Question

(a) Ericson Corporation’s total assets are projected to increase by $30 million next year. Ericson is also scheduled to repay $14 million in debt next year. Other than this repayment, no changes in liabilities are currently scheduled. Ericsons’s income is projected to be $4 million, half of which will be paid as a dividend. What is the amount of Ericson’s External Funds Needed (EFN) for next year?

(b) Ericson’s $4 million net income consists of $33 million in revenues, less $25 million in various cash-based costs, and $4 million in depreciation expense.   Also, of the $30 million increase in assets, $2 million is attributable to an increase in inventory and receivables.   No other changes in working capital are anticipated.   What is the amount of Ericson’s operating cash flow?

(c) Evaluate the following statement: In order to maximize shareholder value, it is important that the company always select those investments that provide the highest internal rate of return.

(d) Evaluate the following statement: In order to maximize shareholder value, it is important that the company select projects whose payoffs have low correlations with each other, since this reduces the risk of the company.

Answer 1

Required a.

Particulars	Estimated cash outflow
Increase in asset	$ 30,000,000.00
Repayment of Debt	$ 14,000,000.00
Net Income	$ (4,000,000.00)
Dividend payment	$   2,000,000.00
External Funds needed	$ 42,000,000.00

Required b

Particulars	Operating Cash Flow
Net Income	$   4,000,000.00
Add: Depreciation	$   4,000,000.00
Increase in inventory and receivables	$ (2,000,000.00)
Operating Cash Flow	$   6,000,000.00

Required c

The statement is partially correct. If the situation is such that it requires the company to select any one of the various alternative investment opportunity, it must choose the opportunity with highest IRR. However if there is no limitation on the resources and the company can select various alternatives, the company should then select all the alternatives with positive NPV.

Required d

The statement is true. If Projects with low co relations are selected, the risk of the company is reduced due to diversification. and thus the sharholders value is maximized.

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