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Relevant for MAY 2011 Exam

Suresh Prasad (www.aubsp.com) (15630 Points)

29 January 2011

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LIST OF INSTITUTE’S PUBLICATIONS RELEVANT FOR MAY, 2011 EXAMINATION

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4 Replies

Rekha (MANAGER - FINANCE & ACCOUNTS) (1445 Points)
Replied 29 January 2011

https://220.227.161.86/19954list_pubnov2010exam.pdf

Suresh Prasad (www.aubsp.com) (15630 Points)
Replied 03 April 2011

Click here and see our World Cup

Rajuu (cccc) (34 Points)
Replied 05 April 2011

Pls solve the below question.......its from IIMs MBA exam:

Topic : Capital budgeting.

The Reliable Fryer Corp. is considering replacing its old frying pan production line, which has a book value of zero and no salvage value but could be used to support the current level of frying pan sales of $240,000 per year for five more years. The reason the company is looking into replacing the line is that its management feels that they could sell 10,000 frying pans a year instead of 8,000, which is currently the case. In addition, the new production line they are considering would reduce the cost of labor by 75 cents a unit, and an extra 50 cents a unit would be saved due to a more efficient use of the material. At the same time, since less material will be wasted, the raw material inventory will be reduced thus decreasing working capital requirement by $6,000. The material and labor savings will allow the company to keep the frying pan price at the current level over the coming five years. The new machinery will provide the same output as the current machine in the first year, but then its annual output will be increased by 1,000 units a year until it reaches 10,000. The new production equipment can be purchased for $150,000, and its salvage value will be $30,000 at the end of five years, during which the equipment will be depreciated straight-line to zero. Currently, the company’s variable costs associated with the frying pan production are $50,000, and the corresponding fixed costs, that will stay the same if the project is accepted, are $80,000 a year. Using a cost of capital of 10 percent and a tax rate of 40 percent, find the project’s net present value and make a decision regarding the acceptance of the project.

Rajuu (cccc) (34 Points)
Replied 05 April 2011

Few more question from the same paper. please help b eby solving the below questions...they are basically from Capital budgeting and one is from portfolio management. Thank you.

6. The Great Eastern Toy company management is considering an investment in a new product. It would require the acquisition of a piece of equipment for $16 million with a 10-year operational life, providing regular maintenance is carried out. Salvage value of the equipment is estimated at $800,000. The product’s economic life is expected to be 5 years, with annual revenues estimated at $10.8 million during this period. Raw material for the new product is estimated at $95 per unit produced and an inventory equivalent to one month’s production, or 3,000 units, would be needed. Direct costs of manufacture are expected to be $130,000 per month. Work-in-progress and finished goods inventories would rise by $150,000. For tax purpose, fixed assets must be depreciated according to the straight-line method. The corporate income tax rate is 40 percent, so is the capital gain tax rate. The company’s cost of capital is 12 percent.

a. Based on the above data, set out the cash flows expected from the project.

What is the net present value of the project?

7. Reviewing the cash flow forecasts of a new investment project that appear in the table below, the Avon company’s finance manager noted that there was no mention of any impact of the investment on the firm’s accounts receivable and payable. The average collection period on the new product was expected to be 50 days, while new raw material purchases were expected to be settled in 36 days on average. Also, he noted that the standard charges of one percent of sales revenues from new projects had not been made, nor the annual financing charge of 10 percent levied against the book value of the assets used by the project.

How would the project’s profitability be affected by including its impact on Avon’s:

a. Accounts receivable and accounts payable

b. Overhead costs

c. Financial charges

$ thousands	Now	Year 1 to 4	Year 5

1. Revenues		$12,000	$12,000
2. Raw material cost		$4,000	$4,000
3. Direct costs		$1,000	$1,000
4. Depreciation expenses		$4,000	$4,000
5. Pretax operating profit		$3,000	$3,000
6. Tax rate		40%	40%
7. After tax operating profit		$1,800	$1,800
8. Increase in inventories	$400	$0	-$400
9. Capital expenditures	$20,000	$0	$0
10. Aftertax resale value of equipment			$0
11. Cash flow from the project	-$20,400	$5,800	$6,200
12. Net present value of project at 11% cost of capital	$1,274

8. Although he was initially satisfied by the apparent profitability of the new project, the Avon company’s CEO was troubled by some other aspects of the project which he felt the finance manager had left out of the analysis. First, he was concerned whether the new project could possibly cannibalize sales of the existing products made by the firm. In a “worst case” scenario, he believed that a negative impact on after-tax cash flows by as much as $650,000 per year was possible. Secondly, a building owned by the company, but at present unoccupied, would be used to produce the new product. They had recently received an offer from an adjacent business to rent this property for $100,000 per year. Finally, the firm had commissioned and already paid to a consultant $500,000 for a market study of the new product. How would the project’s profitability be affected by including these items in the cash flow estimates that are shown on the table in problem above?

9. You have been asked to estimate the cost of capital for the CAT corporation. The company has 4 million shares and 125,000 bonds of par value $1,000 outstanding. In addition, it has $20 million in short-term debt from its bank. The target capital structure ratio is 55 percent equity, 40 percent long-term debt, and 5 percent short-term debt. The current capital structure has temporarily moved slightly away from the target ratio.

The company’s shares currently trade at $50 with a beta of 0.75. The book value of the shares is $16. The annual coupon rate of the bonds is nine percent, they trade at 108 percent of par, and will mature in 10 years. Interest on the short-term debt is the prime rate less one percent. Prime rate is currently 7.5 percent. The current yield on 10-year government bonds is 5.5 percent. The equity market risk premium is 6.2 percent. The corporate tax rate applicable is expected to be 30 percent. Based on these data, calculate the cost of capital for the CAT corporation.

10. The table appearing below shows the annual realized returns on the following U.S. securities from 1990 to 1999: the stock market [S&P500], corporate bonds, government bonds and treasury bills; the annual inflation rate for each period is shown in the last column.

Time period	S&P 500	Corporate bonds rate	Government bond rate	Treasury bills rate	Inflation rate

1990	-3.27%	6.78%	6.18%	7.81%	6.11%
1991	30.55	19.89	19.30	5.60	3.06
1992	7.67	9.39	8.05	3.51	2.90
1993	9.99	13.19	18.24	2.90	2.75
1994	1.31	-5.76	-7.77	3.90	2.67
1995	37.43	27.20	31.67	5.60	2.54
1996	23.07	1.40	-0.93	5.21	2.54
1997	33.36	12.95	15.85	5.26	1.70
1998	28.58	10.76	13.06	4.86	1.61
1999	21.04	-7.45	-8.96	4.68	2.68

Annual averages:

1990 – 99	18.98%	8.84%	9.47%	4.93%	2.86%
1926 - 99	13.30	5.90	5.50	3.80	3.20

Source: Ibbotson Associates

a. Theory suggests that the riskier the investment, the higher the expected return. To what extend is that illustrated by the data in the table?

b. How do you explain the relatively high volatility in the annual returns on both corporate and government long-term bonds?

What was the market risk premium of the S&P 500 for each of the years 1990 to 1999? For the two periods 1990 – 1999 and 1926 – 1999? What conclusions can you draw from your observations?