ASSIGNMENT II

1. The December 31, 1984, balance sheet and income statement for
Mayberry Cafeterias, Inc. are given

a. Compute the specified ratios, and compare them to the industry

average (better or worse).

b. If you were appointed financial manager of the company, what

decisions would you make based on your findings?

Balance Sheet
Cash $ 17 Accounts Payable $7
Marketable Securities 5 Notes Payable 3
Accounts Receivable 3 Taxes Payable 2
Inventory 16 Other Accruals 3
Prepaid Expenses 6 Current Liabilities $ 15
Current Assets $ 47
Long-term debt $ 35
Gross plant and $ 126 Preferred Stock 10
equipment (57) Common Stock 20
Less: Accumulated 69 Capital contributed in
Dep. excess of par 10
Net Plant and
Equipment Retained Earnings 26
Total Assets $ 116 Total Liabilities and $ 116
Stockholders’ equity

Income Statement
Net Sales $ 1,072
Cost of Goods sold 921
Gross Profit 152

Selling Expense 86
General and Administrative 26
expense 6
Depreciation $ 33
Net Income
4
Interest Expense $ 29
Profit Before taxes
 Taxes 12
Net Income $ 17

1984 Better or Worse 1984 Industry

Mayberry Average (%)
Ratios to Compute
Current 3.13 Better 2.86

Quick 1.67 Worse 2.31

Debt-Equity 0.76 Worse 0.51

Times interest period 8.25 Worse 12.36

Average Collection 1.02 Better 1.06

period 57.56 Worse 95.71

Inventory Turnover 15.54 Worse 16.15

Fixed-asset turnover 0.031 Worse 0.036

Operating profit 0.016 Worse 0.019

margin 0.167 Worse 0.192

Net profit margin 0.26 Worse 0.271

Book return on assets

Book return on equity

Assignment I – Solution

1. A firm might cut its labor force dramatically which could reduce
immediate expenses and increase profits in the short term. Over the long
term, however, the firm might not be able to serve its customers properly
or it might alienate its remaining workers; if so, future profits will
decrease, and the stock price will decrease in anticipation of these
problems.

Similarly, a firm can boost profits over the short term by using less costly
materials even if this reduces the quality of the product. Once customers
 catch on, sales will decrease and profits will fall in the future. The stock
price will fall.

The moral of these examples is that, because stock prices reflect present
and future profitability, the firm should not necessarily sacrifice future
prospects for short-term gains.

2. The key advantage of separating ownership and management in a large

corporation is that it gives the corporation permanence. The corporation
continues to exist if managers are replaced or if stockholders sell their
ownership interests to other investors. The corporation’s permanence is
an essential characteristic in allowing corporations to obtain the large
amounts of financing required by many business entities.

3. a. A share of stock financial

b. A personal IOU financial
c. A trademark real
d. A truck real
e. Undeveloped land real
f. The balance in the firm’s checking account financial
g. An experienced and hardworking sales force real
h. A bank loan agreement financial

4. Agency costs are caused by conflicts of interest between managers and

shareholders, the owners of the firm. In most large corporations, the
principals (i.e., the stockholders) hire the agents (i.e., managers) to act on
behalf of the principals in making many of the major decisions affecting
the corporation and its owners. However, it is unrealistic to believe that
the agents’ actions will always be consistent with the objectives that the
stockholders would like to achieve. Managers may choose not to work
hard enough, to over-compensate themselves, to engage in empire
building, to over-consume perquisites, and so on.

Corporations use numerous arrangements in an attempt to ensure that

managers’ actions are consistent with stockholders’ objectives. Agency
costs can be mitigated by ‘carrots,’ linking the manager’s compensation
to the success of the firm, or by ‘sticks,’ creating an environment in which
poorly performing managers can be removed.

5. Capital budgeting decisions

Should a new computer be purchased?
Should the firm develop a new drug?
Should the firm shut down an unprofitable factory?
Financing decisions
Should the firm borrow money from a bank or sell bonds?
 Should the firm issue preferred stock or common stock?
Should the firm buy or lease a new machine that it is committed to
acquiring?

6. Money markets, where short-term debt instruments are bought and sold.

Foreign-exchange markets. Most trading takes place in over-the-counter

transactions between the major international banks.

Commodities markets for agricultural commodities, fuels (including crude

oil and natural gas) and metals (such as gold, silver and platinum).

Derivatives markets, where options and other derivative instruments are

traded.

7. Financial markets provide extensive data that can be useful to financial

managers. Examples include:

• Prices for agricultural commodities, metals and fuels.

• Interest rates for a wide array of loans and securities, including
money market instruments, corporate and U.S. government bonds,
and interest rates for loans and investments in foreign countries.
• Foreign exchange rates.
• Stock prices and overall market values for publicly listed
corporations are determined by trading on the New York Stock
Exchange, NASDAQ or stock markets in London, Frankfurt, Tokyo,
etc.

8. Liquidity is also important to mutual funds. When the mutual fund’s

shareholders want to redeem their shares, the mutual fund is often forced
to sell its securities. In order to maintain liquidity for its shareholders, the
mutual fund requires liquid securities.

9. The balance sheet shows the position of the firm at one point in time. It
shows the amounts of assets and liabilities at that particular time. In this
sense it is like a snap shot. The income statement shows the effect of
 business activities over the entire year. Since it captures events over an
extended period, it is more like a video. The statement of cash flow is like
the income statement in that it summarizes activity over the full year, so
it too is like a video.

10.Accounting revenues and expenses can differ from cash flows because
some items included in the computation of revenues and expenses do not
entail immediate cash flows. For example, sales made on credit are
considered revenue even though cash is not collected until the customer
makes a payment. Also, depreciation expense reduces net income, but
does not entail a cash outflow. Conversely, some cash flows are not
included in revenues or expenses. For example, collection of accounts
receivable results in a cash inflow but is not revenue. Purchases of
inventory require cash outlays, but are treated as investments in working
capital, not as expenses.

11.Working capital ought to be increasing. The firm will be building up stocks

of inventory as it ramps up production. In addition, as sales increase,
accounts receivable will increase rapidly. While accounts payable
probably will also increase, the increase in accounts receivable will tend to
dominate since sales prices exceed input costs.

12.a. Cash will increase as one current asset (inventory) is exchanged for
another (cash).

b. Cash will increase. The machine will bring in cash when it is sold,
but the lease payments will be made over several years.

c. The firm will use cash to buy back the shares from existing
shareholders. Cash balance will decrease.

ASSIGNMENT III

1. To what amount will the following investments accumulate?

 a. $ 15,000 invested for 5 years @ 10% APR compounded annually.

FV = PV (1 + r)n

FV = 15,000 (1.10)5

FV = 24,157.65

b. $ 15,000 invested for 5 years @ 10% APR compounded quarterly.

FV = PV (1 + r/m)mn

FV = 15,000 (1+0.1/2)2x5

FV = 24433.4194

c. $ 15,000 invested for 5 years @ 10% APR compounded monthly.

= 1500 (1+0.1/4)4x5

= 24579.2466

2. What is the present value of the following future amounts?

a. $ 1800 to be received in 10 years from now discounted back to the
present at 3% APR.

1339.36

b. $ 900 to be received in 5 years from now discounted back to the

present at 5% APR.

705.173

c. $ 1000 to be received in 8 years from now discounted back to the

present at 10% APR.

466.507

d. $ 1000 to be received in 8 years from now discounted back to the

present at 20% APR.

232.568
3. The following future cash flows will be received at the end of the years
indicated: $1500 in year 0, $1,900 in year 1, $1,400 in year 2 and $1,100
in year If the discount rate is 12% per year :

a. What is the present value of all four expected future cash flows?

PV = 1500 + 1900/(1.12)1 + 1400/(1.12)2 + 1100/(1.12)3

PV = 1500 + 1,696.43 + 1,116.07 + 782.958

PV = 5095.458

b. What is the value of the four flows at year 3?

FV = 1500(1.12)3 + 1900/(1.12)2 + 1400/(1.12)1 + 1100

FV = 2,107.40 + 2,383.36 + 1,568 +1100

FV = 7158.76

c. What is the value of the four flows at year 2?

FV = 1500(1.12)2 + 1900/ (1.12)1

FV@ yr 2 = 4,009.6

FV@ yr 2 =1,000(1.12)-1

= 892.86

Total Value @ yr 2 = 5,902.46

4. A firm that has sold a building is going to receive payment in four
installments. The buyer has paid $10,000 at purchase time. The buyer is
going to pay $15,000 one year later, $18,000 two years later, and
$21,000 three years later. Find the present value of the receipts from the
sale if the seller wished to use a discount rate of 6 percent.

=10,000/ (1.06)0 + 15,000/ (1.06)1 + 15,000/ (1.06)2 + 21,000/ (1.06)3

= 10,000 + 14150.9434 + 16019.93592 + 17632.00494

= 57802.88
5. For the situation stated in previous problem, the buyer has paid $10,000
at purchase time. What will be the present value of receipts from the sale
if the buyer pays $18,000 at the end of the first, second, and third year?
The buyer wishes to use a 6 percent discount rate.

PV annuity = 18000 x (2.6703)r=6% , t=3

= 48,114.21

48,114.21 + 10,000 = 58,114.21

6. Eduardo Garcia has a starting salary of $45,000. He expects the salary to

grow at 10% annually for the next nine years. Then for years 11 to 30, the
salary will grow at 8% annually. Finally, for years 31 to 35, the salary will
decline by 5% annually. Assume that the payments are received at the
end of the year and that the required rate of return is 6%. What is the PV
of Eduardo’s projected income stream?
7. What is the present value of stream of receipts of $10,000 every year for
the next 6 years and $6,000 every year for years 7 through 16? The
discount rate is 8 percent.

PV annuity = 10,000(PVDF)r=8% ,t=6

= 46,228.79

PV annuity = 6,000(PVDF)r=8% ,t=9

= 37,481.33
PVsp = 37,481.33*(1.06)-7

= 24,927.23

PV = 24,927.23 + 46,228.79

PV = 71,156.01
8. A savings institution pays interest of 8 percent, paid and compounded
quarterly on deposits of $100,000 or more. What will a $100,000 deposit
become after 2 years? How much is this amount greater than a $100,000
deposit for 2 years, compounded annually at an 8 percent interest rate?

FVsp = 100,000 * (1.02)8

= 117,165.94

FVsp = 100,000 * (1.08)2

= 116,640

FV = 117,165.94 - 116,640

FV = 525.94
9. You are trying to plan for retirement in 10 years, and currently you have
$100,000 in a savings account and $300,000 in stocks. In addition you
plan on adding to your savings by depositing $10,000 per year in your
savings account at the end of each of the next five years and then
$20,000 per year at the end of each of the final five years until retirement.

a. Assuming your savings account returns 7% compounded annually

while your investment in stocks will return 10% compounded annually,
how much will you have at the end of 10 years?

1228,015.41
10.Suppose you would like to be paid $30,000 per year during your
retirement, which starts in 25 years. Assume the $30,000 is an annual
perpetuity and that the expected return is 6% APR. What should you save
per month, for the next 25 years so that you can achieve your retirement
goal?

PV prep @ yr 65 = 30,000/ 0.06 = 500,000

FV annuity

IA = 500,000 / (54.8645)r=6%, t=25

IA = 9,113.36
11.Your brother has just graduated from high school and is seeking your
advice as to whether he should find a job immediately or go to college for
four years and then find a job. He estimates that if he gets a job
immediately, he will earn $15,000 per year for the next 40 years. If he
goes to college first, he estimated that he can earn $30,000 for each of
the 36 years after he gets out. (Whether he goes to college or not, he
plans to retire 40 years from today.) Assume that his time value of money
is 14% and that all cash flows are ordinary annuities. (If he goes to college
first, he can borrow money at 14% too.)

a. What will be the present value of his cash flows if he gets a job
immediately?

PV = PMT (1 – (1 + r)-n / r)

= 15,000 (1-(1.14)-40 / 0.14)

= 106,575.6141
b. What will be the present value of his cash flows if he goes to college
first?

PV = PMT (1 – (1 + r)-n / r)

= 15,000 (1-(1.14)-36 / 0.14)

= 212,369.6125

PV = FV/ (1 + r)n

= 212,369.6125 / (1.14)4
= 125,739.8591

c. What should he do?

He should go for college

12. An investor deposits Rs 100 in a bank account for 5 years at 8 percent
interest. Find out the amount which he will have in his account if the
interest is compounded (a) annually (b) semi-annually (6-months), (c)
quarterly and (d) continuously.

a FVsp = PV ( 1 + r ) t

= 100 (1 + 0.08)5

= 100 (1.08)5

= 100 (1.4693)

FVsp = 146.93

b Semi – Annual compounding

FVsp = PV (1+r)t

= 100 (1.04)10 0.08/2 = 0.04

= 100 (1.4802)

= 148.02

c Quarterly compounding

FVsp = PV (1+r)t

= 100 (1.02)5 x 4

= 100 (1.02)20

= 100 (1.4859)
 = 148.59

d Continuous Compounding

13. If the discount / required rate is 10 percent, compute the present value of
the cash flow streams detailed below: (a) Rs 100 at the end of year 1: (b)
Rs 100 at the end of year 4: (c) Rs 100 at the end of (i) year 3 and (ii)
year 5 and (d) Rs 100 for the next 10 years (for years 1 through 10).

a Rs 100 at the end of year 1 = 100 x 1/ (1.10)1

= 100 x 0.9091

= Rs. 90.91

b Rs 100 at the end of year 4 =100 x 1/ (1.10)4

= 100 x 0.683

= Rs. 68.3

c Rs 100 at the end of

i) Year 3 = 100 x 1/ (1.10)3 = 75.13

ii) Year 5 = 100 x 1/ (1.10)5 = 62.09

75.13 + 62.09 = 137.22

d Rs 100 for the next 10 years ( annuity )

F.V annuity = I.A x ( FVIF annuity )r, t

= 100 x ( FVIF annuity) r = 10 , t = 10

= 100 x (6.1446)

= Rs 614.46

14. Compute the present / discounted value of the following future cash
flows, assuming a required rate of 10 percent: (a) Rs 100 a year for years
5 through 10 and (b) Rs 100 a year for years 1 through 3 (c) nil in year 4
through 5 and Rs 100 year for years 6 through 10.

a) PV annuity = I.A x (PVDF annuity)r =10, t =10

= 100 (6.1446)

= 614.46

PV annuity = I.A x (PVDF)r =10, t =4

= 100 x (3.1699)

= 316.99

614.16-316.99 = 297.47

b) PV annuity = I.A x (PVDF)r =10, t =2

= 100 x (2.4869)

248.69
 = I.A x (PVDF)r =10, t =10

=100 x (6.1446)

=614.46

= I.A x (PVDF)r =10, t =5

= 100 x (3.7908)

= 379.08

PV annuity = 248.69 + 614.46 -379.08

=Rs 484.07

15. An executive is about to retire at the age of 60. His employer has offered
him two post retirement options:(a) Rs 20,00,000 lump sum, (b) Rs
2,50,000 for 10 years. Assuming 10 percent interest, which is a better
option?

PV annuity = IA (PVDF)r =10, t = 10

= 250,000 (6.1446)

= 1536150

Since the lump sum of Rs 200,000 is worth more now the executive
should opt for it.
 16. ABC Ltd. has Rs 10 crore bonds outstanding. Bank deposits earn 10
percent per annum. The bonds will be redeemed after 15 years for which
purpose ABC Ltd wishes to create a sinking fund. How much amount
should be deposited to the sinking fund each year so that ABC Ltd would
have in the sinking fund Rs 10 crore to retire this entire issue of bonds?

17. Assume the rate of interest is 12 percent. Compute the annual

percentage /effective rate (AP/ER) if interest is paid ( a )annually, ( b )
semi-annually, ( c ) quarterly and ( d ) monthly. What are the
implications of more frequent payments of interest?

a) Interest paid at the end of the year

1 + EAR = (1+MIR)1

1 + EAR = (1.12)1

EAR = 1.12 – 1
 EAR = 12%

b) Interest paid at the end of each 6 months period

1 + EAR = (1+MIR)2

1 + EAR = (1.06)2

1 + EAR = 1.1236

EAR = 1.1236 -1

EAR = 0.1236

EAR = 12.36%

c) Interest paid at the end of each quarter

1 + EAR =(1+qir)4

1 + EAR = (1.03)4

1 + EAR = 1.1255

EAR = 1.1255 – 1

EAR = 12.55%

d) Interest paid at the end of each month

1 + EAR = (1+MIR)12

1 + EAR = (1.01)12

1 + EAR = 1.1268
 EAR = 1.1268 -1

EAR = 0.1268

EAR = 12.68%

18. Mr. X has 100,000 to deposit in a bank account for 3 years. Assuming (i)
annual compounding, (ii)semi-annual compounding, (iii)quarterly
compounding at a stated annual interest rate of 4 percent, compute (a)
the amount he would have at the end of third year, leaving all interest
paid on deposits in the bank, (b) the effective rate of interest he would
earn on each alternative, and (c) which plan should he choose?

a i) FVsp = PV (1+r)t

= 100,000 x (1.04)3

= 100,000 x 1.125

FVsp =112,500

aii) FVsp = PV (1+r)t

= 100,000 x (1.02)6

= 100,000 x 1.126

FVsp =112,600
a.iii) FVsp = PV (1+r)t

= 100,000 x (1.01)12

= 100,000 x 1.127

FVsp =112,700

b.i) 1 + EAR = (1+MIR)1

1 + EAR = (1.04)1

EAR = 1.04 – 1

EAR = 4%

b.ii) 1 + EAR = (1 + SAIR)2

1 + EAR = (1.02)2

1 + EAR = 1.0404

EAR = 1.0404 – 1

EAR = 0.0404

EAR = 4.04%

c) Mr X should choose alternate iii as it has resulted the highest future

value as a result of the corresponding highest effective rate of intrest.

ASSIGNMENT IV

1. A firm borrows $25,000 from the bank at 12% compounded annually to

purchase some new machinery. This loan is to be repaid in equal annual
installments at the end of each year over the next five years. Prepare a
loan amortization schedule?

IA = 50,000 / (PVDF)r=12%, t=5

= 50,000 / 1- (1+r)-t / r

= 50,000 / 1-(1.12)-5/ .12

=50,000 / 3.6048

=13870.395
2. Bill Welch is buying out his partner in an avocado orchard. Bill is borrowing
$200,000 and will pay 10% interest on the outstanding balance. Bill has agreed to
pay $25,000 per month for the first five years, $30,000 for the next four, and then
will pay off the remaining balance at the end of the 10th year.

a) Prepare a loan amortization schedule that shows, for the next 10 years, Bill’s
loan payment, interest expense, loan amortization, and remaining loan balance.

b) What is the final (10th) loan payment?

Amortization
Table

Sn Installmen Intere Princi Balan

o t st pal ce
200,0
0 00
195,0
1 25,000 20000 5,000 00
189,5
2 25,000 19500 5,500 00
183,4
3 25,000 18950 6,050 50
176,7
4 25,000 18345 6,655 95
17679. 169,4
5 25,000 5 7,321 75
16947. 156,4
6 30,000 45 13,053 22
15642. 142,0
7 30,000 2 14,358 64
14206. 126,2
8 30,000 41 15,794 71
12627. 108,8
9 30,000 06 17,373 98
10889. 108,89
10 119,787 76 8 0

Final 10th 119,78

Payment 7
3. What is the present value of the following?

a. A $300 perpetuity discounted back to the present at 8 percent.

PV Prep = 300/0.08

= 3750
b. A $1,000 perpetuity discounted back to the present at 12 percent.

PV Prep = 1000/0.12

= 8334

c. A $100 perpetuity discounted back to the present at 9 percent.

PV Prep = 100/ 0.09

= 1111.11

d. A $1300 perpetuity discounted back to the present at 5 percent.

PV Prep = 1300/ 0.05

=26,000

Bonds
4. Trico bonds have a coupon rate of 8 percent, a par value of $1,000, and
will mature in 20 years. If you require a return of 7%, what price would you
be willing to pay for the bond? What happens if you pay more for the bond?
What happens if you pay less for the bond?

PV annuity = 80 (PVDF)r=7%, t=20

= 80[1-(1.07)20 / 0.07] + 100

= 947.521

PVsp = 1000(1.07)-20

= 258.419

Bond Price = PV annuity + PVsp

= 947.521 + 258.419

= 1205.94
5. Sun co.’s bonds, maturing in 7 years, pay 8% interest on a $1,000 face
value. However, interest is paid semi-annually. If your required rate of
return is 10%, what is the value of the bond? How would your answer
change if the interest were paid annually?

Interest paid semi-annually

PV annuity = IA (PVDF)r=5, t=14

40 * 9.8986

= 395.944

PVsp = FV 1/ (1 + r) t

= 1000 * 1/ (1.05)14

= 1000 * 0.5051

= 505.067

Value of bond is 395.944 +505.067 = 901.011

If interest is paid
Annually
PV of Interest 389.47
PMT 2
PV of Face Value $513
902.63
Value of BOND 01

6. Sharp Co. bonds are selling in the market for $1,045. These 15 year bonds
pay 7% interest annually on a $1,000 par value. If they are purchased at
the market price, what is the expected rate of return?
SOLUTION:

YTM = 6.5 %

Rate of Return = 11%

7. National Steel 15-year, $1,000 par value bonds pay 8% interest annually.
The market price of the bonds is $1,085, and your required rate of return is
10 percent.

a) Compute the bond’s expected rate of return.

b) Determine the value of the bond to you, given your required rate of
return.

c) Should you purchase the bond?

A) YTM = (CP + [FV – MV / YRS REMAINING TO MATURITY] / (FV +

MV / 2))

= (80 + [1000 – 1085 / 15] / (1000 + 1085 / 2))

= 74.333 / 1042.5

= 0.071

YTM =7.13 %

Value of
b) Bond
PV of Interest 608.4
PMT 88
PV of Face 239.3
Value 92
Value of 847.8
Bond 8

The bond should not be purchased because Fair Value of Bond is Less than
c) Market Value.
8. You own a bond that pays $100 in annual interest, with a $1,000 par
value. It matures in 15 years. Your required rate of return is 10 percent.

a) Calculate the value of the bond.

b) Calculate YTM

SOLUTION:

B) PV annuity = 100 (PVDF)r=10%, t=15

= 100(7.6061)

= 760.61

PVsp = 1000(1.10)-10

= 385.54

Bond Price = PV annuity + PVsp

= 760.61 + 385.54

= 1146.15

C) YTM = (CP + [FV – MV / YRS REMAINING TO MATURITY] / (FV +

MV / 2))

= (100 + [1000 – 1146.15 / 15] / (1000 + 1146.15 / 2))

= 90.2567 / 1073.075

= 0.0841

YTM =8.41 %
9. The face value of a 10 year, 10 percent bond (with 10 percent coupon
rate) is Rs 1000. The interest is payable semi-annually. Assuming 12
percent required rate of return of investors, compute the value of bond.
What price would an investor be willing to pay, if the interest rate is
payable annually.

SOLUTION:

Interest paid semi-annually

PV annuity = IA (PVDF)r=6, t=20

50 * 11.4699

= 573.495

PVsp = FV 1/ (1 + r) t

= 1000 * 1/ (1.06)20

= 1000 * 0.3118

= 311.805

Value of bond is 573.495 + 311.805 = 885.3

Interest paid annually

PV annuity = IA (PVDF)r=12%, t=10

= 100 * 5.6502

= 565.02

PVsp = FV 1/ (1 + r )t

= 1000 * 1/ (1.12)10

= 1000 * 0.3219
 = 321.9

Value of bond is 565.02 + 321.9 = 887

The investor would be willing to pay Rs 887 for the bond.

10. ABC Ltd paid a dividend of Rs 4 per share at the end of the year. It is
expected to grow by 8 percent each year for the next 4 years. The market
price of the shares is expected to be Rs 60 at the end of 4 years.
Assuming 12 percent required rate of return of investors, at what price
should the shares of ABC Ltd sell?

SOLUTION:

D0 = 4

D1 = 4 * 1.08 = 4.32

D2 = 4.32 * 1.08 = 4.67

D3 = 4.67 * 1.08 = 5.04

D4 = 5.04 * 1.08 = 5.44

Expected price (p0) = Div1 + Div2 + Div3 + Div4

= 4.32(0.893) + 4.67(0.797) + 5.04(0.712) +

5.44(0.567)

= 3.86 + 3.72 +3.59 + 3.09 + 34.02

= 48.28
11. The required rate of return of investors is 12 percent. Assume next year
dividend is Rs 2.5o. Compute the price at which the shares will sell if the
investors expect the earnings to grow (i) at 12 percent, (ii) 14 percent,
(iii) 16 percent.

SOLUTION:

P0 = DIV1 / ( r – g )

i) At 12 percent

P0 = 2.5 / (0.14 – 0.12) = Rs 125

ii) At 14 percent

P0 = 2.5 / (0.14 – 0.14) = ( the formula is invalid since a necessary

condition is r>g)
 iii) At 16 percent

P0 = 2.5 / (0.14 – 0.16) = undefined

12. The required rate of investors is 15 percent. ABC Ltd declared and paid
annual dividend of Rs 4 per share. It is expected to grow @ 20 percent for
the next 2 years and at 10 percent thereafter. Compute the price at
which the shares should sell?

Solution:

Year 1 2

Dividend 4.8 5.67

PVsp 0.8696 0.7561

(15%)

4.174 4.355
PV of dividends for the first two years is 4.174 + 4.355 = 8.53

PV of price after 2 years

P2 = Div3/ r-g * (PVsp 1/ (1.15)2

= 80.75

P0 = Rs 8.53 + Rs 80.75 = Rs 89.28

13. A share is selling for Rs 50 on which a dividend of Rs 3 per share is

expected at the end of the year. The expected market price after the
 dividend declaration is to be Rs 60. Compute (i) the return on investment
in shares, (ii) dividend yield and (iii) capital gain yield.

Solution:

i) r = [ D1 + ( P1 – P0 )] / P0

r = [ 3 + (60-50)]/ 50

r = 0.26

r = 26%

ii) dividend yield = Div 1 / P 0

= 3 / 50

=6%

iii) capital gain yield = P1 – P0 / P0

= 60-50 / 50

= 20 %
14. The Alert Ltd company pays Rs 3 per share as annual dividend.
Assuming 10 percent required rate of return on shares, compute the
value of shares under each of the following growth rate assumptions:
• Annual growth rate, zero (0) percent indefinitely.
• Annual constant growth rate, 5 percent to infinity.
• Annual growth rate 5 percent for the next 3 years, followed by a
constant annual rate of growth of 4 percent in years to infinity.

SOLUTION:

i) Value of shares, zero growth:

P0 = Div 1 / (r – g)

= 3 / .10

= Rs 30

ii) Value of shares, constant growth, g = 5 %

Div 1 = Div o
* (1 + g)

Div 1 = 3 * 1.05

Div 1 = 3.15

P 0 = Div 1 / (r – g)

= 3.15 / (0.10 – 0.05)

= Rs 63

iii) Value of shares, with variable growth in dividends:

D1= 3.0 * 1.05 = 3.15

D2 = 3.15 * 1.05 = 3.31

D3 = 3.31 * 1.05 = 3.47

D4 = 3.47 * 1.04 = 3.61

P 0 = (3.15 * 0.909) + (3.31 * 0.826) + (3.47 * 0.751)

P 0 = 2.86 + 2.73 + 2.61

P 0 = Rs 8.2

P 0 = (PVsp)r=10 , t=3 x Rs 3.61 / 0.06

P 0 = 0.751 x Rs 160.17 = Rs 45.19

Value of share is Rs 8.2+ Rs 45.19 = Rs 53.39 per share

 STOCKS

15.Crosby corporation common stock paid $1.32 in dividends last year

and expected to grow indefinitely at an annual 7% rate. What is the
value of stock if you require an 11 % return?

Solution:

Div 0 = 1.32

Div 1 = 1.32 x 1.07 = 1.4124

P 0 = Div 1 / r – g

P 0 = 1.4124 / 0.11 – 0.07

P 0 = 35.31
 16.Blackburn and Smith common stock currently sells for $23 per share.
The company’s executives anticipate a constant growth rate of 10.5
percent and an end-of-year dividend of $2.50.

a) What is your expected rate of return?

b) If you require a 17% return, should you purchase the stock?

Solution:

P 0 = Div 1 / r – g

23=2.50 / r – 0.105

r = 2.50 / 23 + 0.105

r = 21.37 %

Yes, purchase the share. Because Expected Return is greater than

b) Required Return.
17.Header Motor Inc. paid a $3.50 dividend last year. At a constant growth
rate of 5%, what is the value of the common stock if the investors
require a 20% rate of return?

Solution:

Div 0 = 3.50

Div 1 = 3.50 x 1.05 = 3.675

P 0 = Div 1 / r – g

P 0 = 3.675 / 0.20 – 0.05

P 0 = 24.5
 18.Given that a firm’s return on equity is 18% and management plans to
retain 40% of earnings for investment purposes, what will be the firm’s
growth rate?

g = ROE * plowback ratio

g = 0.18 * 0.40

g = 7.2 %

19.The common stock of Zaldi Co. is selling for $32.84. the stock recently
paid dividends of $2.94 per share and has a projected constant growth
rate of 9.5 percent. If you purchase the stock at the market price, what
is your expected rate of return?

Solution:

R = Div 1
/ P0 +
g
3.219
Div1= 3
Po= 32.84
19.30
r= %
 20.Honeywag common stock is expected to pay $1.85 in dividends next
year, and the market price is projected to be $42.50 by year end. If the
investor’s required rate of return is 11%, what is the current value of
the stock?

r = Div1 + ( p1 – P0) / P0

0.11 = 1.84 + ( 42.50- P0) / P0

P0 = 39.95

Total Cash flow at the end of year

= 44.35
39.9
PV of Future CF @ 11% = 5

21.The market price for Hobart common stock is $43. The price at the end
of one year is expected to be $48, and dividends for next year should
be $2.84. What is the expected rate of return?
SOLUTION:

P 0 = Div 1
/ (1 + r)1 + P1 / (1 + r)1

43= 2.84/ (1 + r)1 + 48 / (1 + r)1

(1 + r)1 = 2.84 + 48 / 43

(1 + r) = 1.1823

r = 1.1823 - 1

r = 18.23 %

22.The common stock of NCP paid $1.32 in dividends last year. Dividends
are expected to grow at an 8% annual rate for an indefinite number of
years.

a) If NCP’s current market price is $23.50, what is the stock’s

expected rate of return?

b) If your required rate of return is 10.5%, what is the value of the

stock for you?

c) Should you make the investment?

SOLUTION:

a) r= Div 1
/P 0
+g

r= 1.4256 / 23.50 + 0.08

 r=0.0606 + 0.08

r=0.1406

r=14.06%

b) P 0 = Div 1 / r – g

P 0 = 1.4256 / 0.105 – 0.08

P 0 = 57

23.Pepperdine, Inc.’s return on equity is 16 percent and the management

plans to retain 60% of earnings for investment purposes. What will be
the firm’s growth rate?

G = ROE * plowback ratio

G = 0.16 * 0.60

G = 9.6 %
 ASSIGNMENT V

1. Determine the internal rate of return on the following projects:

a. An initial outlay of $10,000 resulting in a cash flow of $1,993 at the

end of each year for the next 10 years.

Ye
ar CF
(10,0
0 00)
1,
1 993
1,
2 993
1,
3 993
1,
4 993
1,
5 993
1,
6 993
1,
7 993
1,
8 993
1,
9 993
1,
10 993
IR
R 15.01%

b. An initial outlay of $10,000 resulting in a cash flow of $2,054 at the

end of each year for the next 20 years.

IRR = 20%
 c. An initial outlay of $10,000 resulting in a cash flow of $1,193 at the
end of each year for the next 12 years.

IRR = 6%

2. Determine the internal rate of return on the following projects:

a. An initial outlay of $10,000 resulting in a cash flow of $2,000 at the

end of year 1, $5,000 at the end of year 2, and $8,000 at the end of
year 3.

IRR = 19%
 b. An initial outlay of $10,000 resulting in a cash flow of $8,000 at the
end of year 1, $5,000 at the end of year 2, and $2,000 at the end of
year 3.

IRR = 30%

c. An initial outlay of $10,000 resulting in a cash flow of $2,000 at the

end of year 1 through for 5 and $5,000at the end of year 6.

IRR = 11%
3.
You are considering a project that will require an initial outlay of $54,200.
This project has an expected life of five years and will generate after-tax
cash flows to the company as a whole of $20,608 at the end of each year
over its five-year life. In addition to the $20,608 cash flow from operations
during the fifth and final year, there will be an additional cash flow of
$13,200 at the end of the fifth year associated with the salvage value of
the machine, making cash flow in year 5 equal to $33,808. Given a
required rate of return of 15%, calculate the following:

a. Net present value

b. Profitability index

c. Internal rate of return.

Should the project be accepted?

OUTFLOW 54200
RATE OF RETURN 15%
INFLOW
YEAR1 YEAR2 YEAR3 YEAR4 YEAR5

2 2 2 2 2
after-tax cash flows 0,608 0,608 0,608 0,608 0,608
ADD:additional cash 1
flow 3,200
2 2 2 2 3
NET CASH FLOW 0,608 0,608 0,608 0,608 3,808

5
a. Net present value 2,212
b. Profitability index( pv
of future cashflow/initial
cost) 1
c.Internal rate of return 30%
Should the project be
accepted? yes accepted
IRR
(54
,200)
2
1 0,608
2
2 0,608
2
3 0,608
2
4 0,608
3
5 3,808
4. Kendall Corporation is currently using a stamping machine made by
Bristol Company. The Bristol machine was purchased 5 years ago and has
10 years of depreciable life remaining. The Bristol machine is being
depreciated on a straight line basis toward a zero salvage value. Annual
depreciation charges are $20,000. The machine has a current market
value of $150,000. The Chicago Company has recently introduced what
appears to be a substantially superior stamping machine. It carries a
purchase price of $245,000 and would require installation expenses of
$5,000. It has a depreciable life of 10 years and a salvage value after 10
years of $20,000. The Chicago machine would reduce scrappage resulting
in cost savings before taxes of $10,000 annually. Kendall is a highly
profitable firm with a marginal tax rate of 48% and a discount rate of 10%.
Should it replace the Bristol machine with the Chicago machine? Show
your calculations in support of your answer. Assume straight line
depreciation for the new machine also.

Bristol solutio
machine n:
cost 300000 cost 300000
depreciable life less accumulated
(year) 15 dep. 100000
used life (year) 5 book value 200000
remaining life
(year) 10 less:market value 150000
Annual
depreciation 20,000 lose on sale 50000
current market
value 150,000 tax 48% 24000
net cash flow 174000
Chicago solutio
Company n:
cost 245000
cost savings
installation cost 5000 before taxes 10000
total cost 250000 Dep 23000
depreciable life
(year) 10 EBIT -13000
salvage value 20000 Less: Tax -6240
Annual
depreciation 23000 EAT -6760
Add: Dep 23000
OCF ( Yr 1-10) 16240
CF Yr 10
( 20,000) PV 7711
10
DCF 7,499
Initial Investment 76000

NPV 31,499

Should it replace
the Bristol
machine with the
Chicago machine yes, replace it
5. You are reviewing the project analysis submitted by one of your staff
analysts. You find the analysis to be correct except that the analyst
ignored the effects of changes in net working capital. You expect an
increase in net working capital of $400,000 at time 0, another increase of
$400,000 in one year, a decrease of $200,000 in five year, and a
liquidation of remaining working capital at the end of 10 years. If the
analyst had calculated an NPV of $360,000, what should be the project’s
NPV including the effect of changes in net working capital? The cost of
capital is 10%.

Yr 0 1 5 10
(400 (400 200 600
Working Cap required ,000) ,000) ,000 ,000
Discount factor 1 0.9091 0.6209 0.3855
(400 (363 124 231
PV ,000) ,636) ,184 ,326
DCF (408
 ,126)
(48
NPV ,126)

6.
Syracuse Road building Company is considering the purchase of new tandem
box dump truck. The truck costs $95,000, and an additional $5,000 is
needed to paint it with the firm logo and install radio equipment. Assume
the truck falls into the MACRS three-year class. The truck will generate no
additional revenues, but it will reduce cash operating expenses by
$35,000 per year. The truck will be sold for $40,000 after five-year life. An
inventory investment of $4,000 is required during the life of the
investment. Syracuse Road building is in the 45% income tax bracket.

a. What is the net investment?

b. What is the after-tax net operating cash flow for each of the five years?

c. What is the after-tax salvage value?

d. Assuming a 10% cost of capital, what is the NPV of this investment?

Solution

a. Net Investment Outlay = -I - ΔW + S - T(S - B)

Net Investment Outlay = -($95,000 + $5,000 x (1 - 0.45)) - $4,000 = -

$101,750
b. CFAT1 = (ΔR - ΔE)(1 - T) + TΔD = ($0 - -$35,000)(1 - 0.45) + 0.45(.20 x
$95,000) = $27,800.00
CFAT2 = (ΔR - ΔE)(1 - T) + TΔD = ($0 - -$35,000)(1 - 0.45) + 0.45(.320 x
$95,000) = $32,930.00

CFAT3 = (ΔR - ΔE)(1 - T) + TΔD = ($0 - -$35,000)(1 - 0.45) + 0.45(.1920

x $95,000) = $27,458.00

CFAT4 = (ΔR - ΔE)(1 - T) + TΔD = ($0 - -$35,000)(1 - 0.45) + 0.45(.1152

x $95,000) = $24,174.80

CFAT5 = (ΔR - ΔE)(1 - T) + TΔD = ($0 - -$35,000)(1 - 0.45) + 0.45(.1152x

$95,000) = $24,174.80
c. Net Salvage Value = S -T(S - B) - (1 - T)REX + ΔW
 Net Salvage Value = $40,000 - 0.45($40,000 - .0576 x $95,000) +
$4,000 = $28,462.40
d. NPV = -$101,750 + $27,800 / 1.101 + $32,930 / 1.102 + $27,458 /
1.103 +

$24,174.80 / 1.104 + $24,174.80 / 1.105 + $28,462.40 / 1.105

NPV = $20,562.48
7.
The total present value of all costs associated with an asset over a seven-
year life is $73,285. If the asset has a cost of capital of 11%, what is the
EAC of using this asset?
present
value 73285
rate of
return 11%
year 7

($15,552.
EAC 20)
8. XYZ Corporation is considering two alternative machines. Machine A will
cost $50,000, have expenses (excluding depreciation) of $34,000 per
year, and have a useful life of six years. Machine B will cost $70,000, have
a useful life of five years, and will have expenses (excluding depreciation)
of $26,000 per year. XYZ uses straight line depreciation and pays taxes at
the rate of 35%. The project cost of capital is 13%. Net salvage value is
zero for each machine at the end of its useful life. Assuming the project
for which the machine will be used in profitable, which machine should be
purchased?

Solution

First, find the total cost of operating each machine. Then find the EAC for
each machine.

Machine A Time Item CFBT CFAT PV@13%

0 Capitalization -50,000 -50,000

-
50,00
0

1-6 )E -34,000 -22,100

 -
88,34
6

1-6 Depreciation 0 2,917

11,6
61

TC = -$126,685

Machine B Time Item CFBT CFAT PV@13%

0 Capitalization -70,000 -70,000

-
70,00
0

1-5 )E -26,000 -16,900

-
59,44
1

1-5 Depreciation 0 4,900

17,23
4

TC = -$112,207

Machine A EAC = $31,691: N=6 r=13 PV=126,685

PMT=31,691 FV=0

Machine B EAC = $31,902: N=5 r=13 PV=112,207

PMT=31,902 FV=0
Choose machine A since its EAC is lower.
CAPITAL BUDGETING

Year CFBT

1 Rs 10,000

2 10,692

3 12,769

4 13,462

9. A company is considering an investment proposal to install new milling

controls at a cost of Rs 50,000. The facility ahs a life expectancy of 5
years and no salvage value. The tax rate is 35 per cent. Assume the firm
uses straight line depreciation and the same is allowed for tax purposes.
The estimated cash flows

5 20,385

before depreciation and tax from the investment proposal are as follows:

Compute the following:

i. Pay back period
ii. Average rate of return
iii. Internal rate of return
iv. Net present value at 10 per cent discount rate
v. Profitability index at 10 per cent discount rate.
i) Pay back period

ii) Average rate of return

iii) Internal rate of return

iv) NPV
V) Profitability index

10. Modern Enterprises Ltd is considering the purchase of a new computer

system for its research and development division, which would cost Rs 35
lakh. The operation and maintenance costs (excluding depreciation) are
expected to be Rs 7 lakh per annum. It is estimated that the useful life of
the system would be 6 years, at the end of which the disposal value is
expected to be Rs 1 lakh.

The tangible benefits expected from the system in the form of reduction
in design and draftsmanship costs would be 12 lakh per annum. The
disposal of used drawing office equipment and furniture initially is
anticipated to net Rs 9 lakh.

As capital expenditure in research and development, the proposal

would attract a 100 per cent write-off for tax purposes. The gains arising
from disposal of used assets may be considered tax free. The effective
tax rate is 35 percent. The average cost of capital of the company is 12
per cent.

After appropriate analysis of cash flows, advise the company of the

financial viability of the proposal. Ignore tax on salvage value.
11. Tectonics Ltd is considering a new project for manufacture of pocket
video games involving a capital expenditure of Rs 600 lakh and working
capital of Rs 150 lakh. The capacity of the plant is for annual production of
12 lakh units and capacity utilization during the 6 year working life of the
project is expected to be as indicated below:

The average price per unit of the product is expected to be Rs 200 netting
 a contribution of 40 per cent. The annual fixed costs, excluding
depreciation, are estimated to be Rs 480 lakh per annum from the third
year onwards; for the first and second year it would be Rs 240 lakh and Rs
360 lakh respectively. The average rate of depreciation for tax purposes is
33.33 per cent on the capital assets. The rate of income tax may be taken
at 35 percent. Cost of capital is 15 per cent.

At the end of the third year, an additional investment of Rs 100 lakh would
be required for working capital. Terminal value for the fixed assets may be
taken at 10 per cent and for the current assets at 100 per cent. For the
purpose of your calculations, the recent amendments to tax laws with
regard to balancing charge may be ignored.

Particulars Year
1 2 3 4 5 6
12. The projects consultants Ltd is a consultancy firm. Its main business is
conducting market studies, surveys and techno-economics feasibility and
industry reviews. Its final product is in a form of a printed report. The
normal procedure is to produce handwritten drafts of the report and get it
printed through an independent word processing service agency. Three
copies of each report are prepared for submission to the clients.

On an average 35 studies are completed every year. The average size of

the report is 100 pages. In addition, about 50 proposals are sent in
duplicate to various companies every year, the average size of these
being 20 pages. The reports as well as the proposals are in laser print on
bond paper. The handwritten drafts (printed 3 times for reports and 2
times for proposals) are on ordinary paper.

The external word processing is done at the rate of Rs 10 per page with
one draft free of cost. The variable overheads are 2 telephone calls a day
to the word processing agency for 300 days @ Re 1 to the word
processing agency for 300 days @ Re 1 per call.

Recently, the firm has been offered a computer system with software and
laser printer for Rs 120,000. The system would have no salvage value at
the end of 5 years. The maintenance cost of the system would include Rs
5,000 on account of annual maintenance contract and Rs 15,000 for
spares. The annual insurance of the system is likely to be 1 percent of the
cost. The other associated annual cost s are expected to be as follows:
• Cost of bond paper, Re 0.35 per sheet; cost of ordinary paper @ Re
0.18 per sheet. The experience has been that there is 10 per cent
wastage of both bond and ordinary paper sheets;
• Laser toner, Re 0.10 per sheet;
• Draft print at Re 0.05 per sheet;
• Power charges, Rs 3,000;
• Telephone charges, Rs 100;
• Manpower charges, Rs 3,000 per mouth as salary of a part-time
computer operator;
• Additional working capital requirement, Rs 25,000.

The firm is in the 35 per cent tax bracket. Assuming it would use written
down value method of depreciation at the rate of 25 per cent and its
required rate of return is 10 per cent, should the Projects Consultants Ltd
install its own computer system as an alternative to hiring word
processing service from an outside agency? Assume further that the
company does not have any other assets in the 25 per centblock.
Particulars 1 2 3 4 5