Financial Management

A strategic plan is a long-term plan, usually for three to five years or more, that sets out the firm's mission, objectives and the broad policies and actions (including growth, investment and financing choices) needed to reach them. It guides the shorter-term operating plans and budgets.

The risk-free rate is the return on an investment that has no risk of default and no variability of return, such as the yield on government treasury bills or bonds. It equals the real rate of interest plus the expected inflation, and it is the starting point in the CAPM, $k_s = k_{RF} + (k_M - k_{RF})\beta$.

Operating (accounting) BEP is the sales level at which EBIT is zero, so it covers all fixed costs including depreciation. Cash BEP is the sales level at which the firm just covers its cash fixed costs (fixed costs excluding non-cash charges such as depreciation), so it is lower than operating BEP.

Systematic risk (market risk) is the part of a security's risk that comes from factors affecting the whole market or economy, so it cannot be removed by diversification. It is measured by beta. Example: a rise in interest rates, inflation, a recession or political instability in Nepal lowers the prices of most shares on the NEPSE at the same time.

Ordering cost is the cost of placing and receiving an order, and it does not vary with the size of the order. It includes the cost of preparing purchase orders, communication, transport, inspection, receiving and handling. Total ordering cost = (Annual demand / Order size) x Cost per order.

For terms 2/20, net 50, the discount is lost by paying on day 50 instead of day 20, so credit is used for 30 extra days.

$\text{Cost}=\frac{2}{100-2}\times\frac{360}{50-20}=0.020408\times12=\textbf{24.49\%}$

(The effective annual rate with compounding is $(1.020408)^{12}-1 \approx 27.4\%$.)

An efficient portfolio is one that gives the highest expected return for a given level of risk, or the lowest risk for a given level of expected return. The set of all such portfolios forms the efficient frontier; portfolios below it are inefficient because another portfolio offers a better return for the same risk.

Example. Suppose portfolios A, B and C have the following figures.

B is inefficient, since A gives the same return with less risk, and C gives more return than B for the same risk. A and C are efficient. A rational risk-averse investor chooses among the efficient portfolios according to the risk he can bear.

A stock dividend is a distribution of additional shares of the company to existing shareholders in proportion to their holdings, instead of cash. For example, a 20% stock dividend gives 20 new shares for every 100 held. The company transfers an amount from retained earnings to the common stock and paid-in capital accounts.

Differences from a stock split

Both increase the number of shares and reduce the market price per share, while the shareholder's proportionate ownership stays the same.

(a) Full capacity sales:

$\text{Full capacity sales}=\frac{\text{Actual sales}}{\text{Capacity utilisation}}=\frac{\text{Rs }5{,}000{,}000}{0.90}=\textbf{Rs 5,555,556}$

(b) Target fixed asset-to-sales ratio:

$\frac{\text{Fixed assets}}{\text{Full capacity sales}}=\frac{1{,}700{,}000}{5{,}555{,}556}=\textbf{30.6\%}$

(The current ratio is 1.7 / 5 = 34%, which is above the target because of the 10% spare capacity.)

New shares issued = 20% x 40,000 = 8,000 shares. The market price Rs 600 is used, so the amount capitalised = 8,000 x Rs 600 = Rs 4,800,000.

• Common stock increases by 8,000 x Rs 100 = Rs 800,000.
• Additional paid-in capital increases by 8,000 x (600 - 100) = Rs 4,000,000.
• Retained earnings decrease by Rs 4,800,000.

Shareholders' equity after the stock dividend

Taking a 365-day year:

(a) Inventory conversion period = 365 / 6 = 60.83 days.

$\text{CCC}=60.83+70-40=\textbf{90.83 days}$

(With a 360-day year the inventory period is 60 days and CCC = 90 days.)

(b) Credit sales = 80% x Rs 5,000,000 = Rs 4,000,000.

$\text{Accounts receivable}=\text{Credit sales per day}\times\text{DSO}=\frac{4{,}000{,}000}{365}\times70\approx\textbf{Rs 767,123}$

(With a 360-day year it is Rs 777,778.)

Sales growth: $\Delta S = 3{,}000-2{,}000 = 1{,}000$ (50%). Fixed assets were at full capacity and current assets were at proper levels, so all assets rise in proportion to sales. Spontaneous liabilities are accounts payable and accruals (100 + 50 = 150); notes payable, long-term debt and common stock do not change automatically.

(a) AFN

$\text{AFN}=\frac{A^*}{S_0}\Delta S-\frac{L^*}{S_0}\Delta S-M\,S_1(1-\text{payout})$

$=\frac{1{,}200}{2{,}000}(1{,}000)-\frac{150}{2{,}000}(1{,}000)-0.10(3{,}000)(0.40)$

$=600-75-120=\textbf{Rs 405 million}$

(b) Pro forma balance sheet, December 31, 2022 (Rs million)

Addition to retained earnings = 0.10 x 3,000 x 0.40 = 120.

The AFN of Rs 405 million must be raised from new notes payable, long-term debt or new equity.

(a) Mean and standard deviation (sample, n - 1 = 4)

Market (NEPSE): mean = (15 + 10 - 5 + 20 + 10) / 5 = 10%.

Stock J: mean = (20 + 15 + 5 + 20 + 20) / 5 = 16%.

$\sigma_M=\sqrt{350/4}=\sqrt{87.5}=9.35\%,\qquad \sigma_J=\sqrt{170/4}=\sqrt{42.5}=6.52\%$

(b) Beta

$\beta_J=\frac{\text{Cov}(J,M)}{\sigma_M^2}=\frac{225/4}{350/4}=\frac{225}{350}=\textbf{0.643}$

(c) Required return (CAPM), with the expected market return taken as its mean of 10%:

$k_J=k_{RF}+\beta(k_M-k_{RF})=6+0.643(10-6)=6+2.57=\textbf{8.57\%}$

Annual depreciation (straight line, 5 years) = 80,000 / 5 = Rs 16,000.

Contribution per unit = 30 - 18 = Rs 12.

The only fixed cost given is the depreciation on the installed assets, and the firm breaks even on an accounting basis, so total fixed cost is Rs 16,000 and the fixed cost without depreciation is:

$\text{Cash fixed cost}=16{,}000-16{,}000=\textbf{Rs 0}$

$\text{Accounting BEP}=\frac{16{,}000}{12}\approx1{,}334\text{ units}$

$\textbf{Cash BEP}=\frac{\text{Fixed cost}-\text{Depreciation}}{\text{Contribution per unit}}=\frac{16{,}000-16{,}000}{12}=\textbf{0 units}$

Since depreciation is a non-cash cost, the firm needs no sales to cover its cash costs. Any additional cash fixed cost F would give a cash BEP of F / 12 units.

Annual demand $D$ = 100,000 bags x 50 kg = 5,000,000 kg. Ordering cost $O$ = Rs 500. Carrying cost $C$ = 10% x Rs 25 = Rs 2.5 per kg per year. Daily usage = 5,000,000 / 365 = 13,698.63 kg.

(a) EOQ

$\text{EOQ}=\sqrt{\frac{2DO}{C}}=\sqrt{\frac{2\times5{,}000{,}000\times500}{2.5}}=\sqrt{2{,}000{,}000{,}000}=\textbf{44,721 kg}$

(b) Total inventory cost including safety stock

Safety stock = 10 days x 13,698.63 = 136,986 kg.

• Number of orders = 5,000,000 / 44,721 = 111.8; ordering cost = 111.8 x 500 = Rs 55,902
• Carrying cost of regular stock = (44,721 / 2) x 2.5 = Rs 55,902
• Carrying cost of safety stock = 136,986 x 2.5 = Rs 342,466

$\text{Total inventory cost}=55{,}902+55{,}902+342{,}466=\textbf{Rs 454,270}$

(The purchase cost of the wheat, Rs 125 million a year, is excluded.)

(c) Re-order level

$\text{ROL}=\text{Lead time usage}+\text{Safety stock}=9\times13{,}698.63+136{,}986=123{,}288+136{,}986\approx\textbf{260,274 kg}$

The receptionist's salary is not relevant, as the same receptionist is used with or without the system.

(a) Initial investment

(b) Annual depreciation (straight line, with salvage value of Rs 40,000)

$\frac{590{,}000-40{,}000}{5}=\textbf{Rs 110,000}$

(c) Annual operating cash saving (after tax)

(Check: 150,000 x 0.80 + 110,000 x 0.20 = 142,000.)

(d) Terminal cash flow

Book value at the end of year 5 = 590,000 - 5 x 110,000 = Rs 40,000.

• Sale price = Rs 60,000
• Gain = 60,000 - 40,000 = Rs 20,000; tax at 20% = Rs 4,000
• After-tax salvage value = 60,000 - 4,000 = Rs 56,000

(e) Decision at 10%

PV of annual cash flows = 142,000 x 3.7908 = Rs 538,293

PV of terminal cash flow = 56,000 x 0.6209 = Rs 34,770

$\text{NPV}=538{,}293+34{,}770-590{,}000=\textbf{-Rs 16,937}$

The NPV is negative, so City Bank should not install the intercom system.