Tutorial 1 Week 4

Tutorial 1 Week 4

Chapter 1 (Overview of Financial Management)

Q1.The goal of the managers of companies is to maximize profit. Do you agree? Why or why not?

No! I am not agree. The goal of profit maximization stresses the efficient use of capital resources. It assumes away many of the complexities of the real world and for this reason is unacceptable.

a.One of the major criticisms of profit maximization is that it assumes away uncertainty of returns. That is, projects are compared by examining their expected values or weighted average profit.

b.Profit maximization is also criticized because it assumes away timing differences of returns.

Profit maximization is unacceptable and a more realistic goal is needed. Rather than use this goal, we have chosen maximization of shareholders' wealththat is, maximization of the market value of the firm's common stockbecause the effects of all financial decisions are included. The shareholders react to poor investment or dividend decisions by causing the total value of the firm's stock to fall and react to good decisions by pushing the price of the stock upward. In this way all financial decisions are evaluated, and all financial decisions affect shareholder wealth.

Q2.What is shareholders wealth? Say you own 10,000 shares in Tenaga Nasional. How can you determine your wealth (i.e shareholder wealth)?

Number of shares outstanding times the market price per share.

If we own 10,000 shares of Tenaga Nasional and market share price is RM 15, so, our wealth is 10,000 units x RM 15 = RM 15,000.

Q3.Unethical behavior is acceptable if it brings additional profit to company. Do you agree? Why or why not?

No. THERE IS NO ROOM FOR UNETHICAL BEHAVIOR IN THE BUSINESS WORLD.

Q4.Give three (3) examples of unethical behavior in a company. What can you as a manager do to help ensure your subordinates do not commit the behavior you mentioned above?a. Misleading accounting practices that led to overstated profits, e.g. in the case of Enron and Worldcom.

b. Holding information about bad products.

c. Failing to take costly but needed measures to protect the environment.

Action should be taken by the managers:

a. In house training program on the corporate value and the importance of ethics in the business environment.

b. Close supervision on the information/account reporting to ensure conformity with the accounting practices.

c. Reasonable reward and punishment

Q5.Text book questions:

Q 1-3If investors are more confident that Company As cash flows will be closer to their expected value than Company Bs cash flows, then investors will drive the stock price up for Company A. Consequently, Company A will have a higher stock price than Company B.

Q 1-5A firms intrinsic value is an estimate of a stocks true value based on accurate risk and return data. It can be estimated but not measured precisely. A stocks current price is its market pricethe value based on perceived but possibly incorrect information as seen by the marginal investor. From these definitions, you can see that a stocks true long-run value is more closely related to its intrinsic value rather than its current price.

Q 1-6Equilibrium is the situation where the actual market price equals the intrinsic value, so investors are indifferent between buying or selling a stock. If a stock is in equilibrium then there is no fundamental imbalance, hence no pressure for a change in the stocks price. At any given time, most stocks are reasonably close to their intrinsic values and thus are at or close to equilibrium. However, at times stock prices and equilibrium values are different, so stocks can be temporarily undervalued or overvalued.

Q 1-7If the three intrinsic value estimates for Stock X were different, I would have the most confidence in Company Xs CFOs estimate. Intrinsic values are strictly estimates, and different analysts with different data and different views of the future will form different estimates of the intrinsic value for any given stock. However, a firms managers have the best information about the companys future prospects, so managers estimates of intrinsic value are generally better than the estimates of outside investors.

Q 1-8If a stocks market price and intrinsic value are equal, then the stock is in equilibrium and there is no pressure (buying/selling) to change the stocks price. So, theoretically, it is better that the two be equal; however, intrinsic value is a long-run concept. Managements goal should be to maximize the firms intrinsic value, not its current price. So, maximizing the intrinsic value will maximize the average price over the long run but not necessarily the current price at each point in time. So, stockholders in general would probably expect the firms market price to be under the intrinsic valuerealizing that if management is doing its job that current price at any point in time would not necessarily be maximized. However, the CEO would prefer that the market price be highsince it is the current price that he will receive when exercising his stock options. In addition, he will be retiring after exercising those options, so there will be no repercussions to him (with respect to his job) if the market price dropsunless he did something illegal during his tenure as CEO.

Q 1-9The board of directors should set CEO compensation dependent on how well the firm performs. The compensation package should be sufficient to attract and retain the CEO but not go beyond what is needed. Compensation should be structured so that the CEO is rewarded on the basis of the stocks performance over the long run, not the stocks price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so the CEO will have an incentive to keep the stock price high over time. If the intrinsic value could be measured in an objective and verifiable manner, then performance pay could be based on changes in intrinsic value. However, it is easier to measure the growth rate in reported profits than the intrinsic value, although reported profits can be manipulated through aggressive accounting procedures and intrinsic value cannot be manipulated. Since intrinsic value is not observable, compensation must be based on the stocks market pricebut the price used should be an average over time rather than on a spot date.

Q 1-11Stockholder wealth maximization is a long-run goal. Companies, and consequently the stockholders, prosper by management making decisions that will produce long-term earnings increases. Actions that are continually shortsighted often catch up with a firm and, as a result, it may find itself unable to compete effectively against its competitors. There has been much criticism in recent years that U.S. firms are too short-run profit-oriented. A prime example is the U.S. auto industry, which has been accused of continuing to build large gas guzzler automobiles because they had higher profit margins rather than retooling for smaller, more fuel-efficient models.

Q 1-12Useful motivational tools that will aid in aligning stockholders and managements interests include: (1) reasonable compensation packages, (2) direct intervention by shareholders, including firing managers who dont perform well, and (3) the threat of takeover.

The compensation package should be sufficient to attract and retain able managers but not go beyond what is needed. Also, compensation packages should be structured so that managers are rewarded on the basis of the stocks performance over the long run, not the stocks price on an option exercise date. This means that options (or direct stock awards) should be phased in over a number of years so managers will have an incentive to keep the stock price high over time. Since intrinsic value is not observable, compensation must be based on the stocks market pricebut the price used should be an average over time rather than on a spot date.

Stockholders can intervene directly with managers. Today, the majority of stock is owned by institutional investors and these institutional money managers have the clout to exercise considerable influence over firms operations. First, they can talk with managers and make suggestions about how the business should be run. In effect, these institutional investors act as lobbyists for the body of stockholders. Second, any shareholder who has owned $2,000 of a companys stock for one year can sponsor a proposal that must be voted on at the annual stockholders meeting, even if management opposes the proposal. Although shareholder-sponsored proposals are non-binding, the results of such votes are clearly heard by top management.

If a firms stock is undervalued, then corporate raiders will see it to be a bargain and will attempt to capture the firm in a hostile takeover. If the raid is successful, the targets executives will almost certainly be fired. This situation gives managers a strong incentive to take actions to maximize their stocks price.

Q 1-13a.Corporate philanthropy is always a sticky issue, but it can be justified in terms of helping to create a more attractive community that will make it easier to hire a productive work force. This corporate philanthropy could be received by stockholders negatively, especially those stockholders not living in its headquarters city. Stockholders are interested in actions that maximize share price, and if competing firms are not making similar contributions, the cost of this philanthropy has to be borne by someone--the stockholders. Thus, stock price could decrease.

b.Companies must make investments in the current period in order to generate future cash flows. Stockholders should be aware of this, and assuming a correct analysis has been performed, they should react positively to the decision. The Mexican plant is in this category. Capital budgeting is covered in depth in Part 4 of the text. Assuming that the correct capital budgeting analysis has been made, the stock price should increase in the future.

c.U.S. Treasury bonds are considered safe investments, while common stock are far more risky. If the company were to switch the emergency funds from Treasury bonds to stocks, stockholders should see this as increasing the firms risk because stock returns are not guaranteedsometimes they go up and sometimes they go down. The firm might need the funds when the prices of their investments were low and not have the needed emergency funds. Consequently, the firms stock price would probably fall.

Chapter 3 (Financial Statements, Cash Flows)

Q1.Text book questions:

Q 3-1The four financial statements contained in most annual reports are the balance sheet, income statement, statement of retained earnings, and statement of cash flows.

Q 3-4No! The $20 million of retained earnings would probably not be held as cash. The retained earnings figure represents the reinvestment of earnings by the firm. Consequently, the $20 million would be an investment in all of the firms assets.

Q 3-7The emphasis in accounting is on the determination of accounting income, or net income, while the emphasis in finance is on net cash flow. Net cash flow is the actual net cash that a firm generates during some specified period. The value of an asset (or firm) is determined by the cash flows generated. Cash is necessary to purchase assets to continue operations and to pay dividends. Thus, financial managers should strive to maximize cash flows available to investors over the long run.

Although companies with relatively high accounting profits generally have a relatively high cash flow, the relationship is not precise. A businesss net cash flow generally differs from net income because some of the expenses and revenues listed on the income statement are not paid out or received in cash during the year.

Most other companies have little if any noncash revenues, but this item can be important for construction companies that work on multi-year projects, report income on a percentage of completion basis, and then are paid only after the project is completed. Also, if a company has a substantial amount of deferred taxes, which means that taxes actually paid are less than that reported in the income statement, then this amount could also be added to net income when estimating the net cash flow. The relationship between net cash flow and net income can be expressed as:

Net cash flow = Net income + Non-cash charges Non-cash revenues.

The primary examples of non-cash charges are depreciation and amortization. These items reduce net income but are not paid out in cash, so we add them back to net income when calculating net cash flow. Likewise, some revenues may not be collected in cash during the year, and these items must be subtracted from net income when calculating net cash flow. Typically, depreciation and amortization represent the largest non-cash items, and in many cases the other non-cash items roughly net to zero. For this reason, many analysts assume that net cash flow equals net income plus depreciation and amortization.

Q 3-8Operating cash flow arises from normal, ongoing operations, whereas net cash flow reflects both operating and financing decisions. Thus, operating cash flow is defined as the difference between sales revenues and operating expenses paid, after taxes on operating income. Operating cash flow can be calculated as follows:

Operating cash flow= EBIT (1 T) + Depreciation and amortization

= NOPAT + Depreciation and amortization.

Note that net cash flow can be calculated as follows:

Net cash flow = Net income + Depreciation and amortization.

Thus, the difference between the two equations is that net cash flow includes after-tax interest expense.

Q 3-9NOPAT is the profit a company would generate if it had no debt and held only operating assets. Net income is the profit available to common stockholders; thus, both interest and taxes have been deducted. NOPAT is a better measure of the performance of a companys operations than net income because debt lowers income. In order to get a true reflection of a companys operating performance, one would want to take out debt to get a clearer picture of the situation.

Q 3-10Free cash flow is the cash flow actually available for distribution to investors after the company has made all the investments in fixed assets, new products, and operating working capital necessary to sustain ongoing operations. It is defined as net operating profit after taxes (NOPAT) minus the amount of net investment in operating working capital and fixed assets necessary to sustain the business. It is the most important measure of cash flows because it shows the exact amount available to all investors (stockholders and debtholders). The value of a companys operations depends on expected future free cash flows. Therefore, managers make their companies more valuable by increasing their free cash flow. Net income, on the other hand, reflects accounting profit but not cash flow. Therefore, investors ought to focus on cash flow rather than accounting profit.

Q 3-11Yes! Negative free cash flow is not necessarily bad. It depends on why the free cash flow was negative. If free cash flow was negative because NOPAT was negative, this is definitely bad, and it suggests that the company is experiencing operating problems. However, many high-growth companies have positive NOPAT but negative free cash flow because they must invest heavily in operating assets to support rapid growth. There is nothing wrong with a negative cash flow if it results from profitable growth.

Q 3-13Because interest paid is tax deductible but dividend payments are not, the after-tax cost of debt is lower than the after-tax cost of equity. This encourages the use of debt rather than equity. This point is discussed in detail in later chapters: The Cost of Capital and Capital Structure and Leverage.

Q2.Text book problems.

P 3-5Statements b and d will decrease the amount of cash on a companys balance sheet. Statement a will increase cash through the sale of common stock. This is a source of cash through financing activities. On one hand, Statement c would decrease cash; however, it is also possible that Statement c would increase cash, if the firm receives a tax refund.

P 3-7a.From the statement of cash flows the change in cash must equal cash flow from operating activities plus long-term investing activities plus financing activities. First, we must identify the change in cash as follows:

Cash at the end of the year$25,000

Cash at the beginning of the year 55,000

Change in cash-$30,000The sum of cash flows generated from operations, investment, and financing must equal a negative $30,000. Therefore, we can calculate the cash flow from operations as follows:

CF from operations ( CF from investing ( CF from financing= ( in cash

CF from operations ( $250,000 ( $170,000= -$30,000

CF from operations= $50,000.

b.To determine the firms net income for the current year, you must realize that cash flow from operations is determined by adding sources of cash (such as depreciation and amortization and increases in accrued liabilities) and subtracting uses of cash (such as increases in accounts receivable and inventories) from net income. Since we determined that the firms cash flow from operations totaled $50,000 in part a of this problem, we can now calculate the firms net income as follows:

NI ( ( (

=

NI + $10,000 + $25,000 $100,000= $50,000

NI $65,000= $50,000

NI= $115,000.

P 3-9 MVA

= (P0 ( Number of common shares) ( BV of equity

$130,000,000= $60X ( $500,000,000

$630,000,000= $60X

X= 10,500,000 common shares.

P 3-10a.NOPAT= EBIT(1 T)

= $4,000,000,000(0.6)

= $2,400,000,000.

b.NCF= NI + DEP and AMORT

= $1,500,000,000 + $3,000,000,000

= $4,500,000,000.

c.OCF= NOPAT + DEP and AMORT

= $2,400,000,000 + $3,000,000,000

= $5,400,000,000.

d.FCF= NOPAT Net Investment in Operating Capital

= $2,400,000,000 $1,300,000,000

= $1,100,000,000.

Q3.Profit = Cash Do you agree? Why or why not?

Profit is not the same as cash. Profit is calculated on an accrual basis rather than a cash basis.

Q4.A company has RM2 million of cash and equivalents, RM2 million of inventory, $3 million of accounts receivable, RM3 million of accounts payable, RM1 million of accruals and RM2 million of notes payable. What is the net working capital?

Net working capital = (RM2 mil + RM2 mil + RM3 mil) (RM3 mil + RM1 mil + RM2 mil ) = RM1 mil

Q5.Why the market value of a share sometimes maybe higher than its book value and sometimes lower?Q6.What is depreciation and amortization? Why are these called the non-cash expenses?Q7.How do we evaluate whether the cash flow condition of a company is good?Q8.State the impact of the following transaction on cash flow (+,-,NIL). Explain why?a. An increase in account receivable.Decrease (uses of cash) collect less cash than the reported sales. More credit sales.b. Depreciation of non-current asset.Increase (sources of cash) non cash expense.c. A reduction in accounts payable.

Decrease (uses of cash) pay more cash than the reported purchases. More cash purchases.d. Write-of a bad debt.

Increase (sources of cash) non cash expense.e. An issue of ordinary share.Increase (sources of cash) receive cash from shareholders. Q9.Last year, Samudera Corporation had negative net cash flow; however, cash on its balance sheet increased. What could explain this?

Net cash = net -noncash +noncash

flow

income revenues charges

Samudera generate negative cash flow, most probably because of lower net income due to lower sales amount. However, increase in cash means that Samudera receive more cash compare to the previous year such as collection from debtors, issuing more shares and so on.

Q10.What is MVA & EVA? If the BOD are to evaluate the managers performance which of these measurements do you think they should use and why?

MVA (Market Value Added)

-The difference in the market value of the firm and the capital that has been invested in it. Measures wealth created by the firm.

MVA = Firm Value Invested Capital Firm value = market value of firms outstanding debt and equity securities Invested capital = total funds invested in the firm

EVA (Economic Value Added)

- The change in firm value over a specific period of time. Managers of a firm use EVA to evaluate the performance of the firm over specific intervals of time, usually one year- EVA is calculated as

- EVA can also be calculated as

-EVA is related to MVA in the following way: MVA is the present value of all future EVAs over the life of the firm. Thus, managing the firm in ways that increase EVA will generally lead to a higher MVA.

It is better to use EVA to evaluate the managers performance because of two reasons:

a. EVA shows the value added during a given year, whereas MVA reflects performance over the companys entire life, perhaps even including times before the current managers were born.b. EVA can be applied to individual divisions or other units of a large corporation, whereas MVA must be applied to the entire corporation.Q 11.Firm A implemented an expansion plan in year 2005. Below is the information on NOPAT and after tax cost of capital:

After tax cost of capital:

2004 = 10%

2005 = 13%

NOPAT:

2004 = RM114,000

2005 = -RM78,000

Calculate the firms EVA in 2004 and 2005. Does the expansion plan bring benefit to the company? Why or why not?

Chapter 17 (Financial Forecasting)Q1.What is the AFN equation?

Additional funds needed those funds required from external sources to increase the firms assets to support a sales increase. (Not included spontaneous increase in liabilities and retained earnings).

AFN=[ (A*/S0) S ] - [ (L*/S0) S ] - [ MS1(RR) ]

A*=assets that are tied directly to sales. (must increase if sales are to increase).

S0=sales during the last year.

L*=liabilities that are tied directly to sales. (must increase if sales are to increase).

S1=total sales projected for next year.

S=changes in sales sales growth (S1 S0)

M=profit margin (profit / sales)

RR=retention ratio (percentage of net income that is retained: 1-DPO)

How do the following factors affect AFN or the requirement for external capital?a. Retention ratio (RR) negative relationship.

b. Capital intensity (A*/S0) positive relationship.c. Profit margin (M) - negative relationship.

d. Dividend payout ratio (DPO) - positive relationship.e. Sales growth (S) - positive relationship.Q 2.Is it possible for the AFN to be negative? What would that indicate?

Q3.Text book questions:

Q 17-4Accounts payable, accrued wages, and accrued taxes increase spontaneously with sales. Retained earnings increase, but only to the extent that dividends paid do not equal 100% of net income and the profit margin is positive.

Q 17-5a.+.

b.-. The firm needs less manufacturing facilities, raw materials, and work in process.

c.+. It reduces spontaneous funds; however, it may eventually increase retained earnings.

d.+.

e.+.

f.Probably +. This should stimulate sales, so it may be offset in part by increased profits.

g.0.

h.+.

P 17-1AFN= (A*/S0)(S (L*/S0)(S MS1(RR)

= $1,000,000 $1,000,000 0.05($6,000,000)(0.3)

= (0.6)($1,000,000) (0.1)($1,000,000) ($300,000)(0.3)

= $600,000 $100,000 $90,000

= $410,000.

P 17-9S2005 = $2,000,000; A2005 = $1,500,000; CL2005 = $500,000;

NP2005 = $200,000; A/P2005 = $200,000;

Accrued liabilities2005 = $100,000;

A*/S0 = 0.75; PM = 5%; RR = 40%; (S?

AFN= (A*/S0)(S (L*/S0)(S MS1(RR)

$0= (0.75)(S (S (0.05)(S1)(0.4)

$0= (0.75)(S (0.15)(S (0.02)S1

$0= (0.6)(S (0.02)S1

$0= 0.6(S1 S0) (0.02)S1

$0= 0.6(S1 $2,000,000) (0.02)S1

$0= 0.6S1 $1,200,000 0.02S1

$1,200,000= 0.58S1

$2,068,965.52= S1.

Sales can increase by $2,068,965.52 $2,000,000 = $68,965.52 without additional funds being needed.

Q4.Ahmad Companys balance sheet showed the following amounts as of December 31st:

CashRM10Accounts payable RM 15

Accounts receivable40Accrued liabilities5

Inventories50Notes payable20

Net fixed assets100Long-term debt20

Common stock20

Retained earnings 120 Total liabilities

Total assetsRM200 and equityRM200Last year the firms sales were RM2000, and it had a profit margin of 10 percent and a dividend payout ratio of 50 percent. Ahmad operated its fixed assets at 80 percent of capacity during the year. The company expects to increase next years sales by 37.5 percent, to RM2750, but the profit margin is expected to fall to 3 percent and the dividend payout ratio is expected to rise to 60 percent. What is Ahmads additional fund needed (AFN) for next year?

Forecasted sales (137.5%) = RM 2,750

Original sales (100%) = RM 2,000

Sales growth (37.5%)

= RM 750

Assumption: Ahmad wants to maintain the fixed assets to sales ratio for the next year.

AFN =[ (A*/S0) S ] - [ (L*/S0) S ] - [ MS1(RR) ]

=[(200/2,000) x 750] [(20/2,000) x 750] [ 3% x 2,750 x (1-60%)]=75 7.5- 33

= RM 34.50

Assumption: Ahmad wants to add and use the fixed assets at the 100% capacity.

Current usage of fixed assets

= 80%

Increase in sales

= 37.5%

Additional fixed assets needed= 37.5% - 20% = 17.5%

= RM 100 x 17.5% = RM 17.50

AFN =Additional fixed assets + [(A*/S0) S] - [ (L*/S0) S ] - [ MS1(RR) ]

=17.50 + [(100/2,000)x750][(20/2,000)x750][3%x2,750x(1-60%)]=17.50 + 37.5 7.5 - 33

= RM 14.50

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