HELP GRADUATE SCHOOL

HELP MASTER OF

BUSINESS ADMINISTRATION

Subject code: FIN501

Subject name: Corporate Finance

ASSIGNMENT 1

Part A

HELP Graduate School

Question 1:

a) Calculate the following ratios for 2014 and 2015.

1) Current ratio

Current Assets
Current Liabilities

2015 2014

(34,324 + 3,250 + 7,897 + 6,300) (13,050 + 2,710 + 7,450 + 6,050)

= (3,650 =
+ 10,251 + 28,000 + 2,250 + 188 + 3,000) (2,450 + 11,200 + 25,000 + 1,280 + 0 + 0)

51,771 29,260
= =
47,339 39,930

= 1.093 : 1 = 0.732 : 1

2) Debt to total assets

Total Liabilities
Total Assets

2015 2014

(3,650 + 10,251 + 28,000 + 2,250 + 188 + 3,000 + 4,500) (2,450 + 11,200 + 25,000 + 1,280 + 0 + 0 + 0)
= =
123,071 95,660

51,839 39,930
= =
123,071 95,660

= 42.1% = 41.7%

3) Gross profit rate

Gross profit
Sales
 2015 2014

262,931 254,375
= =
485,625 462,500

= 54.1% = 55%

4) Profit margin

Net income

2015 2014

41,002 44,800
= =
485,625 462,500

= 8.44% = 9.7%

5) Return on assets

Net income
Average assets

2015 2014

41,002 44,800
= 123,071+ 95,660 = 95,660 + 33,180
( 2
) ( 2
)

= 37.49% = 69.54%

6) Return on common stockholders equity

Net income Preferred dividends

Average common stockholders equity
 2015 2014

41,002 18,000 44,800 15,000

= (23,180+250+32,802)+ (23,180+250+19,800) = (23,180+250+19,800)+ 23,180
2 2

= 46.25% = 89.75%

Preferred dividends = $6 x 3,000 = 18,000 Preferred dividends = $6 x 2,500 = 15,000

7) Payout ratio

Cash dividends
Net income

2015 2014

28,000 25,000
= =
41,002 44,800

= 68.3% = 55.8%
 b) Prepare a horizontal analysis of the income statement for Cookie & Coffee Creations
Inc. using 2014 as a base year.

2015 2014 Difference Horizontal

Analysis

$485,625 $462,500 = 485,625462,500 =23,125 23,125

Sales = 5%
462,500

222,694 208, 125 = 222,694-208,125 =14,569 14,569

Cost of goods sold = 7%
208,125

Gross profit 262,931 254,375 = 262,931-254,375 = 8,556 8,556

= 3%
254,375

Operating expenses
Depreciation expense 17,850 9,100 = 17,850 9100 = 8,750 8,750
= 96%
9,100
1,629
Salaries 147,979 146,350 = 147,979-146,350 = 1,629 = 1%
146,350
and wages expense
261
Other 43,186 42,925 = 43,186 - 42,925 = 261 = 1%
42,925
operating expenses
10,640
Total operating expenses 209,015 198,375 = 209,015-198,375 =10,640 = 5%
198,375

Income from operations 53,916 56,000 = 53,916-56,000 = (2,084) (2084)

= -4%
56,000

Other expenses
Interest expense 413 0 = 413 0 = 413
Loss on sale of computer 2,250 0 = 2,250 0 =2,250
equipment
Total other expenses 2,663 0 = 2,663 0 = 2,663
Income before 51,253 56,000 = 51,253 56,000 = (4,747) (4,747)
= -8%
56,000
income tax
Income tax expense 10,251 11,200 = 10,251 11,200 = (949) (949)
= -8%
11,200

Net income $41,002 $44,800 = 41,002 44,800 = (3,798) (3,798)

= -8%
44,800
 c) Prepare a vertical analysis of the income statement for Cookie & Coffee Creations Inc.
for 2015 and 2014.

2015 Vertical 2014 Vertical

Analysis Analysis

$485,625 485,625 $462,500 462,500

Sales = =100% = =100%
485,625 462,500
222,694 208,125
Cost of goods sold 222,694 = 45.86% 208, 125 = 45%
485,625 462,500
262,931 254,375
Gross profit 262,931 = 54.14% 254,375 = 55%
485,625 462,500

Operating expenses
17,850 9,100
Depreciation expense 17,850 = 3.68% 9,100 = 1.97%
485,625 462,500
147,979 146,350
Salaries 147,979 = 30.47% 146,350 = 31.64%
485,625 462,500
and wages expense
43,186 42,925
Other 43,186 = 8.89% 42,925 = 9.28%
485,625 462,500
operating expenses
Total operating expenses 209,015 209,015 198,375 198,375
= 43.04% = 42.89%
485,625 462,500

53,916 53,916 56,000 56,000

Income from operations = 11.10% = 12.11%
485,625 462,500

Other expenses
Interest expense 413 413 0 0%
= 0.09%
485,625

Loss on sale of computer 2,250 2,250 0 0%

= 0.46%
485,625
equipment
Total other expenses 2,663 2,663 0 0%
= 0.55%
485,625

Income before income 51,253 51,253 56,000 56,000

= 10.55% = 12.11%
485,625 462,500
tax
Income tax expense 10,251 10,251 11,200 11,200
= 2.11% = 2.42%
485,625 462,500

Net income $41,002 41,002 $44,800 44,800

= 8.44% = 9.69%
485,625 462,500
 d) Comment on your findings from parts (a) to (c).

The current ratio has changed from 0.732 to 1.093. "Current Assets" is bigger than "Current
Liabilities". This means that managers of Cookie & Coffee Creations Inc are trying to grow the
company and conduct amortization of current liabilities.

Debt to total assets has changed from 41.7% to 42.1%. Debt in 2015 has increased higher than in
2014.

Gross profit has increased 3% and sales have improved by 5% from $462,500 to $485,625, but
the cost of goods sold has changed 7%. This means it has influenced gross profit rate. The result
that gross profit rate has decreased from 55% to 54.1%.

In addition, net income have decreased 8% from $44,800 to $41,002 that it made profit margin to
be decrease from 9.7% to 8.44%

Depreciation expense has increased by 96% and total assets have improved from $95,660 to
$123,071. This means that managers decided to increase assets of company such as machinery
and equipment to increase sales.

Besides, wages and other operating expenses have changed by 1%. This is not a significant
change.

Because the company has invested in purchasing equipment to increase total assets, so return on
assets have decreased from 69.54% to 37.49%.

The increase of stockholders equity has set a requirement to increase amount of cash to pay
dividends, so the payout ratio has changed from 55.8% to 68.3%.
 e) What impact would borrowing an additional $15,000 to buy more equipment have on
each of the ratios in (a) above, assuming that no changes are expected on the income
statement and balance sheet? Comment on your findings.

The impact on borrowing an additional $15,000 to buy more equipment

Current Ratio: current liabilities will increase slightly, but the current ratio decreases
insignificant. It will not exceed the rate 1:1.

Debt to total assets: will increase after total liabilities and total assets increases by $15,000.

Gross profit rate: keep the same values.

Profit margin, Return on assets, Return on common stockholders equity: will decrease because
interest expenses have an impact and reduce net income.

Payout ratio: will increase because net income was decreased

f) What would justify a decision by Cookie & Coffee Creations Inc. to buy the additional
equipment? What alternatives are thee instead of bank financing?

The justification for the decision by Cookie & Coffee Creations Inc to buy additional equipment
that it will need capital. Cash will decrease. Total assets of the company will increase. In this
case, the company is a new business and the purchase of equipment will involve maintaining
production and increase sales.

Besides, instead of bank financing, the company can rent the equipment.
Question 2:

g = 10% g = 8% g = 6% Growth Rate

0 1 2 3 4 5 Years

D1 D2 D3 D4 D5 Dividends

= 0 (1 + 1 )

D1 = $0.80

D2 = $0.80 (1 + 10%) = $0.88

D3 = $0.88 (1+8%) = $0.95

D4 = $0.88 (1 + 8%)2 = $1.03

D5 = $1.03 (1 + 6%) = $1.09

Applying the formula to calculate P in Variable Growth Model (Lawrence J. Gitman, 2015).

1.09
0 = 0.80(1 + 12%)1 + 0.88(1.12)2 + 0.95(1.12)3 + 1.03(1.12)4 + (1.12)4
(12%6%)

= 0.71 + 0.70 + 0.67 + 0.65 + 11.54

= $14.27

If you have $20,700 to invest, I can buy:

$20,700
= = 1,450 shares.
$14.27
Question 3:

i. What was the price of the bond at issue?

Value = $1,000

Semi-annual coupon = (1,000 x 7%)/2 = 35

Years to maturity = 10 x 2 = 20 periods

Yield = 9/2 = 4.5%

1 (1+4.5%)20
0 = 35[ ] + 1,000 (1 + 4.5%)20
4.5%

= 455.3 + 414.64

= $869.94

ii. What is the current price of the bond?

Value = $1,000

Semi-annual coupon = (1,000 x 7%)/2 = 35

Years to maturity = 6 x 2 = 12 periods (of six months)

Yield = 9/2 = 4.5%

1 (1+4.5%)12
0 = 35[ ] + 1,000 (1 + 4.5%)12
4.5%

= 319.15 + 589.66

= $908.81
 iii. If the market yield falls to 6% in two years time, what will the bond's price be at
that time?

Value = $1,000

Semi-annual coupon = (1,000 x 7%)/2 = 35

Years to maturity = 2 x 2 = 4 periods

Yield = 6/2 = 3%

1 (1+3%)4
0 = 35[ ] + 1,000 (1 + 3%)4
3%

= 130.1 + 888.49

= $1,018.59

iv. Explain your results in (i) - (iii).

We can apply bond formulas to calculate P (Bond Values with Semi - Annual Interest, 2010).
P = value of bond = $1,000

Semi annual coupon payment = (value of bond x coupon rate)/2 = ($1,000 x 7%)/2 = 35

Paid semi-annually:

- Question i)

Batlow Ltd. issued 10 year => Years to maturity = 10 x 2 = 20

The price of the bond at issue will apply currently yield => Yield = 9/2 = 4.5%

- Question iii)

The market yield falls to 6% in two years time

=> Years to maturity = 2 x 2 = 4 and Yield = 6/2 = 3%

- Question ii)

The current price of the bond will apply currently yield

=> Yield = 9/2 = 4.5% and 12 periods (of six months)

By paid semi-annually, the price of the bond at issue in 10 year is $869.94; however, the current
price of the bond is $908.81 > $869.94. This means it has grown 4.5% for 3 years. Besides, if the
market yield falls to 6% in two years time, the bond's price will increase from $908.81 to
$1,018.59.
HELP GRADUATE SCHOOL

HELP MASTER OF

BUSINESS ADMINISTRATION

Subject code: FIN501

Subject name: Corporate Finance

ASSIGNMENT 1

Part B

HELP Graduate School

Question 1:

Depreciation Schedule

Year Depreciation Depreciation Depreciation

Allowance Expense Tax Shield

1 20% 85,000 x 20% = 17,000 40% x 17,000 = 6,800

2 32% 85,000 x 32% = 27,200 40% x 27,200 = 10,880

3 19% 85,000 x 19% = 16,150 40% x 16,150 = 6,460

4 12% 85,000 x 12% = 10,200 40% x 10,200 = 4,080

5 11% 85,000 x 11% = 9,350 40% x 9,350 = 3,740

6 6% 85,000 x 6% = 5,100 40% x 5,100 = 2,040

100% $85,000 $34,000

Total cost of SRC

= costs including taxes and delivery + other expense for installing the equipment

= $80,000 + $5,000 = $85,000.

The total depreciation allowances is100%.

Depreciation Expense = (Depreciation allowances x total cost of SRC)

For example, Depreciation Expense in year 1 = $85,000 x 20% = 17,000.

Tax rate is 40%. For example, depreciation tax shield in year 1 = 40% x $17,000 = $6,800.

(Tax rate x total cost of SRC) = 40% x $85,000 = $34,000.

 Projected Cash Flows

Net Depreciation After tax Net Cash PV

Year
Cost Tax Shield Cost Savings Flow after tax Cash Flow

-80,000
0 -85,000 -85,000
-5,000

1 6,800 15,000 (15,000 + 6,800) = 21,800 19,818

2 10,880 15,000 (15,000 + 10,880) =25,880 21,388

3 6,460 15,000 (15,000 + 6,460) = 21,460 16,123

4 4,080 15,000 (15,000 + 4,080) = 19,080 13,032

5 3,740 15,000 (15,000 + 3,740) = 18,740 11,636

6 2,040 15,000 (15,000 + 2,040) = 17,040 9,619

7 15,000 15,000 7,697

8 15,000 15,000 6,998

The after tax cost savings

= (the before-tax operating costs) x (1 Tax) = $25,000 x (1 40%) = $15,000.

Applying the formula to calculate PV (Finance Formulas, 2010).

1
For example, PV Cash Flow in year 1 = (Net Cash Flow after tax) x = 19,818
(1+10%)1
Applying the formula to calculate NPV (Capital Budgeting Techniques, 2010).

NPV = 6,800(1 + 10%)1 + 10,880(1 + 10%)2 + 6,460(1 + 10%)3 + 4,080(1 + 10%)4

1 (1+10%)8
+ 3,740(1 + 10%)5 + 2,040(1 + 10%)6 + 15,000 - 85,000
10%

= $21,311

The economic rationale behind the NPV

NPV is a capital budgeting method for comparing the costs and benefits of proposed
investments or projects. To calculate NPV, we subtract a projects PV of costs from its present
value of benefits. NPV primarily seeks to identify the most viable investment opportunities by
comparing the present value of future cash flows of projects. The rationale behind the NPV
method is its focus on the maximization of wealth for business owners or shareholders. The NPV
method provides straightforward criteria for choosing or rejecting investment projects. Projects
with positive NPVs qualify for selection because their benefits, in terms of target rates of returns,
exceed costs. Investments yield zero NPV when they have equal benefits and costs. This affords
businesses the flexibility to accept or reject such investments. Negative NPVs, on the other hand,
are loss-making investments that must shun completely. The NPV method enables company to
adjust to the challenges of working with limited financial resources. NPV can be used to rank
mutually exclusive or competing investments to determine the ones that fall within the budgeted
limits of the company. For example, they entity may have a viable project that falls beyond its
financial capabilities. Undertaking such an investment would be futile because the company will
lack sufficient funds to support it. NPV rankings provide mechanisms for detecting such
discrepancies. In addition, the NPV is obtained by discounting future cash flows, and the
discounting process actually compounds the interest rate over time. Thus, an increase in the
discount rate has a much greater impact on a cash flow (Chapter 10: The Basics of Capital
Budgeting, 2014).
 Could the NPV of this particular project be different for SRC than for one of Wang's
other potential customers?

Budget Constraints

Capital budgeting is the whole process of analyzing projects and deciding whether SRC should
be included in the capital budget. This process is of fundamental importance to the success or
failure of company as the fixed asset investment decisions chart the course of SRC for many
years into the future. An NPV profile is the plot of a project's NPV versus its cost of capital. The
crossover rate is the cost of capital at which the NPV profiles for project intersect requiring
greater investments or that have greater risk should be given detailed analysis the capital
budgeting process. The process of capital budgeting for investment is completely different, so
the NPV of this particular project for SRC could be different than for one of Wang's other
potential customers (Investopedia, 2015).

Taxes and Interest rate

Interest rate affects the future value cash flows which makes capital investment decisions. The
NPV method uses a compound rate of return, or present value interest factor, to discount the
future cash flows of investments and account for the time value of money. The PVIF basically
converts the value of a projects future cash flows into todays equivalent value. In addition, for
capital budgeting, SRC uses a 10% cost of capital, and the applicable tax rate is 40%, so the
NPV of this project for SRC could be different than for one of Wang's other customers (Andrew
Mackinlay, 2014).
Question 2:

Applying the formula to calculate IRR in excel.

Based on "Net Cash Flow after tax", we can calculate the proposed project's internal rate of
return (IRR): =IRR(B2:B10) = 17%

IRR is measure for evaluating whether to proceed with a project or investment. The IRR rule
states that if the internal rate of return on a project or investment is greater than the minimum
required rate of return, the cost of capital, then the decision would generally be to go ahead with
it. Conversely, if the IRR on a project or investment is lower than the cost of capital, then the
best course of action may be to reject it. The higher the IRR on a project and the greater the
amount by which it exceeds the cost of capital, the higher the net cash flows to the investor. In
general terms, SRC that has to choose one, among several similar projects with equivalent
degrees of risk, may go with the one that provides the highest IRR. The IRR rule is one among a
number of rules used to evaluate projects in capital budgeting. However, it may not always be
rigidly enforced. In addition, mathematically, the IRR is relevant to calculate NPV that causes
NPV to equal $0. We have identified the NPV of this particular project for SRC to be different
than for one of Wang's other potential customers, so IRR will be applying the same (Evaluating
Mineral Projects, 2010).
Question 3:

a) What is the project's payback period?

Year Net Cash Flow after tax

0 -85,000

1 21,800

2 25,880

3 21,460

4 19,080

5 18,740

6 17,040

7 15,000

8 15,000

In year 1, SRC will recover $21,800 of its $85,000 costs.

By the end of year 2,

(21,800 from year 1 + 25,880 from year 2) = $47,680 will have been recovered.

By the end of year 3,

(47,680 from year 2 + 21,460 from year 3) = $69,140 will have been recovered.

By the end of year 4, $88,220 will have been recovered.

85,000 69,140
( ) = 83% => Only 83% of the year 4 cash inflow of $19,080 is needed to complete
19,080

the project's payback period that is 3.5 years (3 years + 83% of year 4).
 b) What is the rationale behind the use of payback period as a project evaluation tool?

The payback method is popular with business analysts for several reasons. The first is its
simplicity. Most companies will use a team of employees with varied backgrounds to evaluate
capital projects. Using the payback method and reducing the evaluation to a simple number of
years is an easily understood concept. Identifying projects that provide the fastest return on
investment is particularly important for companies with limited cash that need to recover their
money as quickly as possible. Managers often use the payback method as an initial screening
tool when evaluating projects. If a project passes the payback period test, it gets further detailed
and sophisticated analysis with methods that use the time value of money and the internal rate of
return (Chapter 10: The Basics of Capital Budgeting, 2014).

c) What deficiencies does payback have as a capital budgeting decision method?

Payback method ignores the time value of money. Cash inflows from project may be irregular,
most of return not occurring until well into future. Project could have an acceptable rate of return
but still not meet the company's required minimum payback period. Model does not consider
cash inflows from project that may occur after initial investment has been recovered. Most major
capital expenditures have a long life span and continue to provide income long after the payback
period. Since it focuses on short-term profitability, an attractive project could be overlooked if
the payback period is the only consideration (Capital Budgeting Techniques, 2010).

d) Does payback provide any useful information regarding capital budgeting decisions?

In capital budgeting, the payback period is the selection criteria that most firms use to select
capital projects. Even today, firms find the payback period selection criteria most useful.
Business owners like to look at the time it takes them to earn back their initial investment in a
capital project. The one advantage of payback period is that it is a method of capital budgeting
and provide useful information to managers who have some sort of rough estimate concerning
when the project will pay back their initial investment. Even considering the more advanced
methods available, it seems that management still wants to rely on this tried and true method
(Investopedia, 2015).
Question 4:

The net present value and internal rate of return techniques are discounted cash flow evaluation
techniques. These are called DCF methods because they explicitly recognize the time value of
money. The NPV, IRR and PI lead to consider the time value of money and result in the same
accept or reject decision when considering an independent project (The Difference Between,
2010).

- NPV PI

The net present value NPV and profitability PI yields same accept or reject rules, because
profitability index PI can be greater than one only when the projects net present value is
positive. In case of marginal projects, net present value NPV will be zero and profitability index
PI will be equal to one. A PI greater than 1.0 indicates that profitability is positive, while a PI of
less than 1.0 indicates that the project will lose money. The main difference is the PI may be
useful in determining which projects to accept if funds are limited. However, the PI may lead to
incorrect decisions when considering mutually exclusive investments. That is a conflict may
arise between the methods if a choice between mutually exclusive projects has to be made
(NPV versus Profitability Index, 2015).

For example,
The net present value NPV method should be preferred, except under capital rationing, because
the NPV reflects the net increase in the firms. As the NPV of project X incremental outlay is
positive, it should be accepted. Project X will also be acceptable if we calculate the incremental
profitability index. This is shown as follows, because the incremental investment has a positive
NPV, 40000 USD and a profitability index PI greater than one, project X should be accepted
(Finance Formulas, 2010).

- NPV IRR

For normal project of NPV profiles to cross, one project must have both a higher vertical axis
intercept and a steeper slope than the other. A project's vertical axis intercept typically depends
on the size of the project and the size and timing pattern of the cash flows, large projects, and
ones with large distant cash flows, would generally be expected to have relatively high vertical
axis intercepts. The slope of the NPV profile depends entirely on the timing pattern of the cash
flow and long-term projects have steeper NPV profiles than short-term ones. Thus, we conclude
that NPV profiles can cross in two situations such as when mutually exclusive projects differ in
scale and when the projects of cash flows differ in terms of the timing pattern of their cash flows.
In addition, the underlying cause of ranking conflicts is the reinvestment rate assumption. All
DCF methods implicitly assume that cash flows can be reinvested at some rate, regardless of
what is actually done with the cash flows. Discounting is the reverse of compounding. Since
compounding assumes reinvestment, so does discounting. NPV and IRR are both found by
discounting, so they both implicitly assume some discount rate. Inherent in the NPV calculation
is the assumption that cash flows can be reinvested at the project of cost of capital, while the IRR
calculation assumes reinvestment at the IRR rate. Normally, the NPV of assumption is better.
The reason is as follows project of cash inflows are generally used as substitutes for outside
capital, that is, project of cash flows replace outside capital and, hence, save the firm the cost of
outside capital. Therefore, in an opportunity cost sense, project of cash flows are reinvested at
the cost of capital (Evaluating Mineral Projects, 2010).
 REFERENCES

Andrew Mackinlay (2014) 'How do Taxes Affect Capital Structure?', Social Science Research.

'Bond Values with Semi - Annual Interest', Valuation of Stocks and Bonds 3.1 Bonds and Bonds
Valuation.

'Capital Budgeting Techniques', Net Present Value.

'Chapter 10: The Basics of Capital Budgeting', Evaluating Cash Flows.

'Evaluating Mineral Projects', The proposed project's internal rate of return.

'Finance Formulas', Present Value.

'Investopedia', DEFINITION of 'Capital Budgeting'.

Lawrence J. Gitman (2015) 'Variable Growth Model - Chapter 7', Principles of Managerial
Finance.

'NPV versus Profitability Index', PROFESSIONAL MANAGEMENT EDUCATION.

'The Difference Between', Homework Simplified.