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Unformatted text preview: 1 P6-2. Assessing credit risk using cash flow forecasts Requirement 1: If Randall’s cash flow forecasts are accurate, it will be unable to repay the loan at the end of Year 4. At the end of Year 1, Randall will have only $95,000 of cash available to make loan interest and principal payments. This amount grows to $1,815,000 by the end of Year 4, a figure that represents the sum of the net change in cash each year ($95,000 + $565,000 + $570,000 + $585,000). But Randall will owe the bank $2,000,000 plus any unpaid interest—interest that totals $200,000 each year using a 10% annual interest rate. Unless Randall has other highly liquid assets that could be sold in Year 4 to generate additional cash, the company will be unable to repay the loan. Consequently, Randall’s credit risk is extremely high. Requirement 2: There are several ways Randall could enhance its credit worthiness and reduce its credit risk. One approach is to focus on generating more operating cash flow each year by growing sales, reducing costs, or both. A second approach is to contractually agree to not pay dividends without bank approval. Curtailment of the company’s planned dividend payments would add another $400,000 to the cash available for loan repayment in Year 4, for a total of $2,215,000. Although dividend curtailment is helpful, Randall is still an extremely high credit risk because the cumulative cash available to pay the loan is less than the combined amount owed (loan principal and interest payments). A third approach is to request repayment over a 5-year rather than 4-year period. Randall would then have the advantage of one more year of operating cash flow, projected to be in excess of $550,000, which would then be available to repay the loan. Randall might also offer to make partial principal payments of say $500,000 each year beginning 2 P6-3. Valuing growth opportunities Requirement 1: The cost of equity capital for eBay is higher than that of Wal-Mart because eBay has a riskier cash flow stream than does Wal-Mart. Wal-Mart has a long history of predictable earnings and operating cash flows from its geographically dispersed retail stores. By comparison, eBay is a relatively young company and its earnings and operating cash flows are more volatile. Requirement 2: To find the NPVGO for each company, you need to solve the following expression: P = X r + NPVGO where P is the current stock price, X is current reported earnings per share for the year, and r is the estimated cost of equity capital. Rearranging terms gives us: P- X r = NPVGO Using this expression and the data provided in the problem statement gives us the following estimates of NPVGO for each company. Earnings Cost of Share price per share equity NPVGO P X r X/r = P- X/r Dell Computer $26.74 $0.82 0.138 $5.94 $20.80 eBay $67.82 $0.82 0.198 $4.14 $63.68 Ford Motor $9.30 $0.99 0.114 $8.68 $0.62 Home Depot $24.02 $1.55 0.121 $12.81 $11.21 Wal-Mart $50.51 $1.83 0.090 $20.33 $30.18 Requirement 3:...
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- Spring '11