FINANCIAL MANAGEMENT FINAL EXAM

Jocelyn Darmawanty
F19401118

1. Here, below is my solutions answer of question 1 :

a) For this part, we have a situation with Vine Co. Vine Co decided to buy a new machinery but
still not decide what to do with the old machinery. So, what decision will be the best?
In this part, we have to calculate the Net Present Value (NPV) and before we start our
calculations we should choose which decision we will choose, either renting or selling the
present machine.
We already know from the question, that if we sell it, we will gain $250 and to get to know how
much we will earn for renting, we must counts its PV like this below :
PV = ($100*1)+($100*(0.909+0.826) = $273.5
The result shows that renting will be more profitable than selling the machine.
Then, we can do the next step and calculate the NPV. As I mentioned above, NPV is a net
present value. It applies to a series of cash flows occurring at different times. The present value
of a cash flow depends on the interval of time between now and the cash flow. It also depends on
the discount rate.
 NPV is positive, inflows exceeds outflows project with return
 NPV is negative, outflows exceeds inflows project with loss
 NPV is zero, inflows outflows no gain, no loss on money

For counting the NPV we can use this formula below :

NPV = Rt/(1+i)^t
where t is time of the cash flow ; i is discount rate ; and R is net cash flow
For this formula, we already know time and discount rate, so we need to count Net Cash Flows.
NCF is the total flow including all payments of the project except those related to capital inflows
and outflows. This indicator measures the financial health of an enterprise and its ability to
increase its value and investment attractiveness.
NCF = Total Cash Inflows – Total Cash Outflows
For inflows, we take rental amount $100/year for the first 3 years and also each year we get
increased revenue 20% ($8,000*20% = $1,600). It counts from 1st year until 5 th year. In
addition, in year 5, we will sell the machine and get $450. We won't add anything more because
as it is said if the machine is hired out rather than sold, it will have no residual value at the end of
the three year period.
For outflows, we have an increase in running costs. Each year increases 18%/year. First, we have
to calculate the running costs with percentages. After that, we have to find difference between
what has been and what will be and we will get the increase.

Year1 = 840*118% = 991.2 Increase = 991.2-840 = 151.2

Year2 = 991.2*118% = 1169.6 Increase = 1169.6-991.2 = 178.4
Year3 = 1169.6*118% = 1380.1 Increase = 1380.1-1169.6 = 210.5
Year4 = 1380.1*118% = 1628.5 Increase = 1628.5-1380.1 = 248.4
Year5 = 1628.5*118% = 19217 Increase = 1921.7-1628.5 = 293.2

We've set all the valuable point, so now we can calculate the NCF. NCF should be counted for
each year starting from the 0 year :

Total NCF:
Year0 = 100-4,000 = -3,900
Year1 = 100+1,600-151.2 = 1,548.8
Year2 = 100+1,600-178.4 = 1,521.6
Year3 = 1,600-210.5 = 1,389.5
Year4 = 1,600-248.4 = 1,351.6
Year5 = 450+1,600-293.2 = 1,756.8

Now, we already have all the things for doing the NPV calculation. First, we have to count it
year by year, and then sum it up.

Total NPV (10%) :

Year0 = -3,900*1 = -3,900
Year1 = 1,548 8*0.909 = 1,407.9
Year2 = 1,521.6*0.826 = 1,256.8
Year3 = 1,389.5*0.751 = 1,043.5
Year4 = 1,351.6*0.683 = 923.1
Year5 = 1,756.8*0.621 = 1,091
NPV = -3,900+1,407.9+1,256.8+1,043.5+923.1+1,091 = $1,822.3
From the NPV result above, we can know that the NPV is positive which means that the
machine should be purchased cause it will make more income for Vine Co.
b) In this part we have to calculate IRR. Internal Rate of Return (IRR) is a method of calculating
an investment's rate of return. The economic sense of this indicator is that it actually shows the
average annual return on project implementation over the review horizon. To calculate IRR we
can use formula below :
IRR = L% + (+NPV/(+NPV- -NPV)) x (H%-L% )
Where, L=Lower discount rate ; H = Higher discount rate ; -NPV = NPV @ lower rate ; +NPV
= NPV @ higher rate
We will compare the percentage of what we have now (10%) and what we want it to be (20%).
We already know the +NPV which we already calculated on previous part. Now we have to find
-NPV.
L% = 10% ; H% = 20%
+NPV = 1,822.3 ; -NPV = -3,900+1,290.2+1,056+804.5+651 5+706.2 = 608.4

NPV (20%)
Year0 = -3,900*1 = -3,900
Year1 = 1,548.8*0.833 = 1,290.2
Year2 = 1,521.6*0.694 = 1,056
Year3 = 1,389.5*0.579 = 804.5
Year4 = 1,351.6*0.482 = 651.5
Year5 = 1,756.8*0.402 = 706.2

IRR = 10%+(1,822.3/(1,822.3-608.4))*(20%-10%) = 10+(1,822.3/1213.9)*10 = 10+15 = 25%

The result of the IRR is higher than the cost of capital 10%. Thus, the investment is profitable for
Vine Co and they should accept it.

2. The 3 main decisions of financial management function are :

a) Investment Decision
Investment Decision relates to the determination of total amount of assets to be held in the firm,
the composition of these assets and the business risk complexions of the firm as perceived by its
investors. It is the most important financial decision. Since funds involve cost and are available
in a limited quantity, its proper utilization is very necessary to achieve the goal of wealth
maximization. The investment decisions can be classified under two broad groups: (i) Long-term
investment decision and (ii) Short-term investment decision. A long-term investment decision is
also called Capital Budgeting Decisions. It involves committing the finance on a long term basis.
The long-term investment decision is referred to as the capital budgeting and the short-term
investment decision as working capital management. Capital budgeting is the process of making
investment decisions in capital expenditure. These are expenditures, the benefits of which are
expected to be received over a long period of time exceeding one year. The finance manager has
to assess the profitability of various projects before committing the funds.
Short-term investment decisions (also called working capital decisions) are concerned with the
decisions about the levels of cash, inventories and debtors. These decisions affect the day to day
working of a business. These affect the liquidity as well as profitability of a business. Short-term
investment decision, on the other hand, relates to the allocation of funds as among cash and
equivalents, receivables and inventories. Such a decision is influenced by tradeoff between
liquidity and profitability. The reason is that, the more liquid the asset, the less it is likely to yield
and the more profitable an asset, the more illiquid it is. A sound short-term investment decision
or working capital management policy is one which ensures higher profitability, proper liquidity
and sound structural health of the organisation.

 Factors Affecting Investment Decision

~ Cash flow of the venture: when an organization starts a venture it invests a huge capital at the
start. Even so, the organization expects at least some form of income to meet everyday day-to-
day expenses. Therefore, there must be some regular cash flow within the venture to help it
sustain.
~ Profits: the basic criteria for starting any venture is to generate income but moreover profits.
The most critical criteria in choosing the venture are the rate of return it will bring for the
organization in the nature of profit for, e.g., if venture A is getting 15% return and venture В is
getting 20% return then one must prefer project B.
~ Investment Criteria: different Capital Budgeting procedures are accessible to a business that
can be utilized to assess different investment propositions. Above all, these are based on
calculations with regards to the amount of investment, interest rates, cash flows and rate of
returns associated with propositions. These procedures are applied to the investment proposals to
choose the best proposal.

b) Financing Decision
Financial decision is important to make wise decisions about when, where and how should a
business acquire fund. Because a firm tends to profit most when the market estimation of an
organization’s share expands and this is not only a sign of development for the firm but also it
boosts investor’s wealth. Consequently, this relates to the composition of various securities in the
capital structure of the company. Once the firm has taken the investment decision and committed
itself to new investment, it must decide the best means of financing these commitments. Since,
firms regularly make new investments; the needs for financing and financial decisions are
ongoing.

Hence, a firm will be continuously planning for new financial needs. The financing decision is
not only concerned with how best to finance new assets, but also concerned with the best overall
mix of financing for the firm.
A finance manager has to select such sources of funds which will make optimum capital
structure. The important thing to be decided here is the proportion of various sources in the
overall capital mix of the firm. The debt-equity ratio should be fixed in such a way that it helps
in maximising the profitability of the concern. The raising of more debts will involve fixed
interest liability and dependence upon outsiders. It may help in increasing the return on equity
but will also enhance the risk.

 Factors affecting Financing Decisions

~ Cost: financing decisions are all about allocation of funds and cost-cutting. The cost of raising
funds from various sources differ a lot. The most cost-efficient source should be selected.
~ Risk: the dangers of starting a venture with the funds from various sources differ. Larger risk is
linked with the funds which are borrowed, than the equity funds. This risk assessment is one of
the main aspects of financing decisions.
~ Cash flow position: cash flow is the regular day-to-day earnings of the company. Good or bad
cash flow position gives confidence or discourages the investors to invest funds in the company.
~ Control: in the situation where existing investors need to hold control of the business then
finance can be raised through borrowing money, however, when they are prepared for diluting
control of the business, equity can be utilized for raising funds. How much control to give up is
one of the main financing decisions.
~ Condition of the market: the condition of the market matter a lot for the financing decisions.
During boom period issue of equity is in majority but during a depression, a firm will have to use
debt. These decisions are an important part of financing decisions.

c) Dividend Decision
Dividends decisions relate to the distribution of profits earned by the organization. The major
alternatives are whether to retain the earnings profit or to distribute to the shareholders. A
decision has to be taken whether all the profits are to be distributed, to retain all the profits in
business or to keep a part of profits in the business and distribute others among shareholders. The
higher rate of dividend may raise the market price of shares and thus, maximize the wealth of
shareholders. The firm should also consider the question of dividend stability, stock dividend
(bonus shares) and cash dividend.

 Factors Affecting Dividend Decisions

~ Earnings: returns to investors are paid out of the present and past income. Consequently,
earning is a noteworthy determinant of the dividend.
~ Dependability in Earnings: an organization having higher and stable earnings can announce
higher dividend than an organization with lower income.
~ Balancing Dividends: for the most part, organizations attempt to balance out dividends per
share. A consistent dividend is given every year. A change is made, if the organization’s income
potential has gone up and not only the income of the present year.
~ Development Opportunity: organizations having great development openings if they hold more
cash out of their income to fund their required investment. The dividend announced in growing
organizations is smaller than that in the non-development companies.

 Other Factors

~ Cash flow: dividends are an outflow of funds. To give the dividends, the organization must
have enough to provide them, which comes from regular cash flow.
~ Shareholders’ Choices: while announcing dividends, the administration must remember the
choices of the investors. Some shareholders want at least a specific sum to be paid as dividends.
The organizations ought to consider the preferences of such investors.
~ Taxes: compare tax rate on dividend with the capital gain tax rate that is applicable to increase
in market price of shares. If the tax rate on dividends is lower, shareholders will prefer more
dividends and vice versa.
~ Stock market: for the most part, an expansion in dividends positively affects the stock market,
though, a lessening or no increment may negatively affect the stock market. Consequently, while
deciding dividends, this ought to be remembered.
~ Access to Capital Market: huge and organizations with a good reputation, for the most part,
have simple access to the capital market and, consequently, may depend less on retained earnings
to finance their development. These organizations tend to pay higher dividends than the smaller
organizations.
~ Contractual and Legal Constraints: while giving credits to an organization, once in a while, the
lending party may force certain terms and conditions on the payback of dividends in future. The
organizations are required to guarantee that the profit payout does not abuse the terms of the loan
understanding in any manner.

Next I want to give an example about :

Investment appraisal techniques in relation to investing decision
a. Identifying investment opportunities
From an analysis of strategic choices, analysis of the business environment, research and
development, or legal requirements. Hence, the key requirement is that investment proposals
should support the achievement of organizational objectives.
b. Screening investment proposals
Companies need to choose between competing investment proposals and select those with the
best strategic fit and the most appropriate use of economic resources.
c. Analyzing and evaluating investment proposals
This is the stage where investment appraisal plays a key role, indicating for example which
investment proposals have the highest net present value.
d. Approving investment proposals
Very large proposals may require approval by the board of directors, while smaller proposals
may be approved at divisional level
e. Implementing, monitoring and reviewing investments
The time required to implement the investment proposal or project will depend on its size and
complexity. Following implementation, the investment project must be monitored to ensure that
the expected results are being achieved and the performance is as expected. The whole of the
investment decision-making process should also be reviewed in order to facilitate organizational
learning and to improve future investment decisions. It revisits the business case to see if the
costs predicted at the initiation of the project were accurate and that the predicted benefits have
actually accrued.

Lastly, here is the conclusion answers of question 2. The three major functions of a finance
manager are investment, financial, and dividend decisions. The investment decision entails
determining assets that the firm needs or projects it needs. Under this function, the finance
manager makes capital investment decisions and working capital management decisions. The
financing decision function entails finding sources of funds to finance investments. The dividend
decision function entails deciding on how to share the returns from investments to the
shareholders.
These functions are highly interrelated. Once the manager determines the assets needed
(investment decision), they have to find sources of capital (financing decision), which might be
equity or debt financing. The managers have to decide on how the profits from investments will
be shared to the investors (dividend decision).

3. For the last question, I will explain different types of bond/debenture. Namely, Normal
Bond, Convertible Bond, and Bond with Warrant. I also want to explain about each bonds
benefits and problems.
a) Normal Bond
Bonds are transferable medium-long term debt securities containing a promise from the issuing
party to pay interest in the form of interest in a certain period and pay off the principal at a
predetermined time to the buyer of the bonds.
The characteristics that must be owned by a bond are as follows :
1. Face value is the principal debt of a bond that will be received by bondholders when the bond
matures.
2. Interest rate is the value of interest received by bondholders regularly (the usual payment of
bond coupons is every 3 or 6 months). Bond coupons are expressed as an annual percentage.
3. Maturity is the date on which the bondholder will get the principal repayment or face value of
the bond held. Bonds that will mature within 1 year will be easier to predict, so they have less
risk than bonds that have a maturity period of 5 years. In general, the longer the maturity of a
bond, the higher the coupon or interest rate.
4. Issuer, knowing and knowing the issuer of bonds is a very important factor in investing in
retail bonds. Measuring the risk of the bond issuer not being able to pay the coupon and principal
on time can be seen from the bond ratings issued by rating agencies such as PEFINDO or Fitch
Indonesia.
Benefits of bonds :

 Bond interest rates are consistent, in the sense that they are not affected by bond market
prices.
 Bondholders can estimate the income to be received because the contract agreement has
determined the rights to be received by the bondholders.
 Bond investment can also protect the risk of bondholders from the possibility of inflation.
 Bonds can be used as collateral for bank loans and to purchase other asset instruments

Problems of bonds :
  Interest rate. Financial market interest rates with bond prices have a negative relationship,
if bond prices rise, interest rates will fall, and vice versa.
 Bonds are very conservative financial instruments, resulting in good yields, with low risk.
 Low bond liquidation rate. This is due to the movement of bond prices, especially when
bond prices decline.
 Risk of withdrawal. If in the bond agreement there is a requirement for the withdrawal of
bonds, the company can withdraw the bonds before maturity by paying a premium.
 Risk of fraud. If the issuing company has liquidity problems and is unable to pay off its
obligations or goes bankrupt, the bondholders will suffer losses.

b) Convertible Bond
Convertible bonds are debt securities that allow the holder of the debt securities to convert them
into shares of the bond issuing company. Switching from bonds to shares applies a pre-agreed
exchange ratio. Convertible notes are bonds that usually have a low coupon rate. This happens
because investors are considered to have been given the privilege to convert their debt securities
into ownership certificates or shares.

Benefits of convertible bonds :

 Minimizing negative sentiment over investors' doubts regarding principal and interest
payments.
 Provide a sense of security to investors in the event of default.
 Low interest for the issuing company.
 Payment flexibility in which certain types of investors have the option of paying debt
securities in cash or exchange for shares.
 The advantage for investors if they choose stock conversion is the appreciation of the
stock price.

Although it tends to benefit both parties, these bonds still carry problems.
Problems of convertible bonds :

 Coupon (interest) is lower than other bonds because there is a stock conversion option.
 The risk of default is higher because on average the companies that issue these bonds are
new companies or still small, so you will inevitably be paid with shares.
 Stock prices will not necessarily increase and generate profits for investors. There is a
risk that the stock price will drop.

The company's reason for publishing

The biggest reason companies issue this type of bond is high expectations for growth and credit
ratings. The company will also get fresh funds for business expansion at a lower cost than bank
loans or conventional bonds. New companies with modest earnings are best suited for this type
of bond. Because convertible bonds do not burden the company to pay off the debt to
bondholders. In addition, another bonus for companies that issue these bonds is the interest that
reduces the company's taxation. Investors also benefit from having the flexibility to convert
bonds into cash (returning principal and interest) or stocks.

c) Bond with Warrant

When you buy a bond with an attached warrant, the warrant gives you the right to buy a certain
number of fixed-price shares of the stock of the company that issues the bond. You are not
obligated to purchase the stock, and the price specified on the warrant may be different from the
price at which the stock is trading on the day you buy your bonds. Warrants are considered
detachable, which means they can be sold or redeemed separately. The price at which the
warrant holder can buy shares of stock is called the strike price or exercise price. Most warrants
can be traded on financial exchanges, and in some cases companies provide incentives to
bondholders who sell or exercise their warrants before the warrants expire. For example, a
company may not pay a dividend to a bondholder who still has outstanding warrants.
Convertible bonds are similar to bonds with warrants in that both types of securities enable the
buyer to purchase company stock at a certain price. The difference is that holders of bonds with
warrants retain the bonds and either sell the warrants or use additional funds to buy stock,
whereas investors who buy convertible bonds use the bonds to buy stock. Call options are also
somewhat similar to warrant bonds in that they give holders the right to buy stock at a certain
price and can be traded. Call options have no underlying value, however, so if they sink to below
the price that an investor pays for them, the investor does not have a bond that continues to hold
value. Warrants with bonds benefit the buyer because they offer a chance to diversify. Instead of
just buying bonds, the buyer has a chance to invest in stock from the same company. This
benefits corporations because they can offer a more attractive investment than pure bonds, which
can increase the bond sales. Like any other type of investment, warrants also have drawbacks
and risks or problems. The leverage and gearing that warrants offer can be high, but these can
also work to the investor's disadvantage.
Lastly, I will explain about the examples of convertible bond and bond with warrant. Both are a
means for a company (frequently, a company whose future prospects are far greater than it’s
current cash position or credit rating) to raise capital at lower cost (and, frequently, on better
terms) than might otherwise be available. They do that by allowing you to profit from potential,
future stock growth in exchange for a lower interest rate.
a) Say X Biotech’ stock has a host of promising cancer drugs that are 2–4 years from approval.
It’s share price is $50 per share and it needs $100 million to fund additional equipment, research
and drug trials. If it sold 5-year bonds, they might cost 7% interest every year, given it’s
middling credit rating. So it offers a 5-year bond for $1000 that pays 4%. But it has a “kicker.”
Instead of getting your $1000 back in 5 years, you can exchange (convert) the bond for 20 shares
of stock, if the stock price is over $80, two years or more from now. Three years later, an
important drug is approved and the stock goes to $85. You get $1700 worth of stock, and the
company no longer has to pay you interest or pay back the $1000 loan. Win-Win. On the other
hand, if the stock goes to $70 after 2 years, you still have a 4%, 5-year bond that you could sell
for $1,300. That’s a convertible bond.

b) A warrant is the “kicker,” detached from a bond or some other deal. It’s just the option to buy
x shares of stock, at a certain price, after some date in the future. A warrant like an option
contract can be bought and sold on it’s own until the date it is either exercised or expires. An
example : at the bottom of the banking crises, Stiven needed $5 Billion in capital at a time when
Financial Firms were failing right and left. Jocelyn lent it to them for a high rate of interest, plus
a “kicker.” Stiven shares were $80 at the time. Jocelyn got warrants that gave him the option to
buy up to 40 Million Stiven shares for $115 over the next 5 years. Three years later, the economy
recovered and Stiven doubled to $160. Those warrants which had been worth little when they
were issued could now be exercised for a $45 per share profit or they could be sold for more than
$45 each, to someone who believed Stiven Shares might go even higher before the warrants
expired in two more years.