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Hi Sir,
Could you help me with the following questions please
1. Operational gearing is concerned with the level of fixed costs as apposed to variable costs. This is true per the MCQ answer bank on OT test. I thought that operational gearing was contribution / PBIT. Contribution = sales – variable costs.
Why is operating gearing concerned with fixed costs as apposed to variable costs?
Also, why in times of growing demand is it beneficial for a company to have a high level of gearing?
2. The share price of CP plc is $4 per share. They announce a 1 for 5 rights issue at $3.10. What is the theoretical value of the rights per existing share.
I think I know how to calculate the TERP – 5 x $4 + 1 x $3.10 = £23.10 / 6 = $3.85 per share. I am unsure how to get back to the answer of $0.15
3. A project requires an investment of $25,000 and is expected to generate a cash inflow of $8,000 a year for 5 years (with the first receipt in one years time). The cost of capital is 10%.
What is the sensitivity to change of the cash inflow each year
Answer = -17.58%
4. Z plc has dividends per share of $0.30, a P/E ratio of 12 and a dividend cover of 3. What is the market price per share
I got back to the answer which is $10.80 by multiplying 0.30 x 12 x 3 but this was just a bit of guess work really! Could you explain the workings please
5. PQR Co has a demand of 7500 units per month. Each unit costs $5, ordering costs are $100 per order and the inventory holding cost is 10% of purchase price per year. There is lead time of 30 days between placing an order and receiving delivery
If they order the EOQ each time, how frequently will they place an order (to the nearest day)?
Answer = every 24 days. I know how to calculate the EOQ which is 6000 units but unsure how to get back to the answer
6. A machine costs $72,000 and has a max life of 3 years. The running costs each year are as follows
Year 1: $7,200
Year 2: $9,600
Year 3: $12,000The estimated scrap values are as follows
Year 1: $24,000
Year 2: $16,600
Year 3: $9,600Cost of capital = 15%
What is EAC if company replaces the machine every 2 years. I was 99% that I was correct with $41,026 but the answer per the revision test was $44,878. Have I just made a stupid error?
Sorry for sending so many Mr Moffat. Thank you so much for your help much appreciated!
Question 1:
There is no standard measure of operational gearing – what you have written is just one way of measuring it. Why is contribution not the same as profit – it is because of the fixed costs! When gearing is examined in F9 (whether financial or operational) the examiner is more concerned that you can explain why more gearing creates more risk and not that you can simply calculate a figure (50% of the exam is explaining and not calculating).
I explain in great detail with examples, as to why the fixed payments (for both types of gearing) create more risk to shareholders, and you must watch the lecture. I am sorry but I cannot type the whole lecture out here.
Question 2:
Again, I really don’t understand why you don’t watch the lectures.
The value of the rights is 3.85 – 3.10 = 0.75 for each new share. Since each new share is for 5 existing shares, the value per existing share is 0.75/5 = 0.15.
Question 3:
The sensitivity is the NPV of the project as a percentage of the present value of the inflows.
It is negative because we only have a problem if the amount of the inflows reduces.Again, there is a lecture on this – the lectures are a complete classroom course covering everything you need to pass F9.
Question 4:
PE ratio = MV / EPS
Dividend cover = EPS / Divi per share
So if PE = MV / EPS, then MV = PE x EPS = PE x (Divi cover x Divi per share)
So MV = 12 x 3 x 0.30 = 10.80
Question 5:
Total demand is 12 x 7500 = 90,000
EOQ = 6,000Therefore they place 90,000/6,000 = 15 orders a year.
With 365 days in a year, they therefore order every 365/15 = 24.3 days
Question 6:
You have made a mistake, but I don’t know what your mistake is.
The PV of the first machine is (72972).
Therefore the EAC = 72972/1.626 = 44,878Thank you very much for the reply Mr Moffat.
Sorry for the delay in response.
I just wanted to clarify a couple of things with you:
On no. 3, I calculate the NPV of the project to be $5,320 and the PV of cash flows to be $30,320. $5,320 / $30,320 x 100 = 17.55%. Am I on the wright track?
Also, on no. 6 I am still unsure where the error I have made is. My workings are below
Year 2
Scrap value 16,600
Running costs (9,600)
Net CF 7,000
DF 15% 0.756
PV 5,292PV 5,292
Less cost of machine (72,000)
Net CF (66,708) / 1.626 = $41,026Could you please advise where my error is!
Thanks a lot Sir
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