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Suggested Solution By Prof. F.R. TariqFor any query please contact at [email protected], 0333-4233770, 0321-4401660

ALLAMA IQBAL OPEN UNIVERSITY ISLAMABAD

LEVEL MBA Semester Spring 2003Paper Financial Management CC. 562/5535 Maximum Marks 100Time Allowed 3 Hrs Pass Marks 40

NOTE ATTEMPT FIVE QUESTIONS. ALL CARRY EQUAL MARKS

Q. 1Why do short term creditors, such as banks, emphasize balance sheet analysis when considering loanrequests? Should they also analyze projected income statements? Why?Q. 1 Answer:-

(Refer to chapter 6 for detailed analysis of Balance sheet and Projected financialstatements)Q. 2

Financial statements for Begalla Corporation follow. Begalla Corporations comparative balance sheets atDecember 31) in millions)

Assets 20X1 20X2 Liabilities 20X1 20X2Cash and equipments $4 $5 Accounts Payable $8 $10Accounts Receivable 7 10 Notes payable 5 5Inventory 12 15 Accrued wages 2 3

Accrued taxes 3 2Total Current assets $23 $30 Total Current

Liabilities $18 $20Net fixed assets 40 40 Long term debt 20 20

Common stock 10 10Retained earnings 15 20

Total $63 $70 Total $63 $70

Begalla Corporations Income statement 20X2 (in millions)

(a) Prepare a cash flow statement using the indirect method for Begallan Corporation.(b) Comment on cash flow statement.

Sales $95

Cost of goods sold $50

Selling general and administrative expenses 15

Depreciation 3

Interest 2 70

Net income before taxes $25

Taxes 10

Net income $15

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Q. 2 Answer: - Begalla CorporationCash Flow Statement

For the year ending December 31, 2002.(Amount in Millions)

Cash Flows from operating Activities:

Net Income $15

Depreciation 5Increase, Accounts Receivable (3)Increase, Inventory (3)Increase, Accounts Payable 2Increase, Wages 1Decrease, Accrued Taxes (1)

_____ 16MCash Flows from Investing Activities:Increase, Fixed Assets (5) (5)

Cash Flow from Financing Activities:

Dividends Paid (10) (10)

Increase in cash and cash equivalent $1MCash and cash equivalent Dec31, 2001 4M

Cash and cash equivalent Dec31, 2002. $5M

(b) Refer to chapter 7 for comments

Q. 3 Jerome J. Jerome is considering investing in a security that has the following distribution ofpossible one- year returns:

(a) What isthe expected return

and standard deviation associated with the investment?(b) Is there much downside risk? How can you tell?

Q. 3 Answer: - (Refer to Q.3 of Spring 2001)

Probability of occurrence .10 .20 .30 .30 .10

Possible return .10 .00 .10 .20 .30

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Q. 4The Anderson Corporation (an all-equity-financed firm) has a sales level of $280,000 with a 10 percentprofit margin before interest and taxes. To generate this sales volume; the firm maintains a fixed assetinvestment of $100,000. Currently, the firm maintains $50,000 in current assets.(a) Determine the total asset turnover for the firm and compute the rate of return on total assets beforetaxes.(b) Corporate the before tax rate of return on assets at different levels of current assets starting with

$10,000 and increasing in $15,000 increments to $100,000.

Q. 4 Answer:-(a) Total Assets Turnover: Net Sales = $280,000 = $1.867 times

Average total assets $150,000

Return on Assets: 10% of $280,000 x 100 = 18.67 %$150,000

(b)Level Current Fixed Total Return on

Assets Assets Assets Assets

1 $10,000 $100,000 $110,000 25.45%2 25,000 100,000 125,000 22.40%3 40,000 100,000 140,000 20.00%4 55,000 100,000 155,000 18.06%5 70,000 100,000 170,000 16.47%6 85,000 100,000 185,000 15.14%7 100,000 100,000 200,000 14.00%

Q. 5The Pawlowski Supply Company needs to increase its working capital by $4.4 million. The following

three financing alternatives are available (assume a 365-days year):a. Forgo cash discounts (granted on a basis of 3/10, net 30) and pay on the final due date.b. Borrow $5 million from a bank at 15 percent interest. This alternative would necessitate

maintaining a 12 percent compensating balance.c. Issue $4.7 million of six-month commercial paper to net $4.4 million. Assume that new paper

would be issued every six months. (Note: Commercial paper has no stipulated interest rate. It issold at a discount, and the amount of the discount determines the interest cost to the issuer.)Assuming that the firm would prefer the flexibility of bank financing, provided the additional costof this flexibility was no more than 2 percent per annum, which alternative should Pawlowskiselect? Why?

Q. 5 Answer: - (a) 3 x 365 x 100 = 56.44%100-3 30 -10

(b) $750,000 x 100 = 17.05%$5,000,000 - $600,000

(c) $750,000 x 100 x 2 = 13.64%$4,400,000

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The bank financing is approximately 3.4 percent more expensive than the commercial paper; therefore,commercial paper should be issued.Q. 6Silicon Wafer Company presently pays a dividend of $1 per share and has a share price of $20.(a) If this dividend was expected to grow at a 12 percent rate forever, what is the firms expected, orrequired return on equity using a dividend discount model approach?

(b) Instead of the situation in part (a), suppose that the dividend was expected to grow at a 20 percent ratefor five years and at 10 percent per year thereafter. Now what is the firms expected, or required return onequity?

Q. 6 Answer:- (a) Ke = D1 + g = $1.12 + 0.12 = 0.176 or 17.6%P0 $20

(b)End of year Dividend per share PV@18% PV@19%1 $ 1.20 $ 1.02 $ 1.012 1.44 1.03 1.023 1.73 1.05 1.03

4 2.07 1.07 1.035 2.49 1.09 1.04

$ 5.26 $ 5.13Year 6 Dividend = $2.74Market price at the end of year 5 using the constant growth dividend valuation model.

P5 = $2.74 = $34.250.18 0.10

P5 = $2.74 = $30.44

0.19 0.10

Present value at time O for amount received at the end of year 5:

$34.25 @ 18% = $14.97$30.44 @ 19% = $12.76

Calculated PV: 18% 19%

PV of year 1 5 $5.26 $5.13PV of year 6 -00 14.97 12.76

$20.23 $17.89

By interpolating we get

= $20.23 - $20.00 x 1% +18%$23.23 -$17.89

18.098 % or 18.10 %

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Q.7 Bruce Read Enterprises in attempting to evaluate the feasibility of investing $95,000 in a piece ofequipment having a 5-year life. The firm has estimated the cash inflows associated with the

proposal as shown in the following table.The firm has a 12 percent cost of capital.Year (t) Cash inflows (CFt)

1 $20,000

2 25,0003 30,0004 35,0005 40,000

(a) Calculate the payback period for the proposed investment.(b) Calculate the net present value (NPV) for the proposed investment.(c) Calculate the internal rate of return (IRR) rounded to the nearest whole percent for the

proposed v investment.(d) Evaluate the acceptability of the proposed investment using NPV and IRR. What

recommendation would you make relative to implementation of the project? Why?

Q. 7 Answer:-

(a) Payback period = 3.57 years(b) NPV = PV of FCIFS ICO

= $104,081 - $ 95,000 = $9,081

(c) IRR: 15.37 15% nearest whole percentage

PV @ 15% = $95,919PV @ 16% = $93.415

$95919 - $95000 x 1% + 15%$95919 - $93415

= 15.37%

(d) Proposed investment is viable because NPV is positive and IRR is greater than firms cost ofcapital. Profit ability index comes to 1.096 times.

Q. 8If all companies had an objective of maximizing shareholder wealth, would people overall ten to

be better or worse off? How?

Q.8 Answer: - (Refer to chapter 1 & 2)

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