Mid-Term Mini Case (1) & (2)

Group Sunday 2 w
Managerial Finance

Presented by: Abdel Rahman Salah Amer

Presented to: Dr Wael Shams El Din

 Mini Case (1)

A. Why is corporate finance important to all managers?

Corporate finance is important to managers as it is necessary to take the

following decisions:

1. It takes the investment decisions, where to invest, which investment

alternative is better and how much return, it will provide in how much time.
Whether the project should be accepted or rejected
2. It is important to take finance decisions, which source of funds is better for
raising money, in corporate finance; managers calculate the cost of capital of
each financial alternative and go with the option that has least cost of capital.
3. It is also important for managers to take dividend decisions, how much
dividend should be given and how much profit should be retained.

B. Describe the organizational forms a company might have as it evolves

from a start-up to a major corporation. List the advantages and
disadvantages of each form

Typically businesses begin as sole proprietorships or partnerships which are

unincorporated businesses

Advantages - it is easy and inexpensive to form

Disadvantages - the limitations of proprietorships, and partnerships such as

difficultly raising capital, unlimited liability, and inability to transfer ownership they
mature into corporations. In contrast a corporation has unlimited life, allows for
easy transferability of ownership, and limited liability

C. How do corporations go public and continue to grow? What are agency

problems? What is corporate governance?

- A corporation can go public through an initial public offering (IPO)

allowing anyone to purchase shares of the company on open stock
exchanges. A company continues to grow by demonstrating increasing
value.
Value is continued generation of cash flows and/or consistently decreasing
the cost of capital.
 - Agency problem is the plausible conflict of interest that might exist
between management and stakeholders. Meaning there must be
measures in place to prevent management from acting on behalf of their
own interests, and not on behalf of the owners. Some methods can
consist of offering stock options to management incentivizing growth.

- Corporate governance is the “set of rules that control the company’s

behavior towards its directors, managers, employees, shareholders,
creditors, customers, competitors, and community.”

D. What should be the primary objective of managers?

Answer: Primary objective of managers should be to maximize the wealth of the

shareholders by maximizing company's stock price and also to achieve the
business goals by working in a team for common target.

1. Do firms have any responsibilities to society at large?

Not covered

2. Is stock price maximization good or bad for society?

Not covered

3. Should firms behave ethically?

. Not covered

E. What three aspects of cash flows affect the value of any investment?

Not covered

F. What are free cash flows?

Free cash flows (FCFs) are the cash flows available for distribution to all of a
firm’s investors (shareholders and creditors) after the firm has paid all expenses
(including taxes) and has made the required investments in operations to support
growth
G. What is the weighted average cost of capital?

The weighted average cost of capital is the rate of return required by investors.
The lower the weighted average cost of capital is, potentially, the more valuable a
company is

H. How do free cash flows and the weighted average cost of capital interact
to determine a firm’s value?

The greater the free cash flows, and the lower the weighted average cost of
capital is the more a company is valued. Free cash flows are divided by the
WACC to determine a company’s value

I. who are the providers (savers) and users (borrowers) of capital? How is
capital transferred between savers and borrowers?

Not covered

J. What do we call the price that a borrower must pay for debt capital? What
is the price of equity capital?

- The price that a borrower must pay for debt capitals the interest rate.

- The price of equity capital is called the cost of equity, “and it consists of
the dividends and capital gains stockholders .The four most fundamental
factors that affect the cost of money, or the general level of interest rates,
in the economy are (1) production opportunities, (2) time preferences for
consumption, (3) risk, and (4) inflation.

- What are the four most fundamental factors that affect the cost of money,
or the general level of interest rates, in the economy?

Not covered

K. What are some economic conditions (including international aspects)

that affect the cost of money?

Not covered
L. What are financial securities? Describe some financial instruments

- Financial securities are instruments that are sold by financial institutions to

variety of clients, institutional, retail, private, and otherwise. Financial securities
can be generalized into three different types (1) debt, (2) equity, (3) derivatives.

- Some financial instruments are: Treasury bills, certificates of deposits (cd’s),

and money market accounts are all lower interest (rate of return) instruments
Which are low risk and can be FDIC insured guaranteeing no loss of principal.
Mortgages, Muni Bonds, Corporate bonds, consumer credit cards, and
commercial loans and the most common type of equity is common stocks

M. List some financial institutions

Some U.S. financial institutions: Bank of America, Citibank, JP Morgan Chase,

Goldman Sachs, Fannie Mae, Freddie Mac, Fidelity, Janus, Vanguard, E-trad
e, Calpers, Federal reserve, AIG, and American Express Some international
financial institutions: Barclays, Banco Santander, Deutche Bank, Scotia Bank,
Westpac, BNP Paribas, BNL Italia, and China Construction Bank. Financial
institution types: Investment banks and brokerages, Savings and Loans
Associations, Credit Unions, Commercial banks, Mutual Funds, Hedge Funds
, Private equity funds, Life Insurance and Pension funds, and Regulatory
Agencies

N. What are some different types of markets?

Physical asset markets, spot markets and futures markets, money and capital
markets, mortgage markets and consumer credit markets, world, national,
regional, and local markets, primary markets and secondary markets, and private
markets and public market

O. How are secondary markets organized?

Not covered
(1) List some physical location markets and some computer/telephone
networks

Not covered

(2) Explain the differences between open outcry auctions, dealer markets,
and electronic communications networks (ECNs).

Not covered
 Mini Case (2)

A-What is capital budgeting?

Capital budgeting decision is critical for a company. It may include

purchase of fixed assets, construction of building, factory, etc, one good
decision may groom the company and one bad may broom the Company.
It is difficult to reverse the capital budgeting decision, once it is taken;
therefore, it is necessary that one should be careful when deciding about
the capital budgeting decision. The following are the key areas to minimize
the risk involved in capital budgeting.
a. Evaluation of capital budgeting using various techniques such as
accounting rate of return method, payback period method, net
present value method and internal rate of return method. The most
powerful is the net present value method, if projects are mutually
exclusive and if not mutually exclusive, then the deciding factor will
be the NPV index.

b. Follow up of completion of capital budgeting. It is necessary that

once the paper work is done, it must be sure that the capital
budgeting has been completed within stipulated time period. For
example, if decision about construction of factory has been taken
within two years. The construction process must be followed on
regular basis, not at the end of 2 years.
c. Comparison of actual results with planned results if they are
achieved then it is said that capital budgeting is successful

.
B-What is the difference between independent and mutually
exclusive projects?

When two projects can be undertaken at one time and they are not
related to each other, it is called independent, but when company
can opt for only one project out of two or many and they are related
to each other, it is called mutually exclusive.
 C-(1) Define the term net present value. What are each
franchises NPV?

The net present value is the difference between present value of

inflows and outflows over the life of the project

.
C-(2) what is the rationale behind the NPV method?
According to NPV, which franchise or franchises should
be accepted if they are independent? Mutually exclusive?

It helps in knowing whether the present value of future cash flows

are equal to the investment which is made today, if the present
value of the future cash flows is less than initial investment, it is
worthless to invest. If both projects are independent, then both
should be accepted as they both have positive NPV, but if they are
mutually exclusive, then the Franchise S should be preferred due to
its higher NPV.

C-(3) would the NPVs change if the cost of capital

changed?

Yes, if the cost of capital goes up, the NPV will go down and vice
versa.

D-(1) Define the term internal rate of return (IRR). What is

each franchise's IRR?

The rate of return at which the NPV is zero if the IRR is bigger than
the cost of capital; it means that the project will have positive NPV,
otherwise not.

D-(2) how is the IRR on a project related to the YTM on a

bond?

Not Covered
E-(1) Draw NVP profiles for Franchises L and S. At what
discount rate do the profiles cross?

Not covered

E-(2) Look at your NPV profile graph without referring to the

actual NPV's and IRR's. Which Franchise or franchises
should be accepted if they are independent? Mutually –
exclusive? Explain. Are your answers correct at any cost of
capital less than 23.6%?

Not covered

F-(1) what is the underlying cause of ranking, conflicts

between NPV and IRR?

The drawback of IRR is as it is expressed in terms of percentage

regardless of the size of the investment, however, the NPV is
preferred for both mutually and independent projects, if the projects
are mutually exclusive the project with higher NPV is selected
regardless of its size of investment, but if they are independent then
the NPV Index is used, the preference is given to projects with higher
NPV index.

F-(2) what is the reinvestment rate assumption, and now

does it affects the NPV versus IRR conflict?

Under the IRR it is assumed that the investment is made at the rate of
IRR, while under NPV the rate of investment is used as the cost of
capital.
 F-(3) which method is best? Why?

The NPV is preferred for both mutually and independent projects, if

the projects are mutually exclusive the project with higher NPV is
selected regardless of its size of investment, but if they are
independent then the NPV Index is used, the preference is given to
projects with higher NPV index

.
G-(1) Define the term Modified IRR (MIRR). Find the MIRRs
for Franchises L and S.

Only difference in the IRR and the MIRR is the reinvestment rate,
under MIRR it is assured that the rate of reinvestment is the cost of
capital.

G-(2) what are the MIRR's advantages and disadvantages

vis-a-vis the regular IRR? What are the MIRR's advantages
and disadvantages vis-a-vis the NPV?

The MIRR gives a better picture due to its use of cost of capital as
reinvestment rate. Therefore the MIRR is always smaller than IRR.
However, the best method is NPV for decision making as discussed
earlier.

H-(1) what are normal and non normal cash flows?

Not covered

H-(2) what is Project P’s NPV? What is its IRR? It's MIRR?

0 1 -0.8 -08
1 0.9090 5 4.5454
2 0.8264 -5 -4.1322
NPV -0.3867
IRR 0
H-(3) Draw Project P’s NPV profile. Does Project P have
normal or non normal cash flows? Should this project be
accepted?

Not covered

I- What does the profitability index (PI) measure? What are

PIs of S and L.

Profitability index is used where two projects have different amount of

investment to be made, it helps in ranking the project. The company
will put all money which has the higher PI.

J-(1) what is the payback period? Find the paybacks for

Franchise L and S.

Payback period tells in how many years the initial investment will be
recovered.

J-(2) what is the rationale for the payback method?

According to payback criterion, which franchise or
franchises should be accepted if the firm's maximum
acceptable payback is 2 years and if Franchise L and S are
independent? If they are mutually exclusive?

Payback is not used to evaluate the project acceptance as it does not

consider the cash flow for the whole project. It also does not make
difference whether it is mutually exclusive or independent, only the S
is acceptable as the target payback period is 2 years and S payback
period is 1.6 years.
J-(3) what is the difference between the regular and
discounted payback periods?

In the regular payback period the future cash flow are used while
under the discounted payback period, the present value of future
cash flows are used.

J-(4) what is the main disadvantage of discounted payback?

Is the payback method of any real usefulness in capital
budgeting decisions?

Due to its disability to cover the future cash flow for the whole life of
the project, it is not used for the evaluation of capital budgeting. k.
As a separate project (Project P), you are considering sponsorship of
a pavilion at the upcoming World's Fair. The pavilion would cost
$800,000 and it is expected to result in $5 million of incremental cash
inflows during its single year of operation. However, it would then take
another year, and $5 million of costs, to demolish the site and return it
to its original condition. Thus, Project P's expected net cash flows
look like this (in millions of dollars): year Net Cash Flows

K. (1) what is each project’s initial NPV without replication?

Year PFIF L S PV L PV S
0 1 -100000 -100000 --100000 -100000
1 0.909091 60000 33500 54545.45 30454.55
2 0.826446 60000 33500 49586.78 27685.95
3 0.751315 0 33500 0 25169.05
4 0.683013 0 33500 0 22880.95
NPV 4132.23 6190.49

K- (2) what is each project’s equivalent annual annuity?

L = 60000 , S = 33500
 K-(3) now applies the replacement chain approach to
determine the projects’ extended NPVs. Which project
should be chosen?

`
Year PFIF L S PV L PV S
0 1 -100000 -100000 -100000 -100000
1 0.9090 60000 33500 54545.45 30454.55
2 0.826446 60000 33500 49586.78 27685.95
3 0.751315 -40000 33500 30052.59 25169.05
4 0.683013 60000 33500 40980.81 22880.95
NPV 15060.45 6190.49

Franchise L should be chosen.

K-(4) now assumes that the cost to replicate Project S in 2

years will increase to $105,000 because of inflationary
pressures. How should the analysis be handled now, and
which project should be chosen?

Still the increase in 5000 will make the NPV to 10060.45 which is
more than Franchise S, therefore the decision is unchanged

L- What is the project’s NPV if it is operated for the

full 3 years? Would the NPV change if the company planned
to terminate the project at the end of Year 2? at the end of
year 1? What is the project’s optimal (economic) life?

Yes it will further increase in terms of negativity to $529

At the end of Year 1 , It will further increase but the amount cannot
be calculated as no data is given. The optimal life
Is 3 years with lowest negative NPV.
M- after examining all the potential projects, you discover
that there are many more projects this year with positive
NPVs than in a normal year. What two
problems might this extra large capital budget cause?

A: Availability of fund

B: Ranking of projects