Principles of Finance

This document provides study material and solved assignments for Principles of Finance. It covers topics such as cash flows, accounting profit, financial cash flow, capital gains, corporate tax, liquidity ratios, and more.

Principles of finance

CLO Covered: 1
Activity 1
Emphasis on Cash Flows: Worldwide Rugs is a rug importer located in the United States that
resells its import products to local retailers. Last year Worldwide Rugs imported $2.5 million
worth of rugs from around the world, all of which were paid for prior to shipping. On receipt of
the rugs, the importer immediately resold them to local retailers for $3 million. To allow its retail
clients time to resell the rugs,
Worldwide Rugs sells to retailers on credit. Prior to the end of its business year, Worldwide Rugs
collected 85% of its outstanding accounts receivable.
a. What is the accounting profit that Worldwide Rugs generated for the year?
Solution a.
Sold rugs = $3,000,000
Imported rugs = $2,500,000
Accounting profit = $500,000
b. Did Worldwide Rugs have a successful year from an accounting perspective?
Solution b.
The result for profit of Worldwide rugs showed that it is a successful year as they
reached $500,000. It is a success since the sales revenue realized is higher than the cost of
purchasing rugs.
c. What is the financial cash flow that Worldwide Rugs generated for the year?
Solution c.
Cash Collected from the sale of rugs to customers 85%= $2,550,000.00 Cash outflow/ Cash used to
purchase rugs for resale = $2,500,000.00 Net Cash flow from operating activities = $50,000.00
d. Did Worldwide Rugs have a successful year from a financial perspective?
Solution d.
Illustration:
Cash received from customers-85% of sales = $2,550,000
Cash used to purchase rugs for resale = $2,500,000
Net cash flow (Financial Profit) = $50,000

e. If the current pattern persists, what is your expectation for the future success of
Worldwide Rugs?
Solution e.
Looking at its current pattern with this kind of net cash inflow and the net profit
realized, the performance of Worldwide Rugs is expected to improve its performance.
Net profit is positive = $500,000
Net Cash inflow = $ 50,000
Net profit margin = 17%
The net profit margin is above 10% which is an average margin in the
merchandising industry.
Sold rugs =$3,000,000
Imported rugs =($2,500,000)
Accounting profit = $500,000
CLO Covered: 2
Activity 2
Montgomery Enterprises, Inc., had operating earnings of $280,000 for the year just ended.
During the year the firm sold stock that it held in another company for $180,000, which was
$30,000 above its original purchase price of $150,000, paid 1 year earlier.
a. What is the amount, if any, of capital gains realized during the year?
Solution a.
Capital Gain = $180,000 sales price $150,000 purchase price = $30,000 capital gain
b. How much total taxable income did the firm earn during the year?
Solution b.
1. Taxable Income = Ordinary Income + Capital Gains Income
2. Taxable Income = $280,000 ordinary income + $30,000 capital gains income=
$310,000

c. Use the corporate tax rate schedule given in Table 2.1 to calculate the firm’s total taxes
due.
Solution c.
1. $310,000 taxable income falls in the $100,000 to $335,000 tax
bracket
2. Taxes Due = $22,250 + 39% x $210,000 = $104,150 taxes due
d. Calculate both the average tax rate and the marginal tax rate on the basis of your findings.
Solution d.
1. Marginal Tax Rate = Scheduled Tax Rate of next dollar of income = 39%
2. Average Tax Rate= Taxes owed/ taxable income= $104,150/$310,000= 33.6

CLO Covered: 3
Activity 3 (a.)
All values ($000):
ABC company had a sale of 112,760 for the year ended 2014. The cost of goods sold for the
same period was 85,300. If the operating expenses were recorded as selling expense of 6,540 and
G&A of 9,400, what will be the ‘operating profit’ of the company? If the bank note interest was
850 and the bond interest was 2,310, what will be the ‘net profit before taxes’? Calculate the ‘net
profit after taxes’ considering a tax value of 3,344. Also Calculate the EPS and DPS, if the
outstanding shares in 2014 are 1,300 and the dividends paid in 2014 on common stock was
2,800.
ABC Company Income Statement ($000)
Sales revenue 112,760
Cost of Goods Sold (85,300)
Gross Profit 27460
Operating Expenses:
Selling expense (6,540)
General & Administrative expenses (9,400)
Total Operating Expense (15,940)
Operating Profits (EBIT-Earnings before interest and taxes) 11,520
Interest expense:
Interest on bank notes: (850)
Interest on bonds: (2,310)
Total Interest expenses (3,160)
Net Profit before taxes (EBT- Earnings before taxes) 8,360
Taxes (3,344)
Net Profit after taxes (Net Income) 5,016
Earnings per share $ 3.86
Dividends per share $ 2.15
Shares outstanding (000) = 1,300 ; Dividends paid on common stock = 2,800

CLO Covered: 3
Activity 3 (b.)
Liquidity Ratios
Current Ratio = Current assets ÷ Current liabilities 1.97
Quick (Acid-Test) Ratio = (Current assets – Inventory) ÷ Current liabilities 0.89
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Activity Ratios
Inventory Turnover = Cost of goods sold ÷ Inventory 3.10
Average Collection Period = Accounts Receivable ÷ (Annual sales/365) 59.3
Total Asset Turnover = Sales ÷ Total assets 1.38
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Debt Ratios (or Leverage)
1. Debt Ratio = Total liabilities ÷ Total assets 0.58
2. Times Interest Earned Ratio = EBIT ÷ Interests 3.65
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Profitability Ratios
Return on Equity (ROE) = Net profit after taxes (Net Income) ÷ Total stockholder’s equity 0.15

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Conclusion
It can be concluded from the above that the firm is performing well in the market but still
there are many loop holes in the market and thus has to be analysed in an appropriate manner so
that it can lead to the overall growth and development of the company in the long run.

CLO Covered: 3
Activity 3 (c.)
All values ($000):
ABC company has a net cash of 2,540 as of 31st December 2014. The inventories stand at
27,530. The accounts payable is 9,721, whereas the accounts receivables is 18,320. The notes
payable and accrued taxes payable are 8,500 and 3,200 respectively. The company also has
‘other current liabilities’ of 4,102. The company has market securities of 1,800. It owns plant and
equipment worth of 43,100 with an accumulated depreciation of 11,400. The company also has a
long-term bond debt of 22,000. Prepare a balance sheet and find out ‘total current assets’, ‘total
gross fixed assets’, ‘net fixed assets’, ‘total assets’, ‘total current liabilities’ and ‘total liabilities.
If the ‘common stock ($10par)’ is 13,000, ‘paid in capital’ in excess of par on common stock is
10,000, and retained earnings are 11,367, then calculate the ‘Total stockholders’ equity’ and
‘Total liabilities & equity’.
ABC Company Balance Sheet ($000)
Assets
Cash 2,540
Marketable securities 1,800
Accounts receivable 18,320
Inventories 27,530
Total current assets 50,190
Plant and equipment 43,100
Total gross fixed assets43,100
Less accumulated depreciation(11,400)
Net fixed assets 31,700
Total assets 81,890
Liabilities and Net Worth
Accounts payable 9,721
Notes payable 8,500
Accruals 3,200
Other current liabilities 4,102
Total current liabilities25,523
Long term debt 22,000
Total liabilities 47,523
Common Stock ($10par) 13,000
Paid-in capital 10,000
Retained earnings 11,367
Total stockholders' equity 34,367
Total liabilities & equity 81,890

CLO Covered: 4
Activity 4
Depreciation and Cash Flow Question
A firm expects to have earnings before interest and taxes (EBIT) of $160,000 in each of the next
6 years. It pays annual interest of $15,000. The firm is considering the purchase of an asset that
costs $140,000, requires $10,000 in installation cost, and has a recovery period of 5 years. It will
be the firm’s only asset, and the asset’s depreciation is already reflected in its EBIT estimates.
a. Calculate the annual depreciation for the asset purchase using the MACRS depreciation
percentages in Table 4.2 on page 117.
Solution a.
Depreciation expense for each year is as follows
(MACRS depreciation percentages table 4.2)
The cost of the asset is the purchase cost + installation cost
$140,000 + 10,000 = $150,000
Year Cost (1) Percentage (from
table 4.2)
(2)
Depreciation
[(1) × (2)]
(3)
1. $150,000 20% $30,000
2. 150,000 32% 48,000
3. 150,000 19% 28,500
4. 150,000 12% 18,000
5. 150,000 12% 18,000
6. 150,000 5% 7,500
Total 100% $150,000

b. Calculate the firm’s operating cash flows for each of the 6 years, using Equation 4.3. Assume
that the firm is subject to a 40% tax rate on all the profit that it earns.
Solution b.
Earn before interest and tax (EBIT) = $160,000
Interest annual payable = $15,000
Taxes = 40%
Operating cash flow (OCF) = [EBIT × (1 - T)] + depreciation
For first year depreciation
OCF = [ 160,000 × (1 – 0.40)] + 30,000
= 160,000 × 0.6 + 30,000
= 96,000 × 30,000
= $126,000
For year 2 depreciation
OCF = [160,000 × (1 – 0.40)] + 48,000
= 160,000 × 0.6 + 48,000
= 96,000 + 48,000
= $144,000
For year 3 depreciation
OCF = 96,000 + 28,500
= $124,500
For year 4 and year 5 depreciation being 12%
OCF = 96,000 + 18,000
= $114,000
For year 6depreciation
OCF = 96,000 + 7,500
= $103,500

c. Discuss the significance of each value calculated in parts B.
Solution c.
The values that are calculated above possess a lot of value as it can be seen that the
depreciation for the first year is $126,000 while it increased to $144,000 in the second year.
While for the third year it dropped to $124,500 whereas for the 4th and the 5th year it again
dropped and was at $114,000 and for the 6th year it was $103,500. Thus by calculating this it can
be said that the depreciation trend can be analysed and evaluated in an appropriate manner.
Activity 5
As part of your financial planning, you wish to purchase a new car exactly 5 years from today.
The car you wish to purchase costs $14,000 today, and your research indicates that its price will
increase by 2% to 4% per year over the next 5 years.
a. Estimate the price of the car at the end of 5 years if inflation is (1) 2% per year and (2)
4% per year.
Solution a. (1) inflation at 2%
The price of the car at the end of 5 years is;
FV5 = PV (1+ r) n
fv =14000 × (1 + 0.02)5
fv =14000 × 1.1041
fv = $15,457.4
a. (2) inflation at 4%
The price of the car at the end of 5 years is;
FV5 = PV (1+ r) n
fv = 14000 × (1 + 0.04)5
fv = 14000 × (1.2167)

fv = 17,033.8
b. How much more expensive will the car be if the rate of inflation is 4% rather than 2%?
Solution b. The difference between (2) and (1) is;
$17,033.8 – 15,457.4 = $1,576.4
c. Estimate the price of the car if inflation is 2% for the next 2 years and 4% for 3 years
after that.
Solution c. The value of the car at the end of 2 years with 2% inflation and the next 3
years with 4% inflation is;
2 years with 2% inflation = 14,000 × (1.02)2
= 14,000 × 1.0404 = $ 14,565.6
3 years with 4% inflation= 14,565.6 × (1.04)3
= 14,565.6 × 1.1249 = $16,384.32
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1. You just won a lottery that promises to pay you $1,000,000 exactly 10 years from today.
Because the $1,000,000 payment is guaranteed by the state in which you live,
opportunities exist to sell the claim today for an immediate single cash payment.
a. What is the least you will sell your claim for if you can earn the following rates of return
on similar-risk investments during the 10-year period?
(1) 6%
Solution (1) At 6%
growth FV10 = $1,000,000
PV = FV10 / (1 + 0.06)10
= 1,000,000 / (1.7908) = $558,409.65
The least to sell the ticket today is $558,409.65
(2)9%

Solution (2) At 9% growth
PV = 1,000,000 / (1.09)10
= 1,000,000 / 2.3674 = $422,404.33
(3)12%
Solution (3) At 12% growth
PV = 1,000,000 / (1.12)10
= 1,000,000 / 3.1058 = $321,978.23
b. Rework part a under the assumption that the $1,000,000 payment will be received in 15
rather than 10 years.
Solution b. At 6% growth 1,000,000 payment at the end of
15 years is PV15 = 1,000,000 / (1.06)15
= 1,000,000 / 2.3966 = $417,257.78

c. On the basis of your findings in parts a and b, discuss the effect of both the size of the rate
of return and the time until receipt of payment on the present value of a future sum.
Solution c. It can be observed that, as the interest increases the present value decreases, and the
longer the year, the lower the present value.
Therefore, selling the lottery at the rate of 6% or lower will be better if higher present
value is needed.
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2. An insurance agent is trying to sell you an immediate-retirement annuity, which for a
single amount paid today will provide you with $12,000 at the end of each year for the
next 25 years. You currently earn 9% on low-risk investments comparable to the
retirement annuity. Ignoring taxes, what is the most you would pay for this annuity?
Solution 2. 25 years annuity at
9% rate Future value
(FV) = $12,000
PV25 = (12,000 / 0.9) × [1 – 1/ (1 + 0.09)25]
= 13,333.33 × [1 – 1/ 8.6231]
= 13,333.33 × [1 – 0.1160]
= 13,333.33 × 0.884 = $11,786.66
The highest value to pay for this annuity is $11,786.66
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3. Value of a single amount versus a mixed stream
Gina Vitale has just contracted to sell a small parcel of land that she inherited a few years
ago. The buyer is willing to pay $24,000 at the closing of the transaction or will pay the
amounts shown in the following table at the beginning of each of the next 5 years.
Because Gina doesn’t really need the money today, she plans to let it accumulate in an
account that earns 7% annual interest. Given her desire to buy a house at the end of 5
years after closing on the sale of the lot, she decides to choose the payment alternative—
$24,000 single amount or the mixed stream of payments in the following table—that
provides the higher future value at the end of 5 years. Which alternative will she choose?
Solution 3. We first have to find the future value of the lump sum $24,000 today
and the future values of the mixed stream of these values 2,000, 4,000,
6,000, 8,000, 10,000.
Where, the future value of the lump sum is:
PV5 = 24,000
r = 7%
n = 5

FVn = pv × (1 + r) n
Fv5 = $24,000 × (1 + 0.07)5
= 24,000 × 1.40 = 33,662.24
The future value of the mixed
stream Pv1 = $2,000
R = 7%
n = 4 because is Ordinary
Annuity pv1 = $2,000 × (1 + 0.7)4
= 2,000 × 1.31 = $2,629.59
FV2 = $4,000 × (1 + 0.07)3
= 4,000 × 1.23 = 4,900.17
FV3 = $6,000 × (1 + 0.07)2
= 6,000 × 1.14 = $6,869.4
FV4 = $8,000 × (1 + 0.07)1
= 8,000 × 1.07 = $8,560
FV5 = 10,000 × (1 + 0.07)0
= 10,000 × 1 = $10,000
Years PV FV PV
FV5
PV
$24,000 - -
1
- 25,680 2,000
2,621.59
2 -
27,477.60 4,000
4,900.17
3 -
29,401.03 6,000
6,869.4
4 -
31,459.10 8,000
8,560
5 -
33,661.24 10,000
10,000
FV5 $33,661.24 $32,951.16

I will advise Gina to choose the single payment over the mixed stream payment
because; she will be better off taken the lump sum today than chosen the mixed stream of
payment base on the calculation and the figures. She will also have a lot of opportunities to
invest the money for five years if she chooses the single payment method.