ACCOUNTING AND FINANCE ASSIGNMENT -

Question 1 - Answer all parts of this question

Creative Developers (CD) is analysing the possibility of marketing a new generation of widgets. CD estimates that if the widgets were to be manufactured internally, the required up-front expenditure would amount to £750,000. Initiating the manufacturing activity will mean that CD will not be able to rent out its current warehouse space any longer. Currently, the warehouse yields £100,000 a year. CD estimates that it will be able to sell its widgets for £10 each. Variable costs are £5.5 per unit and CD forecasts an annual sales volume of 100,000 units between years 1 and 5. (After year 5, the considered generation of widgets will be out of fashion and the predicted sales are zero.) Offering the product will result in additional investments in receivables and inventory as well as in the need to maintain a cash balance. Moreover, to reflect deferred payments to suppliers the balance of accounts payable will be created. Projected end-of year balances are as follows:

Assume that cash flows arrive at the end of each year, except for the initial outlay of £750,000. CD predicts that it will be able to obtain £250,000 for the sale of its production facility at the end of the project, that is, in year 5.

a. Calculate the cash flow that will be generated by the project each year. Explain each step of your analysis.

b. Based on cash flows obtained in part (a), calculate the economic value added (EVA) for each year of the project's life assuming that the capital invested depreciates by £100,000 a year (so it amounts to £650,000 at the end of year 1 and to £250,000 at the end of year 5).

c. Calculate the net present value (NPV) of the project based on cash flows obtained in (a) assuming that the cost of capital is 10%. Would you recommend investing in the project? Subsequently, calculate the present value (PV) of all EVAs. What is the relationship between the two obtained values (that is, the NPV and the PV of EVAs)?

d. Now, consider the possibility of outsourcing the production of widgets. In such a case, CD will be able to buy them from an outside supplier for £9.5 each without the need to install the production facility, to maintain working capital, or to use the warehouse. Which of the two alternatives (outsourcing vs. in-house production) is optimal?

e. Derive the relationship between the Equivalent Annual Benefit (EAB) figure and the annual EVAs generated by an investment project. In other words, what particular function of EVAs is the EAB?

Question 2 - Answer all parts of this question

Suppose that three states of the economy (Recession, Moderate growth and Boom) will occur with equal probabilities. The following further information on returns is available:

a. Calculate the expected rate of return and the standard deviation of returns of the stock of each firm.

b. Calculate the covariance between the returns of both firms.

c. Explain why covariance is not the best measure of the degree with which the prices of assets co-move. Which measure captures more precisely the degree of co-movement? Motivate your answer.

d. Assume that the beta of Welsh Power stock is 0.75 and that the standard deviation of the market return is 12%. Calculate the systematic risk of Welsh Power and, subsequently, conclude what proportion of the total risk of Welsh Power (measured as the standard deviation) is systematic.

e. Assuming that the CAPM holds, the risk-free interest rate is 5%, and that the market risk premium is 6%, determine whether Welsh Power stock is over- or undervalued. (Motivate your answer.)

f. Now, calculate the weights of Welsh Power and Scottish Utilities in the portfolio that minimises the standard deviation of returns. What is the standard deviation of the returns of such a portfolio?

Question 3 - Answer all parts of this question

Consider a firm whose expected market value next year equals £5 million. The firm has outstanding debt of £6 million due in one year. The firm can expand at a cost of £3 million payable now. The estimated market value of the firm following the expansion will equal £9 million in one year. (Assume that the information about the possible expansion is currently not publicly available and that the markets are efficient in the semi-strong sense.) Suppose that the risk-free interest rate is 10%, all cash flows are risk-free, and that there are no taxes.

a. If the firm chooses not to expand, what is the value of the firm's equity today? What is the value of its debt today?

b. What is the net present value (NPV) of the considered capacity expansion?

c. Suppose the firm considers raising £3 million from equityholders to finance the expansion. Calculate the value of the firm's equity and debt today if the expansion was decided upon. Would equityholders be willing to provide the £3 million necessary to finance the expansion in the first place? Explain your answer.

d. Assume that the creditors are willing to (unconditionally) reduce the face value of debt to £4 million. Would it be optimal for equityholders to invest in the expansion project in such a case?

e. What is the market consensus regarding the probability of the creditors being willing to reduce the face value of debt to £4 million if the current equity value is £1 million?

f. What is minimum reduction in the face value of debt (from the original £6 million) that would make equityholders invest in the project?