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Finance Questions

QUESTION 1

  1. NPV ANALYSIS OF NEW MACHINE

NEW MACHINE

 

T0

T1

T2

T3

Initial Investment

            (12,000,000)

     

At Sale Value Old Equip

                 1,500,000

     

Cost Savings

       

Skilled Labor

 

               336,960

               347,069

               357,481

Unskilled Labor

 

               702,000

               723,060

               744,752

Running Cost

 

               500,000

               535,000

               572,450

Annual maintenance cost

300,000

345,000

396,750

Major Service

   

           1,000,000

 

Less Incremental Costs

     

Annual maintenance cost

            (300,000)

            (315,000)

            (330,750)

Major Service

   

         (2,000,000)

 

Running Cost

 

         (1,000,000)

         (1,050,000)

         (1,102,500)

Training Cost

                  (150,000)

            (154,500)

            (159,135)

 

Skilled Labor

 

            (673,920)

            (694,138)

            (714,962)

Unskilled Labor

 

         (3,510,000)

         (3,615,300)

         (3,723,759)

EBIT

 

         (3,799,460)

         (4,883,444)

         (3,800,538)

Tax Rate at 27.50%

 

         (1,044,852)

         (1,342,947)

         (1,045,148)

PAT

 

         (4,844,312)

         (6,226,391)

         (4,845,686)

OCF

            (10,650,000)

         (4,844,312)

         (6,226,391)

         (4,845,686)

NPV at 9%

            (24,076,710)

     

 

The NPV is negative at rate of 9% with $-24,076,710. This means that the cost of new machine that would incur to the company if it chooses to invest is $24,076,710.

  1. NPV ANALYSIS OF OLD MACHINE

 

OLD MACHINE

 

t0

t1

t2

t3

Annual Maintenance

 

                (300,000)

                 (345,000)

                        (396,750)

Major service

   

             (1,000,000)

 

Running Cost

 

                (500,000)

                 (535,000)

                        (572,450)

Skilled Labor

 

                (673,920)

                 (694,138)

                        (714,962)

Unskilled Labor

 

             (1,404,000)

             (1,446,120)

                     (1,489,504)

Total Cost

 

             (2,877,920)

             (4,020,258)

                     (3,173,665)

Tax Rate at 27.50%

 

             (791,428.0)

         (1,105,570.8)

                     (872,758.0)

Total Cost After Tax

 

         (3,669,348.0)

         (5,125,828.4)

                 (4,046,423.3)

NPV at 9%

($10,805,263)

     

 

The NPV is negative at rate of 9% with $-10,805,263. This means that the cost of old machine that would incur to the company if it chooses to keep old machine is $10,805,263.


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  1. RECOMMENDATION:

The NPV is the capital budgeting technique that calculates the present value of net cash inflows that are generated by the project including its salvage value less the initial investment on the project. Since the NPV for the new machine is given to be -$ (24,076,710) and the NPV of old machine is given to be -$(10,805,263), so it seems to stick with old machine as it will cost less for the company. Although the new machine is saving 50% of the labor cost, still the incremental costs are more as compared to the benefits it might bring.

  1. DIFFERENCES AND CHOICE:

The cost of new machine is $13,271,447 more than the old machine cost over next three years. This means that by installing new machine, the company will incur $13,271,447 extra cost given the rate of 9% WACC. It is recommended to the company to carry on with the older machinery as the NPV of cost is much lower for the older machine as compared to new machine.

Part B)

  1. WACC increased by 1%

New NPV of Old Machine:

NPV

($10,612,130)

 

New NPV of New Machine

NPV

            (23,840,333)

The NPV of new machine has fallen from $10,805,263 to $10,612,130 and the NPV of old machine has fallen to $23,840,333 from $24,076,710. This is because WACC is the rate that is used by the firms to discount the cash flows to find NPV. Both NPV and WACC are found to be inversely related, any increase in WACC will cause a reduction in NPV. This is because a higher interest rate means the company will have to set aside less today for earning a specified amount in future. With higher WACC, the projected cash flows will be discounted today at a higher rate, thus reducing the overall net present value and vice versa.

  1. Base Rate Entity

If the firm enters into base rate entity, its tax rates are set to reduce to 27.5% for year 2019-2020. However, for the current scenario, the tax rate is already set at 27.5%, hence no changes will incur today. However, for 2020-21 and 2021-22 the tax rates will be 26.0% and 25.0%. Hence, following are the new NPVs on given new rates. Both NPVs have fallen with decrease in tax rates.

New NPV of Old Machine

NPV

($10,693,240)

New NPV of New Machine

NPV

            (23,941,688)

 

  1. Increase in Salary

With the increase in salaries by 5% annually, the NPV has risen for both the machines from $10,805,263 and $24,076,710 to $10,934,965 and $24,273,016 respectively. This is because the operational costs have risen and more cost is incurring in future to be discounted at 9%.

New NPV of Old Machine

NPV

($10,934,965)

New NPV of New Machine

NPV

            (24,273,016)

 

  1. Change in Sale Price of Old Machine

This will only affect the NPV of new machine to reach at $22,76,710 from $24,076,710. This reduction is because the initial investment has been lowered by further $1,500,000.

New NPV of New Machine

NPV

            (22,576,710)

  1. The All Four Effects

With all four effects i.e. change in sale value, increase in WACC, changes in Tax rates and increase in salaries, the NPV of new machine has fallen from $24,076,710 and the NPV of old machine has fallen from $10,805,263 to $10,627,139.

New NPV of Old Machine

NPV

($10,627,139)

New NPV of New Machine

NPV

            (22,396,776)

 

  1. Other Factors to Consider

The management can take into account the revenue streams, changes in tax regimes, changes in salaries, depreciation and other costs that are related to new and old machines while making decisions about which machinery to choose.

QUESTION 2:

  1.  

Monthly Closing and Opening Prices of WOW

Months

Opening

Closing

January

27.17591

27.16182

February

27.14

27.2075

March

26.6995

26.7155

April

26.75316

26.83895

May

28.69522

28.64913

June

29.353

29.3935

July

30.75727

30.71182

August

29.26174

29.25435

September

27.9085

27.959

October

27.88583

27.96583

November

29.11381

29.1481

December

28.79737

28.83789

 

The rates are calculated by taking the average of day one opening price of month till last day opening price of month. For example, the first value is calculated by taking the average of the opening and closing values incurred in January.

Monthly Closing and Opening Prices of RIO

Months

Opening

Closing

January

56.03143

55.94857

February

55.84368

55.79316

March

52.00619

51.88429

April

53.98286

53.91

May

56.99545

57.01045

June

56.97381

57.02762

July

54.56286

54.61286

August

49.55043

49.45348

September

48.79684

48.74579

October

49.38609

49.22609

November

49.51714

49.60381

December

47.49722

47.29

 

The rates are calculated by taking the average of day one opening price of month till last day opening price of month. For example, the first value is calculated by taking the average of the opening and closing values incurred in January.

Monthly Closing and Opening Prices of All Ordinary Index

Months

Opening

Closing

January

6170.81816

6172.249978

February

6047.72002

6041.550024

March

6023.455029

6012.750024

April

5935.815764

5946.494706

May

6163.943508

6166.200025

June

6205.989966

6214.279981

July

6331.695468

6335.327282

August

6382.226096

6384.930431

September

6304.349951

6299.299951

October

6055.520813

6039.170817

November

5867.061895

5857.00951

December

5692.520996

5690.294691

The rates are calculated by taking the average of day one opening price of month till last day opening price of month. For example, the first value is calculated by taking the average of the opening and closing values incurred in January.

  1. MONTHLY HOLDING RETURNS

RIO

Months

HDR %

January

4.00%

February

-2.67%

March

-2.96%

April

6.25%

May

3.62%

June

-3.28%

July

2.49%

August

-9.06%

September

9.72%

October

-3.14%

November

-6.74%

December

-0.58%

Holding Period Returns =  =  = 4.00%

Whereas, selling Price is closing price at each month.

WOW

Months

HDR %

January

0.37%

February

-1.06%

March

-2.63%

April

6.38%

May

2.41%

June

7.24%

July

-1.54%

August

-5.95%

September

0.67%

October

3.05%

November

1.47%

December

0.89%

Holding Period Returns =  =  = 0.70%

Whereas, selling Price is closing price.

All Ordinary Index

Months

HDR %

January

0.51%

February

-1.99%

March

-3.40%

April

3.45%

May

0.85%

June

2.71%

July

1.22%

August

0.97%

September

-1.59%

October

-6.32%

November

-2.98%

December

-0.69%

Holding Period Returns =  =  = 0.51%

Whereas, selling Price is closing price.

  1. GRAPHS

 

  1. STANDARD DEVIATIONS
 

RIO

WOW

All Ord

Standard Deviation

5.27%

3.50%

2.67%

 

  1. ANNUAL HOLDING RETURNS
 

RIO

WOW

All Ord

Annual HDR

-0.20%

0.94%

-0.61%

F & G. COVARIANCES AND BETAS

 

RIO

WOW

Standard Deviation

5.27%

3.50%

Covariance

0.04%

0.02%

Variance

0.28%

0.12%

Beta

0.153

0.196

RIO Beta =  =  = 0.153

WOW Beta =  =  = 0.196

  1. CAPM MODELS

RIO

CAPM = Rf + β (Rm-Rf)

CAPM = 2.5% + 0.153 (-0.20% - 2.5%)

CAPM = 2.9131

WOW

CAPM = Rf + β (Rm-Rf)

CAPM = 2.5% + 0.196 (0.94% - 2.5%)

CAPM = 2.19424

  1. INVESTMENT DECISION

As a rational investor, I will choose to invest in WOW because it has higher beta of 0.196 and higher holding return of 0.94% as compared to RIO which has a beta of 0.153 and the holding return of -0.20%.

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