Real Estate and Financial Analysis

1

Agricultural Economics 432

Real Estate and Financial Analysis

Spring 2007

Part I: Financial Analysis

Penson

First Hour Examination – B

NAME:______ANSWER KEY______

This examination consists of five questions. You have the choice of answering question 5 or question 6. Do not complete both of these questions. Please read each question carefully. Avoid giving extraneous information (i.e., “filler”). Use graphs/formulas whenever possible to help tell your story. Use the back of the page if necessary. Good luck!

Question 1 _____ of 20 points

Question 2 _____ of 20 points

Question 3 _____ of 15 points

Question 4 _____ of 25 points

Question 5 _____ of 20 points

OR

Question 6 _____ of 20 points

TOTAL _____ of 100 points

1.Suppose you are considering investing in a $40,000 capital improvement to your business, which has an economic life of 25 years. Assume further that you plan to sell this improvement 10 years from now. If the expected net cash revenue generated by this investment is $5,000 annually and you choose a discount rate of 8%, would you make this investment if: (20 points)

(SHOW ALL WORK FOR PARTIAL CREDIT)

1. The market value of the purchased improvement was only $20,000 ten years from now?

NPV = 5,000(EPIF.08,10) – 40,000 +20,000(PIF.08,10)

= 5,000(6.710) – 40,000 + 20,000(0.463)

NPV = 33,550 – 40,000 + 9,260 = $2,810

Yes, the NPV is positive. There is no capital gain associated with the eventual sale of the assets.

1. What would this market value have to be 10 years from now before you would be indifferent between making and not making this investment?

Set NPV equation equal to zero and solve for the terminal value (T)

0 = 33,550 – 40,000 + T(0.463)

T = 6,450  0.463 = $13,930.88 is breakeven or value if indifferent

Check by substituting solution for T into first equation:

33,550 – 40,000 + 13,930.88(0.463) = 0

1. Given the following information from a firm’s financial statements, please calculate and evaluate the firm’s liquidity, solvency, profitability and debt repayment capacity. (20 points)

Cash receipts from sales175,000

Interest payments on long term loans 15,000

Long term loan less current payment 80,000

Land and buildings400,000

Machinery and equipment225,000

Cash 50,000

Other current assets 20,000

Hired labor expenses 16,000

Allowance for income taxes 20,000

Capital expenditures 45,000

Depreciation 40,000

Accounts payable 10,000

Current payment on long term loans 25,000

Cash operating expenses 95,000

Other long term liabilities 10,000

Other current liabilities 15,000

(SHOW ALL WORK FOR PARTIAL CREDIT)

Current assets is $$70,000 and current liabilities is $70,000.

Current ratio is 1.00 so firm is liquid, but not in a strong position.

Total liabilities is $160,000 and total assets is $695,000.

Debt ratio is 0.23 and leverage ratio is 0.29 so firm is solvent

ROA is 2.88%=$15,000 + $5,000)/$695,000 and net income is positive ($5,000)

Term debt and capital lease coverage ratio is 0.80or net income plus interest divided by total annual payment. The debt burden ratioor total liabilities divided by net income is 32. So the firm is under major financial stress in meeting current loan payments.

1. Please define or graphically illustrate each of the following terms. Make sure you correctly label all graphs used in your answers: (15 points)

Long term planning curve

The LAC curve is an envelope of a series of short run total cost curves. It demonstrates sizes of firms associated with economies of size or diseconomies of size and the risk associated with overexpansion if market prices in the industry fall. You could have also drawn the LAC curve in making these remarks.

Coefficient of variation

Standard deviation of net cash flows divided by the mean or expected value of net cash flows. Measures the business risk per dollar of expected net cash flows.

Portfolio effect

The potential reduction in required rate of return as a result of investing in a new project with negatively correlated ROA.

Optimal capital structure

Combination of debt and equity capital for a firm that minimizes its weighted average cost of capital. You could have also drawn the graph depicting the minimum point on the WACC curve.

Required rate of return

The rate of return used to discount future net cash flows and terminal value. Reflects the risk free rate of return, business risk premium and financial risk premium.You could have drawn the risk-return preference curve as well.

4.Assume you are considering investing in the following project. The economic life of the project is three years. (25 points)

Year 1 Year 2 Year 3

Expected net cash flow 15,000 19,000 18,000

Coefficient of variation .08 .10 .12

Risk free rate of return 0.05 0.06 0.05

Slope of risk/return curve 0.30 0.33 0.35

Shift coefficient for leverage 0.05 0.05 0.05

Total assets 200,000 300,000 400,000

Total debt 100,000 150,000 200,000

Total equity 100,000 150,000 200,000

Leverage ratio 1.00 1.001.00

If the net capital outlay for this project is $35,000, no additional working capital is needed, and the market value of assets required under this project is $10,000 at the end of the third year, would you make the investment? Why?

(SHOW ALL WORK FOR PARTIAL CREDIT)

Business risk premium:Financial risk premium:

Year 1 = .30(.08) = .024 Year 1 = .05(1.0) = .05

Year 2 = .33(.10) = .033 Year 2 = .05(1.0) = .05

Year 3 = .35(.12) = .042 Year 3 = .05(1.0) = .05

Required rate of return:FV interest factors:

Year 1 =.05+.024+.05=.124 Year 1 = 1.124

Year 2 =.06+.033+.05=.143 Year 2 = (1.124)(1.143) =1.285

Year 3 =.05+.042+.05=.142 Year 3 = (1.124)(1.143)(1.142)=1.467

NPV=15,000/1.124+19,000/1.285+18,000/1.467+10,000/1.467 -35,000

NPV = 13,345.2+14,786.0+12,270.0+6,816.6-35,000

NPV=12,217.8

Yes, if this is the only project I am considering because the NPV for this project is positive.

5.Suppose you are considering expanding the size of your business. You are currently earning an annual rate of return of 10 percent on your existing assets with a standard deviation of 2 percent. You expect to earn a rate of return of 11 percent on a new project with a standard deviation of 3 percent. The new investment would represent 10 percent of the expanded operation while the existing assets would represent 90 percent of total assets after expansion. (20 points)

(SHOW ALL WORK FOR PARTIAL CREDIT)

1. If and the correlation coefficient between the returns from the firm’s existing assets and the new project is 1.00 and the standard deviation after expansion is 2.06 percent, would you adjust the required rate of return calculated for the new project alone. Is so, why and how much? If not, why not?

CV(ROA)EX = .02/.10 = .20

CV(ROA)T = .0206/(.90(.10)+.10(.11)) = .0206/.101) = .2040

No, since the addition of the perfectly positively correlated project increases the risk exposure from a CV of .20 to a CV of .2040.

1. If the correlation coefficient were instead –1.00 and the standard deviation after expansion is 1.52 percent, would you adjust the required rate of return calculated for the new project alone? Is so, why and how much? If not, why not?

CV(ROA)EX = .02/.10 = .20

CV(ROA)T = .0152/(.90(.10)+.10(.11)) = .0152/.101) = .1505

Yes, since the addition of the perfectly negatively correlated project decreases the risk exposure from a CV of .20 to a CV of .1505. This would warrant a reduction of almost 25 percent in the business risk premium for the new project.

6.Assume a firm produces two products (donuts and bread). Assume further that the firm has three activities (mixing, baking and shipping). Consider the following information on the firm’s overhead: (20 points)

Driver Activity

Overhead Total DonutsBread

Mixing $50,000 30,00010,00020,000

Baking $20,000 10,000 6,000 4,000

Shipping $10,000 20,00015,000 5,000

If the firm bakes 150,000 boxes of donuts and 200,000 loaves of bread, please determine the overhead per box of donuts and per loaf of bread using activity based cost (ABC) accounting. How does this differ from the conclusions drawn if you do not use ABC accounting?

(SHOW ALL WORK FOR PARTIAL CREDIT)

Overhead activity per driver:

Mixing $50,000/30,000 = $1.67

Baking $20,000/10,000 = $2.00

Shipping $10,000/20,000 = $0.50

Donut overhead activity:Bread overhead activity:

Mixing$1.67(10,000) = $16,700$1.67(20,000) = $33,400

Baking$2.00(6,000) = $12,000$2.00(4,000) = $8,000

Shipping $0.50(15,000) = $7,500$0.50(5,000) = $2,500

Total $36,200 $43,900

Per unit charge using ABC:

Donuts = $36,200/150,000 = $0.241

Bread = $43,900/200,000 = $0.2195

Traditional per unit charge:

All products = $80,000/350,000 = $0.228

Overhead costs associated with bread using ABC accounting is less than the traditional approach while donuts are actually more than the traditional approach. Thus the traditional approach understates thecost of producing donuts and overstates the cost of producing bread.