Question

Project Case: Focus Drilling

Focus Drilling Supplies has been growing steadily over the last 20 years. With increased exploration in the mining sector, the company has decided to expand their facilities for supplies and custom drill bit production to meet the increased demand.

The expansion will occur over 4 years and is expected to require $2.8 million.

Management has developed a payment plan for carrying out this expansion. The plan requires a cash input of $300,000 now, $700,000 one year from now, $800,000 two years from now, and finally, $1,000,000 four years from now.

While Focus Drilling is able to allocate $2.6 million dollars from the cash reserves to fund the project, there is no other contingency fund for cost overruns or construction delays. However, any interest earned on the expansion fund during the four-year time frame will be set aside for the project.

Before the final decision on implementation, the company treasurer is asked to assess the plan to determine if the current $2.6 million allocation will meet the $2.8 million in payment obligations of the plan over the four-year period. The Treasurer has predicted interest rates over the next four years to be as follows:

Year 1: interest rate of 4.5% p.a. compounded semi-annually

Year 2: interest rate of 5.0% p.a. compounded semi-annually

Year 3: interest rate of 5.0% p.a. compounded semi-annually

Year 4: interest rate of 5.5% p.a. compounded semi-annually

As an alternative, the Treasurer has found that the $2.6 million cash allocation could be invested at a fixed rate of 5.2% p.a. compounded quarterly for a period of five years.

The company can withdraw part of the money from either investment at any time without penalty to meet the cash payment requirements.

Questions (total of 40 marks)

In a single Word doc, answer each of the following questions based on the Focus Drilling case, including any calculations and rationale used.

Can Focus Drilling meet the cash payment requirements of the expansion given the variable interest rates given above? Use today as a focal date. Show your calculations. (12 marks)

What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion? (3 marks)

Can Focus Drilling meet the cash payment requirement by investing with the fixed five-year interest rate given above? Show your calculations. (9 marks)

What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion? (3 marks)

Which investment strategy should the company select and why? (3 marks)

Since the Treasurer’s investment plan has a guaranteed rate for five years, suppose the company decided to delay the expansion for twelve months to take advantage of this fact. The payment plan to fund the expansion would retain the same payment schedule. However, the final payment in the last year would increase by 10%, due to projected increase in construction costs. What is the equivalent value, twelve months from now, of the cash available to fund the expansion? Show your calculations. (2 marks)

Twelve months from now, what is the total of the value of the required cash payments? Show your calculations. (3 marks)

Twelve months from now, what is the difference between the value of the funds available from (6), and the total present value of the required payments determined in (7)? Show your calculations. (1 marks)

What is the accumulated value of this difference at the end of the expansion period? Show your calculations. (2 marks)

In your opinion, should the proposed expansion be delayed or not? Explain your choice, giving advantages and risks. (2 marks)

Answer 1

Q.1Can Focus Drilling meet the cash payment requirements of the expansion given the variable interest rates given above? Use today as a focal date. Show your calculations.

solution :

year	opening Balance(A)	Interest Rate compounded Semi annually (B)	Balance at the year end= C= Ax(1+B/2)^(Nx2)	cash withdrawl(D)	Balance(C-D)
0	26,00,000	0	26,00,000		26,00,000
1	26,00,000	4.50 %	2,404,664.38 [26,00,000[1 +(0.045/2)]^(1x2)]	700,000	17,04,664.38
2	17,04,664.38	5.00%	1,790,963.01 [(1704664.38*(1+(0.05/2))^(1*2)]	800,000	9,90,963.01
3	9,90,963.01	5.00%	1,041,130.51 [(990963.01*(1+(0.05/2))^(1*2))]	0	1,041,130.51
4	1,041,130.51	5.50 %	1,099,180.04 [(1041130.51*(1+(0.055/2))^(1*2))]	1,000,000	99,180.04

Q2 What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?

solution :

After the Focus Drilling has completed its payment plan for the expansion and invested the remainder in the variable interest rates, they will have a balance of $99,180.04 remaining for incidentals

Q3.Can Focus Drilling meet the cash payment requirement by investing with the fixed five-year interest rate given above? Show your calculations

solution :

PV=2,600,000; I= 5.2%4=0.013; N=5*4=20

FV=PV(1+i) ^n

FV=2600000 (1.013) ^20

FV=2600000(1.294759)

FV= $3,366,373.16

Value of money at the end of 5yrs if invested=3,366,373.16

The cash requirement for the expansion =$2,800,000.00

Effect Function 5 years

Nominal Annual Interest Rate 5.2000%

Total compounding periods 4

Answer 5.3023%

Option 2

Time	Avail funds	Funds required	Funds remaining	Effective interest	Period in years	Earned interest
0	2600000	300000	2300000	5.3023%	1	121952.48
1	242192.48	700000	1721952.48	5.3023%	1	91302.77
2	1813255.25	800000.00	1013255.25	5.3023%	1	53725.65
3	1066980.90	-	1066980.90	5.3023%	1	56574.33
4	1123555.23	1000000.00	123555.23	5.3023%	1	6551.25
5	130106.47	-	130106.47	end

Q4.What, if any, is the accumulated value of the difference between the allocated cash available and the total cash payments required for the expansion?

solution :

After payment plan at 4 years the balance and interest earned $123555.23

At the end of 5 years $130106.47

Interest earned on the balance after 5 years $6551.25

Q5.Which investment strategy should the company select and why?

solution ;

The company should base the decision on which investment yields the maximum cash at the end of the payment plan

Option 1 yield a balance of $99180.04

Option 2 yields balance of $123555.23

The company should select option 2 with the fixed interest rate of 5.2% p.a compounded quarterly because it yields a bigger balance at the end of 4 years. Another important consideration for option 2 would be the interest rate to be fixed for 5 years .

With option 1 the company could shortfall on money which could halt expansion.

Q6. Since the Treasurer’s investment plan has a guaranteed rate for five years, suppose the company decided to delay the expansion for twelve months to take advantage of this fact. The payment plan to fund the expansion would retain the same payment schedule. However, the final payment in the last year would increase by 10%, due to projected increase in construction costs. What is the equivalent value, twelve months from now, of the cash available to fund the expansion? Show your calculations

Solution ;

PV=2,600,000, I/Y=5.2%, i=5.2/4 =0.013;n=4

FV = PV (1+i)^n

FV = 2,600,000 (1.013)4

FV=2,600,000 (1.053023)

FV= 2,737,859.32 value of the fund available for expansion twelve months for now.

Q7. Twelve months from now, what is the total of the value of the required cash payments? Show your calculations. (3 marks)

Solution :

PV= 2,800,000;I/Y=5.2 i= 5.2/4=0.013;n =4

FV = 2,800,000 (1+0.013)4

FV =2,800,000 (1.053023)

FV=2,948,463.89 Future Value of the required payment for expansion twelve month from now.

Q8.Twelve months from now, what is the difference between the value of the funds available from (6), and the total present value of the required payments determined in (7)? Show your calculations.

Solution :

Value of funds available twelve months from now $2737859.32

Value of fund required twelve months from now $2948463.89

                                                                             -$210604.57

Q9.What is the accumulated value of this difference at the end of the expansion period? Show your calculations.

Solution ;The accumulated difference at the end of expansion period is $193,062.08

Q.10 In your opinion, should the proposed expansion be delayed or not? Explain your choice, giving advantages and risks.

solution ;

Advantage

more money yielded through investment for project, that can serve as an increased contingency fund for cost overruns or delays.

Risks:

Risk of being obsolete

Risk of inflation in pricing

in my opinion should delayed the project.

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