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BUSINESS FINANCE 1
Answer 1A
1. The Principle of Risk and Return
The risk and return theory suggest that investors must be mindful of risk and return, when the
losses are higher and the return rates lower, the return rates lower. We have to equate the return
with the risk for corporate finance. In order to ensure maximum return rates, investors need both
direct calculation and relative measurement to calculate risk and income.
2. Time Value of Money Principle
This theory concerns the valuation of capital, which decreases the value of money as
time goes by $1 of the market value after any time or years is better than $1. We ought to worry
about the rate of inflation in the economy before saving or taking money. The required rate of
return must be above inflation, so the return will balance the loss of inflation.
3. Cash Flow Principle
The theory of cash management primarily concerns cash inflow and cash outflow and in the
previous time more cash outflow is preferred than later. This theory also follows the principle of
the time benefit, because it favors more advantages earlier than later years.
4. The Principle of Profitability and liquidity
The theory of liquidity and profitability is indeed very important for the investor, since both
profitability and liquidity have to be guaranteed by the investor. The marketability of the
investment shows liquidity, i.e., how quick it is to get money from the sale of the investment.
Investors, on the other hand, would invest in order to optimize benefit at a moderate to lower risk
level.
5. Principles of diversity
By constructing an ideal portfolio, this theory helps to minimize risk. Never put all your eggs in
the same basket, and if it breaks all of your eggs crack, and then put eggs into another basket to
minimize the risk. The idea is to have a portfolio. This theory includes investment by investors in
risk-free investments and volatile investments so that the risk will potentially be smaller.
Investment diversification guarantees risk elimination.
6. The Hedging Principle of Finance
We have the hedging theory to prove that we need to take a credit from acceptable sources, to
finance short-term funds and to control the fund from long-term sources for long-term pleasure.
Long-term sources are to be used for fixed asset funding.

BUSINESS FINANCE 2
 Answer 1B

a) Return on equity b) Return on Assets c) Earnings per share d) Price earnings ratio
ROE = Net Income / Equity ROA = Net Income / Earnings Per share = P/E ratio = Price per
Capital Total Assets Net Income / No. of share / Earning per share
Net Income = 0.35 x $5000000 shares
= $1750000 = $1750000 / = $85 /$35
Debt ratio = Debt / Total $4500000 = $1750000 / 50000
Assets
0.45 = Debt / 4500000
Debt = 4500000 x 0.45 =
$2025000
Equity Capital = Total Assets
- Debt 
Equity = 4500000 - 2025000 =
$2475000
ROE = Net Income / Equity
= 1750000 / 2475000

ROE = 70.72% Approx. ROA = 38.89% EPS = $35  P/E ratio = 2.43 approx.
Approx.

Answer 2
 Monthly Mortgage Payment = P × r × (1 + r)n-1/((1 + r)n-1- 1)
                                                  = 350,000*(.0483/12) *(1+(.0483/12))30-1/ (1+(.0483/12))30-1-1
                                                  = $979.26
 How much furniture Lisa can afford:
Present Value of Repayment to be made = $50*PVAF (8.5% p.a., 52 Weeks)
                                                  =$50*49.8937367 = $2,494.69

BUSINESS FINANCE 3
 Answer 3

a) Arithmetic Average Return = 0.14 – 0.13 + 0.156 + 0.17 + 0.195 / 5 = 0.531 / 5 = 0.1062
or 10.62%
Geometric Average Return = 5√ (1+0.14) (1-0.13) (1+0.156) (1+0.17) (1+0.195) – 1
= 5√1.6030 – 1
= 1.60300^0.20 – 1
= 1.09897 – 1
= 0.09897 or 9.897%

B) Following is the Calculation 

States Portfolio Return(A) Prob(P) A*P A-E(A) (A-E(A))2 P*(A-E(A))2

i Ii iv v vi
Mild Recession -2.5 0.25 - 0.625 -13.9500 194.60250 48.650625

Normal 13.5 0.45 6.075 2.0500 4.20250 1.891125

Growth 20 0.3 6 8.5500 73.10250 21.930750

E(A) 11.45 Variance 72.472500

 Return Expected = Sum of (Probability * Portfolio Returns) = Σ (A*P) = 11.45%

 Portfolio return variance = ΣP*(A-E(A))2 = 72.4725%2
 Standard Deviation of Portfolio Return = √72.4725 = 8.5131%

C) Expected Return = Risk Free rate + (Market Return - Risk Free Rate) * Stock beta 
Putting the Value given in the above equation and assuming Market Return of Portfolio = X we
got,
13.2 = 3.5 + (X- 3.5) 1.2
13.2 = 3.5 + 1.2X - 4.2
13.2-3.5+4.2 = 1.2X

BUSINESS FINANCE 4
X=13.9/1.2
X= 11.5833
 Rate of return = 11.5833%

Answer 4A
a. Bond price = Present value of coupons+ Present value of face value

= 10.5%*1000*(1-1/ (1+9.7%) ^16)/9.7% + 1000/ (1+9.7%) ^16

=105*7.965469313 +1000/4.398514634
=$1063.72
 
b. Price of share = Dividend Expected / (Average return rate-growth rate)
=6.5*104.5%/ (11.5%-4.5%)
=6.7925/7%
=$97.04
 
c. Share price = Annual dividend/rate
= 15%*100/12.5%
=$120
 
Answer 4B
Structure of No. of Market Current Structure of Cost WACC
capital shares price Market capital
Value
Ordinary 68000 $35 238000 52.63 7.92% 4.17%
Equity shares
Preference 15000 $75 1125000 24.88 10.67% 2.65%
Shares shares
Bonds 850 shares $1196.4 1016940 22.49 5.20% 1.17%

4521940 8.00%

(a) Current Market Value of the company

BUSINESS FINANCE 5
  Total Market Value = Current Market Value of ordinary equity + Current Market Value
of Preference Equity + Current Market Value of bonds
= $ 2380000 + $ 1125000 + $ 1016940
= $ 4521940
 
(b) Capital Structure of the company
Ordinary shares = 52.63 %
Preference shares = 24.88 %
Bonds = 22.49 %
Equity funding capital structure = Ordinary shares + Preference Shares
                                                                = 52.63 % + 24.88 %
                                                                = 77.51 %
 
(c) Weighted average cost of capital of the company (WACC)

 WACC = Ordinary shares structure value + Preference shares structure value + bonds
share structure value
             = 4.17 % + 2.65 % + 1.17 % 
             = 8.0 %

Answer 5
A) Identify which project should your company accept based on Net present value
method?
Answer: Project Diamond
Reason: Decision rule Based on NPV
 NPV > 0, then Accept the project
 NPV< 0, then reject the project
Both projects in that case have NPV > 0, so that both projects can be invested.

BUSINESS FINANCE 6
But the NPV of the Diamond project is higher than the NPV of the project among mutually
exclusive projects with the highest NPV..
NPV of Project Gold = $251,615.25
NPV of Project Diamond = $286,441.29
 
Working:
NPV     = Present Value of Future cash flows – Initial investment
 
Present value of future cash flows: 
Present Value = Cash Flows ÷ (1 +R)N
R = Discount rate =9%
N = number of years
 
NPV of Project Gold
Initial investment = $485,000
Future cash flow present value
Year Cash Flow Workings for present Value Present Value
 
1 $105,850 =$105,850÷ (1.09)1 $97,110.09
2 $153,250 =$153,250÷(1.09)2 $128,987.46
3 $225,650 =$225,650÷(1.09)3 $174,243.20
4 $245,000 = $245,000÷(1.09)4 $173,564.18
5 $250,350 = $250,350÷(1.09)5 $162,710.32
- - Present value of future cash flows $736,615.25
NPV Calculation
NPV     = Present Value of Future cash flows – Initial investment
            = $736,615.25 – $485,000
            = $251,615.25
           

BUSINESS FINANCE 7
 NPV of Project Diamond
Initial investment = $520,000
Present value of future cash flows calculation
Year Cash Flow Workings for present Value Present Value

1 $117,050 =$117,050 ÷(1.09)1 $107,385.32

2 $162,400 =$162,400 ÷(1.09)2 $136,688.83
3 $275,500 =$275,500 ÷(1.09)3 $212,736.55
4 $255,000 = $255,000 ÷(1.09)4 $180,648.43
5 $260,000 = $260,000 ÷(1.09)5 $168,982.16
- - Present value of future cash flows $806,441.29
NPV Calculation
NPV     = Present Value of Future cash flows – Initial investment
            = $806,441.29 – $520,000
            = $286,441.29

 
B)
Answer: None of the projects
Explanation:

1. Where the actual acceptable payback time is shorter than or equal to: Accepting Approval
2. If the amount of payback reaches the full payback period acceptable: Removal

The highest appropriate repayment duration is 2,5 years and the reimbursement period of both
projects is over 2.5 years. So, all projects should be rejected. Project Gold Discounted payback
period = 3.49 years

 Project Diamond Discounted payback period = 3.35 years

BUSINESS FINANCE 8
Workings:
The payback period is the same period where the cumulative current value of the cash inflow is
equal to the original expenditure in money. However, the time frame in which it lies should be
stated if the exact number does not coincide. We would measure the fraction of the year after
that.

Discounted payback period of Project Gold

Initial investment = $485,000
Calculation of cumulative present value of cash flows
Note
Formula for calculating present value of cash flows is given below;
Present value = Cash flows ÷ (1 + R)N
R = Discount rate = 9%
N = number of years
Present value of future cash flows calculation
Yea Cash Flow Workings for present Value Present Value Cumulative
r present value of
cash flow
1 $105,850 =$105,850÷(1.09)1 $97,110.09 $97,110.09
2 $153,250 =$153,250÷(1.09)2 $128,987.46 $226,097.55
3 $225,650 =$225,650÷(1.09)3 $174,243.20 $400,340.75
4 $245,000 = $245,000÷(1.09)4 $173,564.18 $573,904.93
5 $250,350 = $250,350÷(1.09)5 $162,710.32 $736,615.25
 
Discounted Payback period in this case will lie between year 3 and year 4. Since up to 3 year a
sum of $400,340.75 shall be recovered, balance of $84,659.25 (i.e., $485,000 – $400,340.75)
shall be recovered in the part of 4th year.

 Computation is as follows

 = Balance recoverable ÷ present value Cash flow of year4

= $84,659.25 ÷ $173,564.18

BUSINESS FINANCE 9
= 0.487769127
= 0.49 years
Discounted Payback period = 3.49 years
Amount of $400,340.75 is recovered in 3 years’ time and amount of $84,659.25 (i.e.
$485,000 – $400,340.75) is recovered in 0.49 years therefore total payback = 3.49 years
 
Calculation of discounted payback period of Project Diamond
Initial investment = $520,000
Calculation of cumulative present value of cash flows
Yea Cash Flow Workings for present Value Present Value Cumulative
r present value
of cash flow
1 $117,050 =$117,050 ÷(1.09)1 $107,385.32 $107,385.32
2 $162,400 =$162,400 ÷(1.09)2 $136,688.83 $244,074.15
3 $275,500 =$275,500 ÷(1.09)3 $212,736.55 $456,810.70
4 $255,000 = $255,000 ÷(1.09)4 $180,648.43 $637,459.13
5 $260,000 = $260,000 ÷(1.09)5 $168,982.16 $806,441.29
 
Discounted Payback period in this case will lie between year 3 and year 4. Since up to 3 year a
sum of $456,810.70 shall be recovered, balance of $63,189.30 (i.e. $520,000 – $456,810.70)
shall be recovered in the part (Fraction) of 4th year.

Computation is as follows
= $63,189.30 ÷ $180,648.43
= 0.349791579
= 0.35 years
Discounted Payback period = 3.35 years
Amount of $456,810.70 is recovered in 3 years’ time and amount of $63,189.30 (i.e.
$520,000 – $456,810.70) is recovered in 3.35 years.

Answer 6

BUSINESS FINANCE 10
a) The corporation shall settle on the list of shareholders entitled for dividends at that particular
time, the ex-dividend date. Every now and again, shares change hands and then a cut-off date
would be needed. To eliminate the arbitration option, the ex-dividend price is appropriate. As
buyers profit from the dividend because purchasers have not earned the ex-dividend date, the
price would be lowered to meet the investment rate. 
Current market price = $72
Dividend paid = $8
Tax on dividend = 15%
so, Actual benefit to shareholders = $8 x (1-0.15%) =$6.8
Ex-Dividend price = $72-$6.8 = $65.2
b) Since the company follows the residual dividend policy, the dividend paid will be net profit
less than investment requirements. 
Dividend Paid = $3,546,000 - $1,045,000 = $2,501,000.
Dividend Pay-out ratio = $2,501,000/$3,546,000 = 70.53%
c)
Dividend Paid now = $8,500,000
Dividend to be paid next year = $12,500,000
PV of dividend paid next year = $8,500,000 + $12,500,000/ (1+0.12) = $19,660,000
Current value of Per share = $19,660,000/1500,000 shares = $13.12 per share

BUSINESS FINANCE 11