Iinvestment finance
Allen
assign.pdf
FIN 422 ASSIGNMENT 1
Due at 3:00 p.m. on Thursday, January 30, 2014.
Instructions:
1. Each person in the class must submit his/her individual assignment. 2. Attach a covering page to the front of your assignment giving your name, course
number, section number (B1 or B2), and instructor’s name.
3. Hand in your assignment at the assignment drop-off box located outside the General Office on the third floor of the School of Business building. Be sure to
place your assignment in the slot that is allocated for the class (FIN 422 B1 or
FIN 422 B2).
4. Do not write down a single number solution to a question. Show your work, that is, show the important elements of your solution.
5. In an effort to reduce round-off error, carry any calculations to at least four decimal places.
Note: Assignments handed in after 3:00 p.m. on the due date will not be accepted.
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1. Enrique Rodrigues has $65,000 this year. He faces the investment opportunities
represented by point B in the following figure. He wants to consume $22,000 this year
and $65,100 next year. This pattern of consumption is represented by point F.
(a) [1] What is the market interest rate?
(b) [2] How much must Enrique invest in financial assets and productive assets today if
he follows an optimum strategy? Note: Productive assets are nonfinancial assets or real
assets.
(c) [1] What is the NPV of his investment in nonfinancial assets?
HINT: In the diagram that follows, sketch the investment opportunities curve. It begins
at the point on the horizontal axis labelled $65,000 and is tangent to the straight line with
slope (1 )r at point B.
Note:
The coordinates of point D are (0; $91,500).
The coordinates of point F are ($22,000; $65,100).
The coordinates of point B are ($32,500; $52,500).
The coordinates of point A are ($65,000; $13,500).
The coordinates of point C are ($76,250; 0).
$91,500
$65,100
$52,500
$13,500
$22,000 $32,500 $65,000 $76,250
F
F
B
A
C
D
2. [4] A capital investment project will require an initial outlay of $55,000 and is
expected to generate an after-tax net cash flow of $7,500 in one year. After-tax net cash
flows are then expected to grow at a rate of “g” per year for 5 years, ending 6 years from
today. In each year after that in perpetuity, after-tax net cash flows are expected to grow
at a fixed rate of 1.5% per year. The project’s cost of capital is 21%.
If the terminal value of the project at the end of year 6 is $53,486.08, what is the project’s
NPV?
Note: Terminal value at the end of year 6 is the value at that time of the after-tax net cash
flows that the project is expected to generate after that date.
3. (a) [12] In 2011, WestJet Airlines Ltd. considered adding a new short-haul, low-cost,
regional airline to its fleet. The regional airline would use a turbo-prop aircraft, allowing
WestJet to provide service to new, smaller communities where the larger 737 aircraft did
not make sense economically.
You have been assigned the task of determining the net cash flows, NPV, and IRR of the
proposed regional airline. To conduct the required analysis, refer to the financial
statements given in the Excel file “Assignment1wjaDATAw14” posted to the class
website in uLearn, under Assignments. Use the data for FY 2011.
Build an Excel worksheet with a column for each year of the expected life of the project.
(Note: Consider how depreciation is to be measured when identifying the number of
columns to include in the worksheet.) For each year, derive free cash flow using the
formula: C NI CCA NWC KExp
(1 )[ ] .cT R E CCA CCA NWC KExp
Assumptions are as follows:
The project is evaluated on the basis of a five-year life.
Development of the new airline will require an initial investment equal to 9% of Net Fixed Assets for the fiscal year 2011. The project will then require an
additional investment equal to 6% of initial investment after the first year, a 4%
increase after the second year, and a 2% increase after the third, fourth, and fifth
years. See below for a HINT on the calculation.
First-year revenues for the new airline are expected to be 11% of total revenue for the fiscal year 2011. The new airline’s revenues are expected to grow at 16% for
the second year, then 11% for the third year, and 6% annually for the final two
years.
The new airline’s profitability will be similar to WestJet’s existing projects in 2011, so estimate [R – E] (or gross profit) each year using the 2011
EBITDA/Sales profit margin.
Determine annual depreciation by assuming WestJet depreciates the assets by the straight-line method over a 10-year life, that is, assume that capital expenditures
made in years 0, 1, 2, 3, 4, and 5 will be depreciated on a straight-line basis over
the following periods, respectively: years 1-10, years 2-11, years 3-12, years 4-13,
years 5-14, and years 6-15.
Determine WestJet’s tax rate by using the income tax rate in 2011.
Calculate the net working capital (NWC) required each year by assuming that the level of NWC will be a constant percentage of the project’s sales. Use WestJet’s
2011 NWC/Sales ratio to estimate the required percentage. (Use only accounts
(& notes) receivable, account payable, and inventory to measure working capital.
Other components of current assets and liabilities are harder to interpret and not
necessarily reflective of the project’s required NWC, e.g., WestJet’s cash
holdings.) See below for a HINT on the calculation.
To determine the free cash flow, calculate the additional capital investment and the change in net working capital each year.
WestJet has an estimated cost of capital of 12%.
Instructions:
Your answer to this question should be reported in a paper copy of an Excel worksheet. In a worksheet, show your derivation of the NPV of the project.
Also report the IRR.
In the worksheet, express all monetary amounts (in millions of dollars) to two decimal places.
HINT: Calculation of capital expenditures:
In a spreadsheet, calculate the Net Fixed Assets of the project at times 0, 1, 2, 3, 4, and 5.
In the next row, calculate Capital Expenditure.
At time 0, Net Fixed Assets = 9% of Net Fixed Assets as recorded in the balance sheet
for the fiscal year 2011.
At time 1, Net Fixed Assets = Net Fixed Assets at time 0 multiplied by 1.06.
At time 2, Net Fixed Assets = Net Fixed Assets at time 1 multiplied by 1.04.
At time 3, Net Fixed Assets = Net Fixed Assets at time 2 multiplied by 1.02.
At time 4, Net Fixed Assets = Net Fixed Assets at time 3 multiplied by 1.02.
At time 5, Net Fixed Assets = Net Fixed Assets at time 4 multiplied by 1.02.
At time 0, Capital Expenditure = Net Fixed Assets at time 0.
At time 1, Capital expenditure = Net Fixed Assets at time 1 - Net Fixed Assets at time 0.
At time 2, Capital expenditure = Net Fixed Assets at time 2 - Net Fixed Assets at time 1.
At time 3, Capital expenditure = Net Fixed Assets at time 3 - Net Fixed Assets at time 2.
At time 4, Capital expenditure = Net Fixed Assets at time 4 - Net Fixed Assets at time 3.
At time 5, Capital expenditure = Net Fixed Assets at time 5 - Net Fixed Assets at time 4.
HINT: Calculation of increase in net working capital:
Get NWC at times 0, 1, 2, 3, and 4 by multiplying the NWC/Sales ratio times sales (or
revenue) at times 1, 2, 3, 4, and 5, respectively. Let NWC at time 5 be zero.
Get the increase in NWC at times 0, 1, 2, 3, 4, and 5.
At time 0, increase in NWC = NWC at time 0.
At time 1, increase in NWC = NWC at time 1 – NWC at time 0.
At time 2, increase in NWC = NWC at time 2 – NWC at time 1.
At time 3, increase in NWC = NWC at time 3 – NWC at time 2.
At time 4, increase in NWC = NWC at time 4 – NWC at time 3.
At time 5, increase in NWC = NWC at time 5 – NWC at time 4.
(b) [1] If you assume that development of the new airline will require an initial
investment equal to 8% of Net Fixed Assets for the fiscal year 2011 (rather than 9%),
holding all other assumptions the same as in (a), what is the NPV of the project?
