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# Financial Management 562 Autumn 2000

## 1 Prepared by Mohammad Muzammil

Q.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 and
December 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 = 1.120
Since the bond is perpetual bond, the current price is considered as the present value of this
bond.
Therefore,
V=I/k
Where 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 %

## 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 = 1.1
Asset turnover = 5 times
Fixed asset turnover = 12.037
Current ratio = 2
Average collection period = 16.837 days
Assume that all sales are on credit and a 360 days year.
Cash Current liabilities
Receivables Bonds payables
Inventory Net worth
Total current assets Tot. liabilities and net worth
Plant and equipment
Total assets Rs.325,000
Cash 28,495 J Current liabilities 95,000 E

## Plant & Equip. 135,000 C

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

Calculation C

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

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

12.037

Calculation D

Calculation E

Calculation F

Calculation G

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

Calculation H
Quick ratio = Quick asset / Current liabilities = 1.1

Calculation I

21.38

Calculation J

## 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

## 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

## 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

## Net present value at 15 %

Year Cash flow P.V factor Present value

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

Profitability index at 15 %

## 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?

(a)

## Breakeven sales = SBE = ?

FC 3,000,000 3,000,000
QBE = ------------- = --------------- = -------------- = 12,000,000 half pint

## 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

(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

## 16,000,000 – 12,000,000 4,000,000

(d)

EBIT = Q ( SP – VC ) – FC

## = 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

B0 = 4 %

BN = 3 %

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

For K = 10 %

ΔP = [ – K (ΔI ) – S0 (BN – B0 )]

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

For k = 20 %

ΔP = [ – K (ΔI ) – S0 (BN – B0 )]

## = [ 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 2001

1 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 is
expected 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 value

At 18 % of dividend

========

## 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 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

7.83318

======

– 0.10) = 30.397

## 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 the
facts 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?

Period 0 1 2 3 4

A
B

(Rs.25000)

(Rs.25000)

Rs.10000

Rs.10000

Rs.15000

Rs.35000

Rs.60000

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

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

## 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

## 4,320 = 20 + 4.54 = 24.54 %

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

## 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

## 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.

## 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?

## 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 in
receivables is expected to remain unchanged.

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

## SO = Current sales = 100, 000

SN = New sales = 90, 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

Credit sales

360 ( Y1 )

3, 240, 000

360 ( Y2 )

000 ( X1 – 3 )

3, 240, 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.

## % discount days in a year

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

2 365

100 – 2 30 – 10

1 365

100 – 1 30 – 10

2 365

100 – 2 45 – 10

3 365

100 – 3 45 – 10

1 365

100 – 1 60 – 10

3 365

100 – 3 30 – 10

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
next
month 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.

## 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.

FIRM J FIRM L

## Degree of Operating leverage

Leverage (DOL)

Q(P–V)

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

Q ( P – V ) – FC

## 100, 000 (2.00 – 1.70 )

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

## 100, 000 ( 0.30)

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

## 100,000 ( 0.30) – 6,000

30,000

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

= 1.25

## 100, 000 ( 2.50 – 1.00 )

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

## 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

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

= 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, 000
Q6 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.

## 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

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

PV for project A at 20 % = 20, 000 (2.991) = 59, 820

## 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.

## 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.

## 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).

## 1 Prepared by Mohammad Muzammil

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.

## 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.

## Sale 100, 000 100, 000 100, 000

Sale of asset 8, 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

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.

## 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)

## 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 and
overly 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

## 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
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%.

## 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

## 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 or
10 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.

## 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.

## 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 = 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.

## 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.

## 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.

## 1 Prepared by Mohammad Muzammil

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:

## 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:

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

(d) 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

= \$33,083

## 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?

## 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 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

## 2 35,000 0.826 28910 0 0.826 0

3 35,000 0.751 26285 75,000 0.751 56325

(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

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

(Difference b/w maximum value and

(6,493) / 14,668

For project B

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

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

(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 for
project 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

## -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 0.5

XYZ

R (%) – 30 0 10 50

## Compute risk and return for these stocks

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

## -0.1 0.05 -0.005 -0.141 0.019881 0.00099405

0.05 0.1 0.005 0.009 0.000081 0.0000081

Σ 0.12 0.017591

R' = 0.12/5

0.041

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

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

## 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 variation

Q.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 direct
production 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
SO = 100,000 (360) = 36,000,000

## 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 = 0.02
ΔI = Incremental change in investment in receivable

## = [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

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?

## Cost of placing an order = Oc = 10

Carrying cost = Cc = 0.5

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

100,000,000 = 10,000

√ Cc √ 0.5 √ 0.5

## 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?

## 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?

## 1 Prepared by Mohammad Muzammil

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 value
would you place on the stock if an 18 percent rate of return was required?

Phase: one

Phase: two

Phase: 3

= 32.69

## 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?

Balance sheet

## Accounts receivable 7 10 Notes payable 5 5

Inventory 12 15 Accrued wages 2 3

Accrued taxes 3 2

## Net fixed asset 40 40 Long term debt 20 20

Common stock 10 10

Retained earnings 15 20

Total 63 70 Total 63 70

## 1 2.00 (1 + 0.15) 1 = 2.30 0.847 1.95

2 2.00 (1 + 0.15) 2 = 2.65 0.718 1.90

## 6 3.04 (1 + 0.10) 3 = 3.04 4.05 1.50

Income statement 20X2

Sales 95

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:

## Depreciation 3 Addition to fixed asset 3

Increase accrued wages 1 Increase accounts receivable 3

## Increase cash and equivalent 1

____ _____

21 21

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

Net income 15

Depreciation 3

## Cash and cash equivalent, December 31, 20X1 4

Cash and cash equivalent, December 31, 20X2 5

## 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):

## 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 quarter

Q1Q2Q3Q4

## Alternative 2: Issuing 500,000 intermediate term debt and rest is financed

by bank borrowing

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

Q1Q2Q3Q4
Incremental borrowing 0 500,000 900,000 0

## 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

Q1Q2Q3Q4

## 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 of
interest 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 shortterm
debt.
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?

## 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?

## (\$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

Inventories

## 8. The debt ratio was 60 %

Balance sheet

Mughal Industries

## 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)

## ‘ Share holder’s equity 900,000

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

Calculation A.

Calculation B.

300,000

Calculation C.

+ Inventory

Calculation D.

Calculation E.

=240,000

Calculation F.

## 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.

## 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?

## 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 1.00
2 14 18 0.70

3 8 15 1.20

4 11 17 0.08

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

## 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 to
save each year?

## X = 50,000 / 12.028 = 4,257

Q6 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.

## 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)

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?

## 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?

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

Q.8 Briefly explain the following:

## (b) Matching principle

(c) Going concern

## (f) Preference shares

Financial Management 562 Spring 2000

## 1 Prepared by Mohammad Muzammil

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

m=4

0.0375 ) 48

## = 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 company
extend 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 = Incremental change in investment in receivable

## = 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.

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

2,500,000 = 1.56

## Price earning ratio = 37 / 1.56 = 23.72

(b)
Dividend yield = Dividend per share / Market price per share

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

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

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

2. Equity financing

## 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 = (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

## • 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:

Σ 0.452 0.194467

R' = 0.452/11

0.041

## Coefficient of variation = SD / R’ = 0.44 / 0.041 = 10.73

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

## 0.1 0.05 0.005 0.067 0.004489 0.00022445

0.15 0.1 0.015 0.117 0.013689 0.0013689

## 0.5 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

## 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.

## Fixed asset turnover = 6

Sales = Rs.2,400,000

## Inventory _________ Total debt

Current assets Common stock Rs.

## 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:

800,000

360 = 250,000

= 500,000

## 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

## 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

1 \$26000 \$14000

2 12000 14000

3 12000 14000

4 4000 14000

## 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 14,000

2 12,000 38,000 14,000 28,000

4 4,000 14,000

## 1 0.909 26,000 23634 14,000 12726

2 0.826 12,000 9912 14,000 11564

## 4 0.683 4,000 2732 14,000 9562

Σ 45290 Σ 44366

project X project Y

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

Present value at 19 %

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

1 0.84 26,000 21840 14,000 11760

## 4 0.499 4,000 1996 14,000 6986

Σ 39424 Σ 36932

project X project Y

## 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)

## 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 0.60
Case 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

## 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 all
paid 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 share

c. 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.

## 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)

## 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 cost
Long term debt

0.06

Preferred stock

0.00625

Common stock

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

0.1001

Cost 0.12435
Financial Management 562 Spring 2002

## 1 Prepared by Mohammad Muzammil

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.

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

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

## 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.

## 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?

3, 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.

FC = Rs.380, 000
P = Rs.63.50
V = Rs.16

## ( 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.

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

(d) Using the percentage computed in c, calculate the DOL

## 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

## 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

Total 104081

## 2 25000 0.7561 18902.5 0.7432 18580

3 30000 0.6575 19725 0.6407 19221

## 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 %

## 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?

## 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 2003

1 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

## Inventory 12 15 Accrued wages 2 3

Accrued taxes 3 2

## 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

## 0Selling, general and administrative expanses 15

Depreciation 3

Interest 2 70
Net income before tax 25

Taxes 10

Net income 15

Net income 15

Depreciation 3

## Cash and cash equivalent on 20x2 5

==

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

## 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

R=0

R’ = 0.11

SD = 0.114

R – R’ 0 – 0.11

SD 0.114

or 16.7 %

## For 10% return

R – R’ 0.10 – 0.11

SD 0.114

## 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.

## 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

## 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

----

2 365 2 365

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

100 – 2 30 – 10 98 20

Cost of alternative b

## 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

## 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?

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

( Ke – g )

## 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.

V = 20

D0 = 1

g = 0.10

## 2.488 ( Ke – 0.1 ) + 2.737

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

( 1 + Ke)5 ( Ke – 0.1 )

---------

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

2.76188

= ------------- = 163.909
0.01685

---------

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

2.8614

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

0.1

## = --------------------------------- = ----------------------------------- = ------------

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

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

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

## ( 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:

## 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:

Sum 104085

## (c) IRR of the project:

NPV at 15 %

Year C.F PV at 15 % PV

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 period

95, 000 20, 000 75, 000

30, 000 20, 000

## 35, 000 - 15, 000

NPV at 16 %

Year C.F PV at 16 % PV

Sum 93405

## 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?

## 1 Prepared by Mohammad Muzammil

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

## Net income after tax 142,000

EBIT + lease payment

## 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.

## = 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 %?

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

Portfolio 2 return = ( 14 – 10 ) / 12 = 0.33

## 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

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

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

*2

= 16 + 0.12 = 16.12

For project B

## 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

1.119

For project B

## 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?

## Year end inventory = 15, 000

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

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

= 360 / 60 = 6 days

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

over
= 360 / 30 = 12 days
Operating 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.

## = 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 %.

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

D D D P3

8 8 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?

## 1 Prepared by Mohammad Muzammil

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?

## 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% 1.3

Union Paint Co. 14.5% 0.8

## If the analysis expectations are correct which stocks are overvalued?

Undervalued?

R = Rf + β (Rm – Rf)

## 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 a
year)

1 365

## 100 – 1 30 – 202 365

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

## (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
used
more 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?

## 1 Prepared by Mohammad Muzammil

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

## 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.

## 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

## 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.

## 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.)

## 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

## 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

Payments

## 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)

## 2 Prepared by Mohammad Muzammil

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:

## 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.

## 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 2
percent 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

Interest \$1,250

\$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 business
strategies 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 ) = \$30.00

c. 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.)

0123456789

││││││││││
RRRRRR

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

123456789123

PVA9 │ │ │ │ │ │ │ │ │ ─ PVA3 │ │ │

RRRRRRRRRRRR

## 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 compound
animal 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?

15 %

## V = D / (R – g ) = 2 / (0.15 – 0.11) = 2 / 0.04 = 50

Q.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.

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

## = (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 or
10 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):

## 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

Q1Q2Q3Q4

## 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

Q1Q2Q3Q4

## 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

Q1Q2Q3Q4

## 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 of
interest 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 shortterm
debt.

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, and
70% equity.

## 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, and
cash, \$10,000.

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

## 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