Humber College Financial Controllership II ACCT 352-TEST # 1 (worth 20% of final grade) Winter 2021 Question #1 (12 marks) The following data reflect the current financial condition of Bay Roberts Fisheries

Humber College

Financial Controllership II

ACCT 352-TEST # 1

(worth 20% of final grade)

Winter 2021

Question #1 (12 marks)

The following data reflect the current financial condition of Bay Roberts Fisheries.

Value of debt (book value = market value)                                          $ 1,000,000

Market value of equity (P  x shares)                                                          5,257,143

                Total value of firm                                                                           $ 6,257,143

Sales, last 12 months                                                                                      $12,000,000

Variable operating costs (50% of sales)                                      6,000,000

Fixed operating costs                                                                                         5,000,000

Tax rate (T)                                                                                                                            40%

At the current level of debt, the cost of debt, k_d  , is 8% and the cost of equity, k_e  , is 10.5%.  The current market price of Bay Roberts Fisheries is $20 per share.  Management questions whether the capital structure is optimal and wants to see if the share price can be increased, so the financial vice-president has been asked to consider the possibility of issuing $1 million of additional debt and using the proceeds to repurchase shares.  It is estimated that if the leverage is increased by raising the level of debt to $2 million, the interest rate on new debt will rise to 9% and k_e   would rise to 11.5%. The old 8% debt will remain outstanding and is not senior to the new debt.

REQUIRED:

 a)           Should Bay Roberts Fisheries increase its debt to $2 million? Use the following formula.

                                V = D + (EBIT - I) (1 - T)

                                                                k_e

b)            If the firm decides to increase its level of debt to $3 million, the old debt must be refinanced and paid out.  The cost of the $3 million of debt will be 12%, and k_e   will rise to 15%.  What level of debt should the firm choose; $1 million, $2 million, or $3 million?

C) Calculate the number of common shares that would be repurchased if the debt level is increased to $2 million and $3 million.

Question #2       (10 marks)

Cans-R-Us (CRU) is a recycling company located in the suburbs of Maroochy.  CRU is currently evaluating a potential new investment which will require approximately $200 million in new financing.  You have been asked to help in the decision by determining CRU’s weighted average cost of capital. 

There are 15 million CRU common stock outstanding and their current market value is $21.50 per share.  CRU’s most recent earnings were $3.10 per share and last year’s dividend was $1.24 per share.  CRU has maintained constant dividend payout ratio over its history and earnings are expected to grow at an average rate of 2% per year for the foreseeable future.

CRU also has 8 million preferred shares outstanding which are currently trading at $40. The preferred shares have a stated par value of $35 and a stated dividend rate of $4 per share. 

Finally, CRU has a $300 million face value long-term debt issue outstanding which has eight years left to maturity, carries a 10% coupon with interest paid semi-annually, and is currently priced at $1,116.52 to provide for a yield of 8%. 

Flotation costs are expected to be 2% after-tax on both common and preferred shares and 4% before-tax on debt.  CRU’s tax rate is 51%.

Required:

What is the weighted average cost of capital assuming new common equity is issued?

Question #3  (  9  MARKS )

You have been asked to evaluate two mutually exclusive proposals for your company.  The finance department has confirmed that the cost of capital is 13% and that the risk free rate is 8%.  The expected after tax cash flows for the two proposals are as follows:

                Year                       Proposal A                          Proposal B

                  0                            ($ 42,000)                            ($ 50,000)

                  1                            $ 25,000                                        -

                  2                            $ 25,000                                        -

                  3                            $ 25,000                               $ 80,000

Risk analysis of each cash flow distribution has provided the following certainty equivalent coefficients.

                Year                       Proposal A                          Proposal B

                  0                                  1.0                                          1.0

                  1                                    .9                                            -

                  2                                    .7                                            -

                  3                                    .4                                            .75

Required:

1. Calculate the NPV of both proposals using the Certainty Equivalent method.
2. If the firm were to use the Risk Adjusted Discount Rate method instead of the Certainty Equivalent method, calculate the discount rates which would yield the same NPV amount obtained for Proposal A and Proposal B in part (a) .

Question #4       ( 11 marks)

Zoom Technologies Inc. is considering expanding its operations into digital music devices.  Zoom anticipates an initial investment of $1.3 million and , at an operational life of 3 years for the project.  Zoom’s management team has considered several probable outcomes over the life of the project, which it has labeled as either “successes” or “failures”.  Accordingly, Zoom anticipates that in the first year of operations there is a 65 percent chance of “success”, with after-tax cash flow of $800,000, or a 35 percent chance of “failure”, with and meager $1,000 cash flow after tax.

If the project “succeeds” in the first year, Zoom expects three probable outcomes regarding net cash flows after tax in the second year.  These outcomes are $2.2 million, $1.8 million, or $1.5 million, with probabilities of 30 %, 50%, and 20% respectively.  In the third and final year of operations, the net cash flows after tax are expected to be either $35,000 more or $55,000 less than they were in Year 2, with and equal chance of occurrence.

If, on the other hand, the project “fails” in Year 1, there is a 60 percent chance that it will produce net cash flows after tax of only $1,500 in years 2 and 3.  There is also a 40 percent chance that it will really fail and Zoom will earn nothing in Year 2 and will ge out of this line of business, terminating the project and resulting in no net cash flows after tax in Year 3.

The opportunity cost of capital for Zoom Technologies is 10 percent.

Required:

1. Construct a decision tree representing the possible outcomes
2. Determine the joint probability for each possible sequence of events.
3. What is the project’s expected NPV

Question #5       ( 8  Marks)

North Pole Fishing Equipment Corp. and South Pole Fishing Equipment Corp. would have identical Beta’s of 1.2 if both of them were all-equity financed.  The capital structures of the two firms are as follows:

                                North Pole Fishing                           South Pole Fishing

                                Equipment Corp.                              Equipment Corp.                                                             

Debt                      $1,000,000                                           $1,500,000

Equity                     1,500,000                                             1,000,000

The expected market rate of return is 11.25 percent, and the three-month Treasury bill rate is 4.25 percent.  The corporate tax rate is 40 percent (assume that the bond beta is zero).

Required:

1. What are the levered Betas of the two firms, respectively?
2.  What are the required rates of return on the two firms’ equity?
3. Give an intuitive explanation of the different Betas and the returns on equity obtained in parts (a) and (b).