Essays on Financial Management: Diversifiable Risk Term Paper

Financial Management - Business Finance Final Exam Section A A1. Diversifiable risk is also known as unsystematic risk because market circumstances do not affect it. Diversifiable risk can be lowered by investing in a number of different shares, so as to reduce the chance of losing everything at once. On the other hand, market risk is derived from changes in the economy; events such as a recession or an increase in interest rates. All of these factors are cyclical in that that all balance out over the long term and so can be predicted to some extent. A2. The guiding principle for a financial manager to decide on a choice of capital structure is linked with the strategic goals of the firm. If debt is too high, then the company will have to find new capital too reduce long-term debt, which will improve the overall prospects of the company. A3. A sensitivity analysis is used to predict an outcome based on a number of potential situations. The main purpose is to see whether one variable has an effect on another. One such example is the effect that a higher interest rate will have on the price of a company’s stock. A4. The Dividend Irrelevance Theory asserts that a firm’s dividend policy will not be affected by a change in the stock or cost of capital of that company. The only thing that impacts the value of a business is the risks they take and how they make profit. Investors are often not concerned about the dividend policy of a company that they invest in because they sell some equities if they need cash fast. A5. Average Return = 55/ 5 = 11 Standard Deviation = 64 / (5-1) = 16% Coefficient of Variation = 16/ 11 = 1.4545 x 100 = 145.45% A6. a) 2nd year growth rate = 42.9% 3rd year growth rate = 25% 4th year growth rate = -50% 5th year growth rate = 28% Average growth rate of dividend = 11.475% b) 0.96 (1 + .11475) / .25 - .11475 = $7.91 Section B B1. a) i) Unit Sales = 14,000 - 26,000 Cost Price per Unit = $36 - $44 Selling Price per Unit = $48 - $112 Depreciation = $50,000 Expenses per year = $160,000 - $240,000 ii) Unit Sales = 14,000 Cost Price per Unit = $44 Total Cost = $616,000 Selling Price per Unit = $48 Total Revenue = $672,000 Depreciation = $50,000 Tax = $672,000 * 0.34 = $228,480 Expenses per year = $240,000 Total Net Profit = ($462,480) iii) I believe that the project should be considered because of the potential benefits that it has to offer. The above figures don’t make for great reading, but this is only in a worst case scenario where business is really bad. To look at it another way, in a best case scenario the total profit would be $775,920. Of course, this is unlikely to happen either. But, in reality, the actual profit will be somewhere between these two figures, but most likely on the positive side rather than the negative. b) i) Dividend = $6,000 - (0.20 x $12,000) $6,000 - $2,400 = $3,600 ii) $6,000 - $3,600 = $2,400 iii) Debt: Equity = 4:1 x/ 12,000 - x 4x = 12,000 - x 5x = 12,000 x = $2,600 iv) 12,000 - 2,600 - 2,400 = $7,000 B2. a) i) NPV = $3,390 ii) NPV = -$30,290 iii) IRR = 11.26% b) i) Cost of Equity = .05 + (1.2 x .08) = 14.6% ii) Cost of Equity = .70 x (1 + .08) = $.756 (.756/ 4) + .08 = 26.9% iii) .22 -.05 = .17 or 17% c) (1 + .0733)/ (1 + .02) - 1 = 0.5225 x 100 = 5.23%