CHAPTER 21

Solutions Manual

Chapter 21 Financial Risk Management Financial Risk Management Chapter 21

CHAPTER 21

financial risk management

Suggested Answers to the Review Questions and ProblemsI.Questions1. Refer to page 520.2. Refer to pages 520 through 521.3. Refer to page 521.4. Refer to pages 522 through 523.

5. Refer to pages 524 through 527.

6. Refer to page 532.

7. Refer to pages 527 though 528.

8. Refer to pages 537 through 538.

9. Refer to pages 538 through 539.

10. A decision tree is an analytical tool used in a problem in which a series of decision has to be made at various time intervals, with each decision influenced by the information that is available at the time it is made.

The decision branches will be drawn as broken lines emerging from square nodes and the outcomes of a trail as solid lines emerging from round nodes. The square nodes, from which the decision branches are drawn, represent the points at which decision maker selects his decision. The round nodes represent the points at which the outcome of the decision arises. The decision maker has no control over the outcome and can only estimate the probability of the various outcomes actually occurring. When all of the decisions and outcomes have been represented on the tree, each of the possible routes through tree is considered and the monetary payoff is shown at the end of each route. Any costs incurred by the decisions are indicated along the appropriate branches.II.Multiple Choice Questions1. D2. D3. B

III.ProblemsProblem 1Expected Profit:Product X = 0.20 (- P8,000) + 0.10 (- P5,000) + 0.30 (P11,000) + 0.20 (P14,000) + 0.20 (P17,000) = P7,400Product Y = 0.15 (- P12,000) + 0.15 (- P10,000) + 0.40 (P14,000) + 0.20 (P16,000) + 0.10 (P18,000) = P7,300Analysis:

Based on the above data, the choice will be made for Product X.

Problem 2

(a)To break-even, the company must earn enough total contribution to cover its fixed costs. The contribution to fixed costs and profits is P2.50 per unit (P6 3.5 per unit). To break-even, sales must be as follows:

The probability that sales will equal or exceed 13,600 units is the probability that sales will be 14,000, 16,000 or 18,000 units, which is (0.25 + 0.30 + 0.20) = 0.75 or 75%. (b)To earn profit of P10,000, the company must earn enough contribution to cover its fixed costs (P34,000) and then make the profit, so total contribution must be P44,000. To earn this contribution, sales must be as follows:The probability that sales will equal or exceed 17,600 units is the probability of sales being 18,000 units, which is 0.20 or 20%. Problem 3

ProbabilitySales Volume

(units)Expected Sales Volume (units)

0.102,000200

0.306,0001,800

0.308,0002,400

0.2010,0002,000

0.1014,000 1,400

1.007,800

EV of contribution[7,800 x (12 8)]P31,200

Less: Additional fixed overhead 20,000

EV of additional cash profit per annumP11,200

(a) Calculation of expected value of NPV of project

YearCash FlowDCF @ 10%PV of Cash Flow

0P (40,000)1.0000P (40,000)

1 6 11,2004.355048,776

63,0000.5645 1,694

Expected NPVP 10,470

(b) Calculation of minimum volume of sales per annum required to justify the projectAt break-even, the NPV would be zero. Taking the cost of the equipment and its residual value, the minimum required PV of annual cash profit would be as under:PV of capital outlay P40,000

PV of residual value 1,694

PV of actual cash profit required for NPV of 0P38,306

Discount factor of 1 per annum 6 years @ 10% is 4.355Annual cash profit required (P38,306/4.355)P 8,796

Annual (cash) fixed costs 20,000

P28,796

Annual contribution required for NPV = 0

Contribution per unit

= P4

Sales required to break-even:

Problem 4

Annual cash inflow(P4,500 x 2.9137)P13,112

Less: Project cost 12,000

Net present valueP 1,112

(a) Sensitivity for Project CostIf the project cost is increased by P1,112, the NPV of the project will become zero. Therefore, the sensitivity for project cost is:

(b) Sensitivity for Annual Cash InflowIf the present value of annual cash inflow is lower by P1,112, the NPV of the project will become zero. Therefore, the sensitivity for annual cash flow is:

(c) Sensitivity for Cost of CapitalLet x be the annuity factor which gives a zero NPV (i.e., x is the IRR)- P12,000 + P4,500 x=0

P4,500 x=P12,000

x=P12,000/P4,500

x =2.6667

Hence, x = 2.6667 and at 18% for 4 years, the annuity factor is 2.6667.

Analysis:The cash inflow is more sensitive, since only 8.5% change in cash inflow will make the NPV of the project zero. Problem 5PV of Savings

Year 1(P60,000 x 0.9259)P 55,554

Year 2(P70,000 x 0.8573) 60,011

P115,565

Less: PV of Running Cost

Year 1(P20,000 x 0.9259)P18,518

Year 2(P25,000 x 0.8573) 21,432 39950

Net savings 75,615

Less: Purchase cost of plant 70,000

Net present value P 5,615

(a) Sensitivity for Plant CostIf the purchase cost of plant increases by P5,615, the NPV of the project will become zero. Therefore, the sensitivity for plant cost is:

(b) Sensitivity for Running CostIf the present value of running cost increases by P5,615, the NPV of the project will become zero. Therefore, the sensitivity for running cost is:

(c) Sensitivity for SavingsIf the savings decrease by P5,615, the NPV becomes zero. Therefore, the sensitivity for savings is:

Analysis:

Savings is the most sensitive.100

Sensitivity %

x

8.48%

=

P1,112

P13,112

100

x

9.27%

=

P1,112

P12,000

100

x

4.86%

=

P5,615

P115,565

100

x

14.06%

=

P5,615

P39,950

100

x

8.02%

=

P5,615

P70,000

7,199 units

17,600 units

=

=

P44,000

P2.50

P28,796

P4

13,600 units

=

=

P34,000

P2.50

Contribution required

Contribution per unit

=

29%

=

18% 14%

14%

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