Practice Questions – Fall II, 2018/19

Time value of money, cost of capital and Capital budgeting decision

Q1: The management of LB Co is evaluating an investment in a new coffee roasting machine. The
company has taken great care to estimate the future cash flow for the roasted coffee beans that the
machine will produce and finally, they manage to present the estimated cash flow for the project in the
table below:

Year 0 1 2
Estimated cash flow in million (1000) 800 600

The company believes that 10% returns is available elsewhere on the capital market for a similar risk
project.

Required:
(a) Calculate the net present value and profitability index of the planned investment projects. (2
marks)
(b) Calculate the payback period of the planned investment projects. (1 marks)
(c) Discuss the financial acceptability of the investment projects. (3 marks)
(d) State clearly any limitations and assumptions that you made in your calculations. (2 marks)
Q2: The directors of Delta Co are considering a planned investment project costing $28m, payable
immediately. The following information relates to the investment project:

Years 1 2 3 4

Project Cash flow 10,168 11,58 12,682 14,894

5
The views of the directors of Delta Co are that all investment projects must be evaluated over four years
of operations. Both net present value and payback must be used, with a maximum payback period of
two years. The after-tax cost of capital of Delta Co is 12%.

Required:
(a) Calculate the net present value of the planned investment project. (2 marks)
(b) Calculate the payback period of the planned investment project. (2 marks)
(c) Discuss the financial acceptability of the investment project. (2 marks)
(d) State clearly any limitations and assumptions that you made in your calculations. (3 marks)

Q3: The director of XYZ Fried Chicken is evaluating a proposal to open a fast food restaurant in a
university campus. The restaurant will cost $14.5 million to open. Expected cash flows are $4.1 million
per year for five years. Both net present value and payback must be used, with a maximum payback
period of three years. The after-tax cost of capital of Delta Co is 12%.

Required:
(a) Calculate the net present value of the planned investment project. (2 marks)
(b) Calculate the payback period of the planned investment project. (2 marks)
(c) Discuss the financial acceptability of the investment project. (2 marks)
(d) State clearly any limitations and assumptions that you made in your calculations. (2 marks)

Financial statement analysis

Q1: Dan Inc. is a publicly traded company involved in selling personal computers (PCs), servers, data
storage devices, network switches, software, computer peripherals, HDTVs, cameras, printers, MP3
players, and electronics built by other manufacturers. The company is well known for its unique
organization capital and innovative supply chain management. With the publication of the latest
financial statements for the year to 30 Jan 2017, the CEO made a brief statement and it includes the
following two points:

- The company was performing well and it has a highly talented management.
 - One of the key success factor of our management is the adoption of working capital
management strategy. We believe that managing investment in working capital lead to
managing long-term investment efficiently and effectively and hence creating value to our share
holder.
The CEO expressed a desire to make Dan Inc. the leading technology firm company through a rapid
expansion i.e. short cut to growth via acquisition. He plans to acquire his direct competitor so as to
increase Dan Inc. market share.

Given below are extracts from the recent financial statements, some ratios, and other financial
information for Dan Inc.

Dan Inc.

Year ending 30 November financial ratios

2015 2016 2017 Industry

KPI

NPM (%) 23 22 19 16
TAT 0·79 0·85 1.01 0.8
ROA (%) 18.17 18.7 19.2 12.8
Current Ratio 0·80 0·65 0·63 0.6
Total liability / Total assets ratio (%) 40 46 51 52
Share $ 93 94.5 95 ------
Days Inventory Held 36 37 31 40
Days A/R Outstanding 50 49 42 60
Days A/P Outstanding 43 43 33 34

Required:

Prepare a report for the Dan’s board of directors. In your report you should

(a) Critically evaluate Dan Inc.’s performance and conclude whether the chief executive
officer’s opinion has the greater validity. (10 marks)
(b) State clearly any limitations and assumptions that you made in your calculations.
(2marks)
 (c) Marks will be awarded for Professional format, structure and presentation of the
report. (2 marks)

Q2: Squair Co is an international airline which flies to more than 226 international destinations in 118
countries. Squair Co experienced rapid initial growth but in recent years the company has been facing a
range of difficulties and challenges. The following are the key financial data and information for recent
years ending 31 December

Squair Co 2016 2015 Industry average

Net profit margins 8% 12% 10%

Total Asset Turnover (TAT) 0.78 0.74 0.77
Return on Assets (ROA) 6.2% 8.7% 7.6%
Debt ratio 54% 80% 48%

The following information is relevant:

(i) The numbers of flights operated by Squair Co has remained the same in 2015 and 2016.
(ii) It is expected that there will be an increase in cost of license charged by three major airports
at the beginning of 2017.
(iii) The licenses with five more major airports are due to expire in Dec 2017.

Required:

Prepare a report for the top management. In your report you should

(a) Critically analyze and discuss the recent financial performance and financial
conditions of Squair Co and highlight areas of concern for the future (9 marks)
(b) State clearly any limitations and assumptions that you made in your calculations.
(3marks)
(c) Marks will be awarded for Professional format, structure and presentation of the
report. (2 marks)

Q3: You have been appointed as a financial analyst by Ramada Co. Ramada Co has identified Applied Co
as a possible acquisition within the same industry. Your role is to critically assess the financial
performance and conditions of Applied Co and highlights area of concerns to the members of Ramada’s
board of directors.

The following are the key financial data and information for recent years ending 31 December

Applied Co 2017 Industry average KPI

 Gross profit margins % 61 45
Operating profit margins % 37.6 28
Days of account receivable outstanding (days) 40 41
Current ratio 1:1 1.6:1
Quick ratio 0.57:1 1.4:1
Debt/ equity ratio % 220 240

Required:

Prepare a report for the Ramada’s board of directors. In your report you should

(a) Critically analyze and discuss the recent financial performance and financial
conditions of Squair Co and highlight areas of concern for the future (4 marks)
(b) State clearly any limitations and assumptions that you made in your calculations.
(2marks)
(c) Marks will be awarded for Professional format, structure and presentation of the
report. (2 marks)

Q3: Given below are abstract of the financial information relates to RAJ Co, which has considering
raising $ 50 million of new debt finance to support existing business operations. Assume that it is now 31
Dec 2015. RAJ Co has been experiencing trading difficulties due to a continuing depressed level of
economic activity:

Financial information for recent years ending 31 December

RAJ Co, 2015 2014 2013

$m $m $m
Profit before interest and tax 25.3 26.6 29.3
Interest charges 5.5 5.3 4.8
profit before tax 19.8 21.3 24.5
Taxation expense 5.9 6.4 7.3
Net profit 13.9 14.9 17.2
Debt ratio 47%

Dividend and share price information of RAJ Co

RAJ Co, 2015 2014 2013

$m $m $m
Total cash div paid 9.5 9.5 9.5
Share price at end of year 4.17 4.59 5.10
Average data on industry

-Debt ratio 49% -Interest coverage 10 times

Required:

Prepare a report for the top management. In your report you should

(a) Critically analyze and discuss the recent financial performance and financial
conditions of RAJ Co and comment on the proposal to raise $50 million of new debt
finance (6 marks)
(b) State clearly any limitations and assumptions that you made in your calculations. (2
marks)
(c) Marks will be awarded for Professional format, structure and presentation of the
report. (2 marks)

CAPM, Stock & Bond Valuation

Q1: HF is small company listed in a junior stock market. Its shares have a beta value of 1.09, the
expected market return is 10% and the risk-free return is 4.5%. HF company’s dividends is expected to
grow at 20 percent for the next five years – initial growth period (IGP). After that, the growth is expected
to be 4 percent forever. The dividend just paid was $2 per share.

Required:
(a) Explain how to measure the unsystematic risk and why is important in investment
decision process. (3 marks)
(b) Estimate the expected rate of returns using CAPM model. (2 marks)
(c) Define and graph the security market line using the data in (b). (2 marks)
(d) Estimate the value of HF’s shares. (4 marks)
(e) State clearly any limitations and assumptions that you made in your calculations. (2 marks)

Q2: You have just graduated from MBA program with finance major. Immediately after graduation you
have been hired as a financial analyst in a highly prestigious listed company name Cornejo. Your first
assignment is to estimate the cost of equity capital and stock price of the company. Your assistant
gathered the following information for you:

 The dividend per share (DPS) record of the company over the last 5 years is as follows:

Year Dividend per Share (DPS)

t −5 7.80
 t −4 9.4

t −3 10.85

t −2 11.2

t −1 11.7

t0 10

 Risk free rate is 3.5 percent

 Market risk premium is 5 percent
 Cornejo Co has an estimated beta of 1.10
 The company’s dividend growth rate is expected to remain constant for the foreseeable
future.
Required:
(f) Estimate the company’s cost of equity capital using CAPM. (3 marks)
(g) Draw and briefly define the security market line (SML). (2marks)
(h) Extrapolate a past growth rate. (2 marks)
(i) Estimate the current price of the company’s shares. (3 marks)
(j) State clearly any limitations and assumptions that you made in your calculations. (2
marks)

Q3: Ram’s stock is currently selling for $160.00 per share and the firm's dividends are expected
to grow at 5 percent indefinitely. In addition, Ram’s stock most recent dividend was $5.50. The
expected risk free rate of return is 3 percent, the expected market return is 8 percent, and Ram’s
stock has a beta of 1.20.

Required:
(a) Estimate the expected return based on the dividend valuation model. (3 marks)
(b) Estimate the required rate of return using CAPM and Draw the security market line (SML).
(3marks)
(c) Would Ram’s stock be a good investment at this time? Explain. (3 marks)
(d) State clearly any limitations and assumptions that you made in your calculations. (2
marks)
Q4: The Slinger Metal Fabricating Company entered into a loan agreement with its bank to finance the
firm’s working capital. The loan called for a floating rate that was 30 basis points over an index based on
LIBOR. In addition, the loan adjusted weekly based on the closing value of the index for the previous
week within the bounds of a maximum annual rate of 2.55% and a minimum of 1.95%.

Week(t) LIBOR (t) % LIBOR (t-1)+Spread Loan rate

1 2.3
2 2.25 ? ?
3 1.66 ? ?
4 1.58 ? ?
5 1.35 ? ?
6 1.63 ? ?
7 1.88 ? ?
8 1.78 ? ?
9 1.93 ? ?
10 1.66 ? ?

Required:
(a) Calculate the LIBOR (t-1) +Spread and Loan rate for the weeks 2 through 10. (3marks)
(b) Is the ceiling rate or floor rate violated during the loan period? (2 marks)
(c) To finance its long term investment, the Slinger Metal Fabricating Company has also
issued a 12% bond that is to mature in nine years. The bond had a $1,000 par value, and
interest is due to be paid annually. If the yield to maturity 10%, estimate the price of this
bond (3 marks)
 Formulae Sheet

E¿
D 1=D 0 (1+ g)
 D0
g=
√
N −1

D N−1
-1

D1
P 0=
ERR−g
Unsystematic risk = the expected rate of return- the required rate of return

Payback period is the number of years and /or months needed to recover the initial cash outlay required
to make the investment

NPV= present value of all cash inflow – cash outflow

n
CF t
NPV =∑ −CF 0
t=1 (1+i)t
PI = present value of all cash inflow/ cash outflow
n
CF t
PI =∑ /CF 0
t=1 (1+i)t

Stock valuation using variable growth model = present value of dividends during the initial growth
period + the present value of price of stock at the end of initial growth period
N

∑ D0 (1+ g1 )t ¿ DN +1
P0= t=1 t
+
(1+ R CE ) ( R ¿ ¿ CE−g2 )(1+ R CE )N