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ALLAMA IQBAL OPEN UNIVERSITY ISLAMABAD

ATTEMPT FIVE QUESTIONS. ALL CARRY EQUAL MARKS

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

(Refer to chapter 6 for detailed analysis of Balance sheet and Projected financial statements)
Q. 2 Financial statements for Begalla Corporation follow. Begalla Corporations comparative balance sheets at December 31) in millions) Assets
Cash and equipments Accounts Receivable Inventory Total Current assets Net fixed assets

20X1
$4 7 12 $23 40

20X2
$5 10 15 $30 40

Liabilities
Accounts Payable Notes payable Accrued wages Accrued taxes Total Current Liabilities Long term debt Common stock Retained earnings Total

20X1
$8 5 2 3 $18 20 10 15 $63

20X2
$10 5 3 2 $20 20 10 20 $70

Total

$63

$70

Begalla Corporations Income statement 20X2 (in millions) Sales Cost of goods sold Selling general and administrative expenses Depreciation Interest Net income before taxes Taxes Net income $95 $50 15 3 2

70 $25 10 $15

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

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Page 22 of 29 Q. 2 Answer: Begalla Corporation Cash Flow Statement For the year ending December 31, 2002. (Amount in Millions) Cash Flows from operating Activities: Net Income Depreciation Increase, Accounts Receivable Increase, Inventory Increase, Accounts Payable Increase, Wages Decrease, Accrued Taxes Cash Flows from Investing Activities: Increase, Fixed Assets Cash Flow from Financing Activities: Dividends Paid Increase in cash and cash equivalent Cash and cash equivalent Dec31, 2001 Cash and cash equivalent Dec31, 2002. $15 5 (3) (3) 2 1 (1) _____ (5)

16M (5)

(10)

(10) $1M 4M $5M

(b)

Refer to chapter 7 for comments

Q. 3 Jerome J. Jerome is considering investing in a security that has the following distribution of possible one- year returns: Probability of occurrence Possible return .10 .10 .20 .00 .30 .10 .30 .20 .10 .30 (a) What is the expected return

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

Q. 3

Answer: -

(Refer to Q.3 of Spring 2001)

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Page 23 of 29 Q. 4 The Anderson Corporation (an all-equity-financed firm) has a sales level of $280,000 with a 10 percent profit margin before interest and taxes. To generate this sales volume; the firm maintains a fixed asset investment of $100,000. Currently, the firm maintains $50,000 in current assets. (a) Determine the total asset turnover for the firm and compute the rate of return on total assets before taxes. (b) Corporate the before tax rate of return on assets at different levels of current assets starting with $10,000 and increasing in $15,000 increments to $100,000. Q. 4 Answer:(a) Total Assets Turnover: Net Sales = $280,000 Average total assets $150,000 Return on Assets: (b) Level 10% of $280,000 $150,000 Fixed Assets $100,000 100,000 100,000 100,000 100,000 100,000 100,000 x 100

$1.867 times

18.67 %

Current Assets $10,000 25,000 40,000 55,000 70,000 85,000 100,000

Total Assets $110,000 125,000 140,000 155,000 170,000 185,000 200,000

Return on Assets 25.45% 22.40% 20.00% 18.06% 16.47% 15.14% 14.00%

1 2 3 4 5 6 7

Q. 5 The Pawlowski Supply Company needs to increase its working capital by $4.4 million. The following three financing alternatives are available (assume a 365-days year): a. Forgo cash discounts (granted on a basis of 3/10, net 30) and pay on the final due date. b. Borrow $5 million from a bank at 15 percent interest. This alternative would necessitate maintaining a 12 percent compensating balance. c. Issue $4.7 million of six-month commercial paper to net $4.4 million. Assume that new paper would be issued every six months. (Note: Commercial paper has no stipulated interest rate. It is sold at a discount, and the amount of the discount determines the interest cost to the issuer.) Assuming that the firm would prefer the flexibility of bank financing, provided the additional cost of this flexibility was no more than 2 percent per annum, which alternative should Pawlowski select? Why? Q. 5 Answer: (a) 100-3 (b) $750,000 $5,000,000 - $600,000 $750,000 $4,400,000 x 100 3 x 30 -10 = 365 x 100 = 56.44%

17.05%

(c)

100 x 2

13.64%

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Page 24 of 29 The bank financing is approximately 3.4 percent more expensive than the commercial paper; therefore, commercial paper should be issued. Q. 6 Silicon Wafer Company presently pays a dividend of $1 per share and has a share price of $20. (a) If this dividend was expected to grow at a 12 percent rate forever, what is the firms expected, or required return on equity using a dividend discount model approach? (b) Instead of the situation in part (a), suppose that the dividend was expected to grow at a 20 percent rate for five years and at 10 percent per year thereafter. Now what is the firms expected, or required return on equity? Q. 6 Answer:(b) End of year 1 2 3 4 5 Dividend per share $ 1.20 1.44 1.73 2.07 2.49 PV@18% $ 1.02 1.03 1.05 1.07 1.09 $ 5.26 PV@19% $ 1.01 1.02 1.03 1.03 1.04 $ 5.13 (a) Ke = D1 P0 + g = $1.12 + 0.12 $20 = 0.176 or 17.6%

Year 6 Dividend = $2.74 Market price at the end of year 5 using the constant growth dividend valuation model. P5 = $2.74 0.18 0.10 = $34.25

P5

$2.74 0.19 0.10

= $30.44

Present value at time O for amount received at the end of year 5: $34.25 @ 18% $30.44 @ 19% Calculated PV: PV of year 1 5 PV of year 6 -00 18% $5.26 14.97 $20.23 = = $14.97 $12.76 19% $5.13 12.76 $17.89

By interpolating we get = $20.23 - $20.00 $23.23 -$17.89 18.098 % or 18.10 % Suggested Solution By Prof. F.R. Tariq For any query please contact at azeez786@hotmail.com, 0333-4233770, 0321-4401660 x 1% +18%

Page 25 of 29 Q.7 Bruce Read Enterprises in attempting to evaluate the feasibility of investing $95,000 in a piece of equipment having a 5-year life. The firm has estimated the cash inflows associated with the proposal as shown in the following table. The firm has a 12 percent cost of capital. Year (t) Cash inflows (CFt) 1 $20,000 2 25,000 3 30,000 4 35,000 5 40,000 (a) Calculate the payback period for the proposed investment. (b) Calculate the net present value (NPV) for the proposed investment. (c) Calculate the internal rate of return (IRR) rounded to the nearest whole percent for the proposed v investment. (d) Evaluate the acceptability of the proposed investment using NPV and IRR. What recommendation would you make relative to implementation of the project? Why? Q. 7 Answer:(a) (b) Payback period = 3.57 years NPV = PV of FCIFS ICO = $104,081 - $ 95,000 = $9,081 IRR: 15.37 PV @ 15% PV @ 16% 15% nearest whole percentage = = $95,919 $93.415 x 1% + 15%

(c)

$95919 - $95000 $95919 - $93415 = 15.37%

(d) Proposed investment is viable because NPV is positive and IRR is greater than firms cost of capital. Profit ability index comes to 1.096 times. Q. 8 If all companies had an objective of maximizing shareholder wealth, would people overall ten to be better or worse off? How?

Q.8 Answer: -

(Refer to chapter 1 & 2)

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