Financial Management Questions: Portfolio Management, Investment Decisions, and Capital Structure

Question 1

Suppose you are a senior portfolio manager of an international investment bank that oversees a USA investment portfolio with total assets of £28 billion. For company B&G Ltd., you know the following information:

EBIT= £840,000

Interest rate = 7% (before tax)

Expected market return (Rm) = 8%

Total debt = £1.5 million

Tax rate= 35%

β of B&G = 1.4

Total equity = £4.5 million

Risk free rate (Rf) = 5%

a) What do you think about the current structure of capital of this company? Is this company creating value?

b) The CFO suggests buying back shares (at their book value) and thus reducing the equity capital to £2.5 million (again book value). They will use cash for the buyback and everything else ceteris paribus. Is this a good suggestion? Critically evaluate your answer. [25 marks]

Question 2

A firm has three options for investment: A, B, and C. The initial investments and cash flows are presented in the table below.

a) Consider the discount rate at 15% and compute the payback period, NPV, and IRR and advise on the best course of action. [15 marks]

b) Determine and evaluate the benefits and drawbacks of the methods and explain which one is superior and why. [10 marks]

Question 3

The owner of a local coffee chain, Morning Café, is thinking about replacing some of the older coffee machines. The existing machines are old and require maintenance. The finance department has gone through the outgoing payments and reported that the machines cost £110,000; buying new ones for all the branches in the country will cost £125,000. Based on experience, we know that the new machines will last for five years, and the company will be able to sell them for £25,000. The depreciation rate for the existing machines is £20,000 per year, and the finance manager will write them off in three years. The owner knows that if they do not replace the machines with new ones now, the machines will need to be replaced after two years. There is a buyer for the old machines now who is offering £35,000 per machine. If the owner doesn’t sell them right now and instead keeps them for another two years, they would be able to sell the machines for £12,000 each. Considering the maintenance cost of the existing machines, the owner will be able to save £25,000 per year (cost of operation) by buying new ones. New machine operating cash flow (for 5 years)

Old machine

operating

cash flow

The initial cost

of old machine

using after tax

salvage value Tax rate

Discount rate

25,000 7,500 65,500 8% 2%

a) Use your knowledge to explain the best decision. Is it better to substitute the old machines with the new ones? [25 marks]

b) What would the cash flow be, assuming we are not concerned with what’s going to happen in two years and we are just wondering whether we should replace the machines or not? [25 marks]