Budgeting, Capital Structure, and Working Capital Management

Q. NO. 1) What are the main three question of corporate finance?
Please briefly explain them

and indicate how they are related to area of balance sheet of the company.
Corporate finance is the area of finance that’s deal with the source of funding, capital structure of
corporation, the action managers takes to increase the value of the shareholders and the tools and
analysis is used to allocate the financial resources. The main aim of corporate finance is to
maximize the value of shareholders. The main three question of corporate finance are : Capital
Budgeting, Capital Structure, And Working Capital Management.
 Capital Budgeting: Capital Budgeting is the process of acquiring the fixed assets or
process of the investment in capital projects. Capital budgeting is the technique of
deciding whether or not to acquire capital projects. Capital budgeting is an important of
the financial manager. The impact of capital budgeting is long lasting and it is not easily
revocable. Capital budgeting involves in the substantial amount of funds implies the
commitment of high fixed operating cost and financial costs. Capital budgeting must be
line up to make sure that the business has enough cash to undertake the investments
necessary. A failure to match cash needs to cash sources spells disaster for any business
and, in extreme cases, can result even in bankruptcy.
 Capital Structure: Capital structure refers to mix of long-term sources of capital. Capital
structure is the composition of long-term source of financing. Capital structure issue is
basically associated with the use of debt capital by a company. A company using debt
capital along with equity is called levered firm. The capital structure issue generally
centers around whether or not and to what extent a firm should use debt financing.
 Working Capital management: Working Capital management is the business strategy to

make sure that a company operate efficiently by monitoring and using the current asset
and current liabilities to the best effect. Working capital management covers all the
decision of an organization involving cash flows in the short-term emphasis on the
management of investment in current asset and financing. It focuses on the coordinated
control of firm’s current assets and current liabilities. It is concern with the problem that
arise in attempting to manage the current assent, current liabilities and the inter
relationship that exist between them. Working capital management is used to maintain
the current asset and liabilities at appoint which represent the most satisfactory level of
working capital.
Q. No. 2
Solution:
a) Owner’s Equity= current asset+ net fixed asset-(long term debt + current liabilities)
= 7920 + 17700 – (5890 + 4580)
Balance sheet of Risk surfing ltd
Equity and Liabilities Amount ($) Assets Amount ($)

Equity 15150 Net Fixed asset 17700
Long term debt 5890 Current asset 7920
Current Liabilities 4580
25620 25620
b) Net working capital = current asset - current liabilities
= 7920 - 4580
= 3340
c) Return on equity = 30%
net income/ shareholder equity = 30%
Net income= $3496
Return on asset = net income/ total asset
= 3496/25620
= 0.1364 0r 13.64%
d) No of Outstanding Share = 2000

Market price per share ( MPS) = $12
Earning per Share (EPS) = net income/ no of outstanding share
= 3496/2000
= $ 1.75
Price Earning (PE) Ratio = market price per share / earning per share
= 12/1.75
= $ 6.86
Q. No. 3)
Solution:
a) Effective Annual Interest Rate (EAR)= Effective Rate = (1 + r/m) ^n – 1

where,
r = Annual nominal rate of interest
m = number of compounding period in a year
n = Number of compounding periods the rate is require for
For Bank A
= (1+0.085/2) ^2 – 1
= (1+0.0425) ^2 -1
=1.08680625 – 1
= 0.0868 or 8.68%
For Bank B
= (1+0.0845/4) ^4 -1
= 1.087522 – 1
= 0.08722 or 8.722%
(b) Calculation of maturity amount
A = P (1+ r/n) ^(n*t)
Where:
A = Maturity Amount after t (Time)
r = Interest Rate
n = number of compounding period in a year
t = Time
For Bank B
Maturity Amount = $120,000 (1+ 0.0845/4) ^ (4 *15)
=$120,000 * (1.021125) ^60
= $120,000 * 3.350537
=$420645.0572
Therefor, the maturity amount of Bank A is $420645.0572.
c) present value(p.v)=$120000
future value (fv)= $450000
time(t)=10years
interest rate( r)= ?
now,
fv= pv(1+r)^n
450000 = 120000(1+r) ^ 10
450000/120000 = (1+ r)^ 10
3.75 = (1 +r ) ^ 10
(3.75)^1/10 = ( 1+r)
1.1413086 = 1+r
R= 0.1413 or 14.13%
e) Present value(P.V)= $1200

time(t)= 15 years
interest rate(r) = 8.45%
compounding period(m)= 4
Now,
Future Value = PV(1+r/m)^tm
= 1200*(1+0.0845/4)^4*15
= $4206.45
f) future value (fv)= $12000

compound rate( r ) = 14%
present value(pv)= fv/(1+r)^n
= 12000(1+0.14/4)^15*4
= $1523.216
Q. NO. 4
a) The return of over past five years are 9.7%, -6.2%, 12.1%, 11.5%, 13.3%
Geometric average rate of return
=√n ( 1+ r 1 )∗( 1+r 2 )∗( 1+r 3 )∗(1+ r 4 )∗(1+r 5) -1
Where, r = rate of return
n= number of years
√5 ( 1+ 0.097 )∗( 1−0.062 )∗(1+ 0.121 )∗( 1+0.115 )∗(1+ 0.133) - 1
= √5 1.457202326 – 1
= 1.07821 -1
= 0.07821 or 7.821 %
b) Beta of stock =
Expected Rate of return E(R) = 14.6%
Risk premium = 5.8%
Risk free rate = 5.9%
Inflation rate = 2.7
E( r) = R f + (E( Rm ¿ - R F) * β
14.6 = 5.9 +( 5.8) * β
Β = 1.5
d) weight of stock A=0.45
weight of stock B = 0.55
expected return of stock A = 12.5%
expected return of stock B = 18.5 %
standard deviation of stock A= 15%
standard deviation of stock B = 20%
Expected return of portfolio= 0.45*12.5 +0.55 *18.5
= 15.8%
Standard deviation of portfolio =
(0.45^2 * 0.15^2 + 0.55^2 * 0.262^2 + 2*0.45*0.55*0.15*0.20)^1/2
=0.1775 or 17.75%
Q. NO. 5
a) market price of bond (M)= $1000
maturity yield before tax= 10%
tax rate =30%
maturity yield after tax( k dt ¿ = 10(1-0.3) = 7%
annual interest rate =12%
interest amount(I) = $120
current price of bond = I * ( PVIFA kdt % ,n ¿+ M ( PVIF kdt ,n )
= 120 * ( PVIFA 7 % , 25 yrs ¿+1000∗¿
= 120 * 11.6536 + 1000 * 0.1842
= $1582.95
b) the current price of the ordinary share if the average return of the shares in the same
industry is 9%?
Expected dividend ( D1 ¿ = $7.5
Growth rate (g) = 3%
Rate of return ( K s ¿ = 9%
Now
D1
Cuurent price of share =
¿¿
= 7.5 / (0.09 – 0.03)
= $125
c) ) the current price of the ordinary share if the average return of the shares in the same
industry is 12 %
Expected dividend ( D1 ¿ = $7.5
Growth rate (g) = 3%
Rate of return ( K s ¿ = 12%
D1
Current price of share =
¿¿
= 7.5 / (0.12 – 0.03)
= $83.33
Q. NO.6
a) Calculation of Profitability Index( P.I)
For Equipment 1
Initial cash outlay = $ 186,000
Years Cashflow PVIF8 % PV

1 86,000 0.9259 79627.4
2 93,000 0.8573 79728.9
3 83,000 0.7938 65885.4
4 75,000 0.7350 55125
5 55,000 0.6806 37433
Present value of 317799.7
cashflow=
Profitability Index (P.I)= Present value cash flow / initial cash outlay
= 317799.7/186000
= 1.7086
For Equipment 2
Initial cash outlay = $195,000
Years Cash flow PVIF 8 % Present value

1 97000 0.9259 89812.3
2 84000 0.8573 72013.2
3 86000 0.7938 68266.8
4 75000 0.7350 55125
5 63000 0.6806 42877.8
Present value 328095.1
of cashflow=
Profitability Index = Present value cash flow / initial cash outlay
= 328095.1/195000
=1.68
Therefore, equipment 1 projected should be accepted by company because the profitability index
of equipment 1 is higher than equipment 2.
b) Calculation of Discounted payback period
for Equipment 1
Year Cash PVIF 8 % Discounted cash Cumulative discounted

Flow($) flow($) cash flow
0 (186000) 1 (186000) (186000)
1 86,000 0.9259 79627.4 (106372.6)
2 93,000 0.8573 79728.9 (26643.7)
3 83,000 0.7938 65885.4 39241.7
4 75,000 0.7350 55125 94366.7
5 55,000 0.6806 37433 131799.7
If
Discounted Payback Period (DPBP) = N f −1 +
DCF F
Where,
N f −1= year before full recovery of original investment
I f = unrecovered cost at the beginning of the year of full recovery of original investment
DCF F = total discounted cash flow during the year of full recovery of original investment
Now
26643.7
DPBP = 2+
65885.4
= 2.404 years
For Equipment 2
Year Cash Flow($) PVIF8 % Discounted cash flow($) Cumulative discounted

cash flow
0 (195000) 1 (195000) (195000)
1 97000 0.9259 89812.3 (105187.7)
2 84000 0.8573 72013.2 (33174.5)
3 86000 0.7938 68266.8 35092.3
4 75000 0.7350 55125 90217
5 63000 0.6806 42877.8 133095.1
If
Discounted Payback Period (DPBP) = N f −1 +
DCF F
33174.5
=2+
68266.8
=2.48 years
Equipment 1 project should be accepted because discounted pay back period less than equipment
2.

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Q. NO. 1) What are the main three question of corporate finance?

Please briefly explain them

 Working Capital management: Working Capital management is the business strategy to

= 7920 + 17700 – (5890 + 4580)

Balance sheet of Risk surfing ltd

Equity and Liabilities Amount ($) Assets Amount ($)

b) Net working capital = current asset - current liabilities

c) Return on equity = 30%

net income/ shareholder equity = 30%

Net income= $3496

Return on asset = net income/ total asset

d) No of Outstanding Share = 2000

Earning per Share (EPS) = net income/ no of outstanding share

a) Effective Annual Interest Rate (EAR)= Effective Rate = (1 + r/m) ^n – 1

=$120,000 * (1.021125) ^60

Therefor, the maturity amount of Bank A is $420645.0572.

future value (fv)= $450000

interest rate( r)= ?

e) Present value(P.V)= $1200

f) future value (fv)= $12000

d) weight of stock A=0.45

weight of stock B = 0.55

expected return of stock A = 12.5%

expected return of stock B = 18.5 %

standard deviation of stock A= 15%

standard deviation of stock B = 20%

Expected return of portfolio= 0.45*12.5 +0.55 *18.5

(0.45^2 * 0.15^2 + 0.55^2 * 0.262^2 + 2*0.45*0.55*0.15*0.20)^1/2

a) market price of bond (M)= $1000

maturity yield before tax= 10%

tax rate =30%

maturity yield after tax( k dt ¿ = 10(1-0.3) = 7%

annual interest rate =12%

interest amount(I) = $120

current price of bond = I * ( PVIFA kdt % ,n ¿+ M ( PVIF kdt ,n )

= 120 * ( PVIFA 7 % , 25 yrs ¿+1000∗¿

= 120 * 11.6536 + 1000 * 0.1842

Expected dividend ( D1 ¿ = $7.5

Growth rate (g) = 3%

= 7.5 / (0.09 – 0.03)

Expected dividend ( D1 ¿ = $7.5

Growth rate (g) = 3%

Rate of return ( K s ¿ = 12%

= 7.5 / (0.12 – 0.03)

a) Calculation of Profitability Index( P.I)

Initial cash outlay = $ 186,000

Years Cashflow PVIF8 % PV

Years Cash flow PVIF 8 % Present value

Profitability Index = Present value cash flow / initial cash outlay

b) Calculation of Discounted payback period

Year Cash PVIF 8 % Discounted cash Cumulative discounted

N f −1= year before full recovery of original investment

Year Cash Flow($) PVIF8 % Discounted cash flow($) Cumulative discounted

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Expected return of portfolio= 0.4512.5 +0.55 18.5

(0.45^2 * 0.15^2 + 0.55^2 * 0.262^2 + 20.450.550.150.20)^1/2