20PT31 MAR 2021

THIAGARAJAR SCHOOL OF MANAGEMENT (AUTONOMOUS)

I PGDM (2020-22) MID TERM EXAMINATION - III TRIMESTER
CORPORATE FINANCE – II (20PT31)

TOTAL TIME: 2 HOURS MAXIMUM MARKS: 50

SECTION A (2*15=30)
QUESTION 1:
Rainbow Products is considering the purchase of a paint-mixing machine to
reduce labor costs. The savings are expected to result in additional cash flows
to Rainbow of $7,000 per year. The machine costs $45,000 and is expected to
last for 20 years. Rainbow has determined that the cost of capital for such an
investment is 15%.

a. Compute the payback (PB), discounted payback period (DPB), net

present value (NPV), and internal rate of return (IRR) for this machine.
Should Rainbow purchase it? Assume that all cash flows (except the
initial purchase) occur at the end of the year, and do not consider taxes.
(5 MARKS)
b. For a $200 per year additional expenditure, Rainbow can get a “Good
As New” service contract that essentially keeps the machine in new
condition forever. Net of the cost of the service contract, the machine
would then produce cash flows of $6,800 per year in perpetuity. Should
Rainbow Products purchase the machine with the service contract?
(5 MARKS)
c. Instead of the service contract, Rainbow engineers have devised a
different option to preserve and actually enhance the capability of the
machine over time. By reinvesting 20% of the annual cost savings back
into new machine parts, the engineers can increase the cost savings at
a 5% annual rate. What should Rainbow Products do? (5 MARKS)

Note: Calculate PB, DPB, NPV and IRR in each sub-division

QUESTION 2
Suppose you own a concession stand that sells hot dogs, peanuts,
popcorn, and beer at a ball park. You have three years left on the contract
with the ball park, and you do not expect it to be renewed.

Long lines limit sales and profits. You have developed four different
proposals to reduce the lines and increase profits.

The first proposal is to renovate by adding another window. The second

is to update the equipment at the existing windows. These two renovation

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projects are not mutually exclusive; you could take both projects. The third
and fourth proposals involve abandoning the existing stand. The third
proposal is to build a new stand. The fourth proposal is to rent a larger stand
in the ball park. This option would involve $2,000 in up-front investment for
new signs and equipment installation; the incremental cash flows shown in
later years are net of lease payments.

You have decided that a 12% discount rate is appropriate for this type
of investment. The incremental cash flows associated with each of the
proposals are:

Incremental Cash Flows

Project Investment Year 1 Year 2 Year 3
Add a New Window -$85,000 55,000 50,000 45,000
Update Existing Equipment -70,000 35,000 30,000 25,000
Build a New Stand -150,000 75,000 70,000 65,000
Rent a Larger Stand -2,000 10,000 12,000 13,000

a. Using the internal rate of return rule (IRR), which proposal(s) do you
recommend? (5 marks)
b. Using the net present value rule (NPV), which proposal(s) do you
recommend? (5 marks)
c. How do you explain any differences between the IRR and NPV rankings?
Which rule is better? (5 marks)

SECTION B – CASE ANALYSIS (1*20=20)

Ameritrade Holding Corporation (AMTD) is a deep-discount brokerage firm

that has recently completed an IPO. Management at Ameritrade is considering
substantial investments in technology and advertising to exploit emerging
economies of scale, but is unsure of the appropriate cost of capital. Primary
sources of revenue are transaction revenue and interest revenue. Transaction
revenues consisted of brokerage commissions, clearing fees, and payment for
order flow, which were cash payments received by Ameritrade for routing
orders to execution agents. Interest revenues were offset by interest payments
to customers based on credit balances maintained in brokerage accounts.
Virtually all of Ameritrade’s revenues were directly linked to the stock market.
A substantial decline in the stock market could therefore lead to a steep
decline in Ameritrade’s brokerage commissions and net interest revenues.
Full-service brokers were less sensitive to market movements than deep-
discount brokers like Ameritrade. Full-service brokers received asset
management fees, which partially shielded the revenue stream from market
declines. Moreover, most full-service brokerage firms such as Merrill Lynch

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diversified their revenue stream by engaging in investment banking activities

such as mergers and security underwritings.

MISSION:

Ricketts decided Ameritrade’s mission was ‘to be the largest brokerage firm
worldwide based on the number of trades.’ Ricketts’ strategy called for price
cutting, technology enhancements, and increased advertising. First,
Ameritrade would reduce commissions from $29.95 to $8.00 per trade for all
Internet market orders. To ensure competitors such as Charles Schwab and
E*Trade did not follow Ameritrade’s lead and try to compete on price,
Ameritrade would have to become the low-cost provider of reliable online
brokerage services. State of the art technology was the only way to prevent
system outages and move towards the goal of 100% reliability. Therefore, up
to $100 million would be budgeted for technology enhancements which also
would increase trade execution speed - an important attribute to individual
investors. Finally, Ameritrade’s advertising budget would be increased to
$155 million for the 1998 and 1999 fiscal years combined.

THE RATE OF RETURN ON THIS PROJECT:

If the expected returns on investment were greater than the cost of capital, he
was going to invest, even if there was a chance of bankrupting the firm.
Ricketts felt that the expected return on investment was very high, on the
order of 30% to 50%. But, he also knew that some members of his
management team were not nearly as optimistic as he was, estimating the
expected investment returns at only 10% to 15%.

COST OF CAPITAL ESTIMATE – THE ISSUE

Different estimates
A CS First Boston analyst report employed a discount rate of 12%
when evaluating Ameritrade. The CFO at Ameritrade often used a 15%
discount rate. Other managers at Ameritrade who that the borrowing cost of
8-9% was the appropriate rate.

What type of business?

Was Ameritrade a discount brokerage firm or instead a
technology/Internet firm? A recent analyst report from ABN-AMRO valued
Ameritrade on a comparables basis using Internet firms such as Yahoo,
Mecklermedia, and Netscape. In addition, E*Trade management continued to
insist that E*Trade, while deriving all of its revenues from brokerage
operations, was a brokerage firm, and thus should not be valued as an
internet firm.

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Required:
a. What is the estimate of the risk-free rate and the market risk premium
that should be employed in calculating the cost of capital for Ameritrade
using the CAPM model? (5 MARKS)
b. Ameritrade does not have a beta estimate as the firm has been publicly
traded for only a short time period. Explain how to calculate the asset
beta and cost of capital for Ameritrade using the CAPM? (5 MARKS)
c. Using the stock price and returns data and the capital structure
information, calculate the asset betas for the comparable firms and also
the cost of capital of Ameritrade. (10 MARKS)

Note: Refer Exhibits 1 to 4 in excel for solving subdivisions a and c