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Financial Principle

Question 3

Huawei is considering replacing an existing production line with a new line that has a greater output capacity and operates with less labour than the existing line.

 

Existing Production line

The book value is $100,000, and the asset will be depreciated by $20,000 per year for the next five years. If you sell the existing production line now, it is expected to be sold for $80,000. Both the book value and market value of the line at the end of year five will be zero.

 

New Production line

The new line would cost $800,000, have a 5-year life, and would be depreciated using the straight-line depreciation method over five years. At the end of 5 years, the new line could be sold for $200,000. Because the new line is more automated, it would require fewer operators, resulting in a saving of operating expense of $40,000 per year. Additional sales with the new machine are expected to result in additional net cash inflows of $ 60,000 annually. The new line is however expected to have an adverse impact on another side of the business, and an annual operating cost of this side-effect is supposed to be $10,000 per year.

If Huawei invests in the new line, a one-time investment of $10,000 in the additional working capital will be required. Huawei will get back the additional working capital at the end of year 5. The tax rate is 30 percent; the opportunity cost of capital is 10 percent. What is the NPV of the new production line? Should Huawei take on the new production line?

Solution

New Production line-

·         Computation of depreciation-

Initial cost or say, the book value of the asset is $800,000. This production line exhibits the method of straight line depreciation. Straight line depreciation explains the machines are depreciating in a uniform manner every year. The life of the production line is five years, and the sold value is $200,000. Therefore, the depreciation is calculated by-

($800,000-$200,000)/5 = $120,000(Damodaran, 2010).

·         Savings-

This existing new production line is automated compare to the old. Therefore, fewer operators are required for this production line. A savings of operating expenses of $40,000 per year is created with this new production line.

·         Additional cash inflows-

There is an increment of the additional net cash inflows of $60,000 annually. It is generated from the extra sales with the new machine. It is considered as the pre tax revenue for the new production line. Now, one-time investment in this new production line made by Huawei is $10,000. It is the initial outlay. There is a tax imposition of 30%.  One important thing is the opportunity cost of capital or the market interest rate. It is recorded as 10%.Here, the NPV will be calculated on the cash flow of $60,000 per year. It is the pre tax revenue. If the NPV is derived on the basis of the pre tax scenario, then the tax rate and the depreciation does not create any role in calculating pre tax NPV. The incremental cash flows can be organized as a cumulative cash flow of $ 60,000 per year. It is intuitive to plot this increment in cash flows as a cumulation of the $60,000 pre tax revenue every year.

·         Now, the NPV for the new production line= ${-10,000+ $60,000/(1+0.1)1 + 120,000/(1+0.1)2 + 180,000/(1+0.1)3 + 240,000/(1+0.1)4 + 300,000/(1+0.1)5}= ${-10,000+54545.45+ 99173.55+ + 135236.66+ 163923.22+186276.39}

= $ 629155.27(Approximate).

It is rational for Huawei to accept the new production line, as the positive value of the NPV of the new production line. Therefore, this production line is beneficial for Huawei.

Question 6

The role of financial managers is maximising shareholders' wealth. To achieve this, a financial manager would like to increase the firm's stock price. Therefore, the goal of financial managers is to maximise the current share price. If we assume that the financial market is efficient, why is the goal of a financial manager to maximise the firm's current share price rather than future share price? In other words, are there any differences between the goal of maximising current share price and the goal of the maximizing future stock price? Discuss the reasons why.

Solution

An efficient arbitrage achieves efficiency in the financial market. Efficient financial market means, quick and effective arbitrage process will eliminate any profit opportunities and back market prices of shares to the fundamental or fair value. The arbitrageurs earn a profit by buying the securities, when its price starts to decline (by pushing up their prices) and sell when its price starts to rise (by pushing down their prices) and spends some time to observe the prices to converge to fundamentals(Chandra, 2008). In the present context, the efficient market plays the major role. When the price is increased then, quick and efficient arbitrageur starts to sell their stocks at the high price. Quick and effective is important here because; substitute securities are readily available in the market. Therefore, the arbitrageurs have faced a competition to earn profits. Finally, the supply of stocks will exceed the demand; therefore, the prices of stocks will come down to its fair value(Groh, 2013). If the arbitrageurs are not enough quick and effective to the available news and information, then the profit earning is not possible. The final proposition is that there will be no differences between the goal of maximising current share price and the future share price when the efficient market assumption prevails. Whether it is the current or future price of stock, the accessibility of all relevant news and information is most important factor (Chandra, 2008). In a nutshell, quick and accurate response to the information and non-reaction to non-information are the two broad pillars of the efficient market proposition. The conclusion is that if the financial manager wants to maximise the shareholders' wealth by increasing the current share prices, then whether it will be profitable or not to the shareholders, totally depend on the activity and rationality of shareholders in the market.

References

Brealey, R. A. & Myers, S. C., 2010. Capital Investment and Valuation. 7th ed. New York: McGraw Hill.

Chandra, P., 2008. Financial Management. 4th ed. New York: Tata McGraw-Hill Education.

Damodaran, A., 2010. Applied Corporate Finance. 3rd ed. Hoboken, New Jersey: John Wiley & Sons.

Groh, S., 2013. Efficient Market Hypothesis in Africa's Sub-Saharan Stock Markets. 3rd ed. Verlag: Grin .