FIN 300 Lecture Notes - Lecture 10: Capital Cost Allowance, Canada Revenue Agency, Capital Cost

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24 Nov 2017

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9. 4 other effects on incremental free cash flows. Identify the most common options available to managers in projects and understand why these options can be valuable. Cost allowance (cca): for financial purposes, cca is not usually used. Humza javed: the incremental cca deduction claimed at the end of the tax year is undepreciated capital cost multiplied by the cca rate: Taxes: marginal corporate tax rate, the tax rate a firm will pay on an incremental dollar of pre-tax income. Example 9. 1: taxing losses for projects in profitable companies. Loblaw companies ltd. plans to launch a new line of high-fibre, zero-trans-fat breakfast pastries. The heavy advertising expenses associated with the new product launch will generate operating losses of million next year for the product. Loblaw expects to earn pre-tax income of million from operations other than the new pastries next year. We need loblaw"s pre-tax income with and without the new product losses and its tax rate of.

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The following Balance Sheet extract relates to the Snapple Company:

Bonds payable $1,000,000

Common Stock $3,000,000

Preferred Stock $2,000,000

Additional Information:

The bonds are 8%, annual coupon bonds, with 9 years to maturity and are currently selling for 95% of par.

The companyâs common shares which have a book value of $25 per share are currently selling at $20 per share.

The company has an equity beta of 1.5 and the current Treasury bill rate is 3.5%. The market risk premium is 1.5%

The preferred dividends are 5% preferred shares with a book value of $100 per share. These shares are currently selling at $80 per share.

The Companyâs tax rate is 35%.

Required:

a) Calculate Snappleâs cost of debt. [5 marks]

b) Calculate Snappleâs cost of equity. [5 marks]

c) Calculate Snappleâs cost of preferred shares. [3 marks]

d) Calculate Snappleâs Weighted Average Cost of Capital [8 marks]

e) Explain why the cost of debt is cheaper than the cost of equity. [3 marks]

f) Explain why the cost of retained earnings is equivalent to the cost of an existing issue of common stock. [4 marks]

g) Outline two (2) reasons why a firmâs cost of capital is critically important. [2 marks]

The Beacon Inc. is considering two mutually exclusive projects, each with an initial investment of $150,000. The companyâs board of directors has set up a 4-year payback requirement and has set its cost of capital at 9%. The cash inflows associated with the two projects are as follows:

Year		*Cash Inflows (CFt)*
Project A		Project B
1	$45,000		$75,000
2	$45,000		$60,000
3	$45,000		$30,000
4	$45,000		$30,000
5	$45,000		$30,000
6	$45,000		$30,000

a) Calculate the payback period for each project. [2 marks]

b) Calculate the NPV for each project at 7% and 9%. [6 marks]

c) Based on b) above which project would you choose and why.[ 2 marks]

d) Briefly explain why firms engage in âcapital rationingâ [2 marks]

e) What are Real Options? What are some major types of real options? [3 marks]

The Lifeâs Good Corporation 2012 income statement shows the following:

Income Statement 2012
Sales	$ 5,250,000
Costs	2,173,000
Other expenses	67,400
Depreciation expense	179,000
EBIT	$ 2,830,600
Interest expense	85,555
EBT	$ 2,745,045
Taxes	89,000
Net income	$ 2,656,045
Dividends	$ 169,000
Addition to retained earnings	$ 2,487,045

Lifeâs Good Corp. also issued $106,700 in new equity during the year and redeemed $65,300 in outstanding long-term debt.

i. Calculate the operating cash flow for the firm. (2 marks) $2,920,600

ii. Calculate the cash flow to creditors. (2 marks) $150,855

iii. Calculate the cash flow to stockholders. (2 marks) 62,300

iv. Define free cash flow (FCF) and state one of the equations for computing FCF. (3 marks)

Clarkâs Drug Store, a medium-size drugstore located in Bridgetown Barbados, is owned and operated by Robert Clark. Clarkâs sells pharmaceuticals, cosmetics, toiletries, magazines, and various novelties. Clarkâs most recent annual net income statement is as follows:

Sales Revenue	$2,600,000
COGS	1,460,000
Wages and Salaries	250,000
Rent	190,000
Depreciation	70,000
Utilities	95,000
Miscellaneous	30,000
Total Expenses	2,095,000
Net Profit before Tax	505,000

Clarkâs sales and expenses have remained relatively constant over the past few years and are expected to continue unchanged in the near future. To increase sales, Clarkâs is considering using some floor space for a small soda fountain. Clarkâs would operate the soda fountain for an initial three-year period and then would reevaluate its profitability. The soda fountain would require an incremental investment of $85,000 to lease furniture, equipment, utensils, and so on. This is the only capital investment required during the three-year period. At the end of that time, additional capital would be required to continue operating the soda fountain, and no capital would be recovered if it were shut down.

The soda fountain is expected to have annual sales of $670,000 and food and materials expenses of $380,000 per year.

The soda fountain is also expected to increase wage and salary expenses by 6% and utility expenses by 5%. Because the soda fountain will reduce the floor space available for display of other merchandise, sales of non-soda fountain items are expected to decline by 10%.

Calculate net incremental cash flows for the soda fountain. (6 marks)

ii. Assume that Clarkâs has the capital necessary to install the soda fountain and that he places a 12% opportunity cost on those funds. Should the soda fountain be installed? Why or why not? (4 marks)

5. âIn order for a project to be acceptable, its required rate of return must exceed the cost of debtâ. Do you agree? In light of the statement, define what is cost of capital and what role does it play in long-term investment decisions? (5 marks)

6. What do you understand by the term net proceeds in context with a bond sale? How do floatation costs affect the net proceeds? (3 marks)

7. Go-geta Corp. issued 10-year bonds 2 years ago at a coupon rate of 6 percent. The bonds make semiannual payments. If these bonds currently sell for 98 percent of par value, what is the YTM? (2 marks)

FV	$1000
PV	$ (980.00)
Coupon	$ 30.00

8. ABC Company has an unusual dividend policy. The company has just paid a dividend of $5 per share and has announced that it will increase the dividend by $2 per share for each of the next four years, and then never pay another dividend. If you required a 9 percent return on the companyâs stock, how much will you pay for a share today? (5 marks)

Dividend D0		5.00
Div increase yrly		2.00
Required return		9.00%
Stock Price
Factor		Price
D (1)	1.09	5.00	4.59
D (2)	1.1881	7.00	5.89
D (3)	1.295029	9.00	6.95
D (4)	1.411582	11.00	7.79

9 âWhile contemplating to create a portfolio, it is imperative to study the correlation amongst the assets that constitute the portfolioâ. Discuss the statement and explain how diversification helps in reducing the risk of the portfolio as compared to the individual risks of constituting assets. (5 marks)

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The goal of the firm is to ____ because _____. Answer maximize shareholders' wealth; it considers all risks invest funds in real estate; the return is longer maximize shareholders' profit; it is a short term outlook closely matching management goals Mike is paying $8,000 a year on his mortgage at 6% nominal annual interest. He has 15 more years to make payments. He wants to sell his house today. The lowest [minimum] price he can sell the house without losing any money on the house would be about ___. Answer $120,000 $ 50,000 $77,698 $ 186,208 A firm's net income before tax, EBT [NIBT] (on the income statement) is affected by _____. Answer taxes interest dividends Common Stock as listed on the Balance Sheet could include which of the following? Answer A) retained earnings B) additional paid in capital over par value C) preferred capital Both A) and B) If an asset is sold for ___ than its basis, the tax effect would be ____. Answer A) more; capital gain and depreciation recapture B) less; depreciation recapture C) more; capital loss Both A) and B) The main reason for a firm to have assets is to _______. Answer generate revenue match the liabilities and equity both of the above be able to borrow money and pay its debts none of the above The only risk you would NOT have in loaning money to the United States Government (Uncle Sugar) is _____ risk. Answer liquidity maturity default A(n) ____ shows _____. Answer balance sheet; sources and uses of funds income statement; net income as of a specific date cash flow statement; how well the firm is doing relative to its competition You can compare dollars _____ because ______. Answer computed using equations; any math is always correct at any point in time; time is never a factor if they are at nominal value; that is when decisions are made only at the same point in time; dollars can be invested to earn interest There ___ a tax benefit to the company with paying preferred dividends because _______. Answer is; investors can write them off is not; investors declare them as income is; the company can use the payments as an expense is not; the company cannot use the payments as an expense XYZ issued a 6% coupon, $1,000 par, 30 year to maturity bond. It is now 6 years to maturity. What is the price of the bond if the yield to maturity [market interest rate] is 10%? Answer $1,000 $659.46 $825.79 $705.33 The valuation process can be described as ______. Answer calculating the present value of an expected future cash flow using the investor's required rate of return as the discount rate calculating the future value of an expected future cash flow using the investor's required rate of return as the discount rate amortizing the value of the asset over its holding period The ______ is the minimum required rate of return a firm must earn on its investments. Answer net present value opportunity cost of capital or weighted average cost of capital. internal rate of return gross profit margin The value of an asset is the _____ dollar price someone is willing to pay for it. Answer usual maximum minimum Companies use ____ in capital budgeting project analysis because ________. Answer accounting profit; that is the total net income after tax cash flow; that is what the owners would receive from the project and reinvest accounting profit; that is what the owners would receive from the project and reinvest after tax cash flow; that is the result of prudent accounting When borrowing money, you want to know the ____ interest rate because ____. Answer nominal; it is the easiest to find. effective; it is the true cost of borrowing risk free; that is what the government pays Fed funds; that is what you would pay the bank Cash available to pay out to the investors after the firm pays for new investments or additions to working capital is _____. Answer a statement of cash flows operating after tax cash flow free cash flow net income An organization that raises money from investors and provides financing for individuals and businesses is a ___. Answer factor federal government regulatory unit state government taxing authority financial intermediary Negatives/cons of the Net Present Value (NPV) technique include: Answer least conservative reinvestment assumption multiple rates of return for non-conventional cash flows all of the above none of the above A fixed exchange rate means a country _____. Answer can only use gold coins as money is limited in the amount of paper money it can print can print money as the economy demands Your company is considering an investment with the following expected cash flows: Initial Investment = $407,596 Operating Cash Flows = $73,428 per year Terminal Cash Flow = $11,872. The company's WACC is 11% for similar risk projects. The proposed project would have an expected life of 9 years. Your boss asks you to do the analysis. You would tell your boss this proposed project ___ because ____. Answer is acceptable; NPV is about $3,620 is acceptable; NPV is zero should be rejected; NPV is about -$5,660 [negative $5,660]. should be rejected; NPV is zero All ratios are ___ and a reason to analyze ratios is ____. Answer good; to continue to look productive good and bad; because seemingly good ratios can be masking something bad bad; to try to rework the numbers to have them look good basically irrelevant; there really is no need to analyze financial statements When analyzing financial statements, ratio analysis gives ____ and provides insight into ____. Answer very little useful information; practically nothing good practice in logical thinking; what has occurred and the logic behind it financiers something to do during slow periods; how the financier spends his time accountants a reason to provide financial statements; why accountants do what they do while at work Given: Economic State[i]: Good Average Expected Return[i]: 10% 8% Probability[i]: 30% 70% What is the Standard Deviation? Answer 3% 8.4% 0.92% 5.6% Chapter 9: XYZ has a projected project to install a new press. The expected cash revenue is $175,000 per year. Expected yearly expenses are: Operatinf costs of $50,000; Rental of $17,000; Utilities of $20,500; and Depreciation of $10,000. The tax rate is 35%. What is the expected After-Tax Operating Cash Flow for the first year? Answer $65,500 $60,375 $77,500 $97,500 A stock just paid a dividend of $1.60 per year. The dividend is expected to grow at 3% per year indefinately. Equally risky stocks offer expected rates of return of 8%. What should be the stock price? Answer 53.33 $16.00 $32.96 None of the above. A plot of the CAPM is the _____. Answer wrong thing to do Security Market Line a function showing how to calculate TVM All of the above. Derivatives are used to ___. Answer divide one number by another find old ways to do things hedge risk none of the above With the end of the Gold Standard in the 1970's, what new risk did business face in the international market? Answer Comjpetition Exchange rate Worker compensation Property taxes One of the positive aspects [pros] of a Floating Exchange Rate System is ____. Answer money can be printed as needed to support financial/economic growth no/reduced inflation economic growth is reduced as a result of reduced liquidity [lower money supply] business planning is more difficult A(n) ____ contract obligates the seller to execute the contract and the contract is executed. Answer backwards forward future option What policies did countries institute after the Great War that help lead to the Great Depression? Answer A. Mandatory military service B. Trade restrictions C. High tariffs D. Isolationism Only B., C. and D. All of the above

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FIN 300 Lecture Notes - Lecture 10: Capital Cost Allowance, Canada Revenue Agency, Capital Cost

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