Kelts Company Currently Uses A Machine That Was Purchased: Finance Homework, TCD, Ireland

QUESTION 1

Kelts Company currently uses a machine that was purchased live years ago. This machine is being depreciated on a straight-line basis toward a €500 salvage value, and it has 10 years of remaining life. Its current book value is €2,600, and it can be sold now for f3,000. Assume, for ease of calculation. that the annual depreciation expense is f350 per year. The firm is offered a replacement machine that has a cost of 15,000, an estimated useful life of ten years, and an estimated salvage value of €1000.

It will cost another €750 to run a session to re-train the users of the machine and this is considered a current expense for tax purposes. The machine will be depreciated on a straight-line basis. This machine will allow an output expansion, so sales will increase by 300 units and each unit sells at an average price of f21. Variable costs are 70% of revenues. In addition, the machine’s greater efficiency will lead to a reduction in fixed operating expenses by f 1,500 per year.

The new machine would require that inventories be increased immediately by €2,000 and accounts payable would simultaneously increase by f500 and these higher levels of inventories and accounts payable will be maintained over the 10-year investment horizon. The corporate tax rate is 12.5%. Projects of similar risk have a beta of 1.3. The expected return on the market is 15% and the risk-free rate of return is 3%.

a. Assume that the project is equity financed. What are the net present value and internal rate of return on the project? Do you recommend investing in the project? Why or why not?

b. Suppose Kelts will borrow €8000 and will pay 6% interest per annum. The interest will be paid once a year and the principal will be repaid at the end of 10 years. What is the adjusted present value of the project with debt financing as described here? Based on the APV, do you recommend investment? Why or why not?

c. Based on the information given above, what is the NPV of the project using the weighted average cost of capital approach? Discuss why the WACC approach may provide a different valuation than the APV approach in this example.

d. Why is the net present value (with and without debt financing) rule most consistent with value maximization? Discuss the various investment criteria and highlight the benefits and limitations of each. Discuss the circumstances under which the NPV analysis may also fail and need to be adapted.

QUESTION 2

a. Snyder Computer Chips Inc is expecting a period of rapid growth. Earnings and dividends are expected to grow at a rate of 15% during the next two years and at a constant rate of 3% thereafter. Snyder’s last dividend was E1.15 and the required rate of return on the stock is 12 percent. How much would you be willing to pay for the stock today?

b. Does the dividend policy decision affect the value of the firm? Discuss the various theories and factors that may explain the dividend policies adopted by firms.

c. What is the efficient markets hypothesis? Discuss the implications of EMU and briefly explain how each form of market efficiency may be tested.

QUESTION 3

Discuss the Modigliani-Miller propositions to explain the impact of capital structure choices on the value of the firm. Do empirical results support the MM propositions? If not, what is the possible explanation? Do theory and empirical findings support the existence of an optimal or target debt ratio?

QUESTION 4

You are considering the following stocks for your portfolio. Stock A has an expected return of 15% and a standard deviation on returns of 20%. Stock B’s returns will come from the following return distribution: Event Probability Return on Stock B Boom 0.1 0.26 Average growth 0.6 0.10 Recession 0.3 -0.05

a. What is the expected return and standard deviation of return on Stock B?

b. The correlation coefficient between the two stocks is -0.7. What is the expected return and standard deviation for the minimum variance portfolio consisting of investments in stocks A and B?

c. Use the information above to discuss the issues of total risk and systematic risk. Which risk can investors reasonably expect to get compensated for? How would a well-functioning market ensure that investors, on average, get compensated only for the ‘relevant’ risk? In your discussion, incorporate a discussion of the Capital Asset Pricing Model as well as its alternatives which are commonly used to price relevant risk. Make sure you identify all variables in any equations.