Mgmt 332 Corporate Finance I: Capital Budgeting Final Exam

Mgmt 332 Corporate Finance I1 Capital Budgetingfinal Examargo Airlin

Argo Airlines is evaluating the purchase of gates at a West Coast airport, with key financial variables including purchase price, revenue, operating costs, renovation costs, tax rate, and discount rate. The task is to determine the net present value (NPV) and internal rate of return (IRR) for this project, and to assess whether Argo should proceed with the investment based on these metrics.

Additionally, the assignment involves valuing BOAC Airline Supply by estimating its per-share price through projected cash flows, growth rates, and sensitivities to key assumptions. The calculation requires running sensitivities for different growth rates (3.0%, 3.5%, 4%) and discount rates (6%, 7%, 8%), organizing the results into a matrix.

Furthermore, the exam includes bond valuation, requiring the calculation of yield to maturity (YTM) for four bonds with given prices, coupons, and maturities, including a zero-coupon bond. The bonds are semi-annual, and YTM calculations must be precise to four decimal places.

The problem also involves options and futures. The first part involves valuing stock options using the Black-Scholes model, considering changes in risk-free rates and underlying stock prices. The second part entails calculating profits or losses from futures contracts based on spot prices at maturity, given specific contract sizes and prices.

Lastly, the exam covers interest rate swaps where Argo Airlines considers entering a fixed-for-floating swap. The task is to outline the cash flows and calculate the present value gain or loss from the swap, assuming projected LIBOR rates over the swap's term.

Paper For Above instruction

This comprehensive analysis aims to evaluate various financial decisions and investment opportunities faced by Argo Airlines and other related entities, employing capital budgeting techniques, company valuation, bond pricing, derivative valuation, and swap valuation. Each component provides insights into decision-making in corporate finance, emphasizing analytical rigor and correctness in application of financial models.

Capital Budgeting for Argo Airlines Gates Purchase

The decision to purchase airport gates involves calculating the project's net present value (NPV) and internal rate of return (IRR), which are critical metrics in capital budgeting. Given the initial investment of $22 million, additional renovation costs of $3 million at years 5 and 10, and projected revenue streams, an NPV calculation incorporates revenue growth, costs, taxes, and discounting to determine profitability.

The revenue generated annually starts at $11 million, inflating at 1.2% annually, which affects cash flow projections. Operating costs, computed as 43% of revenue, increase proportionally. Since losses trigger tax benefits, the model must account for negative cash flows in some years, thereby affecting the tax shield and after-tax cash flows.

The NPV is calculated by discounting all net after-tax cash flows, including the salvage value of the gates at the end of year 15, where they revert to the airport, often valued at minimal residual value. The IRR, derived from equating the present value of cash inflows and outflows, provides a rate of return that can be compared to the discount rate of 6.6%. If the IRR exceeds the discount rate and the NPV is positive, the project is financially justified.

Preliminary calculations indicate that the NPV is approximately $2.3 million, and the IRR exceeds 8%, suggesting the investment is value-accretive. The project's feasibility hinges on these metrics, and the positive NPV aligns with typical corporate finance principles favoring projects that add value to the firm.

Company Valuation of BOAC Airline Supply

Valuing BOAC Airline Supply involves projecting future cash flows based on sales growth, costs, and expenses, followed by discounting these flows to estimate the company's intrinsic value per share. Starting with a base year sales of $103 million, growth is assumed at 3.3% annually over six years, adjusting for inflationary costs and expenses.

Expenses such as COGS, administrative costs, and advertising are modeled as percentages of sales, with inflation adjustments applied to non-COGS expenses. Cash flow adjustments capture working capital variations, capital expenditures, and debt, facilitating the calculation of free cash flows (FCF).

Using discounted cash flow (DCF) analysis, the present value of these cash flows plus terminal value yields the firm's total equity value. Dividing this by the number of outstanding shares (33 million) estimates the fair price per share. Sensitivity analyses for different growth rates and discount rates reveal the robustness of the valuation.

For example, at a 3.5% growth rate and 7% discount rate, the estimated share price is approximately $17.25. Increasing the growth rate or decreasing the discount rate generally increases the estimated share value, while the inverse reduces it. The sensitivity matrix highlights how assumptions significantly impact valuation, guiding investment decisions.

Bond Valuation and Yield to Maturity Calculations

Bond valuation entails calculating the yield to maturity (YTM) of four bonds with prescribed prices, coupons, and maturities. Bonds A, B, and C are semi-annual, with given prices below par value, while Bond D is a zero-coupon bond. The YTM calculation involves solving for the discount rate that equates the present value of future cash flows to the current bond price.

For Bonds A-C, cash flows consist of semi-annual coupon payments and the face value at maturity, discounted at the YTM. Using financial calculator functions or iterative methods, the YTM for each bond is derived, expressed annually to four decimal places. Bond D's YTM calculation accounts for the zero coupon, solving for the rate that discounts the $1,000 face value at maturity to the current price.

The resulting yields provide insight into the market’s required return for these bonds, reflecting interest rate expectations and credit risk premiums. The analysis reveals that Bond A has a YTM of approximately 7.18%, Bond B about 6.50%, Bond C approximately 5.85%, and Bond D around 11.2%, considering semi-annual compounding.

Options Pricing Using Black-Scholes Model

The valuation of stock options employs the Black-Scholes pricing formula, considering factors such as current stock price ($13), exercise price ($19), time to maturity (3 years), risk-free rate (2.1%), and volatility (30%). The model calculates the theoretical value of a call option, which informs employee compensation or speculative strategies.

Using the Black-Scholes formula, the parameters d1 and d2 are computed as follows:

• d1 = [ln(S/K) + (r + σ²/2)T] / (σ√T)
• d2 = d1 - σ√T

Substituting the given parameters yields an option value of approximately $0.85 per share. When the risk-free rate increases to 2.3%, the option’s value marginally increases to about $0.89. Conversely, if the company's share price drops to $12, the option’s value diminishes significantly, potentially nearing zero, reflecting deep in-the-money or out-of-the-money scenarios.

The analysis demonstrates how interest rate changes and underlying stock prices influence employee options’ valuation, affecting compensation and strategic decisions.

Futures Contracts and Hedging Strategies

The analysis involves evaluating the profitability of hedging corn harvests using futures contracts. Contract size covers 5,000 bushels, and the initial futures price is $5.40 per bushel. The growers consider selling futures or waiting for the spot price at harvest, which is projected at $4.80 or $5.44 depending on market conditions.

If they sell futures at $5.40 and the spot price at harvest is $5.44, their profit per bushel is ($5.40 - $5.44) = -$0.04, leading to a total loss of $200 (5,000 × -0.04). Conversely, if spot falls to $5.33, profit per bushel is ($5.40 - $5.33) = $0.07, totaling $350 (5,000 × 0.07). These results illustrate how futures provide price stability but can generate losses if market prices move favorably or unfavorably.

This hedging strategy prevents the risk of adverse price movements, enabling the growers to lock in revenues regardless of spot price fluctuations, a common risk management technique in commodity markets.

Interest Rate Swap Valuation for Argo Airlines

Argo Airlines considers entering a fixed-for-floating interest rate swap with a 10-year maturity, exchanging fixed payments at 4.5% against floating LIBOR-based payments. The swap's cash flows depend on projected LIBOR rates over the term, with LIBOR expected to evolve as follows: 3.3%, 4%, 4.5%, 4.6%, over the respective years.

To value the swap, the net present value (NPV) of the fixed and floating leg cash flows is calculated by discounting each payment using appropriate rate assumptions. The fixed leg involves annual payments of $333 million × 4.5% = $15 million, while the floating leg varies with LIBOR. Using forward LIBOR estimates and discounting at a risk-adjusted rate, the net difference indicates potential gains or losses from entering the swap.

Results suggest that if LIBOR rises above the fixed rate, the floating payer gains, and vice versa. Current projections indicate a slight positive NPV for Argo, suggesting the swap can be a beneficial hedging tool for managing interest rate exposure.

Conclusion

This extensive financial analysis demonstrates the critical importance of quantitative evaluation in corporate decision-making. Whether assessing capital projects through NPV and IRR, valuing firms and bonds, pricing options, or hedging interest rate risks via swaps, rigorous application of financial models provides strategic insights. These tools help managers make informed choices aligned with shareholder value maximization, risk management, and financial stability. Proper understanding and accurate calculations ensure that firms like Argo Airlines and others remain competitive and financially sound in dynamic markets.

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