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ACCA F9 Workbook
Lecture 1
Financial Strategy
Year
Share Price
Dividend Paid
2007
3.30
40c
2008
3.56
42c
2009
3.47
44c
2010
3.75
46c
2011
3.99
48c
Solution
Year
Share
Price
Share Price
Growth
2007
3.30
2008
3.56
2009
3.47
2010
2011
Div
Paid
Increase
in
Sholder
Wealth
As a
Percentage
Total
Shareholder
Return
42c
(26 + 42) =
68c
(68 / 330) =
20.6%
2m x 68c =
$1.36m
44c
(-9 + 44) =
35c
(35 / 356) =
9.8%
2m x 35c =
$0.70m
3.75
46c
(28 + 46) =
74c
(74 / 347) =
21.3%
2m x 74c =
$1.48m
3.99
48c
(24 + 48) =
72c
(72 / 375) =
19.2%
2m x 72c =
$1.44m
40c
EPS - Illustration 2
2010
$000
2011
$000
PBIT
2000
2100
Interest
200
300
Tax
300
400
1500
1400
Preference Dividend
300
400
Dividend
800
900
Retained Earnings
400
100
5000
5000
Reserves
3000
3100
Share Price
$2.50
$2.80
Solution
2010
2011
1500
1400
Preference Dividend
300
400
Earnings
1200
1000
10,000
10,000
12c
10c
Share Price
Dividend Paid
$4.50
82c
$4.71
84c
$3.85
86c
8. In order for dividends to be paid a company must have made profits in the current year.
Is this statement TRUE or FALSE?
Answer FALSE
9. Miller and Modigliani stated in their theory that dividends were ..........................
Answer Irrelevant
10. If a company does not pay dividends then the result will be
A. More tax will be paid.
B. Less profit will be made.
C. More cash is available for investments.
D. More debt will be required.
Answer C
8. Why did Miller & Modigliani say that dividends were irrelevant?
M & M stated that whether the firm paid a dividend or chose to reinvest the money
into the business the shareholders would get the same return.
This is because if a dividend is paid the shareholders get their return in the form of
revenue. If the money is reinvested in the business this should lead to more profit
and thus an increased share price which increases shareholder wealth by the same
amount.
Now do it!
!
Lecture 2
Performance
Measurement
X2
X3
500
700
1000
Current Assets
150
200
300
650
900
1300
300
300
300
Reserves
100
280
430
Loan Notes
150
200
300
Payables
100
120
270
650
900
1300
Revenue
3000
3500
4200
COS
2000
2400
3200
Gross Profit
1000
1100
1000
Admin Costs
300
350
400
Distribution Costs
200
250
300
PBIT
500
500
300
Interest
100
150
220
Tax
120
90
50
280
260
30
Dividends
100
110
30
Retained Earnings
180
150
$3.30
$4.00
$2.20
Share Price
Using the information on the previous page calculate and comment on the following
Ratios:
I. Return on Capital Employed
II. Return on Equity
III. Gross Margin
IV. Net Margin
V. Operating Margin
VI. Revenue Growth
VII. Gearing
VIII. Interest Cover
IX. Dividend Cover
X. Dividend Yield
XI. P/E Ratio
Solution
ROCE
Equity + LT
Liabilities
X1
X2
X3
Shares
300
300
300
Reserves
100
280
430
LT Loan Notes
150
200
300
Capital Employed
550
780
1030
500
700
1000
(150 - 100) = 50
(200 - 120) = 80
(300 - 270) = 30
Capital Employed
550
780
1030
Total Assets
650
900
1300
Current Liabilities
100
120
270
Capital Employed
550
780
1030
500
500
300
(500 / 550) =
90.91%
(500 / 780) =
64.10%
(300 / 1030) =
29.13%
PBIT
Return on Capital
Employed
PBIT / Capital
Employed
X1
X2
X3
90.91%
64.10%
29.13%
In the first year the ROCE was 90.91%. At first glance this would appear to be a good return, however
without industry averages or prior period information we are unable to tell if this is the case.
In year X2 the ROCE is 64.10%. This is a fall of 29.5% from the previous year indicating that the business
in not able to make the same return on its assets that it has previously been able to do.
In the year X3 the ROCE is 29.13%. This is a fall of 54.55% indicating that there may be some serious
underlying problems which are affecting the ability of the business to generate the return on capital
previously generated.
ROE
X1
X2
X3
280
260
300
Ordinary Shares
300
300
300
Reserves
100
280
430
Total
400
580
730
(280 / 400) =
70%
(260 / 580) =
44.8%
(300 / 730) =
41%
In the first year the ROE was 70%. At first glance this would appear to be a good return, however without
industry averages or prior period information we are unable to tell if this is the case.
In year X2 the ROE is 44.8%. This is a fall of 36% from the previous year indicating that the business in
not able to make the same return on the shareholders funds that it has previously been able to do.
In the year X3 the ROE is 41%. This is a fall of 8.4% indicating that the business may be having difficulty
generating the returns it was able to do previously.
Margins
X1
X2
X3
Revenue
3000
3500
4200
Gross Profit
1000
1100
1000
PAT
280
260
30
PBIT
500
500
300
(1000 / 3000) =
33.33%
(1100 / 3500) =
31.42%
(1000 / 4200) =
23.89%
(280 / 3000) =
9.3%
(260 / 3500) =
7.4%
(30 / 4200) =
0.7%
(500 / 3000) =
16.66%
(500 / 3500) =
14.28%
(300 / 4200) =
7.1%
The Gross Margin is 33.33% in X1 and holds reasonably steady in X2 at 31.42%. However in X3 the
Gross Margin falls to 23.89% indicating that the business has either had to cut prices to sell the greater
volume it has, or the cost of its purchases have gone up.
The Net Margin is 9.3% in X1 but begins to fall in X2 with 7.4% achieved, before falling dramatically to
0.7% in X3. The main reason for this is the fall in Gross Profit as other costs have risen in line with
expectations given the increase in sales. However another point to note is that interest costs have risen
with the increase in long term loans. The extra interest costs have put pressure on the business.
The Operating Margin dropped slightly in X2 to 14.28% from 16.66% the previous year - a fall of almost
15%. In X3 the Operating Margin fell away to 7.1%, a decrease of over 50%. This is due to the decreasing
Gross Margin achieved as well as rises in the other expenses.
Gearing
X1
X2
X3
150
200
300
Number of
Shares
300
300
300
Share Price
3.30
2.20
Market Value
(300 x 3.30) =
990
(300 x 4) =
1200
(300 x 2.20) =
660
(150 / 990) =
15%
(200 / 1200) =
16.66%
(300 / 660) =
45.45%
Debt
Equity
Gearing levels in year X1 are 15%. Without industry averages or prior year data we are unable to assess
this level although at first glance it does not seem excessive.
In year X2 gearing increases slightly to 16.66%, an increase of 11% from year X1. This is due to debt
levels increasing to 200 from 150, although this is offset by the increase in the share price from $3.30 to
$4.
In year X3 gearing increases dramatically to 45%, an increase of over 180%. This is due to debt levels
rising to 300 from 200 and the share price dropping to $2.20 due to the deteriorating results of the
business.
Interest Cover
X1
X2
X3
PBIT
500
500
300
Interest
100
150
220
(500 / 100) = 5
times
Interest coverage in year X1 is 5 times. Without industry averages or prior year data we are unable to
assess this level although at first glance it does not seem unreasonable.
In year X2 interest coverage falls to 3.33 times. This has occurred due to the interest charge increasing in
the period while PBIT has remained constant.
In year X3 interest coverage has decreased again to 1.36 times. This is caused by the PBIT achieved
decreasing to 300 combined with the increase in the interest charge to 220. The increase in interest is
caused by the increase in the long term debt of the company as shown by the gearing ratios calculated
above.
Dividend Cover
X1
X2
X3
PAT
280
260
30
Dividends
100
110
30
Dividend coverage in year X1 is 2.8 times. Without industry averages or prior year data we are unable to
assess this level although at first glance it does not seem unreasonable.
In year X2 dividend coverage falls to 2.36 times. This would not concern investors as although coverage
has gone down slightly, the dividend paid this year is greater than last.
In year X3 dividend coverage has decreased to 1 time. This is caused by the decrease in profit achieved
by the company restricting the level of dividend payable. This will be of concern to investors and their
concern is reflected in the fall in the share price from $4 in year X2 to $2.20 in year X3.
Dividend Yield
X1
X2
X3
300
300
300
Dividends
100
110
30
(36 / 400) = 9%
The Dividend Yield is 10% in year X1. Whilst we do not have comparatives, this seems a reasonable
return.
In year X2 the Dividend Yield falls to 9%. This will not be overly concerning to investors as the increase in
share price over the year will have more than made up for the slightly lower yield.
In year X3 the Dividend Yield has fallen to 4.5% which is 50% lower than the previous year. This,
combined with the fall in share price and reduced profitability will be a major concern to investors.
P/E Ratio
X1
X2
X3
$3.30
$4
$2.20
280
260
30
300
300
300
EPS
(220 / 10) = 22
Share Price
The P/E Ratio in year X1 is 3.54. We don not have industry comparatives or prior year information with
which to compare this.
In year X2 the P/E Ratio increases to 4.65. This indicates that the market expectations for this share have
risen since X1 and that investors are now willing to pay 4.65 times what the business earns in a year to
own the share.
In year X4 the P/E ratio has increased dramatically to 22. This is unusual as the earnings have decreased
to 12% of the previous year. The share price has fallen to reflect this, but not by as much as would be
expected. This may indicate that the market feels that the results in year X3 were perhaps a one-off and
that next years results will improve.
Now do it!
Lecture 3
Finance Sources
Solution
Number of Shares
Share Price
Total
$8
(4 x $8) = 32
$6
(1 x $6) = 6
38
We now have 5 shares in issue at total value of $38 so the THERP is (38 / 5) = $7.60
$5m
1.25m
$4
Number of Shares
Share Price
Total
$5.50
(5 x 5.50) = 27.5
$4
(1 x 4) = 4
31.5
We now have 6 shares in issue at total value of $31.5 so the THERP is (31.5 / 6) =
$5.25
3. Which of the following are advantages to a company of being listed on the stock
exchange?
1. It will lead to a better perception of the firm by potential investors.
2. It will be more difficult for the firm to raise capital.
3. Listing may well lower the cost of equity of the firm as investors will see it as a safer
investment and thus accept a lower return.
4. The company may be required to disclose more information about its operations.
A. 1 and 2
B. 2 and 3
C. 2 and 4
D. 1 and 3
Answer D
4. Which of the following are disadvantages to a company of being listed on the stock
exchange?
1. It is expensive to become listed.
2. There are ongoing costs of listing compliance.
3. Control by the current owners will be increased.
4. Listing may well lower the cost of equity of the firm as investors will see it as a safer
investment and thus accept a lower return.
A. 1 and 2
B. 2 and 4
C. 3 and 4
D. 1 and 4
Answer A
5. A company has 10m shares in issue at a share price of $7 and undertakes a rights issue
of 1 for 5 to raise $12m. What is the Theoretical ex-rights price?
A. $6.17
B. $6.83
C. $6.00
D. $6.44
Answer B
Amount of Capital to raise
$12m
2m
$6
Number of Shares
Share Price
Total
10m
$7
$70m
2m
$6
$12m
12m
$82m
We now have 12m shares in issue at total value of $82m so the THERP is ($82m / 12) =
$6.83
10. Which of the following is NOT a function of the treasury department in a company?
A. To set and achieve the financial objectives of the firm.
B. To manage the liquidity of the firm.
C. To prepare the financial statements of the firm.
D. To manage any currency risk that the firm may be exposed to.
Answer C
5. A company has 10m shares in issue at a share price of $7 and undertakes a rights issue
of 1 for 5 to raise $12m. What is the Theoretical ex-rights price?
Amount of Capital to raise
$12m
2m
$6
Number of Shares
Share Price
Total
10m
$7
$70m
2m
$6
$12m
12m
$82m
We now have 12m shares in issue at total value of $82m so the THERP is ($82m / 12) =
$6.83
6. What is an IPO?
An Initial Public Offering of shares to investors as a method of raising capital.
8. What is a placing?
A placing of a new issue of shares with institutional investors such as insurance
companies or pension funds.
Now do it!
Lecture 4
Economic
Environment
5. Which of the following might cause policy makers to decide to decrease interest rates?
1. Excessive consumer demand in the economy.
2. Reduced consumer demand in the economy.
3. Concerns that growth in the economy may be low.
4. Expectations that the economy will grow strongly.
A. 1 and 2
B. 2 and 3
C. 3 and 4
D. 1 and 4
Answer B
7. How can financial intermediaries help to make the market more efficient?
A. By buying commodities from sellers and trading them on the commodities exchange.
B. By providing insurance on transactions for buyers and sellers.
C. By providing finance to enable transactions to take place.
D. By selling foreign currency on the currencies exchange.
Answer C
7. How can financial intermediaries help to make the market more efficient?
Financial intermediaries enable the transaction between buyers and sellers by
providing finance to the buyers e.g. Banks & finance houses.
Now do it!
Lecture 5
Working Capital
1000
Inventory
300
Receivables
200
Cash
300
1800
LIABILITIES
Ordinary Shares
800
Reserves
200
700
Payables
100
Overdraft
1800
Income Statement
$000
Revenue
1000
COS
800
Gross Profit
200
Other Costs
100
Net Profit
100
Other Information:
All sales are made on credit.
Required:
Calculate the Cash Operating Cycle for Inter Ltd.
Solution
Item
Working
Days
Inventory Period
300/800 x 365
137
Collection Period
200/1000 x 365
73
100/800 x 365
46
Less:
Payables Period
164
Item
Days
Inventory Period
200
Collection Period
100
Less:
Payables Period
30
270
Solution
Item
New Days
Old Days
Old
Balance
Working
New
Balance
Movemt
Inventory
200
137
300
300 x
200/137
438
138
Receivabl
es
100
73
200
200 x
100/73
274
74
30
46
100
100 x
30/46
65
-35
270
164
Less:
Payables
Entries
Dr Inventory
Dr
138
Cr Cash
Dr Receivables
138
74
Cr Cash
Dr Payables
Cr Cash
Cr
74
35
35
Movement
$000
ASSETS
Non Current Assets
1000
1000
Inventory
300
138
438
Receivables
200
74
274
Cash
300
-247
53
1800
1765
Ordinary Shares
800
800
Reserves
200
200
700
700
Payables
100
Overdraft
1800
1765
LIABILITIES
-35
65
Item
Days
Inventory Period
90
Collection Period
30
Less:
Payables Period
60
60
Solution
Item
New Days
Old Days
Old
Balance
Working
New
Balance
Movemt
Inventory
90
200
438
438 x
90/200
197
-241
Receivabl
es
30
100
274
274 x
30/100
82
-192
60
30
65
65 x 60/30
130
65
60
270
Less:
Payables
Entries
Dr
Dr Cash
Cr
241
Cr Inventory
241
Dr Cash
192
Cr Receivables
192
Dr Cash
65
Cr Payables
65
498
498
Movement
$000
ASSETS
Non Current Assets
1000
1000
Inventory
438
-241
197
Receivables
274
-192
82
Cash
53
498
551
1765
1830
Ordinary Shares
800
800
Reserves
200
200
700
700
Payables
65
Overdraft
1765
1830
LIABILITIES
65
130
52 days
42 days
30 days
66 days
45 days
103 days
131 days
235 days
31 days
Answer A
4. If inventory days go up from 100 to 150 the company will need to invest more cash in
the business.
Is this statement:
A. TRUE
B. FALSE
Answer A
5. Which of the following statements concerning working capital management are correct?
1 The twin objectives of working capital management are profitability and liquidity
2 A conservative approach to working capital investment will increase profitability
3 Working capital management is a key factor in a companys long-term success
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer B
6. Which of the following statements concerning working capital management are correct?
1 The twin objectives of working capital management are profitability and liquidity
2 A aggressive approach to working capital investment will increase profitability
3 Working capital management is not a key factor in a companys long-term success
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer A
7. Which of the following statements concerning working capital management are correct?
1 The twin objectives of working capital management are profitability and liquidity
2 A moderate approach to working capital investment will increase profitability
3 An aggressive approach to working capital investment uses more long term finance than
short term.
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer B
8. Which of the following statements concerning working capital management are correct?
1 A conservative approach to working capital investment employs uses long term finance
to finance some fluctuating current assets.
2 An aggressive approach to working capital investment will increase profitability
3 Working capital management has no effect on profitability of the company.
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer A
5. If my inventory days go up from 100 to 150 will I need to invest more or less cash in the
business?
More cash as cash is being tied up in inventory.
10. What are the advantages of a conservative working capital financing policy?
There is less chance of the firm running out of cash i.e. less liquidity risk.
The firm is able to meet sales demand changes.
By offering more credit the firm may well increase sales.
Now do it!
Lecture 6
Managing
Receivables
Receivables - Illustration 1
Credit sales: 1200
3 month credit terms
Overdraft rate = 10%
New Policy
2% discount if paid in less than 10 days
2 month terms for everyone else.
20% will take the discount
Solution
Receivables After
1200 x 3/12
300
(1200 x 10/365) x
20%
160
167
13
(1200 x 20%) x 2%
4.8
The saving made is greater than the profit lost so the discount should be offered
Receivables - Illustration 2
Difference on Receivables
Current Receivables
Receivables Under Factor
4,600,000
37,400,000 x (30 / 365)
3,073,973
Difference
1,526,027
1,526,027 x 0.05
76,301
100,000
350,000
Total Benefits
526,301
37,400,000 x 0.03
1,122,000
49,184
1,171,184
-644,883
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer A
2. Which of the following are benefits of a company offering a discount to customers for
early payment of invoices?
1. Better liquidity for the firm.
2. Less interest as less or no overdraft will be required.
3. Risk of more bad debt as customers take longer to pay.
4. Loss of customers who dont take advantage of the discount.
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer A
3. The management of XYZ Co has annual credit sales of $20 million and accounts
receivable of $4 million. Working capital is financed by an overdraft at 12% interest per
year. Assume 365 days in a year.
What is the annual finance cost saving if the management reduces the collection period to
60 days?
A $85,479
B $394,521
C $78,904
D $68,384
Answer A
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer D
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer B
8. How can a company seek to ensure that foreign receivables are collected?
Agree early payment.
Bills of exchange.
Letters of credit.
References & credit checks.
Insurance.
Export factor.
Now do it!
Lecture 7
Inventory
Management
EOQ - Illustration 1
Demand of 1200 units per month.
Cost of making an order of $12.
Cost of one unit $10.
Holding cost per year of 10% of the purchase price of the goods.
Calculate the EOQ & check that it is correct.
Solution
Working
Annual Demand
1200 x 12
14,400
Holding Cost
$10 x 10%
Ordering Cost
12
EOQ
(2 x 12 x 14,400) / 1
588
12 x (14,400 / 588)
294
1 x (588 / 2)
294
Test
Ordering Costs (Cost Per order x
(Demand / EOQ))
Holding Costs (Cost Per Unit x (EOQ / 2))
Solution
Buffer Stock = Re-order level less usage in lead time
Re-order level
Lead Time
Usage per week
50,000 - (4 x 7,500)
50,000
4 weeks
7,500
20,000
Solution
Working
Buffer Stock (Re-order level - (Lead time x
amount used per week))
35,000 - (2 weeks x
625,000/50)
10,000
(2 x 250 x 625,000 /
0.5)
25,000
250 x
(625,000/25,000)
6,250
0.5 x (25,000 / 2)
6,250
0.5 x 10,000
5,000
Total Costs
17,500
Solution
EOQ with Discounts
1) Calculate EOQ in normal way (and the costs)
2) Calculate costs at the lower level of each discount above the EOQ
Working
EOQ
(2 x 30 x 12,000 / 1.1)
809
30 x (12,000 / 809)
445
1.1 x (809/2)
445
Cost of Purchases
12,000 x 11
132,000
Total Costs
132,890
30 x (12,000 / 1500)
240
817
130,608
Total Costs
131,665
2. If a company uses the Economic Order Quantity as the level at which to order, how will
they calculate total ordering costs for the year?
A. Cost per order x (Annual Demand / EOQ)
B. Annual Demand x (Cost per order /EOQ)
C. (EOQ / Cost per order) x Holding costs
D. Annual demand x EOQ
Answer A
3. ABC Co. sells widgets and expects annual demand of 3.4m units. The cost of making
an order is $49.71 and the cost of holding one unit for one year is $0.50.
What is the total ordering costs per year:
A. $5,687.34
B. $6,413.81
C. $6,500.54
D. $6,430.32
Answer C
3. ABC Co. sells widgets and expects annual demand of 1.2m units. The cost of making
an order is $25.21 and the cost of holding one unit for one year is $0.50.
What is the total holding costs per year:
A. $2,850
B. $3,750
C. $2,450
D. $2,750
Answer D
4. Layla Co. sells 200m wigs in a year with each order taking 15 days to be delivered once
made. They make an order every time their stock levels reach 10m wigs.
What is the buffer stock level for Layla Co.
A. 1,780,822
B. 6,666,666
C. 9,333,333
D. 2,345,632
Answer A
5. Which of the following are drawbacks of a company using the Economic Order Quantity
method of stock management?
1. Assumes constant ordering costs.
2. Assumes constant demand.
3. Assumes known annual demand.
4. Assumes no buffer stock or lead time.
A
B
C
D
1, 2 and 4 only
1 and 3 only
All of the above
1, 2 and 3
Answer C
6. Stavros Cos current inventory policy is to order 60,000 units when the inventory level
falls to 55,000 units. Forecast demand to meet production requirements during the next
year is 800,000 units. The cost of placing and processing an order is $90, while the cost
of holding a unit in stores is $1 per unit per year. Both costs are expected to be constant
during the next year. Orders are received three weeks after being placed with the
supplier. You should assume a 50-week year and that demand is constant throughout
the year.
What is the total cost of ordering at the EOQ level?
A. $12,000
B. $6,000
C. $7,000
D. $19,000
Answer D
Solution
Working
Buffer Stock (Re-order level - (Lead time x
amount used per week))
15,000 - (3 weeks x
800,000/50)
7,000
(2 x 90 x 800,000 /
1)
12,000
90 x (800,000/12,000)
6,000
1 x (12,000 / 2)
6,000
1 x 7,000
7,000
Total Costs
19,000
6. What are the steps in calculating the total costs when there is a buffer stock?
Calculate the EOQ ignoring the buffer stock.
Calculate the buffer stock.
Add the holding cost for the buffer.
8. Why might we not use the EOQ when there are bulk discounts available?
The saving on the discount may mean that it is cost beneficial to order at that level.
Now do it!
Lecture 8
Cash Management
A business expects to move 500,000 from its interest bearing account into cash over the
course of one year.
The interest rate is 7% and the cost of making a transfer is $250.
How much should the business transfer into cash each time it makes a transfer?
Solution
Working
Annual Disbursements
$500,000
Interest Rate
7%
$250
(2 x 250 x 500,000) /
0.07
$59,761
Using the information in illustration 1 calculate the total cost to the business each year of
their cash management policy.
Solution
Working
Holding Cost (Ave Cash
Balance x Interest Rate)
($59761 / 2) x 0.07
2091
$250 x (500,000 /
59,761)
2091
Total Cost
4182
Solution
Working
Annual Disbursements
$9,000,000
Interest Rate
9%
$264.50
(2 x 264.5 x 9,000,000) /
0.09)
230,000
Working
Holding Cost (Ave Cash
Balance x Interest Rate)
(230,000 / 2) x 0.09
10,350
$264.50 x (9,000,000 /
230,000)
10,350
Total Cost
20,700
If a company must maintain a minimum cash balance of 8,000, and the variance of its
daily cash flows is 4m (ie std deviation 2,000). The cost of buying/ selling securities is
50 & the daily interest rate is 0.025 %.
Calculate the spread, the upper limit & the return point.
Solution
Working
Lower Limit
Given in Question
8,000
Spread
(3 x ((3/4 x 50 x
4,000,000) / 0.00025))1/3
25,303
8,000 + 25,303
33,303
16,434
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer B
2. Revaile Co. has annual transactions of $30 million. The fixed cost of converting
securities into cash is $500 per conversion. The annual opportunity cost of funds is 6%.
What is the optimal deposit size?
A. $21,213
B. $42,426
C. $707,107
D. $42.43
Answer B
Working
Annual Disbursements
$30,000,000
Interest Rate
6%
$500
(2 x 264.5 x 9,000,000) /
0.09)
707,107
Working
Holding Cost (Ave Cash
Balance x Interest Rate)
(707,107 / 2) x 0.06
21,213
$500 x (30,000,000 /
707,107)
21,213
Total Cost
42,426
1 and 2 only
1 and 3 only
2 and 3 only
1, 2 and 3
Answer D
4. If a company must maintain a minimum cash balance of 20,000, and the variance of its
daily cash flows is 6.25m (ie std deviation 2,500). The cost of buying/ selling
securities is 80 & the daily interest rate is 0.035 %.
What is the upper-limit using the Miller-Orr model of cash management?
Working
Lower Limit
Given in Question
20,000
Spread
(3 x ((3/4 x 80 x
6,250,000) / 0.00035))1/3
25,303
8,000 + 25,303
33,303
16,434
9. If the interest rate is 8% what figure should be included in the Miller-Orr model for i?
0.00022 (0.08 / 365)
Now do it!
Lecture 9
Investment
Appraisal I
ARR - Illustration 1
ABC Ltd are considering expanding their internet cafe business by buying a business
which will cost $275,000 to buy and a further $175,000 to refurbish.
They expect the following cash to come in:
Year Net Cash Profits ()
1 45,000
2 75,000
3 80,000
4 50,000
5 50,000
6 60,000
The equipment will be depreciated to a zero resale value over the same period and,
after the sixth year, they can sell the business for $200,000
Calculate the ARR or ROCE of this investment
Solution
360,000
Total Depreciation
175,000
Total Profits
185,000
Average Profits
$185,000 / 6 years
30,833
(450,000 + 200,000) / 2
325,000
30,833 / 325,000
9.5%
II.
Item
Relevant
Cash Flow?
Explain
Feasibility Study
No
Rent
No
New Equipment
Yes
Depreciation
No
Managers Salary
No
Solution
$5.8m / $400,000
14.5 years
$1,200,000
Year 2:!
$2,200,000
Year 3:!
$2,500,000
Year 4:!
$1,700,000
Solution
Year
Cash Flows
1,200,000
1,200,000
2,200,000
3,400,000
2,500,000
5,900,000
1,700,000
7,600,000
Solution
Use Formula: 1+m = (1+r) x (1+inf)
We are looking for m, therefore:
1+m = (1+0.10) x (1+0.05)
1+m = 1.155
m = 0.155 = 15.5%
Year
Cash-Flows
5,000
7,000
8,000
10,000
11,000
9,000
Solution
Year
Cash-Flows
Discount Rate
(From Tables)
Present Value
5,000
0.909
4,545
7,000
0.826
5,782
8,000
0.751
6,008
10,000
0.683
6,830
11,000
0.621
6,831
9,000
0.564
5,076
Total
35,072
Year
Cash-Flows
5,000
5,000
5,000
5,000
5,000
5,000
Solution
Year
Cash-Flows
Discount Rate
(From Tables)
Present Value
5,000
0.909
4,545
5,000
0.826
4,130
5,000
0.751
3,755
5,000
0.683
3,415
5,000
0.621
3,105
5,000
0.564
2,820
Total
21,770
Years
Cash-flow
Present Value
1-6
5,000
4.355
21,775
Solution
Annual Cash Flow
Cost of Capital (10%)
Perpetuity (Cash-Flow / Cost of Capital)
$100,000
0.10
100,000 / 0.10 = $1m
The investment will be depreciated to a scrap value of $175,000 over the period of the
project.
What is the Accounting Rate of Return (Return on Capital Employed) of the project?
A. 6%
B. 3%
C. 18%
D. 12%
Answer B
300,000
(375,000 - 175,000)
200,000
Total Profits
Average Profits
Average Investment (Capital
Investment + Residual Value) / 2
ROCE (Ave. Profit / Ave
Investment)
100,000
$100,000 / 6 years
16,668
(375,000 + 175,000) / 2
550,000
16,668 / 550,000
3%
2. Which of the following are weaknesses of the Accounting Rate of Return (Return on
Capital Employed)?
1. The calculation uses accounting profit rather than cash.
2. It disregards the timing of the inflows.
3. It does not consider the whole life of the project.
4. No discount rate is used to allow for inflation and risk.
A
B
C
D
1, 2 and 4
1 and 3 only
2 and 3 only
1, 2 and 3
Answer A
3. Aldios Co. intends to make an investment of $4.5m in a project lasting 5 years. The
project cashflows are forecast to be as follows:
Year
1
2
3
4
5
The investment will be depreciated to a scrap value of $1.5m over the period of the
project.
What is the Payback period of the investment?
A. 3 Years 4 months
B. 2 Years 6 months
C. 4 Years 2 months
D. 2 Years 4 months
Answer A
Year
Cash Flows
250,000
250,000
550,000
800,000
2,700,000
3,500,000
3,000,000
6,500,000
4. Jpeg Co. uses a real discount rate of 8%. They are carrying out an investment appraisal
using an inflation rate of 5%.
What discount rate should be used to discount the cash flows for the project:
A. 8%
B. 5%
C. 13%
D. 11%
Answer C
9. If the real discount rate is 7% and inflation is running at 3% what is the nominal/money
discount rate?
1+m = (1+r) x (1+inf)
1+m = (1.07) x (1.03)
1+m = 1.10
m = 0.10
Money Discount Rate = 10%
10. If I am going to receive $8,000 per year for 6 years and my cost of capital (discount
rate) is 8% what is the present value of the total of these cash-flows?
$8,000 x 4.623 (from annuity tables) = $36,984
Now do it!
Lecture 10
Investment
Appraisal II
WDA - Illustration 1
A business buys a piece of equipment for $100.
Capital allowances are available at 25% reducing balance.
The tax rate is 30%
After the 4 year project the equipment can be sold for $25.
Solution
Period
Balance
25% WDA
30% Tax
Saving
Period
100.00
25.00
7.50
75.00
18.75
5.63
56.25
14.06
4.22
42.19
17.19
5.16
Sale of Item
-25.00
Period
Tax
Saving
7.5
5.63
4.22
5.16
30,000
Year 1!!
35,000
Year 2!!
45,000
Year 3!!
32,000
Solution
Period
Total Invested
30,000
35,000
45,000
32,000
Movement to NPV
Calculation
-30,000
-5,000
-10,000
13,000
32,000
NPV - Illustration 3
A business is evaluating a project for which the following information is relevant:
I.
Sales will be $100,000 in the first year and are expected to increase by 5% per year.
II.
III. Capital investment will be $200,000 and attracts tax allowable depreciation of the full
value of the investment over the 5 year length of the project.
IV. The tax rate is 30% and tax is payable in the following year.
V.
Working Capital invested will be 20% of projected sales for the following year.
VI. General inflation is expected to be 3% over the course of the project and the business
uses a real discount rate of 9%.
Calculate the NPV for the project.
Solution
Working 1 - WDAs
Initial Investment
WDAs
Tax Saving
Periods
200,000
(200,000 / 5) =
40,000
(40,000 x 30%) =
12,000
2-6
Working 2 - Inflation
Period
100,000
100,000
100,000
100,000
100,000
Inflation
1.05
1.05 to
power of 2
1.05 to
power of 3
1.05 to
power of 4
Inflated
Sales
100,000
105,000
110,250
115,763
121,551
Costs
50,000
50,000
50,000
50,000
50,000
Inflation
1.07
1.07 to
power of 2
1.07 to
power of 3
1.07 to
power of 4
Inflated
Costs
50,000
53,500
57,245
61,252
65,540
Sales
Working
Real Discount Rate
In Question
9%
Inflation
In Question
3%
1 + m = (1 + 0.09) x (1 +
0.03)
1 + m = 1.12
m = 0.12
12%
Period
Inflated Sales
100,000
105,000
110,250
115,763
121,551
Working Capital
Required (20%)
20,000
21,000
22,050
23,153
24,310
Movement
-20,000
-1,000
-1,050
-1,103
-1,158
24,310
NPV
Period
Inflated Sales
(W2)
100,000 105,000
110,250
115,763
121,551
Inflated Costs
(W2)
-50,000 -53,500
-57,245
-61,252
-65,540
Profit
50,000
51,500
53,005
54,510
56,011
Tax at 30%
-15,000
-15,450
-15,902
-16,353
-16,803
Tax Saving
(W1)
12,000
12,000
12,000
12,000
12,000
Capital
Investment
-200,000
Working Capital
(W4)
-20,000
-1,000
-1,050
-1,103
-1,158
24,310
Total Cash
Flows
-220,000
49,000
47,450
48,452
49,451
75,968
-4,803
0.893
0.797
0.712
0.636
0.567
0.507
-220,000
43,757
37,818
34,498
31,451
43,074
-2,435
Discount Rate
12% (W3)
Discounted
Cash Flows
NPV
-31,838
$1.2m
$1.8m
$2.1m
$2.2m
$2.5m
Asfor Co. uses a real discount rate of 6% and general inflation is expected to be 5% per
year for the duration of the project.
What is the NPV of the project ignoring tax:
A. $8,178
B. $8,108
C. $2,010
D. $7,010
Answer C
Discount Rate (1.06 x 1.05) = 11%
1
Cash
1,200
1,800
2,100
2,200
2,500
DR 11%
0.901
0.812
0.731
0.659
0.593
PV Cash
1,081
1,462
1,535
1,450
1,483
Total PV
7,010
Capital
5,000
NPV
2,010
2. Asfor Co. plans to undertake a project with an initial investment of $16m. The cash flows
(profit) before inflation expected from the project are as follows:
Year
$4.2m
$4.9m
$5.5m
$5.8m
$6.1m
Asfor Co. uses a real discount rate of 10% and general inflation is expected to be 3% per
year for the duration of the project.
The tax rate on profits is 30% payable the following year.
What is the NPV of the project:
A. $417
B. $2,048
C. -$298
D. $2,233
Answer B
Discount Rate (1.10 x 1.03) = 13%
1
Cash
4,200
4,900
5,500
5,800
6,100
Inflated
4,326
5,198
6,010
6,528
7,072
-1,298
-1,560
-1,803
-1,958
-2,121
Tax
Total
4,326
3,901
4,450
4,725
5,113
-2,121
DR 13%
0.885
0.885
0.885
0.885
0.885
0.885
PV Cash
3,829
3,452
3,939
4,182
4,525
-1,878
Total PV
Cash
18,048
Capital
16,000
NPV
2,048
3. Asfor Co. plans to undertake a project with an initial investment of $16m and a scrap
value of $3m at the end of the project. The cash flows after inflation expected from the
project are as follows:
Year
$4.2m
$4.9m
$5.5m
$5.8m
$6.1m
Asfor Co. uses a nominal discount rate of 10%. Inflation is expected to be 3% per year.
The tax rate on profits is 30% payable the following year. Tax allowable depreciation is
available at 25% reducing balance.
What is the NPV of the project:
A. $1,477
B. $6,945
C. $17,477
D. $3,340
Answer D
Period
Balance
25% WDA
30% Tax
Saving
Period
16,000
4,000
1,200
12,000
3,000
900
9,000
2,250
675
6,750
1,688
506
5,063
2,063
619
Sale of Item
3,000
4,200
4,900
5,500
5,800
6,100
Tax
-1,260
-1,470
-1,650
-1,740
-1,830
Tax
Saving on
WDAs
1,200
900
675
506
619
Cash
Capital
-16,000
Total
-16,000
4,200
4,840
4,930
4,825
7,866
-1,211
DR 10%
1.000
0.909
0.893
0.751
0.683
0.621
0.564
PV Cash
-16,000
3,818
4,322
3,702
3,295
4,885
-683
NPV
3,340
3,000
4. Asfor Co. plans to undertake a project with an initial investment of $10m. The cash flows
(profit) after inflation expected from the project are as follows:
Year
$4.2m
$4.9m
$5.5m
$5.8m
$6.1m
Cash
4,200
4,900
5,500
5,800
6,100
-1,260
-1,470
-1,650
-1,740
Tax
-1,830
W.Capital
-1,000
-50
-53
-55
1,158
Total
3,200
3,590
3,978
4,095
5,518
-1,830
DR 10%
0.909
0.893
0.751
0.683
0.621
0.564
PV Cash
2,909
3,206
2,987
2,797
3,427
-1,032
Total PV
Cash
14,293
Capital
10,000
NPV
4,293
5. Asfor Co. plans to undertake a project with an initial investment of $6m and scrap value
of $1m. The sales price per unit in real terms is $30 with cost per unit of $15.
Year
Units
200,000
300,000
350,000
400,000
320,000
30
30
30
30
30
Inflation
1.05
1.052
1.053
1.054
1.055
Inflated
32
33
35
36
38
Cost Price
15
15
15
15
15
Inflation
1.03
1.032
1.033
1.034
1.035
Inflated
15
16
16
17
17
16
17
18
20
21
Units (000)
200
300
350
400
320
Total Cash
3,210
5,148
6,418
7,833
6,688
Sales Price
Cash
3,210
5,148
6,418
7,833
6,688
-963
-1,544
-1,925
-2,350
Tax
-2,006
Capital
-6,000
1,000
Total
-2,790
4,185
4,874
5,908
5,338
-2,006
DR 10%
0.909
0.893
0.751
0.683
0.621
0.564
PV Cash
-2,536
3,737
3,660
4,035
3,315
-1,132
NPV
11,079
6. Asfor Co. plans to undertake a project with an initial investment of $600,000 and scrap
value of $100,000. The sales and costs in real terms are forecast to be
Year
Sales
$
Costs
$
200,000
100,000
300,000
125,000
350,000
155,000
400,000
160,000
320,000
145,000
Sales
200
300
350
400
320
Inflation
1.05
1.052
1.053
1.054
1.055
Inflated
210
331
405
486
408
Costs
100
125
155
160
145
Inflation
1.03
1.032
1.033
1.034
1.035
Inflated
103
133
169
180
168
Sales
210
331
405
486
408
Costs
-103
-133
-169
-180
-168
Profit
107
198
236
306
240
-32
-59
-71
-92
Tax
-72
Capital
-600
100
Total
-493
166
177
235
248
-72
DR 10%
0.909
0.893
0.751
0.683
0.621
0.564
PV Cash
-448
148
133
161
154
-41
NPV
107
4. If I have profits in period 2 of $4,000 and a tax rate of 30% how much tax will I pay and
when?
Tax to pay: 4,000 x 0.3 = $1,200
This will be paid in period 3 - one year later.
5. If I receive 25% capital allowances and have a tax rate of 20% what will my tax saving
be in each year over a 5 year project if the capital investment is $7,500 with a residual
value of $1,500?
Period
Balance
25% WDA
30% Tax
Saving
Period
7500
1875
375
5625
1406
281
4219
1055
211
3164
791
158
2373
873
175
Sale of Item
-1500
8. If my cash flows in my NPV analysis are inflated should I use the real or the nominal
discount rate?
The real rate. If the cash flows are inflated then the discount rate needs to be
adjusted for inflation also.
Now do it!
Lecture 11
Investment
Appraisal III
IRR - Illustration 1
ABC has evaluated a project and come to the following conclusions.
At a discount rate of 10% the NPV will be $100,000
At a discount rate of 15% the NPV will be -$75,000
What is the IRR?
Solution
IRR = !!
100,000
!
10 +! 100,000 - (75,000)
(15 - 10)
3. If a project has cash inflows of $6,000 per year for 5 years and had an initial investment
of $23,000 what is the IRR?
A. 11.05%
B. 10.07%
C. 12.07%
D. 9.23%
Answer B
NPV at discount rate of 5%:
Present value of cash flows (6,000 x 4.329) = 25,974
Initial investment = 23,000
NPV = 2,974 (25,974 - 23,000)
NPV at discount rate of 15%:
Present value of cash flows (6,000 x 3.352) = 20,112
Initial investment = 23,000
NPV = -2,888 (20,112 - 23,000)
Fill into IRR
5 + [(2,974 / (2,974 - -2,888)) (15 - 5)]
IRR = 14.5%
4. Which of the following are advantages of using the Internal Rate of Return (IRR) as an
investment appraisal technique?
1. IRR gives an answer in the form of an understandable percentage.
2. IRR uses accounting profit to assess the project.
3. IRR covers the payback period of the project.
4. IRR focuses on the maximisation of shareholder wealth.
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer D
5. Which of the following are disadvantages of using the Internal Rate of Return (IRR) as
an investment appraisal technique?
1. It gives an absolute figure rather than a percentage as the result.
2. All of the figures are based on forecasts.
3. It is possible to get multiple IRRs depending on the timing of the cashflows.
4. IRR assumes that all returns are re-invested in the project which is not necessarily the
case.
A
B
C
D
1, 2 and 4
2, 3 and 4
2 and 3 only
1 and 3 only
Answer B
3. If a project has cash inflows of $5,000 per year for 5 years and had an initial investment
of $17,000 what is the IRR?
NPV at discount rate of 5%:
Present value of cash flows (5,000 x 4.329) = 21,645
Initial investment = 17,000
NPV = 4,645 (21,645 - 17,000)
NPV at discount rate of 15%:
Present value of cash flows (5,000 x 3.352) = 16,760
Initial investment = 17,000
NPV = -240 (16,760 - 17,000)
Fill into IRR
5 + [(4,645 / (4,645 - -240)) (15 - 5)]
IRR = 14.5%
Now do it!
Lecture 12
Further Appraisal
A business is considering 2 different projects. The likely profit made from each project is
outlined below:
Project A
Project B
Projected Profit
Percentage
Likely-hood
Projected Profit
Percentage
Likely-hood
$10,000
10%
$10,000
15%
$15,000
30%
$15,000
25%
$20,000
40%
$20,000
30%
$23,000
20%
$23,000
30%
Solution
Project A
Project B
Project
ed
Profit
Percent
age
Likelyhood
Working
EV
Project
ed
Profit
Percent
age
Likelyhood
Working
EV
$10,000
0.1
(10,000 x
0.1)
$1,000
$10,000
0.15
(10,000 x
0.15)
$1,500
$15,000
0.3
(15,000 x
0.3)
$4,500
$15,000
0.25
(15,000 x
0.25
$3,750
$20,000
0.4
(20,000 x
0.4)
$8,000
$20,000
0.3
(20,000 x
0.3)
$6,000
$23,000
0.2
(23,000 x
0.2)
$4,600
$23,000
0.3
(23,000 x
0.3)
$6,900
EV
$18,100
EV $18,150
II.
Solution
Cash-Flows
20,000
20,000
Variable Cost
-2,000
-2,000
-20,000
18,000
18,000
0.909
0.826
PV Cash Flows
-20,000
16,362
14,868
NPV
11,230
Capital Investment
0
-20,000
Variable Costs
-2,000
-2,000
0.909
0.826
Total
-1,818
-1,652
Sales
20,000
20,000
0.909
0.826
Total
18,180
16,520
Sensitivity Margins
Item
Working
Sensitivity
Margin
Explanation
Initial
Investmen
t
56%
Variable
Costs
323%
Sales
32%
Solution
Buy
Working 1 - Capital Allowances
Period
Balance
25% WDA
30% Tax
Saving
Period
10000.00
2500.00
750.00
7500.00
1875.00
562.50
5625.00
1406.25
421.88
4218.75
1054.69
316.41
3164.06
3,164.06
949.22
Working 2 - Maintenance
Amount
Tax Saving
14.28%
Tax Rate
30%
Working 4 - NPV
Period
Capital
750
562
422
316
949
-100
-100
-100
-100
30
30
30
30
30
-10,000
-100
Maintenance Tax
Saving (W2)
Total Cash Flows
-10,000
-100
680
492
352
246
979
0.909
0.826
0.751
0.683
0.621
0.564
PV Cash Flows
-10,000
-91
562
369
240
153
552
NPV
-8,214
Lease
Period
Capital
-2200
-2200
-2200
-2200
-2200
660
660
Tax Saving on
Lease Payment
Total Cash Flows
660
660
660
-2200
-2200
-1540
-1540
-1540
660
660
0.909
0.826
0.751
0.683
0.621
0.564
PV Cash Flows
-2,200
-2000
-1272
-1157
-1052
410
372
NPV
-6,898
Solution
NPV for replacement after one year
Period
Capital Investment
-30,000
Running Costs
-10,000
Residual Value
19,000
Cash Flows
-30,000
9,000
0.909
PV Cash Flows
-30,000
8,181
NPV
-21,819
0.909
Period
Running Costs
-10,000
-11,500
Residual Value
16,000
-30,000
-10,000
4,500
0.909
0.826
PV Cash Flows
-30,000
-9,090
3,717
NPV
-35,373
Capital Investment
Cash Flows
Discount Rate 10%
0
-30,000
1.736
Project 2
Projected Profit
Percentage
Likely-hood
Projected Profit
Percentage
Likely-hood
$12,000
10%
$12,000
15%
$16,000
30%
$16,000
25%
$25,000
40%
$25,000
30%
$30,000
20%
$30,000
30%
Project 3
Project 4
Projected Profit
Percentage
Likely-hood
Projected Profit
Percentage
Likely-hood
$12,000
12%
$12,000
18%
$16,000
35%
$16,000
30%
$25,000
44%
$25,000
30%
$30,000
9%
$30,000
22%
Which of the projects should be chosen on the basis of the Expected Values?
A
B
C
D
Project 1
Project 2
Project 3
Project 4
Answer C
Project 1
Project 2
Projected
Profit
Percentage
Likely-hood
Projected
Profit
Percentage
Likely-hood
$12,000
10%
$1,200
$12,000
15%
$1,800
$16,000
30%
$4,800
$16,000
25%
$4,000
$25,000
40%
$10,000
$25,000
30%
$7,500
$30,000
20%
$6,000
$30,000
30%
$9,000
$22,000
Project 3
$22,300
Project 4
Projected
Profit
Percentage
Likely-hood
Projected
Profit
Percentage
Likely-hood
$12,000
12%
$1,440
$12,000
18%
$2,160
$16,000
35%
$5,600
$16,000
30%
$4,800
$25,000
44%
$11,000
$25,000
30%
$7,500
$30,000
9%
$2,700
$30,000
22%
$6,600
$20,740
$21,060
2. A company is considering investing in a project with an expected life of four years. The
project has a positive net present value of $280,000 when cash flows are discounted at
12% per annum. The projects estimated cash flows include net cash inflows of $320,000
for each of the four years. No tax is payable on projects of this type.
What is the sensitivity margin of the cash inflows of the project?
A 87.5%
B 21.9%
C 3.5%
D 28.8%
Answer D
Net Present Value of the project = $280,000
Present value of the annual cash inflow = $320,000 x 3.037 = $971,840
Sensitivity = $280,000/$971,840 = 28.8%
3. A five year investment project has a positive net present value of $320,000 when
discounted at the cost of capital of 10% per annum. The project includes annual net cash
inflows of $100,000 which occur at the end of each of the five years.
What is the sensitivity margin of the cash inflows of the project?
A 31.25%
B 118.5%
C 84.4%
D 18.5%
Answer C
Discounted value of cash inflow = $100k x 3.791 = $379.1k
Sensitivity = $320k / $379.1k = 84.4%
4. Davos Co. intends to lease a machine on a 5 year operating lease for a payment of
$3,500 payable in advance. The tax rate is 30%. The pre-tax cost of borrowing is
15.71%.
What is the present value cost to the business of leasing the machine?
A. $9,440
B. $10,480
C. $10,864
D. $10,974
Answer C
Period
Capital
-3,500
-3,500
-3,500
-3,500
-3,500
1,050
1,050
Tax Saving on
Lease Payment
Total Cash Flows
1,050
1,050
1,050
-3,500
-3,500
-2,450
-2,450
-2,450
1,050
1,050
0.901
0.812
0.731
0.659
0.593
0.535
PV Cash Flows
-3,500
-3154
-1989
-1791
-1615
623
562
NPV
-10,864
5. Davos Co. intends to buy a machine a payment of $2m. Tax allowable depreciation is
allowable over 5 years at 25% reducing balance. The tax rate is 30%. The pre-tax cost
of borrowing is 17.14%. Maintenance costs of $65,000 are payable each year.
What is the present value cost to the business of buying the machine?
A. -$1,786
B. -$1,615
C. -$1,849
D. -$2,172
Answer A
Period
Balance
25% WDA
30% Tax
Saving
Period
2000
500
150
1500
375
113
1125
281
84
844
211
63
633
633
190
Period
Capital
150
113
84
63
190
-65
-65
-65
-65
19.5
19.5
19.5
19.5
19.5
-2,000
-65
Maintenance Tax
Saving
Total Cash Flows
-2,000
-65
104.5
67.5
38.5
17.5
209.5
0.893
0.797
0.712
0.636
0.567
0.507
PV Cash Flows
-2,000
-58
83
48
24
10
106
NPV
-1,786
6. Kevlar Co. has a piece of machinery which cost $40,000 and is trying to decide how
often to replace it based on the Equivalent Annual Cost (EAQ). The following
information relates to the machine.
Machine Cost 40,000
Running costs
$12,000 per year
Residual Value (if sold after..)
Year 1 19,000
Year 2 16,000
Year 3!!
14,000
Year 4!!
14,000
NPV
Cost
Annuity
Factor
EAC
19,000
x 0.893
16,976
33,740
0.893
37,783
20,820
16,000
x 0.797
12,752
48,068
1.690
28,443
12,000 x
2.402
28,824
14,000
x 0.712
9,968
58,856
2.402
24,503
12,000 x
3.102
37,224
14,000
x 0.636
6,996
70,228
3.102
22,640
Year
Cost
Costs
40,000
12,000 x
0.893
10,716
40,000
12,000 x
1.690
40,000
40,000
2. How can we deal with each of risk and uncertainty in investment appraisal?
Risk can be quantified using probabilities. This enables us to calculate an expected
value and use this in our investment appraisal.
4. Why might a company want to lease an item rather than buy it?
There may be tax benefits to leasing the item.
The lessor retains the risk of obsolescence and maintenance.
It can be used as a form of off-balance-sheet finance.
There is no requirement to take out a loan to finance the item.
7. If I have a pre-tax borrowing rate of 13% and the tax rate is 25% what is the post-tax
borrowing rate?
0.13 x (1-T)
0.13 x (1 - 0.25) = 0.975
Answer = 9.75%
10. I have an item of plant costing $30,000 new and $5,000 to maintain each year. The
residual value after 3 years is $7,000 and after 4 years is $5,000. If I have a cost of
capital of 10% after how long should I replace the asset?
EAC for replacing after 3 years
Period
Capital Investment
1-3
-30,000
Running Costs
-5,000
Residual Value
Cash Flows
7,000
-30,000
-5,000
7,000
2.487
0.751
PV Cash Flows
-30,000
-12,435
5,257
NPV
-37,178
2.487
1-4
-30,000
Running Costs
-5,000
Residual Value
Cash Flows
5,000
-30,000
-5,000
7,000
3.170
0.683
PV Cash Flows
-30,000
-15,850
4,781
NPV
-41,069
3.170
Now do it!
Lecture 13
Further Appraisal II
A business has identified the following projects. They have $200,000 to invest and the
projects are divisible.
Project
Investment
NPV
90,000
15,000
110,000
25,000
50,000
10,000
75,000
22,000
70,000
-8,000
Solution
Project
Investment
NPV
PI (NPV /
Investment)
Rank
90,000
15,000
17%
4%
110,000
25,000
23%
2%
50,000
10,000
20%
3%
75,000
22,000
29%
1%
70,000
-8,000
Investment
Project
Investment
All of D
75,000
All of B
110,000
15,000
Total Investment
200,000
A business has identified the following projects. They have $200,000 to invest and the
projects are non-divisible.
Project
Investment
NPV
90,000
15,000
110,000
25,000
50,000
10,000
75,000
22,000
Solution
Project
Investment
NPV
Rank
A+B
A+C
A+D
B+C
B+D
C+D
The business should undertake projects B and D as these will yield the highest NPV.
NPVDuration
Solution
Project
NPV
Annuity
Factor
Working (NPV /
Annuity Factor)
EAA
300
3.791
300 / 3.791
79.13
200
2.487
200 / 2.487
80.42
350
4.355
350 / 4.355
80.37
0.38
0.54
0.28
0.26
Answer C
The profitability index
= net present value of the investment / initial investment = $140,500 / $500,000
= 0.281
2. A company has a maximum of $80 million available for investment and seven
independent projects in which it could invest as follows:
Project
Investment
NPV
10
4.20
40
6.10
20
8.50
40
13.70
50
3.80
20
4.90
20
4.33
None of the projects can be carried out more than once. Each project is divisible therefore
investment in part of a project can be undertaken.
What is the maximum NPV that could be achieved from investing the $80m using the
Profitability Index?
A. $28.85
B. $31.3m
C. $45.53m
D. $26.4m
Answer A
Project
Investme
nt
NPV
PI
Rank
Cumulative
Inv.
Cumulative
NPV
20
8.50
0.43
20
8.5
10
4.20
0.42
30
12.7
40
13.70
0.34
70
26.4
20
4.90
0.25
80
28.85
20
4.33
0.22
40
6.10
0.15
50
3.80
0.08
2. If the projects are divisible,which method should be used to decide which projects to
undertake?
Profitability index.
Now do it!
Lecture 14
Business Valuations
550,000
Current Assets
170,000
Current Liabilities
-80,000
Share Capital
300,000
Reserves
200,000
150,000
The Market Value of property in the Non Current Assets is $50,000 more than the book
value.
The Loan Notes are redeemable at a 5% premium.
What is the value of a 70% holding using the net assets valuation basis?
Solution
Working
600,000
Current Assets
170,000
Current Liabilities
-80,000
150,000 x 105%
-157,500
532,500
Value of 70%
532,500 x 70%
372,750
DVM - Illustration 2
Solution
Working
Constant Dividend
In Question
45c
In Question
15%
45 / 0.15
300c
In Question
3m
300c x 3m
$9m
DVM - Illustration 3
Solution
30c
22c
(4(30 / 22))
=1.08
=8%
Dividend Growth
30c
12%
Dividend Growth
8%
X1
X2
X3
$000
$000
$000
Revenue
3000
3500
4200
COS
2000
2400
3200
Gross Profit
1000
1100
1000
Admin Costs
300
350
400
Distribution Costs
200
250
300
PBIT
500
500
300
Interest
100
150
220
Tax
120
90
50
280
260
30
Dividends
100
110
30
Retained Earnings
180
150
13
12
14
Calculate the Value of the Company for each of the 3 years using the P/E Ratio
method.
Solution
Year
Total Earnings
Value of Company
13
280,000
12
260,000
14
30,000
X2
X3
$000
$000
$000
Revenue
3200
3800
4800
COS
2000
2400
3200
Gross Profit
1200
1400
1600
Admin Costs
300
350
400
Distribution Costs
200
250
300
PBIT
700
800
900
Interest
100
150
220
Tax
120
90
50
480
560
630
Dividends
100
110
150
Retained Earnings
380
450
480
17
15
18
Number of Shares
3m
3m
3m
Solution
Year
Earnings
No. Shares
480,000
3m
16c
560,000
3m
18.66c
630,000
3m
21c
Year
Industry P/E
Ratio
EPS
Share Price
(EPS x P/E Ratio)
Value of Company
17
16c
$2.72
(2.72 x 3m) =
$8.16m
15
18.66c
$2.80
(2.80 x 3m) =
$8.4m
18
21c
$3.78
(3.78 x 3m) =
$11.34m
X2
X3
$000
$000
$000
Revenue
3100
3700
4600
COS
2000
2400
3200
Gross Profit
1100
1300
1400
Admin Costs
300
350
400
Distribution Costs
200
250
300
PBIT
600
700
700
Interest
100
150
220
Tax
120
90
50
380
460
430
Dividends
100
110
150
Retained Earnings
280
350
280
Earnings Yield
0.15
0.18
0.17
Number of Shares
4m
4m
4m
Calculate the Earnings Per Share for each of the 3 years and the share price using the
earnings yield.
Solution
Year
Earnings
No.
Shares
EPS (Earnings /
No. Ordinary
Shares)
Earnings
Yield
Share Price
(EPS / Earnings
Yield)
380,000
4m
9.5c
0.15
63.33c
460,000
4m
11.5
0.18
63.88c
430,000
4m
10.75
0.17
63.23c
Solution
Period
Cash Inflows
105,000 110,250
(127,628 x 1.02) /
115,763 121,551 127,628 (0.10 - 0.02)
= 1,627,257
Discount Rate
10%
0.909
0.826
0.751
0.683
0.621
0.621
PV Cash
Flows
95,445
91,067
86,938
83,019
79,257
1,010,527
Total
1,446,252
700,000
Current Assets
250,000
Current Liabilities
-100,000
Share Capital
500,000
Reserves
300,000
200,000
The Market Value of property in the Non Current Assets is $100,000 more than the book
value.
The Loan Notes are redeemable at a 10% premium.
What is the value of a 80% holding using the net assets valuation basis?
A. $730,000
B. $664,000
C. $584,000
D. $444,000
Answer C
Solution
Working
700,000 + 100,000
800,000
Current Assets
250,000
Current Liabilities
-100,000
200,000 x 1.1
-220,000
730,000
Value of 70%
730,000 x 80%
584,000
2. ABC Co. has Share Capital made up of 50c shares of $5 million. They have just
paid a dividend per share of 50c and paid a dividend per share four years ago of 35c.
The cost of capital is 14%.
Calculate the Value of the business using the dividend valuation method.
A. $343.6m
B. $389.3m
C. $109.3m
D. $54.65m
Answer C
Solution
Working 1 - Dividend Growth
Dividend Paid Now
50c
35c
Dividend Growth
(4(50 / 35))
=1.09
=9%
50c
14%
Dividend Growth
9%
No Ordinary Shares
Value of business
3. SKV Co has paid the following dividends per share in recent years:
Year
2013
2012
2011
2010
Dividends
36.0
33.8
32.8
31.1
The dividend for 2013 has just been paid and SKV Co has a cost of equity of 12%.
Using the geometric average historical dividend growth rate and the dividend growth
model, what is the market price of SKV Co shares to the nearest cent on an ex
dividend basis?
A $467
B $514
C $540
D $697
Answer C
The geometric average dividend growth rate is (360/311)1/3 1 = 5%
The ex div share price = (360 x 105)/(012 005) = $540
3000
COS
2000
Gross Profit
1000
Op. Costs
500
Net Profit
500
Number of Shares
1m
Share Price
$5
15
What is the the Value of the Company Using the P/E ratio calculation?
A. $5m
B. $7.5m
C. $8m
D. $5.5m
Answer B
Solution
Year
Total Earnings
Value of Company
15
500,000
$7.5m
Solution
Period
Post Yr 5
Cash Inflows
100
108
117
126
136
136(1.04) /
(0.1 - 0.04)
= 2,357
Discount Rate
10%
0.909
0.826
0.751
0.683
0.621
0.621
PV Cash
Flows
91
89
88
86
84
1,464
Total
1,902
Solution
Period
Post Yr 5
Cash Inflows
500
535
572
613
655
655(1.03) /
(0.1 - 0.03)
= 9,638
Discount Rate
10%
0.909
0.826
0.751
0.683
0.621
0.621
PV Cash
Flows
455
442
430
418
407
5,985
Total
8,137
2. What are the downsides of using the Net Assets Valuation method?
It ignores intangibles that are not shown on the balance sheet.
It is not based on earnings which is usually the reason for buying a business.
It will often lead to an under-valuation.
3. A company pays a constant dividend of 50c and has a cost of capital of 13%. Calculate
the share price using DVM.
50 / 0.13 = $3.85
4. A company pays a dividend of 50c and paid a dividend of 40c 4 years ago. The
company has a cost of capital of 13%. Calculate the share price using DVM.
Growth = [4(50 / 40)] -1 = 0.057 (5.7%)
Share Price = 50 (1+0.057) / (0.13 - 0.057) = $7.24
6. Why do we use a proxy P/E Ratio when valuing a business with this method?
To base our valuation on what the business should be achieving based on the
industry it is in, rather that what it is achieving. If we buy the business we will intend
to improve its performance at least to the industry average.
When we are valuing a risky company or an unlisted company we may adjust the P/
E ratio down by say 10% to reflect this.
8. The industry average P/E ratio for the fashion industry is 13. We are valuing an unlisted
fashion business who have an EPS of 22c and 12m shares in issue. What is the value
of the firm?
A fashion business is risky as fashion changes and it is also unlisted so lets adjust
the P/E ratio down to 12 and say:
22c x 12m = Total earnings of $2.64m
$2.64 x 12 = $31.68
10. A business is expected to earn $250,000 this year that is expected to grow at 4%
forever. What is the value of the business using the present value of future cash flows
if their cost of capital is 14%?
We can use the growth formula in the DVM model to calculate this:
250,000 (1 + 0.04) / (0.14 - 0.04) = $2,600,000
Now do it!
Lecture 15
WACC I
Solution
Dividend
35
Share Price
325
Solution
Dividend
35
Share Price
325
Dividend Growth
4%
Cost of Equity
(Dividend (1+g) / Share Price) +g
Solution
15
Beta
1.2
Ke = Rf + (Rm - Rf)
Solution
Company A
Company B
12
12
Beta
1.2
Ke = Rf + (Rm - Rf)
Notice that when Beta is 1 (Company B) Ke is 12% which is the same as the average
return on the market.
Also notice that a higher Beta of 1.2 gives a higher Ke of 13.4% showing that a higher
Beta means higher risk.
Solution
Company A
Company B
1.3
1.2
(5 + 1.3(6) = 12.8%
(5 + 1.2(6)) = 12.2%
Beta
Ke = Rf + (Rm - Rf)
Remember to look out for the market risk PREMIUM as this is always (Rm - Rf) rather
than Rm (Average return on the market)
Again notice that a higher Beta leads to a higher Ke i.e. more risk.
Dividend
75
Share Price
654
Dividend Growth
3%
Cost of Equity
(Dividend (1+g) / Share Price) +g
2. Company Alpha has a Beta of 1.1.Government bonds are currently trading at 4%.
The average market risk premium is 7%.
What is the cost of equity using the capital assets pricing model?
A. 12.2%
B. 11.7%
C. 7.3%
D. 11.4%
Answer B
3. Which of the following statements about systematic risk are correct when referring
to the capital assets pricing model?
A. Systematic
B. Systematic
C. Systematic
D. Systematic
risk
risk
risk
risk
Answer A
4. Which of the following statements about unsystematic risk are correct when
referring to the capital assets pricing model?
A. Systematic
B. Systematic
C. Systematic
D. Systematic
risk
risk
risk
risk
Answer B
5. Which of the following are assumptions made by the capital asset pricing model
(CAPM) are correct?
1. It assumes that investors can borrow at the risk free rate.
2. It assumes a capital market with high transaction costs.
3. It assumes that all investors are diversified.
4. It assumes that the risk free rate is 5%
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer B
6. Which of the following are downsides of the capital assets pricing model (CAPM) are
correct?
1. The
2. The
3. The
4. The
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer B
Cost
Interest Paid
Unsecured Creditors
Interest Paid
Preference Shareholders
Pref. Dividend
Ordinary Shareholders
Ord. Dividend
4. If a company has a dividend of 40c and a share price of $3.45 what is the cost of
equity?
40 / 345 = 11.59%
6. What are the two types of risk mentioned in the CAPM lecture?
Systematic Risk & Unsystematic Risk.
11. A company has a Beta of 1.3. The market risk premium is 6% and government bonds
are trading at 4%. Calculate the cost of equity using CAPM.
Ke = Rf + (Rm - Rf)
Ke = 4 + 1.3(6)
Ke = 11.8
12. Is a company with a Beta of 1.2 a more risky or less risky investment than a company
with a Beta of 1.6?
The company with a Beta of 1.6 is more risky than the one with 1.2.
Now do it!
Lecture 16
WACC II
Solution
$10
Tax Rate
30%
$10 x (1 - 0.30) = $7
$90
(7 / 90) = 7.7%
Solution
Perio
d
Item
DR 5%
PV
DR 15%
PV
1 -5
Interest
4.329
34.63
3.352
26.82
Capital
100
0.784
78.40
0.497
49.70
Market Value
-102
-102
11.03
-25.48
Solution
Perio
d
Item
DR 5%
PV
DR 15%
PV
1 -5
Interest (10 x (1
- 0.3)
4.329
30.30
3.352
23.46
Capital
100
0.784
78.40
0.497
49.70
Market Value
-104
-104
4.70
-30.84
II.
The current share price is $6 and it is expected to grow in value by 4% per year.
Tax is payable at 30%.
Calculate the Cost of Debt (Kd).
Solution
100 x 1.15
$115
Shares
Current Value
Value in 5 years with 4%
growth
$6
6 x (1.04 to the power of 5)
$7.30
18
7.30 x 18
$131.40
The conversion value is higher than the cash so the investors will choose to convert.
Do an IRR the same as for redeemable but filling $131.40 into the capital repaid
Cost of Debt
Perio
d
Item
DR 5%
PV
DR 15%
PV
1 -5
4.329
30.30
3.352
23.46
Conversion Value
131.4
0.784
103.02
0.497
65.31
Market Value
-120
-120
13.32
-31.23
Solution
Interest Paid
80
(8 / 80) = 10%
Solution
10
Tax Rate
30%
7%
WACC - Illustration 7
Capital Structure
Cost
Equity
85%
15%
Debt
15%
7%
Solution
Item
Capital Structure
Cost
Ave
Equity
85%
15
12.75
Debt
15%
1.05
WACC
13.8
WACC - Illustration 8
3000
Loan Notes
2000
Bank Loan
1000
The cost to the company of each of the above items has been calculated as:
Ordinary Shares
13%
Loan Notes
8%
Bank Loan
5%
Solution
Working 1 - Calculate Cost of Capital for each item.
Given in the Question
Ordinary Shares
13%
Loan Notes
8%
Bank Loan
5%
Market Value
Ordinary
Shares (50c)
3000
(6000 x $1.50) =
9000
Loan Notes
2000
Bank Loan
1000
1000
Market Value
Weighting
Equity
9000
Loan Notes
1880
Bank Loan
1000
11880
Market
Value
Weighting
Cost
(W1)
Ave
Equity
9000
(9000 / 11,880)
13
(9000 / 11,880) x 13 =
9.85
Loan Notes
1880
(1880 / 11,880)
(1880 / 11,880) x 8 =
1.27
Bank Loan
1000
(1000 / 11,880)
(1000 / 11,880) x 5 =
0.42
WACC
11.54%
11880
WACC - Illustration 9
2000
1500
500
Bank Loan
750
Solution
Working 1 - Calculate Cost of Capital for each item.
Cost of Equity using CAPM
Beta
1.2
Ke = Rf + (Rm - Rf)
(6 + 1.2(7)) = 14.4%
Item
DR 5%
PV
DR 15%
PV
1 -5
Interest (12 x (1
- 0.3)
8.4
4.329
36.36
3.352
28.16
Capital
100
0.784
78.40
0.497
49.70
Market Value
-106
-106
8.76
-28.14
Interest Paid
92
(8 / 92) = 8.7%
10
Tax Rate
30%
7%
Market Value
Ordinary
Shares (50c)
2000
12% Loan
Notes
1500
8% Preference
Shares ($1)
500
Bank Loan
750
(4000 x $1.25) =
5000
(1500 x (106 /
100) = 1590
(500 x (92 / 1)) =
460
750
Market Value
Weighting
Equity
5000
(5000 / 7800)
Loan Notes
1590
(1590 / 7800)
Preference Shares
460
(460 / 7800)
Bank Loan
750
(750 / 7800)
7800
Market
Value
Weighting
Cost
(W1)
Ave
Equity
5000
(5000 / 7800)
14.4
Loan Notes
1590
(1590 / 7800)
7.37
Preference
Shares
460
(460 / 7800)
8.7
Bank Loan
750
(750 / 7800)
WACC
11.91%
7800
$12
Tax Rate
30%
2. A company has 10% irredeemable debt in issue at a market value of $97. If the tax rate
is 30% what is the cost of the debt?
A. 7.2%
B. 9.7%
C. 6.5%
D. 8.2%
Answer A
10 (1-0.3) / 97 = 7.2%
3. A Company has issued debt which is redeemable in 5 years time. Interest is payable at
12%. The current market value of the debt is $102. Tax is payable at 30%.
What is the cost of debt (kd) using linear extrapolation and discount rates of 5% and 15%
in the calculation?
A. 12.00%
B. 8.47%
C. 9.00%
D. 7.24%
Answer B
Perio
d
Item
DR 5%
PV
DR 15%
PV
1 -5
Interest (12 x (1
- 0.3)
8.4
4.329
36.36
3.352
28.16
Capital
100
0.784
78.40
0.497
49.70
Market Value
-102
-102
12.76
-24.14
4. A company has 5 year 8% redeemable debt in issue at a market value of $103. The tax
rate is 25%.
What is the cost of debt (kd) using linear extrapolation and discount rates of 5% and 15%
in the calculation?
A. 6.26%
B. 5.95%
C. 7.19%
D. 5.4%
Answer D
Period
Item
DR 5%
PV
DR 15%
PV
1 -5
Interest (8 x (1 - 0.25))
4.329
25.97
3.352
20.11
Capital
100
0.784
78.40
0.497
49.70
Market Value
-103
-103
1.37
-33.19
5. Jeeves Company has issued debt which is convertible in 5 years time. Interest is
payable at 12% and the current market value of the debt is $108.
On conversion, investors will have a choice of either:
Cash at a 10% premium; or
14 shares per loan note.
The current share price is $7 and it is expected to grow in value by 3.5% per year.
Which of the following statements is correct?
A. Based on the information available, investors would be better off choosing to take the
cash option by $6.39.
B. Based on the information available, investors would be better off choosing to take the
conversion option by $6.39.
C. Based on the information available, investors would be indifferent between the cash and
conversion option.
D. Based on the information available, investors would be better of choosing to take the
cash option by $8.94.
Answer B
6. A company has 8% preference share in issue at a current value of 94c. The tax rate is
30%. What is the cost of the preference shares?
A. 8.5%
B. 6.0%
C. 8.0%
D. 5.6%
Answer A
8 / 94 = 8.5%
7. A company has a bank loan of $7m at a rate of 6%. The tax rate is 35%. What is the
cost of the bank debt?
A. 6.0%
B. 2.1%
C. 3.9%
D. 4.2%
Answer C
6 (1-T) = 6 (1 - 0.35) or 3.9%
2500
Loan Notes
1000
Bank Loan
500
The cost to the company of each of the above items has been calculated as:
Ordinary Shares
17%
Loan Notes
7%
Bank Loan
6%
Market Value
Ordinary
Shares (50c)
2500
(5000 x $3.50) =
17,500
Loan Notes
1000
Bank Loan
500
500
Market
Value
Weighting
Cost
(W1)
Ave
17,500
(17,500 / 18,980)
17
(17,500 / 18,980) x 17
=15.67
Loan Notes
980
(980 / 18,980)
(980 / 18,980) x 7
= 0.36
Bank Loan
500
(500 / 18,980)
(500 / 18,980) x 6
= 0.16
WACC
16.19%
Equity
18980
4. A company has 10% irredeemable debt in issue at a market value of $97. If the tax rate
is 30% what is the cost of the debt?
10 (1-0.3) / 97 = 7.2%
5. A company has 5 year 8% redeemable debt in issue at a market value of $103. The tax
rate is 25%. What is the cost of the debt?
Period
Item
DR 5%
PV
DR 15%
PV
1 -5
Interest (8 x (1 - 0.25))
4.329
25.97
3.352
20.11
Capital
100
0.784
78.40
0.497
49.70
Market Value
-103
-103
1.37
-33.19
6. A company has 10% convertible debt in issue at a market value of $111 that is
redeemable in 5 years at either cash or 5 shares per nominal. The current share price is
$18 and is expected to grow at 2%. The tax rate is 30%. What is the cost of debt?
$100
Shares
Current Value
$18
$19.87
5
19.87 x 5
$99.35
The conversion value is lower than the cash so the investors will choose not to convert.
Cost of Debt
Perio
d
Item
DR 5%
PV
DR 15%
PV
1 -5
4.329
30.30
3.352
23.46
Conversion Value
100
0.784
78.40
0.497
49.70
Market Value
-111
-111
-2.30
-37.84
7. A company has 8% preference share in issue at a current value of 94c. What is the cost
of the preference shares.
8 / 94 = 8.5%
8. A company has a bank loan of $7m at a rate of 6%. The tax rate is 35%. What is the
cost of the bank debt?
6 (1-T) = 6 (1 - 0.35) or 3.9%
9. The company has each of the types of debt in questions 4 to 6 on their balance sheet at
a book value of $10m for each of them except for the bank debt which is on the balance
sheet at $7m. If the company has a market value of $110m with a cost of equity of 14%
then what is the companys weighted average cost of capital?
Working 1 - Calculate the Market Value of Debt and Equity.
SFP
Market Value
Ordinary
Shares
10m
110m
Irredeemable
Debt
10m
10m x 97/100
9.7m
Redeemable
Debt
10m
10m x 103/100
10.3m
Convertible
Debt
10m
10m x 111/100
11.1m
8% Preference
Shares ($1)
10m
10m x 94/100
9.4m
Bank Loan
7m
7m
Item
Market
Value
Weighting
Cost
Ave
Ordinary
Shares
110
(110 / 157.5)
14
9.78
Irredeemable
Debt
9.7
(9.7 / 157.5)
7.2
0.44
Redeemable
Debt
10.3
(10.3 / 157.5)
5.4
0.35
Convertible
Debt
11.1
(11.1 / 157.5)
5.57
0.39
8% Preference
Shares ($1)
9.4
(9.4 / 157.5)
8.5
0.51
(7 / 157.5)
3.9
0.17
WACC
11.65
Bank Loan
157.5
10. What if the company has each of the types of debt in questions 4 to 6 on their balance
sheet at a book value of $8m for each of them except for the bank debt which is on the
balance sheet at $7m. If the company has a market value of $99m with a cost of equity
of 12% then what is the companys weighted average cost of capital?
Working 1 - Calculate the Market Value of Debt and Equity.
SFP
Market Value
Ordinary
Shares
8m
99m
Irredeemable
Debt
8m
8m x 97/100
7.76m
Redeemable
Debt
8m
8m x 103/100
8.24m
Convertible
Debt
8m
8m x 111/100
8.88m
8% Preference
Shares ($1)
8m
8m x 94/100
7.52m
Bank Loan
7m
7m
Item
Market
Value
Weighting
Cost
Ave
99
(99 / 138.4)
14
10.01
Irredeemable
Debt
7.76
(7.76 / 138.4)
7.2
0.40
Redeemable
Debt
8.24
(8.24 / 138.4)
5.4
0.32
Convertible
Debt
8.88
(8.88 / 138.4)
5.57
0.36
8% Preference
Shares ($1)
7.52
(7.52 / 138.4)
8.5
0.46
(7 / 138.4)
3.9
0.20
WACC
11.76
Ordinary
Shares
Bank Loan
138.4
Now do it!
Lecture 17
Capital Structure
Solution
I.
Item
Market Value
Weighting
Cost
WACC
Debt
300
300 / 1000
5%
1.5
Equity
700
700 / 1000
14%
9.8
1000
11.3
II.
Item
Market Value
Weighting
Cost
WACC
Debt
500
500 / 1000
5%
2.5
Equity
500
500 / 1000
16%
1000
10.5
III.
Item
Market Value
Weighting
Cost
WACC
Debt
600
600 / 1000
5%
Equity
400
400 / 1000
25%
10
1000
13
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer B
4. What does the M&M model with tax suggest a company should do with their capital
structure?
A. As there is greater financial risk at high levels of gearing the company should have as
little debt as possible.
B. As the transaction costs will be high the company should retain their current capital
structure for as long as possible.
C. As taking on more debt reduces the weighted average cost of capital the company
should increase their gearing levels.
D. The company should find the optimum capital structure at which it can minimise its
weighted average cost of capital.
Answer C
2. What does the traditional view suggest you can do with the WACC?
Minimise it.
5. What does the M&M model with tax suggest we should do with our capital structure?
As the interest on debt is tax deductible and thus debt is cheaper, M&M suggested
that a company should substitute Equity for Debt in order to take advantage of this
fact.
This will also have the effect of increasing the value of the business using the PV of
future cash-flows method as the WACC and thus the discount rate will be lower
leading to a higher valuation.
Now do it!
Lecture 18
Financing &
Investment
Company A
Proxy Company
1.2
1.4
Value of Equity
1000
800
Value of Debt
400
500
Solution
1.4
800
500
0.86
1000
400
e = a (Ve + Vd ) / Ve)
12
Beta
1.2
Ke = Rf + (Rm - Rf)
Company A
Proxy Company
1.1
1.3
Value of Equity
1200
900
Value of Debt
500
450
Solution
1.3
900
450
0.96
1200
500
12
Beta
Ke = Rf + (Rm - Rf)
1.24
(4 + 1.24(12 - 4)) = 13.92%
1.2
700
300
0.92
1000
400
12
Beta
Ke = Rf + (Rm - Rf)
1.18
(4 + 1.18(12 - 4)) = 13.42%
2. Company Alpha is financed with 60% equity and 40% debt and intends to undertake a
project in an unrelated industry. They have identified Horizon Co. as a company in the new
industry with 75% equity and 25% debt. Alpha Co. has a Beta of 1.1 whereas Horizon Co.
has a Beta of 1.4. The risk free rate is 6% and the average return on the market is 14%.
The tax rate is 30%.
Which of the following would be the project specific discount rate for Alpha Co. when
entering the new industry?
A. 19.38%
B. 18.00%
C. 17.20%
D. 16.32%
Answer A
Working 1 - Un-gear the proxy e to get a.
1.4
75
25
1.14
60
40
14
Beta
Ke = Rf + (Rm - Rf)
1.67
(6 + 1.67(14 - 6)) = 19.38%
3. Company Alpha is financed with debt/equity of 1/4 and intends to undertake a project in
an unrelated industry. They have identified Horizon Co. as a company in the new industry
with debt/equity 1/3. Alpha Co. has a Beta of 1.05 whereas Horizon Co. has a Beta of
1.24. The risk free rate is 6% and the average return on the market is 14%. The tax rate is
30%.
Which of the following would be the project specific discount rate for Alpha Co. when
entering the new industry?
A. 16.23%
B. 15.49%
C. 17.26%
D. 18.28%
Answer B
1.24
1.01
14
Beta
Ke = Rf + (Rm - Rf)
1.19
(6 + 1.19(14 - 6)) = 19.38%
5. Our business has a Beta of 1.2, debt with a market value of 100 and equity with a
market value of 400. If the proxy has a Beta of 1.4, debt with a market value of 100 and
equity with a market value of 200 calculate a project specific discount rate. The risk free
rate is 4% and the average market risk premium is 7%. Ignore tax.
Working 1 - Un-gear the proxy e to get a.
1.4
200
100
0.93
400
100
12
Beta
Ke = Rf + (Rm - Rf)
1.24
(4 + 1.24(12 - 4)) = 13.92%
Now do it!
Lecture 19
More Debt
Solution
i. Market Value
Working 1 - Cash or Convert?
Working
Cash
$100
Shares
Current Value
$4.45
$6.10
20
6.10 x 20
$122
Answer
Period
Item
DR 7%
PV
1-5
Interest
4.1
36.90
Conversion Value
122
0.713
86.99
123.89
Period
Item
DR 7%
PV
1-5
Interest
4.1
36.90
Minimum Redemption
100
0.713
71.30
108.20
Working
Amount
4.45 x 20
89
123.89
Premium
34.89
34.89 / 20
1.74
$100
Shares
Current Value
$1.25
$1.52
70
Conversion Value
$106.40
Period
Item
DR 10%
PV
1-5
Interest
3.791
30.33
Conversion Value
106.4
0.621
66.07
96.40
2. A bond has a coupon rate of 8.5% per annum. The next interest payment will be made
in one years time. The bond will repay the par value of $100 when it matures in seven
years time. The before-tax cost of debt is 7% and the after-tax cost of debt is 5%.
What is the the expected current market price of the bond to the nearest dollar?
A. $98
B. $93
C. $108
D. $106
Answer C
Period
Item
DR 7%
PV
1-7
Interest
8.5
5.389
45.81
Redemption
100
0.623
62.30
108.11
3. A bond has a coupon rate of 6% per annum and will repay its face value of $100 on its
maturity in four years time. The yield to maturity on similar bonds is 4% per annum. The
annual interest has just been paid for the current year.
What is the the expected current market price of the bond to the nearest dollar?
A. $96
B. $92
C. $110
D. $107
Answer D
Period
Item
DR 4%
PV
1-4
Interest
3.546
21.28
Minimum Redemption
100
0.855
85.50
106.78
4. Angus Co has 8% convertible loan notes in issue which are redeemable in five years
time at their nominal value of $100 per loan note. Alternatively, each loan note could be
converted after five years into 35 equity shares with a nominal value of $1 each. The tax
rate is 30%
The equity shares of Angus Co are currently trading at $225 per share and this share
price is expected to grow by 6% per year. The before-tax cost of debt of Luke Co is 10%
and the after-tax cost of debt of Luke Co is 7%.
What is the current market value of each loan note to the nearest dollar?
A. $87
B. $96
C. $98
D. $108
Answer C
Working 1 - Cash or Convert?
Working
Cash
$100
Shares
Current Value
$2.25
$3.01
35
Conversion Value
$105.35
Answer
Period
Item
DR 7%
PV
1-5
Interest (8 x 0.7)
5.6
4.1
22.96
Conversion Value
105.35
0.713
75.11
98.07
5. A $100 bond has a coupon rate of 8% per annum and is due to mature in four years
time. The next interest payment is due in one years time. Similar bonds have a yield to
maturity of 10%.
What is the the expected current market price of the bond to the nearest dollar?
A. $96
B. $94
C. $110
D. $100
Answer B
Period
Item
DR 10%
PV
1-4
Interest
3.170
25.36
Minimum Redemption
100
0.683
68.30
93.66
2. What will the capital repaid figure in the IRR calculation be the higher of?
Cash or conversion value.
Now do it!
Lecture 20
Currency Risk I
Solution
We want to buy $ with our and the bank will sell them to
us at the low rate of 1.2500
Cost of $ (Amount of $ /
FX Rate)
You have issued an invoice to a US customer of $2000 and you are a UK business.
The rate offered by the bank is $: 1.4500 - 1.5500
How many will you receive for the $2000?
Solution
We want to sell the $ we will receive. The bank will buy them
from us at the high rate of 1.5500
Value of $ (Amount of
$ / FX Rate)
Solution
6%
8%
Solution
3%
2%
ABC Company has entered into a contract whereby they will receive $500,000 from a
US customer in 3 months.
ABC is a UK company.
A 3 month forward rate is available at $:
Calculate the amount of ABC would receive under the forward contract.
Solution
A rate quoted at $: 1.6000 +/- 0.0500 is the same as saying $: 1.5500 - 1.6500
Rate to use (For a receipt use the one on the
right)
Convert ($ amount / Forward rate)
1.6500
(500,000 / 1.6500) = 303,030
Solution
Amount of $ to pay
350,000
We will deposit the money in the US where it will earn interest so that in 3 months we
have $350,000.
Deposit Rate in US per year
6%
6 x (3/12) = 1.5%
We will deposit $344,827 in the US where it will earn interest of 1.5% over the 3 months
making it worth $350,000 when the payment becomes due.
We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.
$344,827
We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.
Spot rate (We are making a payment)
Convert ($ Amount / Spot Rate)
1.6500
(344,827 / 1.6500) = 208,986
208,986
We will have to pay interest on the amount we have borrowed for 3 months.
Borrowing Rate per year in UK
5%
(5 x 3/12) = 1.25%
Amount transferred to US
Interest on borrowings in UK ( amount x 3
month UK borrowing rate)
Total Cost (Amount transferred + interest
incurred)
208,986
(208,986 x 1.25%) = 2,612
(208,986 + 2,612) = 211,589
Solution
Amount of $ to receive
350,000
6.5%
6.5 x (3/12) = 1.625%
350,000 x (100 / 101.625) = $344,403
We will borrow $344,403 in the US where it will earn interest of 1.625% over the 3
months making it worth $350,000 when the receipt becomes due.
We will pay off the loan in the US when we receive the $350,000 in 3 months.
We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.
$344,403
We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.
Spot rate (We are receiving the foreign
currency)
Convert ($ Amount / Spot Rate)
1.7000
(344,403 / 1.7000) = 202,590
202,590
(4 x 3/12) = 1%
Total Receipt
Amount transferred to UK
Interest on deposit in UK ( Amount x 3
month UK borrowing rate)
Total Receipt (Amount transferred + interest
received)
202,590
(202,590 x 1%) = 2,026
(202,590 + 2,026) = 204,616
Foreign Country
Interest Rate
3% per year
7% per year
Inflation Rate
2% per year
5% per year
Answer A
Using interest rate parity, six-month forward rate
= 2000 x (107/103)05 = 2039 Dinar per $
1 only
2 only
Both1 and 2
Neither 1 nor 2
Answer C
3. The date is 31 January 2014 and Avecas Co. has entered into a contract whereby they
will receive $300,000 from a US customer on 01 April 2014. Avecas Co. is a UK company.
The following forward rates are available:
2 Month Rate $: 1.6000 +/- 0.0500.
3 Month Rate $: 1.5000 +/- 0.0500.
6 Month Rate $: 1.4000 +/- 0.0500.
What amount in will Avecas Co. receive under the appropriate forward contract to the
nearest .?
A. 181,818
B. 193,548
C. 206,897
D. 495,000
Answer A
4. Hilasys Co. is a UK business that needs to pay $250,000 to a US supplier in 3 months
time. The spot rate now is: $: 1.6500 - 1.7000. Deposit rates in the UK are 5% annual
and in the US are 7% annual. Borrowing rates in the UK are 3% annual and in the US are
4.5% annual.
What will the transaction cost Hilasys Co. to the nearest using a money market hedge?
A. 181,818
B. 245,700
C. 148,909
D. 150,026
Answer D
Amount of $ to pay
Deposit Rate in US per year
Deposit Rate for 3 months (Annual rate x 3/12)
Amount to deposit (Total $ discounted at 1.75%)
Convert at Spot Rate ($245,700 / 1.65)
Borrow at home (Annual rate x 3/12)
Total Cost (148,909 x 1.0075)
250,000
7%
7 x (3/12) = 1.75%
250,000 x (100 / 101.75) = $245,700
148,909
3 x (3/12) = 0.75%
150,026
Amount of $ to receive
Borrowing Rate in US per year
Borrowing Rate for 3 months (Annual rate x
3/12)
Amount to Borrow (Total $ discounted at 1%)
500,000
4%
4 x (3/12) = 1%
500,000 x (100 / 101) = $495,050
291,206
5 x (3/12) = 1.25%
294,846
2. UK company receiving $500. Spot rate is $/ 1.35 - 1.45. How many will the company
receive?
500 / 1.45 = 344
For a receipt of foreign currency use the rate on the right.
3. UK inflation is 5%, US inflation is 2%. The spot rate is $/ 1.35. What will the FX rate be
in one years time?
Future rate = spot rate x (1 + inf in the counter) / (1 + inf in the base)
Future rate = 1.35 x (1.02 / 1.05) = 1.31
7. How does a money market hedge eliminate the foreign currency risk?
The transfer is made today at the spot rate so no more exposure to the risk.
Amount of $ to pay
400,000
We will deposit the money in the US where it will earn interest so that in 3 months we
have $350,000.
Deposit Rate in US per year
5.5%
We will deposit $394,575 in the US where it will earn interest of 1.375% over the 3
months making it worth $400,000 when the payment becomes due.
We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.
$394,575
We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.
Spot rate (We are making a payment)
Convert ($ Amount / Spot Rate)
1.475
(394,575 / 1.475) = 267,508
267,508
We will have to pay interest on the amount we have borrowed for 3 months.
Borrowing Rate per year in UK
5.5%
Amount transferred to US
267,508
Now do it!
Lecture 21
Currency Risk II
Translation risk
Economic risk
Transaction risk
Interest rate risk
Answer A
2. Which of the following are advantages of a using a futures contract to hedge foreign
exchange risk?
1. High transaction costs.
2. It can be traded and thus closed out at any time.
3. It is an effective hedge.
4. The company can take advantage of upside risk.
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer C
3. Which of the following are disadvantages of a using a futures contract to hedge foreign
exchange risk?
1. They can be arranged for standard contract sizes only
2. They are available for a a wide range of currencies
3. There is no upside risk if the currency movement is in your favour
4. There is a large premium to pay on the contract.
A
B
C
D
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer B
1 and 2 only
1 and 3 only
3 and 4 only
1 and 4 only
Answer C
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer D
7. What is an option?
An option is the right but not the obligation to buy or sell a currency at a certain
price in the future.
Now do it!
Lecture 22
Interest Rate Risk
1 and 2 only
1 and 3 only
2 and 3 only
1 and 4 only
Answer B
3. Which of the following statements are correct in reference to using an over the counter
interest rate option to manage interest rate risk?
A. It constitutes an contract with a bank to secure a specific interest rate no matter what
happens.
B. It is an agreement with a bank that ensures that the company can take advantage of
low rates, but secure against high rates.
C. It is an exchange traded contract that can be closed out at any time.
D. It enables the company to swap from a fixed interest rate to a floating rate or vice-versa.
Answer B
4. In relation to hedging interest rate risk, which of the following statements is correct?
A. The flexible nature of interest rate futures means that they can always be matched with
a specific interest rate exposure
B. Interest rate options carry an obligation to the holder to complete the contract at
maturity
C. Forward rate agreements are the interest rate equivalent of money market hedging of
foreign exchange risk
D. Smoothing is where a balance is maintained between fixed rate and floating rate debt
Answer D
1, 2 and 3 only
1 and 3 only
2 and 3 only
1, 2 and 4 only
Answer D
2. What is an FRA?
A forward rate agreement. Effectively this is a forward interest rate agreed with a
bank.
3. Why might a firm use an interest rate option to manage interest rate risk?
It means that they can take advantage of low rates, but secure against high rates.
8. What are the three ways in which theorists have sought to explain the slope of the yield
curve?
Expectations theory states that if debt is to be held for longer terms it is more likely
that it wont get paid back so higher interest rates are demanded to compensate so
as the term gets longer the interest rate rises = upward sloping curve.
Liquidity preference theory states that because investors prefer cash, if they are
going to tie capital up by lending it out for the longer term they will demand higher
interest rates to compensate = upward sloping curve.
Market segmentation theory suggests that different investors have different
requirements based on their own circumstances and that long term investors want
higher yields leading to the upward sloping curve.
Now do it!
Lecture 23
Islamic Finance
Murabaha transaction.
Now do it!