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BFA503 Principles of Financial Management

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0% found this document useful (0 votes)
35 views19 pages

BFA503 Principles of Financial Management

Uploaded by

azad hossain
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Answer to the question no 2

Given Data:

 Number of shares: 2 million


 Offering price: $25 per share
 Net proceeds: $45 million
 Expenses: $500,000

Underwriting and Expenses:

The gross proceeds from the offering are calculated as follows:

Gross Proceeds=Number of Shares×Offering Price=2,000,000×25=$50,000,000

Net Proceeds = $45,000,000

Total Expenses=Gross Proceeds−Net Proceeds=$50,000,000−$45,000,000=$5,000,000

Underwriting Fee=Total Expenses−Expenses=$5,000,000−$500,000=$4,500,000

i. Market Price = $23 per share

The value of shares in the secondary market: Secondary Market Value=2,000,000×23=$46,000,000

Profit=$4,500,000+($46,000,000−$50,000,000)

Profit=500000

ii. Market Price = $25 per share

The value of shares in the secondary market: Secondary Market Value=2,000,000×25=$50,000,000

Profit=$4,500,000+($50,000,000−$50,000,000)

Profit=4500000

iii. Market Price = $28 per share

The value of shares in the secondary market: Secondary Market Value=2,000,000×28=$56,000,000

Profit=$4,500,000+($56,000,000−$50,000,000)

Profit=$10,500,000
Profit of the situation in Part A

 Market Price = $23 per share: Profit = $500,000


 Market Price = $25 per share: Profit = $4,500,000
 Market Price = $28 per share: Profit = $10,500,000

Part B:

In its simplest form, offering the price of an IPO is one of the most important activities of an
investment banker as it involves several crucial steps necessary to set the price that will see the
company achieve its intended capital alongside assisting investors to make informed decisions. Here
are the key factors and methods involved:Here are the key factors and methods involved:

Company Valuation:

Discounted Cash Flow (DCF) Analysis: It involves assessing the current value of the following cash
that the company expects to get in the future.

Comparable Company Analysis: Further evaluating the company against similar companies in the same
industry to check out for ratios such as P/E ratio, EV/EBITDA and so on.

Precedent Transactions: Analyzing the previous sales of similar franchises to identify average cost of
the business.

Market Conditions: Look at trends in the current and projected economic situation, investors’ demand,
and market sentiment patterns for the particular type of security in question. Triggering events that
hinge on market conditions that allow for a higher offering price are also possible.

Company’s Financial Health and Growth Prospects:Company’s Financial Health and Growth
Prospects:

Examination of the company’s balance sheet, income statement, statement of cash flows, projection of
future sales, market share and position in the industry, and the team responsible for managing the
company. This is particularly the case if the company has good growth potential and if it is in a healthy
financial condition.
Demand Assessment: Road shows and investigations pertaining to book selling enable one to know the
extent of capital demand and thus the necessary price to charge.

Pricing Range and Discount: The general price level should be determining instead of having specific
prices for the products, as this offers flexibility. It also said that a slight deviation from the perceived
fair value assists in attracting investors and hence the placement will be successful.

Regulatory Requirements and Costs: Before going public, it would be important to understand the legal
environment of going public and all the probable costs involved in going public to enable the company
to meet all the legal and filing requirements associated with going public.
Answer to the question no 3

Given,

Machine A:

 Initial Cost: $300,000


 Installation Cost: $25,000
 Total Initial Investment: $325,000
 Life: 5 years
 Increase in Annual Revenues: $180,000
 Increase in Annual Expenses: $95,000
 Annual Net Cash Flow: $180,000 - $95,000 = $85,000
 Salvage Value: $30,000

Machine B:

 Initial Cost: $400,000


 Installation Cost: $32,000
 Total Initial Investment: $432,000
 Life: 8 years
 Increase in Annual Revenues: $240,000
 Increase in Annual Expenses: $160,000
 Annual Net Cash Flow: $240,000 - $160,000 = $80,000
 Salvage Value: $55,000

The situation can be solved through Net Present Value

NPV formula

NPV=∑Ct/(1+r)t−Initial Investment

 Ct is the cash flow in year ttt


 r is the discount rate (10%)
 t is the year
NPV for Machine A:

NPVA=∑5t=1{85,000/(1+0.10)t+30,000(1+0.10)5}−325,000

NPVA=322,218+18,627−325,000

NPVA=15845
NPVB=∑5t=1,80000/(1+0.10)t+55,000//(1+0.10)8−432,000

NPVB=426,792+25,662−432,000
=20,454
NPV is high in Machine B so company should select this Machine

Part B: In this case abnormal costs include; Opportunity cost is cost which arises from applying
the capital budgeting decisions.

Opportunity Cost:

Definition: Opportunity cost: this is simply the outside option benefit that’s given up when the decision
is made. In capital budgeting, it means the valuation of an opportunity cost which arises when capital is
committed to a specific project because it denies the same to other better ventures.

Importance: It must be taken into account as it contributes to effectiveness of identifying the proper
investment that would be the most valuable with the available resources. Many authors have noted that
neglecting opportunity costs may result in wrong decisions concerning timely investments.

Example:

Taking the above example now let’s look at the opportunity cost; if a company is willing and able to
invest $1 million, and it decides to invest it in Project A expecting an 8% return, the opportunity cost
could be the 10% return it is losing out by not investing in Project B. Therefore, the net gain is 2% less
for choosing Project A over Project B.

Part C: Rules for Free Cash Flow Calculations Free cash flow (FCF) is one of the most used financial
indicators in current business valuation Five general rules governing the calculation of FCF are as
follows.

Include All Incremental Cash Flows:

 Importance: To estimate the cash inflows, all sources of cash relevant for the profitability of the
project only must be taken into account.
 Exclude Sunk Costs:
 Importance: Sunk costs are based on past events and costs which cannot be retrieved and as
such are irrelevant in decision-making processes on future prospects.

Consider Opportunity Costs:

 Importance: It helps in including the returns from the projects that next best utilize the resources
availably to guarantee that the resources are optimally utilised.
 Include Changes in Net Working Capital:Include Changes in Net Working Capital:
 Importance: In the present jurisdiction, the changes in the current assets and current liabilities
relate to liquidity and cash flow which is vital in the financial health of the company.

Account for Terminal Value:

 Importance: The terminal value is the value of any additional cash flows accruing from the
project beyond the horison period and can be calculated as:
 They allow the FCF calculation to accurately portray the requisite economic effects of the
project to help guide the organization to make better investment decisions.
Answer to the question no 4
Part A: Calculate the Company's Weighted Average Cost of Capital (WACC)
1. Cost of Debt (After-Tax)

Given:

Market price of the bond: $1,024.87

Face value: $1,000

Coupon rate: 9% (semiannual pay, so 4.5% per period)

Maturity: 15 years

Tax rate: 40%

First, calculate the yield to maturity (YTM) of the bonds. This is the internal rate of return (IRR) on the
bond's cash flows.

The semiannual YTM can be found using the bond pricing formula, but it is generally easier to use a
financial calculator or Excel to solve for YTM. Here, I'll use Excel's RATE function to find the
semiannual YTM, then annualize it:

YTM (semiannual)=RATE(30,45,−1024.87,1000)

YTM (semiannual)≈4.365%

Annual YTM:

YTM (annual)=4.365%×2=8.73%

After-tax cost of debt:

Cost of Debt (after-tax)=YTM×(1−Tax Rate)=8.73%×(1−0.40)=5.238%

2. Cost of Preference Shares

Given:
Market price of preference shares: $20

Annual dividend: $1.20

Cost of preference shares:

Cost of Preference Shares= Dividend/ Market Price


= 1.20/20
=6%
3. Cost of Ordinary Shares
Given:
Current price: $20
Dividend next year: $2.20
Growth rate: 7%
Using the Gordon Growth Model:
Cost of Ordinary Shares
 Current price: $20
 Dividend next year: $2.20
 Growth rate: 7%
= (2.20/2)+.07
=18%
4. Market Value of Each Component
Debt: $200,000,000 (Given)
Preference Shares: 2,000,000 shares
×
× $20 = $40,000,000
Ordinary Shares: 14,000,000 shares × $20 = $280,000,000
Total market value:
Total Market Value=200,000,000+40,000,000+280,000,000=520,000,000

5. Proportions of Each Component


wDebt=200,000,000/520,000,000=0.3846
wPreference Shares=40,000,000/520,000,000/=0.0769
wOrdinary Shares=280,000,000/520,000,000=0.5385
6. WACC Calculation
WACC=(0.3846×0.05238)+(0.0769×0.06)+(0.5385×0.18)
WACC=0.02014+0.00461+0.09693
WACC≈0.12168
or
12.17
%
WACC≈0.12168 or 12.17%
Part B: Treatments for Employing Current WACC for Investment Appraisal
1. Similar Risk Profile
Condition: The risk tolerance for the new project cannot be vastly different from the risk tolerance of
similar projects in the existing portfolio of the organization.
Reason: Unlike the cost of equity, WACC is determined with an aim of reflecting the firm’s total risk
and sources of its funds. In this case, the project’s cost of capital could not be well determined if the
company’s WACC is utilised where the nature of risk of the new project is ambiguous.
Action if Not Satisfied: Improve the WACC by aligning it with the risk level related to the project in
question. They might involve the use of a different discount rate than the one representing the average
risk of the entire business as a whole if the risk assessment of the particular project differs from the
average risk.
2. Capital Structure Stability
Condition: In areas of financing, we need to ensure that the company has little fluctuation in capital;
that means, debt, preference shares and equity have to be in right proportions throughout the life of the
project.
Reason: WACC also requires a constant capital structure on which the percentage for each source of
funding is calculated. Where debt and equity ratios Shift significantly, it structurally changes the cost
of capital hence unsuitable for long-term projects with evaluation through the WACC.
Action if Not Satisfied: As the WACC is the cost of capital expected in the duration of the project, it is
recommended to re-compute it. Such could entail prediction of shift in the ratio of the financing
sources and in prompt adjustment of the WACC.
Answer to the question No 5

To determine the change in EBITDA given a 10% increase in revenue, we need to understand the
relationship between revenue, EBIT, and EBITDA. We are given the following information:

 A 10% increase in revenue results in a 23% increase in EBIT to $130,000.


 Fixed costs (cash only) are $99,000.

Let's denote:

 RRR as the original revenue.


 ΔR as the change in revenue,
 EBIT as the original EBIT.
 ΔEBIT as the change in EBIT, which is 0.23×EBIT0

Given that the new EBIT after a 23% increase is $130,000:

EBIT0+ΔEBIT=130,000EBIT

Since ΔEBIT=0.23×EBIT0 :

EBIT0+0.23×EBIT0=130, 000

1.23×EBIT0=130 000

EBIT0=130,0001.23

EBIT0≈105,691

Now, let's calculate ΔEBIT

ΔEBIT=0.23×105,691

ΔEBIT≈24,309

Original EBIT was approximately $105,691, and it increased by $24,309 to reach $130,000.

Fixed Costs and EBITDA

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) is EBIT plus depreciation
and amortization (D&A).

Given that the fixed costs are cash only, they do not include D&A. This implies that all fixed costs are
operational and included in EBIT.
To find the change in EBITDA, we need to add the change in EBIT to the original EBIT without any
additional adjustments for D&A (since we do not have these details).

ΔEBITDA=ΔEBIT

Therefore, the change in EBITDA corresponding to a 10% increase in revenue is the same as the
change in EBIT, which is $24,309.

Summary of Part A

 Change in EBITDA: $24,309

Part B: Degree of Pre-tax Cash Flow Operating Leverage vs. Degree of Accounting
Operating Leverage

Degree of Pre-tax Cash Flow Operating Leverage (DPCFOL)

Definition: DPCFOL measures the sensitivity of pre-tax operating cash flow (EBITDA) to changes in
sales revenue.

Formula: DPCFOL=% ∆ EBITDA/=% ∆ Revenue

Degree of Accounting Operating Leverage (DAOL)

Definition: DAOL measures the sensitivity of EBIT to changes in sales revenue.

Formula: DAOL=%ΔEBIT/%ΔRevenue

Key Differences

 Focus on Cash Flow vs. Accounting Profits:Focus on Cash Flow vs. Accounting Profits:
 DPCFOL: Relates more to operating cash flow, that is operating profit before non-operating
items and expenses such as depreciation and amortization.
 DAOL: Closely committed to accounting profit or Earnings Before Interest and Taxes (EBIT),
because it includes cash and non cash expenses.

Metric Relevance:

DPCFOL: Even more relevant for defining the prospects of the business and its MM capacity, keeping
in mind its readiness to meet its obligations.
DAOL: Can help with understanding the effects introduced by changes in total revenues, and other
non-cash gains or losses.

Importance to Corporate Decision-Makers

 Cash Flow Focus: Managers of companies prefer cash flow figures since cash flow reflects the
operating, investing, and financing activities of a company in a more efficient manner than do
accrual-based earnings.
 Operational Efficiency: The second measure used within this analysis is the degree of pre-tax
cash operating leverage which defines how much additional pre-tax cash flow the managers can
produce for each £1 of operating revenue and it is important to know this for maintaining
adequate financial health.
 Financial Planning: Sources of working capital are the net of cash receipts and cash payments
during a given period and reflect its ability to meet its daily obligations as well as plan for its
capital expenditure needs.

Summary of Part B

DPCFOL: Discusses how responsive EBITDA is to fluctuation in revenue by looking at the cash flow
aspect.

DAOL: The first assesses the variability of EBIT in relation to revenues with particular regard to
accounting profit.

Corporate Interest: Managers still go for profit-relevancy based cash flow metrics (DPCFOL) in order
to have improved picture about liquidity and operation.
Answer to the question no 6

Part A: Dividend Calculations for Well-Led Service Company

Given data

 Earnings for 2023: $50,000,000


 Dividends paid: $20,000,000
 Number of shares: 40 million
 Current market price per share: $31.25

i. Dividend Payout Ratio

Dividend payout ratio means determination of the ratio of the dividend that has been paid to the
earnings of the company.

Dividend Payout Ratio= Dividends Paid /Earnings

Dividend Payout Ratio=$20,000,000/$50,000,000=0.4 or 40%

ii. This constant component of the total dividend payout reflects the stated or planned dividend per
share on an annual basis.

Dividend Per Share= Dividends Paid/Number of Shares

DividendPer Share=$20,000,000/40,000,000=$0.50

iii. Hence, the following is the company’s statement of dividend per share on a quarterly basis.

If the dividends are paid quarterly in equal amounts, each payment would be:If the dividends are paid
quarterly in equal amounts, each payment would be:

The quarterly dividend per share is equal to the annual dividend per share divided by four in this
pattern of distribution.

Quarterly Dividend Per Share= Annual Dividend Per Share/4

Quarterly Dividend Per Share=$0.50 / 4

=$0.125

iv. Current Dividend Yield


Dividend yield is determined by the dividend per share and the current price per share, whereby the
yield is expressed as a percentage.

Dividend Yield= Annual Dividend Per Share/Current Market Price Per Share

Dividend Yield=$0.50/ $31.25

Dividend Yield≈0.016 or 1.6%

Dividend Yield≈0.016 or 1.6%

Summary of Part A

Dividend Payout Ratio: 40%

Annual Dividend Per Share: $0.50

Quarterly Dividend Per Share: $0.125

Current Dividend Yield: 1.6%

Part B: Residual Theory of Dividends and Dividend Smoothing

Residual Theory of Dividends

The theory of residual dividends argues that a company ought to only issue returns of profits to its
investors from the remaining equity capital after all good investment projects have been funded.
According to this theory:

1. Investment Opportunities: Profitable projects should be funded most whilst the idea of financing a
project should not be emphasized.

2. Residual Earnings: The distribution of the earnings comes after the Company has considered all the
likely investments that could be made.

3. No Fixed Payouts: In this context, it is also important to understand that the principal and dividend
payments may change depending on the opportunities of finding other profitable projects and the level
of residual earnings.

Conflict with Dividend Smoothing


Dividend smoothing on the other hand is the process of ensuring that a company declares near constant
dividends for a particular financial year notwithstanding the volatility of the operating profits.

1. Stable Dividends: Managers like to maintain a stable stream of dividends as this renders the opposite
signal to its intended users.

2. Investor Expectations: People have a tendency to conduct subjective estimations of the company’s
performance based on different signals, including the frequency and amount of dividends paid. If a
company decides to cut on the dividend it will convey an improper signal that the management does
not have confidence in future earnings.

3. Conflict with Residual Theory: The residual theory people should use investment opportunities and
residuals in deciding on the appropriate amount of dividends. However, smoothing indicates a higher
and more predictive dividend policy in a given period though it involves use of debt or accumulated
funds in certain years.

Summary

The theory of dividends that underlies such behavior is known as the residual theory of dividends,
which advocates for variable dividend payments depending on the investments and residual income. On
the other hand, dividend smoothing seeks to bring the levels of dividends issued within a certain level
of consistency and reliability, and therefore may contradict the concept or theory of dividend relevancy
which the residual model fulfills to ensure that all available residual gains are distributed among the
stockholders in the form of dividends.
Answer to the question 7

Part A: Expected Return and Standard Deviation

To find the expected return and standard deviation of the returns on Lake Malbena Scenic Tours Ltd.
shares, we will use the following formulas:

Expected Return

The expected return (\(\overline{R}\)) is the average of the returns over the given period.

R=1/N∑i=1N Ri

Where:

N is the number of years

Ri is the return in year \(i\)

Given returns:

Year 1: -8%

Year 2: 3%

Year 3: 16%

Year 4: 5%

ER ={-0.08 + 0.03 + 0.16 + 0.05}/4

ER= .16/4

ER= 4%

Standard Deviation

The standard deviation (\(\sigma\)) measures the dispersion of the returns from the expected return.

σ =√ 1/N∑i=1N (Ri−ER)2

First, calculate the variance (\(\sigma^2\)):

σ 2 = 1/N∑i=1N (Ri−ER)2 Where:


R is each return

ER is the expected return

Let's compute each squared deviation:

1. (R1− E R)2= (-0.08 - 0.04)^2 = (-0.12)^2 = 0.0144\)

2. (R2− E R)2= (0.03 - 0.04)^2 = (-0.01)^2 = 0.0001\)

3. (R3− E R)2= (0.16 - 0.04)^2 = (0.12)^2 = 0.0144\)

4. (R4− E R)2= (0.05 - 0.04)^2 = (0.01)^2 = 0.0001\)

Sum these squared deviations:

0.0144 + 0.0001 + 0.0144 + 0.0001 = 0.0290

Calculate the variance:

σ 2 = 0.0290/4 =0.00725

σ= √ 0.00725 ≈0.0852 or 8.52%

Summary of Part A

Expected Return:4%

Standard Deviation: 8.52%

Part B: Variance vs. Covariance in a Portfolio

In a portfolio of 10 shares with equal proportions, the overall risk (variance) of the portfolio depends
not only on the variances of the individual shares but also on the covariances between the pairs of
shares. Here's a conceptual explanation of the importance of each:

Variance of Individual Shares

Definition: Variance then goes further to calculate the variability of returns within a single share in as
far as mean returns are concerned.

Importance: Fluctuations in the value of a share also expound the fact that the higher the variance, the
higher the risk and volatility associated with the return on that particular share. This is because in a
diversified portfolio, it was found that if all the shares have a high variance, then the risk associated
with the portfolio could be high again.

Covariance Between Shares

Definition: Covariance basically determines the extent to which two shares have positive or negative
correlation. If the movements in each variable are in the same direction, then the covariance will be
positive but if, in the opposite direction, then it is negative. This shows that covariance is an important
determinant of diversification process:

 Positive Covariance: The correlations inherent in shares having an overlap will cause the
portfolio’s risk level to rise.
 Negative Covariance: This is because shares that are inversely positioned to each other have a
positive impact on the overall volatility of a given portfolio.

Relative Importance in a Portfolio

Diversification Effect: The first and major drive for diversification is risk reduction where share of risk
associated with one organization are taken and mixed with those which are not perfectly correlated.

Portfolio Variance Formula: When the investments are in equal portions, that is, when w i = w j and the
sum is equal to 1, the variance of the portfolio the population variance (σp²) in a single line as:

σp² = 1 / N² Σᵢ=1N Σⱼ=1=N Cov(Ri, Rj)

Where:

N is the number of share:

Cov(Ri,Rj) stands for the covariance of the return of any share i and the return of share j

Analysis

Variance Contribution: The variance of every share is added to the portfolio variance of the entire
portfolio. But this one is done by dividing the contribution by the square of the number of shares which
signifies it is less effective in large portfolios.

Covariance Contribution: These are avaled using covariance terms which brings \(N(N-1)\) terms while
variances are only \(N\), implying that covariances are normally larger than variances and hence are
more relevant in determining portfolio risk. Spreading across shares with small or negative coefficients
of variability is the best way of avoiding high risk within the total portfolio.

In addition, it better to round up saying that the covariances of the shares are more egregious than the
individual deviations of shares in the rivalry of a diversified portfolio. This means the choice is to be
designed in such a way that it buys shares which returns don’t correlate to reduce risk as much as
possible.

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