Question

Planning Ahead

Focus Drilling Supplies has been growing steadily over the last 20 years. With increased exploration in the mining sector, the company has decided to expand their facilities for supplies and custom drill bit production to meet the increased demand.

The expansion will occur over 4 years and is expected to require $2.8 million.

Management has developed a payment plan for carrying out this expansion. The plan requires a cash input of $300,000 now, $700, 000 one year from now, $800,000 two years from now, and finally, $1,000,000 four years from now.

While Focus Drilling is able to allocate $2.6 million dollars from the cash reserves to fund the project, there is no other contingency fund for cost overruns or construction delays. However, any interest earned on the expansion fund during the four-year time frame will be set aside for the project.

Before the final decision on implementation, the company treasurer is asked to assess the plan to determine if the current $2.6 million allocation will meet the $2.8 million in payment obligations of the plan over the four-year period. The Treasurer has predicted interest rates over the next four years to be as follows:

Year 1: interest rate of 4.5% p.a. compounded semi-annually

Year 2: interest rate of 5.0% p.a. compounded semi-annually

Year 3: interest rate of 5.0% p.a. compounded semi-annually

Year 4: interest rate of 5.5% p.a. compounded semi-annually

As an alternative, the Treasurer has found that the $2.6 million cash allocation could be invested at a fixed rate of 5.2% p.a. compounded quarterly for a period of five years.

The company can withdraw part of the money from either investment at any time without penalty to meet the cash payment requirements.

Questions

a. Can Focus Drilling meet the cash payment requirements of the expansion given the variable interest rates given above? Use today as a focal date. Show your calculations.

b. What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?

c. Can Focus Drilling meet the cash payment requirement by investing with the fixed five-year interest rate given above? Show your calculations.

d. What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?

e. Which investment strategy should the company select and why?

Answer 1

a.

	Opening Balance (A)	Interest Rate compounded Seminannually (B)	Balance at end of Year= C=A*(1+B/2)^(N*2)	Cash withdrawn (D)	Balance (C-D)
Year 0	2,600,000.00	0	2,600,000.00	300,000.00	2,300,000.00
Year 1	2,300,000.00	4.50%	2,404,664.38	700,000.00	1,704,664.38
			(2300000*(1+(0.045/2))^(1*2)
Year 2	1,704,664.38	5.00%	1,790,963.01	800,000.00	990,963.01
			(1704664.38*(1+(0.05/2))^(1*2)
Year 3	990,963.01	5.00%	1,041,130.51	-	1,041,130.51
			(990963.01*(1+(0.05/2))^(1*2))
Year 4	1,041,130.51	5.50%	1,099,180.04	1,000,000.00	99,180.04
			(1041130.51*(1+(0.055/2))^(1*2))

as per the above calculations Focus drilling is able to meet the cash paymet requirements given the variable interest rates.

b. Accumulated value of the difference between the allocated cash available and total cash payments made is $99180.40.

c.

	Opening Balance (A)	Interest Rate compounded quarterly (B)	Balance at end of Year= C=A*(1+B/4)^(N*4)	Cash withdrawn (D)	Balance (C-D)
Year 0	2,600,000.00	0	2,600,000.00	300,000.00	2,300,000.00
Year 1	2,300,000.00	5.20%	2,421,952.48	700,000.00	1,721,952.48
			(2300000*(1+(0.052/4))^(1*4)
Year 2	1,721,952.48	5.20%	1,813,255.25	800,000.00	1,013,255.25
			(1721952.48*(1+(0.052/4))^(1*4)
Year 3	1,013,255.25	5.20%	1,066,980.90	-	1,066,980.90
			(1013255.25*(1+(0.052/4))^(1*4))
Year 4	1,066,980.90	5.20%	1,123,555.23	1,000,000.00	123,555.23
			(1066980.9*(1+(0.052/4))^(1*4))
Year 5	123,555.23	5.20%	130,106.48	-	130,106.48
			(123555.23*(1+(0.052/4))^(1*4))		Focus

Focus drill can meet its payment requirement by investing with th fixed 5 year interest rate.

d. Accumulated value of the difference between allocated cash available and total cash payment is $130,106.48

e. In both of the options the company is able to meet the cash payments. However under fixed rate option the balnce at the end of year 4 is more as compared to variable interest rates.The company can withdraw the balance at any time without incurring any penalty. Hence they should go with the fixed rate strategy for investment as it gives higher return.