financial management 562 autumn...

Financial Management 562 Autumn 20001 Prepared by Mohammad MuzammilQ.3. The G.M ltd. Has non-callable, perpetual bonds outstanding. When originally issued, the perpetual bonds sold for Rs.955 per bond while today (January 1) their current market price is Rs.1, 120 per bond. The company pays a semiannual interest Rs.55 per bond on June, 30 andDecember 31 each year.As of today (January 1) what is the implied semiannual yield on these bonds?Using your answer to (a), what is the (minimal annual) yield on these bonds? The effective annual yield to these bonds.Current price of bond = 1.120Since the bond is perpetual bond, the current price is considered as the present value of this bond.Therefore,V = I / kWhere I is the amount paid on bond semi annually and k is the implied semi annually yield on this bond

1,120 = 55 / k

k = 55 / 1,120 = 0.05 or 5 %

Nominal yield per annum = 2 ( k ) = 2 ( 0.05 ) = 0.10 or 10 %

Effective yield = ( 1 + nominal yield / 2 )2 – 1= ( 1 + 0.10 / 2 )2 – 1 = ( 1 + 0.05 )2 – 1 = ( 1 .05 )2 – 1

= 1.1025 – 1 = 0.1025 or 10.25 %

Q.4. Complete the following balance sheet for the Range Company using the following information’s.Debt to asset = 60 %Quick ratio = 1.1Asset turnover = 5 timesFixed asset turnover = 12.037Current ratio = 2Average collection period = 16.837 daysAssume that all sales are on credit and a 360 days year.Cash Current liabilitiesReceivables Bonds payablesInventory Net worthTotal current assets Tot. liabilities and net worthPlant and equipmentTotal assets Rs.325,000Cash 28,495 J Current liabilities 95,000 E

Receivable 76,005 I Bond payable 195,000 B

Inventory 85,500 H Total liabilities 290,000 F

Total C. assets 192,000 D Net worth 35,000 G

Plant & Equip. 135,000 C

http://vustudents.ning.com

Total assets 325,000 Liabilities & net worth 325,000 A

Calculation A

Total liabilities and net worth = Total assets = 235,000

Calculation B

Debt to asset = Total debt / Total asset = Bond payable / Total asset = 0.6

Bond payable = Total asset x 0.6 = 325,000 x 0.6 = 195,000

Calculation C

Asset turnover = Sales / Total asset = 5

Sales = Total asset x 5 = 325,000 x 5 = 1,625,000

Fixed asset turnover = Sales / Fixed assets = Sales / Plant & Equipment =

12.037

Plant & Equipment = Sales / 12.037 = 1,625,000 / 12.037 = 135,000

Calculation D

Current asset = Total asset -- Plant & Equipment

Current asset = 235,000 – 135,000 = 190,000

Calculation E

Current ratio = Current asset / Current liabilities = 2

Current liabilities = Current asset / 2 = 190,000 / 2 = 95,000

Calculation F

Total liabilities = Current liabilities + Total debt

Total liabilities = Current liabilities + Bond payable

Total liabilities = 95,000 + 195,000 = 290,000

Calculation G

Net worth = Total liabilities & Net worth – Total liabilities

Net worth = 325,000 – 290,000 = 35,000

Calculation H


Quick ratio = Quick asset / Current liabilities = 1.1

= ( Cash + Receivable ) / 95,000

Cash + Receivable = 1.1 x 95,000 = 104,500

Current ratio = Current asset / Current liabilities = 2

Current asset = 2 x 95,000 = 190,000

Cash + Receivable + Inventory = 190,000

Inventory = 190,000 – Cash + Receivable = 190,000 – 104.500 = 85,500Calculation I

Average collection period = 360 / Receivable turnover

Receivable turnover = 360 / Average collection period = 360 / 16.837 =

21.38

Receivable turnover = Sales / Receivable

Receivable = Sales / Receivable turnover = 1,625,000 / 21.38 = 76,005

Calculation J

Cash + Receivable = 104,500

Cash = 104,500 – 76,005 = 28,495

Q.5. A chemical company is considering investing in a project that costs Rs.400, 000. The estimated salvage value is zero; tax rate is 55 %. The company uses straight line depreciation method and the proposed project has cash flows before tax as follows:

Year 1 2 3 4 5

CFBT 100,000 100,000 150,000 150,000 250,000

Determine the following:

Pay back period

Internal rate of return

Net present value at 15 %

Profitability index at 15 %

End of year 1 2 3 4 5


A CFBT 100,000 100,000 150,000 150,000 250,000

B Depreciation 80,000 80,000 80,000 80,000 80,000

C=A—B Total 20,000 20,000 70,000 70,000 170,000

D=C(0.55) Tax @ 55% 11,000 11,000 38,500 38,500 93,500

E=A—D Cash flow after tax 89,000 89,000 111,500 111,500 156,500

Payback period

Year Cash flow Cumulative cash flow

0 (400,000) (400,000)

1 89,000 (311,000)

2 89,000 (222,000)

3 111,500 (110,500)

4 111,500 1,000

The payback period will be four years.

Internal rate of return

Year cash flow P.V at 14 % P.V at 12 % P.V at 11 %

1 89,000 0.877 78053 0.893 79477 0.901 80189

2 89,000 0.769 68441 0.797 70933 0.812 72268

3 111,500 0.675 75262.5 0.712 79388 0.731 81506.5

4 111,500 0.592 66008 0.636 70914 0.659 73478.5

5 156,500 0.519 81223.5 0.567 88735.5 0.593 92804.5

Total 368988 389447.5 400246.5

Now we can calculate the exact IRR by ratio method:

400,247 – 400,000 = 247

400,247 – 389,448 = 10,799

IRR = 11 + 247 / 10799 = 11 + 0.023 = 11.023 %

Net present value at 15 %


Year Cash flow P.V factor Present value

1 89,000 0.870 77,430

2 89,000 0.756 67,284

3 111,500 0.658 73,367

4 111,500 0.572 63,778

5 156,500 0.497 77,781

Total present value = 359,640

Net present value at 15 % = 359,640 – 400,000 = -- 40,360

Profitability index at 15 %

P.I = Present value of future cash flows / initial investment

P.I = 359,640 / 400,000 = 0.8991

Q.6. Stallings paints company has fixed operating costs of Rs.3 million a year. Variable operating costs are Rs.1.75 per half pint of paint produced and the average selling price is Rs.2 per half pint.

What is the annual operating breakeven point in half pints (QBE)? In rupees of sales (SBE)?

If variable cost decline to Rs.1.68 per half pint, what would happen to the operating break even point (QBE)?

Compute the degree of operating leverage (DOL) at the current sales level of 16 million half pints.

If sales are expected to increase by 15 % from the current sales level, what would be the resulting percentage change in operating profit (EBIT) from current position?

Fixed cost = FC = 3,000,000

Variable cost = VC = 1.75 per half pint

Selling price = SP = 2 per half pint

(a)

Breakeven quantity = QBE = ?

Breakeven sales = SBE = ?

FC 3,000,000 3,000,000


QBE = ------------- = --------------- = -------------- = 12,000,000 half pint

SP – VC 2.00 – 1.75 0.25

SBE = FC + Total variable cost = FC + VC (QBE)

SBE = 3,000,000 + 1.75 ( 12,000,000) = 3,000,000 + 21,000,000 =

24,000,000

(b)

VC = 1.68

FC 3,000,000 3,000,000

QBE = ------------- = --------------- = -------------- = 9,375,000 half pint

SP – VC 2.00 – 1.68 0.22

( c )

Q ( P – V ) Q

DOL at Q units = ---------------------- = --------------

Q ( P – V ) – FC ( Q – QBE )

Q = Present level of sales = 16,000,000

16,000,000 16,000,000

DOL = -------------------------------- = --------------- = 4

16,000,000 – 12,000,000 4,000,000(d)

EBIT = Q ( SP – VC ) – FC

EBIT at present sale = 16,000,000 ( 2.00 – 1.75 ) – 3,000,000

= 4,000,000 – 3,000,000 = 1,000,000

EBIT with 15% increased sale = 1.15 ( 4,000,000 ) – 3,000,000

= 4,600,000 – 3,000,000 = 1,600,000

1,600,000 – 1,000,000

% change in EBIT = ---------------------------- x 100 = 60 %

1,000,000


Q.7. Poris Pottery spends Rs.220,000 per annum on its collection department. The company has 12 million in credit sales, its average collection period of 2.5 months, and the percentage of bad debt losses is 4 %. The company believes that if it were to double its collection personnel, it could bring down the average collection period to 2 months and bad debt losses to 3 percent.The added cost is Rs.180,000, bringing total collection expenditure to Rs.400,000 annually. Is the increased effort worthwhile, if the before tax opportunity cost of funds is 20 %? If it is 10%?

SO = 12,000,000

SN = 12,000,000

ΔS = 0

K = 10% and 20 %

ACP0 = 75 days

ACPN = 60 days

ΔI = Incremental change in investment in receivable

ΔP = Incremental change in profit

B0 = 4 %

BN = 3 %

ΔI = [ ACPN – ACP0 ][ S0/360]

= (60 – 75) (12,000,000 / 360) = - 500,000

For K = 10 %

ΔP = [ – K (ΔI ) – S0 (BN – B0 )]

= [ -- 0.1 ( -- 500,000 ) – 12,000,000 ( 0.03 – 0.04 ) ]

= [ 50,000 – 12,000,000 ( -- 0.01 ) ] = 50,000 + 120,000 = 170,000

For k = 20 %

ΔP = [ – K (ΔI ) – S0 (BN – B0 )]

= [ -- 0.2 ( -- 500,000 ) – 12,000,000 ( 0.03 – 0.04 ) ]

= [ 100,000 – 12,000,000 ( -- 0.01 ) ] = 100,000 + 120,000 = 220,000

The incremental profit for the new policy with 10 % opportunity cost is

Rs.170,000 and with 20 %


opportunity cost is Rs.220,000. Since the additional cost incurred for new credit policy is Rs.180,000, therefore, the company can use new credit policy only with 20 % opportunity cost and not with 10 % opportunity cost.

Financial Management 562 Autumn 20011 Prepared by Mohammad Muzammil

Q1(a) Define financial management and enumerate its functions.

Q1(b) How does the notion of risk and reward govern the behavior of financial manager?

Q2 Tariq Corporation currently pays a dividend of Rs.3 per share and this dividend is expected to grow at a 10 % annual rate for 5 years, then at 8 % for the next three years. After which it isexpected to grow at a 5 % rate forever.

(a) What value would you place on the stock if an 18 % rate return were required?

Phase one and two: present value of dividends to be received over first 8 years

End of year Dividend X present value factor present valueAt 18 % of dividend

1 3.00 (1.10)1 = 3.30000 X 0.847 2.79510

2 3.00 (1.10)2 = 3.63000 X 0.718 2.60634

3 3.00 (1.10)3 = 3.99300 X 0.609 2.43174

4 3.00 (1.10)4 = 4.39230 X 0.516 2.26642

5 3.00 (1.10)5 = 4.83153 X 0.437 2.11138

6 4.83153 (1.08)1 = 5.21805 X 0.370 1.93068

7 4.83153 (1.08)2 = 5.63549 X 0.314 1.76954

8 4.83153 (1.08)3 = 6.08633 X 0.266 1.61896

Sum of present value 17.53016

========

Dividend at the end of year 9 = 6.08633 (1.05) = 6.39095

Value of the stock at the end of 8 years = D9 / (Ke – g) = 6.39095 / (0.18

– 0.05)


= 6.39095 / 0.13 = 49.16115

Present value of 49.16115 = 49.16115 (0.225) = 11.06126

Present value of stock = V = 17.53 + 11.06 = 28.59

(b) Would your valuation change if you expected to hold the stock only for 3 years?

The valuation of stock will be change if we hold the stock for only three years. The calculations are as under.

End of year Dividend X present value factor present value

At 18 % of dividend

1 3.00 (1.10)1 = 3.30000 X 0.847 2.79510

2 3.00 (1.10)2 = 3.63000 X 0.718 2.60634

3 3.00 (1.10)3 = 3.99300 X 0.609 2.43174

7.83318

======

Value of the stock at the end of 3 years = D3 / (Ke – g) = 2.43174 / (0.18

– 0.10) = 30.397

Present value of 30.397 = 30.397 ( 0.609) = 18.51

Value of stock = 18.51 + 7.83 = Rs.26.34

Q3 Zahid Company’s share price is now Rs.80. Six months hence it will be either Rs.95 with probability of 0.65 or Rs.100 with probability of 0.5. A call option exists on the stock that can be exercised only at the end of 6 months at an exercise price of Rs.75.

(a) If you wished to establish a perfectly hedged position, what would you do on the basis of thefacts just presented?

(b) Under each of the two possibilities, what will be the value of your hedged position?

(c) What is the expected value of option price at the end of the period?

Q4 Two mutually exclusive projects have projected cash flow as follows:

Period 0 1 2 3 4

A


B

(Rs.25000)

(Rs.25000)

Rs.10000

0

Rs.10000

0

Rs.15000

0

Rs.35000

Rs.60000

a. Determine the IRR for each project.

IRR for project A

Year cash flow P.V at 30 % P.V at 40 % P.V at 50 %

1 10,000 0.769 7690 0.714 7140 0.667 6670

2 10,000 0.592 5920 0.51 5100 0.444 4440

3 15,000 0.455 6825 0.364 5460 0.296 4440

4 35,000 0.35 12250 0.36 12600 0.198 6930

Total 32685 30300 22480

IRR = Initial present value % + (Difference of present value %)

(Difference b/w maximum value and initial investment ) / difference between two present values

IRR = 40 + (10) (30,300 – 25,000) / (30,330 – 22,480) = 40 + 53,000 /

7,853 = 40 + 6.75 = 46.75%

IRR for project B:

Present value at 20 % = (60,000) (PVIF 0.2, 4 ) = 60,000 (0.482) =

28,920


Present value at 25 % = (60,000) (PVIF 0.25, 4 ) = 60,000 (0.410) =

24,600

IRR = 20 + (5) (28,920 – 25,000) / (28,920 – 24,600) = 20 + 19,600 /

4,320 = 20 + 4.54 = 24.54 %

b. Assume a required rate of return of 10 %, determine the net present value of each project.

Year cash flow P.V at 10 % (A) P.V at 10 % (B)

1 10,000 0.909 9090

2 10,000 0.826 8260

3 15,000 0.751 11265

4 35,000 0.683 23905 0.683 40980

Total 52520 40980

Net present value for project A will be 52,520 – 25,000 = 27,520

Net present value for project B will be 40,980 – 25,000 = 15,980

c. Which project would you select? What assumptions are inherent ion your decision.

We will select project A as it has greater IRR and NPV

Q5 For each of the companies described below would you expect it to have a medium/high or a low dividend pay-out ratio? Explain why?

a. A company with a large proportion of inside ownership, all of whom are high income individuals.

b. A growth company with an abundance of good investment opportunities.

c. A company experiencing ordinary growth that has high liquidity and much unused borrowing capacity.d. A dividend-paying company that experience an unexpected drops in earning from a trend.

e. A company with volatile earnings and high business risk.

Q6 Indicate the likely direction of change in a stock’s P/E ratio if:

a. The dividend-payout decrease

b. The required rate of return rises.

c. The expected growth rate of dividend rises.


d. The risk less rate of return decrease.

Q7 The present ratio of interest on 4 year 0 coupon treasury security is 10% and on 5 year securities 9.0 %.

a. What is the implied forward rate on 1-year loan 4-years in the future?

b. How can you arrange for such a forward contract?

c. Suppose interest rates decline so that the 4- year security yields 8% and the 5- year security 8.40%. What happens to forward rate.

What overall relationship prevails between actual rates and forward rate?

Financial Management 562 Autumn 2002

1 Prepared by Mohammad Muzammil

Q1 Cheryl’s Menswear feels that its credit costs are too high. By tightening its credit standards, bad debts will fall from 5 % of sales to 2 %. However, sales will fall from 100, 000 to 90, 000 per year. The variable cost per unit is 50% of the sale price, and the average investment inreceivables is expected to remain unchanged.

(a) What cost will the firm face in reduced contribution to profit from sales.

SO = Current sales = 100, 000SN = New sales = 90, 000

ΔS = Incremental sales = 90, 000 – 100, 000 = - 10, 000

V = Variable cost as percentage of sales = 0.50

1 – V = Contribution margin as percentage of sales = 1 – 0.50 = 0.50

K = Cost of financing or cost of capital


B0 = Present bad debt percentage = 5 %

BN = New bad debt percentage = 2 %

The firm reduction in contributory margin will be:

[ΔS (1 – V) ] = - 10, 000 ( 1 – 0.5 ) = 10, 000 ( 0.5 ) = - 5, 000

(b) Should the firm tighten its credit standard?

In order to see that firm should tighten its credit standard or not, we have

to see what is the value of the benefit by reduction of bad debts.


Reduction of bad debts = (BN SN– B0 S0) = [ (0.02)(90, 000) –

(0.05)(100, 000)]

= 1, 800 – 5, 000 = - 3, 200

Because the reduction in bad debts Rs.3, 200 is less than the reduction of contributory margin which is Rs.5, 000, the firm should not tighten its credit standard.Q2 Lockbox system can shorten Orient Oil’s Accounts Receivable collection period by 3 days, credit sales are $ 3,240,000 per year, billed on a continuous basis. The firm has other equally risky investments with a return of 15%. The cost of the lockbox is $ 9,000 per year.

What amount of cash will be made available for other uses under the lockbox system?Average collection period existing = X1

New collection period = X2 = X1 – 3

Existing receivable = Y1

New receivable = Y2

360 (Average receivable)

Average collection period = ---------------------------------

Credit sales

360 ( Y1 )

X1 = ------------------ or 3, 240, 000 X1 = 360 Y1 or Y1 = 9, 000 X1

3, 240, 000

360 ( Y2 )

X2 = X1 – 3 = ---------------- or 3, 240, 000 ( X1 – 3 ) = 360 Y2 or Y2 = 9,

000 ( X1 – 3 )

3, 240, 000

Decrease in accounts receivable = Y1 – Y2 = 9, 000 X1 – 9, 000 ( X1 – 3 )

= 9, 000 X1 – 9, 000 X1 + 27, 000 = 27,000

This amount is available for other uses.

What net benefit (cost) will the firm receive if it adopts the lockbox system? Should it adopt the proposed lockbox system?


The cost of using the new system will be Rs.9, 000 per year whereas company can save Rs.27, 000 in investment in receivable. Therefore company can save 27, 000 – 9, 000 = 18, 000 by using the new system.

Q3 Determine the cost of giving up cash discounts under each of the following terms of sale.

Cost of giving up discount

% discount days in a year

= -------------------------- X -------------------------------------------

(100 - % discount) (payment date – discounted period

(a) 2/10 net 30

2 365

= ----------- X ------------ = ( 2 / 98 )( 365 / 20 ) = 0.3724 or 37.24%

100 – 2 30 – 10

(b) 1/10 net 30

1 365

= ----------- X ------------ = ( 1 / 99 )( 365 / 20 ) = 0.1843 or 18.43%

100 – 1 30 – 10

(c) 2/10 net 45

2 365

= ----------- X ------------ = ( 2 / 98 )( 365 / 35 ) = 0.2128 or 21.28%

100 – 2 45 – 10

(d) 3/10 net 45

3 365

= ----------- X ------------ = ( 3 / 97 )( 365 / 35 ) = 0.3225 or 32.25%

100 – 3 45 – 10

(e) 1/10 net 60

1 365

= ----------- X ------------ = ( 1 / 99 )( 365 / 50 ) = 0.0737 or 7.37%


100 – 1 60 – 10

(f) 3/10 net 30

3 365

= ----------- X ------------ = ( 3 / 97 )( 365 / 20 ) = 0.5644 or 56.44%

100 – 3 30 – 10

(g) 4/10 net 180

4 365

= ----------- X ------------ = ( 4 / 96 )( 365 / 170 ) = 0.089 or 8.9%

100 – 4 180 – 10

Q4 Patterson’s Parts Store expects sales of $ 100,000 during each of the next 3 months. It will make monthly purchases of $ 60,000 during this time. Wages and salaries are $ 10,000 per month plus 5% of sales. Patterson’s expects to make a tax payment of $ 20,000 in the nextmonth and a $ 15,000 purchase of fixed assets in the second month and to receive $ 8,000 in cash from the sale of an asset in the third month. All sales and purchases are for cash.

Beginning cash and the minimum cash balance are assumed to be zero.Construct a cash budget for the next 3 months.

Description Month 1 Month 2 Month 3

Opening balance 0 25, 000 15, 000

Sale 100, 000 100, 000 100, 000

Sale of asset 8, 000

Total cash inflow 100, 000 125, 000 123, 000

Purchases 60, 000 60, 000 60, 000

Commission 5, 000 5, 000 5, 000

Wages / Salaries 10, 000 10, 000 10, 000

Tax 20, 000

Fixed asset 15, 000

Total cash outflow 75, 000 110, 000 75, 000

Ending balance 25, 000 15, 000 48, 000


Briefly discuss how the financial manager can use the data in (a) to plan for Patterson’s financing needs.

They do not need any finance but they have to consider the investment of extra cash

Q5 Firm J has sales of 100,000 units at $ 2.00 per unit, variable operating costs of $ 1.70 per unit, and fixed operating costs of $ 6,000. Interest is $ 10,000 per year. Firm R has sales of 100,000 units at $ 2.50 per unit, variable operating costs of $ 1.00 per unit, and fixed operating costs of $62,500. Interest is $ 17,500 per year. Assume that both firms are in the 40% tax bracket.Compute the degree of operating, financial and total leverage of firm J.

Compute the degree of operating, financial and total leverage of firm R.

FIRM J FIRM L

Sale (Q) 100, 000 units 100, 000 units

Sale price ( P) 2.00 2.50

Variable cost (V) 1.70 1.00

Fixed cost (FC) 6, 000 62, 500

Interest charges (I) 10, 000 17. 500

Degree of Operating leverage

Leverage (DOL)

Q ( P – V )

DOL = ----------------------

Q ( P – V ) – FC

100, 000 (2.00 – 1.70 )

= --------------------------------------

100,000 ( 2.00 – 1.70 ) – 6,000

100, 000 ( 0.30)

= ------------------------------

100,000 ( 0.30) – 6,000

30,000

= ------------------------------

30,000 – 6,000 = 24,000


= 1.25

100, 000 ( 2.50 – 1.00 )

= --------------------------------------

100,000 (2.50 – 1.00) – 62,500

100, 000 (1.50)

= ------------------------------

100,000 ( 1.50) – 62,500

150,000

= ------------------------------

125,000 – 62,500 = 62,500

= 2.4

Degree of financial

Leverage (DOF)Q ( P – V ) – FC

DOF= ------------------------

Q ( P – V ) – FC – I

30, 000

= ---------------------------

24, 000 – 10, 000

= 2.14

150, 000

= ----------------------

62, 500 – 17, 500

= 3.33

Total leverage (DOT)

Q ( P – V )

DOT = ------------------------


Q ( P – V ) – FC – I

100, 000

= ----------------------------

24, 000 – 10, 000

100, 000

= ------------------ = 7.14

14, 000

100, 000

= ----------------------------

62, 500 – 17, 500

100, 000

= ------------------ = 2.22

45, 000Q6 Easi Chair Company is attempting to select the best of three mutually exclusive projects. The initial investment and after-tax cash inflows associated with each project are shown in the following table.

Cash flows Project A ($) Project B ($) Project C ($)

Initial investment 60,000 100,000 110,000

Cash inflows (CF) year 1-5 20,000 31,500 32,500

Calculate the payback period for each project.

Pay back period for project A = 60, 000 / 20, 000 = 3 years

Pay back period for project B = 100, 000 / 31, 500 = 3.17 years or 4 years

Pay back period for project C = 110, 000 / 32, 500 = 3.38 years or 4 years

Calculate the net present value (NPV) of each project, assuming that the firm has a cost of capital equal to 13%.

NPV for project A = PV of future cash flows – initial investment

= 20, 000 (3.517) – 60, 000 = 70, 340 – 60, 000 = 10, 340

NPV for project B = PV of future cash flows – initial investment


= 31, 500 (3.517) – 100, 000 = 110, 785.50 – 100, 000 = 10, 785.50

NPV for project C = PV of future cash flows – initial investment

= 32, 500 (3.517) – 110, 000 = 114, 302.50 – 110, 000 = 4, 302.50

Calculate the internal rate of return (IRR) for each project.

IRR for project A

PV for project A at 15 % = 20, 000 (3.352) = 67, 040PV for project A at 20 % = 20, 000 (2.991) = 59, 820

67, 040 – 59, 820 = 7, 220

67, 040 – 60, 000 = 7, 040

IRR = 15 + (7, 040 / 7, 220 ) 5 = 15 + 4.87 = 19.87 %

IRR for project B

PV for project B at 15 % = 31, 500 (3.352) = 105, 588

PV for project B at 20 % = 31, 500 (2.991) = 94, 216.50

105, 588 – 94, 216.50 = 11, 371.50

105, 588 – 100, 000 = 5, 588

IRR = 15 + (5, 588 / 11, 371.50 ) 5 = 15 + 2.457 = 17.547

IRR for project C

PV for project C at 15 % = 32, 500 (3.352) = 108, 940

114, 302.50 – 110, 000 = 4, 302.50

114, 302.50 – 108, 940 = 5. 362.50

IRR = 13 + (4, 302.50 / 5, 362.50 ) 2 = 13 + 1.6 = 14.6

Summarize the preferences dictated by each measure, and indicate which project you would recommend. Explain why.

PROJECT A PROJECT B PROJECT C

PAY BACK PERIOD 3 Years 4 years 4 years

NPV 10, 340 10, 785.50 4, 302.50IRR 19.87 % 17.547 % 14.6 %

Project C is out of question as it has less NPV and IRR in comparison


with project A and B. In selecting between project A and B, project B has more NPV but less IRR than project A. In order to select, we have to calculate profitability index and we will select the project which has greater PI.

PI = present value of future cash flows / initial investment

PI for project A = 10, 340 / 60, 000 = 0.1723

PI for project B = 10, 785.50 / 100, 000 = 0.1078

Therefore we will select project A

Q7 Redenour Supply has an issue of $ 1,000-par-value bonds with a 12% coupon interest rate outstanding. The issue pays interest annually and has 16 years remaining to its maturity date.

If bonds of similar risk are currently earning a 10% rate of return, how much should the Redenour Supply bond sell for today?

V = I (present value annuity factor for 16 years at 10 %) + MV (present value factor for single payment for 16th year at 10 %

V = 120 (7.824) + 1, 000 (0.218) = 938.88 + 218 = 1, 156.88

Describe the two possible reasons that similar risk bonds are currently earning a return below the coupon interest rate on the Redenour Supply bond.

If the required return were at 12% instead of 10%, what would the current value of Redenour Supply’s bond be? Contrast this with your findings in

(a) and discuss.

V = I (present value annuity factor for 16 years at 12 %) + MV (present value factor for single payment for 16th year at 12 %)

V = 120 (6.974) + 1, 000 (0.163) = 836.88 + 163 = 999.88

Q8(a) What is a common-size income statement? Which three ratios of profitability are found on this statement?

Q8(b) Define and differentiate between return on total assets (ROA) and return on equity (ROE).

Which measure is probably of greatest interest to owners? Why?




Q.1(a) Which firm is more profitable firm A with the total assets turn over 10.0 and a net profit of 2% or firm B with the total assets turn over 2.0 and a net profit of 10%? Provide example of both types of firm.

Return on Assets = (Net profit margin) (Total Assets turnover)

Firm A = 2 x 10 = 20 %

Firm B = 10 x 2 = 20 %

Two firms with different net profit margins and total asset turnover may have the same earning power (Return on Assets) Firm A, with a net profit margin of only 2 percent and a total asset turnover of 10 have the same earning power of 20 percent as Firm B, with a net profit margin of 10 percent and total asset turnover of 2. For each firm every dollar invested in assets returns 20 percent.

Q.1(b) Does increasing the firm’s inventory turnover ratio increase its profitability? Why should this ratio be computed using costs of good sold (rather than sales, as is done by some compliers of financial statistics)?

Two problems arise in calculating and analyzing the inventory turnover ratio.

First, sales are stated at market price, so if inventories are carried at cost, as generally are, the calculated turnover overstates the true turnover ratio.

Therefore, it would be more appropriate to use cost of goods sold in place of sales in the numerator of the formula.The second problem lies in the fact that the sales occur over the entire year, whereas the inventory figure is for one point in time. For this reason, it is better to use an average inventory measure.

Q2 Patterson’s part store expects sales of $100,000 during each of the next 3 months. It will make monthly purchases of $60,000 during this time. Wages and salaries are $10,000 per month plus 5% of sales.

Patterson’s expects to make a tax payment of $20,000 in the next month and $1,500 purchase of fixed assets in the second month and to receive $8,000 in cash from the sale of an asset in the third month. All sales and purchases are for cash. Beginning cash and min.

cash balance is assumed to be zero.

A. constructs a cash budget for the next 3 months.

B. briefly discuss how the financial manager can use the data in (a) to plan for Patterson’s financing needs.

Construct a cash budget for the next 3 months.

Description Month 1 Month 2 Month 3

Opening balance 0 25, 000 15, 000

Sale 100, 000 100, 000 100, 000


Sale of asset 8, 000

Total cash inflow 100, 000 125, 000 123, 000

Purchases 60, 000 60, 000 60, 000

Commission 5, 000 5, 000 5, 000

Wages / Salaries 10, 000 10, 000 10, 000

Tax 20, 000

Fixed asset 15, 000

Total cash outflow 75, 000 110, 000 75, 000Ending balance 25, 000 15, 000 48, 000

Briefly discuss how the financial manager can use the data in (a) to plan for Patterson’s financing needs.

They do not need any finance but they have to consider the investment of extra cash

Q3 Sorbond industries have a beta of 1.45, the risk free rate is 8% and the expected return on the market portfolio is 13%. The co. presently pays a dividend of $2 a share, and investors expect it to experience a growth of 10% per annum for many years to come.

a. What is the stock required rate of return according to CAPM?

Β = 1.45 Rf = 0.08 Rm = 0.13 D0 = 2 g = 0.10

R = Rf + β (Rm – Rf ) = 0.08 + 1.45 (0.13 – 0.08) = 0.08 + 0.0725 =

0.1525 or 15.25 %

b. What is the stock’s present market price per share, assuming this required rate?

V = D / (R – g ) = 2 / (0.1525 – 0.10) = 2 / 0.0525 = 30

c. What would happen to the required return and to market price per share if the beta were 0.80? (Assume that all else stay the same)

R = Rf + β (Rm – Rf ) = 0.08 + 0.80 (0.13 – 0.08) = 0.08 + 0.04 = 0.12 or 12 %

V = D / (R – g ) = 2 / (0.12 – 0.10) = 2 / 0.02 = 100

Q4 ZZZ worst co. presently has total assets of $3.2 million, of which current assets comprises $0.2 million. Sales are $10 million annually, and the before tax net profit margin (the firm currently has no interest bearing debt) is 12%. Given renewed fears of potential cash insolvency andoverly strict credit policy, and imminent stock outs, the company is considering higher level of current assets as a buffer against adversity. Specifically, levels of $0.5 million and


$.8 million are being considered instead of 0.2 million presently held. Any additions to current assets would be financed with new equity capital.

Required: Determine the total assets turnover, before tax return on investment, and before tax profit margin under the three alternative levels of current assets.

Present Option 1 Option 2

Sales 10 M 10 M 10 M

Current asset 0.2 M 0.5 M 0.8 M

Total asset = 3.2 – 0.2 + new current asset 3.2 M 3.5 M 3.8 M

EBIT 1.2 M 1.2 M 1.2 M

Total asset turnover = Sales / Total asset 3.125 2.857 2.632

Return on asset = EBIT / Total asset 0.375 0.3429 0.3158

Net profit margin 0.12 0.12 0.12

Net profit = sales (net profit margin) 1.2 M 1.2 M 1.2 M

Q5 The Dud co. purchases raw material on terms of “2/10, net 30”. A review of the co. record by owner, Mr. Dud, revealed that payments are usually made 15 days after purchase are received.When asked why the co. did not take advantage of its discount, the bookkeeper, Mr. Blunder replied that it cost only 2% for these funds, whereas a bank loan would cost the firm 12%.

(a) What mistake is Mr. Blunder making?

Mr. Blunder is making following mistakes.

1- He is not taking advantage of discounts offered to the firm as per terms “2/10, net30.”2- After giving up discounts, he is usually making payments 15 days after purchases are received.

3- Bank loan is more costly than trade credit funds.

(b) What is the real cost of not taking the advantage?

Annual cost if % discount 360

Discount is not = ----------------------- x ---------------------------------------

taken 100 - % discount payment date – discount period= (2 / (100 – 2 ) (360 / [(30 – 20 )] = (2 / 98) (360 / 20) = 0.367 or 36.7 %

But as the Dud company usually makes payments 15 days after purchases are received, the real cost of not taking discounts would be much as worked out below:


= (2 / (100 – 2 ) (360 / [(15 – 10 )] = (2 / 98) (360 / 5) = 1.468 or 156.8 %

(c) If the firm could not borrow from bank and were resort to the trade credit funds, what suggestion might be made to Mr. Blunder that would reduce the annual interest cost?

If the company could not avail discount it should make its payments on the final due date, i.e., 30 days after purchase are received. And if possible, these payments can be stretched for a period of a week or10 days.

Q6 The Crazy horse hotel has capacity to stable 50 horses. The fee for stabling a horse is $100 per month. Maintenance, depreciation and other fixed operating cost total $1200 per month.

Variable operating cost per horse is $12 per month for hay and bedding and $8 for grain.

(a) Determine the monthly break even point (in horses stable)

BE in quantity or QBE = Fixed cost / (Unit sales price – Unit variable cost)

= 1,200 / (100 – 20) = 15

(b) Compute the monthly operating profits if an average of 40 horses are stabled.

Operating profit = 40 (100 – 20 ) – 1,200 = 3,200 – 1,200 = 2,000

Q7 Easi chair co. is attempting to select best of three mutually exclusive projects. The initial investment and after tax inflows associated with each project are shown in following table.

Cash flows Project A Project B Project c

Initial investment (II) $60,000 $100,000 $110,000

Cash inflows $20,000 $20,000 $32,500

a. Calculate the pay back period for each project.

Pay back period for project A = 60, 000 / 20, 000 = 3 years

Pay back period for project B = 100, 000 / 31, 500 = 3.17 years or 4 years

Pay back period for project C = 110, 000 / 32, 500 = 3.38 years or 4 years

(b) Calculate the net present value (NPV) of each project, assuming that the firm has a cost of capital equal to 13%.

NPV for project A = PV of future cash flows – initial investment

= 20, 000 (3.517) – 60, 000 = 70, 340 – 60, 000 = 10, 340

NPV for project B = PV of future cash flows – initial investment


= 31, 500 (3.517) – 100, 000 = 110, 785.50 – 100, 000 = 10, 785.50

NPV for project C = PV of future cash flows – initial investment

= 32, 500 (3.517) – 110, 000 = 114, 302.50 – 110, 000 = 4, 302.50

(c) Calculate the internal rate of return (IRR) for each project.

IRR for project A

PV for project A at 15 % = 20, 000 (3.352) = 67, 040

PV for project A at 20 % = 20, 000 (2.991) = 59, 82067, 040 – 59, 820 = 7, 22067, 040 – 60, 000 = 7, 040

IRR = 15 + (7, 040 / 7, 220 ) 5 = 15 + 4.87 = 19.87 %

IRR for project B

PV for project B at 15 % = 31, 500 (3.352) = 105, 588

PV for project B at 20 % = 31, 500 (2.991) = 94, 216.50

105, 588 – 94, 216.50 = 11, 371.50

105, 588 – 100, 000 = 5, 588

IRR = 15 + (5, 588 / 11, 371.50 ) 5 = 15 + 2.457 = 17.547

IRR for project C

PV for project C at 15 % = 32, 500 (3.352) = 108, 940

114, 302.50 – 110, 000 = 4, 302.50

114, 302.50 – 108, 940 = 5. 362.50

IRR = 13 + (4, 302.50 / 5, 362.50 ) 2 = 13 + 1.6 = 14.6

(d) Summarize the preferences dictated by each measure, and indicate which project you would recommend. Explain why.

PROJECT A PROJECT B PROJECT C

PAY BACK PERIOD 3 Years 4 years 4 years

NPV 10, 340 10, 785.50 4, 302.50

IRR 19.87 % 17.547 % 14.6 %

Project C is out of question as it has less NPV and IRR in comparison with project A and B. In selecting between project A and B, project B has more NPV but less IRR than project A. In


order to select, we have to calculate profitability index and we will select the project which has greater PI.

PI = present value of future cash flows / initial investment

PI for project A = 10, 340 / 60, 000 = 0.1723

PI for project B = 10, 785.50 / 100, 000 = 0.1078

Therefore we will select project A

Q8 (a) contrast the objective of maximizing earnings with that of maximizing wealth.

(b) Explain why judging the efficiency of any financial decision require the existence of goal.



Q.1 You have just opened a new business and expect to generate $250,000 in sales during your first year of operation. You recently looked the following industry average for the selected group of financial ratios:

Asset turnover 1.5

Net profit margin 8%

Gross profit margin 30%

Debt ratio 50%

Current ratio 2.1

Current assets, as % of sales 40%

Calculate the following year end totals, assuming you expect your firm’s financial positions to mirror that of industry:

(a) Total assets

Total Asset turnover = 1 .5 = Sales / Total asset

Total asset = Sales / 1.5 = 250,000 / 1.5 = $166,667

(b) Net profit

Net Profit = Sales (Net profit margin) = $250,000 (0.08) = $20,000

(e) Current assets

Current asset = Sales (0.40) = 250,000 (0.40) = $100,000


(d) Current liabilities

Current ratio = 2 (Current Asset / Current liabilities)

Current Liabilities = Current Asset / 2 = 100,000 / 2 = $50,000(c) Long term debt

Debt Ratio = 0.5 = Total Debt / Total asset = (CL +LTD) / Total assets

LTD = 0.5 (Total asset) – CL = 0.5 (166,167) – 50,000 = 83,083 – 50,000

= $33,083

(f) Cost of goods sold

Cost goods sold = Sales – Sales (Gross profit margin)

CGS = 250,000 – 250,000 (0.30) = 250,000 – 75,000 = $175,000

Q.2(a) Choctaw Oilfield Services made a $225,000 operating profit last year and paid $160,000 in interest expense. How much financial leverage does Choctaw have? If operating profits drop 50 percent this year, what effect does its financial leverage have on Choctaw’s net profit?

Degree of financial leverage = DFL = (Operating profit) / (Operating

profit – Interest expanse)

DFL = (225,000) / (225,000 – 160,000) = 3.46 times

Effect of net profit = 50 % (3.46) = 1.73 or 173 %

Q.2(b) What are the weaknesses of breakeven analysis?

Q.3 GC investment has $ 100,000 in money market fund that it wants to invest. GC has two alternatives with different after tax cash flows, each costing $100,000.Year 1 2 3 4

Project A 0 0 75,000 100,000

Project B 35,000 35,000 35,000 35,000

The cost of capital is I0 percent. Calculate the following and state for each criterion whether or not you should invest.

(a) NPV

Year cash flow P.V at 10 % (B) Cashflow P.V at 10 % (A)

1 35,000 0.909 31815 0 0.909 0

2 35,000 0.826 28910 0 0.826 0


3 35,000 0.751 26285 75,000 0.751 56325

4 35,000 0.683 23905 100,000 0.683 68300

Total 110915 124625

Net present value for Project A = 124625 – 100,000 = 24,625

Net present value for Project B = 110915 – 100,000 = 915

(b) IRR

For project A

Year CF PV factor @15 % PV PV factor @18 % PV

1 0 0.8696 0 0.847 0

2 0 0.7561 0 0.718 0

3 75,000 0.6575 49312.5 0.609 45675

4 100,000 0.5718 57180 0.516 51600

Total 106493 97275

IRR = Initial present value % + (Difference of present value %) (Difference b/w maximum value and

initial investment ) / difference between two present values

IRR = 15 + (18 – 15) (106,493 – 100,000) / (106,943 – 97,275) = 15 + 3

(6,493) / 14,668

IRR = 15 + 1.328 = 16.328 %

For project B

Year CF PV factor @14 % PV PV factor @15 % PV

1 35,000 0.977 34195 0.847 29645

2 35,000 0.769 26915 0.718 25130

3 35,000 0.675 23625 0.609 21315

4 35,000 0.592 20720 0.516 18060

Total 105455 94150



(Difference b/w maximum value and initial investment ) / difference between two present values

IRR = 14 + (15 – 14) (105,455 – 100,000) / (105,455 – 94,150) = 14 + 1

(5,455) / 11,305

IRR = 14 + 0.48 = 14.48 %

If the projects are independent, then company should select both projects and if both projects are mutually exclusive than company should go forproject A who has NPV and IRR greater than B

Q.No.4 The common stocks of ABC co. and XYZ co. are estimated to offer returns over the next year according to the following table:

ABC XYZ

Return Probability Return Probability

-20 0.05 -30 0.1

-10 0.05 0 0.2

5 0.1 10 0.5

10 0.3 50 0.2

20 0.5

ABC

R (%) – 20 – 10 5 10 20

Probability 0.05 0.05 0.1 0.3 0.5XYZ

R (%) – 30 0 10 50

Probability 0.1 0.2 0.5 0.2

Compute risk and return for these stocks

The expected return and standard deviation for stock ABC will be:

Possible retrun Probability Expec, Retun Variance

R P P X R R - R' (R - R')² (R - R')² (P)

-0.2 0.05 -0.01 -0.241 0.058081 0.00290405

-0.1 0.05 -0.005 -0.141 0.019881 0.00099405


0.05 0.1 0.005 0.009 0.000081 0.0000081

0.1 0.3 0.03 0.059 0.003481 0.0010443

0.2 0.5 0.1 0.159 0.025281 0.0126405

Σ 0.12 0.017591

R' = 0.12/5

0.041

Expected return = 0. 041 or 4.1 %

Standard deviation = √ .017591 = 0.1326

Coefficient of variation = SD / R’ = 0.1326 / 0.041 = 3.23

The expected return and standard deviation for Stock XYZ will be:


R P P X R R - R' (R - R')² (R - R')² (P)

-0.3 0.1 -0.03 -0.333 0.110889 0.0110889

0 0.2 0 -0.033 0.001089 0.0002178

0.1 0.5 0.05 0.067 0.004489 0.0022445

0.5 0.2 0.1 0.467 0.218089 0.0436178

Σ 0.12 0.057169

R' = 0.12 / 4

0.03

Expected return = 0. 03 or 3 %Standard deviation = √ .057169 = 0.293


ABC stock will be less risky as it has lower coefficient of variationQ.5 ACME production has daily sales of $100,000. You may assume a 360 days year. Currently all accounts are payable within 30 days. Its new financial manager thinks that by offering a cash discount its sales will increase 25 percent. Acme’s cost of capital is 12 percent and its directproduction expenses are 60 percent of its sales. The financial manager feels that if its terms were 2/10 net, 20, 50 percent of its customers would take the cash discount. The collection expenses are not expected to be significant. Should acme follow its financial manager advice?


SO = 100,000 (360) = 36,000,000

SN = 36,000,000 (1.25) = 45,000,000

ΔS = 45,000,000 – 36,000,000 = 9,000,000

V = 0.6

1 – V = 1 – 0.60 = 0.40

K = 0.12

ACP0 = 30 days

ACPN = 20 days

P0 = 0

PN = 0.5

D0 = 0

DN = 0.02ΔI = Incremental change in investment in receivable

= [ACPN – ACP0] [SN/360] + [V (ACP0) (ΔS/360)]

= [ 25 – 30] [ 45,000,000 / 360 ] + [ 0.6 ( 30) ( 9,000,000 / 360) ]

= (– 5) (125,000) + 450,000 = 450,000 – 625,000 = – 175,000

ΔP = Incremental change in profit ΔP = [ΔS (1 – V) – K (ΔI) – (BN SN–

B0 S0) – (D0 S0 P0 – DN SN P1)]

= [9,000,000 (0.4) – 0.12 ( – 175,000)] = 3,600,000 + 21,000 = 3,621,000

Since profit is increased because of new policy, AC ME should follow its financial manager’s advice.

Q.6 Economics unlimited forecast inventory needs for the coming year at 2.5 million widgets.

Orders have to be placed in multiple of 1,000 widgets and it costs $10 to place an order.

Carrying costs are $.50 per widget. What is EOQ and average inventory level? How many orders are placed during the year?

Annual requirements = A = 2,500,000 widgets

Order to be placed in multiple of 1,000

Cost of placing an order = Oc = 10


Carrying cost = Cc = 0.5

2 ( A) (Oc) 2 (2,500,000) (10) 50,000,000

EOQ = ---------------- = ------------------------ = --------------- = √

100,000,000 = 10,000

√ Cc √ 0.5 √ 0.5

Average inventory = 10,000 / 2 = 5,000

Number of orders per year = 2,500,000 / 10,000 = 250 times

Q.7 Given the following changes state would you think the impact would be on the optimal amount of debt in the firm’s capital structure and why?

a. The federal govt. lowers the corporate income tax.

b. The federal govt. raises the corporate income tax.

c. The asset markets become more efficient.

d. The firm’s assets comprise asset of standardized assets highly demanded by other firms.

e. The product market for the firm’s output become much more volatile and more uncertain.

f. The govt. no longer allows interest expense to be tax deductible.

Q.8(a) The share holders required return for slick manufacturing is 20%. The risk free rate is 12 percent and requires return on the market portfolio is 15 percent. Calculate the slick’s beta coefficient.

R = Rf + β (Rm – Rf) or β = (R – Rf ) / (Rm – Rf ) = (20 – 12) / (15 – 12 )

= 8 / 3 = 2.67

Q.8(b) Describe how break even analysis can be useful for a manager finance?



Q.1. Loquat Foods Company is able to borrow at an interest rate of9 percent for one year. For the year, market participants expect 4 percent inflation.

a. What approximate real rate of return does the lender expect? What is the inflation premium embodied in the nominal interest rate?The expected real rate of return is 5 percent, and the inflation premium is 4 percent.


b. If inflation proves to be 2 percent for the year, does the lender suffer? Does the borrower suffer? Why?

The lender gains in that his real return is 7 percent instead of the 5 percent that was expected. In contrast, the borrower suffers in having to pay a higher real return than expected. In other words, the loan is repaid with more expensive dollars than anticipated.

c. If inflation proves to be 6 percent, who gains and who loses?

With 6 percent inflation, the real return of the lender is only 3 percent, so he suffers whereas the borrower gains.

Q.2. Delphi Products Corporation currently pays a dividend of $2 per share, and this dividend is expected to grow at a 15 percent annual rate for three years, and then at a 10 percent rate for the next three years, after which it is expected to grow at a 5 percent rate forever. What valuewould you place on the stock if an 18 percent rate of return was required?

Phase: one

Phase: two

Total Present value = 10.53

Phase: 3

Dividend at the end of year 7 = 4.05 (1 + 0.05) = 4.25

Value of stock at the end of year 6 = D 7 / (Ke – g ) = 4.25 / (0.18 – 0.05)

= 32.69

Present value of 32.69 = 32.69 (PVIF, 18%,6 ) = 32.69 (0.370) = 12.10

V = 12.10 + 10.53 = 22.63

Q.3(a) What are the different motives given by Keynes for holding cash?

Q.3(b) What is net float? How might a company play the float in its disbursement?

Q.3(c) What are the various sources of information you might use to analyze a credit application?

Q.4. Financial statements for the Begalla Corporation follow.

Balance sheet

Assets 20X1 20X2 liabilities 20X1 20X2

Cash and equivalent 4 5 Accounts payable 8 10

Accounts receivable 7 10 Notes payable 5 5


Inventory 12 15 Accrued wages 2 3

Accrued taxes 3 2

Total current assets 23 30 Total current liabilities 18 20

Net fixed asset 40 40 Long term debt 20 20

Common stock 10 10

Retained earnings 15 20

Total 63 70 Total 63 70

End of year Dividend PVIF 18%, t PV of dividend

1 2.00 (1 + 0.15) 1 = 2.30 0.847 1.952 2.00 (1 + 0.15) 2 = 2.65 0.718 1.90

3 2.00 (1 + 0.15) 3 = 3.04 0.609 1.85

End of year Dividend PVIF 18%, t PV of dividend

4 3.04 (1 + 0.10) 1 = 2.30 3.34 1.72

5 3.04 (1 + 0.10) 2 = 2.65 3.68 1.61

6 3.04 (1 + 0.10) 3 = 3.04 4.05 1.50Income statement 20X2

Sales 95

Cost of goods sold 50

Selling, general and administrative expanses 15

Depreciation 3

interest 2

Net income before tax 25

Taxes 10

Net income 15

(a) Prepare a sources and uses of funds statement for Begalla Corporation.Begalla Corporation Sources and uses of funds statement For December 31, 20X1 to December 31, 20X2 (in milliond) Funds provided by operations:

Net profit 15 Dividend 10

Depreciation 3 Addition to fixed asset 3


Increase accrued wages 1 Increase accounts receivable 3

Increase accounts payable 2 Increase inventory 3

Decreased accrued taxes 1

Increase cash and equivalent 1

____ _____

21 21

(b) Prepare a cash flow statement using the indirect method for Begalla Corporation.

Begalla Corporation Statement of cash flows

For the year ended December 31, 20X2 (in millions)

Cash flow from operating activities:

Net income 15

Depreciation 3

Increase accounts payable 2

Increase accrued wages 1

Increase accounts receivable (3)

Increase inventory (3)

Decrease accrued taxes (1)

Net cash provided by operating activates 14

Cash flow from investing activities

Addition to fixed assets (3)

Net cash flow provided by investing activities (3)

Cash flow from financing activities:

Dividend paid (10)

Net cash flow provided by financing activities (10)

Increase (decrease) in cash and cash equivalent 1

Cash and cash equivalent, December 31, 20X1 4


Cash and cash equivalent, December 31, 20X2 5

Supplemental cash flow disclosures:

Interest paid ........................................ $ 2

Taxes paid .......................................... 11

Q.5 Mendez Metal Specialties. Inc. has a seasonal pattern to its business. It borrows under a line of credit from Central Bank at 1% over prime. Its total asset requirements now (at year end) and estimated requirements for the coming year are (in millions):

Now 1st Q 2nd Q 3rd Q 4th Q

Total asset requirements $4.5 $4.8 $5.5 $5.9 $5.0

Assume that, these requirements are level throughout the quarter. Presently, the company has $4.5 million in equity capital and long term debt plus the permanent component of current liabilities, andthis mount will remain constant throughout the year.

The prime rate presently is 11 % and the company expects no change in this rate for the next year.Mendez Metal Specialties is also considering issuing intermediate - term debt at an interest late of 13.5%. In this regard, three alternative amounts are under consideration: zero, $ 500,000 and $ 1 million.

All additional funds requirements will be borrowed under the company’s bank line of credit.

(a) Determine the total dollar borrowing costs for short and intermediate-term debt under each of the three alternatives for the coming year. (Assume. that there are no changes in current liabilities other than borrowings). Which alternative is lowest in cost’?

Alternative 1: 0 intermediate term debt and all finance is from bank borrowing Bank loan cost = (11 + 1) / 4 = 3 % per quarter

Q 1 Q 2 Q 3 Q 4

Incremental borrowing 300,000 1,000,000 1,400,000 500,000

Bank loan cost 9,000 30,000 42,000 15,000

Total cost of bank loan = 9,000 + 30,000 + 42,000 + 15,000 = 96,000

Alternative 2: Issuing 500,000 intermediate term debt and rest is financed by bank borrowing

Term loan cost = 500,000 (0.135) = 67,500

Q 1 Q 2 Q 3 Q 4


Incremental borrowing 0 500,000 900,000 0

Bank loan cost 0 15,000 27,000

Total cost = 67,500 + 15,000 + 27,000 = 109,500

Alternative 3: Issuing 1,000,000 intermediate term debt and rest is financed by bank borrowing

Term loan cost = 1,000,000 (0.135) = 135,000

Q 1 Q 2 Q 3 Q 4

Incremental borrowing 0 0 400,000 0

Bank loan cost 0 0 12,000 0

Total cost = 135,000 + 12,000 = 147,500

Alternative 1 is lowest in cost because the company borrows at a lower rate, 12 percent versus 13.5 percent, and because it does not pay interest on funds employed when they are not needed.

(b) Is there a consideration other than expected Cost that deserves your attention?

While alternative 1 is cheapest it entails financing the expected build up in permanent funds requirements ($500,000) on a short-term basis. There is a risk consideration in that if things turn bad the company is dependent on its bank for continuing support. There is risk of loan renewal and ofinterest rates changing.

Alternative 2 involves borrowing the expected increase in permanent funds requirements on a term basis. As a result, only the expected seasonal component of total needs would be financed with shorttermdebt.Alternative 3, the most conservative financing plan of the three, involves financing on a term basis more than the expected build-up in permanent funds requirements. In all three cases, there is the risk that actual total funds requirements will differ from those that are expected.Q.6 Compare and evaluate the four major capital budgeting techniques.

Q.7 On the basis of an analysis of past returns and of inflationary expectations, Marta Gomez feels that the expected return on stocks in general is 12 percent The risk-free rate on short term Treasury securities is now 7 percent. Gomez is particularly interested in the return prospects for Kessler Electronics Corporation. Based on monthly data for the past five years, she has fitted a characteristic line to the responsiveness of excess returns of the stock to excess returns of the S&P 500 Index and has found the slope of the line to be 1.67. If financial markets are believed to be efficient, what return can she expect from investing in Kessler Electronics Corporation?

Expected return = .07 + (.12 - .07)(1.67) = .1538, or 15.38%

Q.8. Hayleigh Mills Company has a $5 million revolving credit agreement with First State Bank of Arkansas. Being a favored customer, the rate is set at 1 percent over the bank’s


cost of funds, where the cost of funds is approximated as the rate on negotiable certificates of deposit (CDs).

In addition, there is a ½ percent commitment fee on the unused portion of the revolving credit.

If the CD rate is expected to average 9 percent for the coming year and if the company expects to utilize, on average, 60 percent of the total commitment, what is the expected annual dollar cost of this credit arrangement?

($5,000,000)(0.60)(0.10) = $300,000 in interest

($5,000,000)(0.40)(.005) = 10,000 in commitment fees

Total annual dollar cost = 300,000 + 10,000 = $310,000

What is the percentage cost when both the interest rate and the commitment fee paid are considered?

$310,000 in annual dollar cost / $3,000,000 in useable funds = 10.33%

What happens to the percentage cost if, on average, only 20 percent of the total commitment is utilized?

With 20 percent utilization we have:

($5,000,000)(0.20)(0.10) = $100,000 in interest

($5,000,000)(0.80)(.005) = 20,000 in commitment fees

Total annual dollar cost = 100,000 + 20,000 = $120,000 in annual dollar cost$120,000 in annual dollar cost / $1,000,000 in useable funds = 12%



Q.1(a) What is the purpose of stock market exchange?

Q.1(b) What are the three major functions of finance manager? How are they related?

Q.1(c) If the firm adopts a hedging approach to financing, how would it finance its current assets.

Q.1(d) Explain how efficient inventory management affects the liquidity and profitability of the firm.

Q.2 Complete the 2007 balance sheet of Mughal Industries using the information given below:

Balance sheet

Mughal Industries


December 31, 2007

Cash 45,000 Accounts receivable 180,000

Marketable securities 37,500 Notes payable

Accounts receivable Accruals 30,000

Inventories

Total current assets Total current liabilities

Net fixed asset Long term debt

Share holder’s equity 900,000

Total assets Total liabilities and equity

The following financial data for 2007 are also available:

1. Sales totaled 2,700,000

2. The gross profit margin was 25 %

3. Inventory turnover was 6.00

4. There are 360 days in a year

5. The average collection period was 40 days

6. The current ratio was 1.60

7. The total asset turnover ratio was 1.20

8. The debt ratio was 60 %

Balance sheet

Mughal Industries

December 31, 2007

Cash 45,000 Accounts receivable 180,000

Marketable securities 37,500 Notes payable 240,000 (e)

Accounts receivable 300,000 (b) Accruals 30,000

Inventories 337,000 (a) ‘ ‘

Total current assets 720,000 (c) Total current liabilities 450,000 (d)


Net fixed asset 1,530,000 (g) Long term debt 900,000 (i)

Total liabilities 1,350,000 (h)

‘ Share holder’s equity 900,000

Total assets 2,250,000 (f) Total liabilities and equity 2,250,000 (j)

Calculation A.

CGS = Sale (1 – Gross profit margin) = 2,700,000 (1 – 0.25) = 2,025,000

Inventory turnover = 6.0 = CGS / Inventory

Inventory = CGS / 6.0 = 2,025,000 / 6 = 337,500

Calculation B.

Average collection period = 40 days = (360) (Accounts receivable) / Sale

Accounts receivable = (40) (Sale) / 360 = (40) (2,700,000) / 360 = 300,000

Calculation C.

Total current asset = Cash + Marketable securities + Accounts receivable

+ Inventory

Total current asset = 45,000 + 37,500 + 300,000 + 337,500 = 720,000

Calculation D.

Current ratio = 1.6 = Current asset / Current liabilities

Current liabilities = Current asset / 1.6 = 720,000 / 1.6 = 450,000

Calculation E.

Notes payable = Total current liabilities – Accounts payable – Accruals =

450,000 – 30,000 – 180,000

=240,000

Calculation F.

Asset turnover = 1.2 = Sales / total asset

Total asset = sales / 1.2 = 2,700,000 / 1.2 = 2,250,000

Calculation G.


Fixed asset = Total asset – Current asset = 2,250,000 – 720,000 = 1,530,000

Calculation H.

Debt ratio = 0.6 = Total liabilities / Total asset

Total liabilities = Total asset (0.6) = 2,250,000 (0.6) = 1,350,000

Calculation I.

Long term debt = Total liabilities – Current liabilities = 1,350,000 – 450,000 = 900,000

Calculation J.

Total asset = Total liabilities + Equity = 2,250,000

Q.3 Superior Cement Company has an 8 % preferred stock issue outstanding with each share having $100 face value. Currently the yield is 10 %. What is the market price per share? If the required return becomes 12 %, what will happen to the market price per share?

Interest amount = Face value (Interest rate) = 100 (0.08) = $8

Value of preferred stock with 10 % yield = I / K = 8 / 0.10 = $80

Value of preferred stock with 12 % yield = I / K = 8 / 0.12 = $66.60

Q.4 Using the capital asset pricing model, determine the required return on equity for the following situations:

Case Risk free rate(%) Market return (%) beta

1 10 15 1.002 14 18 0.70

3 8 15 1.20

4 11 17 0.08

5 10 16 1.90Case Rf Rm β R = Rf + β (Rm – Rf)

1 0.10 0.15 1.00 R = 0.10 + 1.00 ( 0.15 – 0.10) = 0.15 or 15.0 %

2 0.14 0.18 0.70 R = 0.14 + 0.70 (0.18 – 0.14) = 0.168 or 16.8 %

3 0.08 0.15 1.20 R = 0.08 + 1.20 (0.15 – 0.08) = 0.164 or 16.4 %

4 0.11 0.17 0.08 R = 0.11 + 0.08 (0.17 – 0.11) = 0.158 or 15.8 %

5 0.10 0.16 1.90 R = 0.10 + 1.90 (0.16 – 0.10) = 0.214 or 21.4 %


Q.5 You need to have $50,000 at the end of 10 years. To accumulate this sum you have decided to save a certain amount at the end of each of the next 10 years and deposited it in the bank. The bank pays 8 % interest compound annual for long term deposits. How much will you have tosave each year?

Let X is the amount to save each year

50,000 = X (FVIFA 0.08, 9 ) + X = X (11.028) +X = 12.028 X

X = 50,000 / 12.028 = 4,257Q6 Multinational industries have a beta of 1.45, the risk free rate is 10 % and the expected return on the market portfolio is 16%. The co. presently pays a dividend of $2 a share, and investors expect it to experience a growth of 10% per annum for many years to come.

a. What is the stock required rate of return according to CAPM?

Β = 1.45 Rf = 0.10 Rm = 0.16 D0 = 2 g = 0.10

R = Rf + β (Rm – Rf ) = 0.10 + 1.45 (0.16 – 0.10) = 0.10 + 0.087 = 0.187

or 18.7 %

b. What is the stock’s present market price per share, assuming this required rate?

V = D / (R – g ) = 2 / (0.187 – 0.10) = 2 / 0.087 = 22.99

c. What would happen to the required return and to market price per share if the beta were 0.80? (Assume that all else stay the same)

R = Rf + β (Rm – Rf ) = 0.10 + 0.80 (0.16 – 0.10) = 0.10 + 0.048 = 0.148

or 14.8 %

V = D / (R – g ) = 2 / (0.148 – 0.10) = 2 / 0.048 = 41.66

Q.7 ARY Company has total annual sales (all credit) of $500,000 and a gross profit margin of 15 %. Its current asset are 100,000; current liabilities 75,000; inventories 30,000 and cash 10,000.

(a) How much average inventory should be carried if management wants the inventory turnover to be 4?

CGS = Sales (1 – Gross profit margin) = 500,000 (1 – 0.15) = 425,000

Inventory turnover = 4 = CGS / inventory

Inventory = CGS / 4 = 425,000 / 4 = 106,250(b) How rapidly (in how many days) must accounts receivable be collected, if management wants to have an average of $50,000 invested in receivable?

Accounts receivable in days = 360 (Receivable) / Credit sales = 360

(50,000) / 500,000 = 36 days


Q.8 Briefly explain the following:

(a) Consistency principle

(b) Matching principle(c) Going concern

(d) Principle of conservation

(e) Concept of materiality

(f) Preference sharesFinancial Management 562 Spring 2000


Q.1 Enumerate the main functions of the financial manager. Also state how does the notion of risk and reward govern the behavior of financial manager?

Q.2 Suppose you were to receive Rs.1000 at the end of twelve years. If yours opportunity rate is 15%, what is the present value of this amount if interest is compound annually? Quarterly? Continuously?

FV = 1,000

k = 0.15

Pv = ?

n = 12 years

(a) Compound annually

Pv = Fv / ( 1 + k ) n = 1,000 / ( 1 + 0.15 ) 12 = 1,000 / ( 1.15 ) 12 = 1,000 / 5.35 = 186.92

(b) Compound quarterly

m = 4

Pv = Fv / ( 1 + k/m ) mn = 1,000 / ( 1 + 0.15 / 4 ) 12x4 = 1,000 / ( 1 +

0.0375 ) 48

Pv = 1,000 / ( 1.0375 ) 48 = 1,000 / 5.8537 = 170.83

(c) Continuous compounding

Pv = Fv / (e ) kn = 1,000 / ( 2.71828 ) (0.15)(12) = 1,000 / ( 2.71828 ) 1.8

= 1,000 / 6.0496 = 165.30


Q.3. The beta of a company is 1.75 and the risk free rate is 8%. The expected return on market portfolio is 14%. The company presently pays a dividend of Rs.3 per share and investors expect it to experience a growth in dividends of 5% per years for many years to come. What is the stocks required rate of return according to CAPM?

K = ?

KM = 0.14

RF = 0.08

D0 = Rs.3.00 / share

β = 1.75

g = 0.05

K = RF + β ( KM – RF )

K = 0.08 + 1.75 ( 0.14 – 0.08 ) = 0.08 + 1.75 ( 0.06 ) = 0.08 + 0.105 =

0.185 or 18.5 %

Q.4. What is meant by intrinsic value and how it is determined? Also explain the concept of incremental analysis.

Q.5. A company presently gives terms of net 30 days. It has Rs.60 million in sales and its average collection period is 45 days. To stimulate demand, the company may give terms of net 60 days.

If it does instigate these terms, sales are expecting to increase by 15%.

After the change, the average collection period to be 75 days. Variable costs are 0.80 for every Rs.1 on sales and the company required rate of return on investment in receivable is 20%. Should the companyextend its credit period. Explain.

SO = 60,000,000

SN = 60,000,000 (1.15 ) = 69,000,000

ΔS = 9,000,000

V = 0.80

1 – V = 0.20

K = 0.20

ACP0 = 45

ACPN = 75




ΔI = [ ACPN – ACP0 ][ S0/360] + [ V ( ACPN ) ( ΔS/360 )]

= [ 75 – 45 ] [ 60,000,000 / 360 ] + [ 0.8 ( 75 ) ( 9,000,000 / 360 ) ]

= 5,000,000 + 1,500,000 = 6,500,000

ΔP = [ΔS ( 1 – V ) – K (ΔI ) ]

= 9,000,000 ( 0.2 ) – 0.2 ( 6,500,000 ) = 1,800,000 – 1,300,000 = 500,000

The company can extend its credit period and get additional Rs.500,000 profits by extending its credit period and due to increased sale.

Q.6. What is meant be APT model? Also explain the assumptions to the theory of capital structure.

Q.7. A company has 2.5 million shares outstanding, stockholders equity of Rs.41.5 million, earnings of Rs.3.9 million during the last 12 months during which it paid dividend of Rs.0.95 million and a share price of Rs.37. Required.

What is the price earning ratio?

What is the dividend yield?

Which is the ratio of market to book value per share?

Given:

Shares outstanding = 2,500,000

Equity = 41,500,000

Earnings = 3,900,000

Dividend = 950,000

Market value of share = 37(a)

Price earning ratio = Market price per share / Earning per share

Earning per share = Earnings / Shares outstanding = 3,900,000 /

2,500,000 = 1.56

Price earning ratio = 37 / 1.56 = 23.72

(b)


Dividend yield = Dividend per share / Market price per share

Dividend per share = Total dividend / Shares outstanding = 950,000 /

2,500,000 = 0.38

Dividend yield = 0.38 / 37 = 0.01 or 1.0 %

( c )

Market to book value per share = Market value per share / Book value per share

Book value per share = Total equity / Shares outstanding = 41,500,000 /

2,500,000 = 16.6

Market to book value per share = 37 / 16.6 = 2.229

Q.8. How can diversification reduce the risk of investment in marketable securities? Also explain briefly the active and passive dividend policy approaches.Financial Management 562 Spring 2001


Q1 Explain any five of the following:

1. Summarize advantages and disadvantages of various forms of business organization

2. Equity financing

3. Various types of financial securities

4. Ordinary annuity and annuity due

5. Efficient market hypothesis EMH

6. Break even point

7. Capital structure of a company

8. Stock dividend versus cash dividend.

Q2 For each of the following cases:

Case Amount of Initial deposit National Interest rate Compounding frequency

Times/ year

Deposit period

In years


A 25, 000 16 % 2 5

B 50, 000 12 % 6 3

(a) Calculate the future value at the end of the specified period.

FV = PV (FVIF i n )

Case A, Interest rate (i) = 0.16 / 2 = 0.08 Period (n) = 5 (2) = 10

FV = 25,000 (FVIF 0.08, 10 ) = 25,000 (2.159) = 53,975

Case B, Interest rate (i) = 0.12 / 6 = 0.02 Period (n) = 3 (6) = 18

FV = 50,000 (FVIF 0.02, 18 ) = 50,000 (1.428) = 71,400

(b) Determine the effective interest rates.

Effective interest rate = (1 + [ i / m ] ) m – 1

Case A = (1 + [ 0.16 / 2 ] ) 2 – 1 = ( 1 + 0.08 ) 2 – 1 = ( 1.08 ) 2 – 1 =

1.1664 – 1 = 0.1664

Case B = (1 + [ 0.12 / 6 ] ) 6 – 1 = ( 1 + 0.02 ) 6 – 1 = ( 1.02 ) 6 – 1 =

1.1262 – 1 = 0.1262

(c) Compare the nominal interest rate, to the effective interest rate. What relationship exists between compounding frequency and the nominal and effective interest rates?

Q3 Kamran manufacturing co. must choose between two asset purchases. The annual rate of return and the related probabilities given in the following table summarize the firm’s analysis to this point.

Project 257

R (%) 10 10 20 30 40 45 50 60 70 80 100

Probability 0.01 0.04 0.05 0.10 0.15 0.30 0.15 0.10 0.05 0.04 0.01

Project 432

R (%) 10 15 20 25 30 35 40 45 50

Probability 0.01 0.04 0.05 0.10 0.15 0.30 0.15 0.10 0.05

For each project compute:

• The range of possible rate of return• The expected value of return

• The standard deviation of the return


• The co-efficient of variation

The range for possible return for project 257 is between 10 % to 100 %

The range for possible return for project 432 is between 10 % to 50 %

The expected return and standard deviation for project 257 will be:


R P P X R R - R' (R - R')² (R - R')² (P)

0.1 0.01 0.001 0.059 0.003481 0.00003481

0.1 0.04 0.004 0.059 0.003481 0.00013924

0.2 0.05 0.01 0.159 0.025281 0.00126405

0.3 0.1 0.03 0.259 0.067081 0.0067081

0.4 0.15 0.06 0.359 0.128881 0.01933215

0.45 0.3 0.135 0.409 0.167281 0.0501843

0.5 0.15 0.075 0.459 0.210681 0.03160215

0.6 0.1 0.06 0.559 0.312481 0.0312481

0.7 0.05 0.035 0.659 0.434281 0.02171405

0.8 0.04 0.032 0.759 0.576081 0.02304324

1 0.01 0.01 0.959 0.919681 0.00919681Σ 0.452 0.194467

R' = 0.452/11

0.041

Expected return = 0. 452 or 45.2 %

Standard deviation = √ .0194467 = 0.44


The expected return and standard deviation for project 432 will be:


R P P X R R - R' (R - R')² (R - R')² (P)

0.1 0.05 0.005 0.067 0.004489 0.00022445


0.15 0.1 0.015 0.117 0.013689 0.0013689

0.2 0.1 0.02 0.167 0.027889 0.0027889

0.25 0.15 0.0375 0.217 0.047089 0.00706335

0.3 0.2 0.06 0.267 0.071289 0.0142578

0.35 0.15 0.0525 0.317 0.100489 0.01507335

0.4 0.1 0.04 0.367 0.134689 0.0134689

0.45 0.1 0.045 0.417 0.173889 0.0173889

0.5 0.05 0.025 0.467 0.218089 0.01090445

Σ 0.3 0.082539

R' = 0.3 / 9

0.033

Expected return = 0. 30 or 30 %Standard deviation = √ .082539 = 0.287


b. Which project would you consider the less risky?

Project 432 is less risky as it has less coefficient of variation

Q4 Financial analysis carried out in Shaheen foundation Ltd. Reflected the following result.

Total asset turnover = 2.0

Current ratio = 2.5

Day sale outstanding = 37.5days

Inventory turnover = 4.8

Debt/total asset = 45%

Fixed asset turnover = 6

Sales = Rs.2,400,000

Cash Rs.50000 Current liabilities Rs.

Account receivable Long term debt ____________

Inventory _________ Total debt


Current assets Common stock Rs.

Net fixed asset Retained earnings

Total asset Rs. Total liability and equity Rs.

Cash 50,000 Current liabilities 320,000 (D)

Account receivable 250,000 (E) Long term debt 220,000 (I)

Inventory 500,000 (F) Total debt 540,000 (H)

Current assets 800.000 (C) Common stock 660,000 (K)

Net fixed asset 400,000 (A) Retained earnings 0 (J)

Total asset 1,200,000 (B). Total liability and equity 1,200,000 (G)

Calculations:

(A) Fixed asset turnover = 6 = Sales / fixed asset

Fixed asset = Sales / 6 = 2,400,000 / 6 = 400,000

(B) Total Asset turn over = 2.0 = Sales / total asset

Total asset = Sales / 2 = 2,400,000 / 2 = 1,200,000

(C) Current Asset = Total Asset – Fixed asset = 1,200,000 – 400,000 = 800,000

(D) Current ratio = 2.5 = Current asset / current liabilities

Current liabilities = Current asset / 2.5 = 800,000 / 2.5 = 320,000

(E) Day sale outstanding = Account receivable turnover

= 37.5 = No of days in a year (A/C receivable ) / sales

A/C receivable = 37.5 (Sales) / No of days in a year = 37.5 (2,400,000) /

360 = 250,000

(F) Inventory = CA – A/C receivable – cash = 800,00 – 250,000 – 50,000 = 500,000

(G) Total liability and equity = Total asset = 1,200,000

(H) Debt / total asset = 0.45

Debt = 0.45 total asset = 0.45 (1,200,000) = 540,000


(I) Long term debt = Total debt – C. liabilities = 540,000 – 320,000 = 220,000

(J) Inventory turnover = 4.8 = CGS / inventory

CGS = 4.8 (inventory) = 4.8 (500,000) = 2,400,000

Since CGS is equal to sales, there is no gross profit and no retained earnings

(K) Equity = Total capital and liability – total debt = 1,200,000 – 540,000 = 660,000

Q5 The cash flows for projects X and Y in Mobil link co. follow. Each project has a cost of $40000

Year Project X Project Y

1 $26000 $14000

2 12000 14000

3 12000 14000

4 4000 14000

a. Calculate each project payback period.

b. Calculate each project NPV at a 10 percent cost of capital.

c. Calculate each projects IRR.

d. Should project X, Y or both be accepted if they are independent projects.

e. Which of the project be accepted if both are mutually exclusive.

Project X Project Y

Year Cash flow Cumulative cash inflow Cash flow Cumulative cash inflow

0 (40,000) (40,000)

1 26,000 26,000 14,000 14,0002 12,000 38,000 14,000 28,000

3 12,000 50,000 14,000 42,000

4 4,000 14,000

Payback period for both projects will be three years.

Year Pv. Factor C.flow PV C.flow PV

1 0.909 26,000 23634 14,000 12726


2 0.826 12,000 9912 14,000 11564

3 0.751 12,000 9012 14,000 10514

4 0.683 4,000 2732 14,000 9562

Σ 45290 Σ 44366

project X project Y

Net present value of project X = 45,290 – 40,000 = 5,290

Net present value of project Y = 44,366 – 40,000 = 4,366

Present value at 19 %

Year Pv. Factor C.flow PV C.flow PV1 0.84 26,000 21840 14,000 11760

2 0.706 12,000 8472 14,000 9884

3 0.593 12,000 7116 14,000 8302

4 0.499 4,000 1996 14,000 6986

Σ 39424 Σ 36932

project X project Y


(Difference b/w maximum value and

initial investment ) / difference between two present values

IRR for project X will be: 0.10 + (0.19 – 0.10) (45,290 – 40,000) /

(45,290 – 39,424)

= 0.10 + (0.09) ( 5,290) / 5,866 = 0.10 + 0.08 = 0.18

IRR for project Y will be: 0.10 + (0.19 – 0.10) (44,366 – 40,000) /

(44,366 – 36,932)

= 0.10 + (0.09) ( 4,366) / 7,434 = 0.10 + 0.053 = 0.153

If both projects are independent then both projects can be accepted.

If both projects are mutually exclusive we will select project X because

its NPV and IRR is greater than project Y.


Q6 (a) Explain capital asset pricing model (CAPM) and its various assumptions.

(b) For each of the following cases use the capital asset pricing model to find out the required return.

Case Risk free rate(%) Market return (%) beta

A 5 8 1.30

B 8 13 0.90

C 9 12 -0.20

D 10 15 1.00

E 6 10 0.60Case Rf Rm β R = Rf + β (Rm – Rf)

A 0.05 0.08 1.30 R = 0.05 + 1.30 ( 0.08 – 0.05) = 0.05 + 0.039 = 0.089

B 0.08 0.13 0.09 R = 0.08 + 0.09 (0.13 – 0.08) = 0.08 + 0.0045 = 0.0845

C 0.09 0.12 – 0.20 R = 0.09 – 0.20 (0.12 – 0.09) = 0.09 – 0.006 = 0.084

D 0.10 0.15 1.00 R = 0.10 + 1.00 (0.15 – 0.10) = 0.10 + 0.05 = 0.15

E 0.06 0.10 0.60 R = 0.06 + 0.60 (0.10 – 0.06) = 0.06 + 0.0240.084

Q7 A multinational company stockholder’s equity account is as follows:

Common stock (400,000 shares at $4) $1,600,000

Paid in capital in excess of par 1,000,000

Retained earnings 1,900,000

Total stockholder’s equity $4,500,000

The earning available for common stockholder from this period operation are $1,00,000 which have been included as partly of $1.9 million retained earnings.a. what is max dividend per share that the firm can pay (assume that legal capital includes allpaid in capital

Maximum dividend per share = 1,900,000 + / 400,000 = 4.75 / share

b. I the firm have $160,000 in cash. What is the largest per share dividend it can pay without borrowing?

Maximum cash dividend = 160,000 / 400,000 = 0.4 per sharec. Indicate the accounts and changes, if any, that will result if the firm pays the dividends indicated in a and b


In case the company is paying stock dividend, than the common stocks will be increased and retained earnings will be decreased with the corresponding amoung

If the company decided to pay cash dividend, than the cash will be reduced and the retained earning will also be reduced with the corresponding amount.

d. Indicate the effects of an $80,000 cash dividend on stockholder’s equity.

The stock holder’s equity will be reduced by 80,000

Q8 ABC telecom Co. has the following capital structure which is considered optimal

(Rs. In million)

Long-term debt 1200000

Preferred stocks 200000

Common stock equity 2600000

Total long-term debt and equity 4000000

The cost of debt is 10 percent before tax, the cost of preferred stock is 12.5 percent and the cost of equity is 15.4 %. The firm’s marginal tax is 40%. What is cost of capital of ABC co?Item Amount of financing Proportion of total finance Cost Weighted costLong term debt

1,200,000 1,200,000 / 4,000,000 = 0.30 (0.1 – 0.4) =

0.06

(0.3) (0.06) = 0.018

Preferred stock

200,000 200,000 / 4,000,000 = 0.05 0.125 (0.125) (0.05) =

0.00625

Common stock

2,6000,000 2,600,000 / 4,000,000 = 0.65 0.154 (0.154) (0.65) =

0.1001

Cost 0.12435Financial Management 562 Spring 2002


Q1. Adair industries are considering relaxing its credit standards to increase its currently sagging sales. As a result of proposed relaxation sales are expected to increase by 10 % from


10,000 to 11,000 units during the coming year. The average collection period is expected to increase from 45 to 60 days and bad debts are expected to increase from 1 to 3 % of sales. The sale price per unit is Rs.40 and the variable cost per unit is rs.31. If the firm’s required rate of return on similar risk investment is 25 %, evaluate the proposed relaxation and make a recommendation to the firm.

SO = Current sales = 10, 000

SN = New sales = 11, 000

ΔS = Incremental sales = 11, 000 – 10, 000 = 1, 000

V = Variable cost as percentage of sales = 31 / 40 = 0.775 or 77.5 %

1 – V = Contribution margin as percentage of sales = 1 – 0.775 = 0.225

K = Cost of financing or cost of capital = 0.25

ACP0 = Current average collection period in days = 45

ACPN = New average collection period in days = 60



B0 = Present bad debt percentage = 1

BN = New bad debt percentage = 3

ΔI = [Increased investment in receivable associated with original sales] + [Investment in receivable

associated with new sales]ΔI = [ Change in collection period ] [ Old sales per day ] + [ V ( ACPN ) ( New sales per day ) ]

ΔI = [ACPN – ACP0] [S0/360] + [V (ACPN) (ΔS/360)]

ΔI = [ 60 – 45] [10,000/360] + [77.5 (60) (1,000/360)]

ΔI = (15) ( 27.78 + 3.59 ) = 15 (31.37) = 470.55

ΔP = [Incremental sales (contributing margin) – (Cost of carrying new receivable) – (Bad debt losses)]

ΔP = [ΔS (1 – V) – K (ΔI) – (BN SN– B0 S0)]

ΔP = [1,000 (22.5) – 0.25 (470.55) – ( 0.03 x 11, 000 – 0.01 x 10,000 )]

ΔP = [22, 500 – 0.25 (470.55) – ( 0.03 x 11, 000 – 0.01 x 10,000 )]

ΔP = [22, 382.36 – ( 330 – 100 )] = 22,382.36 – 220 = 22, 162.36


This indicate that with new proposal, the profit of the company will be increased by Rs.22,162.36, therefore, company should relax its credit standard.

Q2. Barnstead industries turns its inventory 8 times each year, has an average payment period of 35 days, and ahs an average collection period of 60 days. The firm’s total outlays for operating cycle investment are 3.5 million. Assuming 360 days a year.

(a) Calculate the Firm’s operating and cash conversion cycle.

Average payment period = 35 days

Average collection period = 60 days

Average age of inventory = 360 / 8 = 45 days

Operating cycle = Average age of inventory + Average collection period = 60 + 45 = 105 days

Cash cycle = Operating cycle – Average payment period = 105 – 35 = 70 days(b) Calculate the firm’s daily cash operating expenditure. How much negotiated finance is required to support its cash conversion policy?

Operating cycle investment = 3, 500, 000 annually or Rs.9, 722.22 daily3, 500, 000 (70)

Negotiated finance required for cash cycle = -------------------------- = Rs.2, 333, 333

105

Q3 Quick Enterprise has obtained a Rs.10, 000, 90 days bank loan at an annual interest rate of 15 %, payable at maturity. Assume 360 days in a year.

(a) How much interest will the firm pay on the 90 day loan?Amount of interest = 10, 000 (0.15) ( 90 / 360) = 10, 000 ( 0.0375) = Rs.375

(b) Annualize your findings to find the effective annual interest rate for this loan, assuming that it is rolled over each 90 days throughout the year under the same conditions and circumstances.

Effective annual interest rate = ( 1 + 0.0375 )4 – 1 = 1.158 – 1 = 0.158 or 15.8 %

Q4 Briefly describe the pro forma income statement preparation process using percent of sale method. What are the strengths and weaknesses of this approach?

Q5 Winters Design has fixed operating cost of Rs.380, 000, variable cost per unit is Rs.16 and a selling price of Rs.63.50 per unit.

(a) Calculate the operating breakeven point in units.

FC = Rs.380, 000P = Rs.63.50


V = Rs.16

FC 380, 000 380, 000

QBE = --------------- = --------------------- = ------------- = 8, 000

( P – V ) (63.50 – 16.00) 47.50

(b) Calculate the firm’s EBIT at 9, 000, 10, 000 and 11, 000 units respectively.

EBIT = Q ( P – V ) – FC

EBIT = 9, 000 (63.50 – 16.00) – 380, 000 = 9, 000 (47.50) – 380, 000

= 427, 500 – 380, 000 = 47, 500 for 9, 000 units

EBIT = 10, 000 (63.50 – 16.00) – 380, 000 = 10, 000 (47.50) – 380, 000

= 475, 000 – 380, 000 = 95, 000 for 10, 000 units

EBIT = 11, 000 (63.50 – 16.00) – 380, 000 = 11, 000 (47.50) – 380, 000

= 522, 500 – 380, 000 = 142, 500 for 11, 000 units

(c) By using 10, 000 units as a base, what are the % change in units sold and EBIT as sales shown move from the base to the other levels used in b.

For 9, 000 units

Change in sale = 10, 000 – 9, 000 = 1, 000

% change in sales = 1, 000 / 10, 000 = 0.1 or 10 %

Change in EBIT = 95, 000 – 47, 500 = 47, 500

% change in EBIT = 47, 500 / 95, 000 = 0.5 or 50 %

For 11, 000 units

Change in sale = 11, 000 – 10, 000 = 1, 000

% change in sales = 1, 000 / 10, 000 = 0.1 or 10 %

Change in EBIT = 142, 500 – 95, 000 = 47, 500

% change in EBIT = 47, 500 / 95, 000 = 0.5 or 50 %(d) Using the percentage computed in c, calculate the DOL

For 9, 000 and for 11, 000

DOL = % change in EBIT / % change in sales = 50 / 10 = 5

Q6 Bruce Enterprise is attempting to evaluate the feasibility of investing


Rs.95, 000 in a piece of equipment having 5 years life. The firm has estimated the cash flow associated with the proposal as shown in the following table. The firm has 12 % cost of capital.

Year 1 2 3 4 5

Cash inflow 20, 000 25, 000 30, 000 35, 000 40, 000

(a) Calculate pay back period:

Pay back period:

Year Cash Flow Cumulative cash flow

0 (95,000) (95,000)

1 20,000 (75,000)

2 25,000 (50,000)

3 30,000 (20,000)

4 35,000 15,000

Pay back period will be 4 years.

(b) Calculate the NPV for the project at 12 %

Year CF PV factor @ 12%PV

1 20000 0.8929 17858

2 25000 0.7972 19930

3 30000 0.7118 21354

4 35000 0.6355 22242.5

5 40000 0.5674 22696

Total 104081

NPV = 104, 080.5 – 95, 000 = 9, 080.5

(c) Calculate IRR of the project:

PV for the project at 15 %

Year CF PV factor @15 %PV PV factor @16 %PV

1 20000 0.8696 17392 0.8621 17242

2 25000 0.7561 18902.5 0.7432 18580


3 30000 0.6575 19725 0.6407 19221

4 35000 0.5718 20013 0.5523 19330.5

5 40000 0.4972 19888 0.4761 19044

Total 95920.5 93417.5

95, 920.50 – 93, 417.50 = 2503

95, 920.50 – 95, 000 = 920.50

IRR = 15 + 920.50 / 2503 = 15 + 0.368 = 15.368 %

(d) Evaluate the acceptability of the proposed investment using NPV and IRR.

As IRR is greater than the cost of capital and NPV is positive, we will accept the project.

Q7 Dora wishes to estimate the value of an asset expected to provide cash inflow of Rs.3, 000 per year at the end of the year 1 through 4 and Rs.15, 000 at the end of year 5. Her research indicates that she must earn 10 % on low risk, 15 % on average risk and 22 % on high risk asset.

(a) What is the most Dora should pay for the asset if it is classified as low risk, average risk and high risk?

Year CF PV factor PV PV factor PV PV factor PV

at 10 % at 15 % at 22 %

1 3000 0.9091 2727.3 0.8696 2608.8 0.82 2460

2 3000 0.8264 2479.2 0.7561 2268.3 0.672 2016

3 3000 0.7513 2253.9 0.6575 1972.5 0.551 1653

4 3000 0.683 2049 0.5718 1715.4 0.451 1353

5 15000 0.6209 9313.5 0.4972 7458 0.37 5550

Total 18822.9 16023 13032

She should pay Rs.18, 822.90 or less for low risk asset

She should pay Rs.16, 023 or less for average risk asset

She should pay Rs.13, 032 or less for high risk asset.

(b) All things being the same what effect does increasing risk have on the value of an asset?

Explain in the light of your findings in a.

As the risk increase, the investment in asset will be decreased.


Q8 What is the relationship of total risk, non-diversifiable risk and diversifiable risk? Why is nondiversifiable risk the only relevant risk?

Financial Management 562 Spring 20031 Prepared by Mohammad Muzammil

Q.1. Why do short term creditors, such as banks emphasize balance sheet analysis when considering loan request? Should they also analyze projected income statements? Why?

Q.2. Financial statements for the Begalla Corporation follow:

Begalla Corporation

0Balance Sheet

As on December 31 (in millions)

Assets 20X1 20X2 Liabilities 20X1 20X2

Cash 4 5 accounts payable 8 10

Accounts receivable 7 10 Notes payable 5 5

Inventory 12 15 Accrued wages 2 3

Accrued taxes 3 2

Total current assets 23 30 Total liabilities 18 20

Net fixed asset 40 40 Long term debt 20 20

Common stock 10 10

Retained earnings 15 20

Total 70 70 Total 63 63

=== ==== ==== =====

Begalla Corporation

Income statement

Sales 95

Cost of goods sold 50

0Selling, general and administrative expanses 15

Depreciation 3

Interest 2 70


Net income before tax 25

Taxes 10

Net income 15

Prepare cash flow statement using the indirect method.

Comment on cash flow statement.

Cash flow from operating activities:

Net income 15

Depreciation 3

Increase in Accounts receivable (3)

Increase in inventory (3)

Increase in accounts payable (2)

Decreased in accrued taxes (1)

Increased in accrued liabilities 1 11

Cash flow from financing activites:

Dividend paid (10)

Net cash flow 1

Cash and cash equivalent on 20X1 4

Cash and cash equivalent on 20x2 5

==

Q3 Jerome is considering investing in security that has the following distribution of possible one year return.

Probability of occurrence 0.10 0.20 0.30 0.30 0.10

Possible return % -10 0 10 20 30

What is the expected return and standard deviation associated with the investment?R P exp. R R-R' (R-R')² (R-R)²P

RxP

-0.1 0.1 -0.01 -0.2 0.04 0.004


0 0.2 0 -0.1 0.01 0.002

0.1 0.3 0.03 0 0 0

0.2 0.3 0.06 0.1 0.01 0.003

0.3 0.1 0.03 0.2 0.04 0.004

0.5 0.11 0.013

Standard deviation = √ 0.013 = 0.114

Is there much downside risk? How can you tell?

First we will see the possibility of zero return

R = 0

R’ = 0.11

SD = 0.114

R – R’ 0 – 0.11

Z = ---------- = ------------ = - 0.9649

SD 0.114

From normal distribution table the value for Z = - 0.9649 is 0.3330

Therefore probability of zero or less return is = 0.5000 – 0.3330 = 0.167 or 16.7 %

For 10% return

R – R’ 0.10 – 0.11

Z = ---------- = ---------------- = - 0.0877

SD 0.114

Form normal distribution table the value for Z = 0.0877 is 0.033

The probability of return between 0 and 10 % will be 0.330 – 0.033 = 0.297 or 29.7%

For 20 % return

R – R’ 0.20 – 0.11

Z = ---------- = ---------------- = 0.7894

SD 0.114


From normal distribution table the value for Z=0.7894 is 0.2835

The probability of return between 10 and 20% will be 0.2835 + 0.033 = 0.3165 or 31.65 %

From the above calculations, we can conclude that there is no down side risk.

Q.4. The Anderson corporation (an all equity financed firm) has a sale level of Rs.280, 000 with a 10% profit margin before interest and taxes. To generate this sale the firm maintains a fixed asset investment of Rs.100, 000. Currently the firm has Rs.50, 000 in current asset.

(a) Compute the total asset turnover and compute the rate of return on total asset before taxes.

Fixed asset = Rs.100, 000

Current asset = Rs.50, 000

Total asset = 100, 000 + 50, 000 = 150, 000

Sale = Rs. 280, 000

Total asset turnover = sale / total asset = 280, 000 / 150, 000 = 1.867

Return on total asset before taxes = Net profit margin x total asset turnover

= 10 (1.867) = 18.67 %

(b) Compute the before tax rate of return on assets at different levels of current asset starting with

Rs.10, 000 and increasing in Rs.15, 000 increments to Rs.100, 000

F.Asset C.Asset T.Asset N.P.M Sale Asset turnover Return on asset

100,000 10,000 110,000 10 280,000 2.545454545 25.45454545

100,000 25,000 125,000 10 280,000 2.24 22.4

100,000 40,000 140,000 10 280,000 2 20

100,000 55,000 155,000 10 280,000 1.806451613 18.06451613

100,000 70,000 170,000 10 280,000 1.647058824 16.47058824

100,000 85,000 185,000 10 280,000 1.513513514 15.13513514

100,000 100,000 200,000 10 280,000 1.4 14

Q.5. The Pawalowski supply company needs to increase its working capital by 4.4 million. The following three financing alternatives are available. (assume 365 day year)


(a) Forgo cash discount (granted on the basis of 3/10, net 30 and pay on the final due date

(b) Borrow 5 millions from a bank at 15%. The alternate would necessitate maintaining a 12% compensating balance.

(c) Issue 4.7 million of six month commercial paper to net 4.4 million. Assume that new paper would issue every six months.Assuming that the firm would prefer the flexibility of bank financing, provided the additional cost of this flexibility was no more than 2% per annum, which alternative should be selected.

% discount 365

Cost of alternative a = ----------------------- x ---------------------------------------

100 - % discount payment date – discount period2 365 2 365

= ------------ x ----------- = -------- x --------- = 0.3724 or 37.24 %

100 – 2 30 – 10 98 20

Cost of alternative b

Amount of loan = 5, 000, 000

Interest amount = 5, 000, 000 (0.15 + 0.02) = 850, 000

Compensating balance = 5, 000,000 ( 0.12) = 600, 000

Amount of loan actually used = 5, 000, 000 – 600, 000 = 4, 400, 000

Effective interest rate = 850, 000 / 4, 400, 000 = 0.1932 or 19.32 %

Cost of alternative c

Face value of commercial paper = 4, 700, 000

Amount received = 4, 400, 000 for 6 months

Difference = 4, 700, 000 – 4, 400, 000 = 300, 000

Rate of interest for 6 months = 300, 000 / 4, 400, 000 = 0.068

Rate of interest for 1 year = [ (1 + 0.068 )2 – 1 ] = 1.141 – 1 = 0.141 or 14.1 %

The company will choose option C for its working capital financing which has the lower interest rate.Q.6. Silicon wafer company presently pays a dividend of Rs.1 per share and has a share price of Rs.20.


(a) If this dividend was expected to grow at 12% rate forever, what is the firm’s expected or required return on equity using a dividend discount model approach?

D

P = -------------

( Ke – g )

1

20 = -------------- or Ke – 0.12 = 1/20 and Ke = 1/20 + 0.12 = 0.17 or 17 %

Ke – 0.12

(b) Suppose that the dividend was expected to grow at a 20% for 5 years and at 10 % per year thereafter. Now what is the firm’s expected return on equity.

The formula for this type of calculations will be as follows:

V = D0 ( 1 + 0.2)5 / ( 1 + Ke)5 + [ 1 / ( 1 + Ke)5 ] [ D6 / ( Ke – g ) ]

V = 20

D0 = 1

D6 = ( 1 + 0.2)5 ( 1 + 0.1 ) = 2.488 (1.1) = 2.737

g = 0.10

20 = 2.488 / ( 1 + Ke)5 + [ 1 / ( 1 + Ke)5 ] [ 2.737 / ( Ke – 0.1 ) ]

2.488 ( Ke – 0.1 ) + 2.737

20 = ------------------------------------

( 1 + Ke)5 ( Ke – 0.1 )

For Ke = 0.11 the value of R.H.S

2.488 ( Ke – 0.1 ) + 2.737 2.488 ( 0.11 – 0.10 ) + 2.737 0.02488 + 2.737

= --------------------------------- = ----------------------------------- = ------------

---------

( 1 + Ke)5 ( Ke – 0.1 ) ( 1 + 0.11)5 ( 0.11 – 0.1 ) 1.685 ( 0.01)

2.76188

= ------------- = 163.909


0.01685


2.488 ( Ke – 0.1 ) + 2.737 2.488 ( 0.15 – 0.10 ) + 2.737 0.1244 + 2.737

= --------------------------------- = ----------------------------------- = ---------------------

( 1 + Ke)5 ( Ke – 0.1 ) ( 1 + 0.15)5 ( 0.15 – 0.1 ) 2.011 ( 0.05)

2.8614

= ------------- = 28.8614

0.1


2.488 ( Ke – 0.1 ) + 2.737 2.488 ( 0.16 – 0.10 ) + 2.737 0.14982 + 2.737

= --------------------------------- = ----------------------------------- = ---------------------( 1 + Ke)5 ( Ke – 0.1 ) ( 1 + 0.16)5 ( 0.16 – 0.1 ) 2.1 ( 0.06)2.88628

= ------------- = 22.879

0.126For Ke = 0.17 the value of R.H.S

2.488 ( Ke – 0.1 ) + 2.737 2.488 ( 0.17 – 0.10 ) + 2.737 0.17416 + 2.737

= --------------------------------- = ----------------------------------- = ---------------------

( 1 + Ke)5 ( Ke – 0.1 ) ( 1 + 0.17)5 ( 0.17 – 0.1 ) 2.1924 ( 0.07)

2.91116

= ------------- = 18.965

0.1535

By interpolation:

22.879 – 18.965 = 3.914

22.879 – 20.00 = 2.879

Ke = 16 + 2.879 / 3.914 = 16 + 0.735 = 16.735 %


Q.7. Bruce read enterprise is attempting to evaluate the feasibility of investing Rs.95, 000 in a piece of equipment having a 5 years life. The firm has estimated the cash inflows associated with the proposal as shown in the following table. The firm has a 12 % cost of capital.

(a) Calculate the pay back period for the proposed project:The payback period will be 4 years.(b) NPV of the project:

Year C.F PV factor at 12% PV

1 20,000 0.893 17860

2 25,000 0.797 19925

3 30,000 0.712 21360

4 35,000 0.636 22260

5 40,000 0.567 22680

Sum 104085

NPV = 104, 085 – 95, 000 = 9, 085

(c) IRR of the project:

NPV at 15 %

Year C.F PV at 15 % PV

1 20,000 0.87 17400

2 25,000 0.756 18900

3 30,000 0.658 19740

4 35,000 0.572 20020

5 40,000 0.497 19880

Sum 95940

NPV at 15 % = 95, 940 – 95, 000 = 940

Year (t) 1 2 3 4 5

Cash in flow 20, 000 25, 000 30, 000 35, 000 40, 000

Investment Cash flow Value after period95, 000 20, 000 75, 000

25, 000 50, 000


30, 000 20, 000

35, 000 - 15, 000

NPV at 16 %

Year C.F PV at 16 % PV

1 20,000 0.862 17240

2 25,000 0.743 18575

3 30,000 0.641 19230

4 35,000 0.552 19320

5 40,000 0.476 19040

Sum 93405

NPV at 16 % = 93, 405 – 95, 000 = - 1, 595

IRR = 15 + 940 / ( 940 + 1, 595) = 15 + 0.37 = 15.37 %

8. If all companies had an objective of maximizing shareholder’s wealth, would people overall tend to be better or worse off? How?

Financial Management 562 Spring 2004


Q.No.1. If a firm earns its interest expanse 15 times and the interest expanse in 17,000, what is its net income? If it has lease payment of 110,000, what is its fixed financial charge coverage? (Assume a 40% tax rate)

EBIT

Times interest earned = ---------------------

Interest expanses

15 = (EBIT) / 17,000 or EBIT = 15 ( 17,000 ) = 255,000

Earning before interest and tax 255,000

Interest paid 17,000

Earning before tax 238,000

Income tax @ 40 % 95,000

Net income after tax 142,000


EBIT + lease payment

Fixed financial coverage = --------------------------------------------

Interest payment + lease payment

255,000 + 110,000 335,000

= --------------------------- = ----------- = 2.638

17,000 + 110,000 127,000

Q.No.2. Explain the relationship between break even analysis and operating leverage for a firm with high fixed costs. What about a firm high variable cost? What are weaknesses of break even analysis?

Q.No.3. Scifie is attempting to project its year ahead external financing requirements. It projects a 30 % increase in sales from its current level of 25 million. Its spontaneous assets are estimated to be 70 % of sales, and its spontaneous liabilities are 48 % of sales. Scifie’s profit margin is 10 % and its dividend pay out ratio is 25 %. Can you help Scifie estimate its external financing requirement for next year.

Present sales = 25 millions

Projected sales = 25 ( 1.3 ) = 32.5 million

Assets = 32.54 ( 0.70 ) = 22.75 million

Liabilities = 32.5 ( 0.48 ) = 15.6 million

Profit = 32.5 (0.1) = 3.25 millions

Retained earnings = 3.25 ( 1 – 0.25 ) = 3.25 ( 0.75) = 2.4375 million

External finance required = Assets – ( Liabilities + Retained earnings )

= 22.75 – ( 15.6 + 2.4375 ) = 22.75 – 18.0375 = 4.7125 million

Q.No.4 Walter, who is the investment manager for Vista Mutual fund, estimates the following portfolio returns and risks.

Portfolio 1 2 3 4

Expected return % 11 14 18 21

Standard deviation % 5 12 20 30

Which option should he choose if his cost of borrowing is 10 % and risk free investment earn 10 %?

Expected return = [ E(R) – T ] / σ

Portfolio 1 return = ( 11 – 10 ) / 5 = 0.20





Portfolio 3 will give maximum return

Q.No.5. Low enterprises need one of two machines. Machine A costs 18,000 and has a cash flow of 4,900 a year for six years. Machine B costs 24,000 and has cash flow of 6,500 a year for six years. Low has 12 % cost of capital. Calculate each machine NPV, IRR and PI and evaluate the result?

Calculation of NPV

For project A

NPV (12 %) = P.V of future cash flows – Initial investment

= (4,900)(4.111) – 18,000

= 20143.9 – 18,000 = 2143.9

For project B

NPV (12 %) = P.V of future cash flows – Initial investment

= (6,500)(4.111) – 18,000

= 26721.5 – 24,000 = 2621.5

Calculation of IRR

For project A

NPV at 14 % = (4,900)(3.889) – 18,000 = 19056.10 – 18,000 = 1056.10

NPV at 16 % = (4,900)(3.685) – 18,000 = 18056.50 – 18,000 = 56.50

NPV at 18 % = (4,900)(3.498) – 18,000 = 17140.20 – 18,000 = - 859.80

By interpolation IRR = 16 + 56 / ( 859.80 + 56.50 ) = 16 + (56 / 916.30 )

* 2

= 16 + 0.12 = 16.12

For project B

NPV at 14 % = (6,500)(3.889) – 24,000 = 25278.5 – 24,000 = 1278.5

NPV at 16 % = (6,500)(3.685) – 24,000 = 23925.5 – 24,000 = - 47.5


By interpolation IRR = 14 + 47.5 / ( 1278.5 + 47.5 ) = 14 + (47.5 / 1326 ) * 2

= 14 + 0.072 = 14.072

Profitability index:

For project A

PI = PV of future cash flow / Initial investment = 20,143.9 / 18,000 = 1.119

For project B

PI = PV of future cash flow / Initial investment = 26,721.5 / 24,000 = 1.113

Since the profitability index on project A is more we will select Project A

Q.No.6. What are the five characteristics looked by the financial manager in making a credit decision on a customer? What are some of the drawbacks in using this criterion?

Q.No.7 Given the data as below:

Annual sales = Rs.1, 500, 000

Annual cost of goods sold = 900, 000

Annual purchases = 1, 000, 000

Year end accounts receivable = 50, 000

Year end accounts payable = 22, 000

Year end inventory = 15, 000

(a) Calculate the length of operating cycle and briefly describe what it shows.

Inventory turnover = Cost of goods sold / Inventory

= 900,000 / 15,000 = 60 times

Inventory turnover in days = No. of days in a year / Inventory turnover

= 360 / 60 = 6 days

Receivable turn over = Annual net credit sales / Accounts receivable

= 1,500,000 / 50,000 = 30 times

Receivable turn over in days = No. of days in a year / Receivable turn over


= 360 / 30 = 12 daysOperating cycle = Inventory turnover in days + Receivable turnover in days

= 6 + 12 = 18 days

(b) Calculate the length of cash cycle and briefly describe what it shows.

Accounts payable turnover = Purchases / Accounts payable

= 1,000,000 / 22,222 = 45 times

Accounts payable turnover in days = No. of days in a year / Accounts payable turn

= 360 / 45 = 8 days

Cash cycle = operating cycle – Accounts payable turnover in days

= 18 – 8 = 10 days

Q.No.8. BB corporation’s stock has a beta of 1.5. You expect dividend of 8 per year for the next three years. Right now the market rate of return is 16 % and the risk free rate if 12 %.

(a) What is your required return on BB’s stock?

R = required rate of return

Rm = Market rate of return = 0.16

Rf = Risk free rate of return = 0.12

β = 1.5

R = Rf + β ( Rm – Rf ) = 0.12 + 1.5 ( 0.16 – 0.12 ) = 0.12 + 0.06 = 0.18

or 18 %

(b) To obtain you required return, how much will BB stock have to sell for in three years if today’s price is 50

D = dividend = 8

P0 = current price = 50

R = Required rate of return = 0.18

P3 = price of stock after three years

D D D P3

P0 = --------------- + ----------------- + ---------------- + ---------------

( 1 + 0.18 ) ( 1 + 0.18 )2 ( 1 + 0.18 )3 ( 1 + 0.18 )3


8 8 8 P3

50 = ---------- + ------------+ ----------- + -----------

( 1.18 ) (1.18 )2 ( 1.18 )3 ( 1.18 )3

50 ( 1.18 )3 = 8 (1.18 )2 + 8 ( 1.18 ) + P3

50 ( 1.643032 ) = 8 ( 1.3954 ) + 9.44 + 8 + P3

82.1515 = 11.1632 + 9.44 + 8 + P3

P3 = 53.55

(c) If the stock price goes form 50 to 52 in three years, are you receiving enough return for the risk taken?

This price will not give us the required rate of return of 18 %.



Q.1 Define the characteristics line and its beta. Why is beta a measure of systematic risk? What is its meaning?

Q.2 Tripex consolidated industries owns $ 1.5 millions in 12 percent bonds of Solow electronics company. It also owns 100000 shares of preferred stock of Solow, which constitute 10 % of all outstanding Solow preferred shares. In the past year, Solow paid the stipulated on its bonds and dividends of $ 3 per share on its preferred stock. The marginal tax rate of Tripex is 34 %. What taxes must Tripex pay on this interest and dividend?

Interest income = $1,500,000 (12/100 = = $180,000

Dividend Income = 100, 000 x $3 = $300,000

Less exempted 70% = (210,000)

Taxable dividend income = 90,000

Total taxable income = $270,000

Marginal tax rate 34%

Tax payable on interest and diffident income = $270,000 (34/100) = $91,800

Note: It is assumed that tripex consolidated Industries has owned the stock for at least 45 days.

Q.3 Presently the risk free rate is 10% and the expected return on the market portfolio is 15%.

Market analyst return expectations for four stocks listed here together with each stock’s expected beta.


Stock Expected return Expected beta

Stillman Zinc Corp. 17.0% 1.3Union Paint Co. 14.5% 0.8

National Automobile Co. 15.5% 1.1

Parker Electronics, Ins. 18.0% 1.7

If the analysis expectations are correct which stocks are overvalued?

Undervalued?

R = Rf + β (Rm – Rf)

Stilman R = 0.10 + 1.3 (0.15 – 0.10) = 0.165 Undervalued

Union R = 0.10 + 0.8 (0.15 – 0.10) = 0.14 Undervalued

National R = 0.10 + 1.1 (0.15 – 0.10) = 0.155 Correctly priced

Parker R = 0.10 + 1.7 (0.15 – 0.10) = 0.185 Overvalued

Q.4 What is the purpose of balance sheet? An income statement? And why is the analysis of trends in financial ratios important?

Q.5 Determine that annual percentage interest rate for each of the following terms of scale assuming that the firm does not take cash discount but pays on the final day of the net period (assume ayear)

1/20 net 30($5100 invoice)

2/30 net 60($1000 invoice)

2/5 net 10($100 invoice)

3/10 net 30( $250 invoice)

Annual interest cost:

% discount days in a year

= -------------------------- X ------------------------------------------- X Invoice price

(100 - % discount) (Payment date – Discounted period

1 365

(a) = ----------- X ----------- X 5,100 = (1 / 99) (365 / 10 ) (5,100) = 1,880

100 – 1 30 – 202 365


(b) = ----------- X ----------- X 1,000 = (2 / 98) (365 / 30 ) (1,000) = 248

100 – 2 60 – 302 365

(c) = ----------- X ----------- X 100 = (2 / 98) (365 / 5 ) (100) = 149

100 – 2 10 – 53 365(d) = ----------- X ----------- X 250 = (3 / 97) (365 / 20 ) (250) = 141

100 – 3 30 – 10

Q.6 Define a stock dividend and a stock split what is the impact of each on share value? What is dividend reinvestment plan and how might it help the shareholder?

Q.7 What is the difference between a public and private issues of securities? And define a standby arrangement and over subscription privilege. Why are they used? Which do you think is usedmore often?

Q.8 Explain the concept of synergy. What is the purpose of a two tier tender offer? And what are the motivations of going private? Do the shareholders who are bought out gain anything?



Q.1 Give the information that follow, prepare a cash budget for the Sitara Group industries for the first six months of 19X2

a. All prices and costs remain constant.

b. Sales are 75% for credit and 25% for cash.

c. With respect to credit sales. 60% are collected in the month after the sale, 30% in the second month, and 10% in the third. Bad-debt losses are insignificant.

d. Sales actual and estimated are

October 19X1 $300,000 March 19X2 $200,000

November 19X1 350,000 April l9X2 300,000

December l9Xl 400,000 May 19X2 250,000

January 19X2 150,000 June 19X2 200,000

February 19X2 200,000 July 19X2 300,000

e. Payments for purchases of merchandise are 80% of the following month's anticipated sales.

f. Wages and salaries are.


January 30,000 February 40,000 March 50,000

April 50,000 May 40,000 June 35,000

g Rent is $2,000 a month.h. Interest of $7,500 is due on the last day of each calendar quarter, and no quarterly cash dividends are planned.

i A tax prepayment $50,000 for 19X2 incomes is due in April.

j A capital investment of $30,00() is planned in June to be paid for then.

k. The company has a cash balance $100,000 at December 31, l9Xl, which is the minimum desired level for cash. Funds can be borrowed in multiples $5,000 (Ignore interest on such borrowings.)

Cash budget for January to June 19X2

Oct. Nov. Dec. Jan. Feb. March April May June

Sales 300,000 350,000 400,000 150,000 200,000 200,000 300,000 250,000 200,000

Credit sales (75%) 225,000 262,500 300,000 112,500 150,000 150,000 225,000 187,500 150,000

Collection

60 % 135,000 157,000 180,000 67.500 90,000 90,000 135,000 112,500

30 % 67,500 78,750 90,000 37,750 45,000 45,000 67,500

10 % 22,500 26,250 30,000 11,250 15,000 15,000

Cash 75,000 87,500 100,000 37,500 50,000 50,000 75,000 62,500 50,000

Total cash collec. 318,750 233,750 203,750 221,250 257,500 245,000

Payments

Purchases 160,000 160,000 240,000 200,000 160,000 240,000

Rent 2,000 2,000 2,000 2,000 2,000 2,000

Wages 30,000 40,000 50,000 50,000 40,000 35,000

Tax payment 50,000

Capital investment 30,000

Interest 7,500 7,500

Total payment 192,000 202,000 299,500 302,000 202,000 314,500


Net cash inflow 126,750 31,750 (95,750) (80,750) 55,500 (69,500)

Beginning cash 100,000 226,750 258,500 162,750 100,000 155,000

Total 226,750 258,500 162,750 82,000 155,000 85,500

Borrowing 0 0 0 18,000 0 14,500

Ending cash 226,750 258,500 162,750 100,000 155,000 100,000



Q.2 The Kari Kid Corporation manufactures only product: planks. The single raw material used in making planks is the dint. For each plank manufactured 12 dints are required. Assume that the company manufactures 150,000 planks per year, that demand for planks in perfectly steady throughout the year, that it costs $200 each time dims are ordered and that carrying costs are $8 per dint per year.

Required:

(a) Determine the economic order quantity of dints

EOQ = √ 2 A Oc / Cc = √ 2 (1,800,000) (200) / 8 = 9487 dints

(b) What are total inventory costs for Kari Kid?

= C(Q/2)+O(S/Q) = $8 (9487 / 2) + $200 (1,800,000 / 9487) = $75,895

(c) How many times per year would inventory be ordered?

1,800,000 / 9487 = 190 times

Q.3 The Dud Company has been factoring its accounts receivable for the past five years. The factor charges a fee of 2% and will lend up to 80 percent of the volume of receivables purchased for an additional I .5 percent per month. The firm typically has sales of $500,000 per month, 70 percent of which are on credit. By using the factor, two savings would be affected.

a. $2,000 per month that would be required to support a credit department.

b. A bad-debt expense of 1 percent on credit sales.

The firm bank has recently offered to lend the firm up to 80 percent of the face value of the receivables shown on the schedule of accounts. The bank would charge 15 5 percent per annum interest plus a 2percent monthly processing charges per dollar of receivables lending. The firm extends term of net 30 and all customers who pay their bill do so by the 30th day. Should the form discontinue its factoring arrangement in favor of the bank’s offer if the firm borrows, on the average, $100,000 per month on its receivables’?

Factory Cost (Monthly):


Factoring Fee $7,000

Landing 1,500

$8,500

Bank Financing (Monthly):

Interest $1,250

Processing Fee 2,000

Credit department 2,000

Bad debts 3,500

$8,750

The firm should continue its factoring arrangements.

Q.4 North Great Timber Company will pay a dividend of $1.50 a share next year. After this earnings and dividends are expected to grow at a 9 percent annual rate. Indefinitely, Inventory presently requires a rate of return of 13 percent. The company is considering several businessstrategies and wishes to determine the effect of these strategies on the market price per share of its stock.

a. Continuing the present strategy will result in the expected growth rate and required rate of return stated above.

Market price per share = D / (R – g ) = 1.50 / (0.12 – 0.08 ) = $37.50

b. Expanding timber holdings and sales will increase the expected dividend growth rate 11 percent bull will increase the risk of the company. As a result the rate of return required by investors will increase to 16 percent.

Market price per share = 1.50 / (0.15 – 0.10 ) = $30.00c. Integrating into retail stores will increase the dividend growth rate to 10 percent and increase the required rate of return to 14 percent.

Market price per share = 1.50 / (0.13 – 0.09 ) = $37.50

(d) From the standpoint of market price per share, which strategy is best?

The present strategy and strategy ‘C’ result in the same market price per share.

Q.5 Discuss the adjustments in capital budgeting process that should be made to compensate for expected inflation.

Q.6(a) What are the three major functions of the financial manager? How are they related?

Q.6(b) Why are dividends the basis for the valuation of common stock?


Q.7(a) Who is able to issue commercial paper and for what purpose?

Q.7(b) Compare and contrast a line of credit and a revolving credit agreement.

Q.8(a) What is the purpose of a balance sheet? An income statement?

Q.8(b) Explain why a long term creditor should be interested in liquidity ratios.Financial Management 562 Spring 2007


Q.1 Define and explain the following:

• Financial Management,

• The goal of Financial Management

• Progressive taxation

• Average tax rate

Q.2 Assume that you will be opening a savings account today by depositing S 100000. The savings account pays 5 percent compound annual interest and this rate is assumed to remain in effect for all future periods. Four years from today you will withdraw R dollars. You will continue to make additional annual withdrawals of R dollars for a while longer—making your last withdrawal at the end of year 9—to achieve the following pattern of cash flows over time.

Note: today is time period zero; one year from today is the end of time period 1; etc.)

0 1 2 3 4 5 6 7 8 9

│ │ │ │ │ │ │ │ │ │R R R R R R

How large must R be to leave you with exactly a zero balance after your final R withdrawal is made at the end of year 9?

The pattern may be as follows

1 2 3 4 5 6 7 8 9 1 2 3

PVA9 │ │ │ │ │ │ │ │ │ ─ PVA3 │ │ │

R R R R R R R R R R R R

PVA9 – PVA3 = $100,000 = R (PVIFA, 05,9 ) – R (PVIFA, 05,3 ) = R (4.108) – R (2.723)

4.385 R = 100,000 or R = 100,000 / 4.385 = 22.805

Q.3(a) A 20-year bond has a coupon rate of 8%, and another bond of the same maturity has a coupon rate of 15%. If the bonds are alike in all other respects, which will have greater relative market price decline if interest rates increase sharply? Why?


Q.3(b) Could a security’s intrinsic value to an investor ever differ from the security’s market value? If so, under what circumstances?

Q.4 Salt Lake City Services, Inc; provides maintenance services for commercial buildings.

Presently, the beta on its common stock is 108. The risk free rate is now 10%, and the expected return on the market portfolio is 15%. It is January I. and the company is expected to pay a $2 per share dividend at the end of the year, and the dividend is expected to grow a compoundanimal rate of 11% for many years to come. Based on the CAPM and other assumptions you might make what dollar value would you place on one share of this common stock?

Β = 1.08 Rf = 0.10 Rm = 0.15 D0 = 2 g = 0.11

R = Rf + β (Rm – Rf ) = 0.10 + 1.08 (0.15 – 0.10) = 0.10 + 0.05 = 0.15 or 15 %

V = D / (R – g ) = 2 / (0.15 – 0.11) = 2 / 0.04 = 50Q.5 The Dud Company purchases raw materials on terms of "2/10, net 30”. A review of the company’s records by the owner, Ms. Dud, revealed that payments are usually made 15 days after purchases are received. When asked why the firm did not take advantage of its discounts,the bookkeeper, Mr. Blunder, replied that it costs only 2 percent for these funds, whereas a bank loan would cost the firm 12 percent.

(a) What mistake is Mr. Blunder making?

Mr. Blunder is making following mistakes.

1- He is not taking advantage of discounts offered to the firm as per terms “2/10, net30.”

2- After giving up discounts, he is usually making payments 15 days after purchases are received.3- Bank loan is more costly than trade credit funds.

(b) What is the real cost of not taking the advantage?

Annual cost if % discount 360

Discount is not = ----------------------- x ---------------------------------------

taken 100 - % discount payment date – discount period

= (2 / (100 – 2 ) (360 / [(30 – 20 )] = (2 / 98) (360 / 20) = 0.367 or 36.7 %

But as the Dud company usually makes payments 15 days after purchases are received, the real cost of not taking discounts would be much as worked out below:

= (2 / (100 – 2 ) (360 / [(15 – 10 )] = (2 / 98) (360 / 5) = 1.468 or 156.8 %

(c) If the firm could not borrow from bank and were resort to the trade credit funds, what suggestion might be made to Mr. Blunder that would reduce the annual interest cost?


If the company could not avail discount it should make its payments on the final due date, i.e., 30 days after purchase are received. And if possible, these payments can be stretched for a period of a week or10 days.

Q.6 Mendez Metal Specialties. Inc. has a seasonal pattern to its business. It borrows under a line of credit from Central Bank at 1% over prime. Its total asset requirements now (at year end) and estimated requirements for the coming year are (in millions):

Now 1st Q 2nd Q 3rd Q 4th Q

Total asset requirements $4.5 $4.8 $5.5 $5.9 $5.0

Assume that, these requirements are level throughout the quarter.

Presently, the company has $4.5 million in equity capital and long term debt plus the permanent component of current liabilities, and this mount will remain constant throughout the year.

The prime rate presently is 11 % and the company expects no change in this rate for the next year.

Mendez Metal Specialties is also considering issuing intermediate - term debt at an interest late of 13.5 %. In this regard, three alternative amounts are under consideration: zero, $ 500,000 and $ 1 million.

All additional funds requirements will be borrowed under the company’s bank line of credit.

(a) Determine the total dollar borrowing costs for short and intermediate-term debt under each of the three alternatives for the coming year.

(Assume. that there are no changes in current liabilities other than borrowings). Which alternative is lowest in cost’?

Alternative 1: 0 intermediate term debt and all finance is from bank borrowing

Bank loan cost = (11 + 1) / 4 = 3 % per quarterQ 1 Q 2 Q 3 Q 4

Incremental borrowing 300,000 1,000,000 1,400,000 500,000

Bank loan cost 9,000 30,000 42,000 15,000

Total cost of bank loan = 9,000 + 30,000 + 42,000 + 15,000 = 96,000

Alternative 2: Issuing 500,000 intermediate term debt and rest is financed by bank borrowing

Term loan cost = 500,000 (0.135) = 67,500

Q 1 Q 2 Q 3 Q 4

Incremental borrowing 0 500,000 900,000 0

Bank loan cost 0 15,000 27,000


Total cost = 67,500 + 15,000 + 27,000 = 109,500

Alternative 3: Issuing 1,000,000 intermediate term debt and rest is financed by bank borrowing

Term loan cost = 1,000,000 (0.135) = 135,000

Q 1 Q 2 Q 3 Q 4

Incremental borrowing 0 0 400,000 0

Bank loan cost 0 0 12,000 0

Total cost = 135,000 + 12,000 = 147,500

Alternative 1 is lowest in cost because the company borrows at a lower rate, 12 percent versus 13.5 percent, and because it does not pay interest on funds employed when they are not needed.(b) Is there a consideration other than expected Cost that deserves your attention?

While alternative 1 is cheapest it entails financing the expected build up in permanent funds requirements ($500,000) on a short-term basis. There is a risk consideration in that if things turn bad the company is dependent on its bank for continuing support. There is risk of loan renewal and ofinterest rates changing.

Alternative 2 involves borrowing the expected increase in permanent funds requirements on a term basis. As a result, only the expected seasonal component of total needs would be financed with shorttermdebt.

Alternative 3, the most conservative financing plan of the three, involves financing on a term basis more than the expected build-up in permanent funds requirements. In all three cases, there is the risk that actual total funds requirements will differ from those that are expected.

Q.7(a) Marsalis Corporation has an after-tax cost of debt of 8%, a Cost of preferred stock oil 12 % and a cost of equity of 16%. What is the weighted average cost of capital (WACC) for this company? The capital structure of the company contains 20% debt. 10 % preferred stock, and70% equity.

Item Proportion of total finance Cost Weighted cost

Long term debt 0.20 0.08 (0.20) (0.08) = 0.016

Preferred stock 0.10 0.12 (0.10) (0.12) = 0.012

Common stock 0.70 0.16 (0.70) (0.16) = 0.112

Cost 0.14 or 14 %

Q.7(b) HAL's computer Store has operating income of Rs.85,000 and interest expense of Rs,10,000

Calculate the firms degree of financial leverage.


DFL = EBIT / (EBIT – I) = 85,000 / (85,000 – 10,000) = 85,000 / 10,000 = 8.5

Q.8 A company has total annual sales (all credit) ol $400,000 and a gross profit margin of 20 percent. Its current assets are $80,000: current liabilities $60,000 inventories. $30,000, andcash, $10,000.

(a) How much average inventory should be carried if management wants the inventory turnover to be 4?

CGS = Sales (1 – Gross profit margin) = 400,000 (1 – 0.20) = 320,000

Inventory turnover = 4 = CGS / inventory

Inventory = CGS / 4 = 320,000 / 4 = 80,000

(b) How rapidly (in how many days) must accounts receivable be collected, if management wants to have an average of $50,000 invested in receivable?

Accounts receivable in days = 360 (Receivable) / Credit sales = 360 (50,000) / 400,000 = 45 days


financial management 562 autumn...

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