NATIONAL UNIVERSITY OF SCIENCE AND TECHNOLOGY

FACULTY OF BUILT ENVIRONMENT

DEPARTMENT OF CONSTRUCTION ECONOMICS AND

MANAGEMENT

NAME : BENJAMIN MWALE

STUDENT ID : N02128206M
DEPARTMENT : CONSTRUCTION MANAGEMENT AND ECONOMICS

MODULE : CONSTRUCTION FINANCE

COURSE CODE : AQS4203

Assignment 2

Question One

year CFA CFB

0 ($100 million) ($100 million)

1 $10 million $70 million

2 $60 million $50 million

3 $80 million $20 million

Both projects have a cost capital of 10%

a) i. Payback period:

Unrecovered cost at the year before full recovery

years before full recovery + ( ) x no. of
Cash flow of the year of recovery

months

30 000 000
CFA = 2 years + 80 000 000 × 12 months = 2 years 4.5 months

30 000 000
CFB = 1 year + 50 000 000 × 12 months = 1 years 7.2 months

Therefore, project B should be implemented because it has smaller payback period

ii. Calculating using the Net present Value

Project A

Year Cash flow Discount factor Discount value

0 (100 000 000) 1 (100 000 000)

(1 + 0.1)0

1 10 000 000 1 90 909 090.91

(1 + 0.1)1

2 60 000 000 1 49 586 776.86

(1 + 0.1)²

3 80 000 000 1 60 105 184.07

(1 + 0.1)³
NPV =∑(100 000 000) +90 909 090.91+49 586 776.86+60 105 184.07= 18 782 870.02

Project B

Year Cash flow Discount factor Discount value

0 (100 000 000) 1⁄ (100 000 000)

(1 + 0.1)^0

1 70 000 000 1⁄ 63 636 363.64

(1 + 0.1)^1

2 50 000 000 1⁄ 41 322 314.05

(1 + 0.1)^2

3 20 000 000 1⁄ 15 026 296.02

(1 + 0.1)^3

NPV =∑(100 000 000) + 63 636 363.64+41 322 314.05+15 026 296.02= 19 984 973.71

Therefore, project B should be implemented because it has higher NPV.

iii. Calculating using the Internal Rate Of Return

For Project A

Let rate be 20% thus NPV = -3 703 703,704

If we use 15% thus NPV = 6 665 570,806

Since its try and error, we keep on trying:

Let rate be 17% thus NPV = 2 327 466,123

If we use 18% thus NPV = 256 111, 8712

Use 19% thus NPV = -17 53484,389

Therefore, our IRR is between 18% and 19%

positive NPV
IRR = lowest interest rate + (Highest-lowest Interest rate) x positive NPV−(−negative NPV)

256 111,8712
= 18+ (19-18) x 256 111,8712+17 53484,389
= 18.1%
For Project B

Let rate be 18% thus NPV = 7 403 872, 84

If we use 19% thus NPV = 6 600 086,639

Since its try and error, we keep on trying:

Let rate be 20% thus NPV = 4 629 629, 63

If we use 21% thus NPV = 4 147 535,966

Use 22% thus NPV = 1 984 307,057

Use 23% thus NPV = 707 358, 4517

Use 24% thus NPV = -540 431.674

Therefore, our IRR is between 23% and 24%

positive NPV
IRR = lowest interest rate + (Highest-lowest Interest rate) × positive NPV−(−negative NPV)

707 358,4517
= 23+ (24-23) × = 23.56%
707 358,4517+(−540 431.674)

Therefore, we should go for Project B because it has a higher IRR.

iv. Calculate using Accounting Rate of Return

Average Annual Accounting Profit

ARR = × 100
Initial Investment

Given the initial investment for both projects is $100 million.

For Project A

Net Profit Calculation for CFA:

Total Net Cash Flows over 3 years = $10 million + $60 million + $80 million = $150 million

Average Annual Accounting Profit for CFA:

Total Net Cash Flow 150 million

Average Annual Profit = = = 50 million
Number of Years 3

ARR for CFA:

 50 million
ARR = × 100 = 50%
100 million

For Project B

Net Profit Calculation for CFB:

Total Net Cash Flows over 3 years = $70 million + $50 million + $20 million = $140 million

Average Annual Accounting Profit for CFB:

Total Net Cash Flow 140 million

Average Annual Profit = = = 46.67 million
Number of Years 3

ARR for CFB:

46.67 million
ARR = × 100 = 46.67%
100 million

Therefore, comparing the two ARR values, CFA has an ARR of 50%, while CFB has an ARR
of 46.67%. Based on the ARR method, Project A is the better investment option as it offers a
higher return on the initial investment.

b) i. Initial Cash Flow at Time 0

The initial cash flow includes the cost of the machine and the increase in working capital.

Cost of the machine = $180 million

Increase in working capital = $70 million

Initial Cash Flow at Time 0:

Initial Cash Flow = − (Cost of the Machine + Increase in Working Capital)

Initial Cash Flow = − (180+70) = −$250 million

Therefore, the Initial Cash Flow at time 0 is $250 million.

ii. Annual Operating Cash Flows

To calculate the annual operating cash flows, we need to consider the following:

Sales revenue = $200 million per year

Operating costs = $110 million per year

 Cost of Machine
Depreciation = Life of Machine

Tax rate = 40%

Annual Depreciation:

180 million
Annual Depreciation = = 60 million/year
3

Earnings Before Tax (EBT):

EBT = Sales Revenue − Operating Costs − Depreciation

EBT = 200 − 110 − 60 = 30 million

Taxes:

Taxes = EBT × Tax Rate

Taxes = 30 × 0.40 = 12 million

Net Income:

Net Income = EBT − Taxes

Net Income = 30 − 12 = 18 million

Annual Operating Cash Flow:

Annual Operating Cash Flow = Net Income + Depreciation

Annual Operating Cash Flow = 18 + 60 = 78 million/year

Therefore, Annual Operating Cash Flows is $78 million.

iii. Relevant Terminal Cash Flows at the End of Year 3

The terminal cash flows include the recovery of working capital.

Relevant Terminal Cash Flows at the End of Year 3:

Terminal Cash Flow=Recovery of Working Capital

Terminal Cash Flow=70 million

Therefore, Relevant Terminal Cash Flows at the end of Year 3 is $70 million.

iv. Net Present Value (NPV) for the Machine

The NPV calculation involves the initial investment, annual operating cash flows, and terminal
cash flows, discounted at the appropriate discount rate.

Discount Rate: 8%

NPV formula:
𝑛
𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑡 𝑇𝑒𝑟𝑚𝑖𝑛𝑎𝑙 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤
𝑁𝑃𝑉 = ∑ + − 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1 + 𝑟)𝑡 (1 + 𝑟)𝑛
𝑡=1

Where:

• 𝐶𝑎𝑠ℎ 𝐹𝑙𝑜𝑤𝑡 is the annual operating cash flow

• Terminal Cash Flow is the recovery of working capital at the end of year 3

• r is the discount rate

• n is the number of years

Using the given information:

78 78 78+70
NPV = + + − 250
(1+0.08)1 (1+0.08)2 (1+0.08)3

Total NPV Calculation:

NPV = 72.22 + 66.87 + 117.53 − 250

NPV = 256.62 − 250 = 6.62 million

Therefore, NPV for the Machine is $6.62million.

Question Two

a) I. Liquidity Ratios

i. Current Ratio

The current ratio measures the company's ability to pay off its short-term liabilities with its
short-term assets.

Total Current Assets

Current Ratio =
Total Current Liabilities
Using the figures from 2015:

Current Assets = 114,295 + 205,605 + 316,695 = 636,595

Current Liabilities = 205,605 + 25,000 + 50,000 = 280,605
636,595
Current Ratio = ≈ 2.27
280,605
The current ratio of 2.27 suggests that the company has ample current assets to cover its current
liabilities, indicating strong liquidity.

ii. Quick Ratio

The quick ratio measures the company's ability to meet its short-term liabilities without
relying on the sale of inventory.
Current Assets−Inventory
Quick Ratio =
Total Current Liabilities
Using the figures from 2015:
Quick Assets = 636,595−114,295 = 522,300
522,300
Quick Ratio = ≈ 1.86
280,605
The quick ratio of 1.86 shows that the company can meet its short-term obligations without
relying heavily on inventory, which is a positive sign.

II. Profitability Ratios

i. Gross Profit Margin
This ratio measures the percentage of revenue that exceeds the cost of goods sold (COGS).
Gross Profit
Gross Profit Margin = × 100
Sales

Using the figures from 2015:

Gross Profit = 712,545
Sales = 1,400,000
712,545
Gross Profit Margin = × 100 ≈ 50.89%
1400000
The gross profit margin of 50.89% is excellent, indicating that the company retains a significant
portion of sales revenue after covering the cost of goods sold.
ii. Operating Margin
This ratio measures the percentage of revenue left after covering operating expenses.
 Operating Profit
Operating Margin = × 100
Sales

Operating Profit = Gross Profit − Operating Expenses

Operating Profit = 712,545−523,992 = 188,553

Using the figures from 2015:

Sales = 1,400,000
188,553
Gross Profit Margin = × 100 ≈ 13.47%
1,400,000
The operating margin of 13.47% shows efficient control over operating expenses.
iii. Net Profit Margin
This ratio measures the percentage of revenue that remains as profit after all expenses are
deducted.
Net Profit
Net Profit Margin = × 100
Sales
Using the figures from 2015:
Net Profit = 86,170
Sales = 1,400,000
86,170
Net Profit Margin = × 100 ≈ 6.15%
1,400,000
The net profit margin of 6.15% indicates that after all expenses, the company retains a
reasonable percentage of its sales as profit.
III. Efficiency Ratios
i. Stock Days Debtors Days
This measures how quickly a company collects cash from its customers.
Trade Receivables
Debtors Turnover Days = × 365
Sales
Using the figures from 2015:

205,605
Debtors Turnover Days = × 365 ≈ 54 𝑑𝑎𝑦𝑠
1,400,000
The company collects payments from its customers in about 54 days, suggesting a moderate
collection period.
ii. Creditors Days (Payables Days)
This measures how quickly a company pays its suppliers.
 Trade Payables
Creditors Turnover Days = × 365
Cost of Goods Sold
Using the figures from 2015:
180,000
Creditors Turnover Days = × 365 ≈ 96 𝑑𝑎𝑦𝑠
1,400,000 − 712,545
The company takes about 96 days to pay its suppliers, indicating it takes longer to settle its
payables.
IV. Leverage Ratios
i. Debt-to-Equity Ratio
This measures the relative proportion of shareholders' equity and debt used to finance a
company's assets.
Total Debt
Debt − to − Equity Ratio =
Total Equity
Using the figures from 2015:
Total Debt = 280,000+50,000 = 330,000
Total Equity = 1,215,355
330,000
Debt − to − Equity Ratio = ≈ 0.27
1,215,355
A ratio of 0.27 shows that the company has a moderate level of debt compared to its equity,
indicating a balanced capital structure.
ii. Debt Ratio
This measures the proportion of a company's assets that are financed by debt.
Total Debt
Debt Ratio =
Total Assets
Using the figures from 2015:
Total Debt = 330,000
Total Assets = 1,545,355
330,000
Debt Ratio = ≈ 0.21
1,545,355
A debt ratio of 0.21 suggests that 21% of the company's assets are financed by debt, which is
relatively low and indicates a conservative approach to leverage.

Based on these calculations, the company appears to be managing its financials well with
efficient use of inventory, moderate collection periods for receivables, and a conservative
approach to leverage. This supports the financial director's claim of good financial health.
b) Explain how the divergence of management and shareholder objectives can be manages
through the following:

i) Market Forces

Market forces manage the gap between management and shareholder goals by creating
competitive pressures. If companies underperform due to misaligned objectives, their stock
prices may drop, making them targets for takeovers by more efficient businesses. This risk
encourages managers to align their goals with shareholders' interests to improve performance
and keep control.

ii) Agency Costs

Agency costs are expenses related to resolving conflicts between managers and shareholders.
These can be managed through incentives like performance-based pay, stock options, and
bonuses that align managers' interests with shareholders' goals. Monitoring costs, such as audits
and oversight by the board of directors, also help ensure managers act in shareholders' best
interests.

iii) Organizational Structuring

Organizational structuring can address the divergence of objectives by creating clear

governance frameworks. This includes defining roles and responsibilities, setting up
independent boards, and implementing checks and balances. Effective corporate governance
ensures transparency and accountability, aligning management's actions with shareholders'
goals.

Question five
a) Differences Between Debt and Equity Instruments

Debt and equity instruments are essential methods for companies to secure funding, each with
unique features and consequences for both the company issuing them and the investors.

Debt Instruments

Debt instruments are financial products that signify borrowed funds needing repayment over
time, including bonds, loans, and debentures. A key aspect of debt instruments is the
requirement to repay the principal amount along with periodic interest until the maturity date.
Debt holders do not have ownership in the company and thus lack voting rights. In case of
liquidation, debt holders are prioritized and compensated before equity holders, making debt a
safer investment. However, returns on debt are typically lower than equity, providing fixed
interest payments. This lower risk and fixed return make debt instruments a more stable and
predictable investment option.

Equity Instruments

Conversely, equity instruments signify ownership in a company and encompass common and
preferred stock. Equity holders own a share of the company and have voting rights, allowing
them to participate in significant corporate decisions. Unlike debt, equity does not require
repayment; instead, investors might receive dividends, which are portions of the company's
profits. However, these dividends are not guaranteed and may fluctuate based on the company's
performance. In the event of liquidation, equity holders are compensated after debt holders,
with common stockholders being last in line. This lower priority makes equity a riskier
investment. Nonetheless, equity offers the potential for higher returns through dividends and
capital gains if the company performs well and its stock value rises, appealing to investors
willing to take on more risk.

b) To determine which option will raise more funds for financing the expansion, we need to
compare the funds raised through issuing bonds versus issuing stocks.

Option 1: Issuing Bonds

Face value of the bond = $1,000,000

Annual coupon rate = 12%

Interest rate = 9%

Maturity = 6 years

The company will raise $1,000,000 by issuing bonds.

Option 2: Issuing Stocks

Last year’s dividend = $45,000

Supernormal growth rate = 15% for the next 3 years

Constant growth rate = 10% thereafter

Required rate of return = 15%

To find the price of the stock, we use the Dividend Discount Model (DDM) for a stock with
supernormal growth followed by constant growth.

1. Calculate the dividends for the next 3 years:

D1 = $45,000 × (1 + 0.15) = $51,750

D2 = $51,750 × (1 + 0.15) = $59,512.50

D3 = $59,512.50 × (1 + 0.15) = $68,439.38

2. Calculate the stock price at the end of year 3 (P3) using the constant growth
formula:

o D4 = D3 × (1 + 0.10) = $68,439.38 × (1 + 0.10) = $75,283.32

o P3 = D4 / (required rate of return - constant growth rate)

o P3 = $75,283.32 / (0.15 - 0.10) = $75,283.32 / 0.05 = $1,505,666.40

3. Calculate the present value of dividends and P3:

o PV(D1) = $51,750 / (1 + 0.15) = $45,000

o PV(D2) = $59,512.50 / (1 + 0.15)² = $45,000

o PV(D3) = $68,439.38 / (1 + 0.15)³ = $45,000

o PV(P3) = $1,505,666.40 / (1 + 0.15)³ = $1,000,000

Adding these present values gives the total funds raised by issuing stocks:

Total funds = 45,000 + 45,000 + 45,000 + 1,000,000 = $1,135,000

Therefore, issuing stocks will raise more funds ($1,135,000) compared to issuing bonds
($1,000,000).