MANAGERIAL FINANCE MBS 1ST COMMON PROBLEMScomme ACP ADS >’ BVPS iC c cA ccc CDA a cR Cet = Cont 4 nly used symbols “average collection period ‘average daily Sale Cost of the transaction Book value per share Carrying cost Per unit Optimal size of cash transfer Current assets Cash conversion trolled disbursement acco) nthe purchase or sale of marketable securities, beg cycle ants Current liabilities Current ratio Cash receipts during the peri Coefficient of variation Dividend per share Days sales outstanding Depository transfer cheque Expected return asset for J, Requte Earning after taxes Earning before interest and taxes jod t plus 1 d rate of return on stock j Equity multiplier Economic order quantity Earning per share Fixed cost Interest rate on marketable securities Inventory conversion period Opportunity cost Cost of debt before-tax Cost of debt after-tax Cost of external equity Cost of preferred stock Cost of retained earning Market price per share Number of order to be placed Number of periods Net income Ordering costs per order Operating profit ratiooo WS [ACC Equilibrium share repurchase price = Price earning Correlation between the return of assets A & B Current market price per share prior to distribution Payable deferral period 3 The probability of state i’ =‘ Market price per share at time t Quick assets. Quick ratio or acid test ratio = Requirement for the period, Rate of return Receivable conversion period Risk-free rate = Return on the security in state ‘i’ = Holding period return for security ‘) = Holding period return of assets ‘at time t Return on market = Return on assets Return on equity Reorder level = Recorder point = Holding period return of portfolio = Number of shares outstanding prior to distribution, Sales = Total cash usage = Total cost = Total carrying cost =. Times interest earned = Total ordering cost = Variable cost = Variable cost ratio = Weighted average cost of capital = Weight of total funds invested in security j = Weight of risky asset = Variance of return on assets J = Standard deviation of portfolio return = Variance of portfolio return =. Average return of assets |Equity Total assets (1 — DA) = Rs 1,000,000 (1 - 0.50) = Rs 500,000 Therefore tum on maity with 50 percent debt financing: =" Equity Rs 96,000 = Rs 500,000 = 0-192 ive, 19.2% Difference in ROE = 19.2% - 12% =7.2% That is, if the firm finance the required it i il aoraneniy ote a in assets with 50 percent debt then ROE Following financial data are avai e I data are available to you for J.K. Paper during the current year Cash and Marketable securities = Rs 20,000 Fixed assets =Rs 56,700 Sales = Rs 200,000 Net income = Rs 10,000 Quick ratio =2 times Current ratio =3 times Dso =40 days Return on equity = 12% The firm has no preferred stock. Find the firms, a. (i) Accounts receivable (ii) Current liabilities (iii) Current assets (iv) Total asset (v) Return on assets (ROA) (vi) Common equity, and (vi) Long-term debt. b. _ In part (a) you should have found the firm's accounts receivable = Rs 22,222.22. If the firm could reduce its DSO from 40 days to 30 days while holding other things constant how much cash would it generate? If this cash were used to buy back common stock (at book value) and thus reduced the amount of common equity, how would this affect (i) the ROE. (ii) the ROA and (ii) the total debt to total asset ratio? DSO x Sales 40x Rs 200,000 _ a. (i) Account receivable = B80, Sales ee Rs 22,202.22 Cash and marketable securities + Accounts receivable (i) Current liabilities = Geek Batic 220002222222 psn sn (ii) Current asset Current ratio x Current liability =3 times x Rs 21,111.11 ; Rs 63,333.33 (iv) Total assets = Current assets + Fixed assets = Rs 63,333.33 + Rs 56,700 = Rs 120,033.33 Net income __ Rs 10,000 (~) Return on assets = Foray assets = Re 120,033.33 = 0.0833 or 8.33% i i Rs 10,000 (vi) Common equity =Netincome - AS SODS = Rs 83,3383 (vii) Long term debt = Total assets - (Current liabilities + Common equity) = Rs 120,033.33- (Rs 21,111.11 + Rs 83,333.33) = Rs 120,033.33 -Rs 104,444.44 oot =Rs 15,588.89 ‘i58 chapter 2* Mlustration 9 atin analysis: SOLUTION MANAGERIAL FINANCE b. If DSO decreases front 40 released in terms of cash- Reduction in receivable If cash available of value then new book value ie New common equity Hence, Net income () NewROE =WNew equity Rs 10,000 = Rs 77,777.77 Rs 5,555.56 would be use: common equity Me Rs 83,333.33 - RS 5585.56 = RS 77,777.77 days t eivable. Reducti Accounts receW2°= Reduction in DSO ‘Old Bs2BDIDP 19 = RE555556 is given by: = 0.12857 ie. 12.857 % Net income (i) NewROA. = 5;Taseu Decrease in accounts receivable Rs 10,000, Rs 10,000 (iii) Total debt to total assets rat Where, __ Total debt. HO = Total assets Total debt = Long-term debt + Current liabilities = Rs 15,588.89+Rs 21,111.11 =Rs 36,700 0 30 days then 10 days receivable y,, 4 to buy back the common stock a5, 0.08735, i.e. 8.735% Old total assets: Rs 120,033.33 New total assets. = Rs 120,033.33- Rs 5,555.56 = Rs 114,477. 77 ; Rs 36,700_ Old debt ratio = Rs 120,033.33 = 0.3057:1 Rs 36,700 New debt-asset ratio =F 714,477.77 = 0.9206: Central Floor Mills reports the following balance sheet information for 2008 and 2008, Balance Sheet as of December 31, 2008 and 2009 Asses 2008 | 2009 | Liabilities and Owner's Equity | 2008 | 2008 Curent assets: Current tabites: cash Rs9201| Rs 9.682 Accounts payable RS71712| Pssik g Accounts receivable 28426| 20,481 | Notes payable 36,108] suit Inventory 54318) 63682 Total Curent assets [AS97945] RS 102,845 | Total curent abilities Rs 107,620) As he 2 Longe debt 50000| sl Fixed asses 5206478) As 327154] Total ables a Owners equity 5 290.543 Total assets Fs 388,365 | Rs 429,995 | Total abilities and equi ase Based on the balance sheet above, calculate the following financial ratios for each ye" a. Current ratio c Debt-equity ratio e. Total debt ratio Current ratio (CR) -¢4 _ Rs 91,945 Rone = R507, 82 = 0.853 b, Quick Ratio d. Equity multiplier f. Longc-term debt ratioMustration 10 Rat analysis SOLUTION ANauysis OF FINANCIAL STATEMENT + Chapter 2 Rs 102,845 Caw = Re 106,498 ~ 97° CA- Inventory, by. Quik ratio QR) =" CL Rs91,985- Rs 54,318 _ RS37.627- _ QRwsos =" Rs 107,820 ~ Rs 107.820 = 0.349 times Rs 102,845 - Rs 63,682 _ Rs 39,163, _ 9 364 QRue == Rs 106498. RS 106,498 368 times Total debt e._Debt-equity ratio (DE) =" Equity Rs 157,820 DEse = ap pas = 0085 0F 68.5% Rs 141,498 _ 9.490 or 49% DEee) 288,501 Total assets ‘4. Equity multiplier (EM) ="" Equity — _ Rs 388,363 _ 1 ives’. °_030505 oe _Bs 429,999 EM =" Re788,501 = 1490 mes Total debt fe. Total debt ratio (DA) =Total assets Rs 157,820 _ 9 496 or 40.6% DAwos = Rs 388,363 Rs 141,498 DA209 = Rs 429,999 429,999 = 0.329 or 32.9% : Long-term debt {Long-term debt ratio (LTDR) oT eaeetaal Rs 50,000, roo oS psessese ee LTDRavo» Bs35,000- _ 9,081 or 8.1% = "Rs 429,999 Using the following data, complete the balance sheet given below: Debt ratio 50% Quick ratio 08 Total asset turnover 15 times Days sales outstanding 36 days Gross profits margin 25% Inventory turnover 5 times : Balance Sheet Calculation of accounts payable: We have, Debt ratio =05 5960 Chapter 2+ MANAGERIAL FINANCE Total debt Total assets Accounts payable + Long-term debt Rs 200,000 or, Accounts payable + Rs 40,000 = Rs 100,000 Accounts payable = Rs 60,000 Calculation of sales: We have, or =05 or, 5 Total assets turnover Sales 200,000 Rs 300,000 or, 15time Sales Calculation of quick assets: We have, Quick ratio =08 ick assets ‘Accounts payable ick assets or, Rs 60,000 = 08 Quick assets = Rs 48,000 = 08 Calculation of accounts receivable: Wehave, DSO = 36 days 360 days x Accounts receivable a Sales aay e 360 x Accounts receivable on Rs 300,000) | Accounts receivable = Rs 30,000 Calculation of cash: Wehave, Quick assets =Rs 48,000 Cash + Accounts receivable = Rs 48,000 Cash + Rs 30,000 Rs 48,000 Cash. Rs 48,000 — Rs 30,000 = Rs 18,000 Calculation of inventory Wehave. Inventory turnover =5 times Sales Inventory Rs 300,000 °f Tnventory = or, Inventory =F = Rs 60,000ANALYSIS OF FINANGIAL STATEMENT + Chapter2 61 Calculation of fixed assets a Total assets — (Cash + Accounts receivable + Inventory) = Rs 200,000 — (Rs 18,000 + Rs 30,000+Rs 60,000) = Rs 200,000 ~ Rs 108,000 = Rs 92,000. Calculation of cornmon stock: vat gck =Total assets (Accounts payable #Lon-term debt +Retained enrning®) Com = Rs 200,000 ~ (Rs 60,000+Rs 40,000+Rs 65,000) = Rs 200,000 - Rs 165,000 = Rs 35,000. Preparation of balance sheet: Fixed assets Balance Sheet came 5 ‘Accounts receivable Inventories. Fixed asset Total ‘counts payable ‘Long term debt ‘Common stock Retained eamings. pustntloa 11 You are provided with following information of a firm: pePonidentty Sales /Total assets =3 times Return on assets (ROA) % Return on equity (ROE) 5% Calculate, profit Margin and debt ratio soLvTION ‘According to simple DU-Pont equation we know. t ROA = Profit margin ae | | ee Fee non | ofitmargin = Sales/Total assets” 3 f ‘According to extended Du-Pont equation ROE = Profit margin x Total asset a" Equity multiplier a oy 0:15 =003 3% Tdebrratio) 1 or, 015 = 0.09 x G-debr ratio) or, 0.15-0.15 debt ratio = 0.09 or, 0.15 debt ratio = 0.06 ; 0.06 Debt ratio =015 = 04 or 40% tation 12. Crimson Carson Company has the following balance sheet and income setement for 0 anal x2 (in thousands): Balance Sheet : Aocounts payable Aoctuals Shortt loans ‘Curetliabes Long-term debt SharehoWers 69 Cash ‘Accounts receivable Inventories (Ris,800 for 20x1) Total curent assets: Not fixed assets62 Chapter 2* SOLUTION MANAGERIAL FINANCE Income statement Not sales (all credit) Gost of goods sold prelate ‘and administrative expenses: Interest expense Profit before taxes Taxes ‘ Profit after taxes : : mit ratio, (b) the acid-test ray is of this information, compute (a) the curre = = nea ee od (d) the inventory turnover ratio, (e) the debt-to-netyg. the ave , tio, (f) the gross profit margin, (g) the net profit margin, and (h) the rate of retyr, ; ratio, common stock equity. a. Current ratio Current assets__R53,800 5 96 tines Current lial ies” Rs 1,680 b. — Acid-test ratio (Quick ratio) ick assets Rs 1,700 (oh ~ Carrent liabilities Rs 1,680 Where Quick assets. = Cash + Accounts receivable = Rs 400 + Rs 1,300 = Rs 1,700 ©. Average collection period 360 x Receivables a Sales d. Inventory turnover ratio: ITOR = Cost of goods sold Rs 8,930 Average inventories = Rs 1,950 = 458 times Where Average inventories = A L800 + Rs 2.100 = Rs. 1,950 Current ratio = 1.01 times ACP @ Debt to net worth ratio ve = Tolaldebt _Rs3,680 _ 7 Equity = Rs3,449 = £ Gross profit margin GPM = $1085 profit __Rs3,750_ Sales” = Rs 12,680 = .2957 or 29.57% & Net profit margin Profit NPM. = ~litafter taxes __Rs 670 h Sales "= Rs 12,680 = 9.0528 or 5.280% + Rate of return on. common, .1948 or 19.48%nostration 19 fa orahss ation ANALYSIS OF FINANCIAL STATEMENT + Chaptor 2 lowing information: . he fol Consider th Salokya Corporation’s Balance Sheet, December 31, 2009 63 Liabilities and stockholders’ Equity oo a 2,500,000 | Accounts payable a 3500000 | Acoued wages and axes inven Fixed assets, net Zee 500,000 | Notes payable 52,000,000 Se sais eae ae eee fo eee oan = (Common stock +1000.00 nae 1,900,000 1,900,000 Total ibis and o9 eS [Rs 15,000,000 “ivontry at December St 2008 = Ri, 500,000. Salokya Corporation's Statement of Income and Retained Earnings, Year Ended December 31, 2009 Tatsales red Cash Teal (Costs and expenses Cost of goods old (fs 0,000,000) ‘Sling, genera, and administrative expenses (4,100,000), Depreciation (700,000), Injerest on long-term debt (600,000) | __(@,400,000) Nt income before taxes Taxes on income Ntincome ater taxes Less: Dividends on prefered stock Nt income availabe fo common ‘Add: Rained earings 1/1109 Subtotal Dividends paid on common Retained eamings at 12/31/00 Fill in the 2009 column using the data presented Ratio 2007, 2008 2009 1. Current ratio 250% 2 Aci-est ratio 100% 3. Receivables tunover 4. Inventory turnover 5, _Netprofit margin 6 iC 8 Less: Fale of return on equity Fetum on tangible assets Tangble asset tunover b. Evaluate the position of the company from the table. Cite specific ratio levels and trends as evidence. Calculation of financial ratios: 1. Current ratio CR = Curent asets_ _ Rs 6,500,000 ~ Current liabilities “Rs 4,000,000 = 1-625 or 162.5% Where, Current assets. = Cash + Receivables + Inventory = Rs 500,000 + Rs 2,500,000 + Rs 3,500,000 = Rs 600,000 Current liabilities= Notes payable + Accounts payable + Accrued Rs 2,000,000 + Rs 1,000,000 + Re 1,000,000 = RS ‘wages and taxes64 Chapter 26 2. MANAGERIAL FINANCE Acid-test ratio (Quick ratio) ick assets Rs 3,000,000 QR = Current liabilities ~ Rs 4,000,000 = °-75 or 75%, Where Quick assets = Cash + Receivables = Rs 500,000 + Rs 2,500,000 = Rs 3,000,000 Receivables turnover Credit sales __Rs 8,000,000 RTOR = Receivables Rs 7,500,000 = 3:2 times Inventory turnover Cost of goods sold _ Rs 6,000,000 _ Ther: = Average inventory ~ Rs 2,500,000 ~ 24 times Where Rs 3,500,000 Average inventory = 8£1:500,000 + Rs 3,500,000 _ p> 500,000 Net profit margin NPM ~ Netincomeftertex _ 5 1.000.000 _ 0.10 or 10% Return on equity Net income to common stockholders ROE a Rs 880,000, = Be 3,000,000 = 0.2933 or 29.33% Where Equity = Common stock + Retained earnings = Rs 1,000,000 + Rs 2,000,000 = Rs 3,000,000 Return on tangible assets Roa _ Net income after tax __Rs 1,000,000 "Tangible assets “Rs 14,000,000 Where Tangible assets = Current assets + Net fixed assets = Rs 6,500,000 + Rs 7,500,000 = Rs 14,000,000 Tangible assets turnover __— Sales ___ Rs 10,000,000 ~ Tangible assets ~ Rs 14,000,000 ‘Comparison of ratios = 0.0714 or 7.14% TATOR =0.71 times Liquidity position of the firm has been declined over the year and significantly !o* than receivable turnover are also deci respective industry averages, the quality receivables. Firm also see the industry average in the year 2009. Similarly, as inventory turnovet ining over the years, and they are also lowe? firm seems to have slow moving inventoryanalysis is concerned with analyzing financial statements of a firm to identify its nd weakness associated to various aspects of financial performance. It also arison of financial performance of different firms on the basis of financial .d in different financial statements, namely income statement and balance Financial relative strength a consists of the comp: information containes sheet. patio analysis is used as a technique to quantify the relationship between two or more sets of financial data taken from income statement and balance sheet. It provides the information relating to strengths and weaknesses of a financial data in relation to other. Ratio analysis is useful to both internal as well as external parties concerned to a corporate firm. As insiders, management and shareholders use financial ratios to assess earnings potentiality and overall financial performance of a firm. As outsiders, the creditors, government, institutional lenders, bondholders carry out financial ratio analysis to have knowledge about short-term solvency position, fixed charge payment capacity of the firm. Financial Ratios are significant both in internal and external comparison of a firm’s financial performance. As a tool of internal comparison, it can be used to assess the performance of a single firm over the years, which can be used to set up reward basis for management. In external comparison, the ratios of different firm in the same line of business could be used to identify their comparative strength and weakness. There are mainly five types of financial ratios: liquidity ratios, assets management or efficiency ratios, debt management or leverage ratios, profitability ratios and market value ratios. Liquidity ratios measure the firm's ability to satisfy its short-term commitments out of current or liquid assets. These ratios focus on current assets and liabilities and are used to ascertain the short-term solvency position of a firm. ‘Asset management ratios look at the amount of various types of assets and attempt to determine if they are too high or too low with regard to current operating levels. They provide the measure for how effectively the firm's assets are being managed. ‘The debt management ratios indicate the extent to which debt financing is being used by a firm. It is the measure of long-term solvency of a firm. how effectively the firm is being operated and managed. It shows Profitability ratio measures e firm in terms of generating earnings from sales revenue and the operating efficiency of thi assets and capital investment. The market value ratios are used to assess firm's stock price in relation t flows and book value of shares so that it gives indication of what the investors in capital market think of the past performance of the firm. Du-Pont system is a comprehensive model to represent an integrated view on financial analysis, planning and control process relating to a firm. It is used to make castle assessment of firm's ability to maximize return on equity as determined by the si#e of pro! margin, assets, turnover, and leverage factors. 0 its earnings, cash . q r, the There are considerable drawbacks associated with the use of finan ee should be used with extreme care and the analyst must work ysth Bf gener ye understand the quality of financial data rather than the quantitys “eee arent rt Curent ratio Liguidity ratio lnventory turnover pardiya Timber Inc. has current assets of Rs 800,000 and { current liabilities of Fe 500,000, What affect would the following, transact wes ratio? 8 tions have on the firm's current ae wo new trucks are purchased for a total of Rs 100,000 in cash, b. The company borrows Rs 100,000 short-t ‘ Oana lerm to carry an increase in receivables of ¢. Additiunal common stock of Rs 200,000 is sold y and the invested ir expansion of several terminals. a 4. cS aa increases its accounts payable to pay a cash dividend of Rs 40,000 out of cas! ‘ Jegatenc il Works Inc. has current assets of Rs 1 million and current liabilities of a. Whatis the company's current ratio? b. What would be its current ratio if each of the following occurred, holding all other things constant? () A machine costing Rs 100,000 is paid for with cash (i) _ Inventories of Rs 120,000 are purchased and financed with trade credit (iii) Accounts payable of Rs 50,000 are paid off with cash (iv) Accounts receivable of Rs 75,000 are collected. (v) Long-term debt of Rs 200,000 is raised for investment in inventories Rs 100,000 and to pay down short-term borrowings Rs 100,000. Birat Inc, has Rs 875,000 in current assets and Rs 350,000 in current liabilities, Its inital inventory level is Rs 250,000, and it wil raise funds as additional notes payable and use thom to inevease inventory. [low much ean the firm's short-term debt (notes payable) increase without violating a current ratio 2 to 1? What will be the firm's quick ratio after it has raised the maximum amount of short-term funds? Himal Construction Inc. has ending inventory of Rs 423,500, and cost of goods sold for the year just ended was Rs 23,65/450. What is the inventory turnover? The days’ sales in inventory? How long on average did a unit of inventory sit on the shelf before it was sold? (Assume 365 days in a year). credit) of Rs 4,00,000 and a gross Annapurna Trading Inc. has total annual sales (all {80,000, current liabilities Rs 60,000, profit margin of 20 percent Its current assets are Rs inventories Rs 30,000, and cash Rs 10,000. a. How much average inventory, should be carried inventory turnover to be 4? (Assume 360-days year) b. How rapidly must accounts receivable be collected if managemen' only an average of Rs 50,000 invested in receivables? of 14, a current ratio of 30, and ‘and cash and marketable 3. its DSO for that if management wants the t wants to have The Saleways Intemational Ine. had @ quick ratio of 14 = inventory turnover of 6 times, total current assets of Rs 610,000, and securities of Rs 120,000 in 2001. What were company ® annual sa year? Assume there are 365 days in a Yes"68 chapter 2° 1050 and accounts receivables Ties interest ‘eamed rato “Times interest ceamed rao e waNacERIAL FINANG Ine, has RS ran in * ans ted ee bil © accounts receivable. I dayS Sales oUtsany, p50 to the industry average of 35 4. 8 General Moto n time, The company’ ss, The company 55 day’ mers Pteveraressaics vessuring more of i giao adopted the company’s average sales will fay Primates that if this policy dopis this change and succeeds in reducing py 4 cent of ernest ‘Assume a 365-day year bg q hare of Rs 4 last year, and it py yy Limited had eutny 42'inillion during the sag Rs 40. Company has no preferred stock, ang 2 he year. Ifcompany’s year-end debt (which, hat was its year-end debt /assets ratio? percent. Assumint to 35.days and does receivables following t what will be the level of ac ~ 3 nal Company Sater: ‘Total retained earnings book value per share at year-end was new common stock was issued during f its total liabilities) was Rs 120 million, w! and its tax rate is 40 percent. The company, i ssets, Karnali Food Ine. has Rs 12 billion in as Reeeiatie olpercent. Wig! basic earning power ratio is 15 percent, and its return on company’s times-interest-earned ratio? Harper Collins Publisher Inc. had sales of Rs 380,000, cost of goods sold of Rs 1100 depreciation expense of Rs 32,000, and additions to retained earnings of Rs 41,620.1} firm currently has 30,000 shares of common stock outstanding, and the previous yes dividends per share were Rs 1.50. Assuming a 34 percent income tax rate, what wast times interest earned ratio? The long-term debt section of the balance sheet of the SS. Manufacturing Inc. appears: follows: 9% Mortgage bonds Rs 2,500,000 123/4% Second mortgage bonds Rs 1,500,000 10% % Debentures Rs 1,000,000 14 % % Subordinated debentures Rs 1,000,000 If the average earnings before interest and taxes of the company is Rs 1.5 million andé debt is long-term, what is the overall interest coverage? MeMillan Publishing Company has sales of Rs 32 million, total and total debt of Rs 9 million. If the 2 is ROA? What is ROE? assets of Rs 43 mille Profit margin is 7 percent, what is net income? Wk Trishakti Soap Company has sales o ER id ig a By sales of Rs 200,000, a net income of Rs 15,000, and Cash Receivables Inventories Netlined assets Rs 10,000, 50,000 Rs 160,000 ‘Accounts payable Other current bilities Long-term debt equity (Stock can be r much will the ROE cj re-purchs hange?ANALYSIS OF FINANCIAL STATEMENT © Chapter? 69 ‘auto Limited bas Rs 10 billion in total assets. The right side of its balance sheet Re 1 billion in current liabilities, Rs 3 billion in long-term debt and Rs 6 billion The company has 800 million shares of common stock outstanding, Rs 32 per share. What is company’s market /book ratio? Bhairab consis in common equily and its stock price is pacific International Inc. had additions to retained earnings of Rs 275,000 for the year ast ended. The firm paid out Rs 150,000 in cash dividends, and it has ending total equity re Re 6 million. If the firm currently has 125,000 shares of common stock outstanding, Minat arc earnings per share? Dividends per share? Book value per share? If the stock Currently sells for Rs 95 per share, what is the market-to-book ratio? The price-earning, ratio? Janak Textile Inc. recently reported net income of Rs 2 million. The company has 500,000 ‘shares of common stock, and it currently trades at Rs 40 a share. The company continues to expand and anticipates that one year from now its net income will be Rs 3.25 million. Over the next year the company also anticipates issuing an additional 150,000 shares of stock, so that one year from now the company will have 650,000 shares of common stock. ‘Assuming the company’s price-earning ratio remains at its current level, what will be the ‘company’s stock price one year from now? National Dealers, Inc. has sales of Rs 6 million, an asset turnover ratio of 6 times the year, and net profits of Rs 120,000. ‘a. What is the company’s return on assets or earring power? b. The company will install new point of sales cash registers throughout its stores, This equipment is expected to increase efficiency in inventory control, reduce clerical errors, and improve record keeping throughout the system. The new equipment will increase the investment in assets by 20 percent and is expected to increase the net profit margin from 2 percent now to 3 percent. No change in sales is expected. What is the effect of the new equipment on the return on assets or earring power? ‘Assume you are given the following relationship for the Bhaktapur Brick Corporation Sales to assets 1.5 times Return on assets (ROA) 3% Return on equity (ROE) 6% Calculate profit margin and debt ratio of the firm. ‘The Butwal Trading Corporation has net income of Rs 52,300. There are currently 21.50 days’ sales in receivables. Total assets are Rs 430,000, total receivables are Rs 59,300 and the debt to equity ratio is 1.30. What isthe firm's profit margin? Its total assets turnover” Its debt ratio? Its ROE? Assume 365 days in a year The data for various companies in the same industries are as follows: Company (Rs in millon) D Sales Tolal assets Net income H i (return on Determine the total assets turnover, net profit margin, and eaming Power ( assets) for each of the companies.70 Chapter 2+ 2.21] Ratio analysis MANAGERIAL FINANCE rizon Computer Inc. (Millions of Rupees) ‘The following data apply to Ho ee Cash and marketable securities Se a assets Rs ge) Net income a ee See 3. times Days sales outstanding (DSO) e ee Return on equity (ROE) Calculation is based on a 360- days. Horizon has no-preferred stock-only common equ debt. 4. Find Horizon’s (1) account receivable (A/R),(2) current liabilities, (3) current ass (@) total assets, (6) ROA,(6) common equity, and (7) long-term debt b. In part (a) you should have found Horizon’s accounts receivable (A/R)= Rs I million. If Horizon could reduce its DSO from 40 days to 30 days while hold other things constant, how much cash would it generate? If this cash were used buy back common stock (at book value), thus reducing the amount of comm equity, how would this affect (1) the ROE, (2) the ROA and (3) the total debt /o assets ratio? ity, current liabilities and long “Complete the balance sheet and sales information of a company in the table using following financial data: Debt ratio 50% Quick ratio 0.80 times Total assets turnover 15 times Days sales outstanding 36 days Gtoss profit margin 25% Cost of goods sold to inventory 5 times Balance Sheet ‘Accounts payable Long-term debt a ‘Common stock A000 Retained eamings es Total labilities and equity 2 Sr ey Using the information follows, complete the balai > complet ‘a the balance sheet given below: (Assume 3 Long-term debt to net worth Total assets turnover teed Average collection period ee Inventory turnover mae Gross profit margin ae Acid- test Tatio ae 11ANALYSIS OF Fina NCIAL STATEMENT + Ohapter2 74 Balance Sheet ‘ (Cash ‘Accounts receWvable Notes payable Inventory Long-term debt Plant and equipment (Common stock all Retained earings Total assets: 5 cw | Total lables & guy Following are some recent financial statements of Green Product Ine Green Product Ine, Balance Sheet as of Dec. 31, 2008 and 2009 esate 2008 | — 208 Totes and Ea = = auly_|_ 8 | os] S710 Recuspyate Ti fect coable 2am | “2106 | Nawspaye cca) as Ime ace | Soe | Oner =| a Tolalcurentassets | "RS7A40 | —AS7.796] Tol cuvettes | ASTI TESS Lng em debt dave | as0 Fred asets Bs TSS | Fa TOSRE| Tom tt Reoo% | Rases mes equity 515997 | Rs20029 (1,250shares outstanding) s21432 | fa 25,82 | Total abies and equity] Ae zLR2 | ASTER | Green Product Ine. Income Statement for the year ended Dec. 31, 2009 Sales F528 000 Cos of goods sold 11,600 Depreciation Aa Eamings before interest and taxes As 14260 Interest paid 80 Taxable Income [fa t3280 | Taxes @ 35% 4548 Nt income Dividends Rs 4,000, ‘Addition to retained earings Fs 4530 Market price fora shar of stock s63 Caleulate the following financial ratios a. Current ratio b Quick ratio Total assets turnover d, Inventory turnover fe. Receivables turnover f. Total debt ratio g. Debt-equity ratio h. Equity multiplier i, Times interest earned ratio j. Profit margin k. Return on assets 1. Return on equity m.- Price earning ratio rn. Dividends per share 0. Market-to-book ratio Consider the following industry average and financial statements for International ‘Computers Inc. er Balance Sheet as of 31" Dec 2009 Cash ‘Mkt. secures ‘Accounts payable Notes payable NC roohables Other current abi Pa Longtrm debt Sa ‘ad Accuruatad depreciation Retained earings amr ToulANCE 72 chapter? NAGERIAL FIN year ended Dec 31, 2009 income statement for the rene oat et Gross poft 1 ae es Netincome belo | ah vast at aco bo a epee Tet income Industry Average Ratios - Current ratio =2times Debt ratio 30% Times interest earned = 7 times Inventory turnover = 10 times Dso =24 days Fixed assets turnover = 6 times Total assets turnover =3 times Profit margin =3% Return on assets = 9% Return on equity =129% a. Calculate all those necessary ratios to make a comparison to industry avers: ratios. b. Construct a Du-Pont equation for the firm, and compare the company’s ratios to th composite ratios for the industry as a whole. € Do the balance sheet accounts or income statement figures seem to be primar responsible for low profit? d. Which specific accounts seem to be most out of line in relation to other firms in th industry? Bo Following are the data available for Intel Computer and Industry average; i Rimom —qued try average; you a , Calculate the indicated ratios for Intel Computer. b. Construct the Du-Pont equation for Intel Computer. © Make an assessment of Intel's strengths and weaknesses. Balance Sheet of Intel Computer as of December 31. 2009 Rs 64,500 | Cash ee 42000 | Receivables nD | ‘Total current liabilities | eon t a | ean Rs 165,000 | Total current: assets, Rs a us 13250 | Neadases veato arayss ANALYSIS OF FINANCIAL STATEMENT + chapter? 73, Deprecation Gross Prot ID Less: Seng expenses 5 10700 General expenses 57500 Eamings bot interest & taxes $5000 |__ 7500 Interest expenses 5,000 Earnings before taxes 12250 + Taxa 40% of Rs 22,750 Fe22750 Tot Income afer taxes - 9100 Fa 13650 Industry Average [_ asses | Current ratio Days sales outstanding 2times 35 days Inventory turnover = 67 times Total assets turnover =3 times Profit margin 212% Return on assets =3.6% Return on equity 9%. Debt ratio = 60% ‘The Casto Corporation's forecasted 2009 financial statements follow, along with some industry average ratios. ‘a. Calculate Casio's 2009 forecasted ratios, compare them with the industry average data, and comment briefly on Casio's projected strengths and weaknesses. b. What do you think would happen to Casio's ratios if the company initiated cost- cutting measures that allowed it to hold lower levels of inventory and substantially decreased the cost of goods sold? No calculations are necessary. Think about which ratios would be affected by changes in these two accounts. Casio Corporation: Forecasted Balance Sheet as of December 31, 2009 Cash ‘Accounts receivable Inventories Total curent assets Land and building 238,000 Machinery Other fixed assets Total assets ‘Accounts and notes payable ‘Accruals Total curent ables cd pa Long-term debt $575,000 Common stock 254,710 Retained eamings Total abies and Sted Income Statement for 2009 ‘Casio Corporation: Forecas Cost of goods sold Gross operating profit General administrative and selling expenses Depreciation ‘Miscellaneous Eaming before taxes (EBT)74 chapter 2° MANAGERIAL FINANCE Per-share data EPS: ‘Cash dividends PIE ratio Marko price (average) Number of shares, ‘outstandir Financial Ratios (2009)* ‘Quick ratio Current ratio Unventory turnover® Days sales outstanding Fixed assets turnover? Total assets tumover? Return on assets Retum on equity “a Debt ratio Profit margin on sales PIE rao Picash flow ratio.Ilustration 6 Component cost and WACC ar Tax rate (t) = 30% a. After-tax cost of bond (ka) Coupon interest rate = 10.40% ka = ka (1-t) = 10.40% (1 - 0.30) % (1 - 0.30) = 7.28% b. Cost of preferred stock (kes) 72s Calll price 110 Call period years Dp = Face value x Dividend rate = Rs 100 x 0.10 = Rs 10 Il price - Dew price-Vas y, io , RE1IO-Rs 100 kes = Gallprice +2 Vp Soe TET ees De BReTiOT dx Re 100 = 0.1161 oF 11.61% 3 c. — Selling price (Po) =Rs16 Current dividend (Dp) = Rs 2 Growth rate (g) We have, a Cost of equity (ks) = a = 0.125 or 12.5% d. Selling price (Ps) Expected dividend (D:) Growth rate (g) We have, Cost of equity (ki) = +g=722+005= PEt B= Reig + 0.05 = 0.1750 oF 17.50% e. Weighted average cost of capital Sources Weight Alera component Soest ‘Cost x Debt 0.30 7.28% 2.18% Preferred stock 020 11.61 232 Common stock 050 1750 875 Total 4.00 WACC 13.25% ‘Accertain company has the following capital structure, which it considers to be optimal: 5% Proferred stock 15 60 ‘Gomman stock id investors expected earnings and dividends to ‘ure, The company paid dividend of Rs 3.60 y sells at a price of Rs 60 per share. These ‘The company’s tax rate is 40 percent, an grow at a constant rate of 9 percent in the fut per share last year (Da), and its stock currenth ferms would apply to new security offerings: Common: New common stock would have Preferred: New preferred stock could be sold to the public at a price of Rs 100 per share, with a diviend of Rs 11, floatation costs of Rs 5 per share would be incurred. a floatation cost of 10 percent. Debt: Debt could be sol a. Find the component cost of 4 common stock. Jd at an annwal interest rate of 12 percent. jebt, preferred stock, retained earnings, and new106 onapter 3° ‘SOLUTION Ilustration 7 ‘Weighted average. cost of capital a. After-tax cost of debt (kai) MARAGERIAL FINANCE average cost of capital assuming that Calculate the weighted COMM, b. Traneing requirements are all met by retained earnings ven, tax ate () Bom Growth rate (g) =% Last year dividend (Dp) Rs 3.60 Current selling price (Po) =Rs60 Flotation cost on common stack (F) =10% Price of preferred stock (Vps) =Rs 100 Preferred dividend (Dj) Flotation cost Interest rate 2% 1158 or 11.58% Cost of preferred tock (krs) Cost of retained earnings (k,) = hs 8 Rs 360 (1 +0.09) SaemEeee OO = 0.1554 or 15.54% leet eeereecniion etock (2) Bot g- SAGO), 0.09 = 0.1627 or 16.27% Weighted average cost of capital assuming that common stock financing requirements are all met by retained earnings ‘After-tax component Coslx Proportion 1 18% i 174 ax | 12.86% Everest Recording Studio reported earning to Rs 4,200,000 last year. From that, te company paid a dividend of Rs 1.26 on each of its 1,000,000 common shares outstanding ‘The eapital structure of the company includes 40 percent debt, 10 percent. prefer stock, and 50 percent common stock, It is taxed at a rate of 40 percent, a. Ifthe market price of common stock is Rs 40 and dividends are expected to grow a a rate of 6 percent a year for the foreseeable future, what isthe company's ost o financing with retained earning? b. If flotation costs on new shares of common stock amount to RS 1 pe the company's cost of new common stock Le. a " company can issue Ks 2 preferred stock dividend for a market pri e : a spay eayon costs would amount t© Rs 3 per share, What fy goa tes 25 preferred stock financing? : 4 44.__“The company can issue Rs 1,000 par value, 10 percent COUPE, S-YEGE Bons (hat can be sold for Rs 1,200 each. What is the approximate cost of debt? wverest Recording can make i What is the maximum investment that Everest Recorcing a sl ‘on stock? before it must issue new comm: cone What is the WACC for projects with a cost at or belo ? thare, what issoLUTION Ter ene “Ss TERS: SEES Given: Earnings last year = Rs 4,200,000 Dividend per share (Ds) Rs 1.26 Common shares outstanding Proportion of debt (Wa) Proportion of common stock (Ws) Tax rate (t) a. Market price of common stock (Po) = Growth rate on dividend (g) Cost of retained earnings (ks) We have, kK _ Do +g) Rs 1.26 (1 + 0.06) o5 MBSE PIES TS = Rs 40 +0.06 = 0.0934 or 9.34% b. _ Flotation cost on new common stock (F) = Rs 1 Cost of new common stock (ke) = We have, Do(l+g, Rs 1.26 (1 + 0.06) Ke => pk t8= Reddo Rar + 0.06 = 0.0942 or 9.42% «Dividend on preferred stock (D;.) —=Rs 2 Market price of preferred stock (Ps) = Rs 25 Flotation cost (F) Rs3 Cost of preferred stock (ks) =? We have, krs 2S = =0.0008 0F 9.09% 4. Par value of the bond Rs 1,000 Coupon rate Years to maturity (n) years Market price (Va) = Rs 1,200 ‘Approximate cost of debt (ka) We have, je Mowe Fan aL DOD Ra. Tern, Ratio00>2 Reta 0,099. °529% 3 3 (Ke is 5.29%. ‘Therefore, the before tax approximate cost of debt ‘After tax cost of debt (kar) = ka (1 - t) =5.29 (1 - 0.40) = 3.174% Break point We have, : Retained earnin; Break point = Proportion of equity ~ The maximum investment before it must issue new common stock is Rs 5,880,000. Working notes Total dividend 11,000,000 x Rs 1.26 = Rs 1,260,000 Retained earnings = Total earnings ~ Total dividend Rs 4,200,000 - Rs 1,260,000 = Rs 2,940,000’ ts al the end of 19x0,, 50 million: Bord financing Play) 115 percent dividend py urrently sels for Re 3 _ is Rs 10 million of rae few years, dividend ya" i. The tax rate is 40 Perce: timal: What ould eae were used to finance additio SOLUTION Given, Total assets at the end of 19X0 Additional fund needed Interest rate on bond Dividend rate on preferred stock 115% Selling price of preferred stock (Vs) = Rs 100 Selling price of common stock (Po) ‘Net proceed per share (NP) Retained earnings available Dividend yield (D/Po) Growth rate (g) Tax rate (t)COST OF CAPITAL) © Present capital structure of th a. The company desires to increase its assets by Rs 50,000,000. Hence, the required ‘amount of equity capital should be 50 percent of Rs 50 million i.e. Rs 25 million to ‘maintain present capital structure. b. Retained earnings available for the expansion purposes are expected to be Rs 10,000,000. Hence, amount that must be generated externally 1s Rs 19,000,000 (ie. 25,000,000 - Rs 10,000,000). ‘The component costs 1. After-tax cost of new debt (Ka) = ka(1 = 1) = 11% (1-0-4) Bin Gibicigee pierce ie) =22 mus 0.066 or 6.6% 115 or 11.5% 3, Cost of retained earnings (kx) = Dividend yield + Growth rate = 6% + 8% = 14% 4, Cost of new equity (ke) Bb. g =P + 008 = 0.1467 or 14.67% Working note: Di = Po x Dividend yield = Rs 50 x 6% = Rs3 The average cost of equity for 19X1 ‘Sources "Amount Proportion ‘ertax “Aertax component component | Cost x Proportion 14.00% 500% 1487 8.80 18.40%. Equity (internal) Rs 10 milion Equity (extemal) 16 :milion Total As 25 milion WACC= “The average cost of equity for 19X1 is 14.40% ted average cost of capital (if only retained earnings used ie RS 10 million) Proportion | atarizi component ‘After-tax; carat ‘Cost x Debt 040) 660% 2.64% Preferred stock 0.10 1150 115 050. 1400 7.00 WACC = 10.79%fan. 1, 1999. By the end of ip, F Gaswume there 19 no short-term dey, He considered to be optima! Gat par, Preferred ston, in stock current, 7 . The stockholders tg of a dividend yield of ‘are estimated to be Ry me pil budget, what is the rupee pital budget must be must be satisfied internally? How rey fn needed ; Fe wl tere bea break in marginal cost of capita both below and above the break in the =Rs90 million yar =Rs 60 million ntof the capital budget = Rs 30 million ired amount of equity capital should be Rs 15 million (50% of Fs 3 ion) to maintain present capital structure ‘Amount of equity capital Estimated retained earning Rs 3 million New equity fund needed Rs 12 million Cost of retained earning (ks) = Dividend yield + Growth rate =4% + 8% =12% Cost of new equity (ke) = Page are cee Rs 30x 0.04 = Re +0008 = 0.1244 = 12.44% Rs 15 million Where, Po =selling price = Rs 30 NP =net proceed = Rs 27 e Retained earings = Rs 3 million Weight of equity Break points 2 Amount of retained earnii Rs3 million Saal Proportion of equity = Rs 6 million{ustration 10 CO schedule COST OF CAPITAL + Chapters III , Calculation of marginal cost of capital Here, Debt before tax (ka) =11% Debt after tax (Kar) = 11% (1 -0.4) = 6.6% Cost of preferred stock (kp) = 11.5% Cost of retained earning (k;) = 12% Cost of new equity (Ke) = 12.44% i) Marginal cost of capital below the break points Sources ‘Amount | Proportion(W) | Cost x Proportion 24m 04 6.60% 2.64% Preferred stock 6m 04 11.50 1.15 30m 05: 12,00 6.00 979% (@)__ Marginal cost of capital above the break points Proportion (W) Cost Cost x Proportion 24m | 04 6.60% 2.64% em oA 11.50) 115 30m 05 12.48 622 60m, MCC = 10.01% Bagmati Electronic Company (BEC) has the following capital structure, which it consider to be optimal. Debt 40% Preferred stock 10 Common stock 50 100% BEC's expected net income this year is Rs 625,000 Company. continues its dividend ich i {40 percent. Investors expect earnings payout, which is 60 percent. Its ‘marginal tax rate is 40, and dividends to grow ata constant rate of 5 percent in the future. BEC paid a dividend Of Rs 10 per share last year and its stock currently sells at a price of Rs 120. BEC can obtain new capital in the following w2Y*: He ee : f debt can be sold at.an interest rate 2 percent, debt in the ae apes a 200,000 must carry an interest rate of 12 percent, and all debt x 0, 4 Gai nave atvinterest rate of 15 Percen aoe nae preferred stock with 2 dividend of Rs 12 can be sold the public at a i lotation costs of Re § per share will be incurred up eee Se at Ord flotation cost will rise to Rs 10 per share on all lo A ol " preferred stock over Rs Ue oration cost of 5 percent for up to Rs 500,000 Common stock: New commons A on over Rs 500000, sf new stock and 10 percent for BEC has. ie following, independent investment opportuniticsge) on Ti debt, preversed must be carned red used as stan termining aPPYOP" scounting rate ' compu = of return (IRR) te dividend payoy fe net present valye for evaluating Worthing, to determine weighted average cost of i debt holders. After kas required by the ae Sear Peaherisebubyatdar| (3% *2te)- Cost ; K ‘red by the preferred stoc ee rae return required by its common stoc| Se Mee retained earning and ‘externally through equity, ks, can be computed using dividend i ara vaing vand-yiclaplusrisk premivy seater than the cost of internal equity because d ts of capital ‘tal (WACC) is the weighted average of altri rre Reeeeealeainon equity. Company should use tae! \ “market value weights are preferred over bos ht or proportion. Marginal cost of capital (MCC the cost raising an additional rupee of capital. MCC increases as the firm raises more and more capit! during a given period. There are various factors that affect a firm's cost of capital. Demand a supply of capital, marketability of the security, amount of finance, leverage, tax rate, «AP structure etc. are major factors affecting capital structure. value weights to compute weig] 1 a 3 5. 6 y. 8. 9. 10. 1 12. What it a ¥ poe ep you understand by cost of capital? Briefly explain use of cost of capital in finan a you ee cost of debt? Why do you compute after-tax cost of debt? lo you mean by cost of preferred stock? How do you com| 1 2 t @ Why should we assign cost of retained earning? : aoe Pala dies approaches for estimating cost of retained earnings. ve cost of external equity capital higher than the cost of retained earnings? Vhat is WACC? Explain the process of computing WACC. : al t ome a by marginal cost of cost of capital? xplain the break point caused by retained earnings a . Explain factors affecting firm's ee aaAL ings and other sources of long-term financins | How should firms evaluate projects with different risks? Should all divisions within a firm use the firm's composite WACC when considering est ia eetec dastleauty jnanci| Coleg “ e Costly ing mer op leapt a rate after tax cost of debt. Aperpetual bond that has a Rs 1000 par value and coupon interest of 15 percent. A Ag issue would have a flotation costa Rs 50 Delta Company recently sold an issue of 10-year maturity zero coupon bonds. The bonds were sold at 0 deep discount price of Rs 550 each. After flotation costs, Delta | Feceived Rs 528 each, The bonds have a Rs 1,000 maturity value. Compute the after- re cact of debt for these bonds if Delta Company's marginal tax rate is 40 percent. We Blue Star, Ine, is trying to determine its cost of debt, The firm has a debt isoue paistanding with 15 years to maturity that is quoted at Rs 1060, Coupon interest is 13 percent. If the tax rate is 30 percent, what is the after-tax cost of debt? ‘sT Company has sold an issue of Rs 12 cumulative preferred stock to the public at a price of Rs 64 per share. Alter issuance costs, ST Company netted Rs 80 per share: The fompany has a marginal tax rate of 40 percent ie alealate the after-tax cost of this preferred stock assuming that this stock is perpetuity: In Ifthe stock is callable in five years at Rs 100 per share and investors expect it to be Talled at that time, whats the after-tax cost of this preferred stock? ‘The earnings, dividends and stock price of VT, Ine are expected to grow at 8 percent per sar in the future. Company's common stock sells for Rs 120 per share, its last dividend Arse Rs 10, and the company will pay a dividend of Ks 408 per share at the end of the ‘current year. a. Using the discounted eash flow approach, what is its cost of retained earnings? ‘>, If the firm’s beta is 14, the Tsk-free rate is 8.5 percent, and the average retula 07 the market is 145 percent, what will be the figm’s cost of equity using the CAPM approach? G. Tethiefirm’s bonds earn a return of 12 percent what will k, be using the bond-yield- pluscrisk-premium approach? Kesume appropriate size of isk premium 1S 4 percent. 4, Based on the result of Parts 'a’ through vel, what would you estimate company’s cost of retained earnings to be? Mechi Company’s common stock is currently trading, at Rs 80 a share. The stock is expected to pay a dividend of Rs Ga share at the end of the year (Di = Rs 8) and the dividend is expected to grow at a constant rate of 4 percent a year. If the company Were Peet externaliequitysit wouldincur 2 10 percent flotation cost: What are the costs of internal and external equity? The Laksmi Finance Company's (LEC) next expected dividend per share (Di) is Rs 12.72; its growth rate is 6 percent, and the stock now sells for Rs 160. New stock (external equity) can be sold to net the firm Rs 144 per share, ‘a. What is LFC’s cost of retained earnings? b. What is LFC’s percentage flotation cost? €) Whatis LFC’s cost of new common stock? Compute after-tax component cost of following sources of financing: a. A company can sell a 10-year, Rs 1,000 face value bond with an 85 percent coupon for Re 050, An underwriting fee of 2 percent of the face value would be incurred in the issue process. Aerume corporate 12% rate is 30 percent.on sr share on its common growth rate in its di, y's tax rate is 30 pecs | | 2 stated dividend pe, di seu furrent price of the je ion at 12 percent. ; a re an in estment of Rs {annual growth rate" ea indicators "| dividend growth” thet ‘common stock"ACC and pal structure COSTOF CAPITAL + Chapter3 117 ‘a. Aconstant dividend growth valuation model is Sey Secietaivvehits ot WOR a reasonable representation of the b, The firm does not change the risk complexion of its assets nor its financial leverage. The expected dividend at the end of 20X2 is Rs 3.45 per share. Pashupati Electric Company (PEC) uses only debt and equity. It can borrow unlimited oo a Mee, rate of 10 percent as long as it finances at its target capital structure, which calls for 45 percent debt and 55 percent common equity. Its last dividend was Rs 2, its expected constant i 0 growth rate is 4 percent, price of Rs 20. PEC’s tax rate is 40 percent, Two bevaaite Pret Aba ari rojects are available: Project A has ar of return of 13 percent, while P; ia failables Project A hasinirale roject B has a rate of return of 10 : return of 10 percent. All of the company's potential projects are equally risky and as risky as the firm's other assets. a. What is PEC’s cost of common equity? b. What is PEC's weighted average cost of capital? Which projects should PEC select? Seti Sugar Company was recently formed to manufacture nu a new product. The compan} has the following capital structure: . 3 13% Debentures of 2005 ‘Ye%6Pretered stock As 6 millon 2 min 8 milion The common stock sells for Rs 25 a share, and the company has a marginal tax rate of 40 percent. A study of publicly held companies in this line of business suggests that the required return on equity is about 17 percent for a company of this sort. Compute the firm's weighted average cost of capital. Is the figure computed an appropriate critetion for evaluating investment proposals? Explain. PP Corporation has a target capital structure of 40 percent debt and 60 percent common ‘equity. The company’s before-tax cost of debt is 12 percent and its marginal tax rate is 40 percent, The current stock price is Rs 22.50; the last dividend was Rs 2.00; and the dividend is expected to grow at a constant rate of 7 percent. What will be the firm's cost of common equity and its WACC? What will happen to WACC if PP Corporation needs to spend flotation cost on the issue of common stock? Explain. Himalayan Cement Factory has a capital structure that consists of debt and common equity. The company can issue debt at 11 percent. Its stock currently pays a Rs 2 dividend per share , and the stock's price is currently Rs 24.75. The company’s dividend is expected to grow at a constant rate of 7 percent per year, its tax rate is 35 percent; and the company estimates that its weighted average cost of capital is 13.95 percent. What percentage of the company's capital structure consists of debt financing? ABC Company is attempting to evaluate the equity. The ays ao ‘is currently selling for Rs 62.50 per share. The company expects to pay Rs 5,42 per share at the end of the year. The dividends for the past 5 years ire given below: costs of internal and external common Fs 492 ‘The company expects to net Rs 67.50 pet share on a new share after floatation costs Calculate: a. The growth rate of dividends.[and it is expecta, Its before-tax cos,© “Growth ate, cost clilenal and cetera equity COST OF CAPITAL: “Ste crn i te es Debt: ‘The company can sell a 20 year, Rs 1,000 face vi for Rs 970. An underwriting fee of 2 percent of the face v the process. Preferred stock: §g percent preferred stock having face value of Rs 75 can be sold for Rs 72. A fee of Rs 2 per share must be paid to the underwriters. falue bond with a 6 percent coupon ‘alue would be incurred in ‘Common stock: ‘The company’s common stock is currently selling for Rs 90 per share. The company expects to pay a dividend of Rs 4 per share at the end of the coming year. Its dividend payments, which represent a fixed payout of earnings over the past five vyears are given below: Year 1986 70s | ___—1884 785 1382 Dividend (Rs) 3.740. 3.495, 3.266 3,053 2.853, Tris expected that in order to sell the new common stock it must be under priced By Rs and therefore will reach the market at Rs 85 per shave. The company must also pay a Rs 3 per share underwriting fee. : a. Calculate the specific cost of each source of financing including retained earnings b. Given the following book and market value data, ealeulate: (i) The weighted average cost of capital using book value weights, and (i) The weighted average cost of capital using market value weights, Book and market values for each type of capital are as follows Market value Type of capital Book valve Tonge debt is 600,000 5 650,000 Preferred stock 150,000 180,000 ‘Common stock 200,000 470,000 Retained earings 50,000 Total is 1000,000 is 1900,000, I] Compare the weighted average cost of capital calculated ‘above. Explain how are they different. EPS in 1994 was Rs 2. EPS in 1989 was Rs 1.36. The company pays out 40 percent of ils earnings as dividend and the stock currently sells for Rs 21.60 The company expected an earning of Rs 10 million in 1995. Its optimal market value debt-asset ratio was 60 percent and the firm had no preferred stock outstanding, a. Calculate the growth rate in its earnings. Calculate the dividend per share expected in 1995. Assume that the growth rate calculated above will continue: ‘What is the cost of retained earnings? The Mechi Tea Company's ©. A What amount of retained earnings is expected in 1995? BF ast amount of top financing will the cost of equity increase? The sale of new stock would net the company Rs 18.36 per share. utah is the stock? ¢? What is the cost of new common company’s percentage flotation cos! ion next yert. Its dividend payout corporation uses 0 of Rs 30 mill ‘New Nepal Corporation expects earnings ratio is 60 percent. The ratio. is 40 percent, and its debt assels preferred stock. a. What amountof r b. Atwhat amount of financing, will t etained earnings does the corporation expeet next year? here be a break in the MCC schedule?est rate of 11 percen, ‘ tional debt at a rate of 1°, ks in the MCC schedule? in ; now selling for Rs 5p 0) is 50 percent of the Eps, ) growth rate may be base ag zo nl as The firm’s marginal tax raspy ture, which is considered to be optima i its operation by 50 percent requiring ana] | jon stock can be sold to net Rs 43 ‘et the company Rs 54 a shi" to be 12 percent, consisting o! Tate of 8 percent. (The next expe €arnings are estimated to be) ung that all asset expansion (g) Sapital) is included in the pl 6 depreciation, is Rs 135 milo" nuch of the capital budget ™)‘Costs of equity ‘and WACC below Snsaboe he beak point WACO, WMC, and 10S Cost oF CAPITAL + Chapter. 121 d. At what level of capital expenditure will there be a break in Dexter's MCC schedule? e Calculate the WACC (1) below and (2) above the break in the MCC schedule. f, Plot the MCC schedule. Also, draw in an IOS schedule that is consistent with both the MCC schedule and the projected capital budget. National Electric Company (NEC) uses only debt and equity. It can borrow unlimited amount at an interest rate of 10 percent as long as it finances at its target capital structure, which calls for 45 percent debt and 55 percent common equity. Its last dividend was Rs 2; its expected constant growth rate is 4 percent; its stock sells at a price of Rs 25; and new stock would net the company Rs 20 per share after flotation costs. NEC's marginal tax rate is 40 percent, and it expects to have Rs 100 million of retained earnings this year. Two projects are available: Project A has a cost of Rs 200 million and a rate of return of 13 percent, while Project B has a cost of Rs 125 million and a rate of return of 10 percent. All the company’s potential projects are equally risky. a. _ What is NEC’s cost of equity from newly issued stock? b. What is NEC’s marginal cost of capital; i., what WACC cost rate should it use to evaluate capital budgeting projects ( these two projects plus any others that might arise during the year, provided the cost of capital schedule remains as it is currently)? Humble Manufacturing is interested in measuring its overall cost of capital. The firm is in the 40 percent tax bracket. Current investigation has gathered the following data: Debt: The firm can raise an unlimited amount of debt by selling Rs 1,000-par-value, 10 percent coupon interest rate, 10-year bonds on which annual interest payments will be made. To sell the issue, an average discount of Rs 30 per bond must be given. The firm must also pay flotation costs of Rs 20 per bond. Preferred stock: The firm can sell 11 percent (annual dividend) preferred stock at its Rs 100-per-share par value. The cost of issuing and selling the preferred stock is expected to be Rs 4 per share. An unlimited amount of preferred stock can be sold under these terms. Common stock: The firm's common stock is currently selling for Rs 80 per share. The firm expects to pay cash dividends of Rs 6 per share next year. The firm's dividends have been growing at an annual rate of 6 percent, and this rate is expected to continue in the future. The stock will have to be under priced by Rs 4 per share, and flotation costs are expected to amount to Rs 4 per share. The firm can sell an unlimited amount of new ‘common stock under these terms. Retained earnings: The firm expects to have Rs 225,000 of retained earnings available in the coming year. Once these retained earnings are exhausted, the firm will use new ‘common stock as the form of common stock equity financing a. Calculate the specitic cost of each source of financing, b. The firm uses the weights shown in the following table, which are based oo target capital structure proportions, to calculate its weighted average cost of capita ‘sociated with the firm's financial situation. 1. Calculate the single break point ai rene rig (Hint: This point results from the exhaustionated in part (1). th the information shown in the following vestmen! opportunities, draw the irons weighted Margina| {CC) schedule and investment opportunities schedule (10S) o, In g or investment on the x axis and weighte: ‘on the y-axis). _ Initial Investment Rs 100,000 500,000 150,000 200,000 450,000 600,000 300,000 See available ir vi ent do you recommend that the firm ac How much total new financing is required? ere.pr ard D0 soLUTION Uustration 2 DOL, DFL DCL. and EPS. LLUSTRATIVE PROBLEMS ~~ vo unery w use aevt, Nepal Manufacturing sells its finished 20,000 and variable cost per unit is Rs 5. Calculate the firm's EBIT at 10,000 units. Product for Rs 9 per unit, Its fixed costs are Rs b, Calculate'the firm's EBIT for sales of 8,000 and 12,000 units respectively, c. Calculate the percentage chang l ge in sales (from 10,000 units base I associated percentage change in EBIT for the shift in sales indicated aah me . th i d. Use the percentage computed in part c to determine degree of operating leverage. Given, Selling price per unit (8) = Rs9 Fixed costs (FC) Rs 20,000 Variable cost per unit(V) =Rs5 a. Calculation of EBIT if Q = 10,000 units. EBIT =Q(S-V)-FC = 10,000(Rs 9 Rs 5) - Rs 20,000 = Rs 20,000 b. IfQ =8,000 units. EBIT = 8,000(Rs 9 Rs 5) ~ Rs 20,000 = Rs 12,000 IfQ =12,000 units. EBIT = 12,000(Rs 9 ~ Rs 5) ~ Rs 20,000 = Rs 28,000 ¢. Calculation of percentage change in sales and the associated percentage change in EBIT: e (12,000 - 10,000) 0 %Ainsales = 70,000 = 0.2, ie. 20% Rs 28,000 — Rs 20,000) _ 9 49 i.e, 40% % AinEBIT = Rs 20,000 d. Calculation of degree of operating leverages % Ain EBIT 40% _ DOL = 3 in-sales ~ 20%" > times The degree of operating leverage at sales leads ta two percent increase in 2 times implies that an one percentage increase 1" earnings before interests and taxes. fe rechargeable battery for use Nepal Battery Corporation produces one product 4 lg fe recharge in small calculators. Last year 50,000 batteries were sold at statement is shown below:FINANCIAL STRUCTURE AND LEVERAGE + Chapter 4 137 ¢ Nepal Battery wants to change its operation to the more automated process only if it results into increase in sales volume causing the EPS also to increase. At the given : alternatives of financing EPS has been decreased assuming constant level of sales. \ So it does not select either of the financing alternatives If sales are expected to increase, certainly it will have the greatest impact on EPS under debt financing because of higher degree of combined leverage. \ 3 You have developed the following analytical income statement for your corporation. It ' batt DOL represents the most recent year's operations, which ended yesterday. Your supervisor in Oye the financial studies office has just handed you a memorandum that asked for written responses to the following questions: Sales Variable costs Revenue before fixed costs (Contibution margin) Fixed costs At this level of output, whut is the degree of operating leverage? What is the degree of financial leverage? What is the degree of combined leverage? If sales should increase by 30 percent, by what percent would earnings before taxes and net income increase? aoge SOLUTION a. _ Degree of operating leverage: Contribution margin ol EBIT Rs 8000000 _ = Rs 3000000 ~ b. Degree of financial leverage: EBIT DFL = EBT Rs 3000000 = Rs 2000000 c. Degree of combined leverage: Contribution margin DCL = EBT Rs 8000000 _ 4, = Rs 2000000 = 4 times 2.67 times. = 1.5 times. 4. The firm's degree of combined leverage is 4 times, which means that earnings ‘ before tax and net income increase by 4 times greater ratio than the ratio of increase in sales, Therefore if sales increase by 30%, the EBT or net income increases by 120 percent (that is, 30% x 4).001, OFL and DCL DOL, DAL and DCL DOL, DFL and OC. F percent ©! of 60) 15000 shares O° the major oper iB has 3,000 shares of common slog of its product with variable coy Rs 5 Pet ae ‘Rs 150,000 and the company erage seit Bea operat See that are used tO satisfy finang, pre Fock outa ne Tne company = B COMPANY iy reed of the assets: oes t that the coe y cent coupon: Both the companies hay, carrying 1 P of 1000,00 units Heer al and combined evereee finan yut a Firm, which produces Product A: 01 Taxrale In 2008, The Firm's net income was Rs 600,000. a. How many products A were sold in 2008? b. Caleulate the degrees of operating, financial, and combined leverage for the firm. Suppose that the firm restructures its balance sheet, increasing, debt to Rs 1 million. Prepare a pro-forma income statement and calculate the degree of the combined leverage assuming the same level of sales calculated in part (a). Lumbini Auto-parts Suppliers Inc.'s 2009 income statement is shown below: Income Statement for December 31, 2009 (In Rs '000) Sab (Cost of goods sold Gross profit Conbuton margin) Fred operating costs {anise eta wsa OL, DAL ad OTL aos and ROE Your supervisor in the controller's office has just handed you a ‘memorandi FINANCIAL STRUCTURE AND LEVERAGE + Chapter 143 ig table represents the most recent year's operations, which ended yesterday. ‘i is 45,750,000 Netincome “i jum asking for ‘written responses to the following questions: this level of output, what is the degree of operating leverage? ‘What is the degree of financial leverage? “¢. Whatis the degree of total leverage? ‘a. Ifsales should increase by 25 percent, by what percent would earnings before taxes and net income increase? ‘You have the following income statement for your corporation. It represents the most recent year's operations, which ended yesterday. Sales (10,000 units @Rs 20 per uni) ‘Variable cos (10,000 units @ Rs 10 per uni) CContbution margin Fixed cosis(inuding Rs 20,000 annual depreciation) est Interest expense EBT Taxes @50% ‘Your boss tells you to response to the following issues: ‘a. What is the degree of operating leverage? b. Whats the degree of financial leverage? . What is the degree of total leverage? 4. Ifsales should increase by 20 percent, by what percent would earnings before taxes and net income increase? The Asian Company and the Southern Company are identical except for their levees Tatios and the interest rate on debt. Each has Rs 10 million in assets, each earned Rs =~ dnilligns before intereot and taves in 2006 and each has a 40 percent corporate tax rate. ‘Asian, however, has a leverage ratio (debt /total assets) of 30 percent and pays 10 percent interest on its debt, while Southern has a 50 percent leverage ratio, pays 12 percent interest on debt. a. Calculate the rate of return on equity for each firm. b. Observing that Southern has a higher return on equity, raise the leverage ratio from 30 to 60 percent. This will increase ‘Asian's interest rate on debt to 15 percent. Calculate the new rate of return on equity for Asian. Asian‘s' treasurer decides to¥ itlion for new equi as ween saan 70 mon 6 0 on ae «Paper le plans es ae en it may be issued. Te et al i The sworking SPI TY A anures YC ancing ae: 40 per Share the fisn PHO f rupees) ns 0 raters oF 99 (illo of rupee Test and taxes remain at 10 percent of sales ing and the debt financing “Assuming that earnings before inte ‘aleulate earnings per share under both the stock finan alternative at each possible level of sales. Calculate expected earnings per share under both debt and stock financing, b ‘The Latin Corporation plans to expand assets by 50 percent. To finance the expat is choosing between a straight 11 percent debt issue and common stock. Its cu! balance sheet and income statement are shown below. If Latin Corporation finances fs 350000 expansion with debt, the rate on the incremental debt will be 11 percent, an price earnings ratio of the common stock will be 8 times. If the expansion is financed equity, the new stock can be sold at Rs 25. The price/earnings ratio of all the outstandins common stock will remain at 10 times. Latin Corporation balance sheet as of Dec.31, 2009 Tsseis RS 700,000 ] Debt (at 8%) ‘Common stock, Rs 10 par Retained earnings as is 700,000 | Total claims iin Corporation income stat a statement for year ended Dec 31, 2009 Total easts(exdutng inarest) esr ineest BT Tax @ 50% Netincame EPS = Rs 103,600/ 35,000 = PE ratio = 10 timesFINANCIAL STRUCTURE AND LEVERAGE + Chapter © 0” _ghare = 10x Rs 2.96 = Rs 29.60 s{ earnings before interest and taxes (EBIT) are 10 percent of sales, Moarnings. per share at sales levels of Ts 700,000, Ts 1,400,000, Rs 7900000, when financing is with common stock? When financing iS ‘no fixed costs of production) s price earnings ratio, calculate the market value per share of common “each sales level for both the debt and the equity financing. of financing should be used if the firm follows the policy of seeking to ze (i) EPS? ({i) Market price per share? ears that the following probability estimates of future éales have Dect 20 percent chance of Rs 700,000, 30 percent chance of Rs 1,400,000, 30 percent e of Rs 2,100,000, and 20 percent chance ‘of Rs 2,800,000. Calculate expected ues for EPS and market price per share under each financing alternative ‘What other factors should be taken into account in choosing between the two forms ‘of financing? estimated ROE distribution for firms X, Y and Z. Return on equity x 0 % 10 15 20 F Calculate the expected value and standard deviation for firm Z's ROE. (We have _ ROEK=10%, ox = 5.5% : ROEy = 12%, ov =7.7%) Discuss the relative riskiness of the three firms’ returns. (Assume that these distributions are expected to remain constant over time) Now suppose all three firms have the same standard deviation of basic earning power (EBIT/Total assets), ox = oy= 02 = 5.5%, What can we tell about the financial risk of each firm? am ‘The Butwal Textile Inc. (BTI) wishes to calculate next year's return on equity under tneapais _ different leverage ratios. BT's total assets are Rs 14 million, and its corporate tax rate is axdkerd 40 percent. The company is able to estimate next years earning before interest and taxes oa for three possible states of the world: Rs 4.2 million with » 0.2 probability, Rs 2.8 million with a 0.5 probability, and Rs 700,000 with a 0.3 probability. Calculate BIT's expected Serra on. equity, standard deviation, and coefficient of variation for each of the following leverage ratios, and evaluate the results: Teverage [DIA ratio] ‘ O% 10 50 60 Rise Broadband Communication Corporation (BCC) supplies headphones to airlines for use with movie and stereo program. The headphones, Which use the latest electronic faring components, sell for Rs 28.80 per set, and this year’s sales are expected to be 450,000 unite, Variable production costs for the expected sales under present production methods are estimated at Rs 10,200,000 and fixed production costs at present are RS 1,560,000. BCC has Rs 4,800,000 of debt outstanding at an interest rate of 8 percent. There |and there is no preferred stock BI pe 40 percent cOrPOrae ox bck band pond in ne eswiPmet SIE ld investing Be pias t. Also, fixed op investing Bs ty 20 percent. Also, fixed oper unit would 11300000: BCC could raise the req ae ditional 240,000 a rita or by selling _ ‘at 10 percent der th, a auction process, (2) under then, o ae {fit uses common stock? . it undertakes 4 the same FPS, assuming he BCC have the some duction-financing = 0 under the three product i ‘tales level would EPS = 0 un tan with debt financing, and the ng, « is, under the old plan, ¥ t their ca in every respects excep! pit identical in every f these two fins Two firm- X and Y companies ere leverage and earnings 0! i ts, a eee structure. The financial information on assel Sea aces] Rs 10 milion Toa assets 7 Eamigs beer interest and taxes Bane Corporat tx ate coe Debt rao 2] reese - - = What is the retam on equity of each company? Why are they different? Explain b. With return on equity calculated in part could you suggest the Company \¥ increase debt ratio? Explain. a ‘The beta for the Hume Company is 0.8 if it employs no leverage, and its tax rate ii Betedlleveed percent. The financial manager of Hume uses the following expression to calculate fim influence of leverage on beta. Br = [1 + (1-0 (DE)] Bu Where, x = beta of the levered firm fu = beta of the unlevered firm rporate tax rate p DE=debt-equity ratio a. el alternative target leverage ratios are being considered. What will be mn il : a pee stock of Hume Company if the following alternative leverage ® TanurPoved? That is alternative debt equity ratios are 04,08, 1.0, .2 and 16 the financial manager of Hume uses t fe the requ quily, what are the required rates : of ret ‘atios? (The estimated risk-free return is Percent). Hint: Required return = The fina ° ea oe manager wants to '8€ ratio which can be em at this leverage ratio? the SML to estimate the required retu turn on equity at each of the above le 6 percent, and the market risk premit™” Risk free rate + (Market risk premium) (Beta). Keep the beta at 1.5 or below. What is the m2%!" ployed? What is the required rate of return 0”‘ution CAPITAL By, ual Incremental DGETI Annual Incremental Depreciation TING + chapters 91g Year New tach . ine C {3880 — Old Machine m 7 222,200 50000 -preClatlc 3 74.00 sam Toes 37,050 172200 5 24.109 (12.950) L__ sooo | achine Market salvage value Book value Leeman “an fai eect ) ss se Tax adjustment @ 20% (1op00 160,000) 100,000} eta tow to sab aot re mea LL (40,000) 80,000, Annapurna Environment (Pvt) Lid. is a company working for y y B for municipal waste is contemplating to install a recycl The recycle plant costs Rs 800,000. It will cost Rs 50,000 for ee ey the pane ‘r addition these costs, company will have to inves Bits the na \y lave to invest Rs 30,000 in working capital. Since the project fall ironment pollution control category industry, itis entitled to 60 percent investment tax allowance on the invoice price of the plant. Sales revenue ‘operating cost of the proposed plant will be as follows: a“ SE a Fs 300,000 200,000 500,000 350,000 00,000 500,000 850,000 550,000 450,000 300,000 400,000 350,000 300,000 200,000 The economic life of the machine is 8 years and it falls in MACRS 5-year class. The machine will have Rs 100,000 salvage value. Company's marginal tax rate is 20 percent. Answer to the following questions: a. Calculate the cash inflow from investment tax allowance. b. Calculate the initial investment outlay of the project. ¢ Calculate the annual depreciation of the purposed plant. d. Calculate the annual operating cash flows of the project. Calculate the terminal cash flow. f Calculate IRR and NPV of the project: & Should Annapurna Environment (Pvt. Ltd install the recycle plant? Cash inflow from investment tax allowance: Tnvestmient tax credit = Purchase price x Tax rate x ITC rate Rs, 800,000 x 0.20 x 0.60 = Rs. 96,000 b. Calculation of initial investment outlay: Purchase price of recycle plant ‘Installation cost ‘nvestment in working capital tax credit Inia investment outaawaceRiat FINANCE FE nual depreciation: ant 220 chapter 5° Calculation of ane Depreciable basis OOP 272,000 163,200 97,920 97,920 48,969 ting cash flows: é feet 2 3 4 3 r 700 | 5007000 | 600,000 |" 850,000 |" 450,000 Tay Sy 300000 | 000) | 00,000) | 550,000) | 200.000) | soa | 3 200,000) oo] 10000 | 100,000 | 100,000 |” 150,000, ea 200) |_ (97.920) |_ (97.920 : rocco) | (272000) | (6 320) | eee Les: Dapesan (OT ctano00) | (@3200) [2.080 | Sec ah ST econ | “wom | ian | vaso | wie vost | og) 8 EAT Gemny] ery | ose | Ane | ie : 170,000 c Sre000 | 163200 | 97920 | 9720| gan)" T2640 | 99584 | 139.504 | aera 14 year FReease of working capital Cash savage valve ‘Taxon gain rom the sale of ‘aditona cash fow in teminal year f. Calculation of IRR: 380, () Fakoannuity =® — = Rs. 125,714.29 784,000 (i) Fake payback = 75714 99 = 6.2364 (iii) Looking at PVIFA table across 7th year we find that 6.2364 lies in between? pee and 3 percent discount rates. PVIFA at 3 percent is closest to 6.2364 (iv) Trial and Error Table PVIF @ 3% Pv PVIF @ 2% ; 1.00 (784,000) 1.00 2 tenn, 09709 110,683 0.9808 3 ae 0.9426 164,389 0.9612 4 ee o9tsi 109,077 0.9423 5 aa 0.8885 88,480 0.9238 8 49.79 0.8626 120,405, 0.9057 7 490,000" 0.8375 41,701 0.8880 0.8131 154,489. 0.8706. * Cash inflow in 7th year = HEE @s.776) NPV Weknow thatthe 1a e000 + 110,000 = Rs. 190,000 IRR is given IRR=R, + NEVE * NPV. -NPViq * R- Ry) Where, R = lower discount rateSARITAL BUDGETING © Chapter 5 eet higher discount rate Ra, net present value at lower discount rate Nina = net present value at higher discount rate Now. 29586 og. 2) 274 58 inR =2+29,586- (776) “O° = 2 * 29,586 + 776 * a= 2 calculation of NPV Sear Cash flows (Rs) PUF@ 10% Pv (784,000) 7.00 (784,000) 114,000 0.9081 103837 174,400 08264 44.128 112.640 07513 24628 99.584 0.6890 88018 139,584 06209 05,858 49782 0.5685 28,108 190,000 05132 97.508 NPV 71319) Since IRR is less than required rate of return and NPV is less than zero, the project ainsst acceptable. So, Annupurna Environment (Pvt) Ltd. should not install the recycle plant. feniats | Sagarmathe Eavironment (Pvt) Ltd. is planning to establish a paper recycling factory in ian Pokhara Industrial Estate. It set up a separate project analysis unit and appointed Mr. sierert Shyam as project analyst. Mr. Shyam ‘estimated that total project cost would be Rs 300000, In addition, he estimated that the project would generate Rs 50,000 net cash flows for 5 years. He has estimated that price level in Nepalese economy would be 5 peroent during the five years to come, But he has not adjusted this price level while Eetimating the net cash flows of the project. Since he believes that price and cost will inerease in the same proportion so that expected inflation will not affect the profitability of the project. Should Sagarmatha Environment (Pvt) Ltd. establish a paper recycling factory if its required rate of return is 15 percent? sou0TON Step 1: Initial investment outlay: Rs 200,000 Step 2: Conversion of real cash flows into nominal cash flows f Gash Flows, inflation Adjustment Nominal (200,000)(1+ 05)" (200,000.00) '50,000(1+ .05)! 52,500.00 50,000(1+ .05)° 55,125.00 50,000(1+ 05) 87,881.25 50,000(1+ .05)* 60,775.31 50,000(1+ 05) 63,814.08 jet Cash Flows: PVIF sit PV (200,000.00) 1,000 (200,000) 1 152,500.00 0.8696 45,854 2 55,125.00 0.7561 41,680 3 57,881.25 0.6575 38,057 a: 60,775.31 0.5718 34,751 5 63,814.08 0.4972 34,728 Decision: NPV of the proposed paper recycling factory is negative So, Sagarmatha Environment (Pvt) Ltd. should not establish the recycling factory222 Iustration 17 Payback, NPV and IRR TU Model] SOLUTION chapter 5 » MANAGE RIAL FINANCE jdering the purcha yew printing press. The tot se of an is ou ay vay would be partially offset bythe ost RS 1 million 10 years ag, My {As a result of acquisition of 9 a Wells Printing is consi cost of the press is Rs 2.2 million. Thi value, xisting press. The old press has zero book va Ree ee iy for Re million before taxes. be sold currently for Rs 1.2 hos tenet oF we press, sales in a ‘of the next 5 years are expected oe mb RS 1.6 millon product costs (excluding depreciation) will ee ee es These preg ot Preatfect the firm’s net working capital eqvireme cet il be depregrt under MACRS using a 5-year recovery period. The firm is subject to a 40% tay je! both ordinary income and capital gains Wralls Printing’s cost of capital is 1%, | "*% C2] 3 | 2 t required by the new press. Determine the initial investmen! flows attributable to the new press, a b. Determine the operating cash int ¢. Determine the payback period. 4. Determine the net present value ( to the proposed new press. @ Make a recommendation to accep! (NPV) and the internal rate of return, (IRR) rele 1 or reject the new press, and justify your ans a, _ Initial Investment Cost of new press Net proceeds from sale of existing pres — {1,200,000 (1,200,000 -0) 0.40] Initial investment b. Calculation of Operating Cash Flows = (Rs 2,200,000) 720,000 Rs 1,480,000) arr pre [TO] ea | ease | ee ia : ae on pee Ee ee an Ee ae 382,000 536,000 (110000) an Tasco aati 264,000, 110,000 ¢ Calculation of Payback Period Boo] RES 1 Cumulative CFAT ns = : 761,600 4,417,600 4 47200 2054800 8 3,236,000 PBP 9 =Ne, +E 25, Rs.62.400 Ge =2+ Reo = d. Calculation of Nev. Foe NES = 2036 years Pv (Rs 1,480,000) 590,990.40, 618,114.56 473,232.84 395,734.72 347,553.60 23522.40 959,198.32 =CAPITAL BUDGETING « ch; IRR aptor § 223 - NCO Rs 14,80,000 rake payback = Rverage CFAT ~ 546,666.67 = 2.7073 , FA table across 6 period: ing at PVIFA periods, we find 2.7063 i vans to 29 percent. Since cash inflows in the eater coresPor the IRR should be greater th catelation © the closest to 2.7000 which years are larger than average an 29 5 br flow: percent. So let us try at 35 cent Sa bur (As a A i (Rs 14,80,000) 1 (Rs a =I ¢ 485,899.20 0.7353 7 82, reism | 0567 areeaee | ostor thie feo | sar | iems| San | how : 28 1 asa | m2 taseeeo | zie resats88 r ma mem | waste 6,952.00, 2 092.95, azsis7 "We know that IRR is given by ae NPViz IRR = LR +NPVig— NPV * HR LR) 992.96 = 35% + 997-96 + 24,615.76 * (36% — 35%) = 35% + 0.0388%= 35.0388% = 35.04%, a. The NPV of the investment is positive Rs 959,148.32 and the IRR is 35.04% which is higher than the cost of capital of 11%, projec should be accepted gant Asian Printing Co. Pvt. Lt. is considering the purchase of a new generation printing vrachine to replace the existing old one. The existing machine can run for 5 more years itt roduecing annual revenues of Rs 600,000 with cash expenses of Rs 300,000. Its current ‘well Prokevalue is Rs 200,000 and it is being depreciated on straight line basis per yeat down rare book value, The machine could be sold today to net Rs 80,000 and it could be sold ithe end of 5 years to net Rs 50,000. The new machine will cost Rs 500000 plus a8 2 ditional Rs 100,000 to transport it to the printing room and instal it Ik wil genes avsnues of Rs 900,000 but will have cash expenses of Rs 400,000 twill be depreciated thing the straight-line method over a 5-year period at which time will have a book ef Re 200000 and a cash salvage value of Rs 250,000. The new wachine will require vaidfonal working capital of Rs 50,000 to be permanently tied wp during the operation period. The company uses its weighted average cost of capital (WACC) to evaluate the investment proposals. The company’s WACC is Vt percent. The company’ isin pereent tax bracket. The tax on capital gain/Toss is the same 28 in the case of ordinary income. Required: a. NCO bh NPV © IRR 2 ‘uy & Should the firm make the replacement based on above results? Giver Exi ee New machine: Erne machine: Cost of new machine = 5500000 son wining life =5 years installation = Rs 1004 Annual revenues = Rs 600,000 Transportation and insta is Cash expenses = Rs "300,000 ‘Annual revenues = Rs 30s : Cash expenses= Rs 400/ Current book value = Rs 200,000224 = MANAGERIAL FINANCE crane rightine ULMER EEE ethod = Stra i salvage value ~ Rs 200,09 Depreciation meth ie | = Rs 800d of § Additional working capital = Cash salvage value % WACC or k = 11% ae Tax rate (T) = 40% years h Outlay Calculation of Net Cas a Purchase pce ‘Transporation ad instalion ‘xdstonal working capital Cesnsvape ve LO MHC! yen -en0t) «040 “Tex saving on oss on sale of fd machine b. Working notes: 7 i. Calculation of differential depreciation New machine — Book salvage value _ Rs 600,000 — Rs 200,000 __ Dep = tealcae Book: age z = 0mn pen Old machine __ Current BSV- Final BSV _ Rs 200,000- Rs 0 _ Dep.=“"Romaininghite ~~~ RS 40000 Peryear Differential depreciation per year = New dep. per year ~ Old dep. per year = Rs 80,000 - Rs 40,000 = Rs 40,000 Calculation of Cash flow Particulars New 1d Dito ‘onuals revenues Rs 900,000 Rs 600,000 Re 400,000 300,000 ‘ta 7Rs500,000 Rs 300,000 eau 80,000 40,000 ‘on 5 420,000 5 260,000 rr 168,000 104,000 aut FRS252,000 Rs 156,000 Feil 80,000 40,000 75 332,000, Ris 196,000 fii, Caleulation of final year Cash flow Net proceed from sale of new assets = CSV - (CSV -BSV) xT = Rs 250,000 — (Rs 250,000 - Rs 200,000) »0# = Rs 230,000 Net proceed from sale of old assets. = CSV - (CSV - BSV) xT = Rs 50,000 ~ (Rs 50,000 - 0) x 0.40 Differential net proceed Snene net procee: =Rs B = Rs 200,000 aoe 230,000 — Rs 30,000 = Rs 200, = Operating cash flow + Differential net proceed + Working capital = Rs 136,000 + Rs 200,000 bs Calculation of Net Present Value + Rs 50,000 = Rs 386,000 Factor at 11% 1 3.1024 0.5995 NPV.CAPITAL BUDGETING + ch apters—22 gran eter ate fea ° ier csleaate te factor ake factot = Average ‘cash flow ~ Rs 186,000 8065, 4 IFA table across 5 periods, w ang PV periods, we find 2.8065 is the clo: von (0 Js percent, Since cash inflows in the ts be dhe de oe ash flows. the TRR should be less than 23 percent. So iets by at 18 co tis try at 18 percent ‘ Factor at 18 is mT Fata sess) i (93500000) 7 = 4 | ato e301 385,8506, 26388 Wenn. Bsi25742 Tv Ts 1164) py interpolation : PVin @LR+

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