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The Investment Detective
Objective of the case:
This case presents the cash flows of eight unidentified investments, all of equal initial investment size. Your task is to rank the projects. The first objective of the case is to examine critically the principal capital-budgeting criteria.
A second objective is to consider the problem that arises when net present value (NPV) and internal rate of return (IRR) disagree as to the ranking of two mutually exclusive projects.
Finally, the case is a vehicle for introducing the problem created by attempting to rank projects of unequal life and the solution to that difficulty—the equivalent-annuity criterion.
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Assignments:
Fill the yellow part of the excel sheet. And then answer the following questions:
1) Which of the two projects, 7 or 8, is more attractive?
a. How sensitive is our ranking to the use of high discount rates?
b. Why do NPV and IRR disagree?
2) What rank should we assign to each project?
a. Why do payback and NPV not agree completely?
b. Why do average return on investment and NPV not agree completely?
c. Which criterion is best?
3) Are those projects comparable based on NPV?
a. Because the projects have different lives, are we really measuring the “net present” value of the short-lived projects?
4) What is the equivalent-annuity method and when is it called for in project comparisons?
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The key points ABOUT capital budget should be the following:
IRR: Possibly incorrect opportunity cost assumption. Violates value additivity. Multiple IRRs are possible.
NPV: May be difficult to explain.
ROI: Often computed on profits, not cash flow. Ignores time profile of flows and the time value of money.
Payback: Ignores time value of money, although it is a proxy for the liquidity or duration of an investment and is sometimes used in conjunction with NPV.
The Investment Detective
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Principle Investments
US President Donald Trump, in a meeting at the White House on February 27, 2018, ordered the imposition of stiff and strict tariffs on the importation of steel and aluminum. The move, seen as a hallmark of keeping his campaign promises is bound to have numerous effects the world over. In its wake, the imposition of tariffs is expected to rattle the stock markets and cause trade wars between the US and several of its trade allies, especially in the European and Asian regions (Swanson, 2018; Jacobs & Deaux, 2018).
In my opinion, the imposition of such tariffs should be handled with a softer approach. President Trump should initiate discussions and negotiations with the US trade partners and strike a deal rather than suddenly bombard them with such news.
The announcement to impose a 25% tariff on steel and 10% on aluminum imports, despite the expected wrangles, will have a few winners. First is the US steel makers, who in spite of a rising demand, have not been able to meet the demand, resulting in the importation of more steel. A second category is the factory workers in steel and aluminum manufacturing plants. This category of beneficiaries may find more and better jobs.
Principle Investments
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The losers in this announcement include the United States’ trade partners who have been importing steel and aluminum. This list includes Brazil, China, Mexico, and Canada. Asian steel makers have been having a rough time over the past few years, and this announcement is bound to add to their operational and financial woes. A third loser in the development is the relationships that the US has built for a long time, which may end once the tariffs are put in place. In addition, the US steel and aluminum secondary users may get losses on the high costs of importations if the local producers cannot meet the demands.
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Assets
A company must satisfy its customers in order to succeed. A company also needs to sell products and services at a profit. (Non-profit and public organizations are not covered in this course.)
Companies have both tangible and intangible assets and need both of these types.
Goals of Financial Management
Should financial managers focus only on long-term sustainable value or should they account for the short-term demands of shareholders seeking immediate gain? Let us look at an example. A relatively new company without actual profits or a solid business strategy called V.A. Linux (ticker symbol LNUX) went public December 9,1999, at an initial price of $30 per share, and its stock hit $320 per share the same day. In the year 2000, its stock hit a low of 6.
There are numerous stories just like V.A. Linux. In general, maximizing value is a short-term proposition and one that does not always fit every situation in the short term.
Working to maximize shareholder wealth is a simple and obvious management mandate. Complications surface when managers try to balance short-term and long-term goals, sustainable performance, social responsibility expectations, ethical and legal behavior, and sometimes personal objectives. This course will touch on all of these complicating factors.
Goals of Financial Management
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Financial Environment
Financial managers are not independent operators. Financial institutions make their decisions in larger financial environments.
Financial managers need to understand the environment within which their businesses operate. You will look at the markets in which capital is raised and securities are traded and priced, and you will examine institutions that operate in these markets. In the process, you will also explore the principal factors that determine the level of interest rates.
People and organizations with borrowing needs often use the services of different financial intermediaries. This involves analyzing different existing types of financial markets such as primary and secondary markets, equity and bond markets, money markets and capital markets, and some of the recent trends in the financial markets.
It is important to consider different financial intermediaries, which not only efficiently transfer money between borrowers and savers, but essentially create new financial products. There are major types of intermediaries with highly specialized functions in our financial environment.
Goals of Financial Management
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Financial Statement Analysis
There are four basic financial statements: the balance sheet, the income statement, the statement of retained earnings, and the statement of cash flows. These statements contain a lot of information that should be dissected and analyzed to help managers to draw conclusions regarding the overall financial performance of the company.
Ratio Analysis
It is useful to anticipate future conditions and to plan actions that will improve a firm’s future performance. The primary method used to analyze financial statements is ratio analysis. The most important ratios to analyze can be grouped into liquidity ratios, asset management ratios, debt management ratios, profitability ratios, and market value ratios.
Financial Statement Forecasting Techniques
This assessment will focus on some of the techniques used to forecast financial statements as a critical part of the overall financial planning process. Financial forecasting usually starts with a forecast of the firm’s projected sales based on projected or pro forma financial statements. These statements can also provide ratios to be used in evaluating alternative business plans and strategies. Consider the uses and limitations of the additional funds needed (AFN) formula, which is used to estimate additional funds needed to support a higher projected level of sales, as well as the need for a comprehensive approach to forecasting and an understanding of financial and non-financial factors in the financial environment.
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Assets.
Goals of financial management.
Financial environment.
Financial statement analysis.
Ratio analysis.
Financial statement forecasting techniques.
Question to Consider
To deepen your understanding, you are encouraged to consider the questions below and discuss them with a fellow learner, a work associate, an interested friend, or a member of the business community.
Examine a large department store company that has stable sales and a well-established product line (for example, Macy’s). Imagine the following: The store does not foresee growth in future sales, and the company’s target markets are primarily in the United States. If this company plans to move product overseas at a lower cost, what financial and social factors should they be concerned with?
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Financial Ratio Analysis
Using the XYZ Balance Sheet and Income Statement linked in the Resources and the table provided below, complete the following for XYZ Inc.:
Calculate the indicated ratios for XYZ.
Construct the DuPont equation for both XYZ and the industry.
Use your analysis to outline XYZ’s strengths and weaknesses.
Say XYZ had doubled its sales as well as its inventories and common equity during 2013. Do you think this would this affect the validity of your ratio analysis? No calculations are necessary.
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For this part of the assessment, imagine that you are looking into investing in a manufacturing company, such as a car company or a steel company. Your goal is to create a plan for determining the potential strength of an investment in the company (investment analysis) and determining how the company might perform over a selected period of years (forecast).
After considering a potential investment in this manufacturing company, address the following:
What are some of the qualitative factors that must be considered when selecting a company in which to invest?
What financial ratios would you examine, and why?
What non-financial factors would you examine, and why?
Use research from at least two references to support your ideas.
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Investment Analysis and Forecasting
Overview
In 3–6 pages, complete a ratio analysis using a provided balance sheet and income statement, specify how you would analyze a potential investment, and describe how you would forecast a company’s potential success.
An investment analysis has two fundamental components: 1) A financial analysis, such as reviewing current financial ratios within the company, and 2) a non-financial analysis, which is reviewing a company’s strategic vision, employee satisfaction, et cetera. The first two parts of your assessment provide an opportunity for you to demonstrate both of these types of analyses.
The goal of forecasting the performance of a company is to estimate the financial performance of a company over a selected period of years. When forecasting a company’s performance, similar to an investment analysis, you look at both financial and non-financial factors. This is the focus of the last part of your assessment.
Investment Analysis and Forecasting
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Inflation and Interest Rates
Overview
Solve three problems addressing inflation and interest rates affecting the financial environment, including the real risk-free rate, expected interest rate, detailed risk premium, and ratio analysis.
By successfully completing this assessment, you will demonstrate your proficiency in the following course competencies and assessment criteria:
Competency 1: Maximize shareholder wealth.
Compute real risk-free rate of return based on data presented.
Determine yield on 2-year and 3-year Treasury securities.
Competency 2: Evaluate the financial health of the firm
Assess the default risk of a corporate bond.
Context
There are different determinants of market interest rates. Try to answer such questions as, “What determines the shape of the yield curve?” and “How is the yield curve used to estimate future interest rates?,” which are important considerations for financial managers.
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Resources
The following optional resources are provided to support you in completing the assessment or to provide a helpful context.
Brigham, E. F., & Houston, J. F. (2016). Fundamentals of financial management (14th ed.). Boston, MA: Cengage.
Assessment Instructions
For this assessment, complete Problems 1–3 on inflation and interest rates affecting financial environment. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:
You may need an HP 10B II business calculator.
You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.
If you choose to solve the problems algebraically, be sure to show your computations.
If you use a financial calculator, show your input values.
If you use an Excel spreadsheet, show your input values and formulas.
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