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Assignment 1: LU 1 - LU 4

1. What are the basic financial decisions? How do they involve risk return trade-off? Capital budgeting (Investing)Decision Capital Structure (Financing) Decision Working Capital Management Decision Liquidity Decision

Refer to your class notes!

2. What is dealer market? How do dealer and auction markets differ?

The financial markets are composed of the money market and the capital market. Money markets are the markets for debt securities that will pay off in the short term (usually less than one year). Capital markets are the markets for long-term debt (with a maturity of over one year) and for equity shares. The term money market applies to a group of loosely connected markets. They are dealer markets: the market for traders who are trading on their own accounts, as opposed to traders to conduct transactions on behalf of clients. Dealer markets exist to create the greatest liquidity possible for other transactions. One of the most prominent dealer markets is NASDAQ.

Dealers are firms that make continuous quotations of prices for which they stand ready to buy and sell money market instruments for their own inventory and at their own risk. This is different from a stockbroker acting as an agent for a customer in buying or selling shares on most stock exchanges; an agent does not actually acquire the securities.

Following figure shows and example of a dealer market:

Dealer market

Trader A - Sells to dealer for 100- Dealer makes a 10 profit

Dealer Sells to Trader B for 110

Trader B- Trader A receives 100- Trader B pays 110

Dealer earns 10 in profit

In the dealer market, the dealer bears the risk of holding the shares before he can find a counterparty to buy them. In Figure, the dealer finds someone to buy the shares at 110. However, if they are unable to locate counterparty, they may end up with shares that are less than the value at which they were purchased (100). This is known as inventory risk, and constitutes a cost to the dealer. The difference between the dealers buying and selling price is known as the bid-ask spread, which in this case is 10.

Dealer versus Auction Markets

There are two kinds of secondary markets: dealer markets and auction markets. While stock exchange is the part of an auction market, Over-the-Counter (OTC) is a part of the dealer market.

Dealers buy and sell for themselves, at their own risk. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold.

Auction markets differ from dealer markets in two ways. First, an auction market or exchange has a physical location (such as Wall Street in New York). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers thus play a limited role.

3. Annapurna Distillery has sales of $600 and $300 respectively. Depreciation is $150 and interest paid is $30. Taxes were calculated at a straight 34%. Dividends were $30(all figures are in millions of dollars). Calculate the operating cash flow for Annapurna Distillery. Why is it different from net income?

Annapurna Distillery Income Statement Net sales: Less: Depreciation: $ 900 150

EBIT Less: Interest paid

$750 30

Taxable Income Less: Taxes Net Income

$720 245 $475

Dividends Addition to Retained Earnings

$30 445

The net income of Annapurna Distillery is $ 475 and referring to the information stated above, we have:

EBIT + Depreciation - Taxes Operating Cash Flow

$ 750 150 245 $655

As the example illustrates, the operating cash flow is not the same as net income, because depreciation and interest are subtracted out when net income is calculated.

4. Calculate the present value of Rs. 600 received (assume a 5% time preference rate). a. one year from now b. at the end of twenty years.

a. The present value factor at 5% for one year is: 0.952. Therefore, PV of Rs. 600 at the end of one year will be: 600* 0.952= Rs. 571.20 b. The present value factor at 5% for twenty years is: 0.377. Therefore, PV of Rs. 600 at the end of twenty years will be: 600* 0.377= Rs. 226.20

5. Assuming a 10% discount rate, compute the present value of Rs. 1100, Rs. 900, Rs. 1500 and Rs. 700 received at the end of one through four years. The present value at 10% for the stated amount of cash flow will be: Rs (1100*0.909+ 900*0.826+ 1500*0.751+ 700*0.683) = Rs (999.90+743.40+1126.50+478.10) = Rs. 3,347.90