FIN 751 – CORPORATE FINANCIAL POLICY & STRATEGY, FALL 2012 INSTRUCTOR: TOM BARKLEY

CASE #2 – “Groupe Ariel: Parity Conditions and Cross-Border Valuation”

Written reports are to be no more than five typed pages (based on a 12-point Times New Roman font, double-spaced, with 1-inch margins all around). The assignments are due at the beginning of class on Thursday, November 8, 2012.

This case is designed to introduce discounted cash flow valuation techniques in a cross-border setting. Groupe Ariel’s Mexican subsidiary is proposing the purchase and installation of some cost-saving equipment in its plant in Monterrey. The headquarters at Ariel requires a discounted cash flow analysis and an estimated net present value for expenditures of this magnitude. The issue is whether the analysis should be performed in euros or pesos. Relevant cash flows and appropriate discount rates are the focus in this introduction to cross-border capital budgeting. Industry and competitive analysis, international tax factors, remittance policies, etc. may be ignored.

Answer the following questions in your report:
1. Compute the net present value of Ariel-Mexico’s recycling equipment in: (i) Mexican pesos, by discounting peso cash flows at a peso discount rate (“Method A”); and (ii) euros, by translating future peso cash flows into euros at the expected future spot exchange rates (“Method B”). Assume that Ariel’s hurdle rate in France for a project of this type is 8%. Also assume that at the time of analysis, the annual expected inflation is 7% in Mexico and 3% in France. What do you conclude with respect to the NPVs from using the two different valuation approaches? Are they the same? Why or why not?

2. Suppose the Mexican inflation is the same as that in France (i.e. 3%), and both RPPP and UIP continue to hold. Redo the analysis in Question 1. What do you conclude?

3. Assume the same inflation scenario as in Question 2. However, suppose that PPP breaks down (so,...

...consideration in capital budgeting? a Will an investment generate adequate cashflows to promptly recover its cost? b Will an investment generate an acceptable rate of return? c Will an investment have a positive netpresentvalue? d Will an investment have an adverse effect on the environment? 3 Which of the following is not considered when using the payback period to evaluate an investment? a The profitability of the investment over its entire life. b The annual netcashflow of the investment. c The cost of the investment. d The expected life of the investment. Use the following data for questions 4 and 5. Stone Mfg. is considering expanding operations by investing $300,000 in equipment. The equipment has a useful life of eight years, with no salvage value. Straight-line depreciation is used. Stone predicts that net income will increase $37,500 per year as a result of this strategy. 4 Refer to the above data. The payback period for this investment is: a 8 years. b 4 years. c Over 13 years. d 2.5 years. 5 Refer to the above data. Return on average investment for this investment is: a 25%. b 20%. c 12 1/2%. d 15%.
CHAPTER 26 10-MINUTE QUIZ B
NAME SECTION
#
Physician’s Pharmacy is considering the purchase of a copying machine which it will make available to customers at a per-copy charge. The copying machine has an initial...

...to the introduction and production of a new product, a liquid detergent called Blast. Need to consider what types and which cashflows should be included in capital budgeting analysis.
D&D was producing and marketing two major product lines:
1. Lift-Off: Low –suds, concentrated powder.
2. Wave: Traditional powder detergent.
Questions & Answers:
1. If you were in Steve Gasper’s place, would you argue to include the cost from market testing as a cash outflow?
If I’m Steven Gasper’s I would not include the cost from market testing as a cash outflow. The reason is because the cost from market testing was considered as sunk costs. A sunk cost is an outlay that has already occurred, hence by decision under consideration would not been affected by the costs. Since sunk costs are not incremental cost they should not be included in the analysis. In this case initial cost for Blast, $500,000 for test marketing, which was conducted in the Detroit area and completed in the previous June was consider as a sunk cost and it will not affect Danforth & Donnalley Laundry future cashflows regardless of whether or not the new branch is built.
2. What would your opinion be as to how to deal with the question of working capital?
Working capital management deals with the management of current assets which are inventories, payroll, and other cash needs and...

...investment but low rate investment such as T-bills or bonds.
E) Which of the following is true about the NPV and IRR techniques?
1) The NPV and IRR techniques always provide the same ranking of different investment projects.
2) The NPV and IRR techniques explicitly consider the cost of capital and the time value of money.
3) All projects can have only one value for NPV and one value for IRR.
4) The NPV technique cannot provide information on how acquiring the project will contribute to shareholders’ wealth.
Explanation: NPV calculates presentvalue of investment and opportunity cost of capital and IRR takes time value of money and cost of capital into consideration as well.
F) Which of the following is false?
1) The profitability index method explicitly considers the time value of money and the firm’s cost of capital.
2) The payback period is preferred by managers since it is simple, easy to calculate, and estimates how quickly the project cashflows will return the investment in the project.
3) The disadvantages of the payback period method are that it ignores project cashflows which occur after the payback period as well as the time value of money.
4) The profitability index method always ranks all projects in the same way that the IRR method does.
Explanation: In IRR method...

...Exam 2 Part 2
Answer any EIGHT of the ten questions. Each question is worth 5 points.
Return your answers to me by 11:59 PM Sunday 11 November 2012
1. A number of publicly traded firms pay no dividends yet investors are willing to buy shares in these firms. How is this possible? Does this violate our basic principle of stock valuation? Explain.
Our basic principle of stock valuation is that the value of a share of stock is simply equal to the presentvalue of all of the expected dividends on the stock. According to the dividend growth model, an asset that has no expected cashflows has a value of zero, so if investors are willing to purchase shares of stock in firms that pay no dividends, they evidently expect that the firms will begin paying dividends at some point in the future.
2. Explain why some bond investors are subject to liquidity risk, default risk, and/or taxability risk. How does each of these risks affect the yield of a bond?
Liquidity problems exist in thinly traded bonds making some bonds difficult to sell at their actual value. Default risk is the likelihood the corporation will default on its bond obligations. Taxability risk reflects the fact that some bonds are taxed disadvantageously compared to others. If any of these risks exist, investors will require compensation by demanding a high yield.
3. The discussion of asset pricing in the...

...Bonds pay semi-annual coupons unless otherwise stated;
7) Bonds have a par value (or face value) of $1,000; and
8) You may use the back of the exam paper as your scrap paper.
Good Luck.
32 Calculation Questions (4 marks each)
1. The common stock of Robin's Tools sells for $24.50. The firm's beta is 1.2, the riskfree rate is 4%, and the return on the market portfolio is 12%. Next year's dividend is
expected to be $1.50. Assuming that dividend growth is expected to remain constant
for Robin’s Tools over the foreseeable future, what is the firm's anticipated dividend
growth rate?
A)
B)
C)
D)
E)
6.65%
7.48%
9.15%
13.6%
15.0%
Solution: B
r = 4% + 1.2 x (12% - 4%) = 13.6% and
$24.50 = $1.50 / (13.6% - g)
Leads to g = 7.48%
2. What is the yield to maturity on a 10-year zero-coupon bond with a $1,000 face value
selling at $742?
A)
B)
C)
D)
E)
3.03%
7.42%
13.48%
34.78
42.37%
Solution: A
YTM = (1000/742) 1/10 -1 = .03029 or 3.03%
3. Consider the following monthly cashflows (see the diagram below):
X
Today
Z
X
Z
X
Z
1
2
3
4
19
20
Cashflows of an amount X are made for months 1, 3, 5, …, 17 and 19 (the ten oddnumbered months) and cashflows of an amount Z are made for months 2, 4, 6, …, 18
and 20 (the ten even-numbered months). The APR is 6% and is compounded on a...

...(D)
2.
$158.80
$253.06
Bill plans to fund his individual retirement account with the maximum
contribution of $2,000 at the end of each year for the next 20 years. If Bill can
earn an effective return of 12 per cent per annum on his contributions, how much
will he have accumulated at the end of twenty years, rounded to the nearest
dollar?
(A)
(B)
$19,292
(C)
$144,105
(D)
3.
$14,938
$40,000
A firm’s profit before tax is $150 000 and depreciation expense is $30,000.
Assuming a company tax rate of 30%, the firm’s cashflow from operations is:
(A)
$840,000
(B)
$180,000
(C)
$135,000
(D)
$75,000
4.
Given an effective annual interest rate of 14 per cent, the presentvalue of a
perpetuity consisting of yearly payments of $25,000 starting immediately is,
rounded to the nearest dollar
(A)
(B)
$203,571
(C)
$178,571
(D)
5.
$232,071
$156,641
If the presentvalue of a perpetual income stream is increasing, the discount rate
must be
(A)
(B)
decreasing
(C)
increasing proportionally
(D)
6.
increasing
changing unpredictably
Janice would like to send her parents on a cruise for their 25th wedding
anniversary. She has priced the cruise at $15,000 and she has 5 years to
accumulate this money. To the nearest dollar, how much must Janice deposit
annually in an account paying interest of 10 per...

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