Question

Norwich Industries, an established manufacturer of printing equipment, expects its sales to remain flat for the next three to five years due to both weak economic outlook and an expectation of little new printing technology development over that period. Base on that scenario the firm’s management has been instructed by the Board of directors to institute that will allow it to operate more efficiently, earn higher profits, and most important maximize shareholder wealth. In this regard, the firm’s chief financial officer (CFO), Ron Lewis, has been tasked to evaluate the firm’s capital structure, dividend policy, and possible capital projects. Currently the firm has a fixed total capital of $10, 000,000, which is made up of 10 percent debt and 90 percent equity. The firm has 100,000 outstanding ordinary shares and no preference shares. Although Lewis feels that the firm’s current policy of paying out 60 percent of each year’s earnings in dividends is appropriate, he believes that the current capital structure may lack adequate financial leverage. In order to evaluate the firm/s capital structure, Lewis is considering two alternative capital structures – A (30 percent debt ratio) and B (50 percent debt ratio). The interest rate on current debt is 10 percent and is believed to remain the same. Lewis expects the firm’s current earnings before interest and taxes (EBIT) to remain at $1,200,000. The firm has a tax rate of 40 percent. Norwich is considering replacing one of its printers with either of two printers – printer A or printer B. Printer A is highly automated, computer controlled; printer B is less expensive and uses standard technology. In order to analyze these alternatives, Lewis prepared estimates of the initial investment and the relevant incremental cash inflows associated with each printer. These are summarized in the following table: Printer A Printer B Initial investments $660,000 $360,000 Year Profits after tax Cash inflows Profits after tax Cash Inflows 1 $5,000 $128,000 $5,000 $88,000 2 10,000 182,000 15,000 120,000 3 20,000 166,000 10,000 96,000 4 65,000 168,000 20,000 86,000 5 210,000 450,000 100,000 207,000 2 Note that Lewis planned to analyze both printers over a five -year period. At the end of that time the printer will be sold, thus accounting for the large fifth-year cash inflow. Lewis decided to apply the firm’s 13 percent cost of capital when analyzing the printers. Norwich required a maximum payback period of 4.0 years. Suppose the following table summarizes the net present values and associated probabilities for the various outcomes for the two printer alternatives. Net present value Market outcome Probability Printer A Printer B Very poor 5% -$6,000 $500 Poor 15% 2,000 4,500 Average 60% 8,500 8,000 Good 15% 15,000 12,500 Excellent 5% 23,000 16,500 Required: Question 1 (a) How much debt is used in the current and proposed capital structures? (b) What is the expected return on assets? (c) Assuming that the share price stays the same, calculate the earnings per share for the three financing alternatives. (d) What is the level of EBIT at the point of indifference? (e) Find the dividend cover for the three financing alternatives Question 2 (a) Use the payback period to access the acceptability and relative ranking of each printer. (b) Use the following capital budgeting techniques to access the acceptability and relative ranking of each printer: (i) Discounted payback period (DPP) (ii) Net present value (NPV) (iii) Profitability index (PI) (c) Summarize the preferences indicated by the techniques used in (a) and (b) and indicate which printer you would recommend, if either, if the firm has (i) unlimited funds or (ii) capital rationing. 3 Question 3 (a) What the most likely NPVs? (1 mark) (b) Calculate the expected NPV for each printer. (c) Calculate the range of NPVs for each printer. (1 mark) (d) Calculate the standard deviations of NPV for each printer. (e) Which printer has higher relative risk

Answer 1

Answer for Q1 (a)

Debt used in Current scenario - 10% of $10,000,000 = $1,000,000

Debt used in the proposed scenario -

A option (30%) - $ 3,000,000

B option (50%) - $ 5,000,000

Q1 (b)

Expected Roa - Earning / total capital employed

EBIT - $1,200,000

Less Interest - $100,000

EBT - $1,100,000

Less Tax (40% )- $ 440,000

EAT -. $ 660,000

Thus ROA - $660000/1,000,000 = 6.6 %

Q1 (c) - Calculation of earning per share

EAT - $ 660,000

Dividend distribution (60% ) - $ 396000

No of share - 100000

EPS - $ 3.96

Under Part A alternative - Eps will be ($1,200,000 - 300000 = $900,000 , Less Tax 40% - $360,000

Eat = $540,000

Dividend - 60%

EPS - $ 324000/ 100000

Thus - $3.24

Part B , alternative

EPS will be ( $1,200,000 - 500,000 =$ 700,000 , Less 40% Tax - $280,000

EAt = $420,000

Thus Eps is $4.20