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BFIN 305 Summer 1 Assignment 1 Corporate Finance course assignment. 5 questions

Corporate Finance course assignment. 5 questions

Question 2

(2 points)

Union Industries is considering investment in a project to manufacture a new product which
it believes has good potential demand. The investment in the project is expected to be about
AED 400,000. It, though, is not sure about the competition and is worried that the
competition may increase. Accordingly, it is evaluating two possible structures of the project.
One option is to have a project with a shorter life of 3 years with a lower investment where
the company can re-invest again after 3 years should the competition remain low.
Alternatively, it can go ahead with a project with a longer life of 6 years with higher
investment upfront. The details of investment and cash flows are given in the table below.
The Company’s cost of capital which will be the discount rate is 10%.
Particulars
Investment
Cash Flows – Year 1
Cash Flows – Year 2
Cash Flows – Year 3
Cash Flows – Year 4
Cash Flows – Year 5
Cash Flows – Year 6

Option 1
-300,000
75,000
125,000
200,000

Option 2
-600,000
75,000
110,000
150,000
220,000
280,000
320,000

Please answer the following questions:
(A) Using replacement chain method for Option 1 at end of Year 3 and assuming same cash
outflows and inflows, recalculate the NPV and PI.
(B) Does your recommendation of which option is better change or remain the same?
Please explain why or why not has the change happened.
(C) Instead of replacement chain method, use the Equivalent Annual Annuity method.
Calculate the EAA for both options
(D) Give your recommendation of which option is preferable under the EAA method?

Question 3

(1 point)

Acme Industries is contemplating four projects whose details are given below. Its desired
rate of return is 12% and its capital budget is AED 450,000. Further, it believes that idle

C 3.11 – Appendix III: Assessment Instrument Cover Sheet

funds, if any cannot be reinvested at a rate higher than 12%.
(All figures in AED)

Year
Initial Cost
Cash Flow – Year 1
Cash Flow – Year 2
Cash Flow – Year 3
Cash Flow – Year 4
Cash Flow – Year 5
NPV
IRR
PI

Project A
200,000
93,000
93,000
93,000
23,370
18.7%
1.12

Project B
235,000
90,000
85,000
75,000
55,000
50,000
29,827
17.6%
1.13

Project C
190,000
45,000
55,000
65,000
70,000
75,000
27,333
17.2%
1.14

Project D
210,000
40,000
50,000
60,000
65,000
75,000
(7,854)
10.6%
0.96

In evaluating these projects, please respond to the following questions:
(A) If Acme Industries can choose more than one project, explain which combination of
projects is the best
(B) If Acme Industries can choose only one project, explain which one you would
recommend.

Question 4

(2 points)

Al Jassim Ceramics Limited is in the business of manufacturing and sale of ceramic tiles and
ancillary products catering to primarily the needs of hotel industry and households. The
company has grown substantially in the last 3 years assisted by the rising construction
activity in both the hospitality and residential/commercial segments. With a view to further
enhance its growth by developing new markets, it seeks to enter the high growth market in

C 3.11 – Appendix III: Assessment Instrument Cover Sheet

Qatar. To facilitate this it wishes to set up a new factory in Doha which it estimates would
require investment worth AED 80 million. The Company’s business plan indicates that the
retained earnings for the coming year would be AED 15 million. As for the balance, market
conditions indicate the following:
•
•
•

Bonds with a coupon rate of 10% can be sold at par
Preferred stock with annual dividend of 12% can be sold at par
Common stock can be sold to yield AED 58 per share

The current capital structure, considered optimal, is as follows:
• Long term debt
:
AED 175 million
• Pref. Stock
:
AED 50 million
• Equity
:
AED 275 million
Its studies indicate that cost of equity is 16%. The tax rate is 40%.
Q1. Determine how the company should finance the expenditure. Show your calculations
and specifically for the new equity to be issued, show how many shares would have to be
issued
Q2. Calculate the marginal WACC

Question 5
(3
point
s)
Refer to Al Jassim Ceramics Limited in Question 4 above. Explain how each of the following
events, considered individually, would either increase or decrease or would have no effect
on the cost of capital
• Increase in corporate tax rate
• Lending rates will increase
• Beta of the company goes down

C 3.11 – Appendix III: Assessment Instrument Cover Sheet

•

Company decides to substantially increase amount of debt in its capital structure

Question 6

(3 points)

Dubai Metals Limited is an existing profit making company. It wishes to expand its production
capacity of steel products to cater to the rising demand from the construction industry. The
total cost of the project is estimated at AED 55 million. It is considering the following possible
options for financing the cost of the project

1. Selling AED 1,000, 8%, 20 year bonds for which a premium of AED 30 can be
charged though the firm will have to pay a floatation cost of AED 20 per bond.

C 3.11 – Appendix III: Assessment Instrument Cover Sheet

2. Selling 6% preferred stock at par value of AED 105 per share for which the
floatation cost is AED 5 per share
3. Issuing equity shares for which the current market price is AED 75 per share. The
company expects to pay a constant dividend of AED 7 per share in future. For the
issue, the stock will have to be underpriced by AED 3 per share while the
floatation costs will be AED 5 per share.
4. The company expects to have AED 5 million of retained earnings

The preferred capital structure is as under:
o Long term debt

:

30%

o Preferred

:

20%

o Equity

:

50%

The tax rate of the company is 40%.
Calculate:
(a)
(b)
(c)
(d)
(e)

The Pre-tax and Post-tax Cost of Debt
The annual Cost of Preferred Stock
The Cost of Equity
The Cost of Retained Earnings
The WACC of the company

C 3.11 – Appendix III: Assessment Instrument Cover Sheet

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