Programme MBA 3rd year (BFI)

Date

Translation by English Department

Member Name
SHROUQ ABDULAZIZ M AL JENDAN
Member Number
14566MBAF

The First Question: (A):

Percentages on Percentages on the Compensation production Compensation Production

the right side left side (year 2003) (year 2004)

Circulation Current assets/ 3450/ 2778 1.24 times 5210 / 4548 1.1 times
current liabilities

Quick liquidity (current assets – 3450 – 1850 / 0.57 times 5210 – 3166 / 0.44 times
ratio inventory) / current 2778 4548
liabilities

Inventory Cost of sales / 8740 / 1850 4.7 times 12564 / 3166 3.96 times
turnover Average inventory

Return on equity Net profit available 1248 / 8744 % 0.14 2374 / 10518 % 0.22
for the common
shareholders / total
equity

Asset turnover Sales / total assets (15600 / % 1.35 24160 / 15066 % 1.6
11522) x 100

Debt-to-equity Total debts / total 2778 / 11522 % 24.11 4548 / 15066 x % 30.18
ratio assets x 100 100

Return on asset Net profit available 1248 / 11522 % 10. 83 2374 / 15066 x % 15.75
for the common x 100 100
shareholders / total
assets

B) Commenting upon the company’s performance, the following has been found out:

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The general performance represented in the value of the return on equity of the year 2003 (%0.14) is almost
equal to the returns achieved during 2004 (%0.22). However, the company faces a high degree of risk due
to the increase in the debt-to-equity ratio to the total assets in 2004 which have reached (% 30.11) which is
regarded higher than the ratio of the previous year (%24.11). This results in increasing the value of interest
rates and in return decreasing the interest coverage ratio the company keeps comparing that of the year
2003. In addition, another decrease is remarked in the return on assets during the year 2004 (%1.6) with a
higher rate than the year 2003 (%1.3) which indicates the company’s deficiency in exploiting its assets.
Moreover, it is noticed that the inventory turnover ratio during 2004 has decreased 3.6 times than the ratio
achieved during 2003 (4.7 times). Thus, it is necessary to check the analysis developed about the inventory,
recheck the demand and sales rates, the quality reports about products and the company’s systems of sale-
on-credit and collection and eventually seek the opinions of the target customers.

The Second Question:

Capital Asset Pricing Model (CAPM): it is a pricing model which attempts to calculate the needed rate of
return of an asset taking into consideration the sensitivity of that asset to the market risk which is
represented in the quantity beta (β), the expected market return as well as that of the asset. When using the
CAMP, it is assumed that all investors seek to avoid risk and expect high returns. Moreover, they also have
to accept the prices standards of the market for they do not want to affect the prices of assets nor the market
prices. In reference to the stock exchanges, no taxes or any related expensed are imposed and there are no
investment obstacles which might hinder the transactions between investors. Speaking of beta coefficient; it
refers to the total value of risk in large-size markets such as the New York stock exchange. Beta equals
1.000.1 yet every company has its own value of beta coefficient representing the risk degree the company
faces in comparison to the market risk in general. For instance, if the beta coefficient of company A is
estimated by 3.0, this means that the company faces a three-fold increased risk rate than the market risk
rate.

Ks = Krf + B ( Km - Krf)

Ks = the rate of return required (or the rate of return).

Krf = the rate of return without risk (the rate of return upon investment without risk such as the American
bonds in USA).

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B = Beta

Km = the rate of return expected from the markets of financial securities in general.

However, there are a number of disadvantages of using the CAPM that can be summed up as follows:

- Investors who use this pricing model expect to undergo a less degree of risk for having the expected rate
of return while the investors of Wall Street consider that they will have to pay for avoiding risk. If investors
face a certain degree of risk, they prefer lower rates of return and consequently, the Wall Street investors
will face evitable loss.

- The model assumes that the return upon assets is distributed randomly and within variable ratios, which is
not true because the returns are distributed in a normal way. Consequently, the market witnesses higher
deviations than the normal rate with 3 to 6 standard deviations.

- The model claims that the risk degree can be estimated by the increases or decreases rates in the return.
This can be true, yet the other acknowledged standards are preferred by most investors.

- By using this model, it is assumed that all investors have equal abilities in getting the data needed and that
they all agree upon the risk degree and rates of return to be achieved.

- The model can not determine or highlight the differences in the returns of assets. That is why Maureen
scholes, Michael Jensen and Fisher Blake have all assumed that the low-value beta coefficient assets may
provide higher returns than the model expected ones.

- The model ignores the value of taxes and the costs incurred during the commercial transactions between
investors.

- The model claims that all assets can be divided into endless smaller units that can be owned and used in
the market.

- Richard Roll has attacked the pricing model believing that using the asset returns as indicators of the
market portfolios may lead to the deficiency of the CAPM and that the portfolio must contain all the
securities of the market and any objects that can be invested. However, most markets suffer a lack of
credibility and the performance of the assets can not be monitored and thus, it is preferred to use the stock
index instead.

- The model assumes that the individual investors have no preferences in the assets or the markets and they
only seek to balance between the value of returns and the risk degree.

The Third Question:

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 Year 2011 2012 2013 2014
Number of units 400 600 500 200
Employing cost 200 100 100 100
Materials cost 100 100 100 100
Administrative 150 300 300 300
expenses
Total costs 300 150 150 150
Depreciation 375 150 150 150
costs
Total expenses 375 300 300 300
Outcome flow 240000 360000 525000 210000
Income flow 560000 840000 700000 280000
Net cash flow 140000 210000 175000 70000
Cumulative total 595000

Total cash flow during five years is less than the investment costs. Thus, this project cannot cover its costs
during these five years.

The Fourth Question:

Queenside Gymnasium Redmonds Cinemas

 Outcome flow of the current investment $500000 $360000

 Net income flow in the first year $390000 $280000

in the second year $ 90000 $80000

in the third year $120000 $140000

 Income flow from the rest value $70000 $60000

Queenside Gymnasium Redmonds Cinemas

Payback period 0.8 year 0.7 year
Net present value -27.85 50
Revenue rate 5.17 6
This project is rejected This project is accepted

A) Payback period for both projects:

Payback period = Investment costs / Annual income flow for the operating

B) Net present value for both projects:

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NPV = (CF1 . + CF2 . + … + CFn . ) – CF0
(1+i)1 (1+i)2 (1+i)n

Queenside Gymnasium:

NPV = (390 / (1.1)1 + 90 / (1.1)2 + 120 / (1.1)3) – 500 = -27.85

Redmonds Cinemas:

NPV = (280 / (1.1)1 + 80 / (1.1)2 + 140 / (1.1)3) - 360 = 50

C) The internal rate of return for both projects:

Accounting rate of return = The annual net income flow / The original value of investment

Depreciation of the gymnasium = 500.000 / 3 = 166.666

Depreciation of the cinemas = 360.000 / 3 = 120.000

= (Cash inflow – Depreciation) / Value of the investment

= (70.000 – 166.666) / 500.000 = %5.17

= (60.000 – 120.000) / 360.000 = % 6

Definitions:

Payback period:

It is a common method to assess the investments. It is used to estimate the required period of time until an
investment recoups its costs. This method aims to generate cash and to guarantee that the risk will be low
because of the fast payback regardless the profitability.

Net present value (NPV):

It is one of the methods that companies use to evaluate the long-term projects. It aims to ensure that the
evaluated project is able to achieve cash flow whose value is higher than the invested money in this project.

Net present value is the difference between the invested value in the project and the present value of the
expected net cash flow of this project.

Accounting rate of return:

It estimates the profitability of each investment according to either the traditional accounting methods or
the average of investments. The project which achieves higher return rate is accepted.

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The Sixth Question:

Cost of capital Costs of Neper’s costs Costs of raw Costs per unit
consumption materials
11.000 300.000 × %12 100.000 / 4 = 11.000 × 8 = 11.000 × 6 = 19.54
= 36.000 25.000 88.000 66.000
14.000 36.000 25.000 14.000 × 8 = 14.000 × 4 = 18.36
112.000 84.000
16.000 36.000 25.000 16.000 × 6 = 16.000 × 6 = 17.36
128.000 96.000
According to the cost per unit during the three years and in the light of the price per unit which equals 20,
the company can keep producing and selling its product.

The advantage and disadvantage of the net present value:

1- The advantages:

 By this norm the changes in the time value of money and the changes in prices are considered. Thus,
it is easy to determine if an investment is able to cover its costs and achieve revenue or not.
 It calculates the cash revenues of this investment during its life.
 It is better to use this norm when the cash inflow is sometimes positive and at other time is negative.
 It summarizes the data that indicates the profitability of the project.
 It shows the value of the alternative investments using the discount rate which refers to the cost of
capital.

2-The disadvantages:

 In case of differences in the value or in the age of different projects, this norm does not put these
projects in the right order.
 This norm does not assist in determining the productivity of the monetary unit. It gives only the
absolute value of the net income of the project during the operating years. It means that the project
whose cost is 2 million Riyal equals another project whose cost is 10 million Riyal. This problem
could be avoided by both norms: internal rate of return and profit rate.
 Net present value depends on the discount rate and that increases the risks when evaluating the
investments because this norm includes new variable which could cause uncertainty, especially if
the discount rate is determined by individual endeavor.
 This norm does not concern with the uncertainty factors which have great influence on the value of
the project.

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Despite all these criticisms, this norm is very important, but an investor should not depend only on it. He
should use other norms of evaluation such as; the internal rate of return and the profit rate.

The Seventh Question:

Question No. Answer No.

1 1
2 2
3 4
4 3
5 4

The Ninth Question:

1- Net present value NPV:

Net present value = Present value of the expected net cash flow - the invested money in this project.

NPV = (CF1 . + CF2 . + … + CFn . ) – CF0

(1+i)1 (1+i)2 (1+i)n
Net present value of the first machine:

NPV = (20 / (1.12)1 + 20 / (1.12)2 + 20 / (1.12)3 + 20 / (1.12)4 + 20 / (1.12)5) – 120 = 0.37

Net present value of the second machine:

NPV = (20 / (1.12)1 + 30 / (1.12)2 + 50 / (1.12)3 + 70 / (1.12)4 + 20 / (1.12)5) – 120 = 13.5

In case of the equal invested money, the machine whose net value is the highest should be selected. Thus,
the second machine is selected.

2- Accounting rate of return:

It is used to measure the profitability of a project according to the traditional methods of accounting or it
could depend on the average of the investments. The project which achieves the highest revenue rate is
selected

Depreciation = 120 / 5 = 24

Accounting rate of return = The annual net cash inflow / The original value of the investment

= (cash inflow – depreciation) / value of investment

The accounting rate of return of the first machine = (20 – 24) / 120 = % 0.03

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The accounting rate of return of the second machine = (30 – 24) /120 = % 0.05

The second machine is selected because it achieves the highest revenue rate.

3- Payback period:

In order to determine the payback period, the original value of the investment should be determined and the
annual cash inflow from the operating after deducting the operating costs should be estimated.

Payback period = The original value of the investment / Annual cash inflows from operating

The payback period of the first machine = 120 / 20 = 6 years

The payback period of the second machine = 120 / 30 = 4 years

The second machine is selected because its payback period is shorter.