV of project A = [(2003000/0.14) + (2003000/0.14^2) + (2003000/0.14^3) +
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(2003000/0.14^4)] – 4000000
NPV of project A = 6,056,430,633

NPV of project B = ( 0 + 0 + 0 + 11000000/0.14^4) – 1000000

NPV of project B = 28629902540

b. What is the internal rate of return for each of the above projects?

Solution:

IRR is calculated form Microsoft excel using the function of IRR. The values calculated are here
as under:

IRR of project A = 35%

IRR of project B = 29%

c. Compare and explain the conflicting rankings of the NPVs and IRRs obtained in parts A and B
above.

It can be seen above that, project A has higher IRR ratio comparatively. However, if the NPVs
are compared, it can be seen that higher NPV depends on required return. B has greater total
cash flow, but it pays back more slowly than A. Hence, it has a higher NPV at lower discount
rates.

d. If 14 percent is the required rate of return, and these projects are independent, what
decision should be made?

If the projects are independent, then the project with higher NPV should be
considered i.e. B since IRR may not always draw valid conclusions.

e. If 14 percent is the required rate of return, and the projects are mutually exclusive, what
decision should be made?

If the projects are mutually exclusive, then they are ranked NOT on the basis of their returns.
IRR mostly mislead the results. The company always ultimately is interested in creating values
for the shareholders. So, the project with higher NPV, i.e. B is preferred, regardless of the
relative returns.

8. The Bolster Company is considering two mutually exclusive projects:

Year Initial Outlay NPV

0 -$100,000 -$100,000
1 31,250 0
2 31,250 0
3 31,250 0
4 31,250 0
5 31,250 200,000
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The required rate of return on these projects is 12 percent.

a. What is each project's payback period?

Solution:

For project A:

Cash flow till 3rd year = 93750

4th year cash flow= 6250
Required cash flow till 4th year = 31,250
It means, it has to wait = 6250/31250 = 0.2 years more
Hence,
Payback period = 3 + 0.2 = 3.2 years

For project B:

5th year cash flow= 2,00,000

It means, it has to wait = 100000/200000 = 0.5 years more
Hence,
Payback period = 4 + 0.5 = 4.5 years

b. What is each project's net present value?

Solution:

NPV of project A = [(31250/0.12) + (31250/0.12^2) + (31250/0.12^3) + (31250/0.12^4) +

(31250/0.12^5)] – 100,000 = 1,429,330,299

NPV of project B = [0 + 0 + 0 + 0 + 200000/0.12^5] – 100000 = 8,037,451,440

c. What is each project's internal rate of return?

Solution:

IRR is calculated form Microsoft excel using the function of IRR. The values calculated are here
as under:

IRR of project A = 17%

IRR of project B = 15%

d. Fully explain the results of your analysis. Which project do you prefer, and why?

Since, the projects are mutually exclusive, thus they are NOT ranked on the basis of their
returns. IRR mostly mislead the results. The company always ultimately is interested in
creating values for the shareholders. So, the project with higher NPV, i.e. B is preferred,
regardless of the relative returns.
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9. Bonneau Sunglass Co. is considering the factoring of its receivables. The firm has credit sales of
$500,000 per month and has an average receivables balance of $1,000,000 with 60-day credit terms.
The factor has offered to extend credit equal to 85% of the receivables factored less interest on the
loan at a rate of 2% per month. The 15% difference in the advance and face value of all receivables
factored consists of a 2% factoring fee plus a 13% reserve, which the factor maintains. In addition, if
Bonneau decides to factor its receivables, it will sell them all, so that it can reduce its credit costs by
$2,000 a month.

a. What is the cost of borrowing the maximum amount of credit available to Bonneau through the
factoring agreement?

Solution:

Payment frequency = monthly

Amortization period = 2 months = 60 days
Credit sales = $500,000
Receivables (amount borrowed) = $1,000,000
Loan interest rate = 2%
Loan interest rate for 2 months = 2 * 2 = 4%
New credit sales level = 85% of $1,000,000 * 4% = 0.85 * 1,000,000 * 0.04 = $34,000
Factoring and reserve fees = 15% of $34,000 = 0.15 * 34000 = $5,100
Total cost of borrowing maximum amount of credit available to Bonneau through the factoring
agreement = $34,000 + $5,100 = $39,100

b. What considerations other than cost should be accounted for by Bonneau in determining whether
or not to enter the factoring agreement?

Solution:

Above part (a) showed coast of borrowing when all costs of factoring was considered. In order to
assess the feasibility of entering into the factoring agreement, the cost of not factoring must be
calculated and then compared.

New credit cost by factoring all receivables = $500,000 - $2,000 = $49,800

Factoring and reserve fees = 15% of $34,000 = 0.15 * 34000 = $5,100
Total cost of borrowing maximum amount of credit available to Bonneau through the factoring
agreement = $49,800 + $5,100 = $54,900

Since, the cost of factoring is $15,800 less than the cost of not factoring, hence it is financially
beneficial to enter this factoring agreement.

10. The Bike Store orders $2000 worth of supplies every 30 days. If they take advantage of the 3/10 net 30
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discount offered by their supplier, how much would they save over the year? Assume a 360-day year.

Solution:

3/10 net 30 discount means that the company can gain 3% discount if they pay for the supplies in 10
days, even though the total time duration of the payment to be made is 30 days.

30 days price without discount = $2000

1 day price without discount = $2000/30
10 days price without discount = $2000/30 * 10 = $666.7

10 days price with 3% discount = $20

Saving in 10 days = 646.7
Saving in 1 day = 646.7/10
Saving in 360 days = 646.7/10 * 360 = $23,281.2