International School –

Vietnam National University

HELP Bachelor of Business (Hons)

FIN202
FINANCIAL MANAGEMENT

Assignment

Year 2, Semester 1, Batch 7

March 2011

Date of Release: 16 May 2011

ASSESSMENT DETAILS

Due Date: 27 May 2011

Value: 15% of total assessment for this subject

Rationale

This assignment covers Weeks 1 - 10, and builds on previous work.

Criteria

Where necessary, state any assumptions you have made. Please note that assumptions have to
be valid.

Assignments should show all workings and students will be penalised for failing to do this.

You will be assessed on:

 your understanding of the problem;

 choice of method for solving the problem;
 application of techniques.

Part A (30 marks)

Question 1 (10 marks)

a. Explain what is meant by the time value of money and why a bird in the hand is worth
two or more in the bush. Which capital budgeting approach(es) ignores this concept?

b. Why cannot the accounting rate of return be used as a reliable capital budgeting
technique? What are its advantages?

Question 2 (10 marks)

a. Use the following information to calculate the cost of capital for TLC Ltd, on the
assumption that investors can remove all unsystematic risk by diversification.

 The systematic risk of TLC Ltd's equity is 0.80;

 The risk free rate is 10%;

 The expected rate of return on the market portfolio is 15%;

  The sources of funds used by TLC Ltd and their respective market values are as
follows:

Source of Funds Market Value ($m)

Debt (par value $100) 1
Equity 3

 The interest rate on the debt is 11% paid annually. The debt, which is due to
mature in eight years' time, has a current market price of $111.

 The company tax rate is 30%.

b. Under what assumptions is the cost of capital you have calculated for TLC Ltd in (a)
appropriate for a proposed project?

Question 3 (10 marks)

TLC Ltd at present only sells on a cash basis and it averages $50,000 of sales per month, with
associated (variable) expenses of $40,000. It is thought that all customers would accept an
offer of 90 day (three month) free credit terms and that the company's monthly sales would
increase to $55,000 and its associated expenses to $44,000. TLC Ltd's required rate of return
is 1% per month.

a. Assuming that there are no costs associated with providing credit, will TLC Ltd benefit
from offering such credit terms?

b. If expenses remain at 80% of sales, what would the increase in sales need to be in order
to justify the provision of these credit terms?

Part B (70 marks)

This case is intended to be an introduction to the various methods used in capital budgeting
and looks at some of the decisions that may have to be made when evaluating projects. It is
also designed to develop skills in using spreadsheets. You should set up a spreadsheet at the
start to help analyse the problems. When using a spreadsheet, any tables that you wish to
present to the reader should be embedded into a Word document as an ordinary table.

Wang Systems

Although he was hired as a financial analyst after completing his business degree, David
Ong’s first assignment at Wang Systems was with the firm’s marketing department.
Historically, the major focus of David’s sales effort was on demonstrating the technological
superiority of the firm’s product line. However, many of Wang’s traditional customers have
embarked on cost-cutting programs in recent years, and as a result, Wang’s marketing
director asked David’s boss, the Chief Financial Officer, to lend David to marketing to help
them develop some analytical procedures for the sales force to use that will demonstrate the
financial benefits of buying Wang’s products.
Wang Systems manufactures fluid control systems that are used in a wide variety of
applications, including sewage treatment systems, petroleum refining, and pipeline
transmission. The complete systems include sophisticated pumps, sensors, and control units
that continuously monitor the flow rate and the pressure along a line, and automatically adjust
the pump to meet preset pressure specifications. Most of Wang’s systems are made up of
standard components, and most complete systems are priced from $50,000 to $100,000.
Because of the highly technical nature of the products, the majority of Wang’s sales force
have backgrounds in engineering.

As he began to think about his assignment, David quickly came to the conclusion that the
best way to 'sell' a system to a cost-conscious customer would be to conduct a capital
budgeting analysis which would demonstrate the system’s cost effectiveness. Further, he
concluded that the best way to begin was with an analysis for one of Wang’s actual
customers.

From discussions with the firm’s sales people, David decided that a proposed sale to Selangor
River Council (SRC) was perfect to use as an illustration. SRC is considering the purchase of
one of Wang’s standard fluid control systems which costs $80,000 including taxes and
delivery. It would cost SRC another $5,000 to install the equipment, and this expense would
be added to the invoice price of the equipment to determine the depreciable basis of the
system. For taxation purposes the system can be depreciated over 6 years, using the following
schedule, but has an economic life of 8 years and it will be used for that period. After 8 years,
the system will probably be obsolete, so it will have a zero salvage value at that time. Current
depreciation allowances are:

Year 1: 20% Year 2: 32% Year 3: 19%

Year 4: 12% Year 5: 11% Year 6: 6%

This system would replace a control system which has been used for about 20 years and
which has been fully depreciated. The costs for removing the current system are about equal
to its scrap value, so its current net market value is zero.

The advantages of the new system are that (i) it would be more energy efficient, (ii) it would
reduce waste, because the chemical processes could be more carefully controlled, and (iii) it
would require less human monitoring and maintenance. In total, the new system would save
SRC $25,000 annually in before-tax operating costs. For capital budgeting, SRC uses a 10%
cost of capital, and the applicable tax rate is 40%.

Mary Seong, Wang’s marketing manager, gave David a free hand in structuring the analysis.
Now put yourself in David’s position and develop a capital budgeting analysis for the fluid
control systems. As you go through the analysis, keep in mind that the purpose of the analysis
is to help Wang’s sales representatives sell equipment to other nonfinancial people, so the
analysis must be as clear as possible, yet technically correct. In other words, the analysis must
not only be right, it must also be understandable to decision makers, and the presenter –
David, in this case – must be able to answer all questions, ranging from the performance
characteristics of the equipment to the assumptions underlying the capital budgeting decision
criteria.
Question 1 (20 marks)

What is the project's net present value (NPV)? Explain the economic rationale behind the
NPV. Could the NPV of this particular project be different for SRC than for one of Wang's
other potential customers? Explain.

Question 2 (10 marks)

Calculate the proposed project's internal rate of return (IRR). Explain the rationale for using
the IRR to evaluate capital investment projects. Could the IRR for this project be different for
SRC than for another customer? Explain.

Question 3 (10 marks)

Suppose one of SRC executives uses the payback method as a primary capital budgeting
decision tool and wants some payback information.

a. What is the project's payback period?

b. What is the rationale behind the use of payback period as a project evaluation tool?
c. What deficiencies does payback have as a capital budgeting decision method?
d. Does payback provide any useful information regarding capital budgeting decisions?

Question 4 (10 marks)

Under what conditions do NPV, IRR, and PI all lead to the same accept/reject decision?
When can conflicts occur? If a conflict arises, which method should be used, and why?

Question 5 (10 marks)

A second capital budgeting decision that David developed was the choice between two
different Wang’s products. Again, using SRC as a model he produced the following figures.

Expected Net Cash Flows

Year Cheap System Expensive System
0 ($55,000) ($95,000)

1 28,000 40,000

2 20,000 20,000

3 10,000 20,000

4 5,500 10,000

5 4,500 10,000

6 10,000

7 10,000

8 10,000
Both systems are part of Wang's general inventory, and therefore can be replaced indefinitely
in the future. Using SRC's cost of capital of 10%, which system should be purchased? Why?

Question 6 (10 marks)

A third capital budgeting decision that David is able to make is when to abandon a system.
Consider a system that has an engineering life of 4 years (that is, the system will be totally
worn out after 4 years). However, if the system were taken out of service, or 'abandoned'
prior to the end of 4 years, it would have a positive salvage value. Here are the estimated net
cash flows for the system.

Initial Investment and End-of-Year Net

Year
Operating Cash Flow Abandonment Cash Flow
0 ($50,000) $50,000

1 24,000 30,000

2 18,000 20,000

3 12,000 5,000

4 5,000 0

The relevant cost of capital is again 10%. What would the NPV be if the system was operated
for the full 4 years? What if it was abandoned at the end of Year 3? Year 2? Year 1? What is
the economic life of the system?

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