EOC 2.15

Suppose we observe the following rates:

One-year spot rate = 10%

Two-year spot rate = 14%

Expected one-year rate one year from now = 18%

If the liquidity premium theory of the term structure of interest rates holds, what is the liquidity

premium for year 2?

What is the firm's total change in cash from the prior year to the current year?

What is the firm's cash flow from operations?

What is the firm's cash flow from financing?

5.3    

a.   Eighteen-year-old Linus is thinking about taking a five-year university degree. The degree will cost him $25,000 each year. After he's finished, he expects to make $50,000 per year for 10 years, $75,000 per year for another 10 years, and $100,000 per year for the final 10 years of his working career. All these values are stated in real dollars. Assume that Linus lives to be 100 and that real interest rates will stay at 5% per year throughout his life.

i.    Calculate the present value of his lifetime earnings.          (1 mark)

ii.   Calculate the present value of the cost of his schooling.     (1 mark)

iii. Subtract the present value of the schooling cost from his lifetime labour earnings to determine his human capital. Use that value to determine his permanent income, that is, the equal annual consumption Linus could enjoy over the rest of his life.                                         (1 mark)

b.   Linus is also considering another option. If he takes a job at the local grocery store, his starting wage will be $40,000 per year, and he will get a 3% raise each year, in real terms, until he retires at the age of 53. Assume that Linus lives to be 100.

i.    Calculate the present value of Linus’s lifetime earnings, using a spreadsheet or using the growing annuity formula. You can find the formula in the lesson notes, at the end of Note 7 in Lesson 4.         (1 mark)

ii.   Use that value to determine Linus’s permanent income, i.e., how much can Linus spend each year equally over the rest of his life?                                                  (1 mark)

c.   Do you think Linus is better off choosing option a. or option b.? Consider both financial and non-financial measures.                                                                        

What is the firm's total change in cash from the prior year to the current year?

BUSINESS CASE: THIS IS BUSINESS
In recent years, because of the Public Procurement Act, District Assemblies have been given the authority to
award contracts on certain projects, which do not cost more than 150 million cedis. In view of this, at the District
where I work, the Assembly was to construct three markets, at 150 million cedis per project. However, the law
is that before such contracts are awarded, they should be made known to the general public by advertising in
any of the local newspapers. Therefore, these three market projects were subsequently put on tender through
publication in one of the Ghanaian daily newspapers.
One week after the advertisement, I received an Expedited Mail Service (EMS) letter, inviting me to Accra to
meet a man I did not know for an important message at a particular date. Initially I did not want to honour the
invitation. However, upon reflection I decided to go and meet the man because I was expecting some important
information from a brother who was in the United States. On arriving in Accra, specifically at the man’s office
in the Kantamanto commercial area, I was told the man was attending a meeting at a nearby office building and
had directed that I should wait for him. I met the man’s secretary at the office. He served me a bottle of malta
guinness.
About twenty minutes later, the man arrived from the meeting and I was introduced to him. Beaming with
smiles, he in turn introduced himself by mentioning his name as Mr. Opoku Afriyie. As it was already
lunchtime, he suggested that we go to a restaurant for lunch. We found ourselves in a popular restaurant. I was
asked to order whatever I wished to eat. But, as I did not know why I was being entertained, I was not at ease.
The man kept saying, “Oh feel free, you are at home”. There was no doubt that he wanted to impress me.
We, finally, drove back to his office. It was then he introduced himself to me as a building contractor and
explained why he had invited me to Accra. He told me that he had read the advertisement from my Assembly
inviting contractors to bid for the construction of the three markets. He was interested, he continued. He went
on to say that, at a meeting somewhere, a friend told him to contact me because I was the schedule officer for
those projects, he would be grateful and he was prepared to offer something. He ended by saying: “My brother,
this is business that we are talking of. Here is ¢10,000.00 and 2 packets of roofing sheets. I want you to tell
me the bill of quantities and estimated quotations from your consultants, and also quotations from other
bidders”.
In fact, I was flabbergasted and surprised to hear that. For five minutes, I was quiet and the man was doing all
the talking. First, I needed six hundred cedis to pay my younger sister’s school fees. Second, I needed about
one packet of aluminum roofing sheets to renovate my parents’ building. However, because it was difficult to
say no to him and at the same time, I did not want to accept the offer, I politely suggested to the man to submit
his completed contract document, telling him that his chances of winning were high, as at the time nobody had
come for any of the contract forms. He was persistent and was prepared to offer an additional ¢500.00. But I
refused to take anything from him. I then asked to leave; he asked his driver to take me to the State Transport
Yard to take a bus back. He gave me ¢500.00 to pay for my transport fare, which I took.
i. What kind of person would respond to a letter of invitation from an unknown person the way the man
did?
ii. Under what ethical theory will you classify the officer’s action?
iii. Are there times when it is better to be tactful than honest?
iv. Would you have taken the ¢500, 00 as transport fare, explain?
v. What does the term ‘this is Business’ mean in the passage?
vi. Describe the ethics of Mr. Opoku Afriyie
vii. What do you understand by the term ethical dilemma?
viii. Besides this case, mention three other ethical issues that public officials encounter in their daily work
life
ix. Mention four (4) importance of values to you as an individual or the District Assembly you work with.

x. Discuss the Blanchard and Pearl’s model of resolving ethical dilemmas

Case 15-67 Manipulation of Ratios and Ethical Behavior

Pete Donaldson, president and owner of Donaldson Mining Supplies, was concerned about the firm’s liquidity. He had an easy time selling supplies to the local coal mines, but had a difficult time collecting the receivables. He had even tried offering discounts for prompt payment. The outcome wasn’t as expected. The coal mines still took as long to pay as before, but took the dis- count as well. Although he had complained about the practice, he was told that other suppliers would provide the supplies for the same terms. Collections were so slow that he was unable to pay his own payables on time and was receiving considerable pressure from his own creditors.

The solution was a line of credit that could be used to smooth his payment patterns. Getting the line of credit was another matter, however. One bank had turned him down, indicating that he already had too much debt and that his short-term liquidity ratios were marginal. Pete had begun the business with $5,000 of his own capital and a $30,000 loan from his father-in-law. He was making interest payments of $3,000 per year to his father-in-law, with a promise to pay the principal back in 5 years (3 years from now).

While mulling over his problem, Pete suddenly saw the solution. By changing accountants, he could tell the next accountant that the $30,000 had been donated to the business and therefore would be reclassified into the equity section. This would dramatically improve the debt ratio. He would simply not disclose the $3,000 annual payment—or he could call it a dividend. Additionally, he would not tell the next accountant about the $6,000 of safety gear that was now obsolete. That gear could be added back, and the current ratio would also improve. With an improved financial statement, the next bank would be more likely to grant the needed line of credit.

Required:

1. Evaluate Pete Donaldson’s ethical behavior.

2. Suppose that you have been hired as the chief finance officer for Donaldson Mining

   Supplies. You have been told that the $30,000 has been donated to the company. During the second week of your employment, the father-in-law drops in unexpectedly and introduces himself. He then asks you how the company is doing and wants to know if his $30,000 loan is still likely to be repaid in 3 years. Suppose also that on the same day you overhear an employee mention that the safety equipment is no longer usable because regulations now require a newer and different model.

a. Assume that you have yet to prepare the financial statements for the loan application. What should you do?

b. Suppose that the financial statements have been prepared and submitted to the bank. In fact, that morning, you had received a call from the bank, indicating that a decision was imminent and that the line of credit would likely be approved. What should you do under these circumstances?

3. Suppose that Pete invites you in as a consultant. He describes his problem to you. Can you think of a better solution?