Interpreting Financial Ratios and Managing a Portfolio

Interpreting Financial Ratios

Question 1 The table below shows the ratios for three companies: airline, discount clothing store, accounting firm. COMPANY123Debt-equity0.21.20.7Inventory Turnover12.00.3----Current Ratio2.51.51.3Sales/Total Assets4.01.77.0Sales/Receivables40.012.37.2(a)Interpret the ratios in the table to identify the three (3) firms and briefly discuss your reasons using the following format:Company (Number) is the _________________ Reason: _____________________(b)Briefly discuss two (2) reasons why it is difficult to use ratios to compare firms from different countries.(c)Briefly discuss the basis for Mogdiliani and Miller (MM) to claim in their Proposition 1 that capital structure does not matter. Question 2Jack is the manager of a portfolio whose composition is shown below. The market risk premium is 7% and the risk-free rate is 3%.SecurityInvestmentBetaA$5 m1.2B$3 m1.0Treasury Bills$2 mNot given(a)Calculate the beta and expected return of the portfolio.

(b)Appraise and discuss why Jack included Treasury Bills in the portfolio. (c)Jack strongly believes that the stock market would fall in the next one year. Discuss one (1) possible way that he could use to reduce the impact on the portfolio if the stock market were to fall.Question 3The recent trade war has hit the Orange Company severely. Management announced that previous plans to expand its operations would be cancelled. Orange just paid a dividend of $2.50 but announced that next year’s dividend would be cut to $2 per share, and only grow at a rate of 2% per year forever. The market price of the stock was $20 before the announcement. The stock’s expected return is 15%.(a)Calculate the price of the stock after the announcement based on the constant dividend growth model. (b)Explain one (1) limitation of the constant dividend growth model.(c)Briefly discuss two (2)reasons each for an investor to prefer to invest in the convertible bonds of a company over the company’s:(i)Preferred shares(ii)Ordinary sharesQuestion 4DEF Company owns several businesses. The trade wars have caused a general slowdown in business and DEF has decided to downsize. DEF intends to sell its nursery and garden business for $700,000 and has approached XYZ Company as a potential buyer. XYZ is hesitant about purchasing the business as it is not confident about making the business succeed. To sweeten the deal DEF agrees to buy back the business for $400,000 in 3 years’ time if XYZ wants to give up the business then.The details relating to the project are as follows:•Cost of nursery and garden business is $700,000 •No additional working capital is needed•Staff costs are $200,000 per year•Rental of land is $120,000 per year•Projected sales each year is $500,000 •Variable costs (plants, gardening tools, etc.) are 10% of sales•DEF offers buy back the business for $400,000 after 3 years if XYZ does not want to continue with the businessXYZ intends to fund part of its purchase of the business using borrowing. It also intends to maintain a capital structure similar to the typical nursery and gardening firm in the industry. Financial information of a typical nursery and gardening firm are: Typical beta = 1.5 times of market betaRisk-free rate = 3%Market risk premium = 6%Corporate tax rate = 20%Typical debt to equity ratio = 0.5 Typical WACC = 10%(a)Calculate ABC’s cost of equity and cost of debt.(b)Calculate the operating cash flows related to the project.(c)Calculate the NPV of the project assuming XYZ intends to run the business for three years only. Use a discount rate of 10%.(d)Suppose XYZ intends to run the business forever, solve for the IRR associated with the project.(4 marks)(e)Interpret your results from parts (c) and (d) and discuss whether XYZ should buy the nursery and gardening business.Question 5(a)Consider the following pair of bonds which are alike except for the characteristics listed. Bond ABond BCoupon rate6%5%CallableNoYesDiscuss which bond should have the higher yield to maturity.(b)The following financial information relates to XYZ Company:Inventory turnover: 5 timesAccounts receivable turnover = 6 timesAccounts payable turnover = 4 timesXYZ gives its customers a credit period of 60 days. XYZ’s suppliers offer a credit period of 90 days. For simplicity, we assume that the year consists of 360 days. (i)Calculate the operating and cash cycle for XYZ Company.(ii)Evaluate the implications of the cash cycle for XYZ’s working capital management.(c)You are offered the choice of two annuities.A: Receive $100 every year for the next ten years. The first payment starts one year from today.B: Receive $204 every two years for the next ten years. The first payment starts two years from today.Without calculating the present values of the annuities, explain how you can obtain the rate of interest per annum that would make you indifferent between the two annuities