Autumn 2007 Q.No.

1 a) The discount rate is the rate at which the company will be able to invest its cash flows. Is that right? Why or Why not? Please discuss with the help of practical examples. b) Consider the following projects Project C0 C1 C2 C3 C4 C5 A -1,000 0 0 0 0 0 B -2,000 +1,000 +1,000 +4,000 +1,000 +1,000 C -3,000 +1,000 +1,000 0 +1,000 +1,000 i) If the opportunity cost of capital is 10 percent, which projects have a positive NPV? ii) Calculate the payback period for each project. iii) Which project(s) would a firm using the payback rule accept if the cutoff period 3 years were? Q.No.2 Consider the following three stocks: Stock A is expected to provide a dividend of Rs. 10 a share forever. Stock B is expected to pay a dividend of Rs. 5 next year. Thereafter, dividend growth is expected to be 4 percent a year forever. Stock C is expected to pay dividend of Rs. 5 next year. Thereafter, dividend growth is expected to be 20 percent a year for 5 yeas (i.e. until year 6 and zero thereafter). If the market capitalization rate for each stock is 10 percent, which stock is the most valuable? What if the capitalization rate is 7 percent? Q.No.3 Issuing shares is a source of financing for the company. In some countries IPO of common stock are so9ld by auction. Another procedure is for the underwriter to advertise the issue publicly and invite applications for shares at the issue price. If the applications exceed the number of shares offer, then they are scaled down in proportion. If there are too few applications, any unsold shares left with the underwriters. Compare there procedures in Pakistan. Can you think of any better way to sell new shares? Suppose a manager has already estimated a projects cash flows, calculated its NPV, and done a sensitivity analysis. Explain the additional steps required to carry out a Monte Carlo simulation of project cash flows. Suppose it is your task to evaluate two different investments in new subsidiaries for your company, one in your own country and the other in a foreign country. You calculate the cash flows of both projects to be identical after exchange-rate differences. Under what circumstances might you choose to invest in the foreign subsidiary? Give an example of a country where certain factors might influence you to alter this decision and invest at home? Galaxy Company has an agreement with the National Bank by which the bank handles Rs. 4 million in collection each day and requires a Rs. 500,000 compensating balance. Galaxy Company is contemplating canceling the agreement and dividing its Northern region so that two other banks will handle its business. Banks 1 and 2 will each handle Rs. 2 million of collections each other, requiring a compensating balance of Rs. 300,000. Galaxy Companys financial management expects that collection will be accelerated by one day if the Northern region is divided. The T-bill rate is 7 percent. Should the Galaxy Company implement the new system? What will the annual net savings? Compare and contrast three alternative valuation methods with the help of practical examples of any manufacturing organization. What do you understand by warrants and convertibles as used in corporate finance and what is the underlying logic to explain why firms issue them?

Q.No.4

Q.No.5

Q.No.6

Q.No.7 Q.No.8

Solution to Paper-Autumn 2007

Q.No.1

a) Most often the discount rate is the rate at which the company will be able to reinvest its cash flows whenever a project proposal is examined and analyzed, it is definitely assumed that periodic cash flows would be invested at opportunity cost of capital which is also used to discount future cash inflows and outflows to determine the NPV of a project. b)Practice Question No. 1 of Chapter 5: I. Project NPV A - $ 90.91 B +$4,044.73 C +$ 39.47 ii. Project Payback period A B C iii.A & B

1 year 2 years 4 years

Q.No.2

(Practice Question No. 7 of Chapter 4) (A) (B) - $100 = $83.33 Year 1 2 3 4 5 6 $5.00 6.00 7.20 8.64 10.37 12.44 Total: P6 = = $124.40 Dividend PV @ 10% $4.55 4.96 5.41 5.90 6.44 7.02 34.28

PV $124.40/(1.10)6 = $70.22 Current Market Price or Po $ 34.28 + $ 70.22 = $104.50

Q. 3 When companies finance their long term needs externally, they may use three primary methods. A public issue of securities placed through investment bankers. A privileged subscription to the companys own shareholders. A private placement to institutional investors. When a company issues securities to general, public, it usually uses the services of investment bankers. The investment bankers principal functions are risk bearing or underwriting, and selling the securities. For performing these functions investment bankers are compensated by the spread between the price they pay for the securities and the price at which they re sell the securities to investors. For detailed discussion please refer to chapter 19 of Financial Management. Q. 4

Sensitivity analysis allows you to consider the effect of changing one variable at a time. By looking at the project under alternative scenarios, we can consider the effect of a limited number of plausible combinations of variables. Monte Carlo stimulation is a tool for considering all possible combinations. It therefore enables us to inspect the entire distribution of project outcomes. Following steps are required to be carried out under Monte Carlo stimulation. Steps 1 Modeling the project 2 Specifying probabilities 3 Simulate the cash flows 4 Calculate present value For detailed discussion pleas refer to chapter 10 of Corporate Finance. Q. 5 Although cash flows of both projects are identical, I would choose to make investment in foreign subsidiary under the following circumstances. 1. Political and socio economic situation is stable. 2. The currency of the country is quoted at a premium. 3. There are no sanctions from UNO and other international agencies. 4. Business activities are not facing recession period. For example if we are asked make investment in a subsidiary in Afghanistan or Iraq, we would hesitate definitely for the known reasons. For comprehensive answer please refer to chapters 24 of Financial Management titled as International Financial Management. Q. 6 Similar to Q 2 of Chapter 9 of Financial Management: Particulars National Bank Bank 1 Daily Collection Compensating Balance Funds Available Annual Earnings @ 7% Rs. 4,000,000 Rs. 500,000 Rs. 3,500,000 Rs. 245,000 Rs. 2,000,000 Rs. 300,000 Rs. 1,700,000 Rs. 119,000 Rs. 238,000 One Day Expected Reduction in Float Time: Earnings because of reduction in Float Time: The company should implement new system. One Day Rs.4, 000,000 x 1 x 7/100 Rs. 280,000/-

Bank 2 Rs. 2,000,000 Rs. 300,000 Rs. 1,700,000 Rs. 119,000

Q. 7

Financial distress occurs when promises to creditors are broken or honored with difficulty. Sometimes financial distress leads to bankruptcy. Sometimes it only means skating on thin ice. The value of company is equal to its value if all equity financed plus present value of tax shield minus present value of cost of financial distress. According to the trade-off theory of capital structure, the management should choose the debt ratio that maximizes the value of the company. The optimum is reached when the present value of tax savings due to further borrowing is just offset by increase in the present value of cost of financial distress. This is called the trade-off theory of capital structure. This trade-off theory of capital structure recognizes that target ratios may vary from company to company. The companies with safe, tangible assets and plenty of taxable income to shield ought to have high target ratios. Unprofitable companies with risky, intangible assets ought to rely primarily on equity financing. The packing orders theory starts with asymmetric information--a term indicating that managers know more about their companies prospects, risks and values than do outside investors. Managers obviously know more than investors. Asymmetric information affects the choice between internal and external financing, and between the new issues of debt and equity securities. This leads to a packing order in which investment is financed first with internal funds, re-invested earnings primarily, then by new issue of debt and finally with new issues of equity. New equity issues are a last resort when the company runs out of debts capacity. Q. 8: In addition to straight debt and equity instruments, a company may finance with an option, a contract giving its holders the right to buy common stock or to exchange something for it within specified period of time. As a result, the value of the option instrument is strongly influenced by changes in the value of stock. A convertible security is a bond or preferred stock that can be converted at the option of the holder into common stock of the same company. The convertibles give the investor a fixed return from a bond or preferred stock. In addition, the investor receives an option on the common stock. Because of this option, the company can sell the convertible security at a lower yield that it would have to pay on a straight bond or preferred stock issue. A warrant is an option to purchase common stock at a specified exercise price (usually higher than the market price at the time of warrant issuance) for a specified period. Warrants often are employed as sweeteners to a public issue of debt that is privately placed. As a result, the company should be able to obtain a lower interest rate than it would otherwise.

Autumn 2005 Q.No.1 James Consol Company present pays a dividend Rs. 2 per share on its common stock. The Company expects to increase the dividend at a 20% annual rate the first four years and at a 15% rate the next four years and then grow the dividend at 8% rate theater. This phased growth-pattern is in keeping with the expected life cycle of earnings. You require a 15% return to invest in this stock. What value should you place on a share of this stock? Q. No.2 a) Which financial ratios would you be most likely to consult if you were the following? Why? A banker considering the financing of seasonal inventory A wealthy equity investor The manager of a pension found considering the purchase of a firms bonds The president of a consumer products firm b. Why is the analysis of trends in financial ratios important? --------------------------------------------------------------------------------------------------------------------------ABC Company is planning to change its credit terms. The firms current credit terms are net 60 days, and the firms current daily sales average Rs. 100,000/-. The firm is experiencing a cash flow problem and wants to change the terms to net 30 days. In order to offset customer ill will, ABCs credit manager is proposing a 2% discount for payments received within 10 days of the invoice. Management feels that the firm will be able to maintain the same monthly sales and that about 80% of its customers will take the discount. Will the firm be better off with the new terms assuming its discounts rate is 12%? You are offered a new computer for Rs. 22,500/- and the sale person promises it will cut processing and wage costs by Rs. 6000/- before taxes for each of the next five years. If your firms cost of capital is 15% and the tax rate if 40% should you purchase the computer? Base your decision on the NPV and use straight line depreciation. Forecasted sales of PLEASANT Products for the next six months are given below: March Rs. 40,000 June Rs. 35,000 April 50,000 July 30,000 May 40,000 August 30,000 In the past, 20 percent of sales have been for cash and the rest have been on credit. PLEASANT expects to collect 10 percent of these credit sales during the month of sales, 70 percent in the following month, and 18 percent in the second month following the sales (2 percent are uncollectible). Make a cash receipts schedule for PLEASANT for this six-month period. You have just bought a house, and the mortgage company offers you $65,000 loan with payments of $9,282.18 per year for 30 years. What interest rate are you paying, and what is the total amount of interest you will pay? Zaman & Co. is a soft-drink manufacture. Zamans capital structure is 100 percent equity, and management intends to keep the capital structure all equity. Zamans current annual dividend to its common shareholders is Rs. 3.50 per share, and the current price is Rs. 40 per share. Ten yeas ago the firms dividend was Rs. 2.36 per share. Assuming floating costs are zero, answer the following questions. Estimate the cost of capital Calculate the firms cost of capital assuming a floatation cost of 6% XYZ Inc. is contemplating investment in a new project; XYZ is an all equity company. It has a beta of 1.5. The required return on a market portfolio is 12 percent, and the current risk-free rate is 9 percent.

Q. 3

Q. No.4

Q. No. 5

Q.No.6 Q. 7

Q. 8

Solution to Paper-Autumn 2005 Q# 1 year 1 2 3 4 5 6 7 8 Total

Dividend 2.40 2.88 3.46 4.15 4.77 5.49 6.31 7.25

PV @ 15% 2.09 2.18 2.27 2.37 2.37 2.37 2.37 2.37 Rs.18.39

Thereafter constant growth @ 8% P8 = 7.83 ___ =Rs. 111.86 0.15--0.08 PV of 111.86 @ 15% = Rs.36.57 Current Value= Rs.36.57+Rs.18.39 = Q# 2 Q# 3

Rs.54.96 or Rs. 55

Please refer to Ch6 of Financial Management for purpose and use of various ratios. Annual Sales Rs.36,000,000 Rs.36,000,000 Collection Period 60 Days 30 Days Average Recoverable Rs.6,000,000 Rs.3,000,000 Earnings on reduction in receivable @ 12% Rs. 360,000 Amount of discount Rs. 576,000 The firm will not be better off with new terms as amount of discount is greater than expected increase in annual earnings. Q# 4 Cash Flow from Y-1 to Y-5 Gross Earnings Depreciation Savings before tax Tax @ 40 % Saving after tax Add Back Depreciation Net Cash Flows Rs.6000 (4500) Rs1500 (600) Rs.900 Rs.4500 Rs.5400

NPV @ 15% using PVA formula = Rs.18, 102 - Rs.22, 500 = (Rs.4398) Purchase of Computer is not recommended because of negative NPV. Q# 5 Sales 20 % 10% 70% 18% March 40,000 8000 3200 11200 April 50,000 10,000 4000 22400 36400 May 40,000 8000 3200 28000 5760 44960 June 35,000 7000 2800 22400 7200 39400 July 30,000 6000 2400 19600 5760 33760 Aug 30,0000 6000 2400 16800 5040 30240

Q# 6

Principle n i Installment

= $65,000 =30 Years =? = $9,282.18

Rate of interest can be found through interpolation. Using the formula of PVA, first use the rate of 13%, and then use the rate of 15%. Then through interpolation you can find i =14%. Total amount of interest = (Number of Installments) X (Amount of installment) -- (Principle Amount) = Q# 7 Dividend per share 10 Years Ago Currently So we can find growth rate (g) as Follows:1/10 Rs.3.50 -- 1 = 0.04 or 4% Rs.2.36 (a) Cost of capital = Ke = D1 Po = 3.64 __ + 40(1 -- 0.06) QUESTION # 8 If Beta is 1.5 then Ke = Rf + (Rm Rf) Beta = 9 + (12 - 9) 1.5 = If Beta is 1.6 then Ke = 9 + (12 9) 1.6 = 13.8 % 13.5 % 3.64 40 0.04 + 0.04 = 0.131 or 13.1% + g = Rs.2.36 = Rs.3.50 30 X 9,282.18 -- 65,000 = $ 213,465.40

(b)

= 0.1368 or 13.68%

Spring 2004 Q. 1 As a recently hired financial manager you are asked to e valuate the benefits of the leasing rather than purchasing a new computer. You need the asset for three years, and the tax rate is 40 percent. Relevant data are provided in a, b and c below. a. The computer costs $150,000 and could be depreciated over a few years period using the 200 percent declining balance method for depreciation. The financial manager anticipates that the computer will have a market value of $10,000/- at the end of three years. The manufacturer offers a maintenance contract for $3,000/- per year. b. If you decide to purchase the computer your bank will loan you $125,000/- of the $150,000/purchase price. The interest rate on the loan is 10 percent. The loan is traditional term loan with equal annual payments starting in one year, and the loan will be for three years. c. A leasing agent offers the same computer with three annual lease payments of $55,000/per years with the first lease payment being paid immediately. A maintenance provision is included in the lease contract. Finally you have the option to purchase the computer at the end of three years for $10,000/-. However this time you do not anticipate taking the purchase option intending instead to upgrade the hardware in three years. Q. 2 Stylo, Inc, pays a $2 cash dividend per share to its common shareholders. Stylos stock currently sells for $20 per share and is expected to sell for $25 per year. Earning per share is currently equal to $4 per share. Calculate the dividend payout ratio the current dividend yield and the expected return anticipated over the coming year if the stock was purchased at the current price of $20. a) discuss the different between the declaration date, the record rate, the payment date and the ex-dividend date. b) What are the five characteristics looked at by the financial manager in making a credit decision on a customer? Distinguish between reorganization and liquidation. What circumstances dictate whether reorganization is preferred over liquidation? The financial manager of sea burg, Inc, is currently analyzing two different financing alternatives. Sea burg currently has an EBIT level of $ 1,000,000 and is all equity financed with 500,000 shares of common stock outstanding. The firms tax rate is 30 percent. To finance the proposed capital budget sea burg must acquire $2 million of new external funds. Sea burgs financial manager is analyzing two plans: Plane 1 calls for issuing 100,000 shares of new stock at $20 per share and plan 2 calls for issuing $2 million of debt at a 7 percent coupon rate (assume issue cost are negligible and thus ignored). Construct an EBIT-EPS chart for sea burg. Calculate the EBIT break-even level and the EBIT indifference level. Assuming the EBIT is expected to be $1.5 million next year and to remain at that level for the foreseeable future what is your recommendation? To construct a chart use the following EBIT level: $ 1,000,000/- $1,500,000 and $ 2,000,000. a) Choctaw Oilfield Services made a $225,000 operating profit last year and paid $160,000 in interest expenses. How much financial leverage doses Choctaw have? If operating profits drop 50 percent this year, what effect does it financial leverage has on Choctaws new profits? b) What are the weaknesses of break-even analysis? GC investment has $100,000 in a 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 A $0 0 75,000 B $35,000 35,000 35,000

Q. 3

Q. 4 Q. 5

Q. 6

Q. 7

100,000

35,000

The cost of capital is 10 percent. Calculate the following and state for each criterion whether or not you should invest. a) NPV b) IRR Solution to Paper-Spring 2004 Q. 1 Please refer to chapter 26 page 707 (8th Edition) for same type of problem. Cost of new Computer Lost Depreciation tax shield Lease payments Tax Shield on Lease Payment Maintenance Cost Residual Value Net Cash Flow YO 150,000 (55,000) 22,000 117,000 Y1 (40,000) (55,000) 22,000 3,000 (70,000) Y2 (13,333) (55,000) 22,000 3,000 (43,333) Y3 (2667) 3,000 (10,000) (9,667)

Shield of Depreciation: Double (200%) Declining method Year Particulars 1 2 3 150,000 x 2/3 50,000 x 2/3 16,667 10,000

Yearly Depreciation 100,000 33,333 6,667

Book Value 50,000 16,667 10,,000

NPV lease: 117,000 7,000 43,333 9,667 @ 6% = $4,279 As NPV Lease is positive, the company should acquire the asset on lease. Q. 2 Divided Payout Ratio = Dividend Per share Earnings per share = Dividend yield: Dividend Per share Earnings per share = X 100 = 10% 0.50 = or 50%

Expected Return anticipated over the coming year. = 0.35 or 35% Q. 3 (a) Declaration date: The date on which the board of directors announces the amount of dividend or its percentage of face value Record Date: The date set by the board of directors when a dividend is declared, on which an investor must be a shareholder as per companys record to be entitled to the upcoming dividend. Payment Date: The date when the company actually pays the declared dividend

(b) Five characteristics looked at by the financial manager in making a credit decision on a customer. 1. Good Character: Character: customers desire or willingness to honor obligations 2. Sufficient capacity: Customers ability to generate cash to meet obligations 3. Sound financial position: Customers net worth and relationship of net worth to debt 4. Clean track record: Customers status and record of previous payments 5. Fair market reputation What others say about your customer? Q.4 Distinction between Reorganization and Liquidation: Reorganization means recasting of the capital structure of a financially troubled company in order to reduce fixed financial charges. Claim holders may be given substitute securities. Whereas Liquidation is the sale of assets of a company either voluntarily or in bankruptcy. For detailed discussion please refer to chapter 23 of Fundamentals of Financial Management. Q. 5 EBIT Interest EBT Tax 30% EAT No. of shares EPS Common stock $1,000,000 1,000,000 300,000 700,000 600,000 $1.167 Debt 1,000,000 140,000 860,000 258,000 602,000 500,000 $1.204 Common stock 1,500,000 1,500,000 450,000 1,050,000 600,000 $1.750 Debt 1,500,000 140,000 1,360,000 408,000 952,000 500,000 $1.904

At all the three levels of EBIT, we recommend that the company should acquire $2 million by issuing debt at a 7 percent coupon rate because of highest EPS. Common 2,000,000 2,000,000 600,000 1,400,000 600,000 $2.333 Debt 2,000,000 140,000 1,860,000 558,000 1,302,000 500,000 2.604

Indifference point in EBIT is that amount of EBIT which generate same EPS for two or more financing plans. Formula to calculate indifference point (EBIT i) (I T) PD____ Number of Common shares =

350 EBIT 58,800 58,800 840 So indifference point in EBIT is $840,000.

= 420 EBIT 58,800 = 420 EBIT 350 EBIT = 70 EBIT = EBIT

10

Q. 6 (a) Degree of Financial Leverage Or DFL = EBIT or Operating Profit Operating Profit Interest Expenses

$225,000 _________ = 3.46 Times $225,000--$160,000

Effect on Change in Net Profit = Change in Operating Profit X DFL 50% x 3.46 = 173% (b) Weakness of break even analysis: Please refer to chapter 16 of Financial Management. Q. 7 NPV @10% Internal Rate of Return IRR Project A $24,650 17.06% Project B $ 10,945 14.96 %

IRR may be calculated through interpolation. The company should make investment in project A because of higher NPV.

Autumn 2006

11

Q. 1

Galaxy has an agreement with the National Bank by which the bank handles Rs. 4 million in collections each day and requires a Rs. 500,000 compensating balance. Galaxy Company is contemplating canceling the agreement and dividing is Northern region so that two other banks will handle its business. Banks 1 and 2 will each handle Rs. 2 million collection each day requiring a compensating balance of Rs. 300,000 Galaxy Companys financial management expects that collections will be accelerated by one day if the Northern region is divided. The T-bill rate is 7 percent. Should the Galaxy Company implement the new system? What will the annual net saving? a) The discount rate is the rate which the company will be able to reinvest its cash flows. Is that right? Why or why not? Please discuss with the help of practical examples. b) Consider the following projects: Project C0 C1 C2 C3 C4 C5 A -1,000 0 0 0 0 0 B -2,000 +1,000 +1,000 +4,000 +1,000 +1,000 C -3,000 +1,000 +1,000 0 +1,000 +1,000 If the opportunity cost of capital is 10 percent, which projects have a positive NPV? ii. Calculate the pay back period for each project. iii. Which project (s) would a firm using the pay back rule accept if the cutoff period 3 years were? Issuing shares a source of financing for the company. In some countries IPO of common stock are sold by auction. Another procedure is for the underwriter to advertise the issue publicly and invite application for shares at the issue price. If the applications exceed the number of shares offer, then they are scaled down in proportion. If there to few applications, any unsold shares left with the underwriters. Compare there procedures in Pakistan. Can you think of any better way to sell new shares? Bond prices can fall either because of a change in the general level of interest rates or because of an increased risk of default. To what extent do floating rate bonds and putt able bonds protect the investor against each of these risks? Explain your answer with the help of practical examples. Compare and contrast three alternative valuation methods with the help of practical examples of any manufacturing organization. Suppose that there is no relationship between beta and expected returns. Does that mean that beta is an uninteresting statistic? What would you do as an investor? What strategies should a company adopt? Give explanation with the help of practical examples from Pakistan? Suppose the trade-off theory of capital structure is true. Can you prodict how companys debt ratios should change over time? How do these predictions differ from the packing order theories? i.

Q. 2

Q. 3

Q. 4

Q.5 Q.6

Q.7

Q.4 Retractable (or puttable bonds) Retractable (or puttable bonds) give investors the right to demand early repayment; extendable bonds give them the option to extend the bonds life. Putt able bonds exist largely. Because bonds indentures cannot anticipate every action the company may take that could harm the bondholders. If the value of the bonds is reduced the put option allows the bondholders to demand repayment. Potables bonds can sometimes get their issuers into big trouble. During 1990, many bonds issued by Asian companies gave their lenders a repayment option. Consequently, when Asian crises struck in 1997, these companies were faced by a flood of lenders demanding their money back. So it would be beneficial for bondholders to have puttable bonds or bonds with floating rates with some ceiling to protect them against increased risk of default and increasing interest rates. But as these features in bonds are not favorable to the issuing companies which in turn prefer to issue bonds with call option.

12

 For remaining questions, please refer to solution of Autumn 2007 as most of the questions have been repeated.

Solution to Paper-Spring 2007 Q. 1 First of all, present value of outflows (Costs) @ 6%

Project A= Project B= Rs. 66,730 Rs. 77,721

Now you have to give either of the machines on lease (rent), so calculate annual lease payments for economic life of machine. Be careful that lease payments are calculated through formula of annuity due (to be paid in advance). Lease Rent 3 payments 4 payments So Machine A is preferred. Q.2 Quiz 1 of chapter 7 (Corporate Finance) Probability 0.10 0.50 0.40 $500 100 0 Payoff (Probability) (Payoff) (0.10) ($500) = $50 (0.50) ($100) = 50 (0.40) ($0) = 0 Expected Payoff =$100 Expected Rate of Return: As you are investing Rs. 100 and expected payoff is Rs.100, your return would be zero; so expected rate of return is zero. Please note that Variance and standard deviation is not required in the paper question. Q.3 Machine A Rs. 23,551 Rs. 21,160 Machine B

Decision tree:
13

In operations research, specifically in decision analysis, a decision tree (or tree diagram) is a decision support tool that uses a graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. A decision tree is used to identify the strategy most likely to reach a goal. Another use of trees is as a descriptive means for calculating conditional probabilities. Sensitivity Analysis: Analysis of the effect on project profitability of possible changes in sales, costs, and so on. Sensitivity analysis (SA) is the study of how the variation (uncertainty) in the output of a mathematical model can be apportioned, qualitatively or quantitatively, to different sources of variation in the input of a model. Break-even analysis is used to determine the level of sales and the mix of products which are required to just recover all costs incurred during the period. The break-even point is the point at which cost and revenue are equal. There is neither a profit nor a loss at the break-even point. The objective of cost-volume-profit analysis is to determine the level of sales and mix of products which are required to achieve a targeted level of profit. Although management typically plans for a profit each period, the break-even point is of concern. If sales fall below the break-even point, losses will be incurred. Management Project Analysis is the process of identifying, analyzing and deciding (select or reject) investment projects. Reference may be made to the detailed notes emails to all the students. Q.4 (a) Many new companies rely initially on family funds and bank loans. Some of them continue to grow with the aid of equity investment provided by individuals or institutional investors. However, many adolescent companies raise capital from specialist venture-capital firms, which pool funds from a variety of investors, seek out fledgling companies invest in, and then work with these companies as they try to grow. The success of a new business depends critically on the efforts put in by the managers. Therefore, venture capital firms try to structure a deal or prefer to advance money in stages so that management has a strong incentive to work hard. (b) Please refer to the chapters 19 & 20 of Financial Management. 14

Q.5

Quiz # 6 of Chapter 16 (a)

Corporate Finance

Rs.130-Rs.2.75 = Rs.127.25

(b) Nothing the stock price will stay at Rs.130 Number of shares to be repurchased: Rs. 40,000,000 x Rs.2.75= 846,154 shares Rs.130 Stock Price: On announcement=Rs. 130 Ex-Dividend= Rs. 124.50 Number of shares to be issued: 40,000,000 x Rs.2.75 = 883,534 shares Rs.124.75

Q.6 (a) & (b): Instead of issuing convertible bonds, companies sometimes sell a package of
straight bonds and warrants. Warrants are simply long term call options that give the right to buy the companys common stock. For example, each warrant might allow the holder to buy a share of stock for $50at any time during the next five years. Obviously the warrant holders hope that the companys stock will zoom up, so that they can exercise their warrant at a profit. But, if the companys stock price remains below $50, holders will choose not to exercise, and the warrants will expire worthless. Occasionally the companies extend the life of warrants. The cost to do so is not noticeable. For further study, please refer to chapter 22 of Financial Management. Q.7 For detailed discussion please refer to chapter 20 of Financial Management or chapter 14 of Corporate Finance. Q.8 (a) (b) Retention Growth Model: g= b (r) 0.40(0.20) = 0.08 or 8% Total Assets= Rs.1,000,000 growth= 30 % where b is retention ratio and r is Return of Equity

Assets Requirements: Rs. 300,000 Equity= Rs. 1,000,000 ROE= 20% Earnings after tax or Net Income= Rs.200, 000 External Financing Requirements= Rs.300,000-[ 40% of Rs.200,000] = Rs. 220,000 Corporate Finance Q.1 15 Solution to Paper-Autumn 2004

(a)

Capital Rationing: A situation where a constraint or budget ceiling is placed on the total

size of capital expenditure during a particular period. Such constraints or limitations are prevalent in a number of firms, particularly in those that have a policy of internally financing all capital expenditures. Another example of capital rationing occurs when a division of a large company is allowed to make capital expenditures only up to a specified budget ceiling, over which the division usually has no control. With a capital rationing constraint, the company attempts to select the combination of investment proposals that will provide the greatest increase in the value of the company subject to not exceeding the budget ceiling constraint. Soft Rationing: Many firms capital constraints are Soft. They reflect no imperfections in capital markets. Instead they are provisional limits adopted by management as an aid to financial control. Some ambitious divisional managers habitually overstate their investment opportunities. Rather than trying to distinguish which projects really are worthwhile, headquarters may find it simpler to impose an upper limit on divisional expenditures and thereby force the divisions to set their own priorities. Hard Rationing: Soft rationing should never cost the firm anything. If capital constraints become tight enough to hurt, then the firm raises more money and loosens the constraints. But what it cant raise more moneywhat if it faces hard rationing? Hard rationing implies market imperfections, but it does not necessarily mean we have to throw away net present value as a criterion for capital budgeting. It depends on the nature of imperfections. For detailed discussions please refer to chapter 5 of Corporate Finance (page 100 to 103) Quiz Number 5 of Chapter Number 5.

Multiple Internal Rates of Return (IRRS): There is one other situation in which the IRR approach may no

be usablethis is when non-normal cash flows are involved. A project has normal cash flows when one o

more cash inflows (costs) are followed by a series of cash inflows. If, however, a project calls for a larg

cash outflows either sometime during or at the end of its life, then it has non-normal cash flows. Non problem encountered when evaluating non-normal projects is multiple IRRS. This project has two internal rate of return. -50% and +50 %. If we calculate projects NPV by using either of the above rates, it would come to zero. If opportunity cost is 20% then project is attractive because of positive NPV of $14.58. Q.2 16

normal cash flows can present unique difficulties when evaluated by the IRR method. The most commo

Weighted Average Cost of Capital or WACC: (Ke) (We) + (Kd) (Wd) where: Ke= Cost of Equity Kd= Cost of Debt (a) We= Weightage or Proportion of Equity Wd= Weightage or Proportion of Debt Equity= 10,000xRs.50= Rs.500, 000

Long Term Debt= Rs. 300,000

So Weightage of Debt would be 3/8 & Weightage of Equity would be 5/8 WACC= (0.15) (5/8) + (0.08) (3/8) = 0.12375 or 12.375% (b) Now stock price falls to Rs.25 per share, therefore amount of equity would decline to Rs. 250,000 (10,000xRs.25) whereas amount of debt remains the same. In this situation the WACC would be as under: (0.15) (2.5/5.5) + (0.08) (3/5.5) = 0.1118 or 11.18 % Q.3 (a) Project Analysis involves:

Generating investment project proposals consistent with the firms strategic objectives. Estimating after-tax incremental operating cash flows for the investment projects. Estimating project incremental cash flows. Selecting projects based on a value-maximizing acceptance criterion. Reevaluating implemented investment projects continually and performing pre-audits for complete projects. For detailed answer please refer to Chapter 12 of Financial Management. (b) Sensitivity analysis (SA) is the study of how the variation (uncertainty) in the output of a mathematical model can be apportioned, qualitatively or quantitatively, to different sources of variation in the input of a model. In more general terms uncertainty and sensitivity analyses investigate the robustness of a study when the study includes some form of mathematical modeling. While uncertainty analysis studies the overall uncertainty in the conclusions of the study, sensitivity analysis tries to identify what source of uncertainty weights more on the study's conclusions. For example, several guidelines for modeling or for impact assessment prescribe sensitivity analysis as a tool to ensure the quality of the modeling/assessment. To sum up Analysis of the effect on project profitability of possible changes in sales, costs, and so on is called Sensitivity analysis.

C.

Monte Carlo methods in finance is a method of using the random sampling of numbers in order to estimate the solution to a numerical problem. [Monte Carlo in Monaco, famous for its gambling casino]Monte Carlo stimulation is a tool for considering all possible combinations. It therefore enables us to inspect the entire distribution of project outcomes.

Following steps are required to be carried out under Monte Carlo stimulation. 17

Steps 1: Modeling the project 2: 3: 4: Specifying probabilities Simulate the cash flows Calculate present value

For detailed discussion pleas refer to chapter 10 of Corporate Finance. (d) Decision tree: In operations research, specifically in decision analysis, a decision tree (or tree diagram) is a decision support tool that uses a graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. A decision tree is used to identify the strategy most likely to reach a goal. Another use of trees is as a descriptive means for calculating conditional probabilities. In data mining and machine learning, a decision tree is a predictive model; that is, a mapping from observations about an item to conclusions about its target value. More descriptive names for such tree models are classification tree (discrete outcome) or regression tree (continuous outcome). In these tree structures, leaves represent classifications and branches represent conjunctions of features that lead to those classifications. The machine learning technique for inducing a decision tree from data is called decision tree learning, or (colloquially) decision trees.

Q.4
(a) & (b): Economists often define three levels of Market Efficiency. In the first level, prices reflect the information contained in the record of past prices. This is called weak form of efficiency. If the markets are efficient in the weak sense, then it is impossible to make consistently superior profits by studying past returns. Prices will follow a random walk. The second level of efficiency requires that prices reflect not just past prices but all other published information, such as we might get from reading financial press. This is known as semi-strong form of market efficiency. If markets are efficient in this sense, then prices will adjust immediately to public information such as announcement of last quarters earnings, a new issue of stock, a proposal to merge two companies, and so on. Finally, we might envisage a strong form of efficiency, in which prices reflect all the information that can be acquired by the painstaking analysis of the company and the economy. Is such a market we would observe lucky and unlucky investors, but we wouldnt find any superior investment managers who can consistently beat the market.

18

Q.5 Quiz # 6 of Chapter 16 (a) (c) Corporate Finance Rs.130-Rs.2.75 = Rs.127.25 Nothing the stock price will stay at Rs.130

Number of shares to be repurchased: Rs. 40,000,000 x Rs.2.75= 846,154 shares Rs.130 Stock Price: On announcement=Rs. 130 Ex-Dividend= Rs. 124.50 Number of shares to be issued: 40,000,000 x Rs.2.75 = 883,534 shares Rs.124.75

Q.6
(a) Bonds Conversion Value: 4xRs.30= Rs.120 (b) One of reasons bonds are selling above conversion value is current interest rates. These bonds were issued at 10% interest rates. It appears that presently new bonds are issued at lower rates or we can say yield to maturity is less than coupon rate. The other reason could be greater EPS and handsome payouts. ( c) If interest rates have dropped substantially and calling old bonds and issuing new one do not carry heavy expenses the company should call old bonds to save annual interest expense. Q.7 (a) Retractable (or puttable bonds) Retractable (or puttable bonds) give investors the right to demand early repayment; extendable bonds give them the option to extend the bonds life. Putt able bonds exist largely. Because bonds indentures cannot anticipate every action the company may take that could harm the bondholders. If the value of the bonds is reduced the put option allows the bondholders to demand repayment. Potables bonds can sometimes get their issuers into big trouble. During 1990, many bonds issued by Asian companies gave their lenders a repayment option. Consequently, when Asian crises struck in 1997, these companies were faced by a flood of lenders demanding their money back. So it would be beneficial for bondholders to have puttable bonds or bonds with floating rates with some ceiling to protect them against increased risk of default and increasing interest rates. But as these features in bonds are not favorable to the issuing companies which in turn prefer to issue bonds with call option.

19

Project Finance means debt supported by the project, not by the project sponsoring companies. Project finance is largely a claim against cash flows from a particular project rather than against the company as a whole. No two project financing are alike but they have some common features: The project is established as a separate company. The contractors and the plant managers become major shareholders in the project and thus share in the risk of projects failure. The project company enters into a complex series of contracts that distributes risk among the contractors, the plant managers, the suppliers and the customers. The government may guarantee that it would provide the necessary permits, allow the purchase of foreign exchange, and so on. The detailed contractual arrangements and the government guarantees allow a large part of capital for the project to be provided in the form of bank debt or other privately placed borrowing. For comparison between direct debt and project finance please refer to chapter 25 of Corporate Finance. Q.8 (A) Credit Scoring System: Quantitative approaches have been developed to estimate the ability of businesses to serve the credit to them; however, the final decision for most companies extending trade credit (credit extended from one business to another) rests on credit analysts judgment in evaluating available information. Strictly numerical evaluations have been successful in determining the granting of credit to consumers, where various characteristics of an individual or firms are quantitatively rated and a credit decision is made on the basis of total score. The plastic credit cards many of us hold are often given out on the basis of a credit scoring system in which things such as age, occupation, duration of employment or business, home-ownership, years of residence, and annual income are taken into account. With the overall growth of trade credit, a number of companies are finding it worthwhile to use numerical credit-scoring systems to identify clearly unacceptable and acceptable applicants. For further study please refer to chapter 11 of Financial Management. (B) Firms grant free credit because they have to follow the practices in the line in trade in which they are doing business. A single firm cannot be strict enough in granting trade credit otherwise it would be out of business. For example it a toy manufacturing company decides not to sell any product on credit or if any customer demands credit, a percentage of discount is to be charged. And we assume that other toy manufacturers in the same market are extending credit period up to 30 days. Now we can imagine what would happen, the firm following strict credit policy would experience gradual decline in its sales. Solution to Paper-Spring 2007 Q. 1 First of all, present value of outflows (Costs) @ 6% Project A= Project B= Rs. 66,730 Rs. 77,721 20

Now you have to give either of the machines on lease (rent), so calculate annual lease payments for economic life of machine. Be careful that lease payments are calculated through formula of annuity due (to be paid in advance). Lease Rent 3 payments 4 payments So Machine A is preferred. Q.2 Quiz 1 of chapter 7 (Corporate Finance) Probability 0.10 0.50 0.40 $500 100 0 Payoff (Probability) (Payoff) (0.10) ($500) = $50 (0.50) ($100) = 50 (0.40) ($0) = 0 Expected Payoff =$100 Expected Rate of Return: As you are investing Rs. 100 and expected payoff is Rs.100, your return would be zero; so expected rate of return is zero. Please note that Variance and standard deviation is not required in the paper question. Q.3 Decision tree: In operations research, specifically in decision analysis, a decision tree (or tree diagram) is a decision support tool that uses a graph or model of decisions and their possible consequences, including chance event outcomes, resource costs, and utility. A decision tree is used to identify the strategy most likely to reach a goal. Another use of trees is as a descriptive means for calculating conditional probabilities. Sensitivity Analysis: Analysis of the effect on project profitability of possible changes in sales, costs, and so on. Sensitivity analysis (SA) is the study of how the variation (uncertainty) in the output of a mathematical model can be apportioned, qualitatively or quantitatively, to different sources of variation in the input of a model. Machine A Rs. 23,551 Rs. 21,160 Machine B

21

Break-even analysis is used to determine the level of sales and the mix of products which are required to just recover all costs incurred during the period. The break-even point is the point at which cost and revenue are equal. There is neither a profit nor a loss at the break-even point. The objective of cost-volume-profit analysis is to determine the level of sales and mix of products which are required to achieve a targeted level of profit. Although management typically plans for a profit each period, the break-even point is of concern. If sales fall below the break-even point, losses will be incurred. Management Project Analysis is the process of identifying, analyzing and deciding (select or reject) investment projects. Reference may be made to the detailed notes emails to all the students. Q.4 (a) Many new companies rely initially on family funds and bank loans. Some of them continue to grow with the aid of equity investment provided by individuals or institutional investors. However, many adolescent companies raise capital from specialist venture-capital firms, which pool funds from a variety of investors, seek out fledgling companies invest in, and then work with these companies as they try to grow. The success of a new business depends critically on the efforts put in by the managers. Therefore, venture capital firms try to structure a deal or prefer to advance money in stages so that management has a strong incentive to work hard. (c) Q.5 (a) Please refer to the chapters 19 & 20 of Financial Management. Rs.130-Rs.2.75 = Rs.127.25

(d) Rs.130 Number of shares to be repurchased: Rs. 40,000,000 x Rs.2.75= 846,154 shares Rs.130 Stock Price: On announcement=Rs. 132.75 Ex-Dividend= Rs. 127.25 Number of shares to be issued: 40,000,000 x Rs.5.50 = 1,657,250 shares. Rs.132.75 Q.6 (a) & (b): Instead of issuing convertible bonds, companies sometimes sell a package of straight bonds and warrants. Warrants are simply long term call options that give the right to buy the companys common stock. For example, each warrant might allow the holder to buy a share of stock for $50at 22

any time during the next five years. Obviously the warrant holders hope that the companys stock will zoom up, so that they can exercise their warrant at a profit. But, if the companys stock price remains below $50, holders will choose not to exercise, and the warrants will expire worthless. Occasionally the companies extend the life of warrants. The cost to do so is not noticeable. For further study, please refer to chapter 22 of Financial Management. Q.7 For detailed discussion please refer to chapter 20 of Financial Management or chapter 14 of Corporate Finance. Q.8 Retention Growth Model: g= b (r) (c) (d) 0.40(0.20) = 0.08 or 8% Total Assets= Rs.1,000,000 growth= 30 % where b is retention ratio and r is Return of Equity

Assets Requirements: Rs. 300,000 Equity= Rs. 1,000,000 ROE= 20% Earnings after tax or Net Income= Rs.200, 000 External Financing Requirements= Rs.300,000-[ 40% of Rs.200,000] = Rs. 220,000

Solution to Paper-Spring 2006 Q.1 Cost of capital = Ke = D1 + g (A) Rs.1.823 +0.085 = 0.10997 or 11% 23

Po

Rs.73

(B) Now we have to calculate rate of growth by using growth retention formula: g = b (r) where b = retention ratio and r = Return of Equity

g = 0.50 (0.12) = 0.06 or 6% Q.2 (b) under: Probability 0.333 0.333 0.333 Q.3 $10 (20) 0 Payoff (Probability) (Payoff) = $3.33 = (6.67) = 0 (a) Practice Question 13 of Chapter 7 (Corporate Finance) Almost similar to Quiz 1 of Chapter 7, however for your convenience the solution is as

Expected Payoff = ($3.34) If a baby has been given a hammer we all know what could be the repercussions. So if an MBA student who has learnt about Discounted Cash Flows would be applying DCF techniques to all the projects and making entire decisions on the results derived without going into other factors like project classifications, uncertainty of cash flows, reinvestments of inflows, and other multiple variables. So whenever we are making decisions on selection or rejection of a project it should not be based on DCF techniques. A lot of experience and skill is required to take a rational decision. Simply knowledge of DCF techniques without practical exposure in the relevant field would be like a baby with hammer. Q.4 Economists often define three levels of Market Efficiency. In the first level, prices reflect the information contained in the record of past prices. This is called weak form of efficiency. If the markets are efficient in the weak sense, then it is impossible to make consistently superior profits by studying past returns. Prices will follow a random walk. The second level of efficiency requires that prices reflect not just past prices but all other published information, such as we might get from reading financial press. This is known as semi-strong form of market efficiency. If markets are efficient in this sense, then prices will adjust immediately to public information such as announcement of last quarters earnings, a new issue of stock, a proposal to merge two companies, and so on. Finally, we might envisage a strong form of efficiency, in which prices reflect all the information that can be acquired by the painstaking analysis of the company and the economy. Is such a 24

market we would observe lucky and unlucky investors, but we wouldnt find any superior investment managers who can consistently beat the market. Q.5 Net Lease Payment would be = Rs. 100,000 Rs.35, 000 (35% tax) = Rs.65, 000

Please note the lease payments are made in the beginning of each period so present value of five annual payments should be calculated by using formula of PVA (annuity due). If we use 9% rate the value would be Rs. 275,582. Formula of PVA due: (1+i) n 1 PVA= R or PMT - ------------- (1+i) i (1+i) n (1.09)5-1 PVA = Rs.65, 000 ------------0.09 (1.09)5 ---------------------------------------------------------------Q.6 Call Option: A contract that gives the holder the rights to purchase a specified quantity of the underlying asset at a predetermined price on or before a fixed expiration date. The price at which the shares can be purchased is referred to as the exercise or strike price of the option. Typically one option gives you the right to purchase 100 shares. European options differ from American options in than European options can only be exercised on the expiration date. American options can be exercised any time up to the expiration date. If investors purchase a call option, they are anticipating the price of the underlying stock will increase. Through the purchase of an option they ensure that they can purchase shares at a price that will be below their forecasted market price at the date they exercise the option. If the marker price of underlying shares is below or equal to the option strike price, the purchaser will let the option expire without exercising it. The most that a purchaser will lose by purchasing a call option is the price paid for the option. Gains/Losses on Call Options: Lets assume you have purchased a call option for $100. The agreed exercise or strike price is $45 per share. Remember a call option gives the right to purchase 100 shares of underlying stock. (1.09) = Rs, 275,582 =

25

Now we assume that the market price of the underlying share increases to $50, you will have a profit if you decide to exercise your option. The gain is calculated as the difference between the market price of the shares and the strike price multiplied by 100 shares less the cost of option as per calculated below: $50-$45 X 100- $100= $400 if the market price of shares is equal to or less than the strike price, the amount of loss incurred by you is simply the option price of $100, Put Option: A contract that gives the holder the right to sell a specified quantity of the underlying asset at a predetermined price on or before a fixed expiration date. If investors purchase a put option, they are anticipating the price of the underlying stock will decline. Through the purchase of an option they ensure that they can sell shares at a price that will be greater their forecasted market price at the date they exercise the option. If the marker price of underlying shares is greater than or equal to the option strike price, the purchaser will let the option expire without exercising it. The most that a purchaser will lose by purchasing a call option is the price paid for the option. Gains/Losses on Put Options: Lets assume you have purchased a put option for $100. The agreed exercise or strike price is $45 per share. Remember a put option gives the right to sell 100 shares of underlying stock. Now we assume that the market price of the underlying share decreases to $41, you will have a profit if you decide to exercise your option. The gain is calculated as the difference between the strike price of the shares and the market price multiplied by 100 shares less the cost of option as per calculated below: $45-$41 X 100- $100= $300 if the market price of shares is equal to or greater than the strike price, the amount of loss incurred by you is simply the option price of $100, One important item to note about options is that they are not used to raise capital for a company, as the company whose stock are contracted for does not participate in the option contract no does it receive any funds as a result of the option contract or option exercise. Options are attractive to investors as a means of protecting their investment positions. Q.7 Leases come in many forms, but in all cases the lessee (user) promises to make a series

of payments to the lessor (owner). The lease contract specifies the monthly or semi-annually 26

payments, with the first payment usually due as soon as the contract is signed. The payments are usually level, but their time pattern can be tailored to the user needs. When a lease is terminated, the leased equipment reverts to the lessor. However, the lease agreement often gives the user the option to purchase the equipment by making payment of agreed residual value. A lease is a contract. By its terms the owner of an asset (the lessor) gives another party (the lessee) the exclusive right to use the asset, for a specified period of time, in return for the payment of rent. Recent decades have seen an enormous growth in the leasing of business assets such as cars and trucks, computers, machinery and even manufacturing plants. An obvious advantage to the lessee is the use of an asset without having to buy it. For this advantage, the lessee incurs several obligations. First and foremost is the obligation to make periodic lease payments, usually, monthly or quarterly. Also the lease contract specifies who is to maintain the asset. Under full-service (or maintenance lease), the lessor promises to maintain and insure the asset and to pay any property taxes due on it. Under a net lease, the lessee agrees to maintain the asset, insure it, and pay any property taxes. Financial leases are usually net leases. The lease may be cancelable of non-cancelable. An operating lease for office space, for example, is relatively, short-term and is often cancelable at the option of the lessee with proper notice. The term of this type of lease is shorter than the assets economic life. Other examples of operating leases include the leasing of copying machines, certain computer hardware, and automobiles. In contrast, financial leases extend most of the estimated economic life of the asset and cannot be cancelled at the option of the lessee. The lessee is obligated to make lease payments until the lease expiration which generally corresponds to the useful life of the asset. These payments not only amortize the cost of the asset but provide the lessor an interest thereon. Financial leases are also known as capital or full pay-out lease. Most financial leases are arranged for brand new assets. The lessee identifies the equipment, arranges for leasing company to buy it from the manufacturer, and signs a contract with the leasing company. This called a direct lease.

27

In other cases, the firm sells an asset it already owns and gets it on lease from the buyers. These sale and lease-back arrangements are common in real estate. A special form of leasing has become popular in financing of big-ticket assets such as aircrafts, oilrigs, and railway equipment. This device is known as leveraged leasing. The lessor borrows part of the purchase price of the leased asset, using the lease contract as security for the repayment of loan. There are three parties in a leveraged leasing: (1) the lessee, (2) the lessor (or equity participant), and the lender. From the standpoint of lessee, there is no difference between a leveraged lease and other type of lease. Q.8 We make Income Statement assuming the companys sales would increase by 10% and all Income Statement For the Year ending December 31, 2009 Sales: Gross Profit: Rs.4, 400 (10% increase) 3, 850 (87.5% of Sales as before) Rs. 550 (12.5% of Sales as before)

other items increase correspondently.

Cost & Expenses including interest:

We have to calculate rate of growth by using growth retention formula: g = b (r) where b = retention ratio and r = Return of Equity

Retention Ratio = 1 - payout ratio = 50% g = 0.50 (0.25) = 0.125 or 12.5% g = 0.50 (0.275) = 0.1375 or 13.75%

28