Managerial Finance Assignment

Group Members:
Bivek Ratna Tuladhar 12031311
Sachin Pokhrel 12043512

1/15/17 FIN20018
RQ 3-12)

ANS: Financial market helps in the development of the business and lift funds to run a new
industry by raising funds. It helps to transfer funds from savers to the people who need money
for business. There are two methods to transfer funds:

 Direct method
 Indirect method

Direct transfer of funds is the transfer of funds by public by investing in securities like bonds,
shares etc. Any bank or financial system are not included in the direct transfer. Investors always
search for the company which gives them a higher rate of return on their investment. The reasons
behind the shift to the direct movement of funds from investors to the corporate sector. Some of
them are as follows:

Control of Management:

The board of directors can be chosen by shareholders by vote and can boost the value of funds
invested. So by moving straight to the investors can have all information regarding the
management measures and about the financial statement of the company.

Long run economic benefit:

If an investor directly invests in the particular company’s stock, then they get the dividend in the
long term along with the capital gains. For example, if you invested your money in Apple
Corporation 10 years before then now you get a handsome capital gain and dividend too.

A better source of the Income:

As investors can get the dividend on continuously from the company the direct transfer of saving
by shareholders in a corporate sector is a better source of earning. Shareholders can get the good
income because the rate of interest on bonds from the company is relatively high.

Managerial Finance pg. 1

P 4-34) ANS:

Given,

Total price=$50000

Deposit=$100000

Interest=10%

Number of payments (n) =10

Annual payment=?

PV
PMT= 1−(1+i)−n
i

40000
= 1−(1+0.1)−10
0.1

= 6509.81

2
0 6509.81 4 6 8 10
i=10% 6509.81 6509.81 6509.81 6509.81

1 3 5 7 9
6509.81 6509.81 6509.81 6509.81 6509.81

Therefore, the annual payments of Liz Klemkosky will be $6509.81.

Managerial Finance pg. 2

RQ 9-21

Answer:

A market where the values of all property and derivatives at any time in time entirely replicate
all available information is called efficient market. The efficient market hypothesis state the
market is efficient and the prices are fair and their required return are equal to expected return,
since stock prices are fairly priced, it is assured that investor should not waste their time
evaluating stock whether it is undervalued or overvalued or try to find and capitalized on
mispriced securities.

There are three types of hypothesis they are:

1. Weak Form: This form assumes that market should be independent; there is no relation
of past rate with future rates. Share value can be analyzed and investors can investigate
company’s financial obligation to increase their probability of making superior than
market average profit, if fundamental analysis is used.
2. Semi Strong Form: It states that all the information which is available for public is use
to get the current stock price.
3. Strong Form: The strong form states that all the information, which is publicly available
or not have contributed to the current stock price, and investor cannot get advantage.
Here both the public as well as private information is reflected by the price.

Managerial Finance pg. 3

RQ 10-9

Answer:

Investing in equity shares is one of the major approaches to investment which potentially yields
fair rate of returns to investors. However, the expected returns from such investments vary
depending on the movement in stock price taking consideration of the performance of that
particular Stock. Earnings per share (EPS) is arguably the major factor influencing decision-
making process on whether to invest in common stock.

A. Earnings per share (EPS) and Share Price

The relationship between EPS and share price in short run is very complicated because higher
profits/earnings aren’t necessarily mean higher stock price. Similarly, the loss doesn’t always
lead to fall in price. But without earnings, the company cannot survive in business for long. It is
an important variable affecting the market value of the share. Earnings per share (EPS) is the
portion of total earnings/profit allocated to each common stock, net of taxes and preferred
payments. It indicates the state of profitability within a company providing information about
how much income the company generates for each share of stock.It is calculated as:

Net earnings- preferred dividend

EPS=
Total no. of outstanding shares

Suppose, ‘X’ company has $50000 in earnings, a total of 5000 shares and it pays no dividend.
The EPS would be $50000 divided by 5000 or $10. Another company ‘Y’ has $50000 in
earnings, a total of 5000 shares and pays $5000 as a dividend. Now the EPS would be ($50000-
$5000)/5000 or $9. Higher the earnings, higher the EPS. It also depends upon a total number of
shares traded. Lower the no. of shares, higher the EPS. Having higher EPS, the company sends
the information of being at the stronger position. Every investor wants to hold the investment
option which provides higher earnings, which, eventually leads to higher demand thereby

Managerial Finance pg. 4

increasing the total market value of stock. Thus, EPS has a positive impact on a share’s price,
and, circular.

B. Limitations of EPS as a major determinant of Share price

Not all the time firm’s share price moves in the direction of EPS. Taking decisions only based
on higher EPS might not give investors the desirable result they are seeking.

 If the company opts to implement buy-back strategy, the EPS increases even when the
earning is not increasing or static.
 The company might measure its EPS quarterly or semi-annually, or manipulate financial
reports but investor only gets to know about the annual EPS which makes them unable
to predict what’s the actual position.
 There exist various accounting principles regarding EPS. Reported EPS (GAAP EPS),
On-going EPS, Pro-forma EPS, Headline EPS, Cash EPS etc. It totally depends on what
policy a company optimizes.
 P/E ratio, dividend policy and retained earning policy are related with EPS which
provide even further information and further.

EPS is not only the indicator but one of the fundamental factors. There are so many indicators
which reflect the decision regarding where, when and how much to invest in share market.
Technical factors, macroeconomic factors, micro-factors on the company, director’s role, market
sentiments, influence of press and rumors, all affect the firm’s share price. Analysis of these
factors is must in order to make perfect investment including EPS, not alone EPS.

Managerial Finance pg. 5

P 10-20)

BOND VALUATION FORMULA

1
I ⌈ 1− ¿
¿¿

a) Calculate the value of bond.

Given,
Face value(M)=$1000
Coupon amount=$100
Maturity period=15years
Required rate of return=12%

0 pv 2 4 6 8 10 12 14
i=12% 100 100 100 100 100 100 100

1 3 5 7 9 11 13 15
100 100 100 100 100 100 100 100

1
100 ⌈ 1− ¿
¿¿

= 681.08 + 182

= 863.78

Therefore, the value of bond is $863.78

b)

Managerial Finance pg. 6

Formula to be used:

1−(1+i)−t
C [ i
+
F
]
(1+ i)t

i)
Given,
Par value (M) =$1000
Coupon amount=$100
Maturity period=15years
Required rate of return (i) =15%

0 pv
2 4 6 8 10 12 14
i=15% 100 100 100 100 100 100 100

1 3 5 7 9 11 13 15
100 100 100 100 100 100 100 100

1−(1+ 0.15)−15
= 100 [ 0.15
+ ]
1000
(1+0.15)15

= 584.13 + 122

= 707.63

Therefore, value of bond decreases to $707.63 from $863.78 when required rate of return
increases to 15% from 12%.

ii) Given,

Par value (M)=$1000

Coupon amount=$100

Managerial Finance pg. 7

 Maturity period=15years
Required rate of return (i) = 8%

0
pv 2 4 6 8 10 12 14
i=8% 100 100 100 100 100 100 100

1 3 5 7 9 11 13 15
100 100 100 100 100 100 100 100

1−(1+i)−t
C [ i
+
F
]
(1+ i)t

1−(1+ 0.08)−15
= 100 [ 0.08
+ ]
1000
(1+0.08)15

= 855.947+ 315.24

= 1171.189

Therefore, value of bond increases to $1171.189 from $863.78 when required rate of return
decreases to 8% from 12%.

c) ANS:

Formula to be used

1−(1+i)−t
C [i
+
F
(1+ i)t ]

Managerial Finance pg. 8

 i) Given,
Par value (M)=$1000
Coupon amount=$100
Maturity period=5years
Required rate of return (i)=15%

0 2
pv 4
i=15% 100 100

1 3 5
100 100 100

1−(1+ 0.15)−5
= 100 [ 0.15 ]+
1000
(1+0.15)5

= 335.21 + 497.09

= 832.39

Therefore, the value of bond increases to $832.39 when maturity period declines from 15 years
to 5 years at 15% rate of return.

(ii)Given,

Par value (M)=$1000

Coupon amount=$100
Maturity period=5years
Required rate of return (i) =8%

Managerial Finance pg. 9

 0 2
pv 4
i=8% 100 100

1 3 5
100 100 100

1−(1+ 0.08)−5
= 100 [ 0.08
+ ]
1000
(1+0.08)5

= 399.271+680.583

= 1079.85

Therefore, the value of bond decreases to $1079.85 from $1171.1895 when maturity period
declines from 15 years to 5 years at 8% rate of return.

Managerial Finance pg. 10

P 12.10)

a)

The formula to be used:

n
ACF
∑ (1+ k )t
- IO
t =1

a) Given,
Required rate of return (k)=10%
Maturity period (n)= 4 years

NPV of Project A

65000 65000 65000 85000

= -160000 + 1 + 2 + 3 +
(1+0.1) (1+0.1) (1+0.1) (1+0.1)4

= -160000 + 59090.90 + 53719 + 48835.46 + 58056.14

= $59701.5

For project B

Required rate of return (k)=10%

Maturity period (n)= 9years

NPV of Project B

35000 35000 35000 40000 40000 40000 45000

=-160000 + 1 + 2 + 3 + 4 + 5 + 6 + 7 +
(1+0.1) (1+0.1) (1+0.1) (1+0.1) (1+0.1) (1+0.1) (1+0.1)

45000 45000
8 +
(1+0.1) (1+0.1)9

Managerial Finance pg. 11

= -160000 + 31818.18 + 28925.61 + 26296.01 + 27320.53+ 24836.85 + 22578.95 + 23902.11 +
20992.83 + 19084.39

= -160000 + 224945.46

= $64945.46

Equivalent Annual Annuity for Project A:

PVA (i)
EAA 1=
1−(1+i)−n

59701.5(0.1)
=
1−(1+0.1)−4

5970.1
= = $18834.08
0.316

Equivalent Annual Annuity for Project B:

PVA (i)
EAA 2=
1−(1+i)−n

64945.46(0.1)
=
1−(1+0.1)−9

6494.54
= = $11277.16
0.5759

Therefore, we select Project A since EAA of Project A is higher than that of Project B.

b)

Managerial Finance pg. 12

 Formula to be used

Annual Annuity
required rate of return

For Project A

18834.08
=
0.1

= 188340.8

Therefore, the present value of an infinite-life replacement chain for project A is $188340.8

For Project B

11277.16
=
0.1

= 112771.6

Therefore, the present value of an infinite-life replacement chain for project B is $112771.6

Managerial Finance pg. 13

P14-21

Answers:

A. Calculation of market value proportions of debt, preference shares and ordinary

equity comprising capital structure;

Source of capital Amount (in $) Proportion of capital

0.405
Bond (Long-term Debt) 1500000
Pref. Shares
550000 0.149
Ordinary Shares
1650000 0.446
Total 3700000 1.00

The company is optimizing its capital structure having 44.6% of ordinary shares of the total
capital, the most, followed by bond, 40.5% and preference shares of 14.9%.

B. After tax cost of each source of finance;

Cost of long term debt- bond (Kdt):

Cost of bond before tax (kd)= 8%

Tax rate (t) = 30%
Cost of bond after tax (kdt)=kd (1-t)
= 8% (1-0.3)
= 5.6%
Cost of preference shares (Kp):
Cost of pref. shares (Kp) = D0/P
Where,
D0= dividend per share = $0.94

Managerial Finance pg. 14

P = net value per share = $9.09(1-0.4)= $8.7264
Kp = $0.94/$8.7264= 0.1077 or 10.77%

Cost of ordinary shares (Ke):

Ke= [{D0(1+g)/P}/+g]
Where, D0= $0.16
g = growth rate = 9%
P= $3.03(1-.1) = $2.427
Ke= [{0.16(1+0.9)/$2.427}+9%]= 0.1619 or 16.19%

C. After tax weighted average cost of finance for the company;

WACC= Wd*Kdt + Wp*Kp + We*Ke
Where,
Wd = proportion of debt in total capital
Wp = proportion of pref. shares in total capital
We = proportion of ordinary equity in total capital.
WACC= 0.405*5.6 +0.149*10.77 +0.446*16.19
= 11.05%

D. Analysis of best investment alternative;

Premium on return
Projec Cost of investment Rate of return WACC
(%) (Rate of
t (in $) (%) (%)
return-WACC)
A 200000 18 11.05 6.95
B 125000 16 11.05 4.95
C 150000 12 11.05 0.95
D 275000 10 11.05 -1.05

ProjectA yields higher rate of return and also the higher rate of premium on return with 18% and
6.95% respectively. Thus, investment should be made on project A. In case of mutually
exclusive projects, only project D is not suitable due to negative premium on rate of return.

Managerial Finance pg. 15

Managerial Finance pg. 16
P18-14
Answer:

A. Calculation of effective annual rate (EAR) of interest on loan;

Effective annual interest equals internal rate of return because the value of amortized loan over
the period is zero. Thus, calculating EAR on the basis of IRR.
Trial & Error method,
EAR=[lower rate+ {(NPV at lower rate/Absolute Sum) *(Higher rate-lower rate)}]

Suppose, interest rate = 10%

Calculation of NPV,
Cash PV
Year flow ($) factor PV
(25000 ($250,00
0 0) 1 0)
1 69000 0.9091 62727.9
2 69000 0.8264 57021.6
3 69000 0.7513 51839.7
4 69000 0.683 47127
5 69000 0.6209 42842.1
NPV $11,558

Again,
Suppose, interest rate = 12%
Calculation of NPV,
Cash
Flow PV
Year ($) factor PV
(250000 ($250,000
0 ) 1 )
1 69000 0.8929 61610.1
2 69000 0.7972 55006.8
3 69000 0.7118 49114.2
4 69000 0.6335 43711.5

Managerial Finance pg. 17

 5 69000 0.5674 39150.6
NPV ($1,407)

Effective interest rate = [10% + {(11558/(11558+1407) * (12%-10%)}]

= 10%+ 1.78%
= 11.78%

B. Calculation of annual payment of bank loan;

The bank installment is to be repaid twice a year. Hence, first calculating half yearly repayments
and then annual.

Installment amount = [(interest rate* principal) / {1-(1+ int. rate)˄- no. of repayments}]
Where,
Half yearly interest rate = 16/2= 8% (annual int. rate is 16%)
No of repayments = 20
Half early installment amount = [(0.08*300000) / {1-(1+0.08)˄-20}]
= $ 30555.66
Annual installment/repayment amount = $30555.66*2= $61111.33

.
C. Annual rate of interest for term loan from the finance broker;
The interest rate for the loan is equal to IRR because the amount of NPV over the ending
period should be zero after discounting loan amount.

Interest Rate = [lower rate+ {(NPV at lower rate/Absolute Sum) *(Higher rate-lower rate)}]

We know, NPV = [{Repayment amount/(1+k)˄n}- loan amount]

Suppose, interest rate is 7%

NPV = [{$425000/(1+0.7)˄5}-300000] = $3019.13

Suppose, interest rate is 8%

Managerial Finance pg. 18

 NPV = [{425000/(1+0.8)˄5}-300000] = -$10752.14

Now, using interpolation method,

Interest rate = [7% + {$3019.13/($3019.13+$10752.14)} * (8%-7%)] = 7.22%

D. Decision:

Based on above calculations, financing from warehouse manufacturer is the best decision
because it is the cheapest option among all. The company only have to pay a total of $
395,000 (69000*5 +50000) for a period of five years. The second cheapest option is from
finance broker with a total repayment of $ 425,000. The decision of borrowing from the bank
would be most costly with a total of $611,113.20 (61,111.32*10) principal and interest. Thus,
it is suggested to take a loan from warehouse manufacturer.

Managerial Finance pg. 19

Bibliography
(n.d.). Retrieved from http://www.accountingcoach.com/present-value-of-an-ordinary-
annuity/explanation/present-value-of-annuity.

(n.d.). Retrieved from http://finance.zacks.com/relationship-between-earnings-stock-market-

value-4890.html

Gitman, junchau, & Flanagan. Principles of Managerial Finance. Pearson education Australia.

Martin, P., Burrow, M., & Nguyen, H. (2012). Financial Management. Pearson Australia.

Managerial Finance pg. 20