__SECTION 1: SHORT ANSWER PROBLEMS__**Vindaloo Corporation reported retained earnings of $400 on its year-end 2002 balance sheet. During 2003, the company reported a loss of $40 in net income, and it paid out a dividend of $60. We will calculate retained earnings for Vindaloo's 2003 year-end balance sheet.**

**Retained earnings for Vindaloo's 2003.**

Particulars | Amount |

Retained Earning 2002 | 400 |

Less : Loss during The year | 40 |

Less : Divided pay out | 60 |

Retained Earning 2003 | 300 |

**A firm has an ROA of 8%, sales of $100, and total assets of $75. Lets calculate its profit margin.**

Total Assets | $ 75.00 |

8% ROA | $ 6.00 |

(Total Assets * ROA = 75*(8/100) = 6) | |

Total Sales | $ 100.00 |

Profit Margin | $ 6.00 |

(Profit / Total Sales = ) |

**Given the following information: profit margin = 10%; sales = $100; retention ratio = 40%; assets = $200; equity multiplier = 2.0. If the firm maintains a constant debt-equity ratio and no new equity is used, what is the maximum sustainable growth rate (SGR)? (Assume a constant profit margin.)**

Particulars | Details |

profit margin | 10% |

Sales | 100 |

Total Profit | 10 |

Retention | 4 |

Total Assets | 200 |

Equity Multiplier | 2 |

Total equity | 100 |

(Total Assets/ equity multiplier) | |

Total debt | 100 |

Debt Equity ration constant | |

ROE | 0.1 |

Retention Ratio | 40% |

ROE* Retention Retio | 0.04 |

1-ROE* Retention Retio | 0.96 |

SGR=ROE*R.R/1-ROE*R.R | 4.17% |

**Your brother-in-law invests in the stock market and doubles his money in a single year while the market, on average, earned a return of only about 15%, here a discussion is done whether your brother-in-law’s performance a violation of market efficiency or not.**

**No, brother in law performance is not violation of market efficiency; this indicates that Brother in law has taken much higher risk than the average market. If it suits him so be it (Preda, 2009).**

**This could also indicate that the Brother in law had some good market tips and exited at most opportune time without hanging around with the stocks.**

**Iggie's Used Cars will sell you a 2002 Suzuki Aerio for $3,000 with no money down. You agree to make weekly payments of $40 for two years, beginning one week after you buy the car. What is the EAR of this loan?**

**For calculating Ear, formula is**

**Where EAR=Effective annual rate**

**K=Nominal interest rate**

**M=Compounding frequency per year (Randall, 2007)**

**c**

**NOMINAL RATE OF INTEREST= (difference in total amount paid per year/total amount paid)/100**

**[ 4160-3000=1160 For 2 yrs = 580 per yr]**

**=(580/3000)*100= 19.33%**

**Putting value in EAR we get**

**52**

**EAR = (1+19.33/52) – 1**

**Solving this we get EAR= 21.2812 %**

**Rebus company is trying to make a decision between two projects. Their calculations are as below.**

Year | Project I | Project II | |

Payback (yrs.) | 2.053 Year | 1.92 Year | |

Discounted Payback (yrs.) | 2.44 Year | 1.25 Year | |

IRR | 15.41% | 28.44% | |

NPV | 3907 | 3843 |

**Payback period calculation**

PROJECT A | PROJECT B | ||

Cash inflow | cumulative cash inflow | Cash inflow | cumulative cash inflow |

8500 | 8500 | 6500 | 6500 |

9000 | 17500 | 6000 | 12500 |

9500 | 27000 | 7000 | 19500 |

**Project A**

**Payback period = 2 yrs + [18000-17500 / (27000-17500)]**

**= 2.053 years**

**Project B**

**Payback period = 1 yrs + [12000-6500/ (12500-6500]**

**= 1.92 years**

**Discounted Payback period calculation**

PROJECT A | PROJECT B | ||||||

Cash inflow | Discounted fector (11%) | cumulative cash inflow | Cash inflow | Cash inflow | Discounted fector (11%) | cumulative cash inflow | cumulative cash inflow |

8500 | 0.9009 | 7657.65 | 7657.65 | 6500 | 0.9009 | 5855.85 | 5855.85 |

9000 | 0.8116 | 7304.4 | 14962.05 | 6000 | 0.8116 | 4869.6 | 10725.45 |

9500 | 0.7311 | 6945.45 | 21907.5 | 7000 | 0.7311 | 5117.7 | 15843.15 |

**Project A**

**Discounted Payback period = 2 yrs + [18000-14962 / (21907-14962)]**

**= 2.44 years**

**Project B**

**Payback period = 1 yrs + [12000-10725/ (15843-10725]**

**= 1.25**

**Net present value (11%IRR)**

**Project A**

**21907-18000=3907**

**Project 2**

**15843-12000= 3843**

**Calculation of internal rate of return (IRR)**

PROJECT A | | ||||||||

year | cash inflow | discounted factor@15% | discounted cash inflow | discounted factor@16% | discounted cash inflow | discounted factor@14% | discounted cash inflow | | |

1 | 8000 | 0.869 | 6952 | 0.862 | 5992.624 | 0.877 | 5255.5 | | |

2 | 9500 | 0.756 | 7182 | 0.743 | 5336.226 | 0.769 | 4103.5 | | |

3 | 9000 | 0.657 | 5913 | 0.64 | 3784.32 | 0.674 | 2550.6 | | |

3.351 | 20047 | 3.273 | 15113.17 | 3.273 | 11909.7 | | |||

| | | | | | | | | |

IRR using interpretation formula Project A = 15% - (18000-15113.17/ 20047-15113) = 15% - 0.5851 = 15.415% | | ||||||||

| |||||||||

PROJECT B | | ||||||||

year | cash inflow | discounted factor@28% | discounted cash inflow | discounted factor@29% | discounted cash inflow | discounted factor@30% | discounted cash inflow | | |

1 | 6500 | 0.7813 | 5078.45 | 0.7752 | 5038.8 | 0.7692 | 4999.8 | | |

2 | 6000 | 0.6104 | 3662.4 | 0.6001 | 3600.6 | 0.5917 | 3550.2 | | |

3 | 7000 | 0.477 | 3339 | 0.4658 | 3260.6 | 0.4551 | 3185.7 | | |

3.351 | 12079.85 | 3.273 | 11900 | 11735.7 | | ||||

| | | | | | | | | |

IRR using interpretation formula Project A = 29% - (12000-11900/ 12080-11900) = 29% - 0.556 = 28.44% | | ||||||||

| |||||||||

| | | | | | | | |

__SECTION 2__**Problem 1**

Assets | Amount | 25% | 90% capacity of acutal | |

Cash | 50 | 62.5 | 45 | |

Inventory | 150 | 187.5 | 135 | |

FA | 600 | 750 | 540 | |

Total | 800 | 1000 | 720 | |

Liability | Amount | 25% | | |

Accounts payble | 100 | 125 | 90 | |

Notes payble | 100 | 125 | 90 | |

long term Debt | 350 | 434 | 477 | |

Equity | 250 | 250 | 250 | |

800 | 1000 | | ||

Reserves and Surplus | 0 | 66 | 47 | |

| ||||

Particulars | Amount | 25% | 90% of actual | |

Sales | 800 | 1000 | 720 | |

Cost | 600 | 750 | 540 | |

Profit | 200 | 250 | 180 | |

Taxes | 68 | 85 | 61 | |

132 | 165 | 119 | |

**a)**

**External finance if sales increased by 25% :**

**Effect of increase in 25% sasles is already given in the table above.**

**As menationed in question, 40% is retained.**

**So retained profit=165*40/100=66 (add as reserves and surplus to liability)**

**Now if we balance both sides we get Long Term debt = $ 434**

**So total external financing need is $434.**

**Firm is producing at only 90% capacity**

**In this case, looking at figures in above calculation, external financing will increase from $434 to $477 due to decrease in working capacity. Since amount of profit retained is less, the firm has to maintain more external financing to meet its requirement.**

**B) Suppose the firm wishes to maintain a constant debt-equity ratio, retains 60% of net income, and raises no new equity. Assets and costs maintain a constant ratio to sales. What is the maximum increase in sales the firm can achieve.**

**Lets find debt equity ratio.**

Debt-to-Equity Ratio = | Total Liabilities |

Shareholders' Equity |

**= 800/250 = 3.2**

**Looking at the calculation above, there can be no change in total liability or equity amount as debt equity ratio is to be maintained. So any change to be made in liability side can be only done through change on long term debt. As plant is already operating on 100% capacity, the maximum possible sale is $800**

**Problem 2**

**The managers of Magma International, Inc. plan to manufacture engine blocks for classic cars from the 1960s era. Cetain values are given. We will calculate following things**

**1) Depreciation tax shield in the third year for this project (Nissim, 2002).**

**CCA at 30% = Machinery Cost*30%**

**Depreciation tax shield = Machinery cost- CCA**

Machinery cost | CCA @30% | Depreciated Tax shield |

800000 | 240000 | 560000 |

560000 | 168000 | 392000 |

392000 | 117600 | 274400 |

**2) Present value of CCA tax shield**

Machinery cost | CCA @30% | Depreciated Tax shield | Discounting Factor | Present value of Cca tax shield |

800000 | 240000 | 560000 | 0.892857143 | 500000 |

560000 | 168000 | 392000 | 0.797193878 | 312500 |

392000 | 117600 | 274400 | 0.711780248 | 195312.5 |

274400 | 82320 | 192080 | 0.635518078 | 122070.3125 |

192080 | 57624 | 134456 | 0.567426856 | 76293.94531 |

**Discounted Value @ 12% = 1**

^{st}year = 1/1.12**= 2**

^{nd}yr = 1^{st}year discounted rate/ 1.12**3) the minimum bid price the firm should set as a sale price for the blocks if the firm were in a bidding situation**

price of machine | 800000 |

cost for block | 125000 |

fixed cost | 125000 |

total cost | 1050000 |

less salvage value | 150000 |

total cost | 900000 |

less depreciation @30% | 630000 |

add: Tax@35% | 850500 |

**From above table, the firm has to bid a minimum amount of $850500. It can add industry profit to it and bid accordingly.**

**4) NPV of this project**

Inflow | ||||||

Year | Profit | Depreciation | PBT | PAT | Disc Factor @ 8% | PV of Cash Profit |

2 | 150000 | 45000 | 105000 | 36750 | 0.892857143 | 32812.50001 |

3 | 150000 | 45000 | 105000 | 36750 | 0.797193878 | 29296.87502 |

4 | 150000 | 45000 | 105000 | 36750 | 0.711780248 | 26157.92411 |

5 | 150000 | 45000 | 105000 | 36750 | 0.635518078 | 23355.28937 |

6 | 150000 | 45000 | 105000 | 36750 | 0.567426856 | 20852.93696 |

0 | ||||||

Total PV cash profit | 132475.5255 | |||||

Salvage of plant & machinery | 150000 | |||||

TOTAL INFLOW | ||||||

Net cash Inflow | -17524.47454 | |||||

**PROBLEM 3**

**cost of equity based on the dividend growth model**

**Cost of Equity = (Next Year's dividends per share / Current market value of stock) + Growth rate of dividends**

**= (1.8/8)+4% = 6.17%**

**Cost of equity = 6.17 %**

**cost of equity based on the security market line**

**Cost of equity = r**

_{f}+ B_{s}(E_{mkt}- r_{f})**Where: r**

_{f}= the risk-free rate**B**

_{s}= the beta of the investment**E**

_{mkg}= the expected return of the market**Here cost of equity = 4**

_{+ 1.2 (12-4) }= 13.6 %**the cost of financing using preferred stock**

**The cost of preferred stock is equal to the preferred dividend divided by the preferred stock price, plus the expected growth rate.**

**SO here in this case, Cost of Preferred stock = (1.8/83)+12 = 12.01**

**pre-tax cost of debt financing**

**lets calculate**

**1- (Company tax rate/100) = 0.66**

**Pre tax costing = (400000*83)/.66 = $50303030**

**weight to be given to equity in the weighted average cost of capital computation**

**In financial decision making, financing of firm’s assets is done by either debt or equity. The weighted average cost of capital (WACC) measures the average riskiness of a firm's assets by calculating the weight of debt and equity to any given situation. In effect, by calculating a weighted average, a firm can estimate the capital discount of debt and equity in dollar terms.**

**Formula for this is**

**WACC = Wd x Rd(1-T) + Ws x Rs + Wp x Rp**

**where:**

**Wd: the weight of debt (percentage of debt allocated to finance the project)****• Ws: the weight of equity (percentage of equity allocated to finance the project)****• Wp: the weight of preferred stocks (percentage of preferred stocks allocated to finance the project)**

**So for this case, percentage of equity allocated to finance the project = (total equity allocated/ total amount of financing)*100**

**the cost of new financing (including the impact of each of 28-year bonds, preferred shares and common shares), assuming that flotation costs would be 5% of the proceeds of the issue**

**the cost of financing will have effect of floatation cost at 5% will will affect equity.**

**If net income in the next year is expected to be $8,000,000, what would be the common equity breakpoint for new financing, assuming the current capital structure is considered optimal**

**Current capital structure is optimal**

**Breakeven ppoint =**

__Available Retained Earnings =__800000/10 = 80000**Equity Percentage of Total**

**REFERENCES:**

**Randall, S. (2007). “FRB Speech: Creating More Effective Consumer Disclosures".****Preda, A. (2009). “***Framing Finance: The Boundaries of Markets and Modern Capitalism*.” University of Chicago Press.**Nissim, D. (2002). "Valuation of the Debt Tax Shield".***The Journal of Finance*57 (5): 2045–2073.

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