- Question A (40 marks)
This question is to be done on a spreadsheet with the results pasted and submitted in a Word
document. EASTS does not support spreadsheets. Make sure that you show all your
workings – for example, do not simply put down the standard deviation but show how it was
obtained. This does not mean giving the Excel algorithm. Please do not give cell formulae,
cell references, etc, as the reader should be able to follow from a table – as you do in the
text. Also please note using excel formula such as =STDEV() or =COVAR() is not
acceptable).
For this question use the Yahoo! Finance website at http://au.finance.yahoo.com/ for data.
1. Find the monthly opening and closing prices for the period 1 January 2013 – 31 December
2013 for David Jones Limited (DJS), and Westpac Banking Corporation (WBC) and the
market (MKT) as proxied by the All Ordinaries index (^AORD). 3 marks
2. Calculate monthly holding period returns (%) for the period 1 January 2013 – 31
December 2013. The monthly holding period return is the %age return (%) you would
receive if you bought an asset on the first day of the month (opening price) and sold it
on the last day of the month (closing price). (Use 'Close' rather than 'Adjusted Close'
for the selling price and ignore any dividends). 3 marks
- 1 - Fin 516 201430 Assignment 2
3. Graph your results on one graph with returns on the y axis and time on the x axis.
3 marks
4. For DJS, WBC and MKT, what is the average monthly holding period return?
3 marks
5. For DJS, WBC and MKT, what is:
i. The annual holding period return; and 1.5 marks
ii. The standard deviation of the monthly holding period returns? 4.5 marks
6. Calculate the covariance of DJS and WBC over the year. 3 marks
7. If you decide to invest in a portfolio of two assets, calculate the expected portfolio
return and risk if:
i. 40% of wealth is invested in DJS and 60% in WBC 5 marks
ii. 70% of wealth is invested in DJS and 30% in WBC 5 marks
8. Plot DJS, WBC and MKT on a risk / return graph as well as the two portfolios in Q.7.
[See Fig 11.2 of text for example of graph]. 4 marks
9. Which asset or combination of assets would you invest in and explain why? 5 marks
Question B (60 marks)
CASE STUDY Green Fields Wineries, Inc
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.
Green Fields Wineries is a leading New South Wales wine producer. The firm was founded in
1968 by Graham Green who had spent several years in France and who was convinced that
New South Wales could produce wines that were as good as or better than the best France had
to offer. Originally, Graham sold his wine to wholesalers for distribution under their brand
names, but in the early 1970s, when wine sales were expanding rapidly, he joined with several
other producers to form Green Fields Wineries, which then began an aggressive promotion
campaign. Today, its wines are sold throughout Australia.
Green Fields’ management is currently evaluating a potential new product; a light, fruity wine
designed to appeal to the younger generation. The new product, Sparkling Gold, would be
positioned between the various wine coolers and the traditional wines. The new product would
cost more than wine coolers, but less than premium table wine, and in market research
samplings at the company’s headquarters, it was judged superior to various competing products.
Ann Williams, the Chief Financial Officer, must analyse this project, along with other potential
investments, and then present her findings to the company’s executive committee.
- 2 - Fin 516 201430 Assignment 2
Production facilities for the new wine product would be set up in an unused section of Green
Fields’ main plant. Relatively inexpensive, used machinery with an estimated cost of only
$500,000 would be purchased, but shipping costs to move the machinery to Green Fields’ plant
would total $40,000, and installation charges would add another $60,000 to the total equipment
cost. Further, Green Fields’ inventories (the new product requires some aging at the winery)
would have to be increased by $20,000, and this cash flow is assumed to occur at the time of the
initial investment. The machinery has a remaining economic life of 4 years and a special
Australian Tax Office ruling will allow Green Fields Wineries to claim the following annual
depreciation allowances:
Year 1: 33% Year 2: 45%
Year 3: 15% Year 4: 7%
The machinery is expected to have a salvage value of $50,000 after 4 years of use.
The section of the plant in which production would occur has not been used for several years,
and consequently had suffered some deterioration. Last year, as part of a routine facilities
improvement program, Green Fields spent $200,000 to rehabilitate that section of the main
plant. Jeff Adams, the chief accountant, believes that this outlay, which has already been paid
and expensed for tax purposes, should be charged to the wine project. His contention is that if
the rehabilitation had not taken place, the firm would have had to spend the $200,000 to make
the site suitable for the wine project.
Green Fields’ management expects to sell 200,000 bottles of the new wine product in each of
the next 4 years, at a wholesale price of $4 per bottle, but $3 per bottle would be needed to
cover fixed and variable cash operating costs.
In examining the sales figures, Williams noted a short memo from Green Fields’ sales manager
which expressed concern that the wine project would cut into the firm’s sales of wine coolers –
this type of effect is called an externality (or opportunity cost). Specifically, the sales manager
estimated that wine cooler sales would fall by 5 % if the new wine were introduced. Williams
then talked to both the sales and production managers, and she concluded that the new project
would probably lower the firm’s wine cooler sales by $40,000 per year, but, at the same time, it
would also reduce production costs for this product by $20,000 per year, all on a pre-tax basis.
Now assume that you are an assistant to Ann Williams and she has asked you to analyse the
project and then to present your findings in a 'tutorial' manner to Green Fields’ executive
committee.
As Chief Financial Officer, Williams wants to educate some of the other executives, especially
the marketing and sales managers, in the theory of capital budgeting so that these executives
will have a better understanding of her capital budgeting decisions. Therefore, Williams wants
you to ask and then answer a series of questions as set out below. Specifics on the other two
projects that must be analysed are provided in Questions 7 and 8.
Keep in mind that you will be questioned closely during your presentation, so you should
understand every step of the analysis, including any assumptions and weaknesses that may be
lurking in the background and that someone might spring on you in the meeting.
- 3 - Fin 516 201430 Assignment 2
Table 1 below is a suggested way of calculating depreciation amount (complete the
table).
Depreciation Schedule: Table 1
Depn. Depn End-of-Year
Year Allowance Expense Book Value
1 33% ? ?
2 45% ? ?
3 15% ? ?
4 7% 42,000 0
100% ?
Table 2 below is a suggested way of formatting your spreadsheet.
Table 2
Year 0 Year 1 Year 2 Year 3 Year 4
Unit price
Unit sales
Net Investment Outlay
Price
Freight
Installation
Change in NWC
Operating cash flows
Revenues
Operating Costs
Less Depreciation
Other project effects
Before-tax income
Tax
Net income
Plus depreciation
Net operating cash flow
Salvage value
Salvage value tax
Recovery of NWC
Project net cash flow
Note: The WACC (Weighted Average Cost of Capital) is the appropriate discount rate to use
when evaluating this project
You should use a spreadsheet for this case study. However, please note the following:
1. You cannot submit a spreadsheet via EASTS - it will not accept it, neither can you submit a
spreadsheet as an embedded object in a Word document. Construct your table in Excel and
then simply copy and paste into Word.
2. Set up your data in a spreadsheet and use it check your answer but remember you still have
to show how the NPV, etc. was derived. This does not mean giving the Excel algorithm. It
- 4 - Fin 516 201430 Assignment 2
does have to show how the solution was derived. So show how you have discounted the
cash flows.
3. By the time you come to Questions 6, 9 and 10, I will already know if you can correctly
calculate the NPV, etc., so at this point generate your results by changing the nominated
variables in the spreadsheet and put the resulting table in a Word document.
Question 1 6 marks
a. Define the term 'incremental cash flow'. Since the project will be financed in part by debt,
should the cash flow statement include interest expenses? Explain.
b. Should the $200,000 that was spent to rehabilitate the plant be included in the analysis?
Explain.
c. Suppose another wine maker had expressed an interest in leasing the wine production site for
$10,000 a year. If this were true (in fact it was not), how should that information be
incorporated into the analysis?
Question 2 3 marks
Green Field’s overall cost of equity is 15.2%, overall cost of debt is 8% and effective tax rate is
40%. If Green Field’s Debt – Equity Ratio is 1, calculate the Weighted Average Cost of Capital
(WACC) of Green Field.
Question 3 15 marks
Estimate the operating cash flow for the project. (Use Table 2 as a guide.) What are the project’s:
a. Net Present Value (NPV)
b. Internal Rate of Return (IRR)
c. Modified Internal Rate of Return (MIRR)
d. Payback Period
e. Should the project be undertaken? Explain why or why not.
Question 4 5 marks
Now suppose the project had involved a replacement rather than an expansion project. Describe
briefly how the analysis would have to be changed to deal with the replacement project - that is
what new cash flows need to be considered, what cash flows may change or not occur. This is a
descriptive question.
Question 5 5 marks
Assume that inflation is expected to average 5% per year over the next 4 years. Does it appear that
the project’s cash flow estimates are real or nominal? That is, are they stated in constant (current
year) dollars, or has inflation been built into the cash flow estimates? Is the WACC a nominal or a
real rate? Is the current NPV biased, and, if so, in what direction?
- 5 - Fin 516 201430 Assignment 2
Question 6 5 marks
Now assume that the sales price will increase by the 5% inflation rate beginning after Year 0.
However, assume also that operating costs will increase by only 2% annually from the initial cost
estimate, because over half of the costs are fixed by long-term contracts. For simplicity, assume
that no other cash flows (net externality costs, salvage value, or net working capital) are affected
by inflation. What are the project’s NPV and IRR now that inflation has been taken into account?
(Hint: the Year 1, and succeeding cash flows, must be adjusted for inflation because the estimates
are in Year 0 dollars.)
Question 7 6 marks
The second capital budgeting decision which Williams and you were asked to analyse involves
choosing between two mutually exclusive projects, S and L, whose cash flows are set forth below:
Year Expected Net Cash Flow
0 – $200,000 0 – $200,000
1 120,000 1 67,000
2 120,000 2 67,000
3 67,000
4 67,000
Year Expected Net Cash Flow
Project S
Project L
Both of these projects are in Green Fields’ main line of business, premium table wine, and the
investment which is chosen is expected to be repeated indefinitely into the future. Also, each
project is of average risk, and hence each is assigned the WACC as discount rate.
What is each project’s single cycle NPV? Can you make a decision on this information? Why or
why not? If not, what should you do to be able to make a decision? Which project should be
chosen? Why?
Question 8 5 marks
The third decision to be considered involves a fleet of trucks with an engineering life of 3 years
(that is, the trucks will be totally worn out after 3 years). However, if the trucks were taken out of
service, or “abandoned” prior to the end of 3 years, they would have a positive salvage value. Here
are the estimated net cash flows for each truck:
Year
0 – $20,000 $20,000
1 $ 8,400 $12,400
2 $ 8,000 $ 8,000
3 $ 7,000 $ 0
Initial Investment and
Operating Cash Flow
End-of-Year Net
Abandonment Cash Flow
Using the same WACC as discount rate, what would the NPV be if the trucks were operated for
the full three years? What if they were abandoned at the end of Year 2? What if they were
abandoned at the end of Year 1? What is the economic life of the truck project?
- 6 - Fin 516 201430 Assignment 2
Question 9 5 marks
Refer back to the original wine project.
a. What would happen to the project’s NPV if inflation were neutral, that is, if both sale prices
and costs increase by the 5% annual inflation rate? Explain the result.
b. Now suppose that Green Fields is unable to pass along its inflationary input cost increases to
its customers. For example, assume that costs increase by the 5% annual inflation rate, but
that the sales price can be increased at only a 2% annual rate. What is the project’s NPV
under these conditions? Explain the result.
Question 10 5 marks
Return to the initial inflation assumptions in Q5. (5% on price and 2% on costs)
a. Assume that the sales quantity estimate remains at 200,000 units per year. What Year 0 unit
price would the company have to set to cause the project to just break even?
b. Now assume that the sales price remains constant at $4.00 and costs increase at a rate of 2%
pa, what annual unit sales volume would be needed for the project to break even?
