Que 8)

Given: Weight of debt, Wd = 20%

Weight of preferred stock, Wp = 20%

Weight of common stock, We = 60%

  

Cost of debt, Kd = 5%

Cost of preferred stock, Kp = 8%

Cost of common stock, Ke = 14%

Solution:

Weighted average cost of capital,

WACC = Wd * Kd + Wp * Kp + We * Ke

= (20%*5%) + (20%*8%) + (60%*14%)

WACC = 11%

Answer: The weighted average cost of capital, WACC is 11%.

Que 9) Solution

1) The time value of money:

A dollar received today is worth more than a dollar received in future.

As present value < Future value, as long as interest rate are positive.

For example, Present value of 1000 to be received in one year if interest rate is 8% is

                        Present value, PV = 1000 / (1+8%)

                                                   PV = 925.92

So, sooner you get the money the better and sooner you invest the money the better.

 

2) Risk-return trade off

Investor won’t take on additional risk unless he expected to be compensated with additional return.

For higher risk, expected return to be higher.

Every decision you make should be on the risk-reward basis.

For example, if you invest in a risky business like say junk food business, you should demand a higher return.

 

3) Not profit, but Cash is important

‘Do not run out of cash’ is the first rule of any business.

Remember, value of asset = present value of expected future cash flows business will generate.

Cash is what is received by firm and can be used to reinvest or other activities such as paying bills.

 

4) Incremental Cash flows

Incremental cash flow is the potential increase or decrease in a company's cash flow related to the acceptance of a new project or investment in a new asset.

Incremental cash flow is the difference between cash flows if the project is done versus if the project is not done.

In short, incremental cash flow axiom state that it’s only increase or decrease in the cash that really matters for the company.

For example, Project A is projected to have revenues of 200,000 and expenses of 50,000. Project B is expected to have revenues of 325,000 and expenses of 190,000. Project A would require an initial cash outlay of 35,000, and Project B would require an initial cash outlay of 25,000. Even though Project B generates more revenue than Project A, its resulting incremental cash flow is 5,000 less than Project A's due to its larger expenses and initial investment.

Project A’s incremental cash flow = 200000 - 50000 - 35000 = 115000

Project B’s incremental cash flow = 325000 - 190000 - 25000 = 110000

 

 

5) Efficient Capital Markets

Information is incorporated into a security prices at a very fast rate. With this assumption and assuming that information is correct, the prices will reflect all the publicly available information related to the value of firm.

For example, news released in today’s Wall street Journal has already been incorporated into the stock prices.

 

Que 10) Solution

 

• A good business management is the ability to utilize working capital management to maintain a proper balance between growth, profitability and liquidity. A company’s fundamental financial health and operational success as a business is depend largely on proper management of working capital.
• Working capital is the difference between a business's current assets and current liabilities. A business uses working capital in its daily operations.
• The goal of working capital management is to increase the operational efficiency and maintain smooth operations and can also help to improve the company's earnings and profitability.
• Management of working capital include the management of inventory, the management of accounts receivables and management of accounts payables. It also include management of short term debt and liquidity management. An effective working capital management system helps businesses not only cover their financial obligations but also boost their earnings.
• When a company does not have enough working capital to cover its day today expense and obligations, financial insolvency can result and lead to legal troubles, liquidation of assets, and potential bankruptcy.
• Ensuring that the company possesses appropriate resources for its daily activities means protecting the company’s existence and ensuring it can keep operating as a going concern. Scarce availability of cash, uncontrolled commercial credit policies, or limited access to short-term financing can lead to the need for restructuring, asset sales, and even liquidation of the company.

The factors that can affect working capital needs can be endogenous or exogenous. Working capital needs are not the same for every company.

Endogenous factors include a company’s size, structure, and strategy.

Exogenous factors include the access and availability of banking services, level of interest rates, type of industry and products or services sold, macroeconomic conditions, and the size, number, and strategy of the company’s competitors.