AF208 Major Assignment, Semester 1 2017

Full name: Isfandiyar Taunga student ID: s11101079

Due Date: 24th April 2017
Weighting: 20%
Value: 50 marks
Question 1 (15 marks)
California Mining is evaluating the introduction of a new ore production process. Two alternatives are
available. Production Process A has an initial cost of $25,000, a 4-year life, and a $5,000 net salvage
value, and the use of Process A will increase net cash flow by $13,000 per year for each of the 4 years
that the equipment is in use.
Production Process B also requires an initial investment of $25,000 will also last 4 years, and its
expected net salvage value is zero, but Process B will increase net cash flow by $15,247 per year.
Management believes that a risk-adjusted discount rate of 12 percent should be used for Process A.
If California Mining is to be indifferent (same NPV for Process A and B) between the two processes,
what risk-adjusted discount rate must be used to evaluate B?
Working Out:
First we have to find the net present value for Project A as it is calculable as all the necessary
variables are given in the question. Hence:
Project A - Production Process A
Year 0 Year 1 Year 2 Year 3 Year 4
IO -$25,000.00
Cash Flow $13,000.00 $13,000.00 $13,000.00 $13,000.00
Salvage value $5,000.00
Total Cash Flow -$25,000.00 $13,000.00 $13,000.00 $13,000.00 $18,000.00
Discount Factor 1 (1+0.12)^-1 (1+0.12)^-2 (1+0.12)^-3 (1+0.12)^-
4
Present Value -$25,000.00 $11,607.14 $10,363.52 $9,253.14 $11,439.33
Net Present Value $17,663.13

*The net present value is derived from first adding up all the present values for Year 1 to Year
4 and then subtract it with Year 0 present value.
Now that we get the net present value for Project A, then we can work out the discount factor for
Project B assuming that they both have the net present value of $17,663.13. Given that all the
variables are provided, but now we have to solve for the discount factor that will give us the same net
present value. Hence:
 Project B - Production Process B
Year 0 Year 1 Year 2 Year 3 Year 4
IO -$25,000.00
Cash Flow $15,247.00 $15,247.00 $15,247.00 $15,247.00
Total Cash Flow -$25,000.00 $15,247.00 $15,247.00 $15,247.00 $15,247.00
Discount Factor 1 (1 + x)^-1 (1 + x)^-2 (1 + x)^-3 (1 + x)^-4
Present Value -25,000 X1 X2 X3 X4
Net Present Value $17,663.13

From the above working, it shows that we must find for the discount factor that will gives us the net
present value of $17,663.13. This involves solving for x for which I use the online mathematic
calculator to solve for it and it gives 0.16. Hence inserting the X as 0.16 will then give us.
Project B - Production Process B
Year 0 Year 1 Year 2 Year 3 Year 4
IO -$25,000.00
Cash Flow $15,247.00 $15,247.00 $15,247.00 $15,247.00
Total Cash Flow -$25,000.00 $15,247.00 $15,247.00 $15,247.00 $15,247.00
Discount Factor 1 0.86206897 0.7431629 0.64065767 0.5522911
Present Value -25,000 $13,143.97 $11,331.00 $9,768.11 $8,420.78
Net Present Value $17,663.13

Therefore for the two projects to have the same net present value of $17,663.13, the discount factor for
project B will then be 0.16.
Online mathematics solver https is:
http://www.tiger-algebra.com/Algebra-
Calculator.aspx?gclid=CjwKEAjw_uvHBRDUkumF0tLFp3cSJACAIHMYRjlGT0dUTYZ7-
D0ycDkSudPSo5AM96mkzf0v4v2G-BoCWyPw_wcB
Question 2
ABC Corp Ltd has 10 million shares and $600,000 of debt (issues bonds @ 7% p.a.). EBIT is
projected to be $3 million. The company tax rate is 20%. Preference shares pay an annual dividend of
$100,000. Management is considering two options for capital restructure:
Option 1: The Company would borrow $3.5 million at 8% interest rate and use the proceeds to engage
in share repurchase program for 3.5 million shares at the current market price of $1

Option 2: Company can raise $3.5 million by issuing new shares at the current market price of $1.
Required:
a) What is the current EPS for shareholders? (5 marks)
b) What will be the EPS after the change in capital structure under option 1 and option 2? Hint: show
full working form EBIT to Net Profit. (12 marks)
c) Does it make sense for management to go ahead with either of the capital restructure options? If
yes, which of the two options is EPS accretive? (2 marks)
Response: Yes, but only concerning option #2 that is more make-sense to be implemented in
its capital restructuring process. The second option is more EPS accretive as its EPS is 0.8 whereas the
original capital structure EPS is 0.23 and the first option of a proposed capital structure is 0.1612
which both are lesser than the second option for capital structure.

d) What is meant by the term capital structure and what circumstances with respect to Weighted Cost
of Capital (WACC) and the value of the firm define an optimal capital structure? (6 marks)
Response: Capital structure is the mix of contracted debt and equity used by a firm that only
includes long-term funding. It is mostly can be identified as a firm own debt to equity ratio that
provide potential investors with information on how risky a targeted firm is for investing in. An
optimal capital structure is the mixed of contracted debt and equity that maximizes the value of the
firm. In terms of weighted cost of capital and the value of the firm, the optimal capital structure
consists of the right proportion of debt to minimize weighted cost of capital while maximizing the
highest value of the firm.

The weighted cost of capital is defined as the sum of each component cost of capital weighted by
each component costs proportion of the firms capital structure. Circumstances that must occurred
for to attain an optimal capital structure in terms of weighted cost of capital and value of firm include:
The weighted cost of capital debt financing is compared with other high performing firms
cost of capital debt financing within the same industry which should be at least equal to it.
The value of the firm should be maximized in any way possible while its debts are
minimized as low as possible.
Thus the weighted cost of capital debt financing should be least equal to with compared high
performing firms weighted cost of capital debt financing and the value of firm should be maximized
while its debts are minimized as low as possible are the circumstances which must occur within a firm
to attain its optimal capital structure.

Working Out:
Current Capital Proposed Capital Proposed Capital
Structure Structure # 1 Structure # 2

Debt $600,000.00 $3,500,000.00

Ordinary Shares $10,000,000.00 $10,000,000.00 $13,500,000.00
Total debt & Equity $10,600,000.00 $13,500,000.00 $13,500,000.00
# of ordinary shares issued 10000000 13500000 13500000
EBIT $3,000,000.00 $3,000,000.00 $3,000,000.00
Less Preference share | Interest exp $100,000.00 $280,000.00
Earning before tax $2,900,000.00 $2,720,000.00 $3,000,000.00
Less tax @ 20% $580,000.00 $544,000.00 $600,000.00
Net Income available to shareholders $2,320,000.00 $2,176,000.00 $2,400,000.00

EPS $0.23 $0.16 $0.80

From the above table, it shows that:

The current earning per share is $0.23 whereas the changes in earning per share for capital structure
option #1 is $0.16 and for structure option #2 is $0.80.
Question 3
A Makawerete Franchise expects to sell 50,000 big burgers annually. The special burgers can be
ordered by packs only, and each pack contains 10 buns. The cost of placing an order is $50, while the
storage cost is $0.50 perpack. According to their records the average daily sales of Big Burgers is 137,
the maximum-ever daily sales is 250, and the typical minimum sales is 50. Packs with the Big Burgers
normally arrive 10 days after the order. In the past the maximum delivery time was 20 days, and the
minimum was 7 days.
Required:
a) How much is the EOQ? (5 marks)
b) Calculate the reorder point and explain it briefly (5 marks)
c) How would the reorder point change, if the permanent safety stock is 100 packs? (5 marks)
d) What problems can arise from understocking of Burgers? (5 marks)
Working out:

2.. 2 50,000 50
a) Q = Q= = 3,162 burgers
0.5

b) The recorder point is the level of inventory which triggers an action to replenish that particular
inventory stock. It is a minimum amount of an item which a firm holds in a stock, such that
when stock falls to this amount the item must be reordered.

Recorder point formula:

Maximum Demand x Maximum lead time + Buffer Stock
= 250 x 20 + 50 = 5,050 burgers.
Hence if the number of burgers reached 5,050, reorder of burgers is necessary for preventing
understock issue.

c) If the permanent stock is changed to 100 then the recorder point will change to 5,100 that
implies a difference of only 50 quantities of burgers as calculated:
= 250 x 20 + 100 = 5,100 burgers.

d) The problems associated with understocking of the burgers mainly includes financial loss of
any kinds relevant with storage shortage that includes of:
Missing out of sale: The most obvious issue to be faced with understocking is the
missing out of sale if consumers demand is not met by supply at hand.
Losing of consumer loyalties: If this issue is prolonged, then it is highly possible that
consumers will then look for other businesses that can provide for their demands promptly with
quality as well.
Lower business typical and increasing profit: By viewing the business itself, the issue of
understocking will impact their profit as their production will be on hold and while production
is on hold, its limits the number of product it can market hence affect their net profit.
Business operation will be affected: The business operation inflow and outflow will be
impacted as well as clearly there is not enough raw material to do production with. Managers
will cut down any unnecessary expenses in order to make up for the decreased profit that can
affects employees as well.