FMGT exam preparation webinar : Session 4

By Dr Kavita Goel & Dr Donald Winchester

 Objective of this webinar

• Existing exam preparation webinars

• 6th edition and 7th edition of the textbook
• Calculator models – Financial vs Scientific calculators
• Financial tables vs Financial calculators
• Format of the exam
• More activities for practice from topic 3, 5,6,8
Existing FMGT exam preparation webinars:

Session 1
• Topic 3: Break Even analysis & Decision making,
• Topic 5: Bond valuation and Equity valuation
Session 2
• Topic 6: Risk & Return,
• Topic 7: Capital Budgeting
Session 3
• Topic 1: Introduction to financial management,
• Topic 4: Working Capital Management,
• Topic 8: Cost of Capital and Capital Structure
Calculator vs Financial tables

APPENDIX A. Future Value of Single Amount ($1)

n 5% 6% 7% 8% 9%
8 1.477 1.594 1.718 1.851 1.993
9 1.551 1.689 1.838 1.999 2.172
10 1.629 1.791 1.967 2.159 2.367
11 1.710 1.898 2.105 2.332 2.580
12 1.796 2.012 2.252 2.518 2.813

APPENDIX B. Present Value of Single Amount ($1)

n 5% 6% 7% 8% 9%
8 0.677 0.627 0.582 0.540 0.502
9 0.645 0.592 0.544 0.500 0.460
10 0.614 0.558 0.508 0.463 0.422
11 0.585 0.527 0.475 0.429 0.388
12 0.557 0.497 0.444 0.397 0.356

APPENDIX C. Future Value of an Annuity ($1)

n 5% 6% 7% 8% 9%
8 9.549 9.897 10.260 10.637 11.028
9 11.027 11.491 11.978 12.488 13.021
10 12.578 13.181 13.816 14.487 15.193
11 14.207 14.972 15.784 16.645 17.560
12 15.917 16.870 17.888 18.977 20.141

APPENDIX D. Present Value of an Annuity($1)

n 5% 6% 7% 8% 9%
8 6.463 6.210 5.971 5.747 5.535
9 7.108 6.802 6.515 6.247 5.995
10 7.722 7.360 7.024 6.710 6.418
11 8.306 7.887 7.499 7.139 6.805
12 8.863 8.384 7.943 7.536 7.161
6th edition and 7th edition of the textbook

7th edition of the textbook distinguishes between Accounting

break-even analysis and Cash break-even analysis.
Accounting break-even includes depreciation as a fixed cost, on
the assumption that a project is only sustainable if, over time,
there is sufficient cash generated for long-term asset
replacement.
Cash break-even focuses only on whether there is sufficient cash
generated to cover cash fixed costs and variable costs excluding
depreciation as this is non-cash expense.
6th edition of the textbook is talking about Break-even analysis
which is same as Accounting break even analysis.
 Topic 3: Break even analysis example

a) Variable cost for Light's fluorescent tubes is $12.50, and the tubes are sold for $20.00 each. Fixed
costs are $7,500,000. What is the break-even quantity for the fluorescent tubes?

(Accounting) Break Even point (QA)= Total fixed expenses (FC)/Selling price (P)-Variable cost (V)

= $7,500,000/(20.00 – 12.50)

= 1,000,000 units

b) Variable cost for Light's fluorescent tubes is $12.50, and the tubes are sold for $20.00 each. Fixed
costs are $7,500,000. $500,000 in depreciation expense is included in fixed costs. What is the cash
break-even quantity for the fluorescent tubes?

Cash Break Even point (Qc)= Total fixed expenses (FC) – Depreciation (D) /Selling price (P)-
Variable cost (V)

= ($7,500,000 - $500,000) /(20.00 – 12.50)

= 933,333 units
 Topic 3: Decision making example

Currently A Ltd is not doing well in terms of profitability and management asked each manager to
submit a proposal to improve the situation. You have been invited to show the result of each proposal
and recommend the best proposal. You have the following information for the last period:

Production and sales 5000 units

Revenue $50,000

Variable cost 35,000

Fixed cost 20,000

Profit (Loss) (5,000)

The following proposals were suggested by managers:

1) Improve packaging at a cost of $1 per unit, this is expected to increase the selling price by $3 per unit.

2) Launch a new advertisement costing $2,000 in an effort to increase sales by 20%.

3) Decrease selling price by 10% which is expected to increase sales by 40%.

 Topic 3: Decision making example

Production 5,000 units, Revenue per unit $10, Variable cost $7, Fixed cost $20,000

• Improve packaging by $1 per unit, selling price by $3 per unit.

Revenue (5,000*$13) $65,000

Variable cost (5,000*$8) 40,000

Fixed cost 20,000

Profit (Loss) 5,000

• New advertisement costing $2000 in an effort to increase sales by 20%.

• Revenue (6,000*$10) $60,000

• Variable cost(6,000*$7) 42,000

• Fixed cost 22,000

• Profit (Loss) (4,000)

 Topic 3: Decision making example

• Decrease selling price by 10% which is expected to increase sales by 40%.

Revenue (7,000*$9) $63,000

Variable cost (7,000*$7) 49,000

Fixed cost 20,000

Profit (Loss) (6,000)

Recommendation:

Proposal 1 provides the profit or highest return so company should choose proposal 1.
Topic 6: Risk and Return – Single security example

Using the following information, calculate the expected return and standard deviation.

State Probability Return

Boom 20% 40%

Normal 60% 15%

Recession 20% (20%)

Calculation of Expected Returns (using formula 7-3 on p. 196)

E(r)= (0.20)(40%) + (0.60)(15%) + (0.20)(-20%)

= 8% + 9% - 4% = 13%

Standard Deviation of the security (using formula 7-5 on p. 199)

σ = √((40% - 13%)2(0.2) + (15% - 13%)2 (0.6) + (-20% - 13%)2 (0.2))

= √((27%)2(0.2) + (2%)2 (0.6) + (-33%)2 (0.2)) = 19.13%

Topic 6: Risk and Return - Portfolio example

Calculate the portfolio’s expected return and standard deviation on the following :-

Investment Expected Return Standard Deviation Proportion

Fund X 10% 10% 70% of funds

Fund Y 5% 5% 30% of funds

The correlation between funds is 0.50

Calculation of Expected Returns (using formula 8-1 on p. 224) :

(0.7 x 0.1) + (0.3 x 0.05) = 0.07 + 0.015 = 0.085 = 8.5% expected return on portfolio

Standard Deviation of the Portfolio (using formula 8-2 on p. 228) :

= √ (0.72 x 0.12) + (0.32 x 0.052) + (2 x 0.7 x 0.3 x 0.5 x 0.1 x 0.05)

= √ (0.49 x 0.01) + (0.09 x 0.0025) + 0.00105

= √0.0049 + 0.000225 + 0.00105 = √0.006175 = 0.07858 = 7.86% standard deviation of the portfolio
Over to Dr Donald Winchester for topic 5 and 8
examples
 Topic 5: Bond valuation examples

Introduction to Financial Tables: Appendix B = (PVIFi,n) used to the discount face value, FV
 Topic 5: Bond valuation examples

Introduction to Financial Tables: Appendix D = (PVIFAi,n) used to the discount coupons payments, PMT
Topic 5: Bond valuation examples

Face value calculation: 1,0003 /(1.08)3 = $793.83

Coupon payments calculation:

1001 /(1.08)1 = $92.59
1002 /(1.08)2= $85.73
1003 /(1.08)3 = $79.38
The sum of the 3 coupon payments are $257.71

PV = $793.83 + $257.71 = $1,051.54

Tables:
1,000 * 0.794 + 100 * 2.577
$794 + $257.7 = $1,051.70
 Topic 5: Bond valuation examples

Introduction: Now we move from annual to semi-annual bond valuation

examples.
2. ABC has a $1,000 face value, 3-year bond with an annual coupon rate of
10%, paid semiannually. Calculate the bond's price (i.e. PV) when: Market
interest rates on similar bonds are 8%. Using the Financial tables found in
Appendix B (e.g. PVIFi,n) and Appendix D (e.g. PVIFAi,n): (i.e. PV = PMT *
(PVIFAi,n) + FVn * (PVIFi,n).
---------------------------------------------------------------------------------------------------
Face value, FV = 1,000
Appendix D: (PVIFAi,n) n = 3 years / 2 = 6 periods
N 4% 5% 6% 7% 8% Coupon payment, PMT = 1,000 @ 10% /
3 2.775 2.723 2.673 2.624 2.577 2 = $50
4 3.630 3.546 3.465 3.387 3.312 i = 8% / 2 = 4%
5 4.452 4.329 4.212 4.100 3.993
6 5.242 5.076 4.917 4.767 4.623 PV = 50 * (5.242) + 1,000 * (0.790)
= 262.10 + 790
= $1,052.10
Topic 5: Bond valuation examples

PV = 50 * [1 – (1.05)-6 ] / 0.05

= 50 * [1 – 0.746] / 0.05

= 50 * 0.254 / 0.05 = $254

1,000/ (1.05)6 = $746

PV = $254 + $746 = $1,000

Tables:
50 * 5.076 + 1,000 * 0.746
= 253.80 + 746 = $1,000
Topic 5: Bond valuation examples

PV = 50 * [1 – (1.06)-6 ] / 0.06

= 50 * [1 – 0.705] / 0.06

= 50 * 0.295 / 0.06
= 14.7519/ 0.06
= $245.87

1,000/ (1.06)6
= $704.96

PV = $245.87 + $704.96 = $950.83

 Topic 5: Bond valuation summary

Bonds can be described in various ways by their value in relation to their

par value (face value) i.e. at a premium, at par value or at a discount.

Examples 1 and 2 – trade at a premium, because their PV is greater than

their par value.
Example 3 – trades at par value, because their PV is equal to their par
value.
Example 4 – trades at a discount, because their PV is less than their par
value.

These results help highlight the importance of an inverse relationship

between market interest rates and bond prices. Those expecting interest
rates to decrease will buy bonds. On the other hand, those expecting
interest rates to increase will likely sell bonds.
 Topic 5: Share valuation example

A company has a 100 percent payout ratio and recently paid a dividend
of $1.20 per share on its ordinary shares. The dividend is expected to
grow by 3% annually in the future. If the required rate of return on the
stock is 9% per annum, what is the fair value of the stock?
Please solve for the fair value of equity, VE, using the constant dividend
growth model (i.e. see prescribed textbook pp. 306-307):

The following information is provided to calculate VE:

D0 = $1.20
r = 9%
g = 3%
 Topic 5: Share valuation example

The constant dividend growth model is defined as:

D1 = D0(1 + g)
VE = D1 / (r - g)
------------------------------------------------------------------------------------------------
D0 = 1.2
r=9
g=3
D1 = 1.2(1.03) = $1.236
VE = 1.236 / (0.09 – 0.03)
= 1.236 / 0.06
= $20.60
Topic 8: The cost of capital and capital structure example

XYZ Corporation provides you with the following information.

Common stock = 1 million shares, with a current market price of $4.50.
The corporation anticipates paying a $0.45 dividend next year and
expects its dividends to grow at 2 percent forever.
Debt of the corporation has a face value of $5,000,000 bonds and
coupon rate at 5% with an annual before-tax yield to maturity of 6% on
a new issue. The bonds presently sell for $1,100 per $1,000 face value.
The corporations company tax rate is 30%. The corporation does not
expect to issue new securities.
Topic 8: The cost of capital and capital structure example

Derive the market value of the corporation.

------------------------------------------------------------------------------------------------

Total market value of XYZ Corporation

Equity = 1,000,000 x $4.50 = $4,500,000
Debt = 5,000 the number of bonds x $1,100 the market price =
$5,500,000
Total = $10,000,000 market value

To calculate WE:
4,500,000 / 10,000,000 = 0.45 or 45%

To calculate WD:
5,500,000 / 10,000,000 = 0.55 or 55%
Topic 8: The cost of capital and capital structure example

Derive the weighted-average cost of capital for XYZ Corporation.

Cost of Debt, kD = kD (1 – T)
Cost of Equity, kE = (D1 / Pe) + g (14-3a, p. 458)
WACC = WEkE + WD[kD(1 – T)],
where WE is the weight of equity and WD is the weight of debt
------------------------------------------------------------------------------------------------
Cost of Debt, kD = 6% After tax cost of debt = 6% x (1 – 0.3) = 4.2%
Cost of Equity, kE = (D1 / Pe) + g
= (0.45 /4.50 ) + 0.02
= 0.10 + 0.02
= 12%
Topic 8: The cost of capital and capital structure example

WACC =
------------------------------------------------------------------------------------------------

WACC =0.45 x 12% + 0.55 x 4.2%

= 5.4% + 2.31%
= 7.71%
See earlier Capital Structure webinar(s).
 Concluding remarks

 It is important to understand the different buttons on your

calculator – as all calculators can vary.

 Please practice each calculation many times before attempting

your own problems or examples provided.

 Read questions carefully and underline all requirements during

reading time.

 Format of the exam - there will be six questions in total. Attempt

four questions. No exam question(s) are from topic 2. Most of the
questions will have theory as well as calculations.

 Show relevant formulas and workings as much as possible.

Thank You and good luck!