Q1. What are the two major decisions made by financial managers?(1) the investment, or capital budgeting, decision (how much to invest and which real assets to investin)(2) the financing decision (how to raise the necessary cash.)Q2. How does the expected return and risk from investment differ between a bondholder and ashareholder? A bondholder has a contract for specific cash flows at specific dates with a contractual mechanism for dealing with late or missed payments. Payments to bondholders must be made before shareholders.Consequently, the risk and expected return to a bondholder of a particular company is less than thatof the company¶s shareholders. Stockholders are residual claimants meaning they get what is leftover after the company has met its other financial obligations. Their cash flows are less certain, maybe non-existent, and they have no specific contractual arrangement to recover their investment.Therefore, the added risk borne by shareholders is directly related to their expected return.Q3. How do corporations ensure that managers¶ and stockholders¶ interests coincide?Conflicts of interest between managers and stockholders can lead to agency problems. Theseproblems are kept in check by compensation plans that link the well being of employees to that of thefirm; by monitoring of management by the board of directors, security holders, and creditors; and bythe threat of takeover.Q4. What are the differences between the bond¶s coupon rate, current yield, and yield to maturity?
A bond is a long term debt of a government or corporation. When you own a bond, you receive afixed interest payment each year until the bond matures. This payment is known as the coupon. The
coupon rate
is the annual coupon payment expressed asa fraction of the bond¶s
face value
. Atmaturity the bond¶s face value is repaid. In the United States most bonds have a face value of $1,000. The
current yield
is the annual coupon payment expressed as a fraction of the bond¶s price.The
yield to maturity measures
the average rate of return to an investor who purchases the bondand holds it until maturity, accounting for coupon income as well as the difference between purchaseprice and face value.Q5. Why do investors pay attention to bond ratings and demand a higher interest rate for bonds withlow ratings?
Investors demand higher promised yields if there is a high probability that the borrower will run intotrouble and default. Credit risk implies that the promised yield to maturity on the bond is higher thanthe expected yield. The additional yield investors require for bearing credit risk is called the defaultpremium. Bond ratings measure the bond¶s credit risk.Q6.How do changes in working capital affect project cash flows?
Increases in net working capital such as accounts receivable or inventory are investments, andtherefore use cash- that is, they reduce the net cash flow provided by the project in that period. Whenworking capital is run down, cash is freed up, so cash flow increases.
SECTION B [50 MARKS]
Q1.(a) NPVA = -100 + 30 (PVIF2%,1) + 50(PVIF2%,2) + 70(PVIF2%,3)= -100 + 30(0,9804) + 50(0.9612) + 70(0.9423)= -100 + 29.41 + 48.06 + 65.96= 43.43 (2m)NPVB = -100 + 49(PVIFA2%,3)= -100 + 49(2.8839)= -100 + 141.31= 41.31 (2m)if r=2%, choose A. (2m)(b) NPVA = -100 + 30(PVIF12%,1) + 50(PVIF12%,2) + 70(PVIF12%,3)= -100 + 30(0.8929) + 50(0.7972) + 70(0.7118)= -100 + 26.79 + 39.86 + 49.83= -100 + 116.48= 16.48 (2m)NPVB = -100 + 49(PVIFA12%,3)= -100 + 49(2.4018)= -100 + 117.69= 17.69 (2m)if r = 12%, choose B (2m)(c) Change in cost of capital (2m)
[14M]
Q2. (a)Project Payback A 3 (2m)B 2(2m)C 3 (2m)(b) Only B (2m)(c) All three projects (2m)
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