Review Questions Answers PDF

## 11-18 (Payback and discounted payback period calculations) ### (a) Project A | Year | CF | Cum CF | |---|---|---| | 0 | -$1,000 | -$1,000 | | 1 | $600 | -$400 | | 2 | $300 | -$100 | | 3 | $200 | $100 | | 4 | $100 | $200 | | 5 | $500 | $700 | $PPA =2+\frac{$100}{$200}=2.50 \text{ years}$ ###...

## 11-18 (Payback and discounted payback period calculations) ### (a) Project A | Year | CF | Cum CF | |---|---|---| | 0 | -$1,000 | -$1,000 | | 1 | $600 | -$400 | | 2 | $300 | -$100 | | 3 | $200 | $100 | | 4 | $100 | $200 | | 5 | $500 | $700 | $PPA =2+\frac{$100}{$200}=2.50 \text{ years}$ ### Project B | Year | CF | Cum CF | |---|---|---| | 0 | -$10,000 | -$10,000 | | 1 | $5,000 | -$5,000 | | 2 | $3,000 | -$2,000 | | 3 | $3,000 | $1,000 | | 4 | $3,000 | $4,000 | | 5 | $3,000 | $7,000 | $PPB =2+\frac{$2000}{$3000}=2.67 \text{ years}$ ### Project C | Year | CF | Cum CF | |---|---|---| | 0 | -$5,000 | -$5,000 | | 1 | $1,000 | -$4,000 | | 2 | $1,000 | -$3,000 | | 3 | $2,000 | -$1,000 | | 4 | $2,000 | $1,000 | | 5 | $2,000 | $3,000 | $PPC =3+\frac{$1000}{$2000}=3.50 \text{ years}$ Based on a maximum payback period of three years, Projects A and B are acceptable, but Project C should be rejected. ### (b) The correct ranking from shortest to longest payback period is Project A, Project B and Project C. However, this does not necessarily mean that Project A is the best project, because of the limitations of the payback period method: 1. It ignores cash flows after the payback period. 2. It ignores the time value of money. 3. it has no clear-cut way to define the cut-off criterion for the payback period that is tied to the value creation potential of the project. ### (c) Project A | Year | CF | Cum CF | DCF | Cum DCF | |---|---|---|---|---| | 0 | -$1,000 | -$1,000 | -$1,000.00 | -$1,000.00 | | 1 | $600 | -$400 | $545.45 | -$454.55 | | 2 | $300 | -$100 | $247.93 | -$206.61 | | 3 | $200 | $100 | $150.26 | -$56.35 | | 4 | $100 | $200 | $68.30 | $11.95 | | 5 | $500 | $700 | $310.46 | $322.41 | $DPPA =3+\frac{$56.35}{$68.30}=3.83 \text{ years}$ ## Project B | Year | CF | Cum CF | DCF | Cum DCF | |---|---|---|---|---| | 0 | -$10,000 | -$10,000 | -$10,000.00 | -$10,000.00 | | 1 | $5,000 | -$5,000 | $4,545.45 | -$5,454.55 | | 2 | $3,000 | -$2,000 | $2,479.34 | -$2,975.21 | | 3 | $3,000 | $1,000 | $2,253.94 | -$721.26 | | 4 | $3,000 | $4,000 | $2,049.04 | $1,327.78 | | 5 | $3,000 | $7,000 | $1,862.76 | $3,190.54 | $DPP =3 + \frac{$721.26}{$2049.04}= 3.35 \text{ years}$ ## Project C | Year | CF | Cum CF | DCF | Cum DCF | |---|---|---|---|---| | 0 | -$5,000 | -$5,000 | -$5,000.00 | -$5,000.00 | | 1 | $1,000 | -$4,000 | $909.09 | -$4,090.91 | | 2 | $1,000 | -$3,000 | $826.45 | -$3,264.46 | | 3 | $2,000 | -$1,000 | $1502.63 | -$1,761.83 | | 4 | $2,000 | $1,000 | $1366.03 | -$395.81 | | 5 | $2,000 | $3,000 | $1241.84 | $846.04 | $DPPC = 4 + \frac{$395.81}{ $1241.84}= 4.32 \text{ years}$ Based on a maximum payback period of three years, and using discounted payback, none of the projects should be undertaken. ## 9-21 (Bond valuation relationships) ### (a) Using a mathematical formula: $Bond \ value = $70\frac{1-\frac{1}{1.085^{17}}}{0.085}+ $1,000\frac{1}{1.085^{17}}= $867.62 $ ### Using a financial calculator: | Enter | N | I/Y | PV | PMT | FV | |---|---|---|---|---|---| | | 17 | 8.5 | -867.62 | 70 | 1000 | ### Using an Excel spreadsheet: =PV(rate,nper,pmt,fv) or =PV(0.085,17,70,1000) (Answer: -867.62) ### (b) (i) Using a mathematical formula: $Bond \ value = $70 \frac{1-\frac{1}{1.11^{17}}}{0.11} + $1,000\frac{1}{1.11^{17}}= $698.05 $ ### Using a financial calculator: | Enter | N | I/Y | PV | PMT | FV | |---|---|---|---|---|---| | | 17 | 11 | -698.05 | 70 | 1000 | ### Using an Excel spreadsheet: =PV(0.085,17,70,1000) (Answer: -698.05) ### (ii) Using a mathematical formula: $Bond \ value = $70 \frac{1-\frac{1}{1.06^{17}}}{0.06} + $1,000\frac{1}{1.06^{17}}= $1,104.77 $ ### Using a financial calculator: | Enter | N | I/Y | PV | PMT | FV | |---|---|---|---|---|---| | | 17 | 6 | 1,104.77 | 70 | 1000 | ### Using an Excel spreadsheet: =PV(0.06,17,70,1000) (Answer: -1,104.77) ### (c) There is an inverse relationship between the value of a bond and the yield to maturity (YTM). The change in the value of a bond caused by changing interest rates is called interest-rate risk. Based on the answers in part (b), a decrease in interest rates (i.e. YTM) will cause the value of a bond to increase, and vice versa. If the YTM equals the coupon rate, the bond will trade at par value. If the YTM exceeds the coupon rate, the bond will trade at a discount, and if the YTM is less than the coupon rate, the bond will trade at a premium. ## 9-22 (Bond valuation relationships) ### (a) Using a mathematical formula: $Bond \ value = $85\frac{1-\frac{1}{1.09^{15}}}{0.09}+ $1,000\frac{1}{1.09^{15}}= $959.70 $ ### Using a financial calculator: | Enter | N | I/Y | PV | PMT | FV | |---|---|---|---|---|---| | | 15 | 9 | -959.70 | 85 | 1000 | ### Using an Excel spreadsheet: =PV(rate,nper,pmt,fv) or =PV(0.09,15,85,1000) (Answer: -959.70) ### (b) (i) Using a mathematical formula: $Bond \ value = $85\frac{1-\frac{1}{1.11^{15}}}{0.11}+ $1,000\frac{1}{1.11^{15}}= $820.23 $ ### Using a financial calculator: | Enter | N | I/Y | PV | PMT | FV | |---|---|---|---|---|---| | | 15 | 11 | -820.23 | 85 | 1000 | ### Using an Excel spreadsheet: =PV(0.11,15,85,1000) (Answer: -820.23) ### (ii) Using a mathematical formula: $Bond \ value = $85\frac{1-\frac{1}{1.07^{15}}}{0.07}+ $1,000\frac{1}{1.07^{15}}= $1,136.62 $ ### Using a financial calculator: | Enter | N | I/Y | PV | PMT | FV | |---|---|---|---|---|---| | | 15 | 7 | 1,136.62 | 85 | 1000 | ### Using an Excel spreadsheet: =PV(0.07,15,85,1000) (Answer: -1,136.62) ### (c) There is an inverse relationship between the value of a bond and the yield to maturity. If you expect the yield to maturity on a comparable risk bond to decrease to 7%, you should purchase the Stanley bonds at the current market price of $960, because they are cheaper than they will be if market interest rates fall. ## Answers to Question 4 Cash budgeting: veterinary clinic ### 1 Happy Pets #### Budgetary data | | November | December | January | February | March | |---|---|---|---|---|---| | Sales | $200 000 | $225 000| $75 000 | $225 000 | $200 000 | | Purchases | $75 000 | $0 | $125 000 | $75 000 | $100 000 | | Salaries per month | $100 000 | $100 000 | $100 000 | $100 000 | $100 000 | | Other costs per month | $75 000 | $75 000 | $75 000 | $75 000 | $75 000 | #### Following is the cash budget for the quarter ending 31 March: | | January | February | March | |---|---|---|---| | Opening cash Balance | (200,000.00) | (282,500.00) | (325,000.00) | | Cash received from: | | | | | consultations: | | | | | - Sales 2 months ago | 40,000.00 | 45,000.00 | 7,500.00 | | - Last month sales (20%) | 45,000.00 | 15,000.00 | 45,000.00 | | - Current month sales (60%) | 45,000.00 | 135,000.00 | 120,000.00 | | Total Cash Receipts | 130,000.00 | 195,000.00 | 172,500.00 | | Cash Payments: | | | | | - Supplies | 37,500.00 | 62,500.00 | 62,500.00 | | - Previous Month Purchases (50%) | 100,000.00 | 100,000.00 | 100,000.00 | | - Current Month Purchases (50%) | 75,000.00 | 75,000.00 | 75,000.00 | | - Salaries | 100,000.00 | 100,000.00 | 100,000.00 | | - Other Costs | 75,000.00 | 75,000.00 | 75,000.00 | | Total Cash Payments | 212,500.00 | 237,500.00 | 237,500.00 | | Closing Cash Balances | (282,500.00) | (325,000.00) | (390,000.00)| ### 2 The cash budget using a spreadsheet approach shows the implications of the clinic’s present cash management practices. The clinic has a serious cash flow problem with monthly cash disbursement being greater than cash receipts. Over the three-month period the cash balance has moved from $(200 000) to $(390 000). Management needs to seriously consider its pricing policy, the level of business that it is generating, the high level of uncollectable sales (at 10%) and the generous payment terms offered to clients. Management can use the cash flow budget to experiment with pricing and other changes to see what the impact would be on cash flow. An obvious problem lies in the slow payment by most customers (even though this appears to have been improved in the current year), coupled with the high level of bad debts at 10 per cent. Attempts could be made to ask clients to pay on a cash basis for consultations by offering a reasonable discount on immediate payment. (Offering a 5% discount and eliminating all bad debts would raise collections by 5%.) Budgeting will help evaluate the impact of various discount policies.