Question

In: Accounting

As observed in Part I, over twenty percent of Garcia Energy’s inventory is invested in inventory....

As observed in Part I, over twenty percent of Garcia Energy’s inventory is invested in inventory. In order to make this component of its asset base more productive, Garcia Energy is analyzing two potential inventory expansion projects. Option B is more costly and provides larger cash inflows. Project A and Project B are mutually-exclusive projects. Andrew Potts believes that he the impact of this decision will extend out to three years. Garcia Energy’s required return is 10 percent on this project, which is discussed in greater detail in Part B.   Results for Option A are provided. Complete the analysis for Option B, which is over $100,000 more costly (probably bumping the inventory component of total assets above 25 percent), and identify the project that should be selected.

Option A

Option B

Initial Investment: $310,000

Initial Investment: $440,000

Year

Cash Inflow

Year

Cash Inflow

1

$151,790

1

$210,000

2

$151,790

2

$190,000

3

$151,790

3

$180,000

PART A. Capital Budgeting

Time

Cash Flows

Cumulative Cash Flows

Discounted Cash Flows

Cumulative Discounted Cash Flows

0

-440000.00

-440000.00

-440000.00

-440000.00

1

210000.00

-230000.00

190909.09

-249090.91

2

190000.00

-40000.00

157024.79

-92066.12

3

180000.00

140000.00

135236.66

43170.55

Payback Period = 2 years + (40000/180000) = 2.22 years

Discounted Payback Period = 2 years + (92066.12/135236.66) = 2.68 years

NPV = sum of discounted cash flows = -440000 + 190909.09 + 157024.79 + 135236.66 = $43170.55

Profitability Index = (43170.55 + 440000)/440000 = 1.10

If IRR is ‘i’, then,

V = -440000 + 210000/(1+i) + 190000/(1+1)^2 + 180000/(1+i)^3 = 0

For i = 15%, V = 4628.9143

For i = 16%, V = -2446.1848

IRR = 15% + (16% - 15%) * (0 – 4628.9143)/(-2446.1848 -4628.9143) = 15.65%

FV of positive cash flows = 210000 * (1+10%)^2 + 190000 * (1+10%) + 180000 = 643100.0

MIRR = (643100/440000)^(1/3) – 1 = 13.49%

Option A

Option B

Payback Period

2.04

2.22

Discounted Payback Period

2.41

2.68

NPV

67479

43171

Profitability Index

1.22

1.1

IRR

22%

15.65%

MIRR

17.46%

13.49%

Comparing all parameters, Option A is better alternative. Hence, Garcia Energy should choose Option A.

Part B. Stock Price impacts

            During the immediately preceding 4 years, the annual dividend paid on the firm’s common stock has grown from $3.91 to $4.58 (Do), or by approximately a dollar, which equates to a 4% growth rate. Andrew Potts believes that without the proposed investment, the historical annual dividend growth rate will continue into the future. Currently the required rate of return on the common stock is 13%.

            Andres Potts’ research indicates that if the proposed inventory investment is undertaken, the annual rate of dividend growth will rise to 7% and the coming year’s dividend will rise to $4.90 per share. He feels that in the best case, the dividend would continue to grow at this rate each year forever into the future.   Or, essentially, that he would replace this inventory project with a similar project repeatedly in the future. In the anticipated case, the 7% annual rate of dividend growth would continue for only two years, and then at the beginning of the third year the dividend growth rate would return to the 4% rate that was experienced over the past four years.   In the worst case, the firm’s growth rate will drop to 2%, due to the use of valuable managerial resources managing inventory assignment across Garcia Energy and the losses incurred if the economy were to deteriorate in a world where it had amassed extra inventory.

            As a result of the increased risk associated with the proposed risky investment, the required rate of return on the common stock is expected to increase by 1% to an annual rate of 14%. This required rate of return applies regardless of which dividend growth outcome occurs. Armed with the preceding information, Andrews has tasked you with assessing the impact of the proposed risky investment on the market value of Garcia Energy’s stock. In this scenario analysis, your examination has shown that the best case scenario is likely to happen 20 percent of the time, anticipated case 70 percent of the time, and worst case 10 percent of the time.

a. Current condition. Report the current value per share of Garcia Energy’s stock, without project acceptance, based on current required return and historical growth rate continuing into the future.

b  Best case. Find the value of Garcia Energy’s common stock in the event that it undertakes the proposed inventory investment and the subsequent dividend growth rate stays at 7% forever.

c. Anticipated case. Recalculate the current price assuming that after two years the average annual dividend growth rate returns from 7% to 4%.

d. Worst case. Recalculate the current price assuming that project is undertaken and the growth rate drops to 2%.

e. In between 200 and 300 words summarize the above information in Part II.B and provide Andrew Potts with an analysis of his upcoming inventory decision from the perspective of its impact on the current stock price.   Keep in mind that this decision will impact about 44 percent of inventory. Include additional perspective from the Internet using such terms as gross margin return on inventory investment (GMROII)

Part A is alrady answered.

Solutions

Expert Solution

Calculation of Current Price if the Dividend
(a) Current Dividend (D0) 3.91
Dividend next Year (D1) 4.58
Growth Rate of Dividend 4%
Rate of Return 13%
Current Value of Dividend= Next year Dividend/Required rate of return - Growth rate
= 4.58/(.13-.04)
                  50.89
(b) Best Case
Current Dividend (D0) 4.9
Dividend next Year (D1) 4.9
Growth Rate of Dividend 7%
Rate of Return 14%
Current Value of Dividend= Next year Dividend/Required rate of return - Growth rate
=4.90/(.14-.07)
70
(c) Anticipated Case
Current Dividend (D0) 4.9
Dividend after 2 Year (D1) .=4.9*1.04*1.04 5.3
Growth Rate of Dividend 4%
Rate of Return 14%
Current Value of Dividend= Dividend after 2 year/Required rate of return - Growth rate
=5.3/(.14-.04)
53
(d) Anticipated Case
Current Dividend (D0) 4.9
Dividend next Year (D1) 4.9
Growth Rate of Dividend 2%
Rate of Return 14%
Current Value of Dividend= Next year Dividend/Required rate of return - Growth rate
=4.90/(.14-.02)
40.83
Note- Best effort have been made to answer the question correctly, in case of any discrepencies kindly comment and i will try to resolve it as soon as possible.
Please provide positive feedback.

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