Working Capital Cash Flow Cycle

Strickler Technology is considering changes in its working capital policies to improve its cash flow cycle. Strickler's sales last year were $2,700,000 (all on credit), and its net profit margin was 4%. Its inventory turnover was 7.5 times during the year, and its DSO was 44 days. Its annual cost of goods sold was $1,500,000. The firm had fixed assets totaling $430,000. Strickler's payables deferral period is 50 days. Assume 365 days in year for your calculations. Do not round intermediate calculations.

1. Calculate Strickler's cash conversion cycle. Round your answer to two decimal places.
        days
   
2. Assuming Strickler holds negligible amounts of cash and marketable securities, calculate its total assets turnover. Round your answer to two decimal places.
        x
   Calculate its ROA. Round your answer to two decimal places.
        %
   
3. Suppose Strickler's managers believe the annual inventory turnover can be raised to 11 times without affecting sale or profit margins. What would Strickler's cash conversion cycle have been if the inventory turnover had been 11 for the year? Round your answer to two decimal places.
        days
   What would Strickler's total assets turnover have been if the inventory turnover had been 11 for the year? Round your answer to two decimal places.
         x
   What would Strickler's ROA have been if the inventory turnover had been 11 for the year? Round your answer to two decimal places.
        %

Problem 12-16
Unequal Lives

Shao Airlines is considering two alternative planes. Plane A has an expected life of 5 years, will cost $100 million and will produce net cash flows of $30 million per year. Plane B has a life of 10 years, will cost $132 million and will produce net cash flows of $27 million per year. Shao plans to serve the route for only 10 years. Inflation in operating costs, airplane costs, and fares is expected to be zero, and the company's cost of capital is 11%.

1. By how much would the value of the company increase if it accepted the better project (plane)? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answer to two decimal places.
   $ __________________million

2. What is the equivalent annual annuity for each plane? Enter your answer in millions. For example, an answer of $1.2 million should be entered as 1.2, not 1,200,000. Round your answers to two decimal places.

   Plane A	$ _________ million
   Plane B	$ _____________ million

Cost of Trade Credit

Grunewald Industries sells on terms of 3/10, net 60. Gross sales last year were $4,385,500 and accounts receivable averaged $466,000. Half of Grunewald's customers paid on the 10th day and took discounts. What are the nominal and effective costs of trade credit to Grunewald's nondiscount customers? (Hint: Calculate daily sales based on a 365-day year, calculate the average receivables for discount customers, and then find the DSO for the nondiscount customers.) Do not round intermediate calculations. Round your answers to two decimal places.

13. Assuming there is ONE risk factor, the interest rate (IR) risk factor. Investors can borrow at the risk-free rate rf of 3%. Portfolio (A) is well-diversified with the risk-return profile below. If an investor wants to profit $10,000 from a net-zero portfolio, constructed with Portfolio A, IR portfolio, and the risk-free rate. How much does he need to borrow/lend at the risk-free rate?

Portfolio A has a beta of 1.2 and E(R)-rf = 8%

Interest Rate Risk Factor Portfolio has a beta of 1 and E(R)-rf = 6%

a) Borrow $55,556

b) Lend $55,556

c) Borrow $250,000

d) Lend $250,000

e) None of the above

Consider the following option portfolio: You write a January 2012 expiration call option on IBM with exercise price $172, and the price of the call option is $8.93. You also write a January expiration IBM put option with exercise price $167, the price of the put option is $10.85.

Instructions: for parts a, b, and c, enter your answer as a decimal rounded to the nearest cent.

a. What will be the profit/loss on this position if IBM is selling at $159 on the option expiration date? $  

b. What will be the profit/loss on this position if IBM is selling at $180 on the option expiration date? $  

c. At what two stock prices will you just break even on your investment (i.e., zero net profit)?

    For the put, this requires that: $  

    For the call this requires that: $  

d. What kind of “bet” is this investor making; that is, what must this investor believe about IBM’s stock price in order to justify the position?

• betting that the IBM stock price will go up.

• betting that the IBM stock price will go down.

• betting that the IBM stock price will have low volatility.

• betting that the IBM stock price will have high volatility.

Kim Inc. must install a new air conditioning unit in its main plant. Kim must install one or the other of the units; otherwise, the highly profitable plant would have to shut down. Two units are available, HCC and LCC (for high and low capital costs, respectively). HCC has a high capital cost but relatively low operating costs, while LCC has a low capital cost but higher operating costs because it uses more electricity. The costs of the units are shown here. Kim's WACC is 5.5%.

1. Which unit would you recommend?

   1. Since all of the cash flows are negative, the IRR's will be negative and we do not accept any project that has a negative IRR.
   2. Since all of the cash flows are negative, the NPV's cannot be calculated and an alternative method must be employed.
   3. Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.
   4. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since LCC's NPV of costs is lower than HCC's, LCC would be chosen.
   5. Since we are examining costs, the unit chosen would be the one that had the lower NPV of costs. Since HCC's NPV of costs is lower than LCC's, HCC would be chosen.

   -Select-IIIIIIIVVItem 1

2. If Kim's controller wanted to know the IRRs of the two projects, what would you tell him?

   1. The IRR of each project will be positive at a lower WACC.
   2. There are multiple IRR's for each project.
   3. The IRR of each project is negative and therefore not useful for decision-making.
   4. The IRR cannot be calculated because the cash flows are all one sign. A change of sign would be needed in order to calculate the IRR.
   5. The IRR cannot be calculated because the cash flows are in the form of an annuity.

   -Select-IIIIIIIVVItem 2

3. If the WACC rose to 11% would this affect your recommendation?

   1. Since all of the cash flows are negative, the NPV's will be negative and we do not accept any project that has a negative NPV.
   2. When the WACC increases to 11%, the NPV of costs are now lower for LCC than HCC.
   3. When the WACC increases to 11%, the NPV of costs are now lower for HCC than LCC.
   4. When the WACC increases to 11%, the IRR for LCC is greater than the IRR for HCC, LCC would be chosen.
   5. When the WACC increases to 11%, the IRR for HCC is greater than the IRR for LCC, HCC would be chosen.

   -Select-IIIIIIIVVItem 3

   Why do you think this result occurred?

   1. The reason is that when you discount at a higher rate you are making negative CFs higher and this lowers the NPV.
   2. The reason is that when you discount at a higher rate you are making negative CFs smaller and this lowers the NPV.
   3. The reason is that when you discount at a higher rate you are making negative CFs smaller thus improving the NPV.
   4. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the IRR.
   5. The reason is that when you discount at a higher rate you are making negative CFs higher thus improving the NPV.

BEA

is considering a change in its capital structure. BEA currently has $20 million in debt

carrying a rate of 8%, and its stock price is $40 per share with 2 million shares outstanding.

BEA is a zero

-

growth firm and pays out all its earnings as dividends. Th

e firm’s EBIT is

$14.933 million, and it faces a 40% federal

-

plus

-

state tax rate.

The market risk premium is 4% and the risk

-

free rate is 6%. BEA is considering increasing

its debt level to a capital structure with 40% debt, based on market values, and

repurchasing

shares with the extra money that is borrows. BEA will have to retire the old debt in order

to issue new debt, and the rate on the new debt will be 9%. BEA has a beta of 1.00

i.

What is BEA’s current WACC?

ii.

What is BEA’s unlevered beta?

(Hint: use

market values of debt to equity when

un

-

levering, which is the same as using

iii.

What’s BEA’s new beta and cost of equity?

iv.

What’s BEA’S new WACC

(after the change in capital

structure)

?

v.

What’s BEA’s total value of the firm with 40% debt? (after the recapitalization is

fully completed).

vi.

What’s BEA’S value of equity and debt, when debt is 40% of the capital structure?

vii.

What’s the value of a share before the repurchase?

viii.

After retiring the old debt, how much cash is left to repurchase shares?

ix.

How many shares will be outstanding after the rep

urchase?

x.

What will the price of a share be after the repurchase?

1. (a) Suppose that, from 12 students, we want to take a committee of students. How many committees consisting of 4 students can be selected? How many committees consisting of 6 students can be selected?

(b) Suppose we want to select 3 out of 12 students and give them the first and second and third places. Determine the number of possible selections?

7. FX Exposure Management at BMW

BMW Group, owner of the BMW, Mini and Rolls-Royce brands, has been based in Munich since its founding in 1916. But by 2011, only

17 per cent of the cars it sold were bought in Germany. In recent years, China has become

BMW’s fastest-growing market, accounting for 14 per cent of BMW’s global sales volume in

2011. India, Russia and eastern Europe have also become key markets.

The rapid globalization of its operations posed several new financial challenges. Despite rising sales revenues, BMW was conscious that its profits were often severely eroded by changes in exchange rates.   The company’s own calculations in its annual reports suggest that the negative effect of exchange rates totalled C2.4bn between 2005 and 2009. BMW did not want to pass on its exchange rate costs to consumers through price increases. Its rival Porsche had done so at the end of the 1980s in the US and sales had plunged.

To address the issues, BMW took a two-pronged approach to managing its foreign exchange exposure.   One strategy was to use a “natural hedge” – meaning it would develop ways to spend money in the same currency as where sales were taking place, meaning revenues would also be in the local currency. However, not all exposure could be offset in this way, so BMW decided it would also use formal financial hedges.   To achieve this, BMW set up regional treasury centres in the US, the UK and Singapore.

BMW implemented its new FX risk management strategy in several ways.   Regarding the natural hedge strategy it again followed a two-pronged implementation strategy.   The first involved establishing factories in the markets where it sold its products. The second involved making more purchases denominated in the currencies of its main markets. BMW now has production facilities for cars and components in 13 countries. In 2000, its overseas production volume accounted for 20 per cent of the total. By 2011, it had risen to 44 per cent. In the 1990s, BMW had become one of the first premium carmakers from overseas to set up a plant in the US – in Spartanburg, South Carolina. In 2008, BMW announced it was investing $750m to expand its Spartanburg plant. This would create 5,000 jobs in the US while cutting 8,100 jobs in Germany. This also had the effect of shortening the supply chain between Germany and the US market. The company boosted its purchasing in US dollars generally, especially in the North American Free Trade Agreement region. Its office in Mexico City made $615m of purchases of Mexican auto parts in 2009, expected to rise significantly in following years.

Since BMW’s fastest growing markets are in Asia it also had to rethink its Asian strategy in light of risk management needs. A joint venture with Brilliance China Automotive was set up in Shenyang, China, where half the BMW cars for sale in the country are now manufactured. The carmaker also set up a local office to help its group purchasing department to select competitive suppliers in China. By the end of 2009, Rmb 6bn worth of purchases were from local suppliers. Again, this had the effect of shortening supply chains and improving customer service. At the end of 2010, BMW announced it would invest 1.8bn rupees in its production plant in Chennai, India, and increase production capacity in India from 6,000 to 10,000 units. It also announced plans to increase production in Kaliningrad, Russia.

Meanwhile, the overseas regional treasury centres were instructed to review the exchange rate exposure in their regions on a weekly basis and report it to a group treasurer, part of the group finance operation, in Munich. The group treasurer team then consolidates risk figures globally and recommends actions to mitigate foreign exchange risk.

Using operating strategy to address FX risk brought other benefits. By moving production to foreign markets the company not only reduces its foreign exchange exposure but also benefits from being close to its customers. In addition, sourcing parts overseas, and therefore closer to its foreign markets, also helps to diversify supply chain risks.

(a) What is the nature of BMW’s FX exposure?   What fundamental financial principle should BMW use to neutralize the impact of FX rate movements on their results?

(b) How did BMW decide to tackle the problem? Do you see any problems with BMW’s approach and implementation?

(c) What differences if any exist in BMW’s approach to FX exposure management in North

America and Asia?

(d) Why did BMW decide to consolidate FX risk management globally in its Munich group treasury?   What principle are they implementing and what are its advantages for the group?

(e) BMW’s and Western Mining’s pursued to very different strategies to address FX expo- sure. What are their respective FX risk management strategies? Why did each company choose their respective strategy?

Bank Three currently has $600 million in transaction deposits on its balance sheet. The Federal Reserve has currently set the reserve requirement at 10 percent of transaction depositors

If the Federal Reserve decreases the reserve requirement to 8 percent, show the balance sheet of Bank Three and the Federal Reserve System just before and after the full effect of the reserve requirement change. Assume Bank Three withdraws all excess reserves and gives out loans and that borrowers eventually return all of these funds to Bank Three in the form of transaction deposits.

Redo part (a) using a 12 percent reserve requirement.

FINANCIAL LEVERAGE EFFECTS

The Neal Company wants to estimate next year's return on equity (ROE) under different financial leverage ratios. Neal's total capital is $17 million, it currently uses only common equity, it has no future plans to use preferred stock in its capital structure, and its federal-plus-state tax rate is 40%. The CFO has estimated next year's EBIT for three possible states of the world: $4.2 million with a 0.2 probability, $2 million with a 0.5 probability, and $0.9 million with a 0.3 probability. Calculate Neal's expected ROE, standard deviation, and coefficient of variation for each of the following debt-to-capital ratios. Do not round intermediate calculations. Round your answers to two decimal places at the end of the calculations.

Debt/Capital ratio is 0.

RÔE = %

σ = %

CV =

Debt/Capital ratio is 10%, interest rate is 9%.

RÔE = %

σ = %

CV =

​(Proforma balance sheet construction​)Use the following​ industry-average ratios to construct a pro forma balance sheet for​ Karen's Beauty​ Products, Inc

Total asset turnover 1.5 times

Average collection period (assume 365-day year) 16 days

Fixed asset turnover 6 times

Inventory turnover (based on cost of goods sold) 2 times

Current ratio 1.8 times

Sales (all on credit) 3,000,000

Cost of goods sold 75% of sales

Debt ratio 50%

Fill in the assets section of the pro forma balance sheet.  ​(Round all items to the nearest​ dollar.)