FM

What are deferred taxes, and how do they come into being?
Deferred taxes arise because of the timing difference of some expenses as recorded for financial
reporting purposes. It is the difference between taxes actually paid and taxes shown as being paid on
firm’s public statements. (Taxes that will be paid in the future).

What is cash budget? What are the usual steps involved in preparing a cash
budget?
A cash budget is an estimation of the cash inflows and outflows for a business over a specific period of
time. This budget is used to assess whether the entity has sufficient cash to operate.

Steps

1. Determine the beginning cash balance

2. Add receipts
3. Deduct disbursements
4. Calculate the cash excess or deficiency
5. Determine financing needed
6. Establish the ending cash balance

Write a note on cost of capital? Explain independent, mutually

exclusive and Contingent projects?
Cost of Capital

A firm’s cost of capital is defined as the cost of the funds (debt, preferred and common equity) supplied
to it and used to finance investments made by a company. It is also termed the required rate of return
because it specifies the minimum necessary rate of return required by the firm’s investor on new
investments. If a firm earns returns on its new investments that exceed the cost of capital, shareholder
wealth will increase.

Independent Project

An independent project is one whose acceptance or rejection does directly eliminate other projects
from consideration. For example, a firm may want to install a new telephone communication system in
its headquarters and replace a drill press during approximately the same time In the absence of a
constraint on the availability of funds, both projects could be adopted if they meet minimum criteria.

Mutually Exclusive Projects

A mutually exclusive project is one whose acceptance precludes the acceptance of one or more
alternative proposals. Because two mutually exclusive projects have the capacity to perform the same
function for a firm, only one should be chosen.
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Contingent Projects

A contingent project is one whose acceptance is dependent on the adoption of one or more other
projects.

Long Question:
Jenkins Properties had gross fixed assets of 1000 at the end of 2010. By the end of 2011, these had
grown to 1100. Accumulated depreciation at the end of 2010 was 500 and it was 575 at the end of 2011.
Jenkins has no interest expenses. Jenkins expected sales during 2011 to total 500. Operating expenses
(exclusive of depreciation) were forecasted to be 125. Jenkin’s marginal tax rate is 40 percent.

a. What was Jenkin’s 2011 depreciation expense?

b. What was Jenkin’s 2011 earnings after taxes (EAT)?
c. What was Jenkin’s 2011 after-tax cash flow?
d. Show that EATS less the increase in net fixed assets is equivalent to after-tax cash flow less the
increase in gross fixed assets.

Solution:

a)

Depreciation expense = Increase in accumulated depreciation

= 575 - 500
b)

Sales 500
Operating Expense -125
Depreciation -75
EBT 300
Taxes -120
EAT 180

c)
ATCF = EAT + Depreciation
= 180 + 75
= 225

d)

Increase in net fixed assets

100 increase in gross fixed assets
-75 increase in accumulated depreciation
25 increase in net fixed aasets
EAT less increase in NFA = ATCF less increase in GFA
180 – 25 = 225 – 100
155 = 155
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How the opportunity is cost concept used in the capital budgeting process?
In capital budgeting, a company should use an asset's opportunity cost as its cost. An opportunity
cost reduces cash flow just like any other cost because a company is giving up cash flows it would have
otherwise received, which results in lower cash flows.

How does the net present value model complement the objective of maximizing
shareholder wealth?
The net present value method computes the present worth of a project’s benefits over its costs,
evaluated using the firm’s cost of capital. If a project has a positive net present value, it means that
investors are receiving the minimum required rate of return, as measured by the cost of capital, plus
they are receiving something extra. This positive net present value is an additional increment to
shareholder wealth.

What are the primary types of real options in capital budgeting?

An option is an opportunity that gives an owner the right to sell an asset for predetermined price.

However, an owner is obligated to exercise an option. A real option is an opportunity that a company
has to change some aspects of a project or make a decision that will affect the project’s outcomes.

Long Question:
Calculate the internal rate of return and profitability index for a project that is expected to generate
eight years of annual cash flows of Rs 75000. The project has a net investment of Rs 360000 and the
required return on the project is 12 percent.

Solution:
NPV = PV cash inflows – Net investment

0 = 75000(PVIFAr,8) – 360000

(PVIFAr,8) = 4.80

r ≈ 13 Percent ( From Table 4)

𝟕𝟓𝟎𝟎𝟎(𝑷𝑽𝑰𝑭)
𝑷𝑰 = 𝟑𝟔𝟎𝟎𝟎𝟎

= 𝟏. 𝟎𝟑𝟓
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How do retained earnings differ from other sources of financing?
Retained earnings are an internally generated source of financing, whereas other sources of financing
are external (long-term debt, preferred stock, and newly issued common stock).

Why is corporate long term debt riskier than government long term debt?
A low debt to equity ratio is a sign that the company is growing or thriving, as it is no longer relying on
its debt and is making payments to lower it. ... A company's long-term debt may also put bond investors
at risk in an illiquid bond market.

Another common division of government debt is by duration until repayment is due. Short term
debt is generally considered to be for one year or less, and long term debt is for more than ten
years.

Long Question:
Clarke Equipment currently pays a common stock dividend of Rs 3.50 per share. The common stock price
is Rs 60. Analysts have forecast that earnings and dividend will grow at an average annual rate of 6.8
percent for the foreseeable future.

a. What is marginal cost of retained earnings?

b. What is the marginal cost of new equity if the issuance costs per share are Rs 3?

Solution:

a)

Ke = (D1/Po) + g
𝟑.𝟓𝟎(𝟏+𝟎.𝟎𝟔𝟖)
= + 𝟎. 𝟎𝟔𝟖
𝟔𝟎

= 𝟎. 𝟏𝟑 𝒐𝒓 𝟏𝟑%
b)

3.50(1+0.068)
K’e= + 0.068
60−3

= 0.134 or 13.4%
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Long Question
Project S cost Rs. 15000,and its expected cash flows would be Rs 4500 per year for 5 years. Mutually
exclusive project L costs 37500, and its expected cash flows would be 11100 per year for 5 years, If both
projects have a WACC of 14 %, which project would you recommend? Explain.

Solution:
The NPV for Project S would be:

NPV = 4,500 / 1.14 + 4,500 / 1.14^2 + 4,500 / 1.14^3 + 4,500 / 1.14^4 + 4,500 / 1.14^5 -
15,000

NPV = 448.86

For project L:

NPV = 11,100 * ( ( 1 - 1 / 1.14^6 ) / ( 1 - 1 / 1.14 ) - 1 ) - 37,500

NPV = 607.20

Project L has the higher net present value and therefore is an investment that can obtain
you the desired return even at a higher cost so it would be recommendation.