Assignment 1 — Session 2 (Winter)

This assignment is based on Modules
 1
 through 
5
 and is due at the end of Module 
5
. It is worth 
7.5%
of your final course grade.

General instructions

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This assignment is based on Modules 1 through 5 and is due at the end of Module 5. It is worth 5% of your final course grade.

General instructions

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A.    
If this is your first time using the Online Learning Environment, check out the Course Orientation and the quick tutorials in the Support Centre. You will find general assignment FAQs in your Assignment Submission/Group Work area.

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B.    
Prepare your answers to these assignment questions in Word and save them as one Word document on your hard drive. For the recommended format and filename, see the Assignment Submission/Group Work/FAQ area. If this assignment Word file requires you to paste Accpac.RTF reports, Excel.xls sections, or other files, you are strongly advised to refer to How To/Use Software/Excel and/or How To/Use Software/Word, to ensure you successfully submit your completed assignment.

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C.    
When your file is complete and you are ready to submit it for marking, select your Assignment Submission/Group Work area. For help, refer to the quick tutorial Submit assignments.

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Follow these steps to ensure that your marker receives your assignment:

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·         
Select the Grade Centre link.

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·         
Select the exclamation mark (!).

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·         
In the section Your work, select the file. If you can view the unmarked assignment, it is okay. If you are unable to view the assignment, contact your CGA affiliate office for help.

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D.    
For Excel or Accpac data files, you must download and unzip the data files for the course. See the instructions on the Data files page under the Course Modules tab, and click on the session 2 data files link.

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E.     
For questions involving mathematical calculations, you must show your calculations to receive maximum marks. For questions with computer components, follow the given procedure.

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F.     
Adopt a consistent approach to rounding in your calculations. Here are some general guidelines:

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·         
Round all currency numbers to two decimals.

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For $ million, you may omit decimals. For example, $18,824.68 × 542 = $10,202,976.56. You may round this to $10,202,977.

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If the unit is in thousands of dollars, calculate it as $18.82 (thousand) × 542 = $10,200.44 (thousand).

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If you are asked to state the result of the multiplication in $ million, you would respond $10.20 million.

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·         
Round all other numbers to a minimum of four decimal places (unless otherwise directed in the question). For example, if a share is trading at a price per share of $27.25 and has earnings per share of $3.89, then the stock has a price-earnings ratio of $27.25 ÷ $3.89 = 7.0051 and an earnings-price ratio of $3.89 ÷ $27.25 = 0.1428 or 14.28%.

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When in doubt, err on the side of greater accuracy.

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Question 1 (17 marks)

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HiSpeed Ltd. plans to manufacture cross-country skiing equipment. Its cash flows are highly dependent on the weather in early winter. HiSpeed operates under ideal conditions of uncertainty. On August 1, 2014, the beginning of its first year in business, HiSpeed acquires equipment to be used in its operations. The equipment will last two years, at which time its salvage value will be zero. The company finances the equipment purchase by issuing common shares.

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HiSpeed’s annual net cash flows will be $800 if the weather is snowy and $300 if it is not snowy. Assume that cash flows are received at year end. In each year, the objective probability that the weather is snowy is 0.7 and 0.3 that it is not snowy. The interest rate in the economy is 3% in both years.

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HiSpeed will pay a dividend of $50 at the end of each year of operation.

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Required

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a.     
(9 marks)

In 2014, the weather is snowy. Prepare a statement of financial position as at July 31, 2015, the end of HiSpeed’s first year of operations, and an income statement for the year. 

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b.     
(2 marks)

What timing of revenue recognition is implicit in the income statement you have prepared in part (a)? When ideal conditions do not hold, is this timing of revenue recognition relevant? Is it reliable? Explain. 

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c.     
(6 marks) 

Assume that HiSpeed paid the present value you calculated in part (a) for its equipment. Calculate HiSpeed’s net income for the year ended July 31, 2015 on a historical cost basis, assuming that equipment is depreciated on a straight-line basis. Under the more realistic assumption that ideal conditions do not hold, which measure of net income is most relevant? Which is most reliable? Why?          

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Question 2 (18 marks)

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Prem has $2,000 that he wishes to invest for one year. He has narrowed his choices down to one of the following two actions:

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i: Buy bonds of X Ltd., a company that has a very high debt-to-equity ratio. These bonds pay 8% interest, unless X defaults, in which case Prem will receive no interest but will recover his principal. (a₁)

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ii: Buy Canada Savings Bonds, paying 3% interest. (a₂)

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Prem assesses the prior probability of X Ltd. defaulting as 0.40. His utility for money is given by the square root of the amount of his net payoff. That is, if he buys the Canada Savings Bonds, his net payoff is $60, yielding utility of √60 = 7.75, and so on. Prem is a rational decision maker.

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Required

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a.     
(4 marks)

Based on his prior probability calculations, which action should Prem take? Show your calculations. 

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b.     
(9 marks)

Before making a final decision, Prem decides he needs more information. He obtains X Ltd.’s current financial statements and examines its times-interest-earned ratio. This ratio can be either high or low. Upon calculating the ratio, Prem observes that it is low. On the basis of his prior experience in bond investments, Prem knows the following conditional probabilities: 

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