MBA6002 Corporate Finance Case Study 2 Sample

MBA6002 Corporate Finance Case Study 2

Case Study 1

Mr. Vinnie Totti is seeking to purchase an apartment for $200,000. The Wakpak Bank is prepared to lend Vinnie 75% of the purchase price with the remaining amount to be funded from personal savings. The loan repayments to Wakpak are to be made monthly (with the first payment due one month after the loan is provided) for a term of 15 years, and the stated annual interest rate quoted by Wakpak is 9.25% p.a. compounded monthly.

No Question

a What will be the amount of Vinnie’s monthly loan repayments?

b Immediately after paying the 36th loan repayment, Vinnie wishes to pay out the loan in full. How much will be needed to pay out the loan at this time?

c (i) Discuss whether there are benefits to Vinnie from changing the frequency of loan repayments from monthly to fortnightly (with each repayment now being 50% of the monthly payment calculated in part a) of this question), as has been suggested by his colleagues at the local produce market where he works on a casual basis as a delivery driver. (Students should write no more than 100 words for this part of the question).

c (ii) Would there be any disadvantages to Vinnie arising from increasing the frequency of making loan repayments from monthly to fortnightly as indicated in part c)
(i) of this question? (Students should write no more than 100 words for this part of the question).

d (i) Using the information provided at the start of this question (including the interest rate of 9.25% p.a. compounded monthly), however Vinnie commences to make loan repayments which were now equal to an amount of 50% of the repayment calculated in part (a) of this question. Also, the loan repayments were now made at the commencement of each fortnight (that is, the first repayment would be made at the date of the loan and fortnightly thereafter). Given this information, over what approximate total term (expressed in years and months) would Vinnie now repay the loan in full?

d (ii) Ignoring the amount of the final loan repayment to reduce the loan balance to nil, approximately how much interest would Vinnie save (expressed in nominal dollars) by 3 undertaking the repayment strategy in part (d) (i) of this question, as compared to making end-of-month loan repayments over a term of 15 years (as calculated in part a) of this question)?

d (iii) Given the new loan repayment strategy in part (d) (i) of this question, what would be the amount of the final repayment required to reduce the loan balance to nil? Assume 4 that the final repayment will be made 1 fortnight after the last regular fortnightly repayment amount. 

Case Study 2

Sales for the Australian trading company Rooney Enterprises Ltd. during the last financial year (2008) amounted to $3.5 million. The company has a 5-year contract to provide the plastic studs that are screwed into the bottom of football boots to all government primary schools in Australia. The direct costs of Rooney Enterprises Ltd. operations were $2.5 million and other operating expenses totalled $700,000. In addition, the company also earned Australian sourced interest income from investments of $45,000 and incurred interest expenses on borrowings of $30,000.

Dividends paid to shareholders in the 2008 financial year (arising from profits earned in financial years prior to the 2008 year) totalled $87,000. There is also a loan of $395,000 currently owing to the bank as at the end of the 2008 financial year. The company tax rate is 30%.

No Question

a (i) Calculate the tax liability of Rooney Enterprises Ltd. for the 2008 financial year. 4

a (ii) Briefly justify the financial transactions listed above that you have not included in your calculation of the 2008 tax liability of Rooney Enterprises Ltd. (Students should write no more than 100 words for this part of the question).

b What is the maximum amount of fully franked dividends that the company could pay 2 from its 2008 financial year net income?

c What would be the amount of imputation credits associated with the maximum dividend payment possible in part b) of this question?

Case Study 3

Mr. R.I.P. Cobain is offered the following alternatives for a lottery winning:

Option 1: A lump sum payment of $10,000, 12 years from now, or

Option 2: A lump sum payment of $25,000, 25 years from now, or

Option 3: $3,500 today.

No Question Marks

a Showing all calculations, and assuming that Mr. Cobain can otherwise earn a fixed rate of 8% p.a. on his money over each of the next 25 years, which of the options included above would you recommend him to choose based on only financial mathematics principles?
(Students should write no more than 75 words for this part of the question).

b What implicit assumptions are included in your recommendations made in part a) of this question, which may be unrealistic when applied to ‘real-world’ issues and factors?

(Students should write no more than 150 words for this part of the question).

Discussion Questions

No Question

1. Briefly discuss the following statement by providing an informed analysis of the comments made and including your perspective as to which is most appropriate:
“All right, I accept that the objective of a firm is the maximization of its market value to shareholders, but what does this actually mean as I am confused? Does it mean that the firm should maximize today’s share price, today’s dividends, tomorrow’s share price, tomorrow’s dividends, or alternatively the share price at some distant time in the future when the shareholder actually decides to sell their shares?”(Students should write no more than 200 words for this question).

2. In the discipline of finance, we differentiate between cash flows and accounting revenues / expenditures in the process of analyzing time value of money and capital budgeting issues. Briefly discuss why we differentiate between cash flows and accounting revenues / expenditures, and which of the methods (cash flows or accounting net income) do we prefer to use in finance? Justify your response. (Students should write no more than 200 words for this question).

Solution

Case Study 1

Answer 1

Purchase price = $200,000
Loan provided = 75% of $200,000 = $200,000 × 0.75 = $150,000
Remaining funded from personal savings = 25% of $200,000 = $200,000 × 0.25 = $50,000
Loan term = 15 years
Interest rate = 9.25% p.a., compounded monthly
Total number of payments = 15 years × 12 months/year = 180 payments

Part A

M = P.r/1-(1+r)n
r = 9.25%/12
=0.0077
Substituting into formula,
M = 150000 x 0.0077/(1-(1+0.0077)180
= 1156.25/(1-0.25248)
$1547.40

Part B

B = P x (1+r)n –(1+r)p/ (1+r)n-1
B = remaining loan balance after p payments
B = 150000 x (1+0.00770833)180 – (1 + 0.00770833)36/ (1+0.00770833)-1
(1+0.00770833)180 = 4.4746
(1 + 0.00770833)36 =1.3056
Substituting back into formula
B = 150000 x (4.4746 – 1.3056)/(4.4746-1)
=$136824

Part C (i)

Switching from monthly to fortnightly repayments may benefit Vinnie through reducing the overall interest paid over the term of the loan. Because interest is worked out on the outstanding balance, the more frequent the repayments-that is, the faster the loan balance decreases-the less interest will accrue. Even though each fortnightly repayment is 50% of the monthly amount, by making 26 payments in a year instead of 12, results in an extra month repayments every year, thus shortening the loan term and economizing on interest.

Part c (ii)

One potential disadvantage for Vinnie is the more regular cash flow management, since fortnightly repayments will not coincide with his income frequency, assuming he was working on a casual delivery driver whose income could be monthly or irregular. Instead, though each fortnightly payment is half of what was paid monthly, it may appear more burdensome owing to its increased frequency, particularly if other one-off expenses are incurred, which over time may lead to strained finances. If the bank charges more for the increased frequency of payment, this may offset some of the interest savings.

Part d (i)

Loan amount = 75% of $200,000 = $150,000
Annual interest rate = 9.25% compounded monthly
Monthly repayment (from part a) = $1,510.67
Fortnightly repayment = 50% of monthly repayment = $1,510.67 / 2 = $755.34
Fortnights in a year = 26 (since a year has 52 weeks, and 1 fortnight is 2 weeks)
Monthly interest rate
9.25%/12 = 0.00770833
Fortnightly interest rate=(1+Monthly interest rate) 12/26 -1
Fortnightly interest rate= (1+0.00770833)12 /26 – 1
n = log(R/R-P.i)/ log (1+i)
n = log (755.34/(755.34 – 150000.0.003540)/(log(1+0.003540)
First, calculate the denominator inside the logarithm:
755.34−150,000⋅0.003540=755.34−531=224.34

Now calculation of logarithm
n = log(755.34/224.34)/log(1.003540) =344.6 fortnights
Conversion of Fortnights to years and months
Years = 344.6/26 =13 years
Months = (344.6 mod 26) x 12/26 = 3 months
Loan would be in approx. 13 years and 3 months
Part d (ii) - Interest Savings by Switching to Fortnightly Repayments
Total paid (monthly)=1,510.67×180=271,920.60
Total interest (monthly)=271,920.60−150,000=121,920.60
Total paid (fortnightly)=755.34×344=259,837.60
Total interest (fortnightly)=259,837.60−150,000=109,837.60
Interest savings=121,920.60−109,837.60=12,083

Part d (iii) - Final Repayment to Reduce Loan Balance to Nil

We had established earlier that Vinnie would make the last full repayment after 344 fortnights. We found the loan balance after this time to be around -$342.61, which means he would have overpaid, and the extra repayment to reduce the loan balance to zero would not be needed.
Because the final amount of repayment is $0, no further payment is made beyond the last fortnightly payment.

Case Study 2

Part a (i) - Calculate the tax liability of Rooney Enterprises Ltd. for the 2008 financial year
Total revenue=3,500,000+45,000
=3,545,000
Total expenses=2,500,000+700,000+30,000
=3,230,000
Taxable income=3,545,000−3,230,000
=315,000
Tax liability=315,000×0.30
=94,500

Part a (ii) - Justification of financial transactions not included in the tax calculation

The following financial transactions are not subjected to the tax calculation:

1. Dividends paid: Because this is a post-tax distribution of profits, and not an expense that has been deducted from revenue to arrive at taxable income, the dividends paid to the owners ($87,000) do not reduce the taxable income (Smulowitz et al., 2023).

2. $395,000 Loan: The loan outstanding is a liability and does not affect taxable income. Of course, the interest payments are likely to be considered, but as mentioned, that amount has already been accounted for under interest expenses of $30,000.

Part b - Maximum amount of fully franked dividends that the company could pay from its 2008 financial year net income

Net income=Taxable income−Tax liability
= 315,000−94,500=220,500
The maximum fully franked dividend that can be paid is $220,500.

Part c - Amount of imputation credits associated with the maximum dividend payment
Imputation credits = (Fully franked dividend x Tax rate)/ (1-Tax rate)
=(220500*.30)/.70
=94500

Case Study 3

Part a: Calculations and Recommendation
PV = FV (1+r)n
Option 1: Lump sum of $10,000 in 12 years
PV = 10000/ (1+0.08)12 = 3970.04
Option 2: Lump sum of $25,000 in 25 years
PV = 25000/ (1+0.08)25 =3651.23
Option 3: Lump sum of $3,500 today

Recommendation:

Since Option 1 has the highest present value of $3,970.04, I would recommend Option 1.

Part b: Implicit Assumptions

1. Fixed Interest Rate: It is assumed that there will be an 8% fixed return for the next 25 years in this analysis. The interest rates vary, and establishing the same rate for a quite long period of time is considered unreal.

2. Inflation is not taken into account: No consideration is taken towards inflation, which could apparently lower the purchasing power of future lump sums.

3. Risk and Opportunity Cost: The model for MBA Assignment Expert assumes no risk in getting this 8% return, while in reality, there is the possibility of losses on investment or the loss of an opportunity for higher returns.

4. Liquidity and Preference: The analysis did not take into consideration liquidity needs on the part of Mr. Cobain or personal preference. He might consider immediate cash as more valuable than the necessity to wait for larger but delayed payments.
 
Discussion questions

Answer 1

This statement reveals ignorance concerning shareholder wealth maximization. It is the maximization of the long-run market value of the firm; that is, maximization of the present value of future cash flows (Shah 2023). This does not focus on near-term measures of today's share price or dividends, but it rather maximizes the value in a sustainable manner of the company itself.

An exclusive focus on today's share price or dividends may promote short-termism at the expense of the firm's long-term viability. Management should instead focus on those strategies that enhance the total value of the firm, such as profitable growth, prudent risk management, and efficient investment in novelty and capacity (Shah 2023).

The best view is to maximize the present value of future expected cash flows. It considers both dividends and share price over time. It also aligns management's goals with the long-term wealth creation of shareholders, rather than concentrating on any single point in time - now or sometime in the future.

Answer 2

It will be important, in finance, to distinguish between cash flows and accounting revenues/expenditures, because cash flows are a very clear indication of what real money is moved, whereas accounting revenues and expenses may contain non-cash items, such as depreciation and amortization (Pucheta-Martiinez & Garcia-Meca 2019). Cash flows give a more accurate indication of the liquidity of a company, its financial obligations met, investments convened, and value created (Carlon 2019).
In capital budgeting and the time value of money analysis, cash flow is preferred to accounting net income because it addresses the timing of receipt or disbursement of cash and, therefore, represents the real financial consequence of a decision (Carlon 2019). Net income might be misleading since it can be subordinated to certain accounting rules that might not really indicate the actual availability of cash.

Cash flows are essential in methodologies such as NPV or IRR in capital budgeting if one is to take into account the time value of money. Indeed, cash flows have been more critical for assessing the profitability or risk of a project and, therefore, a better base upon which financial decisions may be based.

References

Carlon, S. (2019). Financial accounting: reporting, analysis and decision making. 6th ed. Milton, QLD John Wiley and Sons Australia, Ltd, https://eprints.qut.edu.au/125138/

Pucheta-Martiinez, M. & Garcia-Meca, E. (2019). Monitoring, corporate performance and institutional directors. Australian Accounting Review, 29(1), 208-219. doi:10.1111/auar.12262

Shah, F. (2023). Financial Accounting for Management, Third Edition, Paresh Shah, Oxford University Press. Journal of Business Strategy Finance and Management, 05(01), 58–61. https://doi.org/10.12944/jbsfm.05.01.06

Smulowitz, S., Cossin, D., & Lu, H. (2023). Managerial Short-Termism and Corporate Social Performance: The Moderating Role of External Monitoring. Journal of Business Ethics, 188(4). https://doi.org/10.1007/s10551-023-05498-7