C38FN2 - REVISION HANDOUT

1. Consider the following financial statement information for the Bulldog Corporation:

Items Beginning (£) Ending (£)

Inventory 8413 10158
Accounts receivable 5108 5439
Accounts payable 6927 7625
Net sales £67,312
Cost of goods sold £52,827

Calculate operating cycle and cash cycle. (Show all your workings)

Answer

Inventory turnover = 5.6892 times

Inventory period = 365 days/5.6892 =
64.16 days
Receivables turnover = 12.7642 times
Receivables period = 365 days/12.7642 =
28.60 days
So, the operating cycle is: 64.16 days + 28.60
days = 92.75 days
Payables turnover = 7.2604 times
Payables period = 365 days/7.2604 =
50.27 days
So, the cash cycle is: 92.75 days – 50.27 days =
42.48 days

2. A firm is considering investing in an Oil project with the following cash flows:

Year Net cash flow(£)

1 1,000
2 1,500
3 2,000
4 1,750
5 1,500
6 1,000
7 500
8 500

The firm has a required rate of return of 10%. The initial investment is £6,250.

I. Calculate the payback period

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 II. Calculate the discounted payback

Answer
i. Payback is the length of time for cumulated future cash inflows to equal an initial
outflow. We accept projects if this time is below an agreed cut-off point..
For this project the payback is 4 years.

ii.

Year Net cash Discount Discounted Cumulative

flow(£) factor cash flow discounted
cash flow
0 (6,250) 1 (6,250) (6,250)
1 1,000 0.9091 909.1 (5,340.9)
2 1,500 0.8264 1,239.6 (4,101.3)
3 2,000 0.7513 1,502.6 (2,598.7)
4 1,750 0.6830 1,195.3 (1,403.4)
5 1,500 0.6209 931.3 (472.1)
6 1,000 0.5645 564.5 92.4
7 500 0.5132 256.6 349.0
8 500 0.4665 233.3 582.3

3. Hose plc presently has a capital structure which is 30 per cent debt and 70 per cent
equity. The cost of debt (i.e. borrowings) before taxes is 9 per cent and that for
equity is 15 per cent. The firm’s future cash flows, after tax but before interest, are
expected to be perpetuity of £ 750,000. The tax rate is 30 per cent. Calculate the
WACC and the value of the firm.

Answer

WACC = Ke We + Kd Wd
WACC = 15 ×0.7 + 9(1 – 0.30) ×0.3 = 12.39%
Value of the firm:
750,000/0.1239
= £6,053,268

4. HW plc. has estimated the cost of debt and equity for various financial gearing
levels

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 % of debt Required rate of
return
debt equity
0.80 9.0 35.0
0.70 7.5 28.0
0.60 6.8 21.0
0.50 6.4 17.0
0.40 6.1 14.5
0.30 6.0 13.5

The optimal capital structure is?

Answer

The optimal capital is 40%debt and 60% equity as this structure gives the following
cost:
6.1 × 0.40 + 14.5 × 0.60 = 11.14
This is the lowest value amongst all costs obtained from other structures.

5. Consider the following three projects, prior to answering the following questions.
Assume that the discount rate is 14%.

Cash Flows (in million £)

Year CDMA G4 Wi-Fi
0 (45,000) (45,000) (55,000)
1 21,000 28,000 32,000
2 25,000 19,000 27,000
3 18,000 25,500 28,000

(i) Compute the net present value (NPV) for each of the three projects. (show all
your workings)

(ii) Compute the internal rate of return (IRR) for each of the three projects. (show
all your workings)

(iii) Suppose these three projects are mutually exclusive. Choose the best project
based on the NPV and IRR methods. (show all your workings)

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 (iv) Suppose these three projects are independent and non-divisible. Which
project(s) should be accepted if the company’s budged for these projects is
£100,000? (show all your workings)

CDMA G4 WIFI
$
(1) NPV $ 4,807.23 $ 11,393.06 12,745.00 Select WIFI
(2) IRR 0.20401 0.29003 0.27780 Select G4
(3) Incremental IRR = 22.20%, Select WIFI
(4) G4 +WIFI
Answer

Question 1(a)

Question 1(b)

(i) Re = 18.7%
(ii) Ru= 14.76%

Question 1(c)
(i) The NPV under the current policy is: 100,000
NPV of the credit policy is: 60,181.58
The company should not grant credit since the NPV is lower.
(ii) P = $532.5

6. Eyes of the World plc has traditionally employed a firm wide discount rate for capital
budgeting purposes. However, its two divisions – publishing and entertainment - have
different degrees of risk given by ßP = 1.0, ßE = 2.0, and the beta for the overall firm is
1.3. The firm is considering the following capital expenditures:

Proposed Project Initial Investment IRR

P1 £1M .130
Publishing P2 £3M .121
P3 £2M .090
E1 £4M .160
Entertainment E2 £6M .170
E3 £5M .140

Which projects would the firm accept if it uses the opportunity cost of capital for

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 the entire company? Which projects would it accept if it estimates cost of capital
separately for each division? Use 6% as the risk-free rate and 12% as the
expected return on the market.
Answer
Overall firm cost of capital: 6% + (12%-6%)1.3 = 13.8%
Accept projects E1,E2, and E3.
Publishing cost of capital: 6% + (12%-6%)1.0 = 12%
Accept projects P1 and P2.
Entertainment cost of capital: 6% + (12%-6%)2.0 = 18%
Accept no projects in this division. Results in contrast to Overall cost of capital when
own risk is considered.

7. The management of firm A is considering starting a new project. The project

requires an initial investment equal to £1,000,000. The risk of the project is identical
to that of the firm’s current risky assets. The expected rate of return on the new
project is 15% annually, forever. The firm’s balance sheet (market values) prior to
the announcement of the investment project is as follows:

Fixed assets £ Equity

5000000 £4000000

Cash Debt
£1000000 £2000000

Total Total
6,000,000 6,000,000

There are 100,000 shares outstanding. The beta of the firm’s stock is equal to 1.35;
the beta of its debt is equal to 0.15. The risk-free rate is equal to 4%, and the expected
market risk premium is 7%. Calculate the beta and the expected return of the firm
using the Capital Asset Pricing Model (CAPM). How reliable are CAPM and C-CAPM
in enabling a firm to measure the cost of capital?
Answer

Market value of equity: 4,000,000

Market value of debt: 2,000,000

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Beta of the firm is equal to the weighted average of the beta of debt and equity:
Beta (Firm) = 4/6 * 1.35 + 2/6 * 0.15 = 0.90 + 0.05 = 0.95

Re=rf+beta* market risk premium

Re=4%+0.95*7%= 10.65%

Students should list the advantageous and disadvantageous of these models, and
then explain how reliable each of these models in measuring the cost of capital.

8. For each of the cases shown in the following table, calculate the present value of
the cash flow, discounting at the rate given and assuming that the cash flow is
received at the end of the period noted.

Case Single cash Discount End of

flow rate period(year)
A 7000 12% 4
B 28000 8% 20
C 10000 14% 12

Answer

NPVA=7000*Annuity12% and 4years

NPV B=28000* Annuity8% and 20years
NPV C=28000* Annuity14% and 12years

Good luck
Dr. M. Sherif
Associate Professor of Finance