Ratio
analysis is a very powerful tool for analyzing financial performance that has
many valuable applications and some inherent potential weaknesses. Answer the
following two questions in one paragraph each: (1) identify the major
application of Ratio Analysis and (2) identify some of the potential weaknesses
that are inherent in ratio analysis overall.
The core
formula underlying the time value of money theory, FV= PV x (1+r)nand
its reciprocal
PV =
FV/(1+r)n, is based on the assumption that a dollar today is worth
more than a dollar tomorrow because it is assumed you can invest the dollar
today and earn additional value.
While
this is generally true:
- Can you identify some conditions
where the assumption might not hold? - When the conditions do not
hold, what is the wise course of action for today’s dollar holder? - When the invested dollar
does not earn additional value, are the basic time value formulas still
valid? Explain your answer.
The “Nominal” rate of interest is composed of several components
each of which has an impact on the actual interest charged or received: (1)
Identify these interest rate components, (2) define what they represent, (3)
what determines their magnitude, and (4) specify how they impact on the nominal
rate. Use illustrative examples or formulas if and as necessary.
Traditional financial theory states that there is
an inverse relationship between a bond’s price and the current interest rates,
i.e. when interest rates go up, bond prices fall and when interest rates go
down, bond prices rise.
(1) For the following two scenarios is that
statement true? – provide your supporting rationale.
Scenario 1: You purchase a $1,000 par value bond 5 year
maturity bond with a coupon rate of 5% and a Yield to maturity of 6%, You
plan to sell this bond in 3 years.
Scenario2: You purchase a $1,000 par value bond
5 year maturity bond with a coupon rate of 5% and a yield to maturity of 6%.
You plan to keep the bond to maturity (5 years).
(2) Also identify some factors other than the
interest rate that can affect the price of a bond?
(3) Who bears the risk, gain or loss, of a
change in bond price?
The
Capital Asset Pricing Model (CAPM), is a powerful analytical tool for use
calculating the price of common stock. After reflecting on theory and
application of the CAPM model, post a one paragraph response to each of the
following questions:
1.
What are the primary advantages of the Capital
Asset Pricing Model (CAPM) in pricing common stock?
2. What are some
potential issues in effectively using the (CAPM ) to determine the price of a
stock?
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Answer
in one paragraph each, with supporting rational the following three questions:
1.
In your own words contrast the strength and
weaknesses of each capital budget decision model against the NPV model
2.
Given the Net Present Value (NPV) method of capital
budget analysis is superior to the Internal Rate of Return (IRR) method;
explain why so many companies still use the IRR
method
3. Identify the
capital budget decision model that most appeals to you and why it has its
appeal
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Beta Incorporated has a current WACC of 12.6 % as
shown below:
|
Component |
Capital In $ |
Capital in % |
Cost of Capital % |
Wtd. Cost of Capital |
|
Debt |
$50 Million |
50% |
8% |
4.0 |
|
Preferred Stock |
$10 Million |
10% |
14% |
1.4 |
|
Common Stock |
$40 Million |
40% |
18% |
7.2 |
|
Total Capital |
$100 Million |
100% |
– |
12.6% |
Beta is considering a major capital project which
will cost $30 million and they have accepted an loan contract with Hope Bank
for a $30 Million, 10 Year loan at 10% interest to finance this specific
project. Beta Incorporated uses the NPV model to evaluate capital budgets
and there is some disagreement in the company as to the proper discount rate to
use for this project. Some say: the loan rate (10%), since the loan is
specifically to finance the project; others say the WACC (12.6%); and others
say neither is correct. Given this confusion, they have come to you as their
financial consultant for the correct answer.
1.
In one paragraph present your decision and your
supporting argument
2.
If you answer is Neither 10% or 12%, explain in
words how you would calculate the correct answer.
Having now studied capital budgeting
decisions, working capital management, and cash flows, provide a short
explanation of how the firm’s capital budget plans for next year could impact
on the firms projected working capital and cash flow for that year. Give an
illustrative example with numbers of how these factors interact using two
components of working capital.
