TMP 130 ch. 6 and 7

Under the simplifying assumptions of Modigliani and Miller, an increase in a firm's financial leverage will

increase the variability in earnings per share.

The best financing choice is the one that

maximizes expected cash flows.

Homemade leverage is

the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.

In some instances, additional debt financing can encourage managers to act more in the interests of owners.

True

The accounting rate of return is deficient as a figure of merit because it is insensitive to the timing of cash flows.

True

The evidence indicates that, on average, a company's stock price declines when it announces a new issue of equity.

True

When evaluating investments under capital rationing that are independent and can be acquired fractionally, ranking by the BCR is the appropriate technique.

True

JKL Corporation has a projected times-interest-earned ratio of 4.0 for next year. What percentage could EBIT decline next year before JKL's times-interest-earned ratio would fall below 1.0?

% EBIT can fall = (4.0 − 1)/4.0 = 0.75

The term "financial distress costs" includes which of the following? I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed but not bankrupt IV. Indirect costs related to being financially distressed but not bankrupt

(all) I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed but not bankrupt IV. Indirect costs related to being financially distressed but not bankrupt

Microsoft Corp. reported earnings per share of $1.65 in 2006 and $2.55 in 2016. At what annual rate did earnings per share grow over this period

= RATE(nper, pmt, pv, [fv], [type], [guess]) = RATE(10, 0, −1.65, 2.55) = 4.4%

When considering the impact of distress costs on capital structure, which of the following facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all else equal)?

ABC's cash flows from operations are less volatile than XYZ's.

b. As Nile's banker, would you be comfortable loaning the company this new debt? Briefly explain why, or for what reasons you'd be comfortable or uncomfortable.

Debt (both principal and interest) coverage is relatively strong at 1.5 times, but if the company continues to pay its dividend, its expected ability to pay its pro forma fixed financing charges (or burden) including dividends is right at the edge. Although EBIT can fall 33.6% ((189.8 − 126.08)/189.8 = 33.6%) before TBC falls below 1, Nile has a quite low TCC (1.01) including the burden. There is risk here, and a prudent lender will require covenants that restrict dividend payouts to certain situations, if at all. Covenants (restrictions set in the debt contract) impose additional costs on the firm; this fact should be considered by management as they weigh the costs and benefits of new debt. Nile's banker will compare Nile's coverage ratios to the industry's average of these ratios. If the company has strong and relatively stable CFs, and the ratios are above or within industry averages, the banker will be more comfortable with the added debt.

Squamish Equipment Selected financial information Expected net income after tax next year before new financing $ 40 million Sinking-fund payments due next year on existing debt $ 14 million Interest due next year on existing debt $ 15 million Company tax rate 36 % Common stock price, per share 20.00 Common shares outstanding 18 million Please refer to the financial information for Squamish Equipment above. Calculate Squamish's times-interest-earned ratio for next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent.

EBIT = 40/(1 − 0.36) + 15 = $77.5 Interest = 15 + 0.07(40) = $17.8 Times interest earned = 77.5/17.8 = 4.35 times

Sunk costs should be included in the cash flows for valuing a project only if they are directly attributable to that specific project.

False

The IRR and NPV always yield the same investment recommendations.

False

You plan to buy a new Mercedes four years from now. Today, a comparable car costs $82,500. You expect the price of the car to increase by an average of 4.8 percent per year over the next four years. How much will your dream car cost by the time you are ready to buy it?

Future value = $82,500 × (1 + 0.048)4 = $99,517.41

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns? I. Estimated pro forma coverage ratios II. The recognition that financing decisions do not affect firm or shareholder value III. A range of earnings chart and proximity of expected EBIT to the breakeven value IV. A conservative debt policy that obviates the need to evaluate risk

I. Estimated pro forma coverage ratios III. A range of earnings chart and proximity of expected EBIT to the breakeven value

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Tax benefits IV. Financial flexibility

I. Market signaling III. Tax benefits

Which of the following figures of merit might not use all possible cash flows in its calculations? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Benefit-cost ratio

I. Payback period

Which of the following statements related to the internal rate of return (IRR) are correct? I. The IRR is the discount rate at which an investment's NPV equals zero. II. An investment should be undertaken if the discount rate exceeds the IRR. III. The IRR tends to be used more than net present value simply because its results are easier to comprehend. IV. The IRR is the best tool available for deciding between mutually exclusive investments.

I. The IRR is the discount rate at which an investment's NPV equals zero. III. The IRR tends to be used more than net present value simply because its results are easier to comprehend

Which of the following should be included in the cash flow projections for a new product? I. Money already spent for research and development of the new product II. Capital expenditures for equipment to produce the new product III. Increase in working capital needed to finance sales of the new product IV. Interest expense on the loan used to finance the new product launch

II. Capital expenditures for equipment to produce the new product III. Increase in working capital needed to finance sales of the new product

Financial leverage I. increases expected ROE but does not affect its variability. II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners.

II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners.

Ian is going to receive $20,000 six years from now. Sunny is going to receive $20,000 nine years from now. Which one of the following statements is correct if both Ian and Sunny apply a 7-percent discount rate to these amounts?

In today's dollars, Ian's money is worth more than Sunny's.

Naomi plans on saving $3,000 a year and expects to earn an annual rate of 10.25 percent. How much will she have in her account at the end of 45 years?

Input:4510.250−3,000? niPVPMTFVOutput: 2,333,572 In Excel: = FV(0.1025, 45, −3000) = 2,333,572

Salinas Corporation has net income of $15 million per year on net sales of $90 million per year. It currently has no long-term debt but is considering a debt issue of $20 million. The interest rate on the debt would be 7%. Salinas Corp. currently faces an effective tax rate of 40%. What would be the annual interest tax shield to Salinas Corp. if it goes through with the debt issuance?

Interest tax shield = interest rate × amount of debt × tax rate = 0.07 × 20,000,000 × 0.40 = $560,000

What is the benefit-cost ratio for an investment with the following cash flows at a 14.5-percent required return? YearCash Flow0$(46,500) 1 $12,200 2 $38,400 3 $11,300

PVinflows = (12,200/1.145) + (38,400/1.1452) + (11,300/1.1453) = $47,472.78 BCR = $47,472.78/$46,500 = 1.02

EAC Nutrition offers a 9.5-percent coupon bond with annual payments maturing 11 years from today. Your required return is 11.2 percent. What price are you willing to pay for this bond if the face (or par) value is $1,000?

Price = present value of coupons and face value Coupon payment = 0.095 × 1000 = $95 per year Input:1111.2?951,000 niPVPMTFVOutput: −895.43

You are selling a product on commission, at the rate of $1,000 per sale. To date, you have spent $800 promoting a particular prospective sale. You are confident you can complete this sale with an added expenditure of some undetermined amount. What is the maximum amount, over and above what you have already spent, that you should be willing to spend to assure the sale?

The $800 spent to date is sunk; you cannot recoup this money regardless of how the prospective sale works out. You should be willing to spend up to an additional $1,000 if you are confident doing so will land the sale. Here is another way to look at it. Suppose you are certain an additional expenditure of $900 will guarantee the sale. You then have two options: 1. quit trying and lose $800 already spent, or 2. spend the additional $900 for a total expense of $1,700, which net of the $1,000 receipt from the sale results in a loss of $700. I'd rather lose $700 than $800.

Sol's Sporting Goods is expanding and, as a result, expects additional operating cash flows of $26,000 a year for 4 years. This expansion requires $39,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires an additional $3,000 of net working capital throughout the life of the project; Sol expects to recover this amount at the end of the project. What is the net present value of this expansion project at a 16-percent required rate of return?

The initial investment consists of the fixed assets and incremental working capital: $39,000 + $3000 = $42,000. The working capital amount is recovered at the end of year 4. Solve for the PV of the cash inflows, and then subtract the initial investment: Input: 4 16 ? 26,000 3,000 n i PV PMT FV Output: −74,409.57 NPV = 74,409.57 − 42,000 = $32,409.57

You are the beneficiary of a life insurance policy. The insurance company informs you that you have two options for receiving the insurance proceeds. You can receive a lump sum of $200,000 today or receive payments of $1,400 a month for 20 years. You can earn a 6-percent annual rate on your money, compounded monthly. Which option should you take and why?

The number of monthly periods = 20 × 12 = 240 The monthly interest rate = 6%/12 = 0.5% Input:2400.5?1,4000 niPVPMTFVOutput: −195,413

Your brother will borrow $17,800 to buy a car. The terms of the loan call for monthly payments for 5 years at an 8.6-percent annual interest rate, compounded monthly. What is the amount of each payment?

The number of monthly periods = 5 × 12 = 60 The monthly interest rate = 8.6%/12 = 0.71667% Input:600.7166717,800?0 niPVPMTFVOutput: −366.05

Selected financial information as of Dec. 31, 2017Last year's EBIT (2014)$175.0millionExpected EBIT (2015)$189.8millionCurrent portion of existing long-term debt, due 2015$34millionInterest due in 2015 on existing debt$36millionTax rate 35%Common stock price per share$50.00 Common shares outstanding 20millionDividends per share$2.00 a. Assuming Nile must make a $20 million payment on the new debt next year, calculate the firm's times-burden-covered ratio and times-common-covered ratio (i.e., the number of times EBIT could cover interest, principal payments, and dividends).

a. Interest expense = $36 + 0.07($100) = $43 Upcoming payments on debt = existing + new = 34 + 20 = 54 Times burden covered = EBIT/(interest + debt pmts./(1 − t)) = 189.8/(43 + 54/(1 − 0.35)) = 1.51 Times common covered = EBIT/(interest + (debt pmts. + dividends)/(1 − t)) = 189.8/(43 + (54 + 40)/(1 − 0.35)) = 1.01