Financial management practices question Essay
Refer to Unit Plan, brief the students on learning objectives and learning outcomes of this unit. Refer to Unit Plan, remind students on coursework assessment (mid-term test 1 and 2). Mid-Term Test 1 will be given in WEEK 5 to monitor students’ progress on the understanding of the lectures and tutorials from Topic 1 to 3. Mid Tem test 2 will be given in WEEK 9 to monitor students’ progress on the understanding of the lectures and tutorials from Topic 4 to 7. The duration of each test will be forty five (45) minutes (30 multiple-choice questions and 3 subjective questions). The attendances for these tests are compulsory. All questions are to be answered. The examination is CLOSED BOOK. Inform the students that they need to prepare and answer all the tutorial questions before they attend tutorial class. Students are required to present their answers to tutorial questions. Poor presentation and insufficient efforts in preparation will result in penalty marks deducted from mid term examination at the discretion of lecturer and tutor. Tutorial 2 (Topic 1)
An Introduction to Financial Management
Identify the primary characteristics of each form of legal organization. (a) sole proprietor; (b) partnership; (c) corporation
Using the following criteria, specify the legal form of business that is favoured: (a)organizational requirements and costs
(b)liability of the owners
(c)continuity of business
(d)transferability of ownership
(e)management control and regulations
(f)ability to raise capital
What are some of the problems involved in the use of profit maximization as the goal of the firm? How does the goal of maximization of shareholder wealth deal with those problems?
Describe the primary role of a Financial Manager within a firm.
Firms often involve themselves in projects that do not result directly in profits; for example, Maxis and Magnum frequently support public television broadcasts. Do these projects contradict the goal of maximization of shareholder wealth? Why or why not?
What is agency cost? Provide two examples of agency costs.
Maximising share price does not make sense because investors focus on short-term results rather than long-term consequences. Comment.
Discuss four (4) stakeholders to a firm, excluding its owners.
Refer to Exercise E1-3 (page 35) in Gitman (2009) Principles of Managerial Finance (12th ed.).
Refer to Exercise E1-4 (page 35) in Gitman (2009) Principles of Managerial
Finance (12th ed.). Tutorial 3 (Topic 2)
Financial Statements Analysis and Cash Flows
Using J. B. Chavez Corporation’s financial statements:
(a)Compute the following ratios for both 2008 and 2009.
Acid-test (quick ) ratio
Average collection period
Times interest earned
Total asset turnover
Fixed asset turnover
Operating profit margin
Operating income return on investment
Return on common equity
(b)How liquid is the firm?
(c)Is management generating adequate operating profit on the firm’s assets? (d)How is the firm financing its assets?
(e)Are the common stockholders receiving a good return on their investment?
J.B. Chavez Corporation, Balance Sheet at 31/12/2008 and 31/12/2009 Assets
Notes payable – current (9%)
Plant and equipment
Net plant and equipment
Total owners’ equity
Total liabilities and
J.B. Chavez Corporation, Income Statement for the Years Ending 31/12/2008 and 31/12/2009
Cost of goods sold
Net operating income
Net income before taxes
The annual sales for Salco Inc., were $4.5 million last year. The firm’s end-of-year balance sheet appeared as follows:
Current Assets$ 500,000Liabilities$1,000,000
Net Fixed Assets$1,500,000Owners’ Equity$1,000,000
The firm’s income statement for the year was as follows:
Less: Cost of goods sold($3,500,000)
Gross profit $1,000,000
Less: Operating expenses($ 500,000)
Operating income $ 500,000
Less: Interest expense($ 100,000)
Earnings before taxes $ 400,000
Less: Taxes (50%)($ 200,000)
Net Income $ 200,000
(a) Calculate Salco’s total asset turnover, operating profit margin and operating income return on investment. (b)Salco plans to renovate one of its plants, which will require an added investment in plant and equipment of $1 million. The firm will maintain its present debt ratio of 0.5 when financing the new investment and expects sales to remain constant, while the operating profit margin will rise to 13 percent. What will be the new operating income return on investment for Salco after the plant renovation? (c)Given that the plant renovation in part (b) occurs and Salco’s interest expense rises by $50,000 per year, what will be the return earned on the common stockholders’ investment? Compare this rate of return with that earned before the renovation.
The new owners of Bluegrass Natural Foods, Inc., have hired you to help them diagnose and cure problems that the company has had in maintaining adequate liquidity. As a first step, you perform a liquidity analysis. You then do an analysis of the company’s short-term activity ratios. Your calculations and appropriate industry norms are listed. Ratio
Average collection period
Average payment period
(a)What recommendations relative to the amount and the handling of inventory could you make to the new owner? (b)What recommendations relative to amount and handling of accounts receivable could you make to the new owners? (c)What recommendations relative to amount and handling of accounts payable could you make to the new owners? (d)What results, overall, would you hope your recommendations would achieve? Why might your recommendations not be effective?
Robert Arias recently inherited a stock portfolio from his uncle. Wishing to learn more about the companies that he is now invested in, Robert performs a ratio analysis on each one and decides to compare them to each other. Some of his ratios are listed below.
Net profit margin
Assuming that his uncle was a wise investor who assembled the portfolio with care, Robert finds the wide differences in these ratios confusing. Help him out. (a)What problems might Robert encounter in comparing these companies to one another on the basis of their ratios? (b)Why might the current and quick ratios for the electric utility and the fast-food stock be so much lower than the same ratios for the other companies? (c)Why might it be all right for the electric utility to carry a large amount of debt, but not the
software company? (d)Why wouldn’t investors invest all of their money in software companies instead of in less profitable companies? (Focus on risk and return.)
Refer to Problem P3-9 (page 142) in Gitman (2009) Principles of Managerial Finance (12th ed.).
Refer to Problem P3-6 (page 140-141) in Gitman (2009) Principles of Managerial Finance (12th ed.).
What is net working capital? How is it different from gross working capital? What is the difference between interest-bearing debt and non-interest-bearing debt?
Discuss the reasons why one firm could have positive cash flows and be headed for financial trouble, and another firm with negative cash flows could actually be in a good financial position.
(a)Current ratio shows the ability of the company to meet its short-term obligations when due. The higher the current ratio, the better it is. Discuss. (b)Differentiate between ‘overtrading’ and ‘overcapitalisation’. Which financial ratios could signal these conditions?
Explain five (5) limitations of financial ratio analysis. Give example to illustrate whenever appropriate.
(a)Describe the use of DuPont analysis.
(b)Is it possible for a company to have an increase in operating income
return on investment when its operating profit margin is reducing? Explain.
Explain the term ‘free cash flows’. Briefly explain how to calculate free cash flows from asset perspective. Tutorial 4 (Topic 3)
Sources of Finance
(a)Describe the key role of a financial market and how an economy might lose out when its financial markets are not developed. (b)Explain and discuss how corporations raise capital in the financial markets. (c)What is an investment banker, and what major functions does he or she perform?
(a)Differentiate the following terms:
(i)Primary market and Secondary market
(ii)Initial Public Offering and Seasoned Offering
(b)Why might a large corporation want to raise long-term capital through a private placement rather than a public offering?
Briefly explain disadvantages for firms to go public.
Name two regulatory bodies that supervise and manage the local securities industry in Malaysia. Support your answers with their core functions.
Briefly describe four money market instruments traded in Malaysia.
Identify three distinct ways that savings are ultimately transferred to business firms in need of cash.
Nemo Berhad has 18 million RM0.50 ordinary shares in issue. The current market value of its shares is RM1.70 per share. The directors have decided to announce a one for three rights issue at RM1.25 each. Suppose you hold 3,000 shares of this firm. (a) What, in theory, will be the ex-rights price of the shares? (b) If you wish to sell the rights off, how much could you ask for each? (c)Will it matter to you, if you allow the rights to lapse? Why or why not? Show with computations. (d) Explain any two (2) factors considered in respect to rights issues.
Endo Berhad currently has 4 million shares issued and outstanding, valued at RM2.00 each, and the company has annual earnings equal to 20% of the market value of the shares. A two for five rights issue is proposed at an issue price of RM1.65 each. If the market continues to value the shares on a price/earnings ratio of 5, what would be the value per share if the new funds are expected to earn, as a percentage of the money raised: (i) 15%, (ii) 20%, and (iii) 25%. How would these values from (i), (ii) and (iii) compare with the theoretical ex-rights price? Explain the differences.
Nakamura Berhad is proposing to raise RM25,000,000 from a private placement of new shares to finance its new investment projects. Its floating and issuing costs will be 5% of the gross receipts. The company already has 6,000,000 shares issued and outstanding. The company expected to earn post tax profits of RM3,000,000 from existing operations, plus a 10% post-tax return from the newly-raised funds. Similar businesses in its industry have a P/E ratio of 8. For the placement to be successfully accepted, Nakamura Berhad would have to issue shares at 10% discount to what it considers the market value of the shares ought to be. Calculate a suitable issue price for shares and the number of shares that would have to be issued. What will happen if the issue price is set too low or too high?
Tutorial 5 (Topic 4)
Time Value of Money
As finance manager of Lions Ltd., you are given three investment alternatives to analyze. The cash flows from these three investments are as follows:
END OF YEAR
Assume a 20 percent discount rate. Find the present value of each investment.
Find net present value of an investment that yield the following cash flows: Year 1 to 3: – RM 50,000 per annum
Year 4 until forever: RM 28,000 per annum
Cost of capital for the company is maintained at 12.5% per annum. Should the investment be undertaken?
You are trying to plan for retirement in 10 years and currently you have $100,000 in a savings account and $300,000 in stocks. In addition, you plan to add to your savings by depositing $10,000 per year in your savings account at the end of each of the next five years and then $20,000 per year at the end of each year for the final five years until retirement. (a)Assuming your savings account returns 7 percent compounded annually and your investment in stocks will return 12 percent compounded annually, how much will you have at the end of 10 years? (Ignore taxation). (b)If you expect to live for 20 years after retirement, and at retirement you deposit all of your savings in a bank account paying 10 percent, how much can you withdraw each year after retirement (20 equal withdrawals beginning one year after you retire) to end up with a zero balance at death?
(a)What is time value of money? Why is it important?
(b)How would an increase in the interest rate (i) or a decrease in the holding period (n) affect the future value (FVn) of a sum of money? Explain why. (c)Given a discount rate, future value of a sum of money rises at an increasing rate as time period becomes longer, whereas present value of a sum of money falls at a decreasing rate as time period becomes longer. Explain. (d)What is an annuity? Give some examples of annuities? Distinguish between an annuity and perpetuity.
Hishamuddin wants to buy a house in 2 years, that is expected to cost RM200,000 at that time. He wants to fund with a housing loan but he can afford payments of only RM1,000 per month on a 30 years, 9% loan. He currently has RM20,000 in a fixed deposit account that pay 6% compounded monthly. Calculate how much more cash he needs to pay as down payment.
(Use financial calculator for this question. Show input keyed into the financial calculator) Upon retirement, your goal is to spend 5 years traveling around the world. To travel in style will require RM 250,000 per year at the beginning of each year. If you plan to retire in 30 years from today, what are the equal monthly payments necessary to achieve this goal? The funds in your retirement account will compound annually at 10%.
Refer to Problem P4-27 (page 212-213) in Gitman (2009) Principles of Managerial Finance (12th ed.). Only attempt for Stream A and Stream B.
Refer to Problem P4-34 (page 215) in Gitman (2009) Principles of Managerial Finance (12th ed.). Only attempt for part(b) 16% annual interest for 6 years.
Tutorial 6 (Topic 5)
Risk and Return
Three assets – F, G, and H – are currently being considered by Perth Industries. The probability distributions of expected returns for these assets are shown in the following table.
(a)Calculate the expected value of return, , for each of the three assets. Which provides the largest expected return? (b)Calculate the standard
deviation, ?k, for each of the three assets’ returns. Which appears to have the greatest risk? (c)Calculate the coefficient of variation, CV, for each of the three assets’ returns. Which appears to have the greatest relative risk?
A multinational company is thinking of investing in two overseas locations for a planned expansion of its production facilities. The future returns from the investments depend to a large extent on the economic situation of the countries under consideration. An analysis of the expected rates of return under three different scenarios is as follows: Probability
Expected return of country A
Expected return of country B
(a)Calculate the mean return and the standard deviation of the returns from the investment in each country. (b)What would be the expected return and standard deviation of the portfolio if the available funds were split 20% to country A and 80% to country B, and the correlation between returns of the two countries are: (i) 0
Colours Plc. is considering two mutually exclusive investments: Black and
White. The possible net present values for both projects and the associated probabilities are as follows: BLACK
RM 10 million
RM 15 million
RM 20 million
RM 20 million
RM 25 million
RM 40 million
(a)Determine the levels of risk of each investment project in RM terms. (b)Assuming, the management is risk averse, justify the investment it should accept.
Alternatively, the firm has an opportunity to invest in two overseas locations for a planned expansion of its production facilities. The future returns from the investments depend to a large extent on the economic situation of the countries under consideration. An analysis of the expected rates of return under three different scenarios is as follows: Probability
Expected Return of Region 1
Expected Return of Region 2
*Assume the correlation coefficient between returns from the two countries to be 1.0. (c)What would be the expected return and standard deviation of the portfolio if the available funds were split 60% to Region 1 and 40% to Region 2? (d)Should the firm consider expanding operations in both the regions? Justify.
Mr Rich owns a portfolio consisting shares of five public listed firms. The details of these securities and his asset allocation are provided below: Security
Number of Shares
Market Price per share
The market return is 15% and risk-free investments offer 7%. (a)Calculate the required rate of return for each security in Mr Rich’s portfolio using the Capital Asset Pricing Model. Which securities over-performed? (b)Determine the portfolio beta. Is this portfolio riskier than the market? Justify.
Jamie Peters invested $100,000 to set up the following portfolio one year ago:
(a)Calculate the portfolio beta on the basis of the original cost figures. (b)Calculate the percentage return of each asset in the portfolio for the year. (c)Calculate the percentage return of the portfolio on the basis of original cost, using income and gains during the year. (d)At the time Jamie made his investments, investors were estimating that the market return for the coming year would be 10%. The estimate of the risk-free rate of return averaged 4% for the coming year. Calculate a required rate of return for each stock on the basis of its beta and the expectations of market and risk-free returns. (e)On the basis of the actual results, explain how each stock in the portfolio performed relative to those CAPM-generated required
performance. What factors could explain these differences?
Refer to Problem P5-29 (page 274-275) in Gitman (2009) Principles of Managerial Finance (12th ed.). Question 7
How are total risk, nondiversifiable risk, and diversifiable risk related? Why is nondiversifiable risk the only relevant risk?
(a)What risk does beta measure? How can you find the beta of a portfolio? (b)Define the Security Market Line.
Risk and return are linearly related, but do not necessarily move at the same rate. How then, can different assets be relatively compared?
What impact would the following changes have on the security market line and therefore on the required return for a given level of risk? (a)an increase in inflationary expectations
(b)investors become less risk-averse
Describe any two (2) assumptions of the Capital Asset Pricing Model.
(a)What is price efficiency in the context of stock markets? (b)Elaborate any five implications of market efficiency.
Tutorial 7 (Topic 6 and 7)
Valuation of Bonds and Stocks
Nesta Berhad has a beta of 1.8 and has just paid a dividend of RM0.80 per share. Its dividend is expected to grow at 5% per annum for the foreseeable future. Return on Treasury security is 4% and risk premium for market
portfolio is 10%. Is it worthwhile to purchase Nesta Berhad’s ordinary shares at its current market price of RM5.50 per share?
Dhabi Sdn Bhd paid dividend of RM250,000 this year. Current return to shareholders of companies in the same industry as Dhabi is 12%, although an additional risk premium of 2% is applicable to Dhabi, being a smaller and non-listed company. Dhabi has 1,000,000 authorized ordinary shares, but only 800,000 shares are currently issued and outstanding. What is the fair price for Dhabi’s ordinary shares, if: (a)the current level of dividend is expected to continue for the foreseeable future (b)the dividend is expected to grow at a rate of 4% p.a. into the foreseeable future (c)the dividend is expected to grow at a rate of 3% p.a. for three years, and 2% p.a. thereafter
Home Place Hotels Inc. is entering into a 3-year remodelling and expansion project. The construction will have a limiting effect on earnings during that time, but when it is complete, it should allow the company to enjoy much improved growth in earnings and dividends. Last year, the company paid a dividend of $3.40. It expects zero growth in the next year. In years 2 and 3, 5% growth is expected, and in year 4, 15% growth. In year 5 and thereafter, growth should be a constant 10% per year. What is the maximum price per share that an investor who requires a return of 14% should pay for Home Place Hotels common stock?
Telink Corporation bonds pay $110 in annual coupon interest, with a $1,000 par value. The bonds mature in 20 years. Your required rate of return is 9 percent. (a)Calculate the value of the bond.
(b)How does the value change if
(i)your required rate of return (k) increases to 12 percent, or
(ii)decreses to 6 percent
(c)Interpret your findings in part (a) and (b).
Calculate the yield-to-maturity (YTM) and current yield for each of the bonds below: Bond
Coupon rate (%)
Years to maturity
(Note: For YTM calculation, use the approximate formula)
Barry Ltd issues 7.5% convertible bond that can be converted into 400 ordinary shares in 3 years time or redeem at par of $1,000 on the same date. Debt holders required rate of return is 9% per annum. What is the fair market price of the convertible bond if: (a)current market price of ordinary share is $2.00 and is expected to grow at 5% per annum (b)expected market price for ordinary share is $2.60 three years from today
Refer to Problem P7-16 (page 368) in Gitman (2009) Principles of Managerial
Finance (12th ed.).
Refer to Problem P6-19 (page 322) in Gitman (2009) Principles of Managerial Finance (12th ed.).
An analyst applies the price/ earnings (P/E ratio) multiples rather than the discounted cash flow valuation method because of the assumptions about the fundamentals of growth, risk and payout ratios. Are these two methods similar? Explain.
State four (4) factors that might cause the market value of an asset to deviate from its book value.
What is ‘term structure of interest rates’?
What are the term structure theories that explain an upward sloping yield curve? Tutorial 8 (Topic 8)
Cost of Capital
Ruffles Incorporated reported net earnings of RM4.2 million last year. It paid a dividend of RM1.26 per share for the 1 million shares outstanding. The firm’s capital structure includes 40% debt and 60% common share. The tax rate is 28%. (a)If Ruffles shares are trading at RM40 and dividends are expected to grow at 6%, determine the cost of financing with retained earnings. (b)If underwriting and floatation costs are RM7.00 per share, what is the cost of issuing new shares to the firm? (c)The firm can issue 10%, 5- year bonds at a premium at RM1,200 each. What is the cost of debt financing, if floatation cost is RM25 per bond? Face value of the bond is RM1,000 each. (Note: use trial and error method to find yield to maturity) (d)Calculate Ruffles Inc.’s weighted average cost of capital? (e)What is the maximum investment the firm can make before it issues new shares? What
is the weighted cost of capital if Ruffles Inc. wish to invest beyond this maxium amount of total capital?
As the Finance Director for Ginger Bread Berhad, you have been asked to estimate the firm’s weighted average cost of capital. Using the information below, perform the necessary calculations, using market values. Capital Structure:
11% bonds (redeemable in 5 years) RM80,000
*Ordinary Shares (RM0.25 par) RM90,000
**9% Preference Shares (RM1 par) RM50,000
Retained Earnings RM145,000
Note: The above are all in book values.
? Current dividend, to be paid soon is RM0.20 per share. Dividends are expected to grow at 5% per year. 1 ? The interest rate on short-term bank borrowings stands at 12.6%. ? Stock market prices as at 30 June 2007 (all ex-dividend); *RM1.76 and **RM0.67 respectively. ? Bond market price as at the 30 June 2007 (all ex-interest); RM950. Assume a corporate tax of 28%.
The capital structure for Nealon, Inc., follows:
Nelaon, Inc., Balance Sheet
Type of financing
Percentage of future financing
Bonds (8%, $1,000 par, 16-year maturity)
Preferred stock (5,000 shares outstanding, $50 par, $1.50 dividend) 15%
Floatation costs are (a) 15 percent of market value for a new bond issue, (b)
$1.21 per share for common stock, and (c) $2.01 per share for preferred stock. The dividends for common stock were $2.50 last year and are projected to have an annual growth rate of 6 percent. The firm is in a 34 percent tax bracket.
Market prices are $1,035 for bonds, $19 for preferred stock, and $35 for common stock. There will be sufficient internal common equity funding (i.e., retained earnings) available such that the firm does not plan to issue new common stocks.
What is the weighted average cost of capital if the firm financing are in the above mentioned proportions?
Dillon Labs has asked its financial manager to measure the cost of each specific type of capital as well as the weighted average cost of capital. The weighted average cost is to be measured by using the following weights: 40% long-term debt, 10% preferred stock, and 50% common stock equity (retained earnings, new common stock, or both). The firm’s tax rate is 40%.
Debt The firm can sell for $980 a 10-year,$1,000-par-value bond paying annual interest at a 10% coupon rate. A floatation cost of 3% of the par value is required in addition to the discount of $20 per bond.
Preferred stock Eight percent (annual dividend) preferred stock having a par value of $100 can be sold for $65. An additional fee of $2 per share must be paid to the underwriters.
Common stockThe firm’s common stock is currently selling for $50 per share. The dividend expected to be paid at the end of the coming year (2009) is $4. Its dividend payments, which have been approximately 60% of earnings per share in each of the past 5 years, were as shown in the following table.
It is expected that in order to sell, new common stock must be underpriced $5 per share, and the firm must also pay $3 per share in floatation costs. Dividend payments are expected to continue at 60% of earnings. (a) Calculate the specific cost of each source of financing. (b)If earnings available to common shareholders are expected to be $7 million, what is the break point associated with the exhaustion of retained earnings? (c)Determine the weighted average cost of capital between zero and the break point calculated in part b. (d)Determine the weighted average cost of capital just beyond the break point calculated in part (b).
Using the data for each firm shown in the following table, calculate the cost of retained earnings and the cost of new common stock using the constant-growth valuation model.
Current market price per share
Dividend growth rate
Projected dividend per share next year
Underpricing per share
Floatation cost per share
Federico Berhad has the following capital structure:
Book ValueMarket Value
New corporate bonds can be issued at par if they have a coupon of 7%. The current yield on newly-issued preferred stock is 6%. Risk free rate is 3% and market risk premium is 5%. If Federico Berhad has a stock beta of 2.0 and a corporate tax of 25%, what is the company’s weighted average cost of capital?
(a)How does a firm’s tax rate affect its cost of capital? What is the effect
of the floatation costs associated with a new security issue? (b)Distinguish between internal and external equity. Why is there a cost associated with internal equity?
(a)Why is it crucial for a firm to calculate its cost of capital accurately? (b)Briefly discuss the Modigliani-Miller Proposition 1.
Tutorial 9 (Topic 9)
Analysis and Impact of Leverage
Famous Caterer Berhad (FCB) has an expected sales of RM20 million. Fixed operating costs are RM2.5 million, and the variable cost ratio is 65%. It has an outstanding RM12 million, 8% bank loan and an outstanding shares of 1 million ordinary shares (RM1 par). Assume corporate tax rate is 28%. (a)What is FCB’s degree of operating leverage at a sales level of RM20 million? (b) What is FCB’s current degree of financial leverage? (c) What is the combined leverage of FCB?
(d) Forecast FCB’s earnings per share if sales drop to RM15 million. (e)What information does the degree of financial leverage provide in decision making?
Footwear, Inc., manufactures a complete line of men’s and women’s shoes for independent merchants. The average selling price of its finished product is $85 per pair. The variable cost for this same pair of shoes is $58. Footwear, Inc., incurs fixed costs of $170,000 per year. (a)What is the break-even point in pairs of shoes for the company? (b)What is the dollar sales volume the firm must achieve to reach the break-even point? (c)What would be the firm’s profit or loss at the following units of production sold: 7,000 pairs of shoes? 9,000 pairs of shoes? 15,000 pairs of shoes? (d)Find the degree of operating leverage for the production and sales levels given in the part (c).
Northwestern Savings and Loan has a current capital structure consisting of $250,000 of 16% (annual interest) debt and 2,000 shares of common stock. The firm pays taxes at the rate of 40%. (a)Using EBIT values of $80,000 and $120,000, determine the associated earnings per share (EPS). (b)Using $80,000 of EBIT as a base, calculate the degree of financial leverage (DFL). (c)Rework parts (a) and (b) assuming that the firm has $100,000 of 16% (annual interest) debt and 3,000 shares of common stock.
Discuss factors that influence business risk of a firm.
(a)Distinguish between business risk and financial risk. What gives rise to, or causes, each type of risk? (b)What are business risk and financial risk? How does each of them influence the firm’s capital structure decisions?
A manager in your firm decides to employ break-even analysis. Of what shortcomings should this manager be aware?
Tutorial 10 (Topic 10)
Capital Budgeting Cash Flows
(a)Why do we focus on cash flows rather than accounting profits in making our capital-budgeting decisions? Why are we interested only in incremental cash flows rather than total cash flows? (b)How do sunk costs affect the determination of cash flows associated with an investment proposal?
Garcia’s Truckin’ Inc. is considering the purchase of a new production machine for $200,000. The purchase of this machine will result in an increase in earnings before interest and taxes of $50,000 per year. To operate this machine properly, workers would have to go through a brief
training session that would cost $5,000 after tax. In addition, it would cost $5,000 after tax to install this machine properly. Also, because this machine is extremely efficient, its purchase would necessitate an increase in inventory of $20,000. This machine has an expected life of 10 years, after which it will have no salvage value. Finally, to purchase the new machine, it appears that the firm would have to borrow $100,000 at 8 percent interest from its local banks, resulting in additional interest payments of $8,000 per year. Assume simplified straight-line depreciation and that this machine is being depreciated down to zero, a 34 percent marginal tax, and a required rate of return of 10 percent. (a)What is the initial outlay associated with this project? (b)What are the annual after-tax cash flows associated with this project for years 1 through 9? (c)What is the terminal cash flow in year 10 (what is the annual after-tax cash flow in year 10 plus any additional cash flows associated with termination of the project)? (d)Should this machine be purchased?
A firm is considering the following three separate situations. Situation ABuild either a small office building or a convenience store on a parcel of land located in a high-traffic area. Adequate funding is available, and both projects are known to be acceptable. The office building requires an initial investment of $620,000 and is expected to provide operating cash inflows of $40,000 per year for 20 years. The convenience store is expected to cost $500,000 and to provide a growing stream of operating cash inflows over its 20-year life. The initial operating cash inflow is $20,000, and it will increase by 5% each year. Situation BReplace a machine with a new one that requires a $60,000 initial investment and will provide operating cash inflows of $10,000 per year for the first 5 years. At the end of year 5, a machine overhaul costing $20,000 will be required. After it is completed, expected operating cash inflows will be $10,000 in year 6; $7,000 in year 7; $4,000 in year 8; and $1,000 in year 9, at the end of which the machine will be scrapped. Situation CInvest in any or all of the four machines whose relevant cash flows are given in the following table. The firm has $500,000 budgeted to fund these machines, all of which are known to be acceptable. Initial investment for each machine is $250,000.
Operating cash inflows
For each situation, indicate:
(a)Whether the projects involved are independent or mutually exclusive.
(b)Whether the availability of funds is unlimited or capital rationing exists. (c)Whether accept-reject or ranking decisions are required. (d)Whether each project’s cash flows are conventional or nonconventional.
Covol Industries is developing the relevant cash flows associated with the proposed replacement of an existing machine tool with a new, technologically advanced one. Given the following costs related to the proposed project, explain whether each would be treated as a sunk cost or an opportunity cost in developing the relevant cash flows associated with the proposed replacement decision. (a)Covol would be able to use the same tooling, which had a book value of $40,000, on the new machine toll as it had used on the old one. (b)Covol would be able to use its existing computer system to develop programs for operating the new machine tool. The old machine tool did not require these programs. Although the firm’s computer has excess capacity available, the capacity could be leased to another firm for an annual fee of $17,000. (c)Covol would have to obtain additional floor space to accommodate the larger new machine tool. The space that would be used is currently being leased to another company for $10,000 per year. (d)Covol would use a small storage facility to store the increased output of the new machine tool. The storage facility was built by Covol 3 years earlier at a cost of $120,000. Because of its unique configuration and location, it is currently of no use to either Covol or any other firm. (e)Covol would retain an existing overhead crane, which it had planned to sell for its $180,000 market value. Although the crane was not needed with the old machine tool, it would be used to position raw materials on the new machine tool.
(a)If depreciation is not a cash flow item, why does it affect the level of cash flows from a project in any way? (b)What effect do sunk costs and opportunity costs have on a project’s incremental cash flows?
What are the common reasons for capital rationing? Is capital rationing
DuPree Coffee Roasters, Inc., wishes to expand and modernize its facilities. The installed cost of a proposed computer-controlled automatic-feed roaster will be $130,000. The firm has a chance to sell its 4-year-old roaster for $35,000. The existing roaster originally cost $61,000 and was being depreciated using MACRS and a 7-year recovery period. (Table 1) DuPree pays taxes at a rate of 40% on ordinary income and capital gains. (a)What is the net book value of the existing roaster?
(b)Calculate the after-tax proceeds of the sale of the existing roaster.
(c)Calculate the change in net working capital using the following figures: Anticipated Changes in Current Assets and Current Liabilities Accruals
(d)Calculate the initial investment associated with the proposed new roaster.
Tutorial 11 (Topic 11)
Capital Budgeting Techniques
Clean & Clear Berhad is considering to invest in a developmental research project. The investment opportunities Project A and Project B, are mutually exclusive and have the following estimated cash flows Year
(a)Compute the internal rates of returns for both the projects using trial and error approach. (b)Compute the net present value of both projects given a 10% cost of capital for the firm. (c) If the firm is able to reinvest the cash flows from the projects and earn a 10% annual rate of return, which project has the highest expected rate of return? (d) Which project should the firm adopt? Why?
Healthy Food Inc. is considering switching its manually operated machine with a new automated machine. Although the existing unit has 5 more years of service life, its operating costs are fairly high compared to its revenue. The new automated machine costs RM2.5 million. An additional RM100,000 is needed for transportation and installation. The new machine is expected to generate incremental revenues of RM2 million with an incremental overhead cost of RM700,000 per year. It will be depreciated on a straight line method over 5 years to a salvage value of RM200,000. (a)Define the three basic cash flows involved in a typical capital budget. Is the above investment a
replacement or an expansionary project? Justify. (b) If the firm’s cost of capital is 12%, calculate the following: (i) Payback period
(ii) Net Present Value
(iii) Internal Rate of Return (using trial and error approach) (c)Advice the management on whether it should go ahead with this investment or not. Justify.
Cure Berhad, a leading pharmaceutical firm
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Assets (RM’ million)Liability (RM’ million)
Fixed 4,000 Long-term debt 2,500
Current 1,000 Equity 2,500
Total 5,000 Total 5,000
• The debt is in the form of bonds, with coupon rate of 10%. These bonds are yielding 12% return. The market value is 80% of the face value. • The firm currently has 50 million shares outstanding which is trading at RM80 per share. It pays a dividend of RM4 per share and has a price/earning ratio of 10. • The firm has a beta of 1.2 and Treasury bill offers 8%. Market risk premium is 5.5%. • The tax rate is 28%.
(a)What is the debt/equity ratio for this firm in book value terms? Why does it differ when the ratio is in market value terms? (b)Determine the firm’s current weighted average cost of capital.
Now assume that Cure Berhad is considering an investment project costing RM100 million that has the following estimated annual income statement: EBIT RM20.00 million
Interest RM 4.00 million
EBT RM16.00 million
Taxes RM 4.48 million
Net Income RM11.52 million
Depreciation for this project is expected to be RM5 million a year to perpetuity. Assume cash flow is also for perpetuity. (c)Evaluate this proposal from the shareholders standpoint. (d)Evaluate this proposal from the firm’s standpoint.
(a)What is the fundamental flaw of using the internal rate of return in making investment decisions? (b)Payback period is an appraisal technique that ignores the concept of time value of money. How can it be adjusted for use as an investment decision-making tool?
When might two mutually exclusive projects having unequal lives be incomparable? How should managers deal with this problem?
The B.T.Knight Corporation is considering two mutually exclusive pieces of machinery that perform the same task. The two alternatives available provide the following set of after-tax net cash flow. YEAR
Equipment A has an expected life of three years, whereas equipment B has an expected life of nine years. Assume a required rate of return of 15 percent. (a)Calculate each project’s net present value.
(b)Are these projects comparable?
(c)Compare these projects using replacement chains and EAAs. Which project should be selected? Support your recommendation.
Tutorial 12 (Topic 12)
(a)What is meant by the term dividend payout ratio?
(b)What is the residual dividend theory? Why is this theory operational only in the long term?
(a)Why is stable dollar dividend policy popular from the viewpoint of the corporation? (b)Is it also popular with investors? Why?
What is the logic behind repurchasing shares of common stock to distribute excess cash to the firm’s owner?
The Howe Company’s stockholders’ equity account is as follows: Common stock (400,000 shares at $4 par)$1,600,000
Paid-in capital in excess of par$1,000,000
Total stockholders’ equity $4,500,000
The earnings available for common stockholders from this period’s operations are $100,000, which have been included as part of the $1.9 million retained earnings. (a)What is the maximum dividend per share that the firm can pay? (Assume that legal capital includes all paid-in capital.) (b)If the firm has $160,000 in cash, what is the largest per-share dividend it can pay without borrowing? (c)Indicate the accounts and changes, if any, that will result if the firm pays the dividends indicated in parts (a) and (b). (d) Indicate the effects of an $80,000 cash dividend on stockholders’ equity.
As president of Young’s of California, a large clothing chain, you have just received a letter from a major stockholder. The stockholder asks you to estimate the amount of the dividend that you are likely to pay next year. You have not yet collected all the information about the expected dividend payment, but you do know the following: (1) The company follows a residual dividend policy.
(2) The total capital budget for next year is likely to be one of three amounts, depending on the results of capital budgeting studies that are currently under way. The capital expenditure amounts are $2million, $3 million, and $4 million. (3) The forecasted level of potential earnings next year is $2 million. (4) The target or optimal capital structure is a debt ratio of 40%.
You have decided to respond by sending the stockholder the best information available to you. (a) Describe a residual dividend policy.
(b)Compute the amount of the dividend (or the amount of new common stock
needed) and the dividend payout ratio for each of the three capital expenditure amounts. (c)Compare, contrast, and discuss the amount of dividends (calculated in part (b) associated with each of the three capital expenditure amounts.
Bennett-Farm Equipment Sales, Inc., is in a highly cyclic business. Although the firm has a target payout ratio of 25%, its board realizes that strict adherence to that ratio would result in fluctuating dividend and create uncertainty for the firm’s stockholders. Therefore, the firm has declared a regular dividend of $0.50 per share per year with extra cash dividends to be paid when earnings justify them. Earnings per share for the last several tears are as follows:
(a)Calculate the payout ratio for each year on the basis of the regular $0.50 dividend and the cited EPS. (b)Calculate the difference between the regular $0.50 dividend and a 25% payout for each year. (c)Bennett has established a policy of paying an extra dividend only when the difference between the regular dividend and a 25% payout amounts to $1.00 or more. Show the regular and extra dividends in those years when an extra dividend would be paid. What would be done with the “extra” in years when an extra dividend
is not paid? (d)The firm expects that future earnings per share will continue to cycle but will remain above $2.20 per share in most years. What factors should be considered in making a revision to the amount paid as a regular dividend? If the firm revises the regular dividend, what new amount should it pay?
The following four public listed companies have different dividend policies. •Utara Berhad pays all its earnings in the form of cash annually. • Selatan Berhad is yet to pay any cash dividends and has no such plans in the foreseeable future.
• Timur Berhad repurchases shares as an alternative to a dividend payment. • Barat Berhad offers shareholders the choice of either a small but stable dividend or a script dividend each year. Discuss the advantages and disadvantages of each policy clearly and comprehensively. Tutorial 13 (Topic 13)
Working Capital Management
If sales are projected to be 10,000 units and the order cost/order is $50 and the carrying cost/unit is $300, using the EOQ Model: (a)Calculate the optimal quantity to be ordered.
(b)What is the total inventory cost?
Persie Berhad has determined the following inventory information and relationships: Orders can be placed only in multiples of 300 units
Annual unit usage is 600,000 units (assume a 50-week/year in calculation) The carrying cost is 10% of the purchase price of the goods. The purchase price is RM6 per unit, ordering cost is RM85 per order. The desired safety stock is 6,000 units, excluding the delivery-time stock. Delivery time is 5 weeks Given these information:
(a)What is the Economic Order Quantity (EOQ) level?
(b)At what inventory level should a reorder be made?
Refer to Problem P14-11 in Gitman (2009) Principles of Managerial Finance (12th ed.).
A firm currently offers credit terms of 2/15, n/45. You want to change the credit policy to 2/10, n/40. As a result of this change, sales are expected to rise by 12%, bad debts will rise from 2% to 4%. All sales are credit sales.
Currently 43% of customers pay off their accounts in 15 days with 55% paying in 45 days and 2% paying in 100 days or not at all. The change will decrease those paying early to 42% and will decrease those paying net to 54% with 4% late payers. Assume:
365 day year
COGS, and operating expenses other than bad debt expense, are calculated as a percentage of sales. The current percentage will not be affected by the credit policy change. Interest expense will remain constant
Taxes are at the 40% level
Before credit change
Gross Profit 550,000
Bad debts expense 22,000
Operating expenses 300,000
Interest expense 10,000
Net Profit$ 130,800
Accounts Receivable 100,055
(a)Calculate the new ACP
(b)Calculate the new net income
(c)Calculate the new accounts receivable
(a)Why might a firm choose to factor its receivables (debt factoring)? (b)What is meant by collection policy? What are typical collection policy activities?
(a)Respond to this statement: It is impossible for a firm to have zero net working capital; the firm would be bankrupt. (b)Explain the liquidity/profitability trade off faced by managers in the context of working capital management.