Corporate Finance Assignment ABC Corporation

Question :

1. Construct the firm’s income statements and balance sheets for 2009 and 2010.

2. Calculate the firm’s cash flows (OCF, NCS, change in NWC, CFC, CFS, and FCF) for 2010.  Assume all values are year-end values.

3. Calculate the company’s internal growth rate (IGR) and sustainable growth rate (SGR).

4. Use the SGR to forecast three years of financial statements.  List all assumptions made to create the forecasts.  Use long-term debt as the plug.

5. Use the internal growth rate (IGR) as a permanent growth rate in dividends and estimate the stock price using the single-stage dividend growth model. Use the financial data to find the current dividend per share.  There are 3 million shares outstanding.  What does the dividend growth model predict the stock price to be? How does the required return break down into its income (DY) and price (CGY) components?

6. If the actual stock price is $50, which of the following might be a valid reason for the large discrepancy between the predicted stock price from above and the actual stock price of $35?

a. The market expects the company to grow at a faster rate than the internal growth rate.

b. The market expects the company to grow at a slower rate than the internal growth rate.

c. The market requires a higher return than the 10% you used to find the stock price?

d. The company is doing very poorly.

e. The company is doing very well.

7. ABC corporation has existing property and equipment that is not in use.  The company is considering the use of this property and equipment.  One option is to use the property and equipment to produce a new product.  Estimates for demand of this product are 30,000 units annually for the first 5 years and 20,000 units annually for the following 6 years.  Beyond that, the product is considered to be obsolete and production will cease.  Price and variable costs would be $100 and $65, respectively.  Fixed costs would be $225,000 per year.  If they take this option, they must buy additional equipment for a total of $2 million.  This equipment will be depreciated straight-line over a 15 year period of time.  When the project is ended (in 11 years), it is expected they will be able to sell the equipment for $130,000.  This option also requires an initial net working capital investment of $400,000.  This initial NWC investment can be reduced to $300,000 when sales drop (i.e. from year 5 to year 6).  The net working capital will be fully recouped at the end of the project.  This project is riskier than the average project for the company.  Management has determined that the appropriate discount rate to use will be 12%.  

a. What is this project’s OCF for years 1-5?

b. What is this project’s OCF for years 6-11?

c. What is this project’s FCF for year 0?

d. What is this project’s FCF for years 1-5?

e. What is this project’s FCF for year 6?

f. What is this project’s FCF for years 7-10?

g. What is this project’s FCF for year 11?

h. What is the project’s NPV?

i. What is the project’s break-even price? 

j. Does this company have the internal resources to finance this project?

 Yes

 No

Answer :

Q 1:

1. Income Statement:

2. Cash Flow:

Operating Cash Flow (OCF) = EBIT + Depreciation – Taxes = 345 + 100 – 116 = $329

NCS = Net fixed assets at year-end – Net fixed assets at the beginning of the year + Depreciation = 2000 – 1800 + 100 = $300 (Alan, 2014)

Net Working Capital (NWC) = Changes in current assets – Changes in current liabilities = (700 – 600) – (550 – 450) = 0

CFS = Dividends – Net new equity issued = 0 – (335 – 500) = $165

CFC = Interest – Net new borrowing = 55 – (975 – 900) = - $20

FCF = EBIT (1 – Tax) + Depreciation – Capex – Changes in working capital = 345 (1 – 0.4) + 100 – 300 – 0 = $7

3. Internal Growth Rate (IGR) & Sustainable Growth Rate (SGR):

The formula for calculating IGR is Return on Asset (ROA) multiplied by the Retention Ratio.

ROA is determined as net income divided by average total assets. Here, Net income will be (Sales – COGS - Other expenses – Depreciation – Interest Expense).

Net income for 2009 = 1000 – 500 – 100 – 100 – 50 = $250

Net income for 2010 = 1112 – 556 – 111 – 100 – 55 = $290

Total assets is the sum of total current assets and net fixed assets.

TA (2009) = 600 + 1800 = $2400

TA (2010) = 700 + 2000 = $2700

So, ROA is 290/ ((2400+2900)/2) which came out as 10.94%.

The retention ratio is given as (Net income – Dividend) divided by the net income which can be calculated as (290 – 0)/ 290 = 100%

So, IGR is 10.94%*100% = 10.94%

The formula for calculating SGR is Return on equity (ROE) multiplied by Retention ratio.

Return on Equity can be determined by Net income divided by Shareholder’s funds. Shareholder’s funds in this case is sum of common stock and retained earnings which is coming as (335 + 840) = $1175.

Now, ROA can be given as 290/ 1175 which is 24.68%.

So, SGR is 24.68% * 100% = 24.68%

4. Forecasted Financial Statements:

Assumptions made while calculating forecasted financial statements are:

• Sales and COGS are increasing with SGR of 24.68% while other expenses have been calculated by taking 10% of sales value as was done in actual financials.

• We have assumed to have constant depreciation charges across three years even though the value of fixed assets has changed.

• Value of interest and long term liabilities have been kept as constant.

5. The value of stock price can be determined by below given formula.

Stock price = (Net income (1 + Growth Rate) / No. of outstanding shares)/ (Equity cost – Growth rate) = (290 (1 + 0.1094) / 3) / (0.2468 – 0.01094) = $780.50

As retention ratio in this case is 100%, no dividend will be paid by the company. Also, as dividend is nil we cannot use dividend growth model in order to calculate the stock price.

Required return of income will be CGY which is 10.94% because dividend is nil in this case.

6. Here, the stock price predicted by investor is $50 but the actual price is $35, investor is expecting different growth as compared to what assumed by the market. 

Now, stock price gets calculated as dividend divided by (Required rate of return – growth rate of return), so higher the growth rate, higher the stock price.

Thus, the answer is that market is expecting company to grow at a slower rate than the internal rate of return. Answer is (b).

Q 2:

a. OCF of project for first five years is given as $825,000.

b. OCF of project for 6th to 11th year is given as $475,000.

c. FCF of project for year 0 will be the purchase price of equipment which is $2 million.

d. FCF of project for first five years is given as $425,000

e. FCF of project for year 6 is $175,000.

f. FCF of project for year 7 to year 10 has been given as $75,000.

g. FCF of project for year 11 is $40,05,000

h. Net present value of project can be calculated as Present value (Cash Inflow – Cash Outflow). This is given as (2887443.3 – 2000000) = $887,443.3

i. Break-even price for the project is the price at which present value of cash inflow becomes equal to present value of cash outflow. By looking at the above table, we can see that the breakeven price in this case would be $94.2672.

j. Company has internal resources in the form of unused property and equipment to finance their project (Eva, 2017). 

References

Alan, J. M. (2014). Essentials of Investments, 5th ed. McGraw-Hill Irwin. p. 455. ISBN 0-07-251077-3.

Eva, K. (2017). Interpretation and Application of International Financial Reporting Standards. John Wiley & Sons. pp. 91–97. ISBN 978-0-471-79823-1.