Final Problems for Managerial Finance[1]

8/2/2019 Final Problems for Managerial Finance[1]

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Managerial Finance

ImportantExercises andProblems for theFinalPrepared by Lody


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Previous Final Exam Qs

BMMF Final Exam 2010

Part 1 : answer the first two questions then choose 2 only

Q1 - the same as question (13-10) & (13-8) - [15 mark]

Q2 - he gave us some equations and asks us to find : [10 marks]

(a) the sales

using 3 formulas , i think first we used Current Ration to find Total Liability , then Quick Ratio tofind Inventories then Inventory turnover to get the sales

(b) the DSO

first we must find the Receivables = Total assets - (cash & short-term investments + inventories)

then find the DSO = Receivables / sales / 365

Q3- [7.5 marks]

(a) define LRP

(b) similar question to 1-4

Q4- [7.5 marks]

the same question as 6-1

Q5- [7.5 marks]

the same question as ST-1 from chapter 10

Part 2 : answer only 2 questions

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Q1- what are the key features bond ? and Discuss The relationship between Coupon interest and

Market interest?

Q2-

- What are the differences between Systematic risk and Unsystematic risk ?

- Define Standard Diviation

-

Q3-

what is the difference between Independent & Mutualy Exclusive projects , give example of each

ContentsContents ..................................................................................................................... 3

Interest Rate calculation .............................................................................................. 6

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Problem 1-1 (Expected Rate of Interest) page 42 ..................................................... 6

Another clear answer: (1-1) ......................................................................................... 7

Problem (1-2) page 42, Default Risk Premium ............................................................. 8

A clear answer: (1-2) ................................................................................................... 8

Problem (1-3) page 42, Maturity Risk Premium ............................................................ 9

Problem (1-4) page 42, Expected Rate of Interest ..................................................... 10

Problem (1-5) page 42, , Maturity Risk Premium ........................................................ 11

(3-1) Personal After- Tax Yield ................................................................................... 12

(3-2) Personal After-Tax Yield ................................................................................... 13

(3-6) Cash Flow ......................................................................................................... 14

(3-8) Free Cash Flow ................................................................................................. 16

Problem (4-3) page # 166, Expected and Required Rates of Return .......................... 18

Problem (4-4) page # 166, Required Rate of Return .................................................. 19

Question # (4-5) page 164 ........................................................................................ 19

Question # (4-6) page 164 ........................................................................................ 19

Problem 6-1, page 243, Bond Valuation ..................................................................... 21

(13-1)Liquidity Ratios ................................................................................................ 22

(13-2) Days Sales Outstanding, page 469 .................................................................. 22

Receivable = 40 *20,000 = 80,000 ........................................................................... 22

(13-3) Debt-Ratio, page 469 ...................................................................................... 22

(13-4) Du Pont Analysis, page 469 ............................................................................. 23

(13-5) Ratio Calculations, Page 469 ........................................................................... 24

(13-8) Times- Interest-Earned Ratio, Page 470 .......................................................... 26

Another way to solve this problem(13-8) Times- Interest-Earned Ratio,.....................27

as followed: ............................................................................................................. 27

(13-10) Balance Sheet Analysis (Page 470) ............................................................... 28

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Essay Qs ................................................................................................................... 31

Chapter 1

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Interest Rate calculation

r = r* + IP + DRP + LP + MRP

Here:

r=Required rate of return on a debt security

.r*= Real risk-free rate

.IP= Inflation premium

.DRP= Default risk premium.

LP= Liquidity premium.

MRP= Maturity risk premium.

Problem 1-1 (Expected Rate of Interest) page 42

The real risk free rate of interest is 3%. Inflation is expected to be 2% thisyear and 4% during the next 2 years. Assume the maturity risk premium iszero. What is the yield on 2 and 3 years treasury securities?

r* = 3% ; I1 = 2% ; I2 = 4% ; I3 = 4% ; MRP = 0 ; rT-2 = ? ; rT-3 = ?

r = r* + IP + DRP + LP + MRP.

Since these are Treasury securities,

DRP = LP = 0.

rT-2 = r* + IP2

IP2 = (2% + 4%)/2 = 3%

rT-2 = 3% + 3% = 6%.

rT-3 = r* + IP3IP3 = (2% + 4% + 4%)/3 = 3.33%

rT-3 = 3% + 3.33% = 6.33%.

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A clear answer

R*= 3%

IP1= 2%

IP2= 4%

IP3= 4%

MRP= 0

What is the yield on 2-year Treasury securities? RR= r*+IP+DRP+LP+MRP

So

R2= 3% + (2% + 4%)/2= 3% + 3%= 6%

What is the yield on 3-year Treasury securities?

R3= 3%+ (2% +4% + 4%)/3= 3% + 3.3%= 6.3%

Another clear answer: (1-1)

r*(real Risk-Free) = 3%

IPy1= 2% , IPy2= 4% , IPy3= 4%

MRP = 0

DRP = LRP=0 (because Treasury Securities are backed up

by the government)

ry2 = ? , ry3= ?

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First we will find the interest rate for year 2 then year 3

r = r* + IP + MRP + DRP + LRP

ry2 = 3% + (2+4/2)%

= 3% + 3%

= 6%

ry3 = 3% + (2+4+4/3)%

= 3% + 3.33%

= 6.33%

Problem (1-2) page 42, Default Risk Premium

M= 10 years

R= 6%LP= 0.5%

What is DRP?

8%= 6% + 0.5% + DRP

8%= 6.5 % + DRP

DRP= 1.5%

A clear answer: (1-2)

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Treasury bond10y = 6% = r Corporate bond10y = 8% = r

DRP = LRP = 0 LPR = 0.5 %

DRP = ?

Treasury bond10y = r* + IP + MRP + DRP + LRP

6% = r* + IP + MRP + 0 + 0

Corporate bond10y = r* + IP + MRP + DRP + LRP

8% = r* + IP + MRP + DRP + 0.5%

We will replace the r* + IP + MRP with the 6% of Treasury bond10y

So we will get equation with one variable :

Corporate bond10y = 6% + DRP + 0.5%

8% = 6% + DRP + 0.5%

DRP = 8 6.5 = 1.5%

Problem (1-3) page 42, Maturity Risk Premium

The real risk free is 3%, and inflation is expected to be 3% for the next 2 years. A 2

years treasury security yields 6.2%. What is the maturity risk premium for the 2

years security?

r* = 3%; IP = 3%; rT-2 = 6.2%; MRP2 = ?

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rT-2 = r* + IP + MRP = 6.2%

rT-2 = 3% + 3% + MRP = 6.2%

MRP = 0.2%.

Another clear answer:


IPy1= 3% , IPy2= 3%

ry2=6.2%

MRP = ?

DRP = LP=0 (because Treasury Securities are backed up by the government)

r = r* + IP + MRP + DRP + LP

6.2% = 3% + (3+3/2)% + MRP

MRPy2 = 6.2 6 = 0.2 %

Problem (1-4) page 42, Expected Rate of Interest


IPy1= 3% , IPy2= 4% , IPy3= 3.5%

MRP = 0.0005*(t-1) , where t=number of years of maturity

DRP = LRP=0 (because Treasury Securities are backed up by thegovernment)

ry7 = ?

ry7 = r* + IP + MRP + DRP + LRP

= 3% + (3+4+3.5*5/7)% + 0.0005*(7-1)

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=3%+3.5%+0.3%

= 6.8%

Problem (1-5) page 42, , Maturity Risk P remium


IPy1= 8% , IPy2= 5% , IPy3= 4%

DRP = LP=0 (because Treasury Securities are backed up by the government)ry2 = ry5 = 10%

MRPy5 - MRPy2 = ?

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ry2 = r* + IP + MRP + DRP + LP

10% = 3% + (8+5/2)% + MRPy2

MRPy2= 10 9.5 = 0.5%

ry5 = r* + IP + MRP + DRP + LP

10% = 3% + (8+5+4*3/5)% + MRPy5

MRPy5= 10 8 = 2%

MRPy5 - MRPy2 = 2 0.5 = 1.5%

Chapter 3

(3-1) Personal After- Tax Yield

Corporate Bond

r = 9% the interest here is an income but pronounced in percentage.Tax rate = 36%

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Interest after Tax = ?

NOPAT = EBIT*(1- Tax Rate)

= 9% * (1- 36%)

= 9% * 64%

= 5.76 %

(3-2) Personal After-Tax Yield

Corporate Bond (High Risk)

Municipal Bond(Low Risk) = 6%

Corporate bond yields=r = 8%

Municipal bond yields = r = 6%

the question is : Which Tax Rate that if applied the Municipal Bond will EqualCorporate Bond ?

so we will apply this formula :

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Equivalent pretax yield on taxable bond = Equivalent pretax yield on MunicipalBond / (1 Tax Rate)

8 % = 6 % / (1 tax rate)

Tax rate = 25=

(3-6) Cash Flow

EBIT = $ 750,000

Dep. Expenses = $ 200,000

Equity = 100%

Tax Rate = 40%

We need to find first Net Income, then Net Cash Flow

First, determine net income by setting up an income

statement:

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$ 750,000 EBIT

0 Interest

$ 750,000 EBT

300,000 Taxes (40%)

$450,000 NI ( Net Income)

Solution:

First we will find the Net Income; we will apply the tax on the Earnings beforetaxes

EBT 750,000

Tax (40%) 750,000 * (40/100) = 300,000

Net Income 750,000 - 300,000 = 450,000

Net Income = Earnings Expenses (taxes)

= 750,000 - 300,000

= $ 450,000

Net Cash Flow = Net Income + Depreciation & Amortization

= 450,000 + 200,000

= $ 650,000

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(3-8) Free Cash Flow

(a) (Net Operating After Tax)NOPAT2004 =?NOPAT = EBIT*(1- Tax Rate)

= 150,000 * (1 0.4)

= 150,000 * 0.6

= $ 90.000

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(b) (Net Operating Working Capital)NOWC2004 =? , NOWC2003 =?

Operating Current Asset = Cash + Inventory + Account Receivable

OCA2004= 12,000 + 180,000 + 180,000 = $ 372,000

OCA2003= 10,000 + 200,000 + 150,000 = $ 360,000

Operating Current Liabilities = Account Payable + Accruals

OCL2004 = 108,000 + 72,000 = $ 180,000

OCL2003 = 90,000 + 60,000 = $150,000

NOWC = Operating Current Asset - Operating Current Liabilities

NOWC2004= 372,000 - 180,000 = $ 192,000

NOWC2003= 360,000 - 150,000 = $ 210,000

(c) Total Net Operating Capital or Operating Capital 2003 & 2004 =?Operating Capital = NOWC + Net Fixed Asset (Net plant & equipment)

Operating Capital2003= 210,000 + 250,000 = $ 460,000

Operating Capital2004= 192,000 + 300,000 = $ 492,000

(d) FCF2004 =?Net Investment in Operating Capital = Operating Capital2004- OperatingCapital2003

= 492,000 - 460,000 = $ 32,000

FCF = NOPAT Net Investment in Operating Capital

= 90.000 - 32,000 = $ 58,00017 | P a g e


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Chapter 4

Problem (4-3) page # 166, Expected and Required Rates of

Return

Risk- free rate = rRF = 5%

Market risk premium = MRP = 6%

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Expected Return =? (All the risks, so we add them)

Expected Return= rRF + MRP = 5% + 6% = 11%

Beta = 1.2

Required rate of return =?

Rate of Return = rRF + MRP * Beta = 5% + (6% * 1.2) = 12.2 %

Problem (4-4) page # 166, Required Rate of Return

rRF = 6%

Expected Return = 13%, Beta = 0.7

Required Rate of Return =?

Rate of Return = rRF + (Expected Return- rRF) * Beta

= 6% (13% - 6%) * 0.7 = 10.9 %

Question # (4-5) page 164

Answer: The risk would increase because with high Beta,

the risk increases.

Question # (4-6) page 164According to the Security Market Line (SML) equation, an increase in beta

will increase a companys expected return by an amount equal to the market

risk premium times the change in beta. For example, assume that the risk-free

rate is 6 percent, and the market risk premium is 5 percent. If the companys

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beta doubles from 0.8 to 1.6 its expected return increases from 10 percent to

14 percent. Therefore, in general, a companys expected return will not

double when its beta doubles.

Chapter 6

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Problem 6-1, page 243, Bond Valuation

N= 10 years

Par Value = $1000 (FV)

Coupon Interest = 8%

YTM (Yield to Maturity) = 9% (treated as market interest)

Current Market Price =?

PV Annuity = (1000* 8%) * 6.4177 = 80 * 6.4177 = 513.41

PV = 1000 * 0.4224 = 422.4

Current Market Price = 513.41+ 422.4 = 935.81 > 1000

So, we will sell it at discount.

Chapter 13

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(13-1)Liquidity Ratios

(13-2) Days Sales Outstanding, page 469

DSO[money kept in the hand of customers]= 40 day

Average Daily Sales= $ 20,000

Account Receivable = ?

DSO=Receivables / Average Sales per day

40 = Receivable / 20,000

Receivable = 40 *20,000 = 80,000

(13-3) Debt-Ratio, page 469

A/E = 2.4; D/A = ?

We have Equity Multiplier of 2.4 = Total Assets/common

Equity= A/E = EM

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We want to find Debt-Ratio

Debt Ratios:

Debt to Total Assets = Total Liabilities

Total Assets

D = L/A

We already know that : Assets = Liabilities + Equity .So A = L + E

That means : L= A-E #11 #

D = L/A

D = A-E / A

=A/A E/A

A/E = EM

1/EM

So : D = (A/A) (1/EM) = 1 (1/ 2.4) = 1- 0.4166= 0.5834=

58. 34 %

(13-4) Du Pont Analysis, page 469

ROA = 10 %

Profit Margin= PM= 2%

Return On Equity = ROE= 15%

What is the companys total assets turn over? TAT=?23 | P a g e


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What is the companys Equity Multiplier? EM =? (by how muchthe company assets depend on equity)

Net profit margin = Net Income PM= NI/SSales

Return on Assets = Net Income ROA=NI/ATotal Assets

Return on Equity = Net Income ROE = NI/EEquity

Total Assets Turnover= Sales TAT= S/TATotal Assets

ROE = PM* TAT* EM

15% = Net Income/ Sales * Sales / Total Assets * EM

15% = Net Income / Total Assets * EM

15% = ROA * EM

15% = 10 % * EM

EM = 15/10 = 1.5 %

ROE = PM* TAT* EM

15 = 2 * TAT * 1.5 So, TAT = 15/3 = 5%

(13-5) Ratio Calculations, Page 469

We are given ROA = 3%And TAT = Sales/Total assets = 1.5 .ROA = 3%ROE = 5%24 | P a g e


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Calculate Profit Margin = PM=?And Debt Ratio = DR=?From Du Pont equation: ROA = Profit margin Total assets turnoverROA= Profit Margin * 1.5

3% = Profit margin (1.5)Profit margin = 3%/1.5 = 2%.ORWe can also calculate the companys debt ratio in a similar manner, given thefacts of the problem. We are given ROA(NI/A) and ROE(NI/E); if we use thereciprocal of ROE we have the following equation:

ROE = PM* TAT* EM

5% = Net Income/ Sales * Sales/ Total Assets * EM

5% = Net Income / Total Assets * EM

Return on Assets = Net Income

Total Assets

5% = ROA * EM

5% = 3% * EM

EM = 5/3 = 1.66 %

ROE = PM* TAT* EM

5% = PM * 1.5 * 1.66

PM = 2%

Debt Ratios:

Debt to Total Assets = Total Liabilities

Total Assets

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Assets = Liabilities + Capital (Equity)

3% = L + 5%

Since E is > L , this is not possible & not logical so we will reverse or

replace the Assets with Equity and vice versa

5% = L + 3%

E/A = 3/5 = 0.6 = 60 %

L/A = 2/5 = 0.4 = 40% = Debt Ratio

So, Profit Margin = 2% , Debt Ratio = 40%

(13-8) Times- Interest-Earned Ratio, Page 470

Debt = 500,000

Interest Rate = 10% annually

Sales = $ 2,000,000

Average Tax Rate = 30%

Net Profit Margin on Sales = 5%

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EBIT = $142,857 + $50,000 = $192,857.

TIE = $192,857/$50,000 = 3.86 .

(13-10) Balance Sheet Analysis (Page 470)

Debt Ratio: 50%

Quick Ratio: 0.80x

Total Assets Turnover: 1.5x

Days sales outstanding: 36.5 days (calculation is based ona 365- day a year)

Balance Sheet

Cash AccountPayable

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Total Liabilities = Account Payable + Long- Term Debt

150,000 = Account Payable + 60,000

Account Payable = 150,000 - 60,000 = 90,000

5. Common Stocks = Total Liabilities & Equities (AP+

Long- term debt+ RE)

300,000 (90,000+ 60,000 +

97,500) = 52,500

8. Fixed Assets = Total Assets ( Cash + Account

Receivable+ Inventories)

= 300,000 (27,000 + 45,000 + 90,000)

= 138,000

7.Cash + AR = Quick Ratio * AP

Cash + 45,000 = 0.80 * 90,000

Cash = 72,000 45,000 = 27,000

6. Account Receivable = Sales / 365 * DSO

= 450,000 * 36.5 / 365 =45,000

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Essay QsSummary of Chapter 4 Risk and Return

Q1 What are Investment returns ?

Investment returns measure the financial results of an investment.

Returns may be historical or prospective (anticipated).

Returns can be expressed in Dollar terms or Percentage terms.

Q2 What are Investment risk ?

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Investment risk relates to the probability of earning a return less than that expected.

The greater the chance of a return far below the expected return, the greater the risk.

Q3 What are the differences between Systematic risk and Unsystematic risk ?

Systematic or Market risk (non-diversifiable risk) is the risk which is due to thefactors which are beyond the control of the people working in the market (war, inflation,recession and high interest rates) and that's why risk free rate of return is used to justcompensate this type of risk in market.

Unsystematic or Firm-specific risk (diversifiable risk), is the risk which is due to thefactors which are controllable by the people working in market(such as lawsuits, strikes,successful and unsuccessful marketing programs, winning or losing a major contract) andmarket risk premium is used to compensate this type of risk.

Q4 What beta measure?

Beta measure market risk, which is relevant for stocks held in well-diversified portfolios, is defined as t

contribution of a security to the overall riskiness of the portfolio.

Q5 How is Beta interpreted ?

If b = 1 , stock has average risk

If b > 0 , stock is riskier than average

If b< 0 , stock is less risky than average.

Most stocks have betas in the range of 0.5 to 1.5

Q6 How is market risk measured for individual securities?

It is measured by a stocks beta coefficient.

Summary of Chapter 6 Bonds and their Valuation

Q1 What are the key features of a Bond?

Par Value : Face amount; paid at maturity.

Coupon interest rate : Stated interest rate. Multiply by par value to get dollars of interest. Generfixed.

Maturity : Years until bond must be repaid. Declines.

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Issue date : Date when bond was issued.

Default Risk : Risk that issuer will not make interest or principal payments.

Q2 What is Sinking Fund?

Provision to pay off a loan over its life rather than all at maturity.

Similar to amortization on a term loan.

Reduces risk to investor, shortens average maturity.

But not good for investors if rates decline after issuance.

Q3 What is Yield To Maturity(YTM)?

YTM is the rate of return earned on a bond held to maturity. Also called promised yield.

Q4 What is Reinvestment rate risk?

The risk that CFs will have to be reinvested in the future at lower rates, reducing income.

Illustration: Suppose you just won $500,000 playing the lottery. Youll invest the money and livthe interest OR you buy a 1-year bond with a YTM of 10%.

Year 1 income = $50,000. At year-end get back $500,000 to reinvest.

If rates fall to 3%, income will drop from $50,000 to $15,000. Had you bought 30-year bonds,income would have remained constant.

Long-term bonds: High interest rate risk, low reinvestment rate risk.

Short-term bonds: Low interest rate risk, high reinvestment rate risk.

Nothing is riskless!

Q5 What happens if the company didn't meet its obligation ?

If company cant meet its obligations, it files under Chapter 11. That stops creditors fromforeclosing, taking assets, and shutting down the business.

Company has 120 days to file a reorganization plan.

Court appoints a trustee to supervise reorganization.

Management usually stays in control.

Company must demonstrate in its reorganization plan that it is worth more alive than dead.

Otherwise, judge will order liquidation under Chapter 7.

Q6 What are the payment priority if the company face bankruptcy?

Secured creditors from sales of secured assets.Trustees costsWages, subject to limitsTaxes

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Unfunded pension liabilities.Unsecured creditors.Preferred stock.Common stock.

Q7 - What factors affect default risk and bond ratings?

Financial performance

Debt ratio

Coverage ratios, such as interest coverage ratio or EBITDA coverage ratio

Current ratios

Earnings stability

Regulatory environment

Potential product liability

Accounting policies

Q6 - Discuss The relationship between Coupon interest and Market interest?

Company would call if rd(market return) is below the coupon rate and bond sells at apremium. Use open market purchase if rd is above coupon rate and bond sells at a discount

When rd rises, above the coupon rate, the bonds value falls below par, so it sells at adiscount.

If coupon rate > rd, price rises above par, and bond sells at a premium.So,

If coupon rate < rd, bond sells at a discount.

If coupon rate = rd, bond sells at its par value.

If coupon rate > rd, bond sells at a premium. If rd rises, price falls.

Price = par at maturity.

Summary of Chapter 10 The Basics of Capital Budgeting

Q1 What is capital budgeting?

It is the analysis of potential projects.

In long-term-decisions; involve large expenditures.

It is very important to firm's future.

Q2 What are the steps in capital budgeting?

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Estimate cash flows(inflows & outflows)

Assess risk of cash flows.

Determine r = WACC for project

Evaluate cash flows.

Q3 - How can we Evaluate Cash Flows?

Payback, discounted payback

NPV

Q4 What is the difference between independent and mutually exclusive projects?

Independent Project , if the cash flows of one are unaffected by the acceptance of the othFor example : we can choose to expand the business OR buy a new machine or choose bothalternatives.(they can take one or both)

Mutually Exclusive Project, if the cash flows of one can be negatively impacted by theacceptance of the other. For example : In IT department , either we upgrade the current system or a newer version. I cant select both because they are related together. (they can take one or refuseboth)

Q5 What is the payback period?

The number of years required to recover a projects cost, or how long does it take to get thebusinesss money back.

Q6 What are the strengthens and weakness of payback period?

Strengths of Payback:1. Provides an indication of a projects risk and liquidity.2. Easy to calculate and understand.

Weaknesses of Payback:1. Ignores the Time Value of Money(TVM).2. Ignores Cash Flows occurring after the payback period.

Q7 What is the difference between Normal and No-normal Cash Flow Projects?

Normal Cash Flow Projects: Cost (negative CF) followed by a series of positive cash inflowOne change of signs.

Non-normal Cash Flow Projects: Two or more changes of signs. Most common: Cost (negaCF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine.

Q8 What is Capital Rationing?

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Capital rationing occurs when a company chooses not to fund all positive NPV projects.

Final Problems for Managerial Finance[1]

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