Calculations for St. George Bank Account
|
Year |
Opening Balance |
Interest @ 8% |
Deposit Amount |
Closing Amount |
|
1 |
7000.00 |
560.00 |
4000.00 |
11560.00 |
|
2 |
11560.00 |
924.80 |
4000.00 |
16484.80 |
|
3 |
16484.80 |
1318.78 |
4000.00 |
21803.58 |
|
4 |
21803.58 |
1744.29 |
0.00 |
23547.87 |
3rd year value = $ 21803
4th year value = $ 23547.87
Part b
|
Year |
Annual Cash Inflow |
DCF @ 15% |
Present value of payments |
|
1 |
$ 12,000.00 |
0.870 |
$ 10,434.78 |
|
2 |
$ 12,000.00 |
0.756 |
$ 9,073.72 |
|
3 |
$ 12,000.00 |
0.658 |
$ 7,890.19 |
|
4 |
$ 12,000.00 |
0.572 |
$ 6,861.04 |
|
5 |
$ 12,000.00 |
0.497 |
$ 5,966.12 |
|
6 |
$ 12,000.00 |
0.432 |
$ 5,187.93 |
|
7 |
$ 12,000.00 |
0.376 |
$ 4,511.24 |
|
8 |
$ 12,000.00 |
0.327 |
$ 3,922.82 |
|
9 |
$ 12,000.00 |
0.284 |
$ 3,411.15 |
|
10 |
$ 12,000.00 |
0.247 |
$ 2,966.22 |
|
Total NPV |
$ 60,225.22 |
Maximum amount to be paid= $ 60225.22
Part c
|
Yield to Maturity= |
Coupon Payment + |
Par Value – Market Price |
|
|
Maturity Terms |
|||
|
(Face Value + Market Price)/2 (Fabozzi, 2005). |
|||
|
4+(( 100-91.137)/12) |
|||
|
(100+91.137)/2 |
|||
|
4.74 |
|||
|
95.57 |
|||
|
=4.96% |
|||
|
Bond Equivalent Yield= |
YTM * Frequency of Compounding |
||
|
4.96 * 2 |
|||
|
9.92% |
|||
|
Effective Annual Yield= |
(1+ (r/n))^n)-1 |
||
|
(1+ (0.0992/2))^2-1 |
|||
|
10.17% |
Question 2
Part a: Payback period
Project A
|
Year |
Cash Flows |
DCF @ 15% |
PV of Cash Flows |
Cumulative Cash Flows |
|
0 |
-$ 250.00 |
1.000 |
-$ 250.00 |
-$ 250.00 |
|
1 |
$ 100.00 |
0.870 |
$ 86.96 |
-$ 163.04 |
|
2 |
$ 100.00 |
0.756 |
$ 75.61 |
-$ 87.43 |
|
3 |
$ 100.00 |
0.658 |
$ 65.75 |
-$ 21.68 |
|
4 |
$ 100.00 |
0.572 |
$ 57.18 |
$ 35.50 |
Payback period: 3.38 Years
Project B
|
Year |
Cash Flows |
DCF @ 15% |
PV of Cash Flows |
Present Value of Cash Flows |
|
0 |
-$ 250.00 |
1.000 |
-$ 250.00 |
-$ 250.00 |
|
1 |
$ 100.00 |
0.870 |
$ 86.96 |
-$ 163.04 |
|
2 |
$ 200.00 |
0.756 |
$ 151.23 |
-$ 11.81 |
|
3 |
$ – |
0.658 |
$ – |
-$ 11.81 |
|
4 |
$ – |
0.572 |
$ – |
-$ 11.81 |
Payback Period: Nil
Project A must be selected as it is able to recoup the initial cost of investment of the project and project B must be rejected as it is not expected to even recover initial cost of investment.
Part b: Net present Value
Project A
|
Year |
Cash Flows |
DCF @ 15% |
Present Value of Cash Flows |
|
0 |
-$ 250.00 |
1.000 |
-$ 250.00 |
|
1 |
$ 100.00 |
0.870 |
$ 86.96 |
|
2 |
$ 100.00 |
0.756 |
$ 75.61 |
|
3 |
$ 100.00 |
0.658 |
$ 65.75 |
|
4 |
$ 100.00 |
0.572 |
$ 57.18 |
|
NPV |
$ 35.50 |
Project B
|
Year |
Cash Flows |
DCF @ 15% |
Present Value of Cash Flows |
|
0 |
-$ 250.00 |
1.000 |
-$ 250.00 |
|
1 |
$ 100.00 |
0.870 |
$ 86.96 |
|
2 |
$ 200.00 |
0.756 |
$ 151.23 |
|
3 |
$ – |
0.658 |
$ – |
|
4 |
$ – |
0.572 |
$ – |
|
NPV |
-$ 11.81 |
Project A must be selected as it has higher NPV than Project B.
Part c:
Both the techniques of capital budgeting are giving same outcomes because the one thing that is common between both the methods is the consideration of cash flows (Graham & Harvey, 2002. The cash outlay of both the project is same. However, project B is expected to generate cash inflows for only two years. Therefore, it would not be able to even recoup the project’s initial outlay.
Therefore, both the methods suggests that project A must be selected.
Part d
As other methods Internal Rate of Return and Profitability index can be used to evaluate the proposed projects.
Internal Rate of Return
|
Project A |
|
|
Year |
Cash Flows |
|
0 |
-$ 250.00 |
|
1 |
$ 100.00 |
|
2 |
$ 100.00 |
|
3 |
$ 100.00 |
|
4 |
$ 100.00 |
|
IRR |
22% |
|
Project B |
|
|
Year |
Cash Flows |
|
0 |
-$ 250.00 |
|
1 |
$ 100.00 |
|
2 |
$ 200.00 |
|
3 |
$ – |
|
4 |
$ – |
|
IRR |
12% |
Profitability Index
|
Profitability Index= |
Present Value of Future Cash Flows |
|
Initial Investment |
|
|
Project A |
285.5 |
|
250 |
|
|
PI |
1.14 |
|
Project B |
238.19 |
|
250 |
|
|
PI |
0.95 |
To be accepted a project must have higher IRR than its required rate of return. In the present case, Project A has higher than Project B, therefore, the former project must be accepted. Also, the Profitability index of a project must be greater than 1 in order to accept it (Brijlal, 2008). In the instant case, the PI of Project A is higher than Project B. Thus, project A must be accepted.
Cost of Equity:
|
Weighted Average Cost of Capital |
20% |
|
|
Cost of Debt (kd) |
12% |
|
|
Risk Free Rate ( Rf) |
12% |
|
|
Debt to Equity (ke) |
2 |
|
|
Equity Beta |
1.5 |
|
|
Components |
Proportion |
Percentage |
|
Debt |
2 |
67% |
|
Equity |
1 |
33% |
|
Total Capital Structure |
3 |
100% |
|
WACC= |
Kd (2) + Ke (1) |
|
|
20= |
12(2/3)+Ke(1/3) |
|
|
Ke= |
36.24% |
Part a)
As per Modigliani and Miller’s Proposition I, the capital structure of any entity does not influence its value. This proposition is based on the assumption that there are no taxes. M&M proposition sets that the firm’s leverage would not affect the value of the company in the market. The proportion of both the key components of capital structure of an entity i.e. debt and equity is irrelevant for the identification of the entity’s worth. As per M&M 1, both the debt holders and equity holders have same opportunity of company’s return.
In the current case of ABC Company, the quantum of debt is twice the quantum of equity. Therefore, it can be said that the firm has financed its assets using more of debt and less of internal funds (Damodaran, 2012). However, these proportions are not going to determine the ABC’s value. Rather, the value of real assets of the company is going to determine its value.
The debt is 67% of the total capital structure of ABC Company and equity is 33% of the total capital structure. The Weighted Average Cost of Capital of the company is 20% and cost of debt is 12%. Therefore, using the information it has been identified that the cost of capital would be 36.24%.
As per Modigliani and Miller’s Proposition II, the company’s value depends on the following three points:
- Company’s required rate of return on its assets.
- The cost of debt of the company
- The debt equity ratio
The financial leverage of the company is directly proportionate to the cost of equity of the company. As the debt of the company increase, the equity shareholders assume the fact that the company has more risk. This proposition says that the company’s cost of capital increases with the same proportion of debt of the company. In fact,
|
Re = |
Ro + D/E (Ro- Rd) |
Ro is the cost of capital in case when the company uses only equity as the source of finance.
Part b)
|
Re = |
Ro + D/E (Ro- Rd) |
|
20%+((2/1)*(20%-0)) |
|
|
0.20 |
|
|
CAPM |
Rf + Beta (Rm – Rf) |
|
20% |
12% + beta (20%- 12%) |
|
Beta |
1 |
References:
Brijlal, P., 2008. The use of capital budgeting techniques in businesses: A perspective from the Western Cape.
Damodaran, A., 2012. Investment valuation: Tools and techniques for determining the value of any asset (Vol. 666). John Wiley & Sons.
Fabozzi, F.J., 2005. Bond Markets, Analysis and Strategies”(Int’l Edition)–5th Edition. Prentice Hall.
Graham, J. and Harvey, C., 2002. How do CFOs make capital budgeting and capital structure decisions?. Journal of applied corporate finance, 15(1), pp.8-23.
Order an Essay Now & Get These Features For Free:
Turnitin Report
Formatting
Title Page
Citation
Outline
