Part 1 Fin 534 Homework Set 3, Page 1

Part 1fin 534 Homework Set 3fin 534 Homework Set #) Page 1 of 1 Directions: Answer the

Part 1: Answer the following questions based on the provided stock data; show calculations where applicable and explain your reasoning. Calculate the annual returns for Goodman Industries, Landry Incorporated, and the Market Index, then determine their average returns. Compute the standard deviations of these returns. Forecast dividends for Goodman Industries over the next three years, assuming a 5% growth rate. Finally, determine the maximum price you should pay for Goodman stock given a required return of 13%, holding it for three years and selling at $27.05.

Part 2: Analyze reasons why a short-term project might rank higher under NPV if the cost of capital is high, while a long-term project might be better if the cost is low. Discuss whether changes in the cost of capital can alter the IRR ranking of two projects. Additionally, argue for or against TFC’s decision to expand to the West Coast, using at least two capital budgeting techniques to support your position.

Paper For Above instruction

Analysis of Investment Decisions Based on Stock Performance and Capital Budgeting Techniques

Introduction

Investment decision-making in finance involves multiple methodologies and considerations. This paper explores key aspects of financial analysis, including the calculation of stock returns, risk measurement through standard deviation, dividend forecasting based on growth assumptions, valuation using discounted cash flows, and strategic project ranking based on the cost of capital. Additionally, it discusses the implications of financial metrics in assessing expansion decisions, particularly in the context of TFC's prospective West Coast expansion.

Part 1: Stock Return Analysis and Valuation

Calculating Annual Returns

Annual returns provide insights into the performance of stocks and market indices over time. For Goodman Industries, Landry Incorporated, and the Market Index, the return for each year is calculated using the formula:

\[ R_t = \frac{(P_{t} + D_{t} - P_{t-1})}{P_{t-1}} \]

where \( P_t \) is the ending price, \( D_t \) is the dividend paid during the year, and \( P_{t-1} \) is the price at the beginning of the period.

For example, for Goodman Industries from 2013 to 2014:

- Beginning price (2013): $25.88

- Ending price (2014): $26.59 (assuming from the data, extrapolated)

- Dividend (2013): $1.73

The return:

\[ R_{2014} = \frac{(26.59 + D_{2014} - 25.88)}{25.88} \]

Repeating this process for each year produces a series of returns that can then be averaged to find the mean return.

Standard Deviation of Returns

The risk associated with each stock and index is measured by the standard deviation of returns, which indicates the variability of returns. Using the sample standard deviation formula:

\[ s = \sqrt{\frac{1}{n-1} \sum_{i=1}^{n} (R_i - \bar{R})^2} \]

where \( R_i \) represents each annual return, and \( \bar{R} \) is the average return, the degree of return variability is quantified.

Dividend Forecasting

Assuming a dividend growth rate of 5%, the future dividends over three years are forecasted using the Gordon Growth Model:

\[ D_{t} = D_0 \times (1 + g)^t \]

where \( D_0 = 1.50 \) (latest dividend), \( g = 0.05 \), and \( t = 1, 2, 3 \).

Therefore,

\[ D_1 = 1.50 \times (1 + 0.05) = 1.575 \]

\[ D_2 = 1.50 \times (1 + 0.05)^2 = 1.65375 \]

\[ D_3 = 1.50 \times (1 + 0.05)^3 = 1.73644 \]

Valuation Based on Discounted Dividends

Given a required rate of return of 13%, the maximum price (\( P_0 \)) that one should pay is derived by discounting future dividends and expected selling price:

\[ P_0 = \sum_{t=1}^3 \frac{D_t}{(1 + r)^t} + \frac{P_3}{(1 + r)^3} \]

where \( P_3 \) is the expected sale price of $27.05 after three years.

Calculating each component:

\[ PV_{Dividends} = \frac{1.575}{(1 + 0.13)^1} + \frac{1.65375}{(1 + 0.13)^2} + \frac{1.73644}{(1 + 0.13)^3} \]

\[ PV_{Sale} = \frac{27.05}{(1 + 0.13)^3} \]

Summing these present values yields the optimal purchase price for the stock.

Part 2: Strategic Investment Decisions

Impact of Cost of Capital on Project Ranking

The choice between short-term and long-term projects under the NPV criterion is significantly influenced by the cost of capital. When the cost of capital is high, the present value of future cash flows diminishes, making projects with quicker paybacks and higher short-term benefits more attractive. Conversely, a low cost of capital increases the present value of distant cash flows, favoring long-term projects that may have higher overall benefits over time.

Changes in the cost of capital can cause shifts in project rankings, especially under the IRR criterion. While IRR is primarily a percentage metric and independent of purchase cost, inconsistencies can arise when projects have non-conventional cash flows, leading to multiple IRRs or conflicting rankings when the cost of capital varies. However, in typical situations, a change in the cost of capital does not alter the IRR ranking unless it crosses the IRR of the projects in question, causing a reordering.

TFC’s Expansion to the West Coast: An Evaluation

In analyzing TFC’s decision, financial techniques such as NPV and Payback Period are instrumental. Using NPV, if the present value of expected cash inflows exceeds the initial investment, the project adds value and is therefore favorable. The Payback Period assesses how quickly the initial expenditure can be recovered, emphasizing liquidity and risk. If the NPV is positive and the payback period is acceptable relative to the company’s risk appetite, expansion is justified.

Counterarguments focus on potential risks such as market saturation, increased operating costs, or strategic misalignment. Still, the combination of NPV and Payback Period provides a comprehensive evaluation of financial viability and risk exposure, supporting data-driven decision-making.

Conclusion

Investment decisions in finance involve complex analytical processes that consider historical returns, risk measurement, dividend growth, stock valuation, and strategic project assessment. Effective application of these concepts ensures informed decisions aligned with corporate financial goals. For the case of Goodman Industries and TFC’s expansion, a thorough analysis incorporating multiple techniques offers a balanced view of potential risks and rewards, guiding optimal financial strategies.

References

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