Financial Management | Meaning, Objectives and Functions

FINANCIAL
MANAGEMENT

Table of Contents
QUESTION 1: TIME VALUE OF MONEY..................................................................................1
a) Time Line depicting Cash-flows with Broadbent's Retirement Annuity...........................1
b) Present Value of Annuity (PVA).......................................................................................1
c) Annual deposits made during the accumulation period.....................................................1
d) Calculating periodic payments, if rate of interest become 10%........................................2
e) Calculating periodic payments if retirement annuity is a perpetuity.................................2
QUESTION 2: BOND AND SHARE VALUATION.....................................................................3
A) Current Price of Bond A and B.........................................................................................3
B) Annual Coupon Rate Offered............................................................................................4
C) Buildcorp Commercial PTY Ltd.......................................................................................4
QUESTION 3: CAPITAL BUDGETING.......................................................................................5
QUESTION 4: RISK AND RETURN.............................................................................................6
a) Plotting CAL derived from Risk-Free Asset and Portfolio A............................................6
b) Fraction of portfolio to be invested in A to have a portfolio standard deviation of 12%. .7
REFERENCES................................................................................................................................8

QUESTION 1: TIME VALUE OF MONEY
a) Time Line depicting Cash-flows with Broadbent's Retirement Annuity
Accumulation Period: Year 1 to Year 12 (12 years)
1 2 3 4 5 6 7 8 9 10 11 12
Distribution Period: Year 13 to Year 32 (20 years)
13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33
b) Present Value of Annuity (PVA)
Periodic Payments beyond year 12 = $42,000 per annum = P
Interest Rate at which such payments are made = 20% p.a. = r
Number of years such cash-outflows are incurred = 20 years = n
Present Value at the end of year 12 = P*[(1-(1+r)-n)/(r)]
PVA = $42,000*[(1-(1+0.20)-20)/(0.20)]
= $42,000*[(1-(1.20)-20)/(0.20)]
= $42,000*[(1-0.026)/0.20]
= $42,000*[0.974/0.20]
=$42,000*4.87
=$204,522.35
Hence, $204,522.35 is the lump-sum amount that needs to be accumulated by the end of
year 12 by Broadbent group to provide for the 20 year $42,000 annuity.
c) Annual deposits made during the accumulation period
The present value of annuity equalling an amount of $204,522.35 can be treated as the
future value of annuity payments to be accumulated between year 0 and 12 (Vernimmen, P. and
et.al., 2014).
Thus, PV at the end of year 13 in distribution period= FV at the end of year 12 in
accumulation period = $204,522.35
Thus, FV of annuity = P*[((1+r)n-1)/r]
$204,522.35 = P*[((1+0.09)12-1)/0.09]
$204,522.35 = P*[((1.09)12-1)/0.09]
1

$204,522.35 = P*[(2.812664782-1)/0.09]
$204,522.35 = P*[1.812664782/0.09]
$204,522.35 = P*[20.140719798]
P=($204,522.35)/ (20.14)
P=$10,154.67
Thus, periodic payments (P) during accumulation period is $10,154.67. Therefore,
Broadbent needs to make such deposits every year in order to fully fund Mr. Tim Sprod's
retirement annuity.
d) Calculating periodic payments, if rate of interest become 10%
FV of annuity = P*[((1+r)n-1)/r]
$204,522.35 = P*[((1+0.10)12-1)/0.10]
$204,522.35 = P*[((1.10)12-1)/0.10]
$204,522.35 = P*[(3.138428377-1)/0.10]
$204,522.35 = P*[2.138/0.10]
$204,522.35 = P*[21.38]
P=($204,522.35)/ (20.14)
P=$9564.14
Thus, Broadbent needs to deposit $9564.14 annually during the accumulation period if it
could earn 10 per cent rather$204,522.35 than 9 per cent during the accumulation period.
e) Calculating periodic payments if retirement annuity is a perpetuity
During accumulation period,
PVA = $10,154.67*[(1-(1+0.09)-12)/(0.09)]
PVA = $10,154.67*[(1-(1.09)-12)/(0.09)]
PVA = $10,154.67*[(1-0.36)/(0.09)]
PVA = $10,154.67*[(0.65)/(0.09)]
PVA = $10,154.67*(7.16)
PVA = $72,707.4372
If Retirement Annuity is perpetuity then :
PV = C / R
Where:
PV = Present value
2

C = Amount of continuous cash payments
r = Interest rate or yield
PV = $72,707.4372
r = 0.09
C= $72,707.4372*0.09 = $6,543.67
Therefore, Broadbent has to deposit $6,543.67 annually during the accumulation period if
Mr Sprod's retirement annuity was a perpetuity and all other terms were the same as initially
described.
QUESTION 2: BOND AND SHARE VALUATION
A) Current Price of Bond A and B
Particulars Bond A Bond B
Face Value ($) 40,000 40,000
Years to Maturity 20 20
Coupon Payments Yes No
Method of Payment (yrs/$) First 6 years = No Coupon Payment
6th to 14th year = 2,000 semi-annually
15th to 20th year = 2,500 semi-annually
-
Price of Bond A:
Expected Rate of Return (%) = [(Face Value – Purchase Price)/Purchase Price]
0.12 = ($40,000 – P)/P
0.12*P = $40,000 – P
0.12P+P = $40,000
1.12P = $40,000
P =$40,000/ 1.12
P = $35,714.29
The purchase price of Bond A is equals to $35,714.29.
Price of Bond B:
Expected Rate of Return (%) = [(Face Value – Purchase Price)/Purchase Price]
P = 40,000/ (1.12)20
3

P = 40,000/9.65
P = $4,145.08
The purchase price of Bond A is equals to $4,145.08 (Price of Zero Coupon Bond, 2018).
B) Annual Coupon Rate Offered
Ferro Corp Limited:
Face Value = $1000 = Par Value of Bond
Current Trading Price = $768
Years to Maturity = 5 years
Interest Paid = Semi-annually
Therefore, the number of interest payments made during the year equals two times.
Expected Rate of Return = 10%
Coupon Rate = Annualized Interest or Coupon (i) / Par Value of Bond
Annual Interest payment = Periodic Interest Payment* No. of Payments made in a year
Annual Interest payment = 0.05* 2* 1000 = $100
Coupon Rate =100/ 1000 = 10% or 0.10 (Coupon Rate of a bond, 2019).
C) Buildcorp Commercial PTY Ltd
Dividend Paid = $2 per share
Increase Dividend at 6% rate indefinitely = g
Discount Rate = 16% per annum
i. Firm's Expected Dividend stream for next 3 years:
Particulars Year 0 ($) Year 1 ($) Year 2 ($) Year 3 ($)
Dividend (per
Share)
2 2.12 2.25 2.38
Growth Rate (g in
%)
- 0.06 0.06 0.06
ii. Firm's Current Stock Price:
P0 = D1/ (r-g) = $2.12 / (0.16-0.06) = $2.12 / 0.10 = $21.2
iii. Firm's Expected value in one year:
Firm's Expected Value in one year (EV) = Dividend Expected in the next year
4

EV =D2/ (r-g) = $2.25/ (0.16-0.06) = $2.25/0.10 = $22.5
iv. Expected Dividend Yield, Capital gains Yield and Total Return in Year 1:
Expected Dividend Yield = Dn/P(n-1) = $2.12/$21.20 = 0.1 or 10%
Expected Dividend Yield = (Pn-P(n-1))/ P(n-1) =(22.5-21.2)/21.2 =0.0613 or 6.13%
Total Return = Discount Rate = 16%
QUESTION 3: CAPITAL BUDGETING
Year Cash Inflow PV @ 23%
PV @
18%
PV
@
10%
DCF @
23%
DCF @
18%
DCF @
10%
0 20000000 1 1 1 -20000000 -20000000 -20000000
1 1500000 0.81 0.85 0.91 1219512.20 1271186.44 1363636.36
2 3278000 0.66 0.72 0.83 2166699.72 2354208.56 2709090.91
3 5000000 0.54 0.61 0.75 2686919.59 3043154.36 3756574.00
4 6450000 0.44 0.52 0.68 2817988.84 3326838.24 4405436.79
5 2500000 0.36 0.44 0.62 888003.04 1092773.04 1552303.31
6 2500000 0.29 0.37 0.56 721953.69 926078.85 1411184.83
7 2500000 0.23 0.31 0.51 586954.22 784812.58 1282895.30
8 2500000 0.19 0.27 0.47 477198.55 665095.41 1166268.45
9 2500000 0.16 0.23 0.42 387966.30 563640.18 1060244.05
10 2500000 0.13 0.19 0.39 315419.76 477661.17 963858.22
11 2500000 0.10 0.16 0.35 256438.83 404797.60 876234.75
12 2500000 0.08 0.14 0.32 208486.85 343048.81 796577.04
13 2500000 0.07 0.12 0.29 169501.51 290719.33 724160.95
14 2500000 0.06 0.10 0.26 137806.10 246372.32 658328.14
15 2500000 0.04 0.08 0.24 112037.48 208790.10 598480.12
16 2500000 0.04 0.07 0.22 91087.38 176940.76 544072.84
17 2500000 0.03 0.06 0.20 74054.78 149949.80 494611.67
18 2500000 0.02 0.05 0.18 60207.14 127076.10 449646.97
19 2500000 0.02 0.04 0.16 48948.89 107691.61 408769.98
20 2500000 0.02 0.04 0.15 39795.85 91264.08 371609.07
5

NPV -6533019.28 -3347900.66 5593983.75
IRR -7.08% -3.15% 3.90%
Comment: Since out of the three discounting rates, 10% is the only rate which provides a
positive IRR as well as NPV of $5,593,983.75, it must be taken by the financial managers of the
company.
QUESTION 4: RISK AND RETURN
a) Plotting CAL derived from Risk-Free Asset and Portfolio A
Risky Portfolio A:
Name of Stock Number of
Shares
Share Price ($) Expected
Return (%)
Standard
Deviation (%)
Weight
(Probability)
DREXLA 1000 6 18% 22% 0.5
OGATO 4000 4 14% 20% 0.5
Return of Portfolio A: [0.5*0.18 + 0.5*0.14] = [0.09+0.07] = 0.16 or 16%
Risk of Portfolio A: [0.5*0.22 + 0.5*0.20] = [0.11 + 0.10] = 0.21 or 21%
Risk Free Asset:
A Risk Free Asset is one which does not have a default risk. Such assets include treasury
stocks and government Bonds. In relation to risky Portfolio A such an asset's:
Covariance = Correlation = Risk or Standard Deviation = 0
Capital Allocation Line (CAL):
Capital Allocation Line is one which is the graphical representation of required return
and risk, usually measured in terms of Standard Deviation, of a risk-free asset and a risky
portfolio.
σport =(1-WRF)* σa ; where
σport = Standard Deviation (Risk) of the portfolio when risk free asset is combined with
risky asset
rf = Risk-Free Rate = 0.08
σa = Standard Deviation of Security a = 0.22
6

1- WRF = Amount that can be invested in first asset = Total amount invested less the amount
invested in the second asset
σport =(1-WRF)* σa
σport =(1-WRF)* 0.22
When one combines risky assets with risk-free ones, the standard deviation of the new
portfolio is the linear proportion of standard deviation of the risk asset portfolio which is 0.5.
Thus,
σport =(1-WRF)* σa
σport =(1-0.5)* 0.22
σport =(0.5)* 0.22
σport = 0.11
Thus, it would be a straight line as depicted below:
Expected Returns Standard Deviations
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
0.18
Combined
b) Fraction of portfolio to be invested in A to have a portfolio standard deviation of 12%
Portfolio Standard Deviation is 21%. Out of which 52% forms is invested in A whereas 48% is
invested in B to give the value of 21%. In order to achieve a Portfolio Standard Deviation of
12% one would need to invest:
52% of 12 = Investment in Security A or DREXELA
48% of 12 = Investment in Security B or OGATO
7

Portfolio Standard Deviation = 0.0624 + 0.0576 = 12%
Hence, 0.0624 is the amount that needs to be invested in A to have a portfolio standard
deviation of 12%.
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