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Critically examine “it is prudent to hold large inventories in an inflationary economy”.

Tax Liability and Government Functions

a) The objective is to compute the tax liability of the given corporation.

Taxable income = $ 1,225,000

Corporate Tax = 0.15*(50000-0) + 0.25*(75000-50000) + 0.34*(1225000 -75000) = $411,000

Additional surtax = 0.05*(335,000-100,000) = $11,750

Total tax liability = $ 411,000 + $11,750 = $422,750

b) The government requires money to function and meet the various expenditures with regards to national defence, law and order besides providing various essential services. The primary source of this money is to tax the individuals as they are the recipients of the key services and functions that the government discharges. During the early days of the government, the concept of welfare nation was not in vogue and hence government has limited nations. But with thee acceptance of government being responsible for the welfare of the citizens, there has been a significant growth in the functions of the government and it also taken over critical socio-economic objectives. One of these is to ensure that the wealth distribution amongst individuals is not very skewed. In order to ensure the same, there is a progressive tax system and there are multiple transfer systems whereby tax proceeds are directed to the disadvantaged sections of the society and vulnerable population through a host of schemes (Barkoczy, 2017).  

a) Mean return (Common Stock A) = 0.2*12% + 0.5*18% + 0.3*27% = 19.5%

Mean return (Common Stock B) = 0.1*4% + 0.3*6% + 0.4*10% + 0.2*15% = 9.2%  

Standard deviation = (0.002925)0.5 = 5.41% 

Standard deviation = (0.001276)0.5 = 3.57%

Return per unit risk (Stock A) = 19.5/5.41 =3.6

Return per unit risk (Stock B) = 9.2/3.57 = 2.6

Considering that return per unit risk is higher for common stock A, hence it would be considered the superior option (Damodaran, 2015).

b) Risk with regards to investing refers to the underlying variation in returns. The higher the standard deviation, typically higher is the risk. With regards to portfolio management, there are essentially two types of risk namely systematic risk and unsystematic risk. Systematic risk refers to the risk which cannot be removed through diversification. Unsystematic risk refers to risk which can be removed through effective diversification. This is because unsystematic risk is on account of industry related risks which a well-diversified portfolio can balance and hence reduce the variation in the portfolio returns (Petty et. al., 2015). 

  1. a) Total assets for 2001 = 100% of 18 million = $ 18 million or $ 18,000,000. 

The requisite formula is indicated below.  

For the given situation, A/S = 15/15 =1

L/S = (3.75/15) = 0.25

Change in sales = S1-S = $ 18 million - $ 15million = $ 3,000,000

M is the net profit margin = (1.5/15) =0.1

It is assumed that no dividend is paid and hence D is zero.

Taking the above formula and relevant inputs into consideration, we get

DFN = (1-0.25)*3,000,000 – 0.1*18,000,000 = $ 45,000

b) From the above computations, it is apparent that the total assets would increase from $ 15 million currently to $ 18 million in 2001. However, only a part of these incremental funding would be required from externally which has been estimated as $ 45,000. 

  1. a) The ratio computation is carried out below.
  2. i) Current Ratio = Current Assets/Current Liabilities = 1143/2985 = 0.38
  3. ii) Inventory Turnover = COGS/Inventory = 6537/71 = 92.07

Investment Analysis on Common Stocks A and B

iii) Average collection period = (Receivables/Credit Sales)*365 = (484/11508)*365 = 15.35 days

  1. iv) Debt ratio = Total liabilities/Total assets = (9310/18242) = 51.04%
  2. v) Total asset turnover = (Sales/Total Assets) = (11508/18242) = 0.63
  3. vi) Fixed asset turnover = (Sales/Fixed Assets) = (11508/14961) = 0.77

vii) Operating profit margin = (Operating profit/Sales) = (2794/11508) = 24.28%

viii) Return on common equity = (Net profit available to common equityholders /Total common equity) = (1617/8852) =18.27%

b) The company clearly faces short term liquidity issues as the current ratio of the company (0.38) is significantly lower in comparison to the industry average of 0.70. As a result the company potentially faces short term cash crunch. One of the factors which may be contributing to the same is the high collection period compared to the industry average (Parrino and Kidwell, 2014).

c) There are two aspects to this namely the revenues and the operating profit margin. With regards to the latter, it is apparent that the margins of the company at 24.28% are superior in comparison to the industry average of 21%. However, the total asset turnover of the company is significantly lower in comparison to the industry. As a result, it can be concluded that the company is not generating enough operating profits (Brealey, Myers and Allen, 2014).

d) The debt ratio for the company indicates that 51% of these are liabilities or debt based funding while the remaining 49% is equity based funding. This is marginally worse than the industry average of 50% where both debt and equity have equal contributions to the asset funding (Damodaran, 2015).

a) i) Payback period is referred to as the time required to recover the original investment.

Payback period (Project A)

Initial investment = $50,000

Cash inflows during the first three years = 10,000 + 15,000 + 20,000 = $45,000

Investment remaining to be recovered = $ 50,000 - $45,000 = $5,000

Time required in the 4th year to recover the remaining investment = (5000/25000)= 0.2

Hence, payback period = 3 + 0.2 = 3.2 years

Payback period (Project B)

Initial investment = $100,000

Cash inflows during the first four years= 25,000 + 25,000 + 25,000 +25000 = $ 100,000

Hence, payback period = 4 years

Conclusion

Both the projects are acceptable since payback period is lesser than the project useful life.

ii) The formula for accounting rate of return is indicated below.

ARR = (Average profit per year/Average Investment)*100

Project A (ARR)

Total profit from the project during the useful life = -50,000 + 10,000 + 15,000 + 20,000 + 25,000 + 30,000 = $50,000

Average profit per year = 50000/5 = $ 10,000

ARR = (10,000/50,000)*100 = 20%

Project B (ARR)

Total profit from the project during the useful life = -100,000 + 25,000 + 25,000 + 25,000 + 25,000 + 25,000 = $25,000

Average profit per year = 25000/5 = $ 5,000

ARR = (5,000/100,000)*100 = 5%

Conclusion

Since no minimum threshold is given, hence both projects are feasible since ARR is positive. However, ARR for project A is significant better in comparison to project B.

iii) NPV refers to net present value derived by adding the present value of the net cash flows that occur during the useful project life.

Capital Budgeting Decisions using Payback Period, Accounting Rate of Return, and Net Present Value

Project A (NPV)

Cost of capital = 10%

NPV = -50000 + (10000/1.1) + (15000/1.12) + (20000/1.13) + (25000/1.14) + (30000/1.15) = $22,216.88

Project B (NPV)

Cost of capital = 10%

NPV = -100000 + (25000/1.1) + (25000/1.12) + (25000/1.13) + (25000/1.14) + (25000/1.15) =-$5,230.33

Conclusion

Since project A has a positive NPV, hence it is feasible. However, project B has a negative NPV and hence would not be considered feasible. 

(iv) Profitability index is defined as the ratio of the present value of future cash inflows and the initial investment.

Profitability Index (Project A)

Present value of cash inflows = (10000/1.1) + (15000/1.12) + (20000/1.13) + (25000/1.14) + (30000/1.15) = $ 72,216.88

Hence, profitability index = (72,216.88/50,000) = 1.444

Profitability Index (Project B)

Present value of cash inflows = (25000/1.1) + (25000/1.12) + (25000/1.13) + (25000/1.14) + (25000/1.15) =

Hence, profitability index = (94769.67/100000) = 0.95

Conclusion

Project A is feasible financially since profitability index exceeds 1. However, this is not true for Project B since the profitability index is lower than 1.

b) Capital budgeting refers to the evaluation of various capital projects and decide on the underlying feasibility of the same using various tools and techniques such as NPV. IRR and Payback period. The various factors that impact capital budgeting are as follows (Petty et. al., 2015).

1) Capital available – This is pivotal as it would decide whether the company can invest in multiple projects or have to invest in the most preferable project.

2) WACC – The capital budgeting decision would be impacted by WACC as higher WACC would imply that only few projects would be considered as financially viable.

3) Risk taking capacity – It is noteworthy that in case of capital budgeting , risk is involved considering that future cash flows need to be estimated with precision which can be quite difficult especially when the project duration is quite long running into  several years.

4) Underlying tax rate – As the capital budgeting related decisions are made based on after-tax cash flows, hence the marginal tax rate for the company does not to influence the quantum of cash inflows which in turn would impact the decision undertaken.  

The prices would increase in an inflationary inventory and hence one may consider stocking high inventories so as to realise windfall gains on account from the inventory sales. However, there are certain issues indicated below (Damodaran, 2015).

  • There would be inventory holding costs coupled with wastage and also potential obsolescence costs.
  • It is possible that as the price rises, the consumers may look for a cheaper substitute and thereby demand can potentially drop.
  • Additionally, there may be competition since multiple suppliers may stock up and hence supply at higher prices can outstrip the demand.
  • The above situation may lead to prices coming down.

Owing to the above issues, one must be cautious of over-stocking even in an inflationary environment. 

1) This refers to the fact that in order to earn higher returns, a higher risk has to be assumed. As a result, there is a trade-off involved considering that investors want to earn higher returns but at the same time want to assume lower risks (Parrino and Kidwell, 2014).

2) Time value of money essentially is a concept which highlights the opportunity cost of money owing to the multiple uses of money. As a result, with regards to lending or computing returns, it is imperative to consider the time value of money as the same amount of money today is better than at a later date since money received today can be used to earn interest income (Petty et. al., 2015).

3) Cash is king refers to the notion that the real money is better or superior than any form of investment. This is especially the case when the financial markets are volatile or the prices are very high. Additionally, this phrase is always used in the sense of business analysis where the cash flow statement is considered to be as pivotal if not more as the income statement (Drury, 2016).

4) Incremental cash flows is a concept used in capital budgeting which implies that while evaluating a project’s financial feasibility, it is imperative that only those cash flows which have been incurred because of the project and otherwise would not have been incurred would be considered for analysis to determine the viability of the project (Parrino and Kidwell, 2014).

5) The agency problem tends to refer to the difference in the interests of the shareholders and those of the managers. This happens when ownership and management tend to be different. As a result, there is fear that the management may serve their own interest at the cost of company and shareholders and hence agency costs are incurred so as to lower this problem (Brealey, Myers and Allen, 2014).

6) One of the key considerations with regards to business decisions tends to be taxes. A lot of projects and activities are undertaken by the firms in order to minimise their tax outflow. A key example of this is establishing of new manufacturing facility in states where lucrative income tax rebate or tax holiday is available (Barkoczy, 2017).

7) This is essentially in the context of portfolio theory where it is possible to diversify the diversifiable risk through the formation of a diversified portfolio. However, undiversifiable risk would still remain with regards to the financial market. As a result, it would be incorrect to assume each risk as the same as some of these may be mitigated while the others cannot (Petty et. al., 2015).

8) There are dilemmas as doing the right thing may not lead to profit maximisation. Thus, there is a need for code of ethics so as to focus on the means and not only the output. It is imperative to highlight that only the output (higher profits) produced through proper means would be rewarded and considered superior performance (Parrino and Kidwell, 2014).

9) The curse of the competitive markets is that in the long term the firm cannot earn profits and profit earning is only possible in the short run. As a result, when a new player enters when there is supply shortage, then profit is earned but with time, this is eroded as the firm cannot differentiate from others despite being more experienced.

10) This concept was given by E. Fama who highlighted three forms of market efficiency i.e. weak, semi-strong and strong. In an efficient market, the prices of financial instruments tend to equal their intrinsic value. Also, the fundamental and technical analyses are not useful in such a market. Besides, no market participant can consistently beat the efficient market in returns (Damodarab, 2014). 

References

Barkoczy, S. (2017) Foundation of Taxation Law 2017. 9th ed. Sydney: Oxford University Press.

Brealey, R. A., Myers, S. C. and Allen, F. (2014) Principles of corporate finance, 6th ed. New York: McGraw-Hill Publications

Damodaran, A. (2015). Applied corporate finance: A user’s manual 3rd ed. New York: Wiley, John & Sons.

Drury, C. (2016) Cost and Management Accounting: An Introduction. 6th ed. New York: Cengage Learning

Parrino, R. and Kidwell, D. (2014) Fundamentals of Corporate Finance, 3rd ed. London: Wiley Publications

Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M. and Nguyen, H. (2015). Financial Management, Principles and Applications, 6th ed..  NSW: Pearson Education, French Forest Australia

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