Financial Management Essay: Daisy Brown And Interstate Haulage Ltd.

Net profits and dividend payouts

1. This is a two period certainty model problem.

Assume that Daisy Brownhas a sole income from FantasyLtdin which she owns 15% of the ordinary share capital. Currently, she has no savings.

In February, 2018, Fantasy Ltd reported net profits after tax of $600,000, and announced it expectsnet profits after tax for the currentcalendar year, 2018, to be 30% higher than last year’s figure. The company operates with a dividend payout ratio of 75%, which it plans to continue, and will pay the annual dividend for 2017 in late-May, 2018, and the dividend for 2018 in late-May, 2019.

In late-May, 2019, Daisy wishes to spend $100,000, which will include the cost of an overseas trip.How much can she consume in late-May, 2018 if the capital market offers an interest rate of 10% per year? 

1. This is an annual equivalent costs problem.

Y Ltd has received two offers for a new computer system. System P will cost $200,000 now, has a three year life and costs $10,000 a year to operate. System Q costs $240,000 now, has a four year life and costs $12,000 a year to operate. The relevant discount rate is 6 per cent per annum. Ignoring depreciation and taxes, calculate the AEC for each. Which do you prefer, and why?   

QUESTION 1 continued.   

1. This question relates to the valuation of interest-bearing securities.

Wildcat BankLtd has experienced large losses on its commercial loan portfolio and is unable to meet its next two annual interest payments on its recent issue of unsecured notes. The notes are of $1,000 face value each, mature in May, 2023 and bear a yearly interest coupon payment of 14% per annum.

The Bank paid the interest due this month (May, 2018), and following a meeting of creditors, arranged to defer payment of the next two interest coupons due in May, 2019 and May, 2020 respectively. Under the arrangement with creditors, the Bank will pay the remaining interest coupons (due in May, 2021, May, 2022 and May, 2023) on their due dates, and pay the two deferred coupons (without interest) along with the normal final interest payment and face value of the notes on the maturity date.

Wildcat Bank Ltd’s notes are now seen as risky, and require an 18% per annum return. 

REQUIRED: Calculate the current value of each Wildcat Bank unsecured note.  

QUESTION 4. 

This question relates to capital budgeting.

Interstate Haulage Ltdis considering the purchase of two new modern large truckscosting $500,000 each, which it will fully financewith a fixed interest loan of 8% per annum, with interest paid monthly and the principal repaid at the end of 4 years. The trucks will be used in the company’s interstate and intra-state trucking business. 

The two new trucks will replace three existing smaller trucks and will permit the company to reduce its storage costs by $50,000 a year and its labour costs by $200,000 a year, both over the next 4 years. [Assume these savings are realized at the end of each year.] 

The new trucksmay be depreciated for tax purposes by the straight-line method to zero over the next 4 years. The company thinks that it can sell the trucksat the end of 4 years for $150,000 each. 

QUESTION 4 continued. 

The three smaller old trucks were bought 1 year ago for $250,000 each, with a then life expectancy of 5 years, and have been depreciated by the straight-line method at 20% a year. If the company proceeds with the above purchase, the old trucks will be sold this month for $100,000 each.   

This is not the first time that the company has considered this purchase and replacement. Twelve monthsago, the company engaged Cartage Consultants, at a fee of $20,000 paid in advance, to conduct a feasibility study on savings strategies and Cartagemade the above recommendations. At the time, Interstate Haulage Ltd did not proceed with the recommended strategy, but is now reconsidering the proposal. 

Interstate Haulage Ltdfurther estimates that it will have to spend tax-deductible amounts of $40,000 in 2 years’ time and $50,000 in 3 years’ time overhauling the trucks. 

It will also require additions to current assets of $30,000 at the beginning of the project, which will be fully recoverable at the end of the fourth year. 

Interstate Haulage Ltd’scost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received. 

REQUIRED: 

• Calculate the net present value (NPV), that is, the net benefit or net loss in present value terms of the proposed purchase costs and the resultant incremental cash flows.

[HINT: As shown in the text-book, it is recommended that for each year you calculate the tax effect first, then identify the cash flows, then calculate the overall net present value. Finally, make your recommendation.] 

QUESTION 4  continued.   

• Should the company purchase the new trucks? State clearly why or why not.

1. a) 

Dividend to be received in May 2018 (in $)

=  Net profit for 2018 x share % x dividend pay-out ratio

=  600000 x 15% x 75%

=  67,500 

Dividend to be received in May 2019 (in $)

=  Net profit for 2018 x (1 + growth rate) x share % x dividend pay-out ratio

=  600000 x (1 + 30%) x 15% x 75%

=  87,750 

Amount required in late May 2019 (in $) =  100,000

Dividend to be received in May 2019 (in $) =  87,750 

Remaining (in $) =  100000 - 87750

=  12,250 

Value of 12,250 in May 2018 (in $)

=  Present value of 12,250 for one year at interest rate of 10%

=  12250 / (1 + 10%)

=  11,136 

She can consume in May 2018 (in $) =  67500 - 11136

=  56,364

1. b)

Discount rate = 6%

Cost of System P (in $) =  200,000

Useful life (in years) = 3

Operating cost per annum (in $) =  10,000 

Present value annuity factor for 3 years at 6% =  2.6730 

Annual Equivalent cost (in $)

=  (Cost of system / PVAF) + operating cost

=  (200000 / 2.6730) + 10000

=  84,822 

Discount rate = 6%

Cost of System Q (in $) =  240,000

Useful life (in years) = 4

Operating cost per annum (in $) =  12,000 

Present value annuity factor for 4 years at 6% =  3.4651 

Annual Equivalent cost (in $)

=  (Cost of system / PVAF) + operating cost

=  (240000 / 3.4651) + 12000

=  81,262 

Since AEC of system Q is less than that of system P. System Q should be selected.  

1. c) 

Face value of Notes (in $) =  1,000.00

Coupon rate per annum = 14%

Interest amount (in $) =  Face value x coupon rate

=  1000 x 14%

=  140.00 

Required rate of return = 18% 

As per details given in the question, payment will be done as given below. 

Particulars	Amount ($)	Payment year no.
Interest of May-19 paid in May-23	140.00	5
Interest of May-20 paid in May-23	140.00	5
Interest of May-21 paid in May-21	140.00	3
Interest of May-22 paid in May-22	140.00	4
Interest of May-23 paid in May-23	140.00	5
Repayment	1,000.00	5

Year	Amount	PVF	PV
3	140.00	0.6086	85.21
4	140.00	0.5158	72.21
5	1,420.00	0.4371	620.70
			778.11

Current value of each unsecured note (in $) =  778.11 

Answer 4 

1. a) 

Tax rate = 30%

Cost of capital = 10%

Working capital requirement (in $) =  30,000 

New Trucks 

Cost of each truck (in $) =  500,000

Total cost of truck (in $) =  Cost of each truck x 2

=  500000 x 2

=  1,000,000 

Useful life of new trucks (in years) = 4

Total depreciation on new trucks (in $) =  1000000 / 4

=  250,000.00 

Total salvage value new trucks (in $) =  150000 x 2

=  300,000 

Savings in storage costs (in $) =  50,000

Savings in labour costs (in $) =  200,000 

Tax deductible expenses in year 2 (in $) =  40,000

Tax deductible expenses in year 3 (in $) =  50,000 

Old Trucks 

Carrying value of old trucks (in $) = Cost of truck x 3 x (1 - 20%)

=  250000 x 3 x (1 - 20%)

=  600,000 

Sale price of old trucks (in $) = 100000 x 3

= 300,000 

Initial cash outflow (in $) = Working capital + cost of new trucks

= 30000 + 1000000

=  1,030,000  

Loss on sale of old trucks (in $)

= Carrying value of old trucks - Sale price of old trucks

= 600000 - 300000

=  300,000

Tax savings on loss (in $) =  300000 x 30%

=  90,000 

Net cash outflow on sale of old trucks (in $)

= Loss on sale of old trucks - tax savings

= 300000 - 90000

=  210,000 

Profit on sale of old trucks (in $)

= Sale price of old trucks - Carrying value of old trucks

= 300000 - 0

= 300000

Tax on profit (in $) =  300000 x 30%

=  90,000 

Net cash inflow on sale of new trucks (in $)

= Profit on sale of old trucks - tax on profit

= 300000 - 90000

=  210,000 

Total terminal cash inflow

=  Working capital - Net cash outflow on sale of old trucks + Net cash inflow on sale of new trucks

=  30000 - 210000 + 210000

=  30,000   

Year	1	2	3	4
Savings in storage costs	50,000	50,000	50,000	50,000
Savings in labour costs	200,000	200,000	200,000	200,000
Less: Depreciation	-250,000	-250,000	-250,000	-250,000
Less: Overhauling expenses		-40,000	-50,000
Profit before tax	-	-40,000	-50,000	-
Add: Tax savings	-	12,000	15,000	-
Net profit	-	-28,000	-35,000	-
Add: Depreciation	250,000	250,000	250,000	250,000
Cash flow from operations	250,000	222,000	215,000	250,000

Year	Cash flow	PVF	PV
0	-1,030,000	1.0000	- 1,030,000.00
1	250,000	0.9091	227,272.73
2	222,000	0.8264	183,471.07
3	215,000	0.7513	161,532.68
4	280,000	0.6830	191,243.77
			-  266,479.75

 Net Present Value (in $) = -266,479.75 

b) 

No. Company should not buy new trucks.

Company should not accept this proposal because NPV is negative. It means there will be loss of $266,479.75 on purchase of new trucks given the existing circumstances.