Managerial Finance
2.1
Final Exam
Duration 2 Hours
Name:
Hossam Aly Houssein Aly Abd 22227374
Question (1):
Identify the following statements true or false and correct the false:
1. By raising funds through debt, owners of firms can maintain control
of the firm with a limited investment.
False⋅
Explanation:
When a firm raises funds through debt, it typically involves borrowing money that
needs to be repaid with interest. While this allows the firm to leverage its capital
and invest in projects without diluting ownership, it also comes with the obligation
to repay the debt. Failure to do so can lead to loss of control or bankruptcy.
2. If the internal rate of return is equal to or greater than the company’s
required rate of return, the project is not acceptable.
False⋅
Explanation:
This statement is incorrect. The internal rate of return (IRR) is a discount rate that
makes the net present value (NPV) of a project equal to zero. In other words, the
IRR is the rate at which the present value of cash inflows equals the present value
of cash outflows. The decision rule is as follows:
- If IRR > Required Rate of Return (or hurdle rate), the project is considered
acceptable.
- If IRR < Required Rate of Return, the project is considered unacceptable.
3. Cash distributions can take two basic forms: Cash dividend and free
stocks.
False
Explanation:
Although there are many different ways to distribute wealth, the two most common
ways are stock dividends and cash dividends, not "free stocks."
Cash dividend:
A payment given by a firm to its shareholders in the form of cash, typically
expressed as a dollar amount per share. It is an amount that the company
distributes to its shareholders as a fraction of its profits.This occurs when a
business pays out cash to its shareholders as a portion of its earnings. The number
of shares a shareholder owns typically determines how much cash dividend they
will receive.
Stock Dividends:
An organization may choose to provide its owners more shares of stock as a
dividend rather than cash. A stock dividend or bonus shares are what this is. A
shareholder often receives a certain number of additional shares about the number
of shares they currently possess. A company's payment to its shareholders in the
form of additional shares of stock as opposed to cash is known as a stock dividend.
Typically, it is granted in proportion to how many shares each shareholder already
has.
4. Individuals in upper income tax brackets might prefer higher dividend
payout.
Answer: True.
Dividends are taxed each year they are received by investors, while capital
gains are taxed when realized, which can be deferred. Hence, investors in
high tax bracket tend to prefer lower payout ratio as per tax preference
theory.
5. Stock repurchases sends a positive signal that management believes
that the current price is low.
Answer: True.
When a company repurchases its own stock, it often signals to the market that the
management believes the stock is undervalued.
Explanation:
This is because companies typically buy back shares when they have surplus cash
and consider their stock to be a good investment.
6. Tender offers send a more positive signal than open market repurchases
because the company is stating a specific price.
Answer True
Explanation:
A tender offer, where a company offers to buy back its shares at a specific price,
typically above the current market price, sends a strong signal. It suggests that the
company is confident about its value and future prospects to the extent that it's
willing to pay a premium over the market price. This is often viewed more
positively than open market repurchases, where the company buys back shares on
the open market without specifying a premium price.
Question (2)
Answer the following cases:
A. The expected annual net cash inflow from a project is $22,000 over the next 5
years. The required investment now in the project is $79,310. What is the internal
rate of return on the project?
ANSWER:
To determine the Internal Rate of Return (IRR) of the project, you need to find the
discount rate that makes the net present value (NPV) of the project's cash flows
equal to zero.
Given:
Initial Investment (Outflow) = $79,310
Annual Net Cash Inflow = $22,000 for the next 5 years
IRR Formula:
NPV = 0 = Σ CFt / (1 + IRR)^t
Where:
• NPV = Net Present Value (which we want to equal zero for IRR)
• CFt = Cash Flow in period t
• IRR = Internal Rate of Return (the discount rate we're solving for)
• t = Time period (year)
Method 1;
0 = -79,310 + (22,000 / (1 + r)^1) + (22,000 / (1 + r)^2) + (22,000 / (1 + r)^3) +
(22,000 / (1 + r)^4) + (22,000 / (1 + r)^5)
r= 12%
CONCLUSION
The project's annual cash flows of $22,000 for 5 years, with an initial investment of
$79,310, yield an internal rate of return (IRR) of 12%. It breaks even and earns a
12% annual return over the period.
B. Management at The XYZ Company wants to install equipment. The
equipment cost is $150,000 and has a 7 year life, and will generate
net annual cash inflows of $50,000. Management requires a payback
period of 5 years or less on all investments.
What is the payback period for the Equipment? And explain
why the company accept or not accept the project.
Explanation:
Payback period for equal cash flows = Initial Investment / Cash flows each year
Given
Initial Investment = I = $150,000
Annual cash flows = A = $50,000
Payback period = P
P=IAP=$150,000$/50,000
P=3
Since the payback period is 3 years and as per company standards, the company
requires a payback period of 5 years or less, the project is as per the requirement of
the organization and so the project should be accepted
Question (3)
Durham Hospital has been offered a five year contract to provide medical services for a large
company’ employees. The following are revenue and cost related to this contract.
Cost of special equipment related to the contract
200,000
Working capital required
50,000
Relining equipment in 4 years
50,000
Salvage value of equipment in 5 years
30,000
Annual Services revenue
500,000
Annual Services cost
400,000
•
At the end of five years the working capital will be released and may be used elsewhere
by Durham.
•
Durham Hospital uses a discount rate of 14%.
Should the contract be accepted based on Net Present Value Method?
ANSWER
1. Calculate the present value of the cash inflows
calculate the present value of the cash inflows
PV= FV (1+r)n where
PV is he present value,
FV is the future value,
R is the discount rate,
N is the number of periods.
Using this formula, we can calculate the present value of the annual services
revenue over the five-year period:
PV of annual services revenue =
$500,000 / (1+0.14)^1 +$500,000(1+0.14)^2+$500,000(1+0.14)^3+$500,000(1+0.14)^4+
$500,000(1+0.14)^5=1,716,540.48
2: Calculate the present value of the cash outflows
PV=FV (1+r)n
Using this formula, we can calculate the present value of the cash outflows
over the five-year period:
PV of cash outflows =$200,000+$50,000(1+0.14)1+$50,000(1+0.14)2+$50,000(1
+0.14)3+$30,000(1+0.14)5=331,662.66
3: Calculate the net present value
The net present value (NPV) is the difference between the present value of the cash
inflows and the present value of the cash outflows. Using the values calculated in
steps 2 and 3, we can calculate the NPV:
Explanation:
NPV = PV of annual services revenue - PV of cash outflows
NPV=$1,716,540.48−$331,662.66=$1,384,877.82
NPV=$1,384,877.82
CONCLUSION
The NPV of the contract is $1,384,877.82. Since the NPV is positive, the contract
should be accepted based on the net present value method. This means that the
project is expected to generate a positive return and is therefore a good investment
for Durham Hospital.
Question (4)
Assume a company with 500,000 shares of $10 par common stock
outstanding pays a 20% stock dividend. The pre-dividend market value
is $ 35. The following is the shareholders’ equity accounts before stock
dividend:
Common stock
5,000,000
Additional Paid in Capital
5,000,000
Retrained Earning
5,000,000
Total
15,000,000
How does this impact the shareholders’ equity accounts?
ANSWER
When a company issues a stock dividend, the total number of shares outstanding
increases. The issuance of a stock dividend does not change the total shareholders'
equity but reallocates the equity between different components.
Let's break down the impact of a 20% stock dividend on the shareholders' equity
accounts:
1. Common Stock: The number of shares will increase by 20% of the 500,000
shares outstanding, which is 100,000 shares (20% of 500,000). So, after the
stock dividend, there will be 600,000 shares outstanding (500,000+100,000).
2. Par Value of Common Stock: The par value remains the same at $10 per
share. Therefore, the total par value of the common stock will be 600,000
shares × $10 = $6,000,000.
3. Additional Paid-in Capital (APIC): The stock dividend does not affect the
par value of the shares, but it increases the number of shares outstanding.
The Additional Paid-in Capital will be credited for the value of the newly
issued shares. To determine this, calculate the market value of the shares
issued as a stock dividend:
Market value of 100,000 shares = 100,000 shares × $35 = $3,500,000.
Therefore, the increase in APIC due to the stock dividend = Market value of
100,000 shares - Par value of 100,000 shares =
$3,500,000−$1,000,000(100,000shares×$10)=$2,500,000.
So, after the stock dividend, the APIC will increase by $2,500,000.
4. Retained Earnings: There's no cash outflow for the company when it pays a
stock dividend. Instead, it transfers a portion of its retained earnings to
reflect the value of the shares distributed. The amount transferred from
retained earnings will be equivalent to the value of the APIC increase. Thus,
retained earnings will decrease by $2,500,000.
Common Stock: Increases by the par value of the additional shares issued.
Additional Paid-in Capital (APIC): Increases by the market value of the additional
shares issued minus the par value.
Retained Earnings:
Decreases by the same amount as the increase in APIC.
In summary,
after the 20% stock dividend, the Common Stock will be $6,000,000, APIC will be
$7,500,000, and Retained Earnings will be $2,500,000, maintaining a total
shareholders' equity of $16,000,000.