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Corporate Finance Harvard University Server Building Company Homework

Corporate Finance Harvard University Server Building Company Homework

Question Description

Question 1. SERVER BUILDING COMPANY

Jeff Warren just graduated from UC with a master’s degree in Information Technology. He wants to set up his own server building company to help make networking of businesses run smoothly in his municipality. The servers will play a key role in telephony, internet and intranet connections in corporate organizations and other institutions in the Hilton area. He knows from independent investment research that IT business is striving and very profitable in the State of South Carolina where he wants to locate the business.

Jeff knows that before he can invest his time and other resources in the project, he must obtain financing, which means that he must raise money to pay for the investment cost and other operating expenses. Because his company is not going to be listed in any stock exchange market, he can’t raise equity funding publicly. Therefore, he has decided to raise $800,000 long-term debt from Key Finance Company. The loan must be repaid in 10 years at 5.8% interest rate per year.

Jeff learnt in corporate finance course he took two years ago the advantages and disadvantages of different forms of business organizations (mainly sole proprietorship, partnership and corporation). One disadvantage of sole proprietorship he can easily recall is that it has unlimited liability for business debts and obligations. No distinction is made between personal and business assets. He also remembers that a corporation has advantages of unlimited life, and that owners enjoy limited liability. He is not much concerned for now about advantages and disadvantages of business structures. However, in the future when the business grows in size and wants to change from, say, a sole proprietorship to a partnership or corporation or to some other business entity then he will look into the advantages and the disadvantages. Jeff is worried about the concept of limited liability and how it will affect his personal fortune in the future if he defaults in paying the loan.

The total value of assets in the balance sheet will be $1,100,000 and the total value of debt will be $800,000 once he starts the business. His equity in the business is $300,000. He is also thinking about forming a partnership with one of the guys he met in college. They have agreed to share profits and losses equally if they decide to form a general partnership.

Jeff has approached you to help him understand what limited liability means.

a. Explain limited liability to Jeff.

Specifically, he has asked you to help him answer the following questions.

b. Assuming the debt increased to $2 million at the end of the 10-year maturity period and the total market value of the asset of the business is $1.2 million, how much is Jeff personally responsible for if the business is established as a:

i. sole proprietorship,

ii. Partnership, or

iii. Corporation?

c. Ultimately, what form of business organization would you recommend Jeff to consider. Why?

Question 2. ACCOUNTING AND CASH FLOW

Jeff is happy that once he starts the business, he would be able to generate enough profits to meet his obligations. However, he read from an article published in one of the financial journals that profit is not a good measure of a business cash flow. Jeff wants to know why the revenue and cost figures shown on a standard income statement may not be representative of the actual cash inflows and outflows that occurred during the period of business operations?

Question 3. GRANDMOTHER CALENDAR COMPANY

Use the following information to answer the next five questions about a company Jeff read about: A small business called The Grandmother Calendar Company began selling personalized photo calendar kits. The kits were a hit, and sales soon sharply exceeded forecasts. The rush of orders created a huge backlog, so the company leased more space and expanded capacity, but it still could not keep up with demand. Equipment failed from overuse and quality suffered. Working capital was drained to expand production, and, at the same time, payments from customers were often delayed until the product was shipped. Unable to deliver on orders, the company became so strapped for cash that employee paychecks began to bounce finally, out of cash, the company ceased operations entirely three years later.

  1. Product Sales: Do you think the company would have suffered the same fate if its product had been less popular? Why or why not?
  2. Cash Flow: The Grandmother Calendar Company clearly had a cash flow problem. In the context of the cash flow analysis we developed in Chapter 2, what was the impact of customers’ not paying until orders were shipped?
  3. Corporate Borrowing: if the firm was so successful at selling, why wouldn’t a bank or some other lender step in and provide it with the cash it needed to continue?
  4. Cash Flow: Which is the biggest culprit here: too many orders, too little cash, or too little production capacity?
  5. Cash Flow: What are some of the actions that a small company like The Grandmother Calendar Company can take (besides expansion of capacity) if it finds itself in a situation in which growth in sales outstrips production?

Question 4. TIME VALUE OF MONEY

Jeff Warren after consulting with some PhD students and his Financial Advisor decided to register his server building company as S corporation, which is a special designation that allows small businesses to be taxed as if they were a sole proprietorship or a partnership rather than as a corporation whilst at the same time enjoying limited liability of a corporation. Jeff is satisfied with this choice because he is aware that one of the disadvantages of a corporation is the double taxation of corporate earnings.

Jeff is determined to make sure his business succeeds and has a long-term plan of expanding his business to some emerging countries. He has been reading some articles in finance journals about time value of money and how he can apply the concept to manage his finances and expansion plans. The time value of money holds that it is better to receive money sooner than later. Money that is available today is worth more than money to be received in the future. This is so because money in hand today can be invested to earn a positive rate of return, thereby producing more money tomorrow. On his google search he came across this article:

Schmidt, C. E. (2016). A journey through time: From the present value to the future value and back or: retirement planning: A comprehensible application of time value of money concept. American Journal of Business Education, 9(3), 137 – 143.

The article discusses a contemporary financial planning problem of correctly solving time value of money problems and identifying the cash flows and timing necessary for financial and investment decisions. Schmidt (2016) explains with practical examples the applications of the concept of time value of money to retirement planning, valuing stocks and bonds, setting up loan amortization schedules, and making capital budgeting decisions. Jeff does not fully understand some of the finance terms such as future value of compounding, present value and discounting, perpetuity and annuities etc. that the article discussed. He believes that once he grasps these time value of money concepts, he will be able to make sound financial and investment decisions. His major concern is that these concepts require application of some basic quantitative techniques which he tried to avoid at the graduate school two years ago.

Jeff has approached you for help in answering the following questions:

a. Suppose Jeff has $85,000 to invest in an IRA at an interest rate of 10% per year for his retirement in 10 years. How much money can he accumulate at the end of the time period?

b. Jeff wants to send his daughter to college in 18 years. He has assumed that he would need $100,000 at the time in order to pay for her tuition, room and board, school supplies etc. If he can earn an average of 8% per year, how much money does he need to invest today as a lump sum to achieve that goal?

c. Jeff wants to move $50,000 from his checking accounts and invests it in money market securities for 3 years. The money market earns 7% interest compounded annually. How much can this investment grow at the end of the investment period?

d. Jeff wants to find the present value of the following uneven cash flows he expects to receive in the next 3 years from his business.

Year

Cash Flows

2020

$25,000

2021

$20,000

2022

$15,000

What is the present value of the cash flows assuming the discount rate is 7%?

e. Jeff wants to invest in preferred stocks issued by Camden Company. The company pays $3 dividend per share on its stock. The dividend is expected to grow at a constant rate of 10% per year indefinitely. If Jeff requires a rate of return of 15% on the stock, what is the (estimated) current price of Camden stock?

Question 5. RISK ANALYSIS, REAL OPTIONS AND CAPITAL BUDGETING

Baldwin Corporation is a public corporation listed on New York Stock Exchange (NYSE) market. The company researches, develops, manufactures, and sells various products in the health care industry worldwide. Baldwin Inc. operates in three main segments: Consumer, Pharmaceutical, and Medical Devices segments. The primary corporate objective of the company is to maximize the value of the owners’ equity by increasing the price of its shares in the stock market. Unfortunately, the company’s stock price has been declining over the past year because of declining sales, cash flow uncertainties, and weak financial ratios. The Board of Directors have hired a new CFO, Gregg Williams to turnaround the fortunes of the company. Gregg earned his PhD in Finance from UC in 2018. After his MBA he worked for five years as sales and marketing consultant for a pharmaceutical company. As a result, Gregg does not have much work experience in corporate finance, although in his graduate finance courses, he learnt about time value of money and its applications in financial and investment decisions.

Despite his lack of experience in corporate finance, Gregg wants to create value for the company through efficient management of working capital, and prudent capital budgeting activities by expanding the company’s products into new markets. He is considering a capital investment either in the State of Ohio or North Dakota because of growing market demand for the company’s products in both States and the recent changes to the States’ tax legislations that give tax incentives to new companies. The company has announced plans to invest about $2.2 million in its Medical Devices and Pharmaceutical segments. Gregg believes that decisions such as these, with price tags in the millions, are obviously major undertakings, and the risks and rewards must be carefully weighed. Gregg knows that good financial decisions increase the value of a company’s stock, and poor financial decisions decrease the value of the stock. Gregg is working hard to make Baldwin Inc. one of the leading firms in the health care industry.

Gregg has been reading articles in financial journals on capital budgeting decisions and risk analysis. He has written down the following ideas on project evaluation techniques from book chapters and peer-reviewed articles:

1. The most popular capital budgeting techniques used in practice to evaluate and select projects are payback period, Net Present Value (NPV), and Internal Rate of Return (IRR).

2. Payback period is the number of years required for a company to recover the initial investment cost.

3. Net Present Value (NPV) technique: NPV is found by subtracting a project’s initial cost of investment from the present value of its cash flows discounted using the firm’s weighted average cost of capital. It shows the absolute amount of money in dollars that the project is expected to generate.

Decision Criteria of NPV

If NPV > 0, accept the project

If NPV < 0, reject the project

The decision rule for mutually exclusive project is to select the project with the highest NPV.

4. Internal Rate of Return (IRR) is the intrinsic rate of return the project is likely to generate. The IRR is the discount rate or the rate of return that will equate the present value of the cash outflows with the present value of the cash inflows (i.e. NPV = 0).

Decision Rule:

Accept the project if IRR > cost of capital

Reject the project if IRR < cost of capital

Exhibit 1: The expected cash flows in US$ from the project in Ohio and North Dakota.

Year

Cash flow (Ohio)

Cash flow (ND)

0

(2,000,000)

(2,200,000)

1

180,000.00

150,000.00

2

240,000.00

180,000.00

3

280,000.00

200,000.00

4

300,000.00

290,000.00

5

520,000.00

380,000.00

6

480,000.00

590,000.00

7

530,000.00

410,000.00

8

585,000.00

583,000.00

9

590,000.00

580,000.00

10

592,000.00

620,000.00

The company’s policy is to select projects using NPV technique.

1. You have been hired as a financial consultant to help evaluate the project. Baldwin Inc. wants you to do the following:

a. Calculate the payback period for the two projects.

b. Calculate the IRR of both projects.

c. Use the NPV technique to recommend which investment project it should accept, assuming the cost of capital of financing the Ohio project is 12% and 10% for the North Dakota project?

2. Gregg knows how bad forecast can ruin capital budgeting decisions. If the cost of capital changes from 12% to 13% for Ohio project and remains the same for ND project, does the company have to pursue the project?

3. Gregg wants to analyze the risk of the project using sensitivity analysis and Monte Carlo simulation.

a. Explain to Baldwin Inc. how the two risk analysis models can be used to analyze risk of the project.

4. Gregg has estimated the fixed costs (including depreciation) of the Ohio project to be $1.5 million, sales price is $130, and the variable cost is $70, giving a contribution margin of $60. What is the break-even quantity for this project?

5. Baldwin Inc. wants to know the likely effect of the capital budgeting decision on its stock price (increase, decrease, no change, or not sure). Choose one and explain why.

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