Financial Management: What You Need to Know

Question One 

Part a 

Ratio	Vortex IT Company	Industry Average
Current ratio	1.98	2.0
Days sales outstanding	76 days	35 days
Inventory turnover	5.8 times	6.7 times
Total asset turnover	1.7 times	3.0 times
Net profit margin	1.7%	1.2%
Return on assets	2.9%	3.6%
Return on equity	7.6%	9.0%
Total debt / Total assets	61.9%	60.0%

Current ratio = current assets/current liabilities 

Current assets=655,000 

Current liabilities=330,000 

Therefore, current ration=655,000/330,000 = 1.98 

Days sales outstanding = (account receivables/credit sales) ×365 

Account receivables= 336,000 

Total credit sales= 1,607,500 

Therefore, Days sales outstanding = ( 336,000 / 1,607,500) ×365 = 76 days 

Inventory turnover =cost of goods sold/average inventory 

Cost of goods sold= 1,392,500 

Average inventory= 241,500 

Therefore, Inventory turnover= 1,392,500/241,500= 5. 8 times 

Total asset turnover =Total sales/ average total assets 

Total sales= $1,607,500 

Average total assets= $947,500 

Therefore, Total asset turnover = 1,607,500/947,500= 1.7 times 

Net profit margin = Net profit/total sales 

Net income= $27,300 

Total sales= $1,607,500 

Therefore, Net profit margin = 27,300 / 1,607,500= 1.7% 

Return on assets =Net income/Total assets 

Net income= $27,300 

Total assets= $947,500 

Therefore, Return on assets = 27,300/947,500= 2.9% 

Return on Equity =Net income/Equity 

Net income= $27,300 

Equity = $361,000 

Therefore, Return on Equity = 27,300/361,000= 7.6% 

Total debt / Total assets 

Total debts=$586,500 

Total assets= $947,500 

Therefore, Total debt / Total assets=586500/ 947,500= 61.9% 

Part B: Company’s Strength and Weaknesses 

Strengths 

Net profit margin : Vortex IT Company is more profitable than the average companies in the industry. 

Weaknesses 

Current ratio : Vortex IT Company is less likely than average companies in the industry to use its current assets to settle the current liabilities. 

Day’s Sales Outstanding : Vortex IT Company takes more days to receive payment from credit sales than average companies in the industry, which slows down its financial operations. 

Inventory Turnover : Vortex IT Company is less likely to sell all of its inventory than average companies in the industry, which means it is less competitive. 

Total Assets Turnover : Vortex IT Company is less likely (less efficient) than average companies in the industry to use its assets to generate revenues. 

Return on Assets : Vortex IT Company makes lower profits from its assets compared to average competitors’. 

Return on Equity : Vortex IT Company makes lower profits from its equity compared to average competitors’. 

Total Debt / Total Assets : Vortex IT Company has considerably higher debts than average competitors, which cost it relatively higher tax expenses. 

Question Two: 

XYZ Company, Selected Balance Sheet and Profit and Loss Account Items (millions)
Year	2013	2014	2015
Net income	21.5	22.3	21.9
Sales	305	350	410
Equity	119	124	126
Assets	230	290	350
Return on Equity	21.5/119 = 18.00%	22.3/124= 17.88%	21.9/126= 17.38%

Comment 

Based on the trend, XYZ’s earnings from the equity decreased year over year from 2013 to 2015, symbolizing poor performance, such as increase in expenses. 

Question Three: 

1: Net Operating Profit after Tax 

2014= $ 87,960 

2015= $- 690,560 

2: Net Operating Working Capital 

Net operating working capital= current assets – current liability 

2014=$ 1,124,000-$481,600= $642,400 

2015=$ 1,926,802-$1,733,760= $193,042 

3: Total Net Operating Capital (Invested Capital) 

Total Net Operating Capital (Invested Capital) = Total Assets – Current Liabilities 

2014=$ 1,468,800-$481,600= $987,200 

2015=$ 2,866,592-$1132832= $1733760 

4: Free Cash Flow of 2015 

Free Cash Flow = Operating income – net operating working capital (total assets – cash – current liabilities) 

Therefore Free Cash Flow =$- 866,560 - $1,125,550 = $-1,992,110 

5: Economic Value Added For 2015 

EVA= earnings before interest and tax (1-tax) – IC x wacc (Weighted average cost capital) 

WACC = (Proportion of equity on the capital structure × cost of equity) + [(Proportion of debt on the capital structure × cost of debt) × (1-tax rate)] 

Proportion of equity on the capital structure= 132,832/2,866,592= 4.6% 

Cost of equity=retained earnings ÷ (retained earnings + total equity) = 327,168/ (327,168+132,832) =71.1% 

Proportion of debt on the capital structure=100-4.6=95.4% 

Cost of debt=Interest expense/long-term debt= 176,000/ 1,000,000= 17.6% 

Tax rate=40% 

WACC= (0.046 × 0.711) + [(0.954 × 0.176) × (1-0.4)] =0.0327 + 0.1007 = 0.4277=42.77% 

Earnings before interest and tax= - 690,560 

IC = 1,125,550 

Therefore, EVA=$- 690,560 – (0.4277 × 1,125,550) = $-1,171,957.74 

6: Economic Value Added For 2014 

EVA= earnings before interest and tax (1-tax) – IC x wacc (Weighted average cost capital) 

WACC = (Proportion of equity on the capital structure × cost of equity) + [(Proportion of debt on the capital structure × cost of debt) × (1-tax rate)] 

Proportion of equity on the capital structure= 663,768/1,468,800= 4.5% 

Cost of equity=retained earnings ÷ (retained earnings + total equity) = 203,768/ (203,768+1,468,800) =12.2% 

Proportion of debt on the capital structure=100-4.5=95.5% 

Cost of debt=Interest expense/long-term debt= 62,500/ 323,432= 19.3% 

Tax rate=40% 

WACC= (0.045 × 0.122) + [(0.955 × 0.193) × (1-0.4)] =0.0055 + 0.1106=0.116=11.6% 

Earnings before interest and tax= 209,100 

IC = 978200 

Therefore, EVA= 209,100 – (0.116 × 978200) =$95,628.8 

Question Four 

Amount= principle × (1 + rate/100) period 

Principle= € 10,000 

Rate=12% 

Period=8 

Therefore, Amount= € 10,000 × (1 + 12/100) 8 = €24,759.6 

Question Five 

Principle = Amount÷ [(1 + rate/100) period ] 

Amount = € 10,000 

Rate=8% 

Period=7 years 

Therefore, Principle = € 10,000 ÷ [(1 + 8/100) 7 = € 5,834.9 

Question Six 

Present Value = sum of the four cash flows 

Cash flow = payment ÷ (1+r) r 

1 st Cash flow = € 100 ÷ (1+0.09) 3 = €77.22 

2 nd Cash flow = € 100 ÷ (1+0.09) 4 = €70.84 

3rd Cash flow = € 100 ÷ (1+0.09) 5 = €64.99 

4 th Cash flow = € 100 ÷ (1+0.09) 6 = €59.63 

Therefore, Present value = €77.22 +€70.84+64.99+ €59.63 = €272.68 

Question Seven 

Total investment = principle 1 and principle 2 

Principle = Amount÷ [(1 + rate/100) period ] 

Amount 1 = € 50,000 

Amount 2 = € 60,000 

Rate=5% 

Period 1=5 years 

Period 2=6 years 

Therefore, Principle 1 = € 50,000 ÷ [(1 + 5/100) 5 = € 39,176.3 

Principle 2 = € 60,000 ÷ [(1 + 5/100) 6 = € 44,772.9 

Total investment = € 39,176.3 + € 44,772.9 = €83,949.2 

Question Eight 

Instalment = Amount/period 

Amount= principle × (1 + rate/100) period 

Principle= € 200,000 

Rate=8% 

Period=4 

Amount= € 200,000 × (1 + 8/100) 4 = €272,097.8 

Therefore, yearly Instalment= €272,097.8/4 = €68,024.4 

Question Nine 

Amount/Principle = [(1 + rate/100) period ] 

Let ( 1 + rate/100) = B 

Which means = Amount/Principle = B period 

Amount= €12 million 

Principle=€6 million 

Period = 5 

If you substitute in the main equation, 12/6 = B 5 

Log 2 = 5 log B 

0.06 = log B 

B = anti log of 0.06 = 1.15 

Note that B = ( 1 + rate/100) 

Therefore 1.15 = 1+ r/100 

0.15=r/100 

r=15% 

Question Ten 

a) Nominal interest rate is the amount of interest that does not factor in the inflation rate. In this case, the nominal interest rate is 9% quarterly or 36% per annum 

b) Periodic interest rate is the amount of interest rate paid after a given financial period such as monthly, quarterly, semi-annually and annually. In this case, the periodic interest rate is 9% quarterly or 36% per annum 

c) Annual interest rate is the amount of interest charged after 12 twelve months. In this case, the annual interest rate is 36% . 

Question Eleven 

Instalment = Amount/period 

Amount= principle × (1 + rate/100) period 

Principle= € 50,000 

Rate=9% 

Period=5 

Amount= € 50,000 × (1 + 9/100) 4 = €35,421.3 

Therefore, yearly Instalment= €35,421.3/5 =€7,084.3 

Question Twelve 

Year	Beginning balance	Payment	Interest	Principal repayment	Ending  balance
1	€ 25,000	€ 10,833.3	€ 2500	€ 8333.3	€ 16666.7
2	€ 16666.7	€ 10,000	€ 1666.7	€ 8333.3	€ 8333.3
3	€ 8333.3	€ 9266.6	€ 833.3	€ 8333.3	0

Interest= principle × rate/100 × period 

1 st year 

Principle= € 25,000 

Rate=10% 

Period= 1 

Year 1 

Beginning = € 25000 

Therefore, interest year 1 = € 25,000 × 10%/100% ×1 = € 2500 

Principle Repayment = € 25,000/3 = € 8333.3 

Payment= interest + Repayment = € 2500 + € 8333.3 = € 10,833.3 

Ending Balance =principle - Principle Repayment = € 25000 - € 8333.3 = € 16666.7 

Year 2 

Beginning = € 16666.7 

Interest year 2 = € 16666.7 × 10%/100% ×1 = € 1666.7 

Payment= interest + Repayment = € 1666.7 + € 8333.3 = € 10,000 

Ending Balance = 1 st year’s Ending balance - Principle Repayment = 16666.7 - 8333.3 = € 8333.3 

Year 3 

Beginning = € 8333.3 

Interest year 3= € 8333.3 × 10%/100% ×1 = € 833.3 

Payment= interest + Repayment = € 833.3 + € 8333.3 = € 9266.6 

Ending Balance =2 st year’s Ending balance - Principle Repayment =8333.3 - 8333.3 = 0 

Question Thirteen 

Option 1 is the best alternative since it charges the least interest compared to option 2 and 3. Note that annual interest rate= frequency in a year × the interest rate. Therefore, the annual rate of option 2 is 17.2%, i.e., 8.6%×2; whereas, the annual rate of option 3 is 102%, i.e., 8.5%×12. 

Question Fourteen 

	Expected net cash flows, EUR
Year	Project X	Project Y	Discounting rate= (1+12/100) time	Discounted Cash flow of x = cash flow/discounted rate	Discounted Cash flow of Y = cash flow/discounted rate
0	-10,000	-10,000	1	-10,000	-10,000
1	6,500	3,500	1.12	5803.57	3125
2	3,000	3,500	1.25	2400	2800
3	3,000	3,500	1.40	2142.86	2500
4	1,000	3,500	1.57	636.94	2229.30
NPV				983.37	654.30

The firm should invest in project X since it has the highest Net Present Value, meaning that it is more profitable. 

Question Fifteen 

	Investment outlay, CF 0	NPV	Return on Investment =NPV/CF0
Project 1	45000	18000	40%
Project 2	40000	16000	40%
Project 3	20000	9000	90%
Project 4	18000	8000	44.4%
Project 5	15000	4000	26.7%

Considering its capital capacity, XYZ Company should invest in three projects in the following order; Project 3, Project 4 and Project 2, and then remain with €2,000. 

Question Sixteen 

Part A) 

EAA = [rate × NPV] ÷ [1 – (1+rate) -period ] 

NPV A = € 20,000 

NPV B = € 25,000 

Period A= 3 

Period B= 5 

Rate=12% 

Therefore, EAA of A = [0.12 × € 20,000] ÷ [1 – (1+0.12) -3 ] = € 8326.98 

EAA of B = [0.12 × € 25,000] ÷ [1 – (1+0.12) -5 ] = € 6935.24 

Part B) 

ABC company should purchase equipment A because it has comparatively higher EAA meaning it is more profitable than B. 

Question Seventeen 

year	0	1	2	3	4	5
Equip cost	350000
installation	110000
Net working	73000
Revenues		265000	265000	265000	265000	265000
depreciation		92000	92000	92000	92000	92000
Operating costs		83000	83000	83000	83000	83000
machine after 5yrs						85000
Cash flow (rev–costs)	-533000	90000	90000	90000	90000	175000
Cash flow after 40% tax	-533000	54000	54000	54000	54000	105000
Discounted at 10% =(1+r) year	1	1.1	1.21	1.33	1.46	1.61
Discounted cash flow =cash flow/ discounted at 10%	-319,800	49,090.91	44,628.10	40601.50	36,986.30	65,217.39
NPV = Sum of discounted cash flows						-83275.8

Initial outlay = $533,000 

After Tax Operating Cash Flows 

year	1	2	3	4	5
After tax operating cash flows	54000	54000	54000	54000	54000

Terminal Year After-Tax Non-Operating Cash Flow In Year 5 

= after tax of machine cost = 60% of 85000 =$51,000 

Net Present Value =$- 83275.8 

Investment Decision 

The company should not invest in the machine since it has a negative net present value, meaning that it will make losses. 

Question Eighteen 

WACC = (Proportion of equity on the capital structure × cost of equity) + [(Proportion of debt on the capital structure × cost of debt) × (1-tax rate)] 

Proportion of equity on the capital structure=50% 

Cost of equity=16% 

Proportion of debt on the capital structure=50% 

Cost of debt=17% 

Tax rate=35% 

Therefore, WACC= (0.5 × 0.16) + [(0.5 × 0.17) × (1-0.35)] =0.08 + 0.05525 = 0.13525 =13.53% 

Question Nineteen 

Part A: Value of the Firm 

Value of the firm = (Proportion of equity on the capital structure × cost of equity) 

Proportion of equity on the capital structure=100% 

Cost of equity=17% 

Therefore, value of the firm = 1×0.17 =0.17= 17% 

Part B: Value of the Firm 

Value of the Firm = Proportion of equity on the capital structure × cost of equity) + [(Proportion of debt on the capital structure × cost of debt) × (1-tax rate)] 

Proportion of equity on the capital structure=10000/(10000+15000) =40% 

Cost of equity=17% 

Proportion of debt on the capital structure=15000/(10000+15000Cost of debt=60% 

Cost of debt =7% 

Tax rate=35% 

Therefore, WACC= (0.4 × 0.17) + [(0.6 × 0.07) × (1-0.35)] =0.068 + 0.0273 = 0.0953 =9.53% 

Question Twenty 

Calculate the Initial Cash Flow 

Purchase price of the new machine	- 8,000
Shipping and installation charge	-2,000
Book value of old machine	2,000
Undervaluation	4000
Inventory increase if the new machine is installed	3,000
Accounts payable increase if the new machine is installed	-1,000
Before tax cash flow	-2000
Marginal tax rate	25%
Initial cash flow	€ -1,500