Assignment answer

1. A/
Given
 considering buying a machine costing $120,000
 Machine A will generate net cash inflow of $40,000, $ 30,000 & $ 30,000 in year 1, year
2 & year 3 respectively
 Machine B will generate net cash inflow of $ 50,000, $ 60,000 & $ 70,000 in year 1, year
2 &year 3 respectively
Solution

/
Payback period = sum of income sum of investment

 Payback period for machine A =

Year Cash Flow Net Invested Cash

0 -$120,000
1 +$40,000 -$80,000
2 +$30,000 -$50,000
3 +30,000 -$20,000

The payback period for machine A it takes more than 3 years

/
Payback period = sum of income sum of investment

 Payback period for machine B =

Year Cash Flow Net Invested Cash

0 -$120,000
1 +$50,000 -$70,000
2 +$60,000 -$10,000
3 +70,000 +$60,000
  Payback period for machine B = 2.06 year

 Payback period is more than 3 years for machine A & 2.06 year for machine B
respectively. According to the payback period method, machine B will be given
preference

B/

Given

 considering buying a machine costing $120,000

 The market interest rate is 10%
Solution
$100 × 0.10
- ln(1 - )
DPP = $20
= 7.27 years
ln(1 + 0.10)

2. Given

2013 2012
✔ Account receivable…… 12,250 17,750
✔ Inventory …………….. 7,000 5,000
✔ Account payable ……… 4,000 3,500

Solution

2013 2012 Average

✔ Account receivable…… 12,250 17,750 29,400
✔ Inventory …………….. 7,000 5,000 12000
✔ Account payable ……… 4,000 3,500 7,500

Net sales------------------------60,000

Cost of goods sold------------30,000

A. Inventory period
 First we calculate inventory turnover
- Inventory turnover = Cost of goods sold/average of inventory

= 30,000/12000
 = 2.5

- Inventory period = number of days in a year/ Inventory turnover

= 365/2.5

= 146

B. payable period

- payable period = Account payable* number of days in a year / Cost of goods sold

= 7,500*365/30,000

= 91.25

C. Receivable period

 First we calculate receivables turnover

- receivable turnover = Net sales/average of account receivable

= 60,000/29,400

= 2.04

- Account receivable period = number of days in a year/ receivable turnover

= 365/2.04
= 178.9

D. operating cycle

- operating cycle = inventory period + account receivable period

= 146 +29,400

= 29,546
 E. Cash conversion cycle

Cash Conversion Cycle = DIO + DSO – DPO

Where:

 DIO stands for Days Inventory Outstanding

 DSO stands for Days Sales Outstanding
 DPO stands for Days Payable Outstanding

 First we calculate inventory turnover DIO,DSO and DPO

- DIO = (Average inventory/ Cost of goods sold)* number of days in a year

= (12,000/30,000)*365

= 146

- DSO = (Average of account receivable / total credit sales )* number of days in a year

= (29,400/60,000)*365

= 178.85

- DPO = (Average account payable/ Cost of goods sold)* number of days in a year

= (7,500/30,000)*365

= 91.25

Cash Conversion Cycle = DIO + DSO – DPO

Cash Conversion Cycle = 146 + 178.85 – 91.25= 233.6

F. Opinion toward the result

A good cash conversion cycle is a short one. If your CCC is a low or (better yet) a
negative number that means your working capital is not tied up for long and your
 business has greater liquidity but according to this result there is a bad cash conversion
cycle.

3. Determinants of capital structure and working capital requirement

 Determinants of capital structure

Determinants of capital structure: size, profitability, tangibility, growth opportunities, tax, non-
debt tax shields, volatility, and industry classification.

Size
From the theoretical point of view, the effect of size on leverage is ambiguous. Larger firms tend
to be more diversified and fail less often, so size (computed as the logarithm of net sales) may be
an inverse proxy for the probability of bankruptcy. If so, size should have a positive impact on
the supply debt. However, size may also be a proxy for the information outside investors have,
which should increase their preference for equity relative to debt.

Profitability
There is no consistent theoretical predictions on the effects of profitability on leverage. From the
point of view of the trade-off theory, more profitable companies should have higher leverage
because they have more income to shield from taxes. The free cash-flow theory would suggest
that more profitable companies should use more debt in order to discipline managers, to induce
them to pay out cash instead of spending money on inefficient projects. However, from the point
of view of the pecking-order theory, firms prefer internal financing to external. So more
profitable companies have a lower need for external financing and therefore should have lower
leverage.

Tangibility
it is assumed, from the theoretical point of view, that tangible assets can be used as collateral.
Therefore higher tangibility lowers the risk of a creditor and increases the value of the assets in
the case of bankruptcy. The more tangible the firm’s assets, the greaterits ability to issue secured debt
and the less information revealed about future profits. Thus a positive relation between tangibility and
leverage is predicted.
Growth Opportunities
firms with high future growth opportunities should use more equity financing, because a higher
leveraged company is more likely to pass up profitable investment opportunities. As Huang and
such an investment effectively transfers wealth from stockholders to debt holders. Therefore a
negative relation between growth opportunities and leverage is predicted. As market-to-book
ratio is used in order to proxy for growth opportunities, there is one more reason to expect a
negative relation. The theory predicts that firms with high market-to-book ratios have higher
costs of financial distress, which is why we expect a negative correlation.

Tax
According to the trade-off theory, a company with a higher tax rate should use more debt and
therefore should have higher leverage, because it has more income to shield from taxes. Declare
that debt has no net tax benefits. Collinearly everyone believes taxes must be important to
financing decision, but little support has been found in empirical analysis.

Non-debt Tax Shields

Other items apart from interest expenses, which contribute to a decrease in tax payments, are
labeled as non-debt tax shields (for example the tax deduction for depreciation). Ceteris paribus,
decreases in allowable investment-related tax shields (e.g., depreciation deductions or investment
tax credits) due to changes in the corporate tax code or due to changes in inflation which reduce
the real value of tax shields will increase the amount of debt that firms employ. In cross-sectional
analysis, firms with lower investment related tax shields (holding before-tax earnings constant)
will employ greater debt in their capital structures.

Volatility
Volatility may be understood as a proxy for risk of a firm (probability of bankruptcy). Therefore it is
assumed that volatility is negatively related to leverage. As the variance of the value of the firm’s assets
increases, the systematic risk of equity decreases. So the business risk is expected to be positively related
to leverage.

Industry Classification
some empirical studies identify a statistically significant relationship between industry
classification and leverage, based on a survey of empirical studies: “Drugs, Instruments,
Electronics, and Food have consistently low leverage while Paper, Textile Mill Products, Steel,
Airlines, and Cement have consistently large leverage.

 Determinants of capital structure

A lot of factors influence the total investment in working capital of an enterprise.

The determinants of working capital are as given below:

1. Nature and Size of Business: The requirement of working capital depends on the nature
and size of business manufacturing concerns requires larger amounts of working capital
in comparison to trading concerns.
2. Position of Business Cycle:
Working capital requirement will be higher during times of boom compared to the lean
periods. It can be said that the volume of working capital is directly related with the
volume of production.
3. Production Policy: If the production takes a longer period, there is greater need of
working capital compared to shorter period of production.
4. Market Conditions: If there is a high degree of competition in the market, large
inventory is essential to sell goods. Thus, it requires high amount of working capital.
5. Seasonal Business: In case of seasonal business, working capital requirements of a firm
during the production season will be more.
6. Dividend Policy: Dividend policy also affects working capital. Payments of dividend
causes outflow of cash while retained profits act as source of working capital.
7. Credit Policy: If the firm enjoys a lesser credit period, it has to purchase raw materials in
cash and working capital requirements will be greater.
8. Tax Level: Working capital requirements also depend on the rates of taxes and advance
tax provisions.