Question 1.
Ryan, a financial analyst for DMC Products, a manufacturer of school benches, must evaluate the risk and return of two assets, X and Y. The firm is considering adding these assets to its diversified asset portfolio. To assess the return and risk of each asset, Ryan gathered data on the annual cash flow and beginning- and end-of-year values of each asset over the immediately pre- ceding 10 years, 1994-2003. These data are summarized in the accompanying table. Ryan's investigation suggests that both assets, on average, will tend to perform in the future just as they have during the past 10 years. He therefore believes that the expected annual return can be estimated by finding the average annual return for each asset over the past 10 years.
Return Data for Assets X and Y, 1994-2003
|
Year
|
|
Asset X
|
|
|
Asset Y
|
|
|
Cash flow
|
Value
|
Cash flow |
Value
|
|
Beginning
|
Ending |
Beginning
|
Ending
|
|
1994
|
$1,000
|
$20,000
|
$22,000
|
$1,500
|
S20,000
|
$20,000
|
|
1995
|
1,500
|
27,000
|
21,000
|
1,600
|
20,000
|
20,000
|
|
1996
|
1,400
|
21,000
|
24,000
|
1.700
|
20,000
|
21,000
|
|
1997
|
1,700
|
24,000
|
22,000
|
1,800
|
21,000
|
21,000
|
|
1998
|
1,900
|
17.000
|
23,000
|
1,900
|
21,000
|
22,000
|
|
1999
|
1,600
|
23,000
|
26,000
|
2,000
|
22,000
|
23,000
|
|
2000
|
1,700
|
26,000
|
25,000
|
2,100
|
23,000
|
23,000
|
|
2001
|
2,000
|
25,000
|
24,000
|
2,200
|
23,000
|
24,000
|
|
2002
|
2,100
|
24,000
|
27,000
|
2,300
|
24,000
|
25,000
|
|
2003
|
2,200
|
27,000
|
30,000
|
2,400
|
25,000
|
25,000
|
Ryan believes that each asset's risk can be assessed in two ways: in isolation and as part of the firm's diversified portfolio of assets. The risk of the assets in isolation can be found by using the standard deviation and coefficient of varia- tion of returns over the past 10 years. The capital asset pricing model (CAPM) can be used to assess the asset's risk as part of the firm's portfolio of assets. Applying some sophisticated quantitative techniques, he estimated betas for assets X and Y of 1.60 and 1.10, respectively. In addition, he found that the risk- free rate is currently 7% and that the market return is 10%.
a. Calculate the annual rate of return for each asset in each of the 10 preceding years, and use those values to find the average annual return for each asset over the 10-year period.
b. Use the returns calculated in part a to find (1) the standard deviation and (2) the coefficient of variation of the returns for each asset over the 10-year period 1994-2003.
c. Use your findings in parts a and b to evaluate and discuss the return and risk associated with each asset. Which asset appears to be preferable? Explain.
d. Use the CAPM to find the required return for each asset. Compare this value with the average annual returns calculated in part a.
e. Compare and contrast your findings in parts c and d. What recommendations would you give Ryan with regard to investing in either of the two assets? Explain to Ryan why he is better off using beta rather than the standard deviation and coefficient of variation to assess the risk of each asset.
Question 2.
Flight Central wishes to form an affiliation with a nationally based sales firm to provide business travel packages for its employees.
This client is concerned with the lack of availability of hire cars for his employees and has indicated to Flight Central it would like this risk resolved.
Hence Flight Central has considered trialing a new fleet of hire vehicles in one area in an effort to provide added value to business clients.
This client generates a substantial portion of business to Flight Central and will bring all their travel requirements to them, provided this risk is mitigated. Therefore, Flight Central has investigated the purchase of 10 cars at a cost of $50,000 each.
Each car will have a useful life of 5 years and generate extra income of $600,000 in the first year and increasing by 15% pa each year after.
These vehicles will be depreciated on a straight-line basis over the five-year life of the project and are expected to have a 20% salvage value.
The trial will also require an initial investment of $50,000 in working capital to set up the new business processes. This will be returned at the end of the project.
The project's variable costs are $27,000 for each car and fixed costs are $208,000 per year.
Flight Central currently has a policy of only investing in a project if the return is 10% p.a. or more.
(a) Set out all relevant data in an appropriate table format.
(b) Calculate NPV and estimate IRR.
(c) Would you recommend investing in the project? Justify your choice.
(d) Just before the meeting to discuss the final decision for this project, you realise the analysis has ignored tax rates. The corporate tax rate is 30%. How would you modify your NPV calculations to take into account the tax rate?
Question 3: Below are the cash flows of two franchises: (EX)
|
Expected
|
|
Net Cash Flows
|
|
Year (t)
|
Franchise S
|
Franchise L
|
|
0
|
($100)
|
($100)
|
|
1
|
70
|
10
|
|
2
|
50
|
60
|
|
3
|
20
|
80
|
Depreciation, salvage values, net working capital requirements, and tax effects are all included in these cash flows. You also have made subjective risk assessments of each franchise and concluded that both franchises have risk characteristics that require a return of 10%. You must now determine whether one or both of the franchises should be accepted
1. What is capital budgeting?
2. What is the difference between independent and mutually exclusive projects?
3. Define the term net present value (NPV). What is each franchise's NPV?
4. What is the rationale behind the NPV method? According to NPV, which franchise or franchises should be accepted if they are independent? Mutually exclusive?
5. Would the NPVs change if the cost of capital changed?
6. Define the term internal rate of return (IRR). What is each franchise's IRR?
7. What is the logic behind the IRR method? According to IRR, which franchises should be accepted if they are independent? Mutually exclusive?
8. What is the underlying cause of ranking conflicts between NPV and IRR?