Question

1.A data analytics company wants Short Stop to provide a new client billing process which integrates their current customers with new payment options as well as technical information. The payment for Short Stop’s services would be structured with the specific payments to be $400,000 immediately, a further $300,000 at the end of the 2nd year, $500,000 at the end of the 4th year and $1,000,000 on completion, at the end of the 7th year.
The paid monies can be invested at a nominal rate of 9% p.a. compounded monthly.
To complete the desired work, Short Stop would have to purchase additional computers and data sources immediately which are valued at $1,500,000.
In determining if this project is a viable project for Short Stop, your manager wants you to provide a detailed information on the differences between the effective rate of return and a nominal rate. In what circumstances can we use these to evaluate different investment opportunities?
2. As information becomes increasingly available, additional storage is needed for the handling of client’s insurance capacities. Short Stop is looking to modernise the hardware in which they store the data. Under the proposed idea, Short Stop would purchase dedicated virtual servers and cloud storage which costs $50,000 per year, indefinitely, from the end of year 2 onward (as it takes a year to implement this change). If implemented, this would result in an immediate cost saving of $500,000. Short Stop has estimated that it could invest this money elsewhere, as an alternative, at 8% p.a.
From a business perspective, describe the concept of time value of money in such a way that your description sheds light on how businesses come to financial investment decisions or how investments today can be valued in the future. In the discussion, your manager wants a clear description on the benefits of this concept for the business (or any business).
3. The company has an opportunity to purchase a small company (Trek Travel) which will augment the current operations of the company. The cash flows from the company are variable as it is still a growing company. The owners of the company have indicated that they would be willing to sell the company to Short Stop for $2 million dollars. An independent accountant has reviewed Trek Travel’s annual statements and has estimated the future (yearly) cash flows from its operations to be:
Yr 1: -$100,000, Yr 2: $300,000, Yr 3: $500,000, Yr 4: $600,000, Yr 5: $800,000 and Yr 6: $1,100,000.
Short Stop requires a rate of return of 9% p.a. for an investment of this kind.
As this project is the purchase of another company, your manager wishes for you to explain the objective of maximising / enhancing shareholder wealth. How would the managers of a company achieve this goal?

4. The last project involves rolling out a personal finance advisory platform and includes the servicing and maintenance of the platform. There are two competing clients who would purchase the platform, however due to legal, licensing and competition restrictions, Short Stop can only sell the platform to one of the clients.
The first client is offering a payment structure comprising of quarterly payments of $200,000 over a 6-year period, starting at the end of the 1st quarter.
The second client is offering a different payment structure compromising monthly payments of $60,000 over the 6-year period. Additionally, they will pay $30,000 at the start of each year for 6 years, starting immediately.
Short Stop estimates that the personal finance advisory platform can be created from current embedded systems and augmented with other applications. The required computing hardware can be delivered and installed immediately after the client has been approved, at a cost of $3 million to Short Stop. As such, the rollout of the project can be completed immediately after the choice of client.
Given a required rate of return on a project such as this is a nominal 12% p.a., your manager wishes you to advise on which client Short Stop should choose to maximise value.
Given that the clients offering to pay for the personal finance advisory platform are providing payment plans that are regular, detail using diagrams if needed, how payments received at the beginning of a period differ from payments received at the end of a period. Provide some discussion on the present value and future value of these types of cash flows in terms of how they are calculated

Answer 1

Answer :

1. Effective rate of return :- The effective rate of return is the rate of interest on an investment annually when compounding occurs more than once.

Nominal rate of return : - Inflation can have a major impact upon the capital budgeting decision. The expectation of inflation is captured in the nominal interest rate. The cash flows of the project could be affected by the inflation rate. If nominal interest rates reflect expected inflation, then we should make sure that the cash flows that we are discounting also reflect expected inflation.

Since in the given scenario, we have cashflows without inflation so Effective rate of return will be more apt to determine the viability of project.

2. Below table explains the Time value effect of initial investment and benefits drawn from the same in future :-

#	Cost incurred on storage	Future value of Cost @ 8%	Benefits received	Benefits invested for next 5 years @ 8%
2	50000	73466.40384	500000	734664.0384
3	50000	68024.448
4	50000	62985.6
5	50000	62985.6
6	50000	58320
7	50000	54000
		379782.0518		734664.0384

The benefits received (i.e. $500000) can be invested for next 5 years @ 8 % which will result in inflow of $734664.0384 at the end of 7th year for Short stop. On the other hand per year investment of $50000 will result in cash flow of $379782.0518 (provided the money could have been invested @ 8% ).

Therefore investment in storage facility will result in a long term profit (FV) of $354882.

3. Below is the tabling showing the Present value of cashflow expected from new company over next 6 years :-

	Cashflow	Discounted value @ 9%	Initial Invested
1.00	100,000.00	91,743.12	2,000,000.00
2.00	300,000.00	252,504.00
3.00	500,000.00	386,091.74
4.00	600,000.00	425,055.13
5.00	800,000.00	519,945.11
6.00	1,100,000.00	655,894.06
		2,331,233.15	2,000,000.00

Therefore the investment of $2,000,000 will result in a addition of $331,233 in shareholders wealth.

4. For Client 1, since the payment frequency is quarterly, therefore the nominal rate will be 11.495 % with quarterly compounding.

Now we can use this rate to discount all quarterly cashflow, below is the table with detailed values :-

#	Quarter	Client 1	Present values
1	Q1	200000	194413.0548
2	Q2	200000	188982.1795
3	Q3	200000	183703.0141
4	Q4	200000	178571.3208
5	Q1	200000	173582.9799
6	Q2	200000	168733.9869
7	Q3	200000	164020.4493
8	Q4	200000	159438.583
9	Q1	200000	154984.7099
10	Q2	200000	150655.2545
11	Q3	200000	146446.7413
12	Q4	200000	142355.7917
13	Q1	200000	138379.1217
14	Q2	200000	134513.5389
15	Q3	200000	130755.9401
16	Q4	200000	127103.3087
17	Q1	200000	123552.7126
18	Q2	200000	120101.3015
19	Q3	200000	116746.3046
20	Q4	200000	113485.0286
21	Q1	200000	110314.8554
22	Q2	200000	107233.2402
23	Q3	200000	104237.709
24	Q4	200000	101325.8572
			3433636.984

For Client 1, since the payment frequency is monthly, therefore the nominal rate will be 11.387 % with monthly compounding.

Now we will be using the same rate to discount the monthly cashflows and 12% to discount the yearly cashflows:-

Month	Client 1 (monthly)	Present values(@11.387 pm)	Annual payment	Present Annual values(@12% per year)
1	60000	59436.00187
2	60000	58877.30531
3	60000	58323.86048
4	60000	57775.61801
5	60000	57232.529
6	60000	56694.54501
7	60000	56161.61806
8	60000	55633.7006
9	60000	55110.74555
10	60000	54592.70627
11	60000	54079.53653
12	60000	53571.19057	30000	26785.71429
13	60000	53067.62305
14	60000	52568.78905
15	60000	52074.64408
16	60000	51585.14405
17	60000	51100.2453
18	60000	50619.90459
19	60000	50144.07907
20	60000	49672.72629
21	60000	49205.80421
22	60000	48743.27119
23	60000	48285.08596
24	60000	47831.20766	30000	23915.81633
25	60000	47381.5958
26	60000	46936.21028
27	60000	46495.01137
28	60000	46057.95971
29	60000	45625.01632
30	60000	45196.1426
31	60000	44771.30027
32	60000	44350.45144
33	60000	43933.55858
34	60000	43520.5845
35	60000	43111.49236
36	60000	42706.24568	30000	21353.40743
37	60000	42304.8083
38	60000	41907.14443
39	60000	41513.21858
40	60000	41122.99562
41	60000	40736.44074
42	60000	40353.51947
43	60000	39974.19765
44	60000	39598.44144
45	60000	39226.21732
46	60000	38857.4921
47	60000	38492.23289
48	60000	38130.4071	30000	19065.54235
49	60000	37771.98246
50	60000	37416.92701
51	60000	37065.20906
52	60000	36716.79725
53	60000	36371.6605
54	60000	36029.76803
55	60000	35691.08934
56	60000	35355.59421
57	60000	35023.25273
58	60000	34694.03524
59	60000	34367.9124
60	60000	34044.85509	30000	17022.80567
61	60000	33724.83452
62	60000	33407.82212
63	60000	33093.78964
64	60000	32782.70905
65	60000	32474.55261
66	60000	32169.29283
67	60000	31866.90248
68	60000	31567.35459
69	60000	31270.62244
70	60000	30976.67956
71	60000	30685.49974
72	60000	30397.057	30000	15198.93364
		3119656.766		123342.2197

There PV of Monthly and annual cashflows for client 2 = $3,242,999

Now comparing the cashflow from client1($3,433,637), client 2 ($3,242,999) with short spot's self financing cost($ 3 mn). The client 1 is offering the best deal.