Ratio analysis is a very powerful tool for analyzing financial performance that has many valuable applications and some inherent potential weaknesses. Answer the following two questions in one paragraph each: (1) identify the major application of Ratio Analysis and (2) identify some of the potential weaknesses that are inherent in ratio analysis overall.
The core formula underlying the time value of money theory, FV= PV x (1+r)nand its reciprocal
PV = FV/(1+r)n, is based on the assumption that a dollar today is worth more than a dollar tomorrow because it is assumed you can invest the dollar today and earn additional value.
While this is generally true:
- Can you identify some conditions where the assumption might not hold?
- When the conditions do not hold, what is the wise course of action for today’s dollar holder?
- When the invested dollar does not earn additional value, are the basic time value formulas still valid? Explain your answer.
The “Nominal” rate of interest is composed of several components each of which has an impact on the actual interest charged or received: (1) Identify these interest rate components, (2) define what they represent, (3) what determines their magnitude, and (4) specify how they impact on the nominal rate. Use illustrative examples or formulas if and as necessary.
Traditional financial theory states that there is an inverse relationship between a bond’s price and the current interest rates, i.e. when interest rates go up, bond prices fall and when interest rates go down, bond prices rise.
(1) For the following two scenarios is that statement true? – provide your supporting rationale.
Scenario 1: You purchase a $1,000 par value bond 5 year maturity bond with a coupon rate of 5% and a Yield to maturity of 6%, You plan to sell this bond in 3 years.
Scenario2: You purchase a $1,000 par value bond 5 year maturity bond with a coupon rate of 5% and a yield to maturity of 6%. You plan to keep the bond to maturity (5 years).
(2) Also identify some factors other than the interest rate that can affect the price of a bond?
(3) Who bears the risk, gain or loss, of a change in bond price?
The Capital Asset Pricing Model (CAPM), is a powerful analytical tool for use calculating the price of common stock. After reflecting on theory and application of the CAPM model, post a one paragraph response to each of the following questions:
1. What are the primary advantages of the Capital Asset Pricing Model (CAPM) in pricing common stock?
2. What are some potential issues in effectively using the (CAPM ) to determine the price of a stock?
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Answer in one paragraph each, with supporting rational the following three questions:
1. In your own words contrast the strength and weaknesses of each capital budget decision model against the NPV model
2. Given the Net Present Value (NPV) method of capital budget analysis is superior to the Internal Rate of Return (IRR) method; explain why so many companies still use the IRR
method
3. Identify the capital budget decision model that most appeals to you and why it has its appeal
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Beta Incorporated has a current WACC of 12.6 % as shown below:
| Component | Capital In $ | Capital in % | Cost of Capital % | Wtd. Cost of Capital |
| Debt | $50 Million | 50% | 8% | 4.0 |
| Preferred Stock | $10 Million | 10% | 14% | 1.4 |
| Common Stock | $40 Million | 40% | 18% | 7.2 |
| Total Capital | $100 Million | 100% | – | 12.6% |
Beta is considering a major capital project which will cost $30 million and they have accepted an loan contract with Hope Bank for a $30 Million, 10 Year loan at 10% interest to finance this specific project. Beta Incorporated uses the NPV model to evaluate capital budgets and there is some disagreement in the company as to the proper discount rate to use for this project. Some say: the loan rate (10%), since the loan is specifically to finance the project; others say the WACC (12.6%); and others say neither is correct. Given this confusion, they have come to you as their financial consultant for the correct answer.
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1. In one paragraph present your decision and your supporting argument
2. If you answer is Neither 10% or 12%, explain in words how you would calculate the correct answer.
Having now studied capital budgeting decisions, working capital management, and cash flows, provide a short explanation of how the firm’s capital budget plans for next year could impact on the firms projected working capital and cash flow for that year. Give an illustrative example with numbers of how these factors interact using two components of working capital.
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Jermaine Byrant
Nicole Johnson
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