Calculating Payback: Global Toys Inc Imposes A Payback Cutof

calculating Paybackglobal Toys Inc Imposes A Payback Cutoff Of Th

Global Toys Inc. has implemented a payback cutoff period of three years for its international investment projects. Given two available projects with specified cash flows, the company needs to determine whether to accept either of them based on this criterion. Additionally, various financial analysis techniques such as calculating the Average Accounting Return (AAR), Internal Rate of Return (IRR), Net Present Value (NPV), interest rate risk assessment for bonds, valuation of preferred stock, and stock valuation are discussed. These analyses help in making informed investment decisions by evaluating profitability, risk, and value over time.

Paper For Above instruction

Investment evaluation methods are fundamental tools used by corporations to decide whether to proceed with projects or investments. Among these methods, payback period, AAR, IRR, NPV, and bond and stock valuation are prominently utilized due to their respective strengths in assessing profitability and risk. This paper discusses each of these methods in the context of hypothetical scenarios, illustrating their application and significance in financial decision-making.

Payback Period Analysis

The payback period method measures the time it takes for an investment to recover its initial cost. Global Toys Inc. has set a cutoff of three years, emphasizing liquidity and risk considerations. Suppose Project A requires an initial investment of $55,000, with cash flows of $20,000, $20,000, and $20,000 over three years, and Project B has an initial investment of $95,000 with cash flows of $35,000, $35,000, and $40,000 over the same period. Calculating the payback period involves summing the cash flows annually until they equal or exceed the initial investment.

For Project A, cumulative cash flows over the first two years total $40,000; the remaining $15,000 is recovered in the third year, where cash flow is $20,000. The payback period is slightly less than three years. For Project B, cumulative cash flows after two years equal $70,000; the remaining $25,000 is recovered in the third year, making the payback period again slightly less than three years. Since both projects have payback periods close to but less than or within the three-year cutoff, the decision hinges on further analysis or whether to accept these projects based solely on payback.

Average Accounting Return (AAR)

The AAR evaluates profitability based on average net income relative to initial investments. A plant with an installation cost of $14 million is depreciated straight-line over four years, resulting in an annual depreciation of $3.5 million. Projected net incomes are: $1,253,000, $1,935,000, $1,738,000, and $1,310,000.

The average net income over the four years is calculated as:

(\$1,253,000 + \$1,935,000 + \$1,738,000 + \$1,310,000) / 4 = \$1,558,500.

The initial investment of $14 million minus the total depreciation is the book value, but for AAR, the focus is on income and initial investment. The average AAR is then:

\( \text{AAR} = \frac{\text{Average Net Income}}{\text{Initial Investment}} = \frac{\$1,558,500}{\$14,000,000} \approx 11.13\% \).

This rate helps the firm determine if the project’s profitability exceeds their required threshold, often compared against a company's hurdle rate.

Internal Rate of Return (IRR)

The IRR is the discount rate at which the NPV of cash flows equals zero. Given a project with an initial outlay of \$153,000 and cash inflows over subsequent years, the IRR is calculated to assess profitability against the company’s required return. If the IRR exceeds 11%, the company would accept the project, indicating the investment’s return surpasses their minimum threshold.

Net Present Value (NPV)

The NPV evaluates the value added by a project, considering the time value of money at different discount rates. For the cash flows associated with the previous project, an NPV is computed at 9% and 21% discount rates. If NPV is positive at a 9% discount rate, it indicates profitability; conversely, a negative NPV at 21% suggests the project does not meet higher required returns, guiding the firm to accept or reject based on these analyses.

Interest Rate Risk and Bond Price Sensitivity

Bonds with different maturities are affected differently by interest rate changes. Bond Bill and Bond Ted, both with 7% coupons paid semiannually, show how their prices fluctuate with interest rate shifts. A rise of 2% in rates causes bond prices to fall, with longer-term bonds like Bond Ted being more sensitive. Graphical representation of bond prices versus YTM illustrates this inverse relationship, highlighting the increased interest rate risk associated with longer maturities.

Valuation of Preferred Stock

The value of preferred stock that pays a fixed dividend payable after a delay can be determined using present value techniques. For the 20/20 preferred stock with a $20 dividend starting after 20 years, discounted at 8%, the current price is calculated using the present value of a deferred annuity or the appropriate discounting of the dividend stream, showing how deferred dividends impact valuation.

Stock Valuation and Growth Models

Applying the Gordon Growth Model (Dividend Discount Model), the value of a stock is derived based on expected dividends, growth rate, and required return. For a dividend of $2.72 next year, a 4.5% growth rate, and an 12% required return, the stock price is:

\( P = \frac{D_1}{r - g} = \frac{2.72}{0.12 - 0.045} \approx \$41.23 \).

At an 8% required return, the price increases to approximately \$56.78. These calculations demonstrate the inverse relationship between required return and stock price, highlighting the sensitivity of valuation to market expectations and discount rates.

Conclusion

Financial evaluation techniques such as payback period, AAR, IRR, NPV, bond price sensitivity, and stock valuation are vital tools for making well-informed investment decisions. They help in assessing profitability, measuring risk exposure, especially in interest rate fluctuations, and estimating fair value. Companies like Global Toys Inc. utilize these methods to balance investment returns with acceptable risk levels, aligning financial strategy with corporate goals.

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