EFB210 - Tutorial 1hhhhhh PDF

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EFB210 Finance 1 Tutorial 1: Introduction to Finance Prescribed Reading:  Lecture Notes  Peirson et al. (2015) Business Finance o Ch. 1, skim o Ch. 2, Sections 2.1 to 2.3.7 o Ch. 8, skim o Ch. 9, skim Sections 9.1 and 9.2 o Ch. 10, skim Sections 10.1 to 10.6 Question 1 Briefly explain what the goals of maximising profit and maximising value entail and whether they are consistent with the financial manager’s objective of maximising firm value. Question 2 Identify and explain the three major decisions confronting the financial manager. Are these decisions interrelated or independent?

Question 3 What do you understand by the term ‘capital’? How does transfer of capital occur and why is it important in the finance setting?

Question 4 Distinguish between primary and secondary capital markets.

Question 5 Explain the major differences between debt and equity securities, and briefly detail some examples of each specifying whether they are short or long term source of funding.

Question 6 List and describe the assumptions of Fisher’s separation theorem. What is the major implication of this theorem for financial decision making?

Question 7 Explain NPV and IRR, and discuss the relationship between them. Page 1 of 15

Question 8 An investment requires an outlay of $150 and returns $210 in one period’s time. Using a discount rate of 10%, calculate the NPV and the IRR of the investment and advise whether this is a worthwhile investment.

Question 9 For the following projects Project 1 2 3 4 5 a. b.

I1 $120,000 $145,000 $195,000 $75,000 $225,000

X2 $150,000 $165,000 $215,000 $80,000 $350,000

Calculate the IRR and the NPV using a 10% required rate of return. Which projects should be accepted?

Question 10 A company with $500,000 endowment, has the following investment opportunities available: Project 1 2 3 4

I1 $125,000 $135,000 $155,000 $145,000

X2 $160,000 $145,000 $180,000 $175,000

Assuming perfect certainty, PCM, rational investors, a two-period world, and a market rate of 15%, answer the following questions: a. b. c. d.

Which proposals should the firm undertake? How much will the company invest in period 1? What are the period 1 and period 2 dividends? What is the value of the firm after investing?

Question 11 A firm has the following investment opportunities available: Project 1 2 3 4

I1 $95,000 $49,000 $110,000 $80,000

X2 $108,000 $65,000 $120,000 $95,000

NPV $3,182 $10,091 -$909 $6,364

The required rate of return is 10%, and the firm has an endowment of $300,000. a.

Which projects should the company undertake? Page 2 of 15

b.

Following from your advice above, what is the maximum that Tony (owner of 30% of the company) can consume in period 1, and in period 2? c. If Tony consumes $40,000 in period 1, how much will he consume in period 2? d. If Tony wants to consume $47,400 in period 2, how much can he consume in period 1? Question 12 A company with $500,000 endowment has the following investment opportunities available: Project I1 X2 1 $160,000 $182,000 2 $185,000 $205,000 3 $163,000 $195,000 4 $109,000 $125,000 5 $225,000 $280,000 Assuming perfect certainty, PCM, rational investors, a two-period world, and a market rate of 15%, answer the following questions: a. b. c. d. e.

Which proposals should the company undertake? If the firm follows your advice, how much will be invested in period 1? What are the period 1 and period 2 dividends? What is the value of the firm after investing? Based on the answer to c., i. What is the maximum amount that an owner of 10% of company can consume in period 1? ii. If the owner from i. consumes $10,000 in period 1, how much will they consume in period 2? iii. If the owner from i. consumes $50,000 in period 1, how much will they consume in period 2? iv. If the owner from i. wants to consume $20,000 in period 2, how much can they consume in period 1? MULTIPLE CHOICE

Question 13 Long term funds describes funds a. b. c. d.

with a maturity date of greater than 1 year that are debt related only with a maturity date of greater than 10 years with a maturity date of 1 to 10 years.

Question 14 If F + X = I + D then it follows that F = I - X + D and F will be negative when a. b. c. d.

no dividends are to be paid and no new investments undertaken because of the presently unprofitable investments. dividends are to be paid from the surplus remaining after the investment decision. no dividends are to be paid and the positive funds from operations are insufficient to make new investments. None of the above.

Question 15 According to Fisher’s separation theorem: a. b. c.

Managers must satisfy the consumption needs of the majority of shareholders. Managers must minimise dividend payouts in order to maximise investments. Managers should split evenly all funds available between dividend payouts and investments. Page 3 of 15

d.

Managers do not need to consider shareholders consumption preference when making their investment decisions.

Question 16 The objective of the financial manager is to a. b. c. d.

maximise the profits of the firm maximise the value of the firm maximise both the profits and value of the firm none of the above The following information relates to Questions 17 and 18

Figure 1: The Company with Multiple Shareholder and Capital Markets

Question 17 Referring to Figure 1, which statement is correct? a. b. c. d. e.

On the firm’s production frontier, the points to the left of P represent projects that have returns greater than the market return. The firm’s initial endowment is the distance O to W1. If the firm invests in projects up to point P, only investor C can maximise their utility. Investors A, B and C can maximise their utility if firm pays dividends corresponding to point P. Assuming that the firm invests to point P, the present value of the period 2 dividend can be indicated on Figure 1 by projecting a horizontal line from P to the period 2 axis.

Question 18 Referring to Figure 1, which statement is incorrect? a. b. c. d.

On the firm’s production frontier, the points to the right of P represent projects that have IRRs greater than the market return. Assuming that the firm invests to point P, the present value of the period 2 dividend can be indicated on Figure 1 by projecting a horizontal line from P to the Y axis. The firm’s initial endowment is the distance O to E. If the firm invests in projects up to point P, W1 indicates the value of the firm. Page 4 of 15

e.

Investors A, B and C maximise their utility if they receive the dividends represented by point P. The following information relates to Questions 19 to 22

Assume a two period perfect certainty world and market rate of 10%. A firm with an initial endowment of $500,000 has the following investment opportunities available: Project 1 2 3 4

I1 $121,800 $98,760 $110,000 $105,700

X2 $152,250 $125,425 $118,250 $121,555

Question 19 What are the IRRs of the projects? a. b. c. d.

25%, 27%, 7.5% and 15% 125%, 127%, 107.5% and 115% 10%, 10%, 10% and 10% None of the above

Question 20 What are the NPVs of the projects? a. b. c. d.

$30,450, $26,665, $8,250, $15,855 $26,119, $23,967, $4,330, $8,814 $16,609, $15,263, ($2,500), $4,805 None of the above

Question 21 If the firm undertakes Projects 1, 2 and 4, the period 1 and period 2 dividends will be a. b. c. d.

D1 = $173,740 and D2 = $362,936 D1 = $173,740 and D2 = $399,230 D1 = $191,114 and D2 = $399,230 D1 = $500,000 and D2 = $0

Question 22 If the firm only undertakes Project 1 and pays D1 = $378,200 and D2 = $152,250, how much can the owner of 20% of the firm consume in period 1 if they want to consume $38,150 in period 2? a. b. c.

$68,640 $75,640 $82,640 Page 5 of 15

d.

Insufficient information to solve

Page 6 of 15

ANSWERS Question 1 Maximising profits entails undertaking all profitable projects, which may be defined as those that generate revenues in excess of expenses. The problem with maximising profits is that the profitable projects may be undertaken even though they do not yield an appropriate rate of return. If this occurs, we would find that the value of the firm will actually decrease. On the other hand, maximising value entails undertaking all projects that add value to the firm. This means that they yield an appropriate rate of return, which will maximise the value of the firm. As a result, the present value of the shareholders' consumption is maximised, which implies that shareholder utility (welfare) is maximised. The financial manager's objective is to maximise firm value, hence he/she should seek to undertake all projects that add value to the firm. Question 2 The three major decisions of the financial manager are:  Financing Decision, type of funds, cost of funds and when and where to raise funds;  Investment Decision, evaluation of investment projects, amount and type of assets held;  Dividend Decision, increase or decrease availability of cash to pay out. The role of the financial manager is to acquire the necessary funds and ensure their effective utilisation. Depending on the size of the organisation, there may be a separate person or group who is responsible for financial management. The optimal performance of the firm is determined by reference to the objectives of the firm, in finance we subscribe to the objective of maximising the market value of equity (remember that selecting this objective is a normative decision, we could imagine alternative objectives). Sources are either internal funds (ie. cash flows from operations) or external from individuals, other firms, financial institutions and the government. The use of funds is for asset expenditure, non-asset expenditure or as distribution to owners. In summary,

We cannot change one item without affecting at least one other in the equation. Therefore the decisions must be interrelated and therefore solved simultaneously. Page 7 of 15

Question 3 Capital is the stock of value placed into investments to earn future fund flows. The transfer of capital can occur through capital markets, which enable those with excess supply of capital and those demanding capital to negotiate conditions for transferring these funds. It can also occur through financial institutions that accept funds from depositors or investors, and lend them to borrowers. The transfer of capital is important in the finance setting because it allows financial managers to achieve the objective of maximising firm value. Surplus units can achieve a return on their excess funds while deficit units are able to obtain funds in order to undertake investments.

Question 4 The primary market is where firm's issue of equity or debt securities to raise funds. After the securities have been issued, all subsequent trading of issued securities occurs in the secondary market. The trading that occurs in the secondary market is simply a transfer of ownership of the securities. Therefore, from the perspective of the firm that issued the securities, new funds are only raised in the primary market.

Question 5 Debt represents an obligation to pay a specific amount of money to another party. It may be shortterm (maturity less than 12 months) or long-term (maturity greater than 12 months) with a fixed or floating interest rate. It may be secured or unsecured but always ranks above equity in terms of a claim on assets if the business is liquidated. 

Short term: o Commercial papers are marketable unsecured securities in which the borrower promises to pay a stated amount at a future date. o Bill of exchange is another marketable security in which the issuer (drawer) directs the acceptor (usually a financial institution) to pay a stated amount at a future date.



Long term: o Debentures are a fixed interest security issued by companies and are secured. o Unsecured notes differ from debentures in that they are unsecured. o Corporate bonds generally refer to coupon paying securities.

Equity refers to those securities that provide ownership in the issuing company. Ordinary shares represent an ownership interest in the issuing company and give voting rights, but have a residual interest in the net assets of the company and are therefore riskier than other classes of investors. They do not have a maturity date and therefore provide long term funds to the company.

Page 8 of 15

Question 6 The assumptions underlying Fisher's separation theorem are:   

There are only two periods, the present and next period; There is certainty, this means that all opportunities are known and there is no risk; The capital market is perfect, hence there is only one interest rate, all parties have equal access to information, and there are no transaction costs or taxes; All investors are rational, a therefore will purse utility or wealth maximisation; The company's managers act in the shareholders' interests, and therefore will pursue the objective of maximising firm value.

 

The major implication for the financial manager's decision making is that the company can make investment decisions independently of shareholders' preferences. This means that the company should invest in all positive NPV projects as these will maximise the value of the firm and shareholders should use the capital market to achieve their preferred levels of consumption.

Question 7 NPV (Net Present Value) is the difference between the present value of all the future net cash flows from an investment (discounted at an appropriate rate) and the initial cash outlay. It represents the additional value the firm accrues from the investment. IRR (Internal Rate of Return) is the percentage return that the project generates and coincides with the discount rate that would generate a zero NPV. All projects with an IRR greater than the required rate of return will have a positive NPV while all projects with an IRR less than the required rate of return will have a negative NPV.

Question 8

NPV =

X2 −I 1 ( 1+i )

210 −150 ( 1.1) ¿ 40.91 ¿

IRR=

X2 −1 I1

210 −1 150 ¿ 0.4∨40 % ¿

Page 9 of 15

Question 9 a. Project 1 2 3 4 5

I1 $120,000 $145,000 $195,000 $75,000 $225,000

X2 $150,000 $165,000 $215,000 $80,000 $350,000

NPV $16,364 $5,000 $455 -$2,273 $93,182

IRR 25.0% 13.8% 10.3% 6.7% 55.6%

X2 −I 1 ( 1+i ) 150,000 NPV 1= −120,000 ( 1.1 ) ¿ 16,364.64 NPV =

X2 −1 I1 150,000 −1 IRR1= 120,000 ¿ 0.25 IRR=

b.

Projects 1, 2, 3 and 5 should be selected as they all have positive NPVs and IRRs > i.

Question 10

a.

Project I1 1 $125,000 2 $135,000 3 $155,000 4 $145,000 Select Projects 1, 3 and 4 as NPVs > 0.

X2 $160,000 $145,000 $180,000 $175,000

NPV $14,130 -$8,913 $1,522 $7,174

Information for b., c. and d. P1 Endow I1 D1 b. c. d.

P2 500,000 (425,000) 75,000 (75,000) 0

X2 D2

515,000 (515,000) 0

I1 = 425,000 D1 = 75,000 and D2 = 515,000 Firm Value W1 = D1 + D2/(1+i) = 75,000 + 515,000/(1.15) = 522,826.09 Note the sum of NPVs = 14,130 + 1,522 + 7,174 = 22,826, which is the increase in firm value: NPV is accretive. Page 10 of 15

Page 11 of 15

Question 11

a.

Project I1 1 $95,000 2 $49,000 3 $110,000 4 $80,000 Select Projects 1, 2 and 4 as NPVs > 0.

X2 $108,000 $65,000 $120,000 $95,000

NPV $3,182 $10,091 -$909 $6,364

Information for b., c. and d. P1

P2 300,000 X2 268,000 (224,000) D2 (268,000) 76,000 0 D1 (76,000) 0 Tony is entitled to 30% of the firm’s dividends, so his D1 = 22,800 and D2 = 80,400. Endow I1

b.

Max C1 = D1 + D2/(1+i) = 22,800 + 80,400/1.1 = 95,891 Max C2 = D1(1+i) + D2 = 22,800(1.1) + 80,400 = 105,480

c. P1 D1 C1

P2 22,800 (40,000) (17,200) 17,200 0

F1

D2 F2

80,400 (18,920) 61,480 (61,480) 0

C2

F2 = F1(1+i) = 17,200 x 1.1 = 18,920 d. P1 D1 F1 C1

P2 22,800 30,000 52,800 -52,800 0

D2 C2 F2

80,400 (47,400) 33,000 (33,000) 0

Note that I started in column P2 and then complete P1 F1 = F2/(1+i) = 33,000 / 1.1 = 30,000

Page 12 of 15

Question 12

a.

Project I1 1 $160,000 2 $185,000 3 $163,000 4 $109,000 5 $225,000 Select Projects 3 and 5 as NPVs > 0.

X2 $182,000 $205,000 $195,000 $125,000 $280,000

P1 Endow I1

b. c. d.

P2 500,000 (388,000) 112,000 (112,000) 0

D1

NPV -$1,739 -$6,739 $6,565 -$304 $18,478

X2 D2

475,000 (475,000) 0

I1 = 388,000 D1 = 112,000 and D2 = 475,000 W1 = D1 + D2/(1+i) = 112,000 + 475,000/1.15 = 525,043.48 Note the sum of NPVs = 6,565 + 18,478 = 25,043 is equal to increase in firm value: NPV is accretive.

e.

D1 = 11,200 and D2 = 47,500 i. Max C1 = D1 + D2/(1+i) = 11,200 + 47,500/1.15 = 52,504 ii. P1 D1 C1

P2 11,200 (10,000) 1,200 (1,200) 0

F1

D2 F2

47,500 1,380 48,880 (48,880) 0

C2

iii. P1 D1 C1

P2 11,200 (50,000) (38,800) 38,800 0

F1

D2 F2

47,500 (44,620) 2,880 (2,880) 0

C2

iv. P1 D1 F1 C1

P2 11,200 23,913 35,113 (35,113)

D2 C2 F2

47,500 (20,000) 27,500 (27,500) Page 13 of 15

0

0

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Question 13 Question 14 Question 15 Question 16 Question 17 Question 18 Question 19 Question 20 Question 21 Question 22

A D D B D B A C B A

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