Managerial Finance

32

ManagerialFinance

ManagerialFinance

Assignment1

Problem1-4: Marginal cost-benefit analysis

Item

Amount ($)

Total benefits from new robotic

560,000

Less: Benefits from old robotic

400,000

Marginal benefits

160,000

Cost of new robotic

220,000

Less: proceeds from the sale of old robotic

70,000

Marginal cost

150,000

Net benefit

10,000

  1. Marginal benefit = $ 160,000

  2. Marginal cost = $ 150,000

  3. Net benefit = 10,000

  4. The marginal benefit of $ 160,000 in this case exceeds the marginal cost of $ 150,000, which means that manager should consider replacing the robotic to get a net benefit of $ 10,000.

  5. Other factors that the manager should consider in making the final decision include the impact of the decision on cash flow, risk associated with the decision, and the timing.

Problem1-6

Maximizingthe shareholder wealth and ethical constraints

Thestatement that managers should maximize the shareholder wealth withregard to ethical constraints means that organizational managersshould do their best to increase the profits for the companyshareholders. However, measures taken to maximize the companyprofitability should not include unethical activities.

Ethicalconsiderations

Ethicaldecisions should be consistent with four major ethical guidelines.First, the manager should any decision or action does not single outindividuals or groups in unfair ways. Secondly, actions taken by themanagement should not violate legal and moral rights of groups orindividuals. Third, actions should conform to the moral standardsthat are acceptable to the society and the business community. Themanagement should consider whether there exist some alternativecourses of action that are likely to cause less harm. These ethicalconsiderations reduce the risk of litigation, maintain a positiveimage of the company, reduce the risk of judgment cost, and increaseshareholders’ confidence. This improves that cash flow and increasethe share price.

Problem 2-7

Asset

Purchase price ($)

Sale price

Capital gain ($)

Tax paid ($)

A

3,000

3,400

400

160

B

12,000

12,000

0

0

C

62,000

80,000

18,000

7,200

D

41,000

45,000

4,000

1,600

E

16,500

18,000

1,500

600

  1. Amount of capital gain for each asset is $ 400, $ 0, $ 18,000, $ 4,000, and $ 1,500 for assets A, B, C, D, and E respectively.

  2. Amount of tax paid is $ 160, $ 0, $ 7,200, $ 1,600, and $ 600 for assets A, B, C, D, and E respectively.

Problem2-8

Ethicalissues arise when insider trader has critical information that otherinvestors may not have. For example, it would be considered unethicalif an insider sells shares upon receiving the information that islikely to reduce the share prices significantly in the near future.Such information would help the insider gain more than otherinvestors. Similarly, it would be unethical for the shareholder tobuy share after receiving the information that the share price willincrease significantly in the near future. In essence, ethical issuesarise when the insider uses critical information to make more gainsor avoid loses using the information that other investors do nothave.

Casestudy 1

  1. Positive aspects of option 1: Loan capital

MeritEnterprise will have three major benefits by using loans in itsexpansion project. First, the company will retain its ownership. Thisis because the bank will not require to be issued with shares in thecompany, but it will consider the company assets as collateralsecurity for the loan. Secondly, the lending bank will not interferewith the management of the company, which means that taking a loanwill not interfere with the stability of the company. Third,secondly, the lending bank will monitor the performance of thecompany, which will increase its profitability and efficiency.

Drawbacksof option 1

Thereare two major drawbacks of taking option one. First, the MeritEnterprise has to repay the loan irrespective of whether it makesprofits or not. Secondly, merit risks losing its property in case itfails to repay the loan in the future irrespective of the reasons forthe failure.

  1. Positive aspects of option 2: Equity

Shareholderswill not be given dividends in case the company fails to makeprofits, which will protect the company’s cash flow and the overallfinancial status. Merit will retain its assets irrespective ofwhether it makes enough profits to pay dividends or not.

Drawbacksof option 2

Bytaking the second option, the current owners of Merit will relinquishpart of their company’s ownership to other investors. This might berisky since the nature of the new investors is unknown. This meansthat the Merit cannot predict the interests or intentions of the newinvestors. In addition, the company will be required to invest moreon internal controls in order to enhance its capacity to comply withthe new disclosure requirements.

Recommendation

Sarashould recommend option 1 (bank loan) for the company. This isbecause the bank will not assume the ownership of the company. Thisimplies that the bank loan will shield the Merit Enterprises fromunpredictable shareholders who might interfere with the investmentobjectives of the company. In addition, the loan option will ensurethat the management remains stable since the bank will not requirebeing included in the management structure of the company.

Assignment2

Problem3-19:Common size income statement

Creek Enterprise Common-Income statement for the year ended December 31, 2011

Item

2012 (%)

2011 (%)

Sales

100

100%

Less: Cost of goods sold

70

65.9

Gross profit

30

34.1

Less: Operating expenses

Selling expenses

10

12.7

General and administration expenses

6

6.3

Lease expenses

0.67

0.6

Depreciation expenses

3.33

3.6

Total operating expenses

20

23.2

Operating profits

10

10

Less: Interest expenses

3.33

1.5

Net profits before tax

6.67

9.4

Less: Taxes (rate = 40 %)

2.67

3.8

Net profit after tax

4

5.6

Less: Preferred stock dividends

0.33

0.1

Earnings available for common stockholders

3.67

5.5

Allitems are expressed as a percentage of sales.

Differencesin the common statement for the years ended 2011 and 2012 indicatesthat there are two major items that require further analysis andinvestigation. These items include the cost of good sold, whichincreased by 4.1 % and lease expenses, which increased by 1.83 %. Theincrease in the two items affected the net profits and earnings thatwere available for the shareholders.

Problem4-19

  1. Pro-forma statements

Red Queen Restaurant pro-forma income statement for the year ended December 31, 2013 (percentage of sales method)

Item

Amount ($)

Sales

900,000

Less: Cost of goods sold

675,000

Gross profit

225,000

Less: Operating expenses

112,500

Less Depreciation for the new machine

17,000

Net profit before taxes

95,500

Less taxes (40 %)

38,200

Net profit after tax

57,300

Less cash dividends

35,000

To retained earnings

22,300

Percentageof change in sales =12.50 %. This was obtained by (900,000-800,000) $100,000 by 800,000 and multiplying by 100 %. Therefore, the cost ofsales and operating expenses were expected to increase by 12.5 %. RedQueen will not be able to retain $ 30,000 as expected. This amountwill be less by (30,000-22,300) $ 7,700.

  1. Pro-forma balance sheet

Red Queen Restaurant pro-forma Balance Sheet, December 31, 2013 (Judgmental approach)

Assets

Liabilities and Stockholder’s equity

Cash

30,000

Accounts payable

112,500

Marketable securities

18,000

Taxes payable

9,550

Accounts receivable

162,000

Other current liabilities

5,000

Inventory

112,500

Total current liabilities

127,050

Total current assets

322,500

Long-term debt

200,000

Net fixed assets

375,000

Total liabilities

327,050

Total assets

697,500

Common stock

150,000

Retained earnings

197,300

Total

674,350

External financing required

23,150

Total liability and stockholder’s equity

697,500

Computations

Accountsreceivable = 18 % of annual sales

=18/100 * 900,000 = 162,000

Inventorywill change at the same rate as the annual sales

Therefore,inventory = 100,000 + (12.5 / 100 * 100,000)

=112,500

Netfixed assets

=Asset value at the end of 2012 + new acquisition – depreciation forthe year 2013

=350,000 – 42,000 -17,000

=375,000

Accountspayable will change directly with change in sales

Therefore,accounts payable = 100,000 + (12.5 / 100 *100,000)

=112,500

Taxespayable = 1/4 of tax liability on pro-forma income statement

Therefore,taxes payable = 1 /4 *38,200

=9,550

Retainedearnings = retained earnings for 2012 + amount of retained earningsin 2013 pro-forma income statement

=175,000 + 22,300

=$ 197,300

  1. The amount of external financing required is $ 23,150, which is obtained by subtracting the total liabilities from the value of total assets. That is $ 697,500 – $ 674,350 =23,150. The value of $ 23,150 is the balancing figure for the two sides.

Problem5-16

  1. Present value

Pv=FVn / (1+r) n

AlternativeA:

FV3=28,500

n= 3 years

r= 0.11

Therefore,PV3 = 28,000 / (1+0.11)3

=$ 20,473.36

AlternativeB:

FV9= $ 54,000

N= 9 years

R= 0.11

PV9= 54,000 / (1+0.11) 9

=$ 21,109.94

AlternativeC:

FV20= 160,000

N= 20

R=0.11

PV20= 160,000 / (1+0.11)20

=$ 19,845.43

  1. Alternative A and B are worth $ 20,473.36 and $ 21,109.94 respectively, which implies that they are acceptable. Alternative C is worth $ 19,845.43 today, which implies that it is not acceptable since its value today is less than $ 20,000.

  2. A would take alternative B because it is worth $ 21,109.94 today, which is the highest out of the three alternatives, and expect to receive $ 54,000 after 9 years.

Problem5-19

  1. Future value

  1. Ordinary annuity

Fn= A [((1+ r) n -1) / r]

  1. 2,500 {(1+0.08)10)-1 / 0.08} = 36,216.41

  2. 500 {(1+0.12)6)-1 / 0.12} = 4,057.59

  3. 30,000 {(1+0.0.2)5)-1 / 0.2} = 156,121.20

  4. 11,500 {(1+0.09)8)-1 / 0.09} = 126,827.45

  5. 6,000 {(1+0.14)30)-1 / 0.14} = 2,140,721.08

  1. Annuity due

Fn= A [((1+ r) n -1) / r] (1-r)

  1. 36,216.41 (1+0.08) = 39113.72

  2. 4,057.59 (1+0.12) = 4,544.50

  3. 156,121.20 (1+0.2) = 187,345.44

  4. 126,827.45 (1+0.09) = 138,241.92

  5. 2,140,721.08 (1+0.14) = 2,440,422.03

  1. Comparing the findings

Case

Annuity due

Ordinary annuity

Percentage difference

A

39113.72

36,216.41

8

B

4,544.50

4,057.59

12

C

187,345.44

156,121.20

20

D

138,241.92

126,827.45

9

E

2,440,422.03

2,140,721.08

14

Thecash flow of the annuity due is high in all cases, which implies thatannuity due is more preferred than the ordinary annuity.

Case5: Jill Moran’s case

  1. Total amount that should be accumulated by the end of year 12

PVn= PMT * (PVIFA i,n)

PV20= 42,000 * (PVIFA 0.12,20)

=42,000 * 7.469

=$313,698

Therefore,Sunrise should accumulate $ 313,698 by the end of year 12 in order toprovide $ 42,000 annuity.

  1. The value of end of year deposit

PMT= FVAn/ FVIFA i,n

PMT= 313,698 / (FVIFA 0.09,12)

=313,698 / 20.141

=$ 15,575.10

Therefore,Sunrise should make a $ 15,575.10 end-of-year deposit from year 1 to12 in order to give Moran the $ 42,000 retirement annuity.

  1. Amount that should be deposited if Sunrise would earn 10 %

PMT= FVAn/ FVIFA i,n

PMT= 313,698 / (FVIFA 0.1, 12)

=313,698 / 21.384

$14,669.75

Therefore,should make a $ 14,669.75 end-of-year deposit for it to give the $42,000 annuity

  1. Initial deposit required when annuity is perpetuity

PVp= PMT * (1 / i)

=42,000 * (1 / 0.12)

=42,000 * 8.333

=$ 349,986

Therefore,end of year deposit will be

PMT= FVAn/ (FVIFA I,n)

=349,986/ (FVIFA 0.09,12)

=349,986 / 20,141

=$ 17,376.79

Therefore,Sunrise should deposit $ 17,376.79 if the annuity is perpetuity.

Assignment3

Problem6-8

  1. Risk free interest rate = real interest rate + inflation premium

Rf = r + IP

SecurityA:

Rf= 3 +6 = 9 %

SecurityB:

Rf= 3+ 9 = 12 %

SecurityC:

Rf= 3 +8 = 11 %

SecurityD:

Rf= 3 + 5 = 8 %

SecurityE:

Rf=3 + 11 = 14 %

  1. The major cause of the difference in the rates of risk-free interest rates is the difference in time within which each security is expected to mature. A security with a shorter maturation period is expected to have a lower rate than the one with a long maturation period.

  2. Nominal rate of interest = risk free rate of interest + Risk premium

R1= Rf + RP

SecurityA:

R1= 9 + 3 = 12 %

SecurityB:

R1= 12 + 2 = 14 %

SecurityC:

R1= 11 + 2 = 13 %

SecurityD:

R1= 8 + 4 = 12 %

SecurityE:

R1= 14 + 1 = 15 %

Problem6-14

Valueof a given asset at time zero (Vo) = [CF1 / (1 + r) 1] + [CF2 / (1 +r) 2] + ………

WhereCF is the ash flow

Ris the required rate

Vo= value of the asset

Lowrisk option:

V0= [3,000 / (1+ 0.10)1] + [3,000 / (1+ 0.10)2] + [3,000 / (1+ 0.10)3]+ [3,000 / (1+ 0.10)4] + [15,000 / (1+ 0.10)5]

V0= $ 18,823.40

Averagerisk:

V0= [3,000 / (1+ 0.15)1] + [3,000 / (1+ 0.15)2] + [3,000 / (1+ 0.15)3]+ [3,000 / (1+ 0.15)4] + [15,000 / (1+ 0.15)5]

V0= $ 16,022.59

Highrisk

V0= [3,000 / (1+ 0.22)1] + [3,000 / (1+ 0.22)2] + [3,000 / (1+ 0.22)3]+ [3,000 / (1+ 0.22)4] + [15,000 / (1+ 0.22)5]

V0= $ 13,030.92

Incase Laura cannot assess the risk of the assets, she should pay $13,030.92 because the high risk option is the worst scenario.

Anincrease in the level of risk reduces the value of the asset. In thepresent case the asset has a high value ($ 18,823.40) in a low riskscenario, $ 16,022.59 I an average risk scenario, and $ 13,030.92 inthe high risk scenario.

Problem6-23

  1. Selling prize

BondA

Ba= C * [((1 + r)N-1) / (r * (1 + r) N]+ FV * [1 / (1+ r)N

=60 * [((1 +0.12)5-1) / (0.12 * (1 + 0.12) 5]+ 1,000 * [1 / (1+ 0.12)5

=$ 783.71

BondB:

Bb=140 * [((1 + 0.12)5-1) / (0.12 * (1 + 0.12) 5]+ 1,000 * [1 / (1+ 0.12)5

=$ 1075.10

  1. Number of bonds that Mark can buy

BondA

=20,000/ 783.71

=25.52 bonds

BondB

=20,000 / 1072.10

=18.66 bonds

  1. Yearly interest income

BondA

Yearlyinterest income = 25.52 * 60

=$ 1,531.17

BondB

Yearlyinterest income = 18.66 * 140

=$ 2,611.71

  1. Value of principal payment

Reinvestment account for Bond B

Year

60

87.85

1

60

79.86

2

60

72.60

3

60

66.00

4

60

66

5

60

60

FV

1,000

1,000

Total value of reinvestment

1,366.31

Thereforethe reinvestment value for bond B is $ 1,366.31

Reinvestment account for Bond B

Year

140

204.97

1

140

186.4

2

140

169.4

3

140

154

4

140

140

5

140

140

FV

1,000

1,000

Total value of reinvestment

1,854.71

Therefore,the total value of reinvestment for bond B = $ 1,854.71

Compoundaverage growth rate = (value of total reinvestment / value of initialinvestment) 1/ n

CAGRof bond A = (1,366.21 / 783.71) 1/ 5

=11.77 %

CAGRof bond B = 1,871.54 / 1,072.10) 1/ 5

=11.79 %

  1. Reason for differences in above figures

Theamounts accumulated for the two bonds differ from each other becausebond A tends to pay a higher level of interest bond B. CAGR ratesvary because the rate of reinvestment is considered as 10 % insteadof 12 %. Bond B offers Mark with the better alternative in case he isworried of earning less than a 10 % return.

Problem7-17

  1. Book value per share = Value of assets at sold at book value –liabilities / the number of common stockholders

Bookvalue of all assets = Current assets + fixed assets (as shown in thebalance sheet)

=380,000 + 780,000

=1,160,000

Therefore,book value per share = 780,000 – 420,000 / 10,000

=$ 36

  1. Liquidation value per share = value of assets sold at market value – liabilities / number of common stockholders

Marketvalue of assets

Asset

computation

Liquidation value

Cash

40,000

Marketable securities

60,000

Accounts receivable

90 / 100 *120,000

108,000

Inventories

90 / 100 * 160,000

144,000

Land and building

130 / 100 * 150,000

195,000

Machinery and equipment

70 / 100 * 250,000

175,000

Total

722,000

Liquidationvalue per share = 722,000 – 420,000 / 10,000

=$ 30.2

  1. The book value per share is higher than the liquidation value because the book value cannot show the minimum price at that a share can be valued at in the marketplace. However, most stocks sell at the book value and it is difficult for shares to sell below the book value since investors will have a perception that the stocks are either undervalued or over-valued.

Problem7-22

  1. Maximum cash price

Estimatedgrowth rate

P0= ((D1 / (rs–i))

rs= 0.09 + 0.05 = 0.14

D1= (3.44 * 1.07) = $ 3.68

ThereforeP0= ((3.68 / (0.14 – 0.072)

=$ 52.72

  1. (1). Impact of a decreasing growth rate

D1= 3.61 / (3.44 * 1.0502) = 3.61

Therefore

P0= 3.61 / (0.41 – 0.0502

=$ 40.20 for each share

(2).Impact of a decrease in risk premium

rs= 0.09 + 0.04

=0.13

D1= 3.68

Therefore

P0= 3.68 / (0.13 – 0.0702)

$61.54 for each share

Problem7-23

  1. Generic’s stock value

P0= D / r

=5 / 0.11

=$ 45.45

  1. Assuming a 1 % credibility

P0= D / r

5/ 0.12

=$ 41.67

  1. Difference between a and b

Themajor difference between a and b is the value decline by (41.67 –45.45) $ 3.78 Assignment 4

Problem8-14

a. Expectedreturn

Alternative1

Alternative2

AssetF Asset G Portfolio (kp)Return

Year (wFx kF) + (wGx kG) kp

2001 (16%x .50 = 8.0%) + (17% x .50 = 8.5%) = 16.5%

2002 (17%x .50 = 8.5%) + (16% x .50 = 8.0%) = 16.5%

2003 (18%x .50 = 9.0%) + (15% x .50 = 7.5%) = 16.5%

2004 (19%x .50 = 9.5%) + (14% x .50 = 7.0%) = 16.5%

Therefore,

Alternative3

AssetF Asset H Portfolio Return

Year (wFx kF) + (wHx kH) kp

2001 (16%x .50 = 8.0%) + (14% x .50 = 7.0%) 15.0%

2002 (17%x .50 = 8.5%) + (15% x .50 = 7.5%) 16.0%

2003 (18%x .50 = 9.0%) + (16% x .50 = 8.0%) 17.0%

2004 (19%x .50 = 9.5%) + (17% x .50 = 8.5%) 18.0%

Therefore,

b. StandardDeviation

(1)

(2)

(3)

c. Coefficientof variation

=

d.Recommendation

Alternative2 is the most appropriate because it is negatively correlated with,meaning that it has a low coefficient compared to other options.

Problem8-22

  1. Ranking of stocks

StockC is the least risky with a beta of -0.30, followed by stock A with abeta value of -0.80, while stock B is the riskiest with a beta valueof 1.40. This means that any movement in the market will result inmore significant in changes stock B returns, followed by stock A,while stock C will experience the minimum changes in return.

  1. Effect of an increase in return by 12 %

Asset

Beta

Increase in the market return

Expected effect on asset return

A

0.80

0.12

0.096

B

1.40

0.12

0.168

C

-0.30

0.12

-0.36

  1. Effect of a decrease in return by 5 %

Asset

Beta

Decrease in the market return

Expected effect on asset return

A

0.80

– 0.05

-0.04

B

1.40

– 0.05

-0.07

C

-0.30

– 0.05

0.015

  1. In the case of a decline in the market, a wise investor would select asset C. This is because return on asset C increases with the decline in the market as shown in the table above, unlike asset A and B, whose expected returns decrease when the market declines. Therefore stock C is a defensive asset.

  2. An investor who expects a market rally would select asset B. This is because price of stock B will rise at the highest rate. For example, a rise in the market by 1 point will result in the rise of stock B by 1.40 points.

Problem9-4

After-taxcost to maturity

AlternativeA

Kd= [90 (1,000 – 1,220) / 16] / [(1,220 + 1,000) / 2]

=76.27 / 1,110

=6.87 %

Therefore,

Ki= 6.87 * (1-0.4)

=4.12 %

AlternativeB

Kd= [70 (1,000 – 1,020) / 5] / [(1,020 + 1,000) / 2]

=66 / 1010

=6.54 %

Therefore,

Ki= 6.54 * (1 – 0.4)

=3.92 %

AlternativeC

Kd= [60 (1,000 – 970) / 7] / [(970 + 1,000) / 2]

=64.29 / 985

=6.53 %

Ki= 6.53 % * (1-0.4)

=3.92 %

AlternativeD

Kd= [50 (1,000 – 895) / 10] / [(895 + 1,000) / 2]

=60.50 / 947.50

=6.39 %

Therefore,

Ki= 6.39 * (1 – 0.4)

=3.83 %

Problem9-13

  1. Weighted average cost

Capital type

Book value

Weight of the capital

Cost (%)

Weighted cost (%)

Debt

700,000

0.500

5.3

2.650

Common stock

650,000

0.464

16.0

7.424

Preferred stock

50,000

0.036

12.0

0.432

1,400,000

1.000

10.506

Theuse of WACC

  1. Firms can use WACC in long-term projects because it helps them in maintaining the value. For example, the cost of capital may be compared with the rate of return of the project in order to determine a given project should be accepted.

Interactivecase study 4

  1. Eco’s current cost of long-term debt

Costof long-term debt = [I + (Par value of bond – Nd) / n] / [Nd + parvalue of bond / 2] / 2

WhereI = annual interest

Nd= net proceeds from the sale of bond

N= number of years it takes for bond to mature

Beforetax cost = [(10.5 % * 1000) + (1000 -45-32) / 20] / [1000 + (1000 -45– 32)] / 2

=0.1132

=11.32 %

Aftertax cost = rd (1-T)

Whererd = before tax rate

T=tax rate

Therefore

ri=11.32 * (1-0.4)

=6.79 %

  1. Current cost of preferred stock

Costof preferred stock = Dp/ Np-flotation cost

Where Dp= Dividend on preferred stock / price of preferred stock

Np= Net issuing price of preferred stock

Rps= 8.55 / 95 -7

=9.72 %

  1. Current cost of common stock

rs= Rf+ [b * (rm–Rf]

Where

Rf= risk free rate of return

rm= market return

b= beta

Therefore,the cost of common stock = 0.04 + [1.3 * (0.13 -0.040]

= 0.157

=15.7 %

  1. Current weighted average cost of capital

ra= (wi*ri)+ (wp* rp)+ (w * r s)

Where

Wi= proportion of long-term debt

Wp=proportion of preferred stock

Ws= proportion of stock equity

ra= (0.3 *6.79) + (0.2 * 9.72) + (0.5 * 15.7)

=11.83 %

  1. 1. Current cost of new common stock

Ashift towards a more leveraged capital will increase the risk premiumbecause a leveraged capital is associated with a high risk, thusrequired high premium.

rn= Rf+ [bn* (rm–Rf]

Where

Rn= cost of new stock

Rf= risk free interest

Rm= market return

Therefore

rn= 0.04 + [1.5 * (0.13 -0.040]

rn=0.175

=17.5 %

  1. New weighted average cost of capital

ra= (wi* ri)+ (w * r s)

ra= (0.5 * 6.79) + (0.5 * 17.5)

ra= 12.15 %

  1. The first capital structure that is less leveraged is better that the more leveraged structure. This is because a leveraged capital structure resulted in an increase in the value of beta from 1.3 to a.5. This in turn resulted in an increase in the average weighted cost of capital from 11.83 % to 12.15 %.

Reference

Gitman,J. &amp Zutter, J. (2012). Principlesof Managerial finance (3rded.).Upper Saddle River. Prentice Hall.

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