ACC-501 Final Term Subjective What is optimal credit policy state? 3

ACC-501
Final Term Subjective
What is optimal credit policy state? 3
The optimal amount is determined by the point at which the incremental cash flows from increased
sales are exactly equal to the incremental costs of carrying the increased investment in accounts
receivable.
The carrying costs associated with granting credit are of three types
•The required return on receivables
•The losses from bad debts
•The cost of managing credit and credit collection
What is difference between market value and book value? 3
The true value of any asset is its market value, which is simply the amount of cash we would get if
we actually sold it.
The values shown on the balance sheet for the firm’s assets are book values and generally are not
what the assets are actual worth.
How cost of debt can be measured? 3
Cost of debt is the return that firm’s creditors demand on the new borrowings.
This cost of debt can be observed directly or indirectly using the interest rates in the financial
markets.
Alternatively, we can use the firm’s bond ratings to estimate the interest rates on newly issued
bonds of same rating.
Define benchmarking and its method? 5
Benchmarking is to establish a standard to follow for comparison.
Some methods of benchmarking are:
•Time-Trend analysis
•Peer Group Analysis
Describe difference type of firm's inventory and retail business? 5
Inventory Types
•Raw Material
•Work-in-Progress
•Finished Goods
Retail Business Types
•Retail Stores
•Retailing without a Store
•Retailing through Mail Order
•Retailing through the Internet
•Retailing through Vending Machines
What is the best cash policy? 5
Cash Reserves
•Pros – firms will be less likely to experience financial distress and are better able to handle
emergencies or take advantage of unexpected opportunities
•Cons – cash and marketable securities earn a lower return and are zero NPV investments
Maturity Hedging
•Try to match financing maturities with asset maturities
•Finance temporary current assets with short-term debt
•Finance permanent current assets and fixed assets with long-term debt and equity
Interest Rates
•Short-term rates are normally lower than long-term rates, so it may be cheaper to finance with
short-term debt
•Firms can get into trouble if rates increase quickly or if it begins to have difficulty making
payments – May not be able to refinance the short-term loans
With a compromise policy, the firm keeps a reserve of liquidity which it uses to initially finance
seasonal variations in current asset needs. Short-term borrowing is used when the reserve is
exhausted.
Electronic Data Interchange (EDI) and its advantages
Electronically transfer financial information and funds between parties, thereby eliminating paper
invoices, paper cheques, mailing and handling
Length of time required to initiate and complete a business transaction is shortened considerably,
and float is sharply reduced or eliminated.
Advantages
•Collection for payments through cheques
•Having mailed all cheques to one location
•Have different collection points to reduce mailing time
•Outsource the collection process
•Preauthorized payment system
•Lockboxes
Define portfolio....What is portfolio weight give example.
Portfolio is the group of assets such as stocks and bonds held by an investor
Portfolio weights are the percentages of the total portfolio’s value that are invested in each portfolio
asset.
If we have $50 in one asset and $150 in another, then our total portfolio is worth $200.
The percentage of first asset in portfolio is $50/200 = 0.25, while the same for the second asset is
$150/200 = 0.75
So, the portfolio weights are 0.25 and 0.75
Difference between Cash Cycle and Operating Cycle
Cash cycle
•The time between cash disbursement and cash collection. (We spend cash on day 30, but don't
collect until day 105. so we have to arrange finances $1,000 for 105 – 30 = 75 days)
Operating Cycle
•The time period between the acquisition of inventory and the collection of cash from receivables
(in our example, it is 105 days)
Days
Activity
0
Acquire inventory on credit
30
Pay for inventory
60
Sell inventory on credit
105
Collect on sale
Cash Effect
None
-$1,000
None
+$1,400
Two aspects of short term financial policy
•Flexible policy
•Restrictive policy
Operating cash flow of Rs. 200,000, Net working capital has decreased by Rs. 50,000 and there
is a net capital spending of Rs. 0 during the year. Calculate total cash flow. (3marks)
Total cash flow=200000-(-50000)
=250,000
SNK company find the profitability index dividend 2 and price= 200…….. (3marks)
= 2/200=0.01=1
Question 65=3marks ………..Page 136
Define systematic risk and unsystematic risk and also define which risk is eliminated by
diversification 5 marks
Systematic risk
A risk that influences a large number of assets. It is also called market risk
Unsystematic Risk
A risk that affects a single or at most a small number of assets. Because these risks are unique to
individual companies or assets, they are also called unique or asset specific risks.
•“Unsystematic risk is essentially eliminated by diversification, so a relatively large portfolio has
almost no unsystematic risk.”
•Systematic risk can not be eliminated by diversification, as it affects almost all assets to some
degree.
Which issue cover in finance and investment area? 5marks
Finance issue
•In order to start any new business, the following issues become vital
•What long-term investment should be taken on?
•From where to get the long-term financing to pay for investment? Bring in other owners or borrow
the money?
•How to manage everyday financial activities?
Investments
•Deals with financial assets such as stocks and bonds
•It covers the following issues
•Pricing Financial Assets
•Associated Risks and Rewards
•Determining best mixture of financial investment
•Career opportunities in investment
•Stock Brokerage
•Portfolio Management
•Security Analysis
Credit policy and its component 5makrs
Credit policy decisions involve a trade-off between the benefits of increased sales and costs of
granting credit
Components of Credit Policy
•Terms of sale
•Credit Analysis
•Collection Policy
•Credit Period
•Cash Discounts and discount period
•Credit Instruments
Define optimal policy 5marks
•The state vector at time t under policy p contains the potential revenue of each request that is
currently in the system at time t.
•The best job is the request that corresponds to the highest potential revenue in the state vector at
time t.
•The optimal policy chooses the best job to serve at any time t regardless of the order of service
chosen for the rest of the jobs in the system (greedy)
•For this system, the optimal policy is LIFO-PR
What Does Long-Term Solvency Ratio Intend to Address? Name Commonly Ratios? (Marks
3)
These ratios are intended to address the firm’s long-run ability to meet its obligations, or its
financial leverage.
•Total Debt Ratio
•Interest Coverage Ratio
•Cash Coverage Ratio
Define Types of Inventory? (Marks 3)
•Raw Material – starting point in production process
•Work-in-Progress – size of this inventory depends on the length of production process
•Finished Goods – One company’s raw material can be another’s finished good. Steel Sheets and
Automobile Manufacturing
What is "Static Theory of Optimal Capital Structure"? (Marks 3)
A firm borrows up to the point where tax benefit from an extra dollar in debt is exactly equal to the
cost that comes from the increased probability of financial distress.
Difference between Debt and Equity? (Marks 5)
The main differences between debt and equity are the following
•Debt is not an ownership interest in the firm. Creditors generally do not have voting power.
•Corporation’s payment of interest on debt is considered as a cost of doing business and is fully tax
deductible. While dividends paid to stockholders are not tax deductible.
•Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of
the firm, resulting in bankruptcy or financial failure. This possibility does not arise when equity is
issued.
What components return rates normally have.(3)
This return, usually termed as dollar returns, has normally two components:
•Income earned (Dividend)
•Capital gain
What are the recommendation if policies are flexible with regard to correct assets.(3)
•Keep larger cash/marketable securities balances
•Larger investments in inventory
•More liberal credit terms, thus higher accounts receivable
The bonds with lower coupon have greater interest rate risk. …….Explain (3)
If two bonds with different coupon rates have same maturity, the value of the one with the lower
coupon is proportionately more dependent on the face amount to be received. So its value will
fluctuate more as interest rate changes
In other words, bond with higher coupon has a larger cash flow early in its life, so its value is less
sensitive to changes in discount rate
Difference between dividend payout ratio and retention ratio.(5)
Dividend Payout
We have seen earlier that the net income is divided into two pieces.
•The first piece is cash dividend paid to stockholders
•Leftover amount is the addition to retained earnings
A2Z’s Net Income was $363, of which $121 was paid out in dividends. As a percentage:
Dividend Payout ratio = Cash Dividends/Net Income
= 121/363 = 33 1/3%
Retention Ratio
Anything A2Z does not pay out in form of dividends must be retained in the firm. So retention ratio
is:
Retention ratio = Retained Earnings/Net Income
= $242/$363 = 662/3%
So A2Z retains two-thirds of its net income.
The retention ratio is also known as the plowback ratio, as this is the amount which is plowed back
into the business
What is net working capital? What are current assets and order of their liquidity?
Net working capital (NWC) is the difference between the current assets and the current liabilities.
Often the short-term financing is called net working capital management.
The difference between short- and long- term financing is the timing of the cash flows.
Current assets
•Cash and other assets that are expected to convert to cash within one year. Presented on balance
sheet in order of their liquidity
Question No: 43
( Marks: 3 )
Write down the property classes for MACRS method of depreciation.
MACRS Property Classes
Class
Examples _
3-year
Equipment used in research
5-year
Autos, Computers
7-year
Most industrial equipment
Question No: 44
( Marks: 3 )
Write down the primary shortcomings of payback period rule.
•By ignoring time value, we may be led to take investments that are worth less than they cost
•By ignoring cash flows beyond cutoff, we may be led to reject profitable long term investments
•Generally, it tends to bias us towards shorter term investments
Question No: 46
( Marks: 5 )
What is the difference between temporary current assets and permanent current assets?
Temporary current assets
•Sales or required inventory build-up are often seasonal
•The additional current assets carried during the “peak” time
•The level of current assets will decrease as sales occur
Permanent current assets
•Firms generally need to carry a minimum level of current assets at all times
•These assets are considered “permanent” because the level is constant, not because the assets aren’t
sold
Question No: 43
( Marks: 3 )
Write down the components of total return in terms of dividend growth model.
The total return, R, has two components
•Dividend Yield
•Capital gains yield
Question No: 45
( Marks: 3 )
How a firm over all cost of capital is calculated?
When we say that the required return on an investment is, say, 10% we mean that the investment
will have a positive NPV only if its return exceeds 10%.
Alternatively, the firm must earn 10% on the investment just to compensate its investors for the use
of the capital needed to finance the project.
Thus, 10% is the cost of capital associated with the investment.
Question No: 46
( Marks: 5 )
Define the following terms:
•Dealer - An agent who buys and sells securities from a maintained inventory
•Broker - An agent who arranges security transactions among investors, matching investors
wishing to buy securities with investors wishing to sell securities
•Bid Price - The price that the dealer wishes to pay is the bid price and the price at which the dealer
sells the securities is called the ask price.
•Strike Price - The price that the dealer wishes to pay is the bid price and the price at which the
dealer sells the securities is called the strike price.
•Spread - The difference between the bid and ask price is called the spread
Effective annual interest rate calculation in which bank A offer 16.50% rate quarterly, and
Bank B offers 16.75% rate semi annually, so we have to decide which one is better to invest.
BANK A, as it offers 17.55% effective rate and bank B offers 17.45%
Definition of bankruptcy
Unpaid debt is a liability of the firm. If it is not paid, the creditors can legally claim the assets of the
firm, resulting in bankruptcy or financial failure. This possibility does not arise when equity is
issued.
Question No: 47 ( Marks: 5 )
Match the capital budgeting techniques are given in Column A to the criteria in Column B.
Provide the correct answer in Column C.
Column A
Column B
Column C
Net Present Value
Discounted Cash Flow Criteria
Average Accounting Return
Payback Criteria
Payback Period
Discounted Cash Flow Criteria
Internal Rate of Return
Accounting Criteria
Profitability Index
Discounted Cash Flow Criteria
Question No: 43 ( Marks: 3 )
Define Net Present Value (NPV) and write down the NPV rule to accept a project.
The NPV of an investment is the difference between its market value and its cost.
The NPV rule is to take a project if its NPV is positive.
Question No: 44 ( Marks: 3 )
What do you mean by the terms of business risk and financial risk?
Business risk
The risk inherent in the firm’s operations is called the business risk, and we know that this business
risk depends on the systematic risk of the firm’s assets.
Financial risk
The increase in debt financing raises the required return on equity because the risk born by the
investors increases. This extra risk is called financial risk.
Question No: 45 ( Marks: 3 )
Suppose there is an operating cash flow of Rs. 520,000. Net working capital has increased by
Rs. 200,000 and there is a net capital spending of Rs. 120,000 during the year. Calculate total
cash flow.
Question No: 46 ( Marks: 5 )
A replacement project has an initial investment of Rs.10,000; and cash flows are Rs.3,400; Rs.
2,500; Rs.3,900; and Rs.5,200 for years 1 through 4, respectively. The firm has decided to
assume that the appropriate cost of capital is 10%. What will be the net present value of the
project? Is the project feasible?
What is the reason of tax deduction on the difference between book value and market value.
What is the relationship between Capital structure and WACC?
What you about diversification? ……………..3 marks
Sales 50,000/[email protected]/unit
Variable cost 4.50/unit. Fixed cost Rs.8000
Project has no salvage value. Project life is 3 years.
Project cost is 24,000. Depreciation is 8000/year
Investment in net working capital is 10,000
the firm required rate of return is 20%
the tax rate is 34%
Required: calculate the projected net income (5)
Question No: 47
( Marks: 5 )
If you have a portfolio that is worth Rs. 200,000 consisting of three stocks A, B, C and
D. Assume you have divided you investment equally in these four stocks. Expected
returns on Stock s A, B, C and D are 20%, 25%, 15% and 12% respectively. Calculate
the portfolio expected return.
Question No: 47
( Marks: 5 )
A firm has a total value of Rs. 1 million and debt valued at Rs. 400,000. What is the after-tax
weighted average cost of capital if the cost of debt is 12%, the cost of equity is 15% and tax
rate is 35% ?
Question No: 45 ( Marks: 3 )
Suppose there is an expected rate of 20%. What will be the risk premium if risk free rate is (i)
8% and (ii) 12%?
Question No: 46 ( Marks: 5 )
What is the difference between Leverage and Un-levering?