Centre for Postgraduate Studies

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1 Centre for Postgraduate Studies MBF1223 FINANCIAL MANAGEMENT APRIL-MAY INTAKE INDIVIDUAL ASSIGNMENT II This assignment carries a 30% weightage toward final grade. Instruction for Submission of Assignment: Assignments must be submitted to the Lecturer in the class or on the day of final examination. This assignment contains 4 questions. Answer all questions. Q1. Solaray produces solar panels for the housing market. Its management is considering three investment projects for the next years. The company s policy is not to invest in projects that requires more than three years to recover the company s initial investment. The cash flows for the three projects (Project Mars, Project Pluto and Project Saturn) are as follows: Year Project Mars $ Project Pluto $ Project Saturn $ 0 (1,000) (10,000) (5,000) ,000 1, ,000 1, ,000 2, ,000 2, ,000 2,000 (a) Given Solaray s three-year payback period, which of the projects will qualify for acceptance? Page 1 of 5

2 (b) (c) Rank the projects using their payback periods. Which project looks the best using this criterion? Do you agree with this ranking? Why or why or not? If Solaray uses a 10 percent discount rate to analyse projects, what is the discounted payback period for each of the three projects? If the firm still maintains its three-year payback policy for the discounted payback, which projects should the firm undertake? Q2. Cleantech manufactures windmills used to generate clean electricity in remote residential areas. In 2010, the company began working on a new prototype of its tried-and tested windmills. The old model windmills required the use of parts that would wear out over time and require servicing. When the engineers in Cleantech initiated the design of a new windmill in 2013, they explored a number of possible designs and spent over $150,000 in fabricating and testing a new design before perfecting the system that they are now are ready to place into production and begin marketing. To manufacture the new windmill, Cleantech will have to spend $750,000 on new equipment plus $300,000 in advertising and promotion for the launch of the new product. These expenditure will take place during (a) (b) (c) What is the relevant initial cost of the new windmill product investment? Cleantech s management expects to sell 1,500 of the new units per year for the next 15 years and these units will produce free cash flow for Cleantech of $150,000 per year. Furthermore, the company s management estimates that the equipment purchased initially will last for the full 15 years, at which time it will have no salvage value. If the company uses a 10 percent rate of return to evaluate its investments, what is the NPV of the new windmill investment? Just as Cleantech s management was about to launch the new investment, the company s owner received a call from Altenergi inquiring about the possible purchase of the product design patent. Altenergi suggested that it would be interested in paying as much as $110,000 for the exclusive rights to the new technology. Cleantech would have to sign over all its rights to the new design in return for the payment. How should this offer influence Cleantech s decision to initiate manufacturing the new windmill design? Page 2 of 5

3 Q3. Petyr Baelish is reviewing Valyria s financial statements in order to estimate its sustainable growth rate. Refer to the information presented in Table 1 below to answer this question. (a). (1) Identify and calculate the three components of the DuPont formula for (2) Calculate the ROE for 2016 using the three components of the DuPont formula. (3) Calculate the sustainable-growth rate for Petyr Baelish has calculated actual and sustainable growth for each of the past four years and finds in each year that its calculated sustainable-growth rate substantially exceeds its actual growth rate. (b). Cite two courses of action (other than ignoring the problem) Petyr Baelish should encourage Valyria to take, assuming the calculated sustainable-growth rate continues to exceed the actual growth rate. Q4. At year-end 2016, the Wall Street consensus was that Philip Morris earnings and dividends would grow at 20 percent for five years after which growth would fall to a market-like 7 percent. Analysts also projected a required rate of return of 10 percent for the U.S. equity market. (a). Using the data in Table 2, calculate Philip Morris price/earnings ratio and the price/earnings ratio relative to the S&P Industrials Index as of December 31, (b). Using the data in Table 3, calculate Philip Morris price/book ratio and the price/book ratio relative to the S&P Industrials Index as of December 31, (c). State one major advantage and one major disadvantage of each of the two valuation methodologies you used to value Philip Morris stock in Questions a and b above. (d). State whether Philip Morris stock is undervalued or overvalued as of December 31, Support your conclusion using your answers to previous questions and any data provided. (The past 10-year average S&P Industrials Index relative price/earnings and price/book ratios for Philip Morris were 0.80 and 1.61, respectively.) Page 3 of 5

4 Table 1 Valyria Incorporated: Actual 2015 and Estimated 2016 Financial Statements For Fiscal Year Ending 31st December ($ millions, except per share data) Income Statement $ million 2015 $ million 2016 Change (%) Revenue 4,750 5, Cost of goods sold 2,400 2,540 Selling, general, and administrative 1,400 1,550 Depreciation Goodwill amortization Operating income Interest expense Income before taxes Income taxes Net income Earnings per share ($) Average shares outstanding (millions) Balance Sheet Cash Accounts receivable Inventories Net property, plant, and equipment Intangibles Total assets 2,950 3,100 Current liabilities Long-term debt Total liabilities Stockholders equity 2,100 2,200 Total liabilities and equity 2,950 3,100 Book value per share ($) Annual dividend per share ($) Page 4 of 5

5 Table 2 Philip Morris: Selected Financial Statement and Other Data for the Year Ending 31st December ($ millions, except per share data) 2016 Income Statement $'million Operating revenue 56,458 Cost of sales 25,612 Excise taxes on products 8,394 Gross profit 22,452 Selling, general, and administrative expenses 13,830 Operating income 8,622 Interest expense 1,651 Pretax earnings 6,971 Provision for income taxes 3,044 Net earnings 3,927 Earnings per share ($) 4.24 Dividends per share ($) 1.91 Balance Sheet Current assets 12,594 Property, plant, and equipment, net 9,946 Goodwill 18,624 Other assets 6,220 Total assets 47,384 Current liabilities 11,824 Long-term debt 14,213 Deferred taxes 1,803 Other liabilities 7,032 Stockholders equity 12,512 Total liabilities and stockholders equity 47,384 Page 5 of 5

6 Other Data Philip Morris: Common shares outstanding (millions) 920 Closing price common stock $ S&P Industrials Index: Closing price $ Earnings per share $16.29 Book value per share $ END - Page 6 of 5