26768_walter problem in smu mba fin management 2011 spring

8/6/2019 26768_walter Problem in SMU MBA FIN MANAGEMENT 2011 Spring

1/7

MB0045 Financial Management

Set-1

Q.5 The cash flows associated with a project are given below: Year Cash flow0 (100,000)1 250002 400003 500004 400005 30000

Calculate the a) payback period.b) Benefit cost ratio for 10% cost of capital

Ans.

a) Payback period:

The cash flows and the cumulative cash flows of the projects is shown under intable

Table Cash flows and cumulative cash flows

Year Project

Cash flows (Rs.) Cumulative Cash flows

1 25,000 25,000

2 40,000 65,000

3 50,000 115,000

4 40,000 155,000

5 30,000 185,000

From the cumulative cash flow column the initial cash outlay of Rs. 1,00,000 lies

between 2nd year and 3rd year in respect of project.

Therefore, payback period for project is:


2/7

=000,65

000,65000,1002

= 2.54 years

Pay-back period for project B is 2.54 years.

b) Benefit cost ratio for 10% cost of capital

Table: Present Value (PV) of Cash inflows

YearCash inflows

PV factor at 15% PV of Cash in flows

1 25,000 0.909 22,725

2 40,000 0.826 33,040

3 50,000 0.751 37,550

4 40,000 0.683 27,320

5 30,000 0.621 18,630

PV of Cashinflow

139,265

Initial Cash out lay 1,00,000NPV 39,265

Benefit cost ratio

=

PV of Cash

inflow

Initial Cash

outlay

= 139,265

1,00,000

= 1.39


3/7

Q6. A companys earnings and dividends are growing at the rate of 18% pa. The growth

rate is expected to continue for 4 years. After 4 years, from year 5 onwards, the growth rate

will be 6% forever. If the dividend per share last year was Rs. 2 and the investors required

rate of return is 10% pa, what is the intrinsic price per share or the worth of one share.

Ans. :

P = Intrinsic price per share

E = Earnings per share = 18%,

D = Dividend per share = 2

r = Rate of return = 10%

P = [2(1.18)/(1.10)1] + [2(1.18)2/(1.10)2] + [2(1.18)3/(1.10)3]

+ [2(1.18)4/(1.10)4] + [2(1.18)4(1.06)/(1.10)5] + [2(1.18)4(1.06)2/(1.10)6]

+ .

= 2.15 + 2.30 + 2.47 + 2.65 + 2.55 + 2.46

Intrinsic price per share = 14.58


4/7

MB0045 Financial Management

Set-2

Q.4 What is the implication of operating leverage for a firm.

Ans. Operating leverage: Operating leverage is the extent to which a firm uses fixed costs in producing its goods or offering its services. Fixed costs include advertising expenses,administrative costs, equipment and technology, depreciation, and taxes, but not interest on debt,which is part of financial leverage. By using fixed production costs, a company can increase itsprofits. If a company has a large percentage of fixed costs, it has a high degree of operatingleverage. Automated and high-tech companies, utility companies, and airlines generally havehigh degrees of operating leverage.

As an illustration of operating leverage, assume two firms, A and B, produce and sell widgets.Firm A uses a highly automated production process with robotic machines, whereas firm Bassembles the widgets using primarily semiskilled labor. Table 1 shows both firms operatingcost structures.

Highly automated firm A has fixed costs of $35,000 per year and variable costs of only $1.00 perunit, whereas labor-intensive firm B has fixed costs of only $15,000 per year, but its variablecost per unit is much higher at $3.00 per unit. Both firms produce and sell 10,000 widgets peryear at a price of $5.00 per widget.

Firm A has a higher amount of operating leverage because of its higher fixed costs, but firm Aalso has a higher breakeven pointthe point at which total costs equal total sales . Nevertheless,a change of I percent in sales causes more than a I percent change in operating profits for firm A , but not for firm B. The degree of operating leverage measures this effect. The followingsimplified equation demonstrates the type of equation used to compute the degree of operatingleverage, although to calculate this figure the equation would require several additional factorssuch as the quantity produced, variable cost per unit, and the price per unit, which are used todetermine changes in profits and sales:

Operating leverage is a double-edged sword, however. If firm As sales decrease by I percent , itsprofits will decrease by more than I percent, too. Hence, the degree of operating leverage showsthe responsiveness of profits to a given change in sales.

Implications: Total risk can be divided into two parts: business risk and financial risk. Businessrisk refers to the stability of a companys assets if it uses no debt or preferred stock financing.Business risk stems from the unpredictable nature of doing business, i.e., the unpredictability ofconsumer demand for products and services. As a result, it also involves the uncertainty of long-term profitability. When a company uses debt or preferred stock financing, additional risk


5/7

financial riskis placed on the companys common shareholders. They demand a higherexpected return for assuming this additional risk, which in turn, raises a companys costs.Consequently, companies with high degrees of business risk tend to be financed with relativelylow amounts of debt. The opposite also holds: companies with low amounts of business risk canafford to use more debt financing while keeping total risk at tolerable levels. Moreover, using

debt as leverage is a successful tool during periods of inflation. Debt fails, however, to provideleverage during periods of deflation, such as the period during the late 1990s brought on by theAsian financial crisis.

Question No. 5

Answer 5

Total outflow Rs. 150 Million + Rs. 50 Million = Rs. 200 Million

Incremental approach

Revenue Cost

Rs. 250 Million Rs. 100 Million = 150 Million

Pr factor @10% for 5 years = 3.790

@ 150 X 3.790 = Rs. 568.62

Calculation of depreciation:

150

25%

Year Dep Tax saving PV@10% Tax saving

1 37.5 11.25 0.909 10.226

2 28.125 8.4375 0.826 6.969

3 21.09 6.327 0.751 4.751

4 15.82 4.746 0.683 3.241

5 11.87 3.561 0.621 2.211

27.398

Total inflow : 568.62 + 27.398


6/7

= 596.018

+ inflow in 5th

year

50+48 = 98 60.858

X 0.621 656.876

NPV = 656.876 -200

= 456.876

A.6(set -1)

D=40 %

EPS = 40

DPS=16

1.(for40%) 16/12% + (40-16)/12% X 18 %

= 169.33

2.(for 50%) 20/12% + (40-20)/12% X 18 %

= 196.66

3.(for 60%) 24/12% + (40-24)/12% X 18 %

= 224

Q.6 Given the following information, what will be the price per share using the Walter

model.

Earnings per share Rs. 40

Rate of return on investments 18%


7/7

Rate of return required by shareholders 12%

Payout ratio being 40%, 50%, or 60%.

Ans.

D = 40%EPS = 40DPS=161.(for40%) = 16/12% + (40-16)/12% x 18%= 169.332.(for50%) = 20/12% + (40-20)/12% x 18%= 196.663.(for60%) = 24/12% + (40-24)/12% x 18%= 224

26768_walter problem in smu mba fin management 2011 spring

Documents