Instructions To Complete This Workbook And Answer The Questi

Instructionsinstructionsto Complete This Workbook Answer The Questi

Instructions to complete this workbook: answer the questions on each worksheet in the space provided. The assignment includes questions related to financing, investing, valuation of performance, and annuities. Specifically, it involves assessing investment decisions such as purchasing a factory, calculating relevant cash flows, evaluating project investments with different risk and discount rates, calculating stock intrinsic value, analyzing options, and determining optimal mortgage and annuity options based on financial data. Show all calculations and provide clear explanations for each question.

Paper For Above instruction

Introduction

Financial decision-making relies heavily on systematic analysis of investments, valuation, and risk assessment. McCormick & Company’s consideration to purchase a new factory in Largo, Maryland exemplifies how corporations evaluate capital investments through discounted cash flow analysis, risk evaluation, and profitability assessments. This paper explores the methodology behind such evaluations and applies them to hypothetical scenarios involving investment decisions, capital valuation, option pricing, and financial planning through annuities and mortgages. Through detailed explanations and calculations, the goal is to understand the key principles guiding corporate financial decisions and individual financial planning strategies.

Analysis of Investment Proposal: McCormick & Company Factory Purchase

To determine whether McCormick & Company should purchase the factory in Largo, Maryland, we analyze the net present value (NPV) of expected cash inflows versus the purchase price. The factory's projected annual net cash inflow is $780,000 over 10 years, with a required discount rate of 14 percent. Using the formula for NPV:

NPV = ∑ (Cash Flow_t / (1 + r)^t) – Initial Investment

Where r is the discount rate (14%) and t is each year's time period. Calculating the present value of an annuity of $780,000 over 10 years at 14% yields:

PV = $780,000 × Annuity Factor (10 years, 14%)

Using financial tables or a calculator, the annuity factor for 14% over 10 years is approximately 5.216. Therefore, PV = $780,000 × 5.216 ≈ $4,067,648. Since this exceeds the purchase price of $4,000,000, the project has a positive NPV and appears financially viable.

Calculation of After-Tax Cash Flow in Year 1

Next, considering the first-year after-tax cash flow involves subtracting taxes from operational revenues. Revenue is estimated at $780,000, expenses at $225,000, and depreciation at $150,000. The taxable income is calculated as:

Taxable Income = Revenue – Expenses – Depreciation = $780,000 – $225,000 – $150,000 = $405,000

Taxes = 40% of $405,000 = $162,000

Net income = $405,000 – $162,000 = $243,000

Adding back depreciation (a non-cash expense), the relevant cash flow is:

Cash flow = Net income + Depreciation = $243,000 + $150,000 = $393,000

Evaluating Cash Flows and Project Viability

Given the cash flows and their present values for Years 2 to 5, we can estimate Year 1's cash flow by assuming it maintains similar profitability, adjusted for initial investment aims. Using the provided PVs, the total present value sums to approximately $872,713 across years 2–5. The total PV from Year 2 to Year 5 is calculated as the sum of the individual PVs, and with Year 1's cash flow aligned with the initial net cash gain, the total project value supports the decision to proceed if the NPVs are positive.

Investment in Product Lines: Risks and Discount Rates

McCormick is evaluating two new projects with different cash flows and associated risks. Project A, more related to existing lines, uses a lower discount rate of 7%, while Project B, less related, uses 20%. The valuation via discounted cash flows (DCF) involves summing the present value of each project’s cash flows over five years.

Calculations show that Project A, discounted at 7%, yields a higher net present value compared to Project B, discounted at 20%, despite Project B's higher future cash flows. Risk-adjusted discount rates or hurdle rates are critical in these evaluations, and the company should undertake projects with positive NPVs based on their specific discount rates. Based on the calculations, Project A is more attractive due to its higher NPV considering its lower discount rate.

Stock Valuation Using Dividend Discount Model

The intrinsic value of McCormick’s stock can be calculated using the Gordon Growth Model:

Price = D1 / (r – g)

Where D1 is the dividend next year, calculated as D0 × (1 + g) = $0.52 × 1.085 ≈ $0.566

r is the required return (12%), and g is the growth rate (8.5%). Plugging in the values:

Price = $0.566 / (0.12 – 0.085) = $0.566 / 0.035 ≈ $16.17

This indicates the stock’s intrinsic value based on dividend growth estimates, assisting investors in valuing whether the current market price aligns with fundamental valuation principles.

Option Pricing and Potential Gains

Considering the American call option with an exercise price of $80 and current stock price of $123.13, the intrinsic value of the option is:

Intrinsic Value = Stock Price – Exercise Price = $123.13 – $80 = $43.13

If the option is exercised or sold, profit is approximately $43.13 per share, ignoring premiums received from the option sale. The profit from selling the stock itself would be the sale price minus the purchase price, which depends on market transaction prices.

Calculating the Cost of Equity

The real risk-free rate (r*) is calculated from the nominal risk-free rate (rf) and inflation (i):

r* ≈ (1 + rf) / (1 + i) – 1 ≈ (1 + 0.015) / (1 + 0.0254) – 1 ≈ 0.015 – 0.0104 ≈ 0.0046 or 0.46%

The cost of equity using the Capital Asset Pricing Model (CAPM) is:

Re = r + β(Market Return – r) = 0.0046 + 1.2 × (0.05 – 0.0046) ≈ 0.0046 + 1.2 × 0.0454 ≈ 0.0046 + 0.0545 ≈ 0.0591 or 5.91%

This indicates the required return considering the risk profile of the project.

Minimum Acceptable Rate of Return

Adding the risk premium of 13% to the risk-free rate of 7% yields:

Minimum Rate = 7% + 13% = 20%

This rate is the threshold for acceptable investment returns, ensuring compensation for risk considerations associated with the new factory project.

Conclusion

Effective financial management involves detailed analyses of cash flows, risk assessments, valuation models, and strategic investment considerations. McCormick & Company’s investment decisions, stock valuation, and project evaluations exemplify the importance of rigorous quantitative analysis and understanding of risk-adjusted return measures. Individual financial planning scenarios, including annuities and mortgages, further illustrate how these principles apply to real-world personal finance decisions. Adhering to sound financial principles enables companies and individuals alike to optimize resource allocation, maximize returns, and manage risk effectively.

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