BUS5IAF Intro to Accounting and Finance: Operating Profit Margin

Questions:

Q1.

Financial statements – such as the Balance Sheet and the Profit and Loss Statement – communicate past transactions of an organisation. Given this, explain.how these types of financial statements help users make decisions about the future of an organisation.

  • It is impossible to know exactly what will happen in the future because it involves some level of uncertainty.
  • The best way that we can do this in this context is to base future decisions, at least partly, on past outcomes and data.
  • Therefore, even though information from an organisation’s financial statements may be based on past transactions, this information provides a useful basis upon which we can base decisions and judgments about its future performance.

Q2.

Would you expect the operating profit margin to be higher or lower than the gross profit margin? What is a good operating profit margin? Your answer must be written in your own words.

  • Operating profit margin will be lower than the gross profit margin.
  • This is because the gross profit margin is calculated before the deduction of operating expenses.
  • A good profit margin depends on a number of factors with a key factor being the industry that the business competes in.
  • For example, a supermarket often operates on low operating profit margin to stimulate sales and, thereby, increase the total amount of profit generated.
  • A jeweller, on the other hand, may have a high operating profit margin but a much lower level of sales volume.
  • Factors such as the degree of competition, the type of customer, the economic climate and industry characteristics (such as the level of risk) all influence the ideal operating profit margin of a business.

Q3.

What does Net Present Value (NPV) analysis tell you? Why is it considered the best approach for capital budgeting? Your answer must be written in your own words.

  • NPV analysis estimates the impact of an investment opportunity on the value of the firm.
  • It quantifies, in dollar ($) terms, the increase in the value of an organisation arising from a particular decision.
  • It is considered a particularly powerful tool because it focuses on cash as the driver for value and takes into account factors such as cash inflows and outflows, time value of money, and risk.
  • NPV therefore allows you to decide if a decision should (or should not) be pursued based on whether it maximises the value of the firm.

Q4.

What is a firm’s weighted average cost of capital (WACC)? Why is it important? Your answer must be written in your own words.

  • Cost of capital refers to a firm’s required rate of return to their providers of finance, such as lenders (debt) and investors (equity).
  • A weighted average cost of capital (WACC) incorporates the required rates of return of the firm’s lenders and investors and then accounts for the particular mix (i.e. weighting) of the financing sources that the firm uses.
  • It is important to understand because most firms raise capital to fund investments with a combination of debt and equity.
  • A firm’s WACC is simply a weighted average of the cost of the sources of capital and as such, plays an important role in determining whether decisions (e.g. investment decisions) will enhance the value of the firm.

Q5.

Tom turned 25 today and plans to start saving for his retirement. He currently has $10,000 to invest. Assuming an interest rate of 10% p.a. compounding annually, how much will Tom have in 40 years? Round your answer to two (2) decimal places.

  • FVn= C x (1 + r) n
  • FV40= 10,000 (1.10)40
  • FV40= $452,592.56

Q6.

What does it mean to say that two or more investment projects are mutually exclusive?

  • If two or more projects are mutually exclusive, the firm can only choose one of them.
  • This often arises because they use a resource that can only be used for one of the potential projects, such as a piece of land.
  • Once the decision is made to accept one of the projects (the best project), the other projects become no longer available.

Q7.

Chalk and Cheese Ltd has recently issued domestic bonds in order to raise capital for the purposes of expanding. The bonds pay quarterly interest of $20. The bonds have 10 years until maturity and have a par value of $1,000. The market rate of interest is 12%. Based on this information, what is the market value of the bonds issued by Chalk and Cheese Ltd?

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