Assignment

As the manager of the pension fund, considering different investment options will help you make better decisions for your company and your clients. Please respond to the following questions, providing supporting data and showing your calculations.

Question 1: If the pension plan invests $95 million today in 10-year US Treasury bonds (riskless investment with guaranteed return) at an interest rate of 3.5 percent a year, how much will it have by the end of year 10?

Question 2: If the pension plan needs to accumulate $14 million in 13 years, how much must it invest today in an asset that pays an annual interest rate of 4 percent?

Question 3: How many years will it take for $197 million to grow to be $554 million if it is invested in an account with a quoted annual interest rate of 5 percent with monthly compounding of interest?

Question 4: The pension plan also invests in physical assets. It is considering the purchase of an office building today with the expectation that the price will rise to $20 million at the end of 10 years. Given the risk of this investment, there should be a yield of 10 percent annually on this investment. The asking price for the lot is $12 million. What is the annual yield (internal rate of return) of the investment if the purchase price is $12 million today and the sale price 10 years later is $20 million? Should the pension plan buy the office building given its required rate of return?

Question 5: The pension plan is also considering investing $70 million of its cash today at a 3.5 percent annual interest for five years with a commercial bank. The bank in return will pay an annuity due at the beginning of year 6 for the next 15 years. How much will the annual payments be from years 6 to 21, if the rate at which these payments are discounted is also 3.5 percent?

Question 6: The pension plan is about to take out a 10-year fixed-rate loan for the purchase of an information management system for its operations. The terms of the loan specify an initial principal balance (the amount borrowed) of $4 million and an APR of 3.75 percent. Payments will be made monthly. What will be the monthly payment? How much of the first payment will be interest, and how much will be principal? Use the Excel PMT function to provide the answers to these questions.

As the manager of the pension fund, you are frequently targeted by software companies peddling investment simulation software. You have finally narrowed down your choice to two applications. You need to analyze the options by calculating NPV, IRR and Payback Period based on their purchase price and savings to your company over time. Your staff has prepared a cash-flow table to help you. Year zero shows the purchase price of each application, and the figures listed for years 1-3 represent the savings to the company in successive years.

You are considering three possible scenarios.

Question 7: If the payback period is two years, which application should be selected?

Question 8: If the required rate of return is 15 percent, which application should be selected?

Question 9: If the selection criterion is IRR, which application should be selected?

Respond to the questions 7, 8, and 9 above by submitting a single, integrated report that shows your supporting data and calculations. Finally, provide a recommendation and rationale for purchasing either Application I or Application II.

Another one of your responsibilities as CFO is to determine the suitability of new and current products. Your CEO has asked you to evaluate Android01. That task will require you to combine data from your production analysis from Project 2 with data from a consultant's study that was done last year. Information provided by the consultant is as follows:

• initial investment: $120 million composed of $50 million for the plant and $70 million net working capital (NWC)
• yearly expenses from year 1 to year 3: $30 million
• yearly revenues from year 1 to year 3: $0
• yearly expenses from year 4 to year 10: $55 million
• yearly expected revenues from year 4 to year 10: $95 million
• yearly expenses from year 11 to year 15: $60 million
• yearly expected revenues from year 11 to year 15: $105 million
• Revenues will vary between $80 million (minimum) and $105 million (maximum) for years 4 to 10, and between $90 million (minimum) and $110 million (maximum) for years 11 to 15.

This concludes the information provided by the consultant.

You also have the following information:

• The asset beta of the project is 1.5. The expected return to the market is 8 percent, and the market risk premium is 5 percent.

• Assume that both expenses and revenues for a year occur at the end of the year. NWC pays the bills during the year, but has to be replenished at the end of the year.

• Android01 is expected to cannibalize the sales of Processor01 while also reducing the variable costs for the production of Processor01. From years 4 to 10, revenues are expected to fall by $5M, whereas variable costs will go down by $1 million. Processor01 is to be phased out at the end of the 10th year.

• At the end of the 15th year, the plant will be scrapped for a salvage value of $10 million. NWC will be recovered.

Question 10: Calculate the expected cash flows from the Android01 project based on the information provided.

Question 11: Calculate the NPV for a required rate of return of 6.5 percent. Also calculate the IRR and the Payback Period.

The firm decides to raise $30 million by selling equity and debt. The investment bankers hired by your firm contact potential investors and come back with the following numbers:

• Debt that pays $1 million coupons a year and $18 million maturity value after 10 years will sell for $20 million.

• Equity that pays expected dividends of $1.2 million starting next year and growing at a rate of 3 percent per year thereafter sells for $10 million.

Question 12: Calculate the cost of debt, equity, and the WACC.