Question 1 -
HIGHSKY COMPANY
Because of the recent growth the corporate treasurer, Bernard Sock, is concerned that available funds are not being used to their fullest. The projected $1.2 million of internally generated 2017 funds are expected to be insufficient to meet the company's expansion needs.
Bernard has been presented with the following competing investment opportunities by division and product managers. However, since funds are limited, choices of which projects to accept must be made.
Investment Opportunities Schedule
|
Project Identification
|
Project Cost
|
Estimated Annual Cash Inflows
|
Estimated Life (in years)
|
Internal Rate of Return
|
|
A
|
$400,000
|
$82,650
|
6
|
|
|
B
|
$200,000
|
$52,840
|
5
|
|
|
C
|
$800,000
|
$163,400
|
7
|
|
|
D
|
$500,000
|
$115,240
|
6
|
|
|
E
|
$300,000
|
$61,600
|
7
|
|
|
F
|
$500,000
|
$158,120
|
4
|
|
|
G
|
$500,000
|
$131,270
|
5
|
|
Bernard has determined that the optimum capital structure mix was the one that the company presently employed. The company rounds the weights to three decimal points.
Extract from Balance Sheet
|
Assets
|
|
|
Accounts Receivable
|
$125,000
|
|
Inventories
|
$185,000
|
|
Property, Plant & Equipment
|
$4,493,000
|
|
Prepayments
|
$12,000
|
|
TOTAL ASSETS
|
$4,815,000
|
|
Liabilities
|
|
|
Accounts Payable
|
$90,000
|
|
Accrued Revenue
|
$25,000
|
|
Debentures
|
$1,600,000
|
|
TOTAL LIABILITIES
|
$2,015,000
|
|
NET ASSETS
|
$2,800,000
|
|
Shareholders' Equity
|
|
|
Preference Shares
|
$1,200,000
|
|
Ordinary Shares
|
$1,000,000
|
|
General Reserve
|
$125,000
|
|
Retained Profit
|
$475,000
|
|
TOTAL SHAREHOLDERS EQUITY
|
$2,800,000
|
Notes
The Bonds are currently selling at $210.29 each
The Bonds mature in 7 years time
Bond interest is payable half yearly
The Face Value was $200.00
The Coupon Rate is 12.5%
Flotation Cost per Bond are $0.75
Current Market Price of Preference Shares is $19.16
Preference Shares Outstanding: 80,000
Dividends are paid at $1.75 per share
Flotation Cost per Preference Share are $0.25
Current Market Price of Ordinary Shares is $15.37
Ordinary Shares Outstanding 100,000
Dividends are paid at $1.00 per share
Flotation Cost per Ordinary Share $0.50
Tax Rate is 30%
All dividends have just been paid
Payout Ratio is 40%
Dividends per share over the past five years
2017 - $1.000
2016 - $0.982
2015 - $0.921
2014 - $0.832
2013 - $0.825
The company plans a dividend payout ratio of 40 per cent. Total capital expenditures are yet to be determined.
On investigating financing cost data, Bernard discovered the following information:
Long Term Debt
The company can raise $500,000 of additional debt at the current yield of its existing debentures. Any debt in excess of $500,000 will have a before-tax cost of 12.11 per cent.
Preference Shares
Preference capital, regardless of the amount sold, can be issued at the current market price.
Ordinary Equity
The company expects its dividends and earnings to continue to grow at a constant rate per year. The company expects to have $1.2 million of available retained earnings. Once the retained earnings have been exhausted, the firm can raise additional funds by selling new equity at $14.50 per share after flotation costs.
Required -
1. Determine Highsky's existing market value capital structure.
2. The company adjusts the cash-flows for flotation costs. Discuss the appropriateness of this approach.
3. Calculate the after tax cost of each source of financing.
4. Discuss an alternative manner to calculate the Cost of Equity (Ordinary shares)
5. Discuss an alternative calculation of the growth factor used in the dividend growth model
6. Assuming that Highsky maintains this optimum market value capital structure, calculate the breaking points associated with each source of capital.
7. Using the breaking points developed determine each of the ranges of total new financing over which the company's WACC remains constant.
8. Calculate the WACC for each range of total new financing.
9. Using your findings above with the Investment Opportunities Schedule (I0S), draw the company's weighted marginal cost of capital (WMCC) function and 103 on the same set of total new financing or investment (x-axis) - WACO and IRR (y-axis) axes.
10. Which, if any, of the available investments would you recommend the firm accept?
11. Explain your answer, concluding with a discussion of the accept reject decision on the marginal project.
12. Assuming that the specific financing costs do not change what effect would a shift to a more highly levered capital structure consisting of 60 per cent long-term debt, 20 per cent preference capital and 20 per cent ordinary equity have on your findings above? (Note: rework the relevant parts above using these capital structure weights)
13. Which capital structure - the original one or this one -seems better? Why?
Question 2 -
White Ltd operates outdoor amusement centres in a number of country towns. The company has decided to build another centre that is expected to generate a permanent increase in [BIT of $100,000 pa. Current EBIT is $350,000, White currently has a capital structure that utilises bonds, ordinary equity and preference shares. The $200,000 of issued bonds pay 8% pa. Preference shares pay an annual fixed dividend of $150,000. Currently 250,000 ordinary shares have been issued and are trading at $2 per share. The company pays tax at 30%.
a) White needs to raise $500,000 to construct the new amusement centre. Assuming the company can issue new shares at the current market price, what is the impact on EPS if new shares are issued to fund the centre?
B) If new debt can be raised at a 10% interest rate, what is the impact on EPS of using debt rather than a new equity issue?
White Ltd depends on mainly on sunny weather to generate its expected EBIT, Using the information above together with the two following scenarios calculate the impact of the debt and equity financing alternatives if:
a) Weather is good which will increase attendances and increase EBIT to $600,000
b) Weather is poor which will decrease attendances and reduce EBIT to $320,000
c) Calculate the indifference point.
Question 3 -
Tversky and Kahneman (1974) analyse heuristic principles used as devices to reduce the complexity of tasks and to form intuitive judgments of probability -often useful devices, but sometimes leading to systematic mistakes. They draw an analogy with visual perception: we judge the distance of an object by our visual perception of its sharpness and clarity, which is often a useful guide, but in specific circumstances it will be misleading: in fog we overestimate distances; in sunny weather we underestimate them. Similarly, whilst heuristics can be useful devices to enable quick and efficient decision-making, their use does lead to decision-making biases.
Tversky and Kahneman (1972, 1974) explore the connections between heuristics and biases for a range of heuristics commonly employed, including representativeness, anchoring/adjustment and availability. For Tversky and Kahneman, heuristics are intuitive decision-making tools, but the problem is that a range of biases can emerge from the mis-application of these quick decision-making tools. Tversky and Kahneman illustrate with some experimental examples of systematic mistakes from misapplication of heuristics. In describing their experimental evidence, they note that they encouraged their experimental subjects to be accurate and rewarded them for correct answers to deter wishful thinking and other irrational influences not associated with the application of heuristics.
Overall, a large number of heuristics and biases have been identified.
Part A -
Olivia is in her early twenties, intelligent and socially active concerning social issues and often attends demonstrations concerning these issues. Which is more probable;
Olivia is a bank clerk
Olivia is a bank clerk and involved actively in the feminist movement.
Explain your choice?
Part B -
You are at the casino and playing the roulette table where there has been a long run of reds. You are to take the next bet. What colour did you choose and why?
Part C -
A bucket contained around fifty black and red ball. First draw of five revealed four red and one black. These balls were then returned to the bucket and a draw of twenty balls revealed twelve red and eight black. Which of these draws was more likely to be from a bucket containing two-thirds red balls and one-third black balls?
Part D -
Two groups were arranged. The first group contained seventy lawyers and thirty engineers. The second comprised thirty lawyers and seventy engineers. You are informed that one of the people in the groups is called Ben who is thirty-two years old, motivated and highly able, well liked and successful. What is Ben's occupation? How did you come to your decision?
Part E -
You are an air-force fighter pilot and you have the choice of either a parachute or a flak jacket but because both are too heavy you must choose which one to take. Strafing from enemy gunfire was three times more likely than being shot down. You are to take four flights over enemy territory. What would you take on each flight and why?