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FINANCE Case Study No

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MANAGERIAL FINANCE ASSIGNMENT:

CASE STUDY (QUESTION 1, 2 & 3)


CASE STUDY ASSIGNMENT AA701 (FIN 745)

TABLE OF CONTENT

Question 1a..............................................................................................................2

Question 2 a.............................................................................................................4

Question 2 b.............................................................................................................9

Question 2 c............................................................................................................11

Question 3 a............................................................................................................12

Question 3 b............................................................................................................13

Question 3 c............................................................................................................14

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

QUESTION 1 (a) (8 marks)

A RM1, 000 par value bond was issued 25 years ago at a 7 percent coupon rate. It currently
has 10 years remaining to maturity. Interest rates on similar debt obligations are now 12
percent.

i. Compute the current price of the bond using an assumption of annual payments.

Par Value RM1,000


Maturity date, n 35 years
Current year 10 years
Coupon Rate (CR) 7% RM70
YTM 12%

VP = RM70 (FVIFA 12%, 10) + RM1,000 (FVIF 12%, 10)

= RM70 (5.6502) + RM1,000 (0.3220)

= RM395.51 + RM322

= RM717.51

ii. If Mr Raub initially bought the bond at par value, what is his percentage loss (or gain)?

Bought at par value RM1,000


Current value RM717.51
Gain / (Loss) (RM282.49)

Percentage of loss or gain = RM717.51 – RM1,000 x 100 = - 28.3%


RM1,000

Thus, If Mr Raub initially bought the bond at par value, his percentage loss is -28.3%

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

iii. Now assume Mr Raub buys the bond at its current market value and holds it to maturity,
what will his percentage return be?

Bought at current value RM717.51


Value at maturity RM1,000
Gain / (Loss) RM282.49

Percentage of loss or gain = RM1,000 – RM717.51 x 100 = 39.37%


RM717.51

Thus, if Mr Raub initially bought the bond at par value, his percentage gain is 39.37%

iv. Although the same RM amounts are involved in part (ii) and (iii), explain why the
percentage gain is larger than the percentage loss.

Although the return differences in RM value are the same in part (ii) and part (iii), the
percentage gain (i.e. 39.37%) is larger than the percentage loss (i.e. 28.3%) because we
compared the return value (RM) over the cost of which the bond is bought. Thus, the
percentage of gain is larger since it was compared to the cost price which is lower (cost of
RM717.51) than the percentage of loss, compared to the cost price which is higher (cost of
RM1,000).

Part (ii) Part (ii)


Bought at or cost price RM1,000 RM717.51
Current value RM717.51 RM1,000
Gain / (Loss) (RM282.49) RM282.49

RM717.51 – RM1,000 x 100 RM1,000– RM717.51 x 100


% of Gain / (Loss) RM1,000 RM717.51
= (- 28.3%) = 39.37%

Smaller percentage loss Bigger percentage gain

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

QUESTION 2 (a) (10 marks)

KC Sdn Bhd is considering two new investments. Project U calls for the purchase of
earthmoving equipment. Project X represents an investment in a hydraulic lift. The
investment and cash flow patterns are as given in the Table below.

Year Project U Project X


0 2,000,000 2,000,000
1 500,000 1,600,000
2 600,000 500,000
3 700,000 400,000
4 1,000,000

i. Determine the net present value of the projects based on a zero discount rate.

To determine the net present value (NPV) for both Project U and Project X, the formula below is
applied; with initial investment (C o) = 2,000,000; discount rate (r) = 0%; cash flow (C) and time
(T) value corresponding to values in the table above.

NPVu = - RM 2,000,000 + RM 500,000 + RM 600,000 + RM 700,000 + RM 1,000,000

NPVu = RM 800,000 (for Project U with r = 0%)

NPVx = - RM 2,000,000 + RM 1,600,000 + RM 500,000 + RM 400,000

NPVx = RM 500,000 (for Project X with r = 0%)

ii. Determine the net present value of the projects based on a 9 percent discount rate.

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

To determine the net present value (NPV) for both Project U and Project X, the formula below is
applied; with initial investment (Co) = 2,000,000; discount rate (r) = 9%; cash flow (C) and time
(T) value corresponding to values in the table above.

Year Project U PVIF (9%, n) PVCF


0 -2,000,000 1.000 -2,000,000
1 500,000 0.9174 458,700
2 600,000 0.8417 505,020
3 700,000 0.7722 540,540
4 1,000,000 0.7084 708,400
NPVU 212,660

Year Project X PVIF (9%, n) PVCF


0 -2,000,000 1.000 -2,000,000
1 1,600,000 0.9174 1467,840
2 500,000 0.8417 420,850
3 400,000 0.7722 308,880
NPVX 197,570

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

iii. Which project will be chosen based on i? ii?

Based on the net present value (NPV) for both projects in (i) and (ii), Project U is chosen as its
NPV is higher with r = 0% and r = 9%. NPV is used to determine the current value of all future
cash flows including the initial capital investment, generated by a given project. Looking at the
table below, Project U clearly generates a higher return.

Project U Project X

NPV (r = 0%) RM 800,000 RM 500,000

NPV (r = 9%) RM 212,660 RM 197,570

iv. Which project will you choose if the internal rate of return on Project U is 13.25 percent
and the internal rate of return on Project X is 16.30 percent? Justify your answer.

Project U Project X

IRR 13.25% 16.30%

With the given internal rate of return (IRR) of 13.25 percent and 16.30 percent for Project U
and Project X respectively, I will choose Project X since the internal rate of return is higher.
The IRR rule is used to evaluate the attractiveness of projects or investments in capital
budgeting. The IRR is compared with the discount rate in order to evaluate a project. The
project is considered as feasible if the IRR is above the discount rate. If it is below the discount
rate, the project is considered not doable. The higher the IRR on a project, and the greater the
amount by which it exceeds the cost of capital, which also means that the net cash flow to the
company is higher.

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

v. If the two projects are not mutually exclusive, what would your acceptance decision be if
the cost of capital is 8 percent?

Project U Project X

NPV (r = 9%) RM 212,660 RM 197,570

IRR 13.25% 16.30%

Cost of capital 8% 8%

√ √

If the two projects are not mutually exclusive, I would accept both projects as both have
positive NPV and have IRR which are higher than the cost of capital of 8%. Many firms take their
cost of capital or more accurately, their weighted average cost of capital (WACC) as their
discount rate when budgeting for a new project.

vi. Would your decision differ if the annualized net present value is used since the two
projects have a different life span?

Project U Project X

NPV (r = 9%) RM 212,660 RM 197,570

PVIFA(n, i) 3.3121 2.5771


ANPV RM 64,207.00 RM 76,663.69

Yes, I would pick Project X instead, if the annualized net present value is used since the two
projects have different life span. Assuming the discount rate is as per (iv) , r = 9%, the ANPV X
yielded a positive value of RM 76,663.69 which means it is a more profitable investment
compared to Project U with ANPVU of RM 64,207.00, a lesser annualized net present value.

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

vii. Which project will be accepted if the 9 percent discount rate is used? Why?

Accept both Project U and Project X as both have positive NPV (profitable) and have IRR which
are higher than the cost of capital of 8%. In general, an investment whose IRR exceeds its cost
of capital adds value for the company. In addition, the annualized net present value (ANPV) for
both Project U and Project X are positive values.

Project U Project X
NPV (r = 9%) RM212,660 √ RM197,570
IRR 13.25% 16.30% √

Cost of capital 8% 8%

ANPV RM 64,207.00 RM 76,663.69 √


Accept project? √

However, if I have to prioritize one, then I would choose Project X as the ANPV X is higher than
ANPVU (greater projected earnings generated by Project X). Rule of NPV is more superior to the
IRR rule. However, the annualized net present value is the most accurate in this case as the two
projects have a different life span.

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

QUESTION 2 (b) (5 marks)

Tajuddin & Sons Incorporation has a capital structure which is based on 40 percent debt, 5
percent preferred stock, and 55 percent common stock. The pre-tax cost of debt is 7.5
percent, the cost of preferred is 9 percent, and the cost of common stock is 13 percent. The
company's tax rate is 39 percent. The company is considering a project that is equally as risky
as the overall firm. This project has initial costs of RM325,000 and annual cash inflows of
RM87,000, RM279,000, and RM116,000 over the next three years, respectively. What is the
projected net present value of this project?
To compute the net present value (NPV) of the said project, we need to consider the discount
rate. A common practice of many firms when budgeting for a new project is to take
the weighted average cost of capital (WACC) as the discount rate.

Weight Cost of Debt/Equity


Debt 40% 7.5% (Pre-Tax)
Tax Rate 39%
Equity 60%
Preferred Stock 5% 9%
Common Stock 55% 13%

WACC After Tax = 40% x [0.075 x (1 – 0.39)] + (5% x 0.09) + (55% x 0.13)
= 1.83% + 0.45% + 7.15%

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

= 9.43%
Next, with the initial cost of the project and future cash flows, we can compute the NPV as per
below:

Year Project PVCF

0 (Initial cost) - RM 325,000 - RM 325,000

1 RM 87,000 RM 79,502.88

2 RM 279,000 RM 232,986.85

3 RM 116,000 RM 88,521.51

NPV = RM76,011.24

NPVproject = - RM 325,000 + RM 87,000 + RM 279,000 + RM 116,000 = RM76,011.24


(1+0.0943)1 (1+0.0943)2 (1+0.0943)3

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

QUESTION 2 (c) (5 marks)

Deep Mining and Precious Metals are separate firms that are both considering a silver
exploration project. Deep Mining is in the actual mining business and has an after-tax cost of
capital of 12.8 percent. Precious Metals is in the precious gem retail business and has an
after-tax cost of capital of 10.6 percent. The project under consideration has initial costs of
$575,000 and anticipated annual cash inflows of $102,000 a year for ten years. Which firm(s),
if either, should accept this project?

To evaluate which firm should accept the project, NPV for both firms are computed using their
after-tax cost of capital as the discount rate. Applying the below formula for NPV, the NPV
attained for both firms are tabulated as per the following.

Deep Mining Precious Metals


Discount rate 12.8% 10.6%
Year 10 10
Initial costs -$575,000 -$575,000
Annual cash inflows $102,000 $102,000
NPV -$17,071 $35,912

NPVDM = - $17,071

NPVPM = $ 35, 912

In conclusion, Precious Metals is to accept the project as it has a positive NPV based on its
after-tax cost of capital. It is assumed that an investment with a positive NPV will
be profitable, and an investment with a negative NPV will result in a net loss. 

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

QUESTION 3 (a) (5 marks)

In exchange for a RM30,000 payment today, a well-known company will allow you to choose
one of the alternatives displayed in the table below. Your opportunity cost is 11%.

Alternatives Single Amount


A RM48,500 at end of 3 years
B RM74,000 at end of 9 years
C RM260,000 at end of 20 years

i. Find the value today of each alternative.

Alternatives Rate Years PV= FV x PVIF Present Value Acceptable?

√ A 11% 3 PVA = RM 48,500 x 0.7312 RM 35,463.20 > RM30,000


B 11% 9 PVB = RM 74,000 x 0.3909 RM 28,926.60 < RM30,000
√ C 11% 20 PVC = RM 260,000 x 0.1240 RM 32,240.00 > RM30,000

ii. Are all the alternatives acceptable, that is, worth RM30,000 today?

No, not all alternatives are acceptable. Alternative A and Alternative C are acceptable as their
present values are worth more than RM30,000; to be precise; they are worth RM35,463.20 and
RM32,240.00 respectively. Alternative B’s present value is RM28,926.60 which is less than
RM30,000 and thus, Alternative B is not acceptable.

iii. Which alternative, if any, will you take?

I will take Alternative A as it has the highest return within the shortest period (less risky).

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

QUESTION 3 (b) (5 marks)

You have just made a RM1,500 contribution to your individual retirement account. Assume
you earn a 12 percent rate of return and make no additional contributions. How much more
will your account be worth when you retire in 25 years than it would be if you waited another
10 years before making this contribution?

Alternatives Rate Years FV = PV x FVIF Future Value

A 12% 25 FVA = RM 1,500 x 17.000 RM 25,500.00

B 12% 15 FVB = RM 1,500 x 5.4736 RM 8,210.40

Difference = RM 17,289.60

The account is worth (RM 25,500.00 - RM 8,210.40 = RM 17,289.60) more when I retire. The
difference of ten years, if I have waited ten years to make a contribution , would result to
RM17,289.60 more in the retirement account.

The future value interest factor for the period of 25 years and 15 years make all the difference, having
both the contribution value and the rate of return kept constant.

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CASE STUDY ASSIGNMENT AA701 (FIN 745)

QUESTION 3 (c) (5 marks)

Jamaliah Ismail has been offered an investment that will pay her RM5,000 three years from
today.

i. If her opportunity cost is 8% compounded annually, what value should she place on this
opportunity today?

Years Rate PV = FV x PVIF Present Value

3 8% PV = RM 5,000 x 0.7938 RM 3,969

Jamaliah Ismail should place RM 3,969 or less on this opportunity today.

ii. What is the most she should pay to purchase this payment today?

The most she should place is RM 3,969 to purchase this payment today. This is because the
computation of the present value is done using the assumption that the rate of return is at least
8%, which is her opportunity cost. Anything above RM3,969 is considered not favourable.

iii. If Jamaliah can purchase this investment for less that the amount calculated in (ii) what
does that imply about the rate of return that she will earn on the investment?

It implies that the rate of return she will earn on the investment is higher than 8% (which is her
opportunity cost). It is assumed that when the rate of return is higher than the opportunity
cost, it is a good investment.

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