Question 1

Orange, Inc. is currently a market leader in biomedical test equipment, but the firm’s future has never been more uncertain, as it is contemplating two projects that fall into the “unchartered waters” category. The CEO, Tim Jobless, who also owns 50.1% of the firm’s 1 million outstanding shares, often disagrees with the rest of the shareholders.

The first project under evaluation is production of the ePhone, a smartphone that is more smart than phone. Its marketing department has engaged Ripoff Consults Ltd, a marketing research firm, that estimates ePhone annual unit sales to be 20,000 at the planned price point of $500 per phone over the next ten years, after which fickle consumers are likely to move on to the next big thing. Orange Inc’s operations managers estimate variable costs to be $200 per phone, and annual fixed costs to be $1 million. Initial investment in fixed assets and net working capital are $2.5 million and $500,000 respectively. The fixed assets are expected to be worthless by the end of the project and the net working capital investment non-recoverable.

Tim Jobless’ pet project under consideration, however, is his self-proclaimed revolutionary eSlate, which is basically four ePhones in a sleek exterior—minus the phone. As a gesture of goodwill, Ripoff Consults Ltd estimates at “no additional charge” the annual unit sales of the eSlate to be 8,000 units at the target price of $600 per unit over the next five years. Variable costs are expected to be $300 per unit, and annual fixed costs $500,000. Net capital spending and changes in net working capital for this tablet project are exactly the same as those for the ePhone project, and fixed assets will be depreciated on a straight-line basis to zero book value over the respective projects’ lives. Despite having completed its end of the deal, Ripoff Consults Ltd allows Orange, Inc. to delay for five years’ payment of their consulting fee of $800,000.

Undertaking the eSlate project will result in a 20 percent reduction of ePhone sales (i.e., some prospective customers of the ePhone are likely to use the smartphone as everything but a phone) whereas undertaking the ePhone project will not result in cannibalization of eSlate sales. Should both projects be undertaken, this will result in annual fixed cost economies of $300,000.

Orange, Inc. is currently an all-equity firm but plans to raise debt in the near future to achieve their desired debt-equity ratio of 1.0. Orange, Inc.’s beta is 2.0, while unlevered Cherry, Inc., a likely competitor that specializes only in smartphones and tablets has a beta of 1.5. The expected market portfolio return is 13%, and the risk-free return is 5%. The marginal corporate tax rate is 30%. Assume that Orange, Inc. can borrow at the risk-free return and that financial distress is costless.

For the coming year, the annual dividend by Orange, Inc. will be 20% of the yearly CFFA attributable to the project(s), if undertaken. Tim Jobless is planning to increase the dividend payout to 30% for the coming year, but dissenting shareholders are satisfied with the current dividend policy and propose that Time Jobless relies on “homemade dividends” instead. Analysts expect Orange, Inc.’s target stock price to be $20 in a year.

(a) Calculate and justify discount rates for the ePhone and eSlate projects. (12 marks)

(b) What is the optimal investment decision for Orange, Inc.? (16 marks)

(c) (i) Show how Tim Jobless can rely on “homemade dividends” to effectively create his desired payout. (7 marks)

(ii) Given that Tim Jobless and other shareholders do not see eye to eye on matters of importance to the company, show how reliance on “homemade dividends” for the coming year may not be Tim Jobless’ best interest. (5 marks)

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Question 2

You work in the treasury department of a manufacturing company and have been tasked to prepare a short-term financial plan for the coming year. The projected sales forecasts for the next five quarters are, respectively, $210m, $180m, $245m, $280m, and $240m. The firm sells on credit and takes, on average, 30 days to collect from its customers; $68m in receivables are currently outstanding. Also, the firm orders a quarter in advance on credit—purchases in a given quarter is 60% of next quarter’s sales and the firm typically takes 50 days to pay its suppliers. Quarterly selling, general, and administrative expenses are estimated to be 25% of corresponding quarterly sales, and the firm expects to pay quarterly dividends of $12m. The purchasing manager plans to acquire a high-performance machine in the second quarter for $160m.

The firm would like to maintain a consistent cash balance of $10m in a non-interest bearing bank account. Although it currently has $64m in cash, it would like to redirect excess cash to short-term money market investments. Shortfalls, should they occur, are to be financed to achieve the target cash balance as well. 90-day commercial paper with a face value of $100,000 is selling at $98,814 and Treasury bills of a similar maturity are selling at 99.11% of par value; yields of both instruments are expected to remain stable over time. The firm has a $400m line of credit with a quoted quarterly rate of 1.6% and a compensating balance of 5%, which should be sufficient for its short-term financing needs. However, it also has the option to factor its receivables at a 1.5% discount.

(a) Compare the yields on the 90-day commercial paper and Treasury bill. In which money market instrument should the firm invest its cash surpluses, assuming yield is the only consideration? (5 marks)

(b) Compare the effective rate for the line of credit and the factoring of receivables. Which is the less costly option for the firm to finance its cash deficits? (9 marks)

(c)Show how the firm’s accounts receivables is expected to change over the next four quarters. (5 marks)

(d) Show how the firm’s accounts payables is expected to change over the next four quarters. (7 marks)

(e) Using your answers to parts (a) through (d), construct a short-term financial plan for the next four quarters, including:

(i) all cash receipts (2 marks)

(ii) all cash disbursements (6 marks)

(iii) net cash flow (1 mark)

(iv) how the amount of short-term investments changes (3 marks)

(v) how the amount of short-term debt changes (3 marks)

(vi) how the target cash balance is maintained (5 marks)

Question 3

As part of a capital raising exercise, Immaturity, Inc. sold 20-year, 6% semi-annual coupon bonds with a face value of $1,000 at a discounted price of $950 each.

(a) Calculate the yield to maturity on these bonds. (3 marks)

(b) Suppose an investor that buys these bonds reinvests the coupon payments received. How much in total would the investor have at maturity if he reinvested his received coupons at:

(i) 4.30%, compounded semiannually? (3 marks)

(ii) 6.45%, compounded semiannually? (3 marks)

(c) What is the actual average return when coupons are reinvested as in parts 3(b)(i) and 3(b)(ii), expressed as an annual quoted rate with semiannual compounding? The yield to maturity is often interpreted as the average annual expected return if an investor holds the bond until it matures. What is the implicit assumption in this interpretation? (5 marks)

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