Assignment Ist 562 FM Spring 2010

Financial Management (562)
Department of Business Administration

Block No. 13, H-8
Islamabad

Assignment No. 01
Submitted to:
MR. SARFRAZ AHMED RIZVI
House No. C-133
Aleemabad, Malir Extension Colony,
KARACHI (0345- 219 5179)
Submitted By:
Muhammad Hammad Manzoor
MBA (HRM)-3rd Semester
Regular Student Roll No. 508195394
th
508, 5 Floor, Continental Trade Centre (CTC)
Block – 08, Clifton, KARACHI
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By: M. Hammad Manzoor, MBA HRM-III, 508, 5th Floor, Continental Trade Centre (CTC), Clifton – 08, Karachi. (Roll No. 508195394)
Email: explorationist@gmail.com, Cell: 0321-584 2326
Q. No. 1 (a): Read the following case carefully, and then gives the answer
of the questions given below. The case:
Management V/s Shareholder:

The annual shareholders meeting at the Mustafa Company brought some shock to the
management and the board of directors, when a group of shareholders complained
vigorously about the company's financial policies. However, expressions of
dissatisfaction by one or two shareholders had not been, uncommon in the past, the
company's senior executives were surprised by the degree of support for the protest group
voice by other stockholders.
Shareholder Complaints:
The initial target of the complaints was the company's policy of not paying dividend in almost
two years. The chairman of the board, Mr. Salman Mustafa, responded that the company
had been experiencing poor profitability and had needed all available funds to
maintain its investments. Other shareholders rose to complain that the company's policy of
not using borrowed money limited its ability to make investments and pay dividends. Again
the chairman responded, this time citing the need for caution in the way the company was
financed. He gave several examples of multinational companies that had been heavy
borrowers and had recently gone bankrupt. To this another shareholder complained that, if
the company were more aggressive in its investment policies, there would be enough
money for everything. "Until you start taking some chances of new ideas and new products,
our stock prices will continue to go down instead of up. I could have earned more by putting my
money in government bonds", complained the shareholder.
"Admit it", another shareholder shouted, "You increase your wealth with your fancy salaries
and fancy offices couldn't careless about us little investors. But then why would you?.Most
of you don't even own stock in the. Company." Losing his temper, the Chairman replied
angrily that his own ancestors had founded the business and still owned almost 10 percent
of the shares outstanding. He added that the company, adding, "And I'm not saying that just
because my son, Ahmed is president. After all, nobody forced you to buy your stock and
nobody's forcing you to keep it. In fact, I would personally be more than happy to buy your
stock from you with my own money. Now I ask the rest of you shareholders", concluded the
Chairman broadly, "would you rather have your company be safe and secure or bankrupt?"
1. Identify the principal financial policies being debated.
2. Considering the perspective of management only, what tendencies do you see in
each of these financial policies?
3. Considering the perspective of shareholders only, what tendencies do you sec in
each of these financial policies?
4. The Mustafa Company's creditors are not directly mentioned in the case, but
what do you think their preferences would be with regard to each of the
financial policies?
5. Use some ideas of your own to indicate how Mustafa Company's shareholders
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might persuade management to move in the direction of shareholders'

preferences.
Answer)
The essence of the debate is whether economic recovery and stabilization of the financial
system are two distinct and unconnected events. The prevailing view is something like the
framework within which we need to engineer a global economic recovery is macroeconomics.
Since current macroeconomic theory deals only with Keynesian policy (fiscal and monetary
policy), the only tools we have are fiscal and monetary expansion.
The disposal of non-performing assets and injection of capital are necessary steps in
stabilizing the financial system, but to the best of our knowledge there is no clear link
between this and a macroeconomic recovery. However, if we achieve an economic recovery
through fiscal and monetary policy, the volume of non-performing assets will ease,
eliminating the need for policies specifically designed to dispose of bad assets.
Signs of economic recovery are now emerging and fears of the crisis overwhelming the world
economy are starting to fade. Yet if the policy responses of US and European governments
toward the disposal of non-performing assets begin to falter, the financial systems of Europe
and the US will once again be vulnerable to recurring financial crises, There have been those
who have recognized that cleaning up banks’ balance sheets and rehabilitating debtors are
necessary preconditions for an economic recovery, but this recognition has been based purely
on empirical principles. The existing theoretical structure of macroeconomics is incapable of
addressing macroeconomic performance and the stability of the financial system in an
integrated context. For example, in the standard New Keynesian or Neoclassical
macroeconomic models, the economic agents are the household, corporate, and government
sectors, and the financial sector is simply treated as an innocuous veil between these three
sectors. The issue of non-performing assets is invariably viewed as a microeconomic issue
related to the banking industry.
In fact, the crisis we are currently experiencing may call for a change in the theoretical
structure of macroeconomics. In my view, a macroeconomic approach that encompasses
financial intermediaries and places them at the centre of its models is necessary. The new
approach should satisfy three requirements:
• The focus should be on the function of financial institutions as media of exchange and
the conditions that might cause payment intermediation to malfunction. Perhaps this
kind of macro model can be built on the framework of the monetary theory of Lagos
and Wright (2005), which explicitly considers the role of money as a medium of
exchange.
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• The new macroeconomic approach should provide a unified framework for discussing
the cost and effectiveness of various policy responses to the current global crisis in an
integrated context, in which fiscal policy, monetary policy, and bad asset disposal can
be compared and relative weightings can be given to all three.
• To provide a unified framework for policy analysis, the new approach should make it
easy to embed a model of financial crises into the standard business cycle models (i.e.,
the dynamic stochastic general equilibrium models).
I have elsewhere attempted to construct a theoretical model that satisfies these

requirements, in which I assume that assets such as real estate now function as media of
exchange given the development of liquid asset markets but are unable to fulfil this function
during a financial crisis (see Kobayashi 2009a). With a model like this, we can regard a
financial crisis as the disappearance of media of exchange, which triggers a sharp fall in
aggregate demand. In this case, both macroeconomic policy (fiscal and monetary policy) and
bad asset disposals can be understood as responses targeting the same goal – restoring the
amounts of media of exchange (inside and outside monies).
Thus we can compare and analyze these policies in an integrated context.
Article: Bad asset Disposal should not be left to Financial Community Insiders
If macroeconomic policy and financial stabilization through bad asset disposals are designed to
eradicate the same externality, financial stabilization is not just a problem for the financial
community – it is crucial for the recovery of the overall economy.
Therefore, the design and execution of policies capable of disposing of non-performing assets
are not tasks that should be left to financial community insiders. We need to openly discuss
what financial stabilization policies should look like (for practical lessons on the policy package
from Japan’s experience, see Kobayashi 2008, 2009b). Bad asset disposals including capital
injections for financial institutions (or temporary nationalization) and the rehabilitation of debt-
ridden borrowers must be considered alongside fiscal stimuli and monetary easing, with a new
awareness that they also constitute macroeconomic policies. Perhaps, we need to adopt a new
paradigm of economic thought.
Shareholders or stockholders own parts or shares of companies. In large corporations,

shareholders are people and institutions that simply invest money for future dividends and for
the potential increased value of their shares, whereas in small companies they may be the
people who established the business or who have a more personal stake in it. When investors
buy shares of companies, they receive certificates that say how many shares they own. Owning
shares of a company often entitles an investor to a part of the company's profits, which is
issued as a dividend. In addition, shareholders are typically offered a fixed payout per share if
the company is bought out. Because they are partial owners of a company, shareholders are
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allowed to vote at shareholder meetings for certain company actions (such as approving or
rejecting a merger proposal), review company accounts, and receive periodic reports on
company performance. If shareholders cannot attend annual meetings, they are permitted to
vote by proxy by mailing in their vote. Furthermore, if a company decides to issue more shares,
current shareholders have the option to buy shares before they are offered to the public.
Shareholders are entitled to vote on a variety of issues, although the specific areas where
shareholders have a say are determined by state laws and corporate bylaws. Generally,
shareholders have the right to appoint a corporate president, elect members to a board of
directors, and vote on significant changes in a corporation. These significant changes might
include changes in the line of business, change of company name, and company divestments,
acquisitions, and mergers. Boards of director’s act on behalf of the shareholders and, in
practice, make most decisions such as appointing corporate officers and reviewing corporate
policies, finances, and strategies. Shareholders may vote only during a corporation's annual
shareholder meeting or at a special shareholder meeting, which would normally be called by
the board of directors. A notice of the meeting and a notice of the agenda (the major points of
the meeting) must be provided before each shareholder meeting. Shareholder voting power is
proportionate to the number of shares each shareholder owns. For example, if a corporation
had two shareholders one with 400 shares and one with 100 shares the one with 400 shares
would wield far greater voting power.
Shareholders may own two kinds of stock: common stock and preferred stock. Owners of
common stock have the last claim to company profits and assets and they may receive
dividends at the discretion of a company's board of directors. In addition, common stock does
not have a fixed value. Holders of common stock, therefore, profit when a company performs
well and suffer losses when a company does not perform well. Nonetheless, common
stockholders are typically the bulk of a publicly traded firm's shareholders and in many cases
enjoy voting privileges that preferred stockholders lack. On the other hand, owners of preferred
stock have first claim to a company's profits and assets. Investors may own three different kinds
of preferred stock:
1. Stock with preferred dividends that entitles them to a fixed dividend rate.
2. Stock with preferred assets that allow them to receive to the first cut of the money from a
company's sale, and
3. Stock with both preferred dividends and preferred assets. Shareholders also may own
redeemable and convertible stock.
Redeemable stock allows a company to repurchase it at some point, whereas convertible stock
enables stockholders to exchange preferred stock for common stock. Companies sell their
stocks to raise money. While they have other financing options such as loans and bonds,
companies may choose to issue stocks because they need to raise more capital than they can
readily borrow, because equity capital may be viewed as less costly than debt financing, or
because favorable stock market conditions may present an opportunity for private owners to
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receive cash for part or all of their shares. Companies may sell their stocks either through
private placement or public offerings. Private placement is usually limited to large institutions
or a small group of individuals.
Before the rise of the publicly traded corporation, often the families that founded companies
were the shareholders, managers, and members of the board of directors. But because these
companies needed to raise increasing amounts of capital to expand, they eventually had to turn
to outside investors. As a result, outside parties quickly became managers and members of the
board. After offering shares to the public, founding family members still retained control of
their corporations in many cases; however, shares also were dispersed among a variety of
investors who had small holdings.
Mustafa Company’s shareholders might persuade management to move in the direction of

shareholder’s preferences.
Managers of a company that focuses on shareholder value will strive to remain abreast of
share-holder interests. Consequently, Andrew Black et al. suggest in In Search of Shareholder
Value that managers must think like entrepreneurs in order to meet shareholders' needs and
add to shareholder value, which may require some refocusing if managers are accustomed to
simply following the directions of their superiors. To create additional shareholder value,
managers must concentrate on a company's primary revenue-generating functions and running
a company as efficiently as possible, which should help a company become a product or service
leader and establish closer ties with consumers. Consequently, managers must begin their
effort to increase shareholder value by identifying the key revenue-generating functions and
then by promoting them.
Furthermore, managers must distinguish between the interests of shareholders who have long-
term interests in a company's worth and those who have short-term interests. Then they must
strive to implement growth strategies that will benefit both kinds of investors insofar as
possible, even though these interests may be in conflict with each other, according to J.P.
Donlon and John Gutfreund. However, this approach has come under the attack of employee
advocates and other critics. In corporate theory, companies traditionally have been viewed
according to the stakeholder model. This model suggests that a company can improve its
financial conditions by attending to the needs and desires of its stakeholders, which include not
only shareholders but also employees, distributors, customers, and so on. Shareholder and
employee interests are sometimes viewed as being at odds with each other, especially around
issues such as layoffs. According to the stake-holder model, managers should weigh the
interests of one group of stakeholders against the interests of another in order to manage a
company fairly. Hence, the shareholder value approach is controversial in that it gives priority
to shareholder needs.
Supporters of the shareholder value approach defend their position by arguing that if a
company is beholden to more than one interest group, then it will face the dilemma of having
to decide between the different groups. If it must decide between competing interests, then
the company must base this decision on some additional reason, but companies are hard-
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pressed to determine what the deciding criterion should be if not increasing shareholder value.
The stakeholder model offers no suggestions. Without a decisive criterion, a company would
constantly face this kind of dilemma, which would drastically slow-down the decision-making
process. Such a dilemma could manifest itself, for example, as a proposal that would increase
shareholder value and meet customer needs, but would result in the reducing the workforce.
However, a company does not ignore the interests of other stakeholders while concentrating
on shareholder value. For example, employees will quit if their interests are not attended to
and customers will patronize the competition if their needs are not met, and so management
inevitably must take their needs into consideration. Finally, advocates of this approach contend
that if a company fails to be profitable, then it will have to close, which would benefit none of
the stakeholders.
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Q. 2 (a) Critically
examine the relationship between ROE and ROA. Give
example in support of your answer.
Answer)
Since ROE = ROA (Equity Multiplier) in order for ROE to equal ROA the equity multiplier must be
one. In other words, the total assets to total shareholders' equity ratio must be one. The return
on assets (ROA) percentage shows how profitable a company's assets are in generating
revenue.
ROA can be Computed as:

This number tells you what the company can do with what it has, i.e. how many dollars of
earnings they derive from each dollar of assets they control. It's a useful number for comparing
competing companies in the same industry. The number will vary widely across different
industries. Return on assets gives an indication of the capital intensity of the company, which
will depend on the industry; companies that require large initial investments will generally have
lower return on assets.
Return on Equity:
Return on equity (ROE) measures the rate of return on the ownership interest (shareholders'
equity) of the common stock owners. It measures a firm's efficiency at generating profits from
every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE
shows how well a company uses investment funds to generate earnings growth.
The Formula:
ROE is equal to a fiscal year's net income (after preferred stock dividends but before common
stock dividends) divided by total equity (excluding preferred shares), expressed as a
percentage. As with many financial ratios, ROE is best used to compare companies in the same
industry. High ROE yields no immediate benefit. Since stock prices are most strongly
determined by earnings per share (EPS), you will be paying twice as much (in Price/Book terms)
for a 20% ROE company as for a 10% ROE company. The benefit comes from the earnings
reinvested in the company at a high ROE rate, which in turn gives the company a high growth
rate. ROE is presumably irrelevant if the earnings are not reinvested.
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Q. 2 (b) What are the five groups of ratios? Give two or three examples of each
kind.
Answer:
These essential financial ratios give you a powerful insight into how your business is doing.
Financial ratios help you to measure where your business stands, where it’s been and where it’s
heading. They also help you measure yourself against industry benchmarks, and see how you’re
tracking against your business plans. There are plenty of ratios to choose from. Here are our top
five.
• Gross profit margin

• Net profit margin
• Current ratio
• Inventory turnover
• Return on owner’s equity
GROSS PROFIT MARGIN

Your gross profit margin tells you the average gross profit on each dollar of sales before
operating expenses. The equation is simple:
Your gross profit margin will depend on the industry you’re in, so it’s important to measure
yourself against industry benchmarks. It’s an essential starting point for assessing the
profitability of each product but it still doesn’t tell you whether your business is making a profit
over all. For that you need the net profit margin.
NET PROFIT MARGIN

Your net profit margin is the percentage profit your business makes for every dollar of revenue
whether you’re making a profit after covering all of your costs.
Again, your target net profit margin will be at least partly determined by your industry. Some
retailers, for example, run high-volume, low-margin businesses, while others sell a small
number of expensive items with plenty of margin built in.
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Again, your target net profit margin will be at least partly determined by your industry. Some
retailers, for example, run high-volume, low-margin businesses, while others sell a small
number of expensive items with plenty of margin built in.
CURRENT RATIO
You’re making profitable sales but are they enough to cover short term liabilities? To answer
that, you need the current ratio. It helps to measure the solvency of your business by
comparing your current assets (like unpaid invoices) to your current liabilities (unpaid bills and
the like):
As a rule of thumb, you want your current ratio to be 2 or more. In other words, your assets
should be at least double your liabilities, meaning you have plenty of capacity to meet them. If
sales are growing and you have a short operating cycle, a lower number may be OK. But if you
have a long operating cycle, you might want your current ratio to be higher, to make sure
liabilities don’t get out of control.
INVENTORY TURNOVER
If you have trading stock, then inventory turnover is an incredibly useful number. It shows you
how many times your business’ inventory is sold and replaced over a particular period:
So, if you’ve spent $200,000 buying stock over the year, and you keep an average of $20,000
worth of stock on hand, then your inventory turnover is 10 times a year.
Inventory turnover varies by industry but as a rule of thumb the higher it is the better. A low
turnover indicates you have a lot of money tied up in stock for long periods of time, which is
not good for cash flow. Too high a figure could indicate you’re not keeping enough stock on
hand!
RETURN ON OWNER’S EQUITY

Return on owner’s equity compares your net business income to the equity you’ve invested in
the business. It reveals how much you’re making from your investment:
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So if you’ve invested $200,000 of your own money in the business, but it’s generating a net
income of $100,000 a year, then your return on owner’s equity is 50%. This ratio is a great way
to compare what you’ve earned from your business to what you might have earned from
another investment. If you’re just starting up, it might not be as high as you’d like, but it tends
to increase over time as your business grows, especially if your personal investment remains
the same.
Q. 2 (c) The most recent income statement of Allied Chemical Ltd is given below.
Prepare a common-size income statement based on this information. Give
interpretation to the standardized net income. What percentage of sales goes to
cost of goods sold?
Allied Corporation
2008 Income Statement
(Rs. In millions)
Sales Rs. 4,053
Cost of goods sold 2,780
Depreciation 550___
Earning before interest and taxes Rs. 723
Interest paid 502___
Taxable income Rs. 221
Taxes (34%) 75____
Net income Rs. 146
Dividends Rs. 47
Allied Corporation
Income Statement
For the period Ended 2008
Sale 4053 100%
-C.G.S 2780 68.59%
=G.P 1273 31.41%
-Depreciation 550
=Earning before Interest Tax 723
-Interest 502
-Taxable Income 221
-Taxes (34%) 75
=Net Income 146
-Dividends 47
=Addition to Retained Earning 99
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Q. 3 (a) Find the amount to which Rs.500 will grow under each of the following
Conditions:
i. 12 percent compounded semi-annually for 5 years.
ii. 12 percent compounded quarterly for 5 years.
Answer)
Given Data:
PV = 500
i = 12%
n = 5%
Fv = Pv (1 + i)n
i. 12% Compounded Semi-Annually for 5 year

n
Fv = Pv (1 + i )
= 500 (1+12/2) 5x2
= 500 (1+6 %) 10
=500 (1.06)10
= 500 (1.7908)
Fv = 895.40
ii. 12% Compound quarterly for 5 Year

Fv = Pv (1 + i %)nx4
=500 (1+12/4)5x4
=500 (1+.3)20
=500 (1.03)20
=500 (1.8061)
Fv = 903.05
iii. 12% Compounded Monthly for 5 Year

Fv =Pv (1 + i %)nx12
=500 (1 + 12/12)5x12
=500 (1 + 1)60
=500 (1.8167)
Fv=908.35
Q. 3 (b) Setup an amortization schedule for Rs.25000 loan to be repaid in equal

installments at the end of the next 5 years. The interest rate is 10 percent.
Pv = 25000
i = 10%
n = 5%
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PvA = FvA (Pvi FAi% ny)

25000 = FvA (Fvi FA10% 5y)
25000 = FvA (3.791)
25000 = FvA
3.791
6595 = FVA (Amortization)
The amortization schedule is as follow:
Year Installment Repayment Principle Ending

Balance Interest (10 % of principal
x Amount or (Payment –
Reaming Interest)
Balance)
0 25000
1 6595 2500 4095 20905
2 6595 2090 4505 16400
3 6595 1640 4955 11445
4 6595 1144 5451 5994
5 6595 601 5994 0
Q. 3 (c) The Moonless Corporation has just paid a dividend of Rs.3 per share. The
dividend of this company grows at a steady rate of 8 percent per year. Based on
this information, what will the dividend be in 5 years?
Answer
Div = 3
g = 8%
What will the dividend be in 5 Year.
Future Value Dividend

FV=D (1+i) n
Do = 3
D1 = 3 (1.08) = 3.24
D2 = 3.24 (1.08) = 3.50
D3 = 3.50 (1.08) = 3.78
D4 = 3.78 (1.08) = 4.08
D5 = 4.08 (1.08) = 4.41
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Q. 4 (a) Stock A and B have the following probability distributions of expected

future returns:
Probability km kj
0.3 15% 20%
0.4 9 5
0.3 8 12
i. Calculate the expected rate of return for the market and Stock A.
ii. Calculate the standard deviations for the market and Stock A.
iii. Calculate the coefficients of variation for the market and Stock A.
STOCK “A”
Probability km (r) Pxr r-r~ (r-r~)2 (r-r~)2 x P
(P)
0.3 0.15 0.045 0.045 0.002025 0.0006075
0.4 0.09 0.036 -0.015 0.000225 0.00009
0.3 0.08 0.024 -0.0025 0.000625 0.0001875
∑ Pxr = r~
0.105=r~ 0.000885
√0.000885 = 0.020
STOCK “B”
Probability km (r) Pxr r-r~ (r-r~)2 (r-r~)2 x P
(P)
0.3 0.20 0.06 0.084 0.007056 0.0021168
0.4 0.05 0.02 -0.066 0.004356 0.0017424
0.3 0.12 0.036 0.004 0.000016 0.0000048
∑ Pxr = r~
0.116=r~ 0.003864
√0.003864 = 0.062
STOCK “A” = r~=0.105, Ỏ2=0.000885, Ỏ=0.02

STOCK “B” = r~=0.116, Ỏ2=0.003864, Ỏ=0.062
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Q. 4 (b)
Rehman has Rs.100,000 to invest in a portfolio containing stock A, stock B, and a
risk free asset. He must invest all of his money. Rehman’s goal is to create a
portfolio that has an expected return of 13% and that has only 70% of the
overall market. If A has an expected return of 20%, a beta of 1.3 and the risk-
free rate is 7%, how much money will he invest in stock A? Also give
interpretation to the answer.
Answer:
Investment 100000
Expected Return 13%
20%
B = 1.30
R7 = 7%
Ki = Rf + B ( Rm - Rf )
20% = 7% + 1.30 ( Rm - 7%)
20% - 7% = 1.30 ( Rm – 9.1% )
13% + 9.1% = 1.30 Rm
22-1% = Rm
1.30
20.8% = 20.8% = Rm
Expected Return is small differed from the Market Rate of Return. In stock A invest Rs. 100000.
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Q. 5 (a)
What is the relationship between the required rate of return on an investment
and the cost of capital associated with that investment?
Answer;
Return on capital calculated in a way that takes into account the risks associated with income.
Example: Being able to compare a high-risk, potentially high-return investment with a low-risk,
lower-return investment helps to answer a key question that confronts every investor: is it
worth the risk? There are several ways to calculate risk-adjusted return. Each has its strengths
and shortcomings. All require particular data, such as an investment's rate of return, the risk-
free return rate for a given period, and a market's performance and its standard deviation. The
choice of calculation depends on an investor's focus: whether it is on upside gains or downside
losses.
The two most-used measures for evaluating an investment are the net present value and the
internal rate of return. (Two earlier tutorials discussed these concepts. See the tutorials list for
links to tutorials for discounting future income and the internal rate of return.) It is often
assumed that higher is better for both of the net present value and the internal rate of return.
In particular, it is usually stated that investments with higher internal rates of return are more
profitable than investments with lower internal rates of return. However, this is not necessarily
so. In some situations, an investment with a lower internal rate of return may be better, even
judged on narrow financial grounds, than an investment with a higher internal rate of return.
This interactive lecture explores why and when this reversal takes place. To review, both the
net present value and the internal rate of return require the idea of an income stream, so let's
start there. An income stream is a series of amounts of money. Each amount of money comes
in or goes out at some specific time, either now or in the future. The income stream represents
the investment; the income stream is all you need to know for financial evaluation purposes. In
real life, individuals, charitable institutions, and even for-profit businesses have social or other
goals when selecting investments. For businesses, the benefits of community good will are no
less real for being difficult to measure precisely. For enterprises with social as well as financial
goals, the measures discussed here are still useful: They tell you how much it costs you to
advance your social goals. Here is an income stream example, from the interactive lecture
about the internal rate of return.
Year 0 1 2 3 4 5 6
Income amounts -$1000 $200 $200 $200 $200 $200 $200
Here we see seven points in time and, for each, a dollar inflow or outflow. At year 0 (now), the
income amount is negative. Negative income is cost, or outgo. In this example, the negative
income amount in year 0 represents the cost of buying and installing the machine. In the future,
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at years 1 through 6, there will be net income of $200 each year. All of the amounts in the
income stream are net income, meaning that each is income minus outgo, or revenue minus
cost. In year 0, the cost exceeds the revenue by $1000. In years 1 though 6, the revenue will
exceed the cost by $200. This investment evidently has no salvage value. That is, there is
nothing that can be sold in year 6, the last year. If there were, the amount that could be
realized from the sale would be added to the income amount for year 6. For simplicity, all my
examples have the incomes and outgoes at one-year intervals. Real-life investments can have
income and expenses at irregular times, but the principles of evaluation are the same. Now let's
discuss our two measures in connection with this income stream:
Net Present Value
The net present value of an income stream is the sum of the present values of the individual
amounts in the income stream. Each future income amount in the stream is discounted,
meaning that it is divided by a number representing the opportunity cost of holding capital
from now (year 0) until the year when income is received or the outgo is spent. The opportunity
cost can either be how much you would have earned investing the money someplace else, or
how much interest you would have had to pay if you borrowed money. See the interactive
lecture on discounting future income for more explanation. That tutorial has a nifty
spreadsheet setup for calculating present values that you can copy and use in your own
spreadsheet. The word "net" in "net present value" indicates that our calculation includes the
initial costs as well as the subsequent profits. It also reminds us that all the amounts in the
income stream are net profits, revenues minus cost. In other words, "net" means the same as
"total" here. The net present value of an investment tells you how this investment compares
either with your alternative investment or with borrowing, whichever applies to you. A positive
net present value means this investment is better. A negative net present value means your
alternative investment, or not borrowing, is better.
Consider again this income stream:
Year 0 1 2 3 4 5 6
Income amounts -$1000 $200 $200 $200 $200 $200 $200
Let's assume that the discount rate (the interest rate that you could earn elsewhere or at which
you could borrow) will not change over the life of the project. This makes the calculation
simpler. With this assumption, we can use the usual formula:
Present Value of any one income amount = (Income amount) / ((1 + Discount Rate)
to the a power)
a is the number of years into the future that the income amount will be received (or spent, if
the income amount is negative). The net present value (NPV) of a whole income stream is the
sum of these present values of the individual amounts in the income stream. If we still assume
that income comes or goes in annual bursts and that the discount rate will be constant in the
future, then the NPV has this formula:
17/20
Varying Future Interest Rates
The future interest rate does not have to be constant for this theory to apply. The interest rate
can vary, but that makes the formulas messier. For example, if r1 is the expected interest rate
next year, and r2 is the expected interest rate the year after that, then the present value today
of I2 income in year 2 is I2/(1+r1)(1+r2). The I 's are income amounts for each year. The
subscripts (which are also the exponents in the denominators) are the year numbers, starting
with 0, which is this year. The discount rate assumed to be constant in the future is r. The
number of years the investment lasts is n.
Three properties of the net present value of an income stream are:

1. Higher income amounts make the net present value higher. Lower income amounts make the
net present value lower.
2. If profits come sooner, the net present value is higher. If profits come later, the net present
value is lower.
Internal Rate of Return
In the example we've been using, if you keep the income amounts at their original -1000, 200,
200, 200, 200, 200, and 200, and set the discount rate to 0.0547, the net present value
becomes 0. This discount rate, 0.0547 or 5.47%, is the internal rate of return for this investment
it is the discount rate that makes the net present value equal 0. You can try this below, by
setting the discount rate to 0.0547. If you now raise any of the income amounts in years 1
through 6 (feel free to edit an income amount and see for yourself), you will need a higher
discount rate to bring the net present value back to 0. That would seem to imply that projects
with higher incomes have higher internal rates of return. Similarly, if you lower any of the
income amounts in years 1 through 6, then a lower discount rate will be needed to bring the
net present value back up to 0. That would seem to imply that projects with lower incomes
have lower internal rates of return. These seeming implications are actually often true, if the
projects being compared have about the same shape, with the costs coming early and the
benefits coming late, and if the projects being compared switch from net outgo to net income
at about the same time. Otherwise, though, the implications might not be true.
The NPV Curve
One way to understand how the net present value and the internal rate of return can give
seemingly different advice is to use what I will call the net present value curve, or NPV curve.
The NPV curve shows the relationship between the discount rate and the net present value for
a range of discount rates. The present value at a given discount rate, such as 5%, and the
internal rate of return are each points on the NPV curve. The NPV curve, the relationship
between the discount rate and the net present value has a formula that can be written like this:
18/20
This, of course, is the formula we saw already for the net present value, for annualized costs
and revenues and a constant discount rate. Each I is an income amount for a specific year. The
subscripts (which are also the exponents in the denominators) are the year numbers, starting
with 0, which is this year. The constant discount rate is r. The number of years the investment
lasts is n. In Weeks's study of professionals' incomes, n was about 44, because costs and
incomes were calculated from age 21 to age 65. We'll use an example with an n of 6, so the
formula fits on your screen:
This is our machine investment example that we have been using all along. The NPV is a
function of r. Graphed, it looks like this:
The blue curve shows the net present value for discount rates (r) from 0 to 0.1 (0% to 10%). The
red dots are the two points we get from our measures. The left red dot shows the net present
value at the discount rate of 0.05 (5%). The right red dot shows the internal rate of return,
because it is where the curve crosses the horizontal line indicating an NPV of 0. That right red
dot is between the 0.05 and 0.06 marks on the r axis, so the internal rate of return is between
0.05 and 0.06. (The actual internal rate of return is about 0.0547, as we saw earlier.) Imagine
we have another possible investment, which has this NPV equation:
19/20
This investment is like the first, except that the net profit in years 1 through 6 is $220 per year,
rather than $200. I would say that this investment has a similar "shape" to the first, because the
costs and profits come at the same times. Also, the size of the initial outlay is the same for both.
The only difference is the amount of profit. Here's a graph with both investments on it:
The green curve is the second investment. It is above and parallel to the first investment's blue
curve. The left orange dot shows the net present value of the second investment at the
discount rate of 0.05. The net present value there is a little over $100. This is higher than the
left red dot, so the net present value at r=5% of the green-line investment is higher than the net
present value at r=5% for the blue-line investment. The right orange dot shows where the
second investment's curve crosses the NPV=0 line. This is well to the right of the first
investment's internal rate of return dot. The internal rate of return for the second investment is
much higher (further to the right).
Q. 5 (b)
The earnings, dividends and stock price of Ehsaan technologies Inc. are expected
to grow at 7% per year in the future. Ehsaan’s common stock sells for Rs.23 per
share, its last dividend was Rs.2.00, and the company will pay a dividend of
Rs.2.14 at the end of the current year.
i. What is company’s cost of equity?
ii. If the firm’s beta is 1.6, the risk-free rate is 9%, and the expected return on
the market
is 13%, what will be the firm’s cost of equity using the CAPM approach?
20/20
Answer Q. 5 (b)
i. Do = 2
Po = 23
g=7
D1 = D ( 1 + g ) Di = 2.147
= 2(1.07)
Ke = Dividend1 + g
Po
=2.14 + 7%
23
= 9.3% + 7%
= 16.30%
ii. CAPM
Ki = Rf + B ( Rm – Rf )
= 9% + 1.20 ( 13% - 9% )
= 9% + 1.20 ( 4% )
= 9% + 4.8%
= 13.8%
21/20

Assignment Ist 562 FM Spring 2010

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Assignment Ist 562 FM Spring 2010

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Financial Management (562)

Department of Business Administration

Financial Management (562)

Management V/s Shareholder:

might persuade management to move in the direction of shareholders'

I have elsewhere attempted to construct a theoretical model that satisfies these

Thus we can compare and analyze these policies in an integrated context.

Shareholders or stockholders own parts or shares of companies. In large corporations,

Mustafa Company’s shareholders might persuade management to move in the direction of

ROA can be Computed as:

• Gross profit margin

GROSS PROFIT MARGIN

NET PROFIT MARGIN

RETURN ON OWNER’S EQUITY

i. 12% Compounded Semi-Annually for 5 year

ii. 12% Compound quarterly for 5 Year

iii. 12% Compounded Monthly for 5 Year

Q. 3 (b) Setup an amortization schedule for Rs.25000 loan to be repaid in equal

PvA = FvA (Pvi FAi% ny)

The amortization schedule is as follow:

Year Installment Repayment Principle Ending

Future Value Dividend

Q. 4 (a) Stock A and B have the following probability distributions of expected

STOCK “A” = r~=0.105, Ỏ2=0.000885, Ỏ=0.02

Net Present Value

Varying Future Interest Rates

Three properties of the net present value of an income stream are:

Internal Rate of Return

The NPV Curve

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