Capital allocation principles and common pitfalls — MCQs

Norvale Manufacturing is evaluating an automated production system intended to replace part of its existing assembly process. The company's corporate development team asks analyst Elena Ruiz to estimate the project's incremental cash flows and determine a project-specific cost of equity. Norvale reports and evaluates all project cash flows in nominal USD terms. The equipment would be purchased and installed immediately, and all operating cash flows would occur at each year-end. Six months ago, Norvale paid an external consultant to complete a feasibility study. That payment is non-refundable, and the study has no alternative use. The project also requires land that Norvale has owned for several years. The land is not currently used in operations and could be sold immediately for the after-tax amount shown in Exhibit 1. If the project is accepted, the land must be retained throughout the project's four-year life. The project requires an initial investment in inventories and receivables net of spontaneous financing. Management expects the full net working-capital investment to be recovered when the project ends. The equipment will be depreciated on a straight-line basis to a zero book value. The salvage amount in Exhibit 1 is already stated after tax, so Ruiz should not apply an additional tax adjustment to it. Norvale can use any project tax losses immediately against taxable income from its other operations. Ruiz concludes that Norvale's consolidated equity beta is unsuitable because the project has greater operating risk than the company's existing business. She identifies a publicly traded pure-play comparable whose debt is treated as risk-free for purposes of unlevering beta. Norvale intends to finance the project at the target debt-to-equity ratio reported in Exhibit 2. Ruiz plans to unlever the comparable-company equity beta and then relever the resulting asset beta using Norvale's project target. Separately, the operating team proposes changes to inventory purchasing, customer credit administration, and supplier-payment timing. Ruiz evaluates these proposals using the cash conversion cycle, defined as days inventory outstanding plus days sales outstanding minus days payables outstanding. The proposed changes are expected to occur simultaneously and have no effect on annual sales volume.

Calder Manufacturing is evaluating a five-year automated production project. The project will begin immediately and all operating cash flows will occur at each year-end. Calder spent USD 1.2 million last year on a feasibility study. The study has been completed, has no resale value, and Calder will not recover its cost whether the project is accepted or rejected. The equipment's installed cost and other project inputs are shown in Exhibit 1. The equipment will be depreciated for tax purposes on a straight-line basis from its installed cost to its expected salvage value over the project's five-year life. The expected Year 5 salvage value equals the equipment's tax book value at that date, so disposal will produce no taxable gain or loss. The project will use vacant land already owned by Calder. The land could be sold today for net proceeds of USD 3.0 million. If the project is accepted, Calder expects to sell the land for USD 3.6 million when the project terminates at the end of Year 5. The land's tax basis is expected to equal its net sale price, so there will be no tax effect from either the current opportunity cost or the future disposal proceeds. The initial net working-capital investment consists of incremental receivables and inventory net of incremental accounts payable. Calder expects the full USD 1.0 million investment to be recovered at the end of Year 5. No additional working-capital investment will be required during the project. Calder is profitable and can use all project tax deductions when they arise. Its marginal corporate tax rate is 25%, and the project's required return is 10%. The project does not affect the cash flows of Calder's existing products, and the financing method will be evaluated separately from the investment decision. For an independent NPV calculation, Calder's analyst specifies an initial project outflow of USD 16.0 million, annual operating cash inflows of USD 3.5 million in Years 1–5, and an additional terminal cash inflow of USD 6.6 million at the end of Year 5.

An investor purchases common shares of a corporation. Compared to a partnership, this form of ownership is best described as having:

An issuer seeks limited owner liability, perpetual existence, and readily transferable ownership interests, while accepting possible entity- and investor-level taxation. The most appropriate organizational form is a:

A project has an asset beta of 0.90 and target debt-to-equity of 0.80. With a 25% tax rate, 3% risk-free rate, 5% equity premium, and 5% pre-tax debt cost, the project WACC is closest to:

A company has 5.0 million shares at USD 24 and annual earnings of USD 9 million. It uses USD 12 million of excess cash to repurchase shares at market value. Post-repurchase EPS is closest to:

Tern Consumer Products is a publicly traded manufacturer of household products. An equity analyst is reviewing Tern before recommending whether it should be added to a concentrated consumer-sector portfolio. Tern has two share classes. Class A shares are publicly traded and carry one vote per share, whereas Class B shares are held primarily by the founder and carry ten votes per share. The two classes have equal rights to dividends and liquidation proceeds. The analyst identifies a supplier contract as a potential governance concern. The supplier is controlled by the founder's sibling and charges prices approximately 8% above those of several potential suppliers. Tern's management states that the premium reflects higher product quality and reliable delivery, but the board has not obtained competitive bids, a fairness opinion, or an independent quality assessment. Details of Tern's governance structure are presented in Exhibit 1. Tern has accumulated cash exceeding the amount required for planned capital expenditures and its board-approved minimum liquidity reserve. Management proposes using USD 90 million to repurchase shares in the open market. The repurchase would be financed entirely with cash; outstanding debt would not change. Management expects no immediate change in operating income. The analyst notes that the effect on intrinsic value per share depends partly on whether the repurchase price is below or above estimated intrinsic value. Tern also uses plastic packaging that may become subject to stricter environmental regulation. Under the analyst's base case, the regulation has a 70% probability of taking effect within two years. Compliance would require additional production equipment and would increase annual packaging costs. Some customers may also shift toward competing products with recyclable packaging. Management has not included these possible effects in its forecasts because the regulation has not been enacted. The analyst records three statements in Exhibit 2. In evaluating them, the analyst applies a financial-materiality perspective: an environmental or social factor is incorporated into valuation when it can reasonably affect expected cash flows, risk, or the cost of capital. The analyst does not assume that stronger ESG practices, a share repurchase, or concentrated control is inherently beneficial or detrimental without considering issuer-specific effects.

Apex Industrial Group is a publicly traded conglomerate with aerospace, industrial automation, and medical-device operations. Management is considering developing a specialised automation division with operating risk different from Apex's existing businesses. Because Apex's consolidated beta does not reflect the new division's risk, an analyst selects a publicly traded pure-play comparable company. Exhibit 1 presents the comparable company's leverage and beta together with the proposed division's target capital structure. Both the comparable company's debt and the division's prospective debt are assumed to have zero beta. The analyst will use the standard tax-adjusted unlevering and relevering equations. Apex is also evaluating a leveraged acquisition unrelated to the new division. The acquisition would initially be financed with substantial debt. Management plans to repay most of that debt from asset sales and operating cash flows during the first four years after closing. Consequently, the debt-to-enterprise-value ratio is forecast to decline materially each year before stabilising. The analyst wants a valuation framework that can estimate the target's value as if all-equity financed and then separately incorporate the present value of interest tax shields and other financing side effects. Following the acquisition review, Apex's board considers two restructuring alternatives summarised in Exhibit 2. The medical-devices subsidiary has limited operating links with Apex's other divisions, and investors have difficulty comparing its performance with focused healthcare companies. Under Alternative 1, Apex would distribute the subsidiary's shares to existing Apex shareholders in proportion to their Apex holdings. The subsidiary would have its own management, board, and public listing after the distribution. Apex would not receive sale proceeds. Alternative 2 addresses Apex's currently elevated leverage. Participating creditors would surrender USD 120 million of senior debt and receive newly issued Apex common shares. The exchange would not alter Apex's operating assets or generate cash. Management expects lower contractual interest obligations to reduce financial distress risk. Because new shares would be issued to creditors and existing shareholders would not receive additional shares, the existing shareholders' collective percentage ownership would decline. Assume the exchange has no immediate tax effect and that the market values of other securities remain unchanged at announcement.