TMP 130XF Final Study Guide

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 * 100% = 75%

Breakers Bay Inc. has succeeded in increasing the amount of goods it sells while holding the amount of inventory on hand at a constant level. Assume that both the cost per unit and the selling price per unit also remained constant. All else held constant, how will this accomplishment be reflected in the firm's financial ratios?

increase in the inventory turnover rate

The sustainable growth rate of a firm is best described as the

maximum growth rate achievable, excluding any external equity financing while maintaining a constant debt-equity ratio.

Which of the following are examples of diversifiable risk? I. An earthquake damages Oakland, California. II. The federal government imposes an additional $1,000 fee on all business entities. III. Employment taxes increase nationally. IV. Toymakers are required to improve their safety standards.

I and IV only

Klamath Corporation has asset turnover of 3.5, a profit margin of 5.2%, and a current ratio of 0.5. What is Klamath Corporation's return on equity?

Insufficient information to find ROE

JM Case Inc. has a market value of $5 million with 500,000 shares outstanding. The book value of its equity is $1,750,000. If the company repurchases 20 percent of its shares in the stock market, what will be the book value of equity if all else remains the same?

JM Case will pay $10 per share for the 100,000 shares (= 0.20 × 500,000) it repurchases. This reduces the book value by $1 million. Assuming all else remains the same, the new book value should be $750,000.

Which of the following statements regarding junk bonds is true?

Junk bonds have higher priority in bankruptcy than preferred stock.

At the end of 2017, Stacky Corp. had $500,000 in liabilities and a debt-to-assets ratio of 0.5. For 2017, Stacky had an asset turnover of 3.0. What were annual sales for Stacky in 2017?

Liabilities/Assets = 0.5 = $500,000/$1,000,000 So Assets = $1,000,000 Then, Sales/$1,000,000 = 3 So sales = $3,000,000

Please refer to the financial data for Link, Inc. above. Which of the following statements best describes how the Link's short-term liquidity changed from 2016 to 2017?

Link's short-term liquidity has deteriorated considerably, but from a high initial base.

Please refer to the information for FM Foods above. Estimate the appropriate weight of equity to be used when calculating FM's weighted-average cost of capital.

Market value of equity = $40 × 240 million = $9,600 million. Weight of equity = 9,600/(9,600 + 1,250) = 0.8848 or 88.5%.

Atmosphere, Inc. has offered $860 million cash for all of the common stock in ACE Corporation. Based on recent market information, ACE is worth $710 million as an independent operation. For the merger to make economic sense for Atmosphere, what would the minimum estimated present value of the enhancements from the merger have to be?

Minimum economic value in PV terms = $860 million − $710 million = $150 million

Which one of the following statements is true? a) Debt instruments offer residual claims to future cash payouts. b) Bonds with call provisions will have lower coupon rates than otherwise identical bonds. c) Bondholders enjoy a direct voice in company decisions. d) Bonds are low-risk investments that do well in inflationary periods. e) Preferred shareholders are the first investors to be repaid in bankruptcy liquidation. f) None of the options are correct.

None of the options are correct.

Milano Corporation has experienced growth of 20% for each of the last 5 years. Over this 5-year period, Milano's return on equity has never exceeded 15%, its profit margin has held steady at 5%, and its total asset turnover has not changed. Over the 5-year period, Milano paid no dividends and issued no new equity. Based on this information, which of the following can you most likely infer about Milano's performance over the past 5 years?

Note first that g > g* because g = 20% and g*<15%. With g > g* one of PRAT must increase. P has held steady at 5%, R has remained at 100%, A has not changed. Thus T (leverage) must have increased.

What is the benefit-cost ratio for an investment with the following cash flows at a 14.5-percent required return?

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

Zack owns a bond that will pay him $35 each year in interest plus a $1,000 principal payment at maturity. The $1,000 principal payment is called the

Par value.

At the end of 2016, Crane Industries, Inc.'s stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What was the percentage change in the share price in fiscal year 2017?

Percentage change in share price = (34.88 − 30.75)/30.75 = 4.13/30.75 = 13.43%.

Which one of the following is an example of systematic risk?

The Federal Reserve unexpectedly announces an increase in target interest rates.

Ptarmigan Travelers had sales of $420,000 in 2016 and $480,000 in 2017. The firm's current asset accounts remained constant. Given this information, which one of the following statements must be true?

The collection period decreased.

Microsoft Corp. reported earnings per share of $2.10 in 2006 and $3.00 in 2016. At what annual rate did earnings per share grow over this period?

The compound annual growth rate is 3.6 percent. = RATE(nper, pmt, pv, [fv], [type], [guess]) = RATE(10, 0, −2.10, 3.00) = 3.6%

Which one of the following statements is false?

The design of financial instruments is greatly constrained by law and regulation.

In venture-capital valuation, the post-money valuation is equal to the pre-money valuation plus the amount of the venture capitalist's investment.

True

Issue costs of equity are high relative to those of debt.

True

Shelf registration is possible for both debt and equity issues.

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

The forecast for retained earnings on the 2019 balance sheet can be determined as 2018 retained earnings plus projected 2019 after-tax earnings less projected 2019 dividends.

True

The payback period measures the amount of time the company must wait to recoup its initial investment.

True

When an acquirer purchases all of a target firm's equity, it must assume the target's liabilities.

True

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

True

Table 3.1 presents R&E Supplies' financial statements for the period 2014 through 2017, and Table 3.5 presents a pro forma financial forecast for 2018. Use the information in these tables to answer the following questions. a. Calculate R&E's sustainable growth rate in each year from 2015 through 2018. Assume the dividend payout ratio was the same in 2015-17 as forecasted in 2018. (Round your answers to 1 decimal place.)

Use PRAT for each year

Which of the following is a reason why a company's market value of equity differs from its book value of equity?

Values of assets on the balance sheet typically reflect historical cost, adjusted for appropriate depreciation.

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?

You should accept the $200,000 lump sum because the monthly payments are only worth $195,413 to you today. In Excel: = PV(0.005, 240, 1400) = −195,413

Steve has estimated the cash inflows and outflows for his sporting goods store for next year. The report that he has prepared summarizing these cash flows is called a

cash budget.

Which of the following securities has a purely residual claim against a firm's cash flows?

common stock

Which one of the following ratios identifies the amount of sales a firm generates for every $1 in assets? a) current ratio b) retention c) debt-to-equity d) asset turnover e) return on assets

d) asset turnover

Which one of the following is a source of cash?

decrease in accounts receivable

Which one of the following policies most directly affects the projection of the retained earnings balance to be used on a pro forma statement?

dividend policy

A times-interest-earned ratio of 3.5 indicates that the firm

has EBIT equal to 3.5 times its interest expense.

Principal amounts are usually exchanged

in currency swaps.

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 pre-tax cost of debt

is based on the current yield to maturity of the firm's outstanding bonds.

The best financing choice is the one that

maximizes expected cash flows.

The weighted-average cost of capital for a firm is the

rate of return a firm must earn on its existing assets to maintain the current value of its stock.

The most popular yardstick of financial performance among investors and senior managers is the

return on equity.

Homemade leverage is

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

On a common-size balance sheet, all accounts are expressed as a percentage of

total assets.

You are estimating your company's external financing needs for the next year. At the end of next year, you expect that owners' equity will be $80 million, total assets will amount to $170 million, and total liabilities will be $70 million. How much will your firm need to borrow, or otherwise acquire, from outside sources during the next year?

170 - (80+70) = $20 million

Please refer to the pro forma financial statements for Royal Corporation above. If Royal Corporation plans to issue $100 in new equity in 2017, what should be the projection for shareholders' equity for 2017?

2016 Shareholders' Equity + 2017 Retained Earnings + New Equity Issued = 4,942 + (409 - 102) + 100 = $5,349

Please refer to the financial data for Link, Inc. above. The current ratio for Link at the end of 2017 is

249,801/90,558 = 2.76

Wax Music expects sales of $437,500 next year. The profit margin is 4.8 percent, and the firm has a 30 percent dividend payout ratio. What is the projected increase in retained earnings?

Change in retained earnings = $437,500 × 0.048 × (1 − 0.30) = $14,700

ZZZ Corporation's income statement shows a provision for income taxes of $65 million in 2017. At the end of 2016, ZZZ's balance sheet reported income taxes payable of $12 million and deferred taxes of $18 million. At the end of 2017, their balance sheet shows income taxes payable of $15 million and deferred taxes of $17 million. What were ZZZ's taxes paid in 2017?

Deduction = Deferred - Payable = 17 - 15 = 2 million Provision - Deduction = 65 - 2 = 63 million

Which of the following would NOT be considered a use of cash?

Depreciation

At the end of 2016, Crane Industries, Inc.'s stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What was the dividend yield in fiscal year 2017?

Dividend yield = 0.55/30.75 = 1.79% Use BOP equity!

Which of the following statements is true?

Due to required cash investments in current assets, fast-growing and profitable companies can literally "grow broke".

Failing to include real options in a project valuation could cause the NPV of the project to be overestimated.

False

If a company seeks to maximize firm value, it should never grow at a rate above its sustainable growth rate.

False

In reality, the cost of equity is always less than the cost of debt because firms are not obligated to pay out cash to shareholders.

False

In the steps a company takes to prepare for an IPO, the "road show" precedes the "bake-off".

False

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 interest tax shield reduces a firm's taxes by the amount of interest on its debt.

False

When conducting a discounted cash flow analysis of a project, it is important to always include a careful estimate of financing costs in the project's cash flows.

False

Accounting rules require U.S. companies to depreciate research and development (R&D) expenditures using the straight-line method.

False because such expenditures are too inconsistent

Please refer to the financial data for Link, Inc. above. Link's gross margin for 2017 is

(274,219 − 209,628)/274,219 = 23.6% None of the above

Please refer to the selected financial information for Boss Stores above. What is the retention ratio for 2016?

1 − (0.58/19.70) = 0.97

Please refer to the financial data for Link, Inc. above. Assume a 365-day year for your calculations. Link's payables period in days, based on cost of goods sold, at the end of 2017 is

13,962/(209,628/365) = 24.3

To estimate Missed Places, Inc.'s (MP) external financing needs, the CFO needs to figure out how much equity her firm will have at the end of next year. At the end of the most recent fiscal year, MP's retained earnings were $158,000. The Controller has estimated that over the next year, gross profits will be $360,700, earnings after tax will total $23,400, and MP will pay $12,400 in dividends. What are the estimated retained earnings at the end of next year?

158,000 + 23,400 − 12,400 = $169,000

Which of the following statements concerning a firm's cash flows and profits is false?

A company that sells merchandise at a profit will generate cash soon enough to replenish cash flows required for continued production.

Which one of the following statements is correct concerning the cash balance of a firm?

A cumulative cash deficit on a cash budget indicates the need to acquire additional funds.

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.

You are preparing pro forma financial statements for 2017 using the percent-of-sales method. Sales were $100,000 in 2016 and are projected to be $120,000 in 2017. Net income was $5,000 in 2016 and is projected to be $6,000 in 2017. Equity was $45,000 at year-end 2015 and $50,000 at year-end 2016. Assuming that this company never issues new equity, never repurchases equity, and never changes its dividend payout ratio, what would be projected for equity at year-end 2017?

All of net income was added to equity in 2016, so all of net income will be added to equity in 2017. $50,000 + $6,000 = $56,000.

Which of the following would increase a company's need for external finance, all else equal?

An increase in the dividend payout ratio

You constructed a pro forma balance sheet for next year and found that external financing required was negative (i.e., the company projected a financing surplus). Which of the following options, all else equal, would NOT correct the projected imbalance?

An increase in the retention ratio

Ruff Wear expects sales of $560, $650, $670, and $610 for the months of May through August, respectively. The firm collects 20 percent of sales in the month of sale, 70 percent in the month following the month of sale, and 8 percent in the second month following the month of sale. The remaining 2 percent of sales is never collected. How much money does the firm expect to collect in the month of August?

August collections = 0.20($610) + 0.70($670) + 0.08($650) = $643

JM Case Inc. has a market value of $5 million with 500,000 shares outstanding. The book value of its equity is $1,750,000. What is JM Case's price per share?

Book value does not matter. 5,000,000/500,000 = $10

What is the length of the cash conversion cycle for a firm with $3 million in inventory, $1.5 million in accounts payable, a collection period of 40 days, and an annual cost of goods sold of $18 million?

CCC = Days Inventory Outstanding + Collection Period − Payables Period = Inventory/(COGS/365) + Receivables/(Sales/365) − Payables/(COGS/365) = 3/(18/365) + 40 − 1.5/(18/365) = 60.8 + 40 − 30.4 = 70.4 days

What type of financial instrument is depicted in the position diagram shown below?

Call option

Please refer to the financial information for Foodtek, Inc. above. Assuming the company neither sold nor salvaged any assets during the year, what were Foodtek's capital expenditures (in $ millions) during 2014?

Capital expenditures = Change in net fixed assets + depreciation = 105 + 65 = 170

On May 1, Vaya Corp. had a beginning cash balance of $175. Vaya's sales for April were $430, and May sales were $480. During May, the firm had cash expenses of $110 and made payments on accounts payable of $290. Vaya's accounts receivable period is 30 days. What is the firm's beginning cash balance on June 1?

Cash balance = $175 − $110 − $290 + $430 = $205

The sources and uses of cash over a stated period of time are reflected in the

Cash flow statement.

Which one of the following accurately orders the rate of return on financial securities from highest to lowest over most of recorded market history (the 1928-2016 period)?

Common stocks, long-term corporate bonds, long-term government bonds, short-term government bills

Primavera Holdings has a profit margin of 25%, an asset turnover of 0.5, and financial leverage (assets to equity) of 1.5. Primavera has $20 billion in assets, of which half, is in cash and marketable securities. Assume that Primavera earns a 3 percent after-tax return on cash and securities. What would Primavera's return on equity be if it paid out 90% of its cash and marketable securities as a dividend to shareholders?

Currently, equity = $13.33 billion (20/13.33 = 1.5), sales = 10 (10/20 = 0.5) and net income = 2.5 (2.5/10 = 25%). Paying a $9 billion dividend would reduce assets to $11 billion and equity to $4.33 billion. Net income would fall by 3% × $9 billion = $0.27 billion, to $2.23 billion. ROE would then be 2.23/4.33 = 51.50%

Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3.00 per share. It also has $2 million in face value of debt that trades at 90% of par. What is the appropriate debt ratio (D/(D+E)) to use for calculating Company X's weighted-average cost of capital?

D = 0.9 × $2 million = $1.8 million E = $3 ×2 million = $6 million D/(D+E) = 1.8/(1.8 + 6) = 0.231

Ellsbury Corporation has a goal to reduce its cash conversion cycle. Which of the following actions, holding all else equal, is likely to accomplish this goal?

Ellsbury increases the efficiency of its production process, reducing by 10% the average time it takes to convert raw materials to finished products.

A sporting goods manufacturer has decided to expand into a related business. Management estimates that to build and staff a facility of the desired size and to attain capacity operations would cost $450 million in present value terms. Alternatively, the company could acquire an existing firm or division with the desired capacity. One such opportunity is a division of another company. The book value of the division's assets is $250 million and its earnings before interest and tax are presently $50 million. Publicly traded comparable companies are selling in a narrow range around 12 times current earnings. These companies have book value debt-to-asset ratios averaging 40 percent with an average interest rate of 10 percent. a) Using a tax rate of 34 percent, estimate the minimum price the owner of the division should consider for its sale

EBIT = $50 million. As a stand-alone company, typical debt would be 0.40 × $250 million = $100 million. At a 10% interest rate, interest expense would be $10 million. Therefore, profit before tax = $50 − 10 = $40 million. Profit after tax = $40(1 − 0.34) = $26.4 million. Therefore the value of the division's equity relative to comparable firms is $26.4 × 12 = $316.8 million. Adding liabilities, Value of division = $316.8 + $100 = $416.8 million. This should be the owner's minimum acceptable price.

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

Please refer to the financial information for Squamish Equipment above. For next year, calculate Squamish's times-burden-covered ratio if Squamish sells 2 million new shares at $20 a share.

EBIT = 40/(1 − 0.36) + 15 = $77.5 Times burden covered = 77.5/[15 + 14/(1 − 0.36)] = 2.10 times

Hayesville Corporation had net income of $5 million this year on net sales of $125 million per year. At the beginning of this year, its debt-to-equity ratio was 1.5 and it held $75 million in total liabilities. It paid out $2 million in dividends for the year. What is Hayesville Corporation's sustainable growth rate?

Equity = 75/1.5 = $50 million ROE = 5/50 = 0.1 Retention ratio = (5 - 2)/5 = 60% SGR = 60% * 0.1 = 6%

A recent annual income statement for Stone Creek Roofing is shown below. Assume that during the year, Stone Creek spent $180 on new capital equipment and increased current assets net of non-interest-bearing current liabilities by $120. What was Stone Creek's free cash flow in this year?

FCF = EBIT(1 − t) + Depreciation − Fixed investment − Working capital investment FCF = 800(1 − 0.25) + 200 − 180 − 120 = 500

A company incurs costs of financial distress only after declaring bankruptcy.

False

ABC Corp. has an outstanding debt of $50 million on which it pays a 4 percent fixed interest rate annually. ABC just made its annual interest payment and has three years remaining until maturity. ABC wants to swap its fixed rate payments for floating rate payments. A bank offers ABC a three-year interest rate swap with annual payments in which ABC will pay LIBOR, currently at 4.2 percent, and receive a 3.8 percent fixed rate on $50 million notional principal. Suppose that LIBOR turns out to be 4.3 percent in one year, 4.4 percent in two years, and 4.5 percent in three years. Including interest payments on ABC's outstanding debt and payments on the swap, what will be ABC's net interest payments for the next three years?

For each year, ABC will pay its original lender 4% of $50 million each year, receive 3.8% of $50 million from the bank, and pay the bank the floating rate on $50 million. ABC will pay -2,200,000 in the first year, -2,250,000 in the second year, and -2,300,000 in the third year.

Which of the following is NOT a typical reason for differences between profits and cash flow?

Goodwill

Please refer to the income statement for VGA Associates below. Assuming that cost of goods sold are variable and operating expenses are fixed, what was VGA Associates' breakeven sales volume in 2017?

Gross margin = 50,000/200,000 = 25%. Breakeven sales volume = Operating expenses/Gross margin = $20,000/0.25 = $80,000.

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 and III only

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 and III only

Which of the following statements are correct? I. Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner. II. If you can borrow all of the money you need for a project at 5%, the cost of capital for this project is 5%. III. The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds. IV. A firm's weighted-average cost of capital is NOT the correct discount rate to use for all projects undertaken by the firm.

I and IV only

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 only

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

I, II, III, and IV

Which of the following can affect a firm's sustainable rate of growth?

I, II, III, and IV

You are developing a financial plan for a corporation. Which of the following questions will be considered as you develop this plan? I. How much will our sales grow? II. Will additional fixed assets be required? III. Will dividends be paid to shareholders? IV. How much new debt must be obtained?

I, II, III, and IV

Which of these ratios, or levers of performance, are the determinants of ROE? I. profit margin II. financial leverage III. times interest earned IV. asset turnover

I, II, and IV only

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 and III only

Please refer to Oscar's financial statements above. Assume a constant debt-equity ratio, net profit margin, and dividend payout ratio, and further assume all of Oscar's expenses, assets, and current liabilities vary directly with sales. What is the pro forma net fixed asset value for next year if sales are projected to increase by 7.5 percent?

Pro forma net fixed assets = $10,850 × (1 + 0.075) = $11,663.75

Please refer to Oscar's financial statements above. Assume a constant profit margin and dividend payout ratio, and further assume all of Oscar's assets and current liabilities vary directly with sales. Assume long-term debt and common stock remain unchanged. Sales are projected to increase by 10 percent. What is Oscar's external financing need for next year?

Projected total assets = $14,500 × 1.10 = $15,950 Projected total liabilities = $1,920 × 1.10 + $3,500 = $5,612 Projected total equity = $7,500 + (($1,580 + ($1830 - $450) × 1.1) = $10,598 External financing needed = $15,950 − ($5,612 + $10,598) = −$260

Please refer to the financial information for Foodtek, Inc. above. During 2017, what was the cost of merchandise (in millions of dollars) produced by Foodtek?

Purchases - Starting Inventory + Ending Inventory = 223 - 34 + 29 = $218

Which one of the following statements does NOT describe a problem with using ROE as a performance measure?

ROE is a forward-looking, one-period measure, while business decisions span the past and present.

At the end of 2016, Crane Industries, Inc.'s stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What rate of return did the common stockholders earn in fiscal year 2017?

Rate of return = (34.88 + 0.55 − 30.75)/30.75 = 15.22%

You are estimating your company's external financing needs for the next year. Your first-pass pro forma financial statements showed a large financing deficit for next year. Which of the following changes to your company's operating plan would reduce the financing deficit if incorporated in revised pro forma financial statements?

Reduce the collection period. This will reduce accounts receivable and result in less financing need for assets.

Which of the following statements is correct if a firm's pro forma financial statements project net income of $12,000 and external financing required of $5,000?

Retained earnings cannot grow by more than $12,000.

JM Case Inc. has a market value of $5 million with 500,000 shares outstanding. The book value of its equity is $1,750,000. If the company repurchases 20 percent of its shares in the stock market, there are no taxes or transaction costs, and all else remains the same, what should the market value of the firm be after the repurchase?

Since nothing else has changed, the market value should fall by exactly the amount of the cash paid in the transaction. The new market value will be $4 million. Another way to think about this is to note that repurchase of the shares will reduce cash by $1 million (or increase liabilities by the same amount if financed with debt), and thus the firm is worth $1 million less to the owners after the repurchase, or $4 million. After repurchasing 100,000 shares (= 0.20 × 500,000), 400,000 shares will be outstanding, and the price per share remains $10 ($4 million/400,000).

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?

Solution 1: = Future value = $82,500 × (1 + 0.048)4 = $99,517.41 Solution 2 in Excel: = FV(0.048, 4, 0, −82500) = 99,517.41

Identify the sources and uses of cash for Blackhurst Corporation for 2017 based on the following year-end balance sheets.

Sources: Cash, Inventory, Bank Loan, and Equity Uses: AR, Net Fixed Assets, Long-Term Debt

Please refer to the selected financial information for Boss Stores above. What is the sustainable growth rate for 2016?

Sustainable growth = g* = Change in Equity/Equitybop = (211.03 − 191.90)/191.90 = 9.97%

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: In Excel: =PV(0.16, 4, 26,000, 3,000) =74,409.57 NPV = 74,409.57 − 42,000 = $32,409.57

Which of the following statements concerning the cash flow production cycle is true?

The movement of cash to inventory, to accounts receivable, and back to cash is known as the firm's working capital cycle.

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% In Excel: = PMT(0.0071667, 60, 17800) = −366.05

Which of the following factors, when increased, will tend to cause the value of a put to decrease (all else equal)?

The price of the underlying stock

Suppose you purchase a put option on XYZ stock when the stock price is $40. The option premium is $2, and the strike price is $39. What is your net profit on the put option if the stock price is $41 at maturity?

The put option is out of the money at maturity, so the net profit is −$2.

The price of a call option tends to be lower when which of the following is higher (all else equal)?

The strike price

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

True

Ginormous Oil entered into an agreement to purchase all of the outstanding shares of Slick Company for $60 per share. The number of outstanding shares at the time of the announcement was 82 million. The book value of liabilities on the balance sheet of Slick Co. was $1.46 billion. What was the cost of this acquisition to the shareholders of Ginormous Oil?

The value of the bid to Ginormous's shareholders is the value of the assets acquired in the merger. This would include the value of the equity acquired and the liabilities that accompany the equity. Therefore, the cost of the acquisition was ($60 × 82 million shares) + $1.46 billion = 6.38 billion.

A firm's WACC is the appropriate discount rate to value a project undertaken by the firm only if the project has the same risk as the firm's existing assets.

True

A reduction in long-term debt is a use of cash.

True

All else equal, increasing the assumed payables period in a financial forecast will decrease external funding required.

True

An acquirer should be willing to pay a higher control premium for a poorly managed company than for a well-managed company.

True

An average-risk project that has an NPV of zero when its cash flows are discounted at the weighted-average cost of capital will provide sufficient returns to satisfy both stockholders and bondholders.

True

Sequoia Furniture Company's sales over the past three months, half of which are for cash, were as follows: March: $408,000 April: $658,000 May: $528,000 a) Assume that Sequoia's collection period is 60 days. What would be its cash receipts in May? What would be its accounts receivable balance at the end of May? b) Now assume that Sequoia's collection period is 45 days. What would be its cash receipts in May? What would be its accounts receivable balance at the end of May?

a) Cash = (408*0.5) + (528*0.5) = $468,000 A/R = (528*0.5) + (658*0.5) = $593,000 b) With a 45-day collection period, cash collected on May 1 is from credit sales made in mid-March, and collections on May 31 are from credit sales made in mid-April. Therefore: Cash = (408,000/2 + 658,000/2)/2 + 264 = $266,500. A/R: 264,000 + (329,000/2) = $428,500.

In the above financial statements, Royal Corporation has prepared (incomplete) pro forma financial statements for 2017 based on actual financial statements for 2016. Royal Corp. used the percent-of-sales method, assuming a sales growth rate of 10% for 2017. If capital expenditures are planned to be $1,615 in 2017, then what would be the appropriate projection for net fixed assets in 2017?

2017 net fixed assets = 2016 Net Fixed Assets + Capital Expenditures - 2017 Depreciation = 4,048 + 1,615 − 1,100 = $4,563

You manage a real estate investment company. One year ago, the company purchased 10 parcels of land distributed throughout the community for $ 11.2 million each. A recent appraisal of the properties indicates that five of the parcels are now worth $9.2 million each, while the other five are worth $17.0 million each. Ignoring any income received from the properties and any taxes paid over the year, calculate the investment company's accounting earnings and its economic earnings in each of the following cases: a) The company sells all of the properties at their appraised values today. b) The company sells none of the properties. c) The company sells the properties that have fallen in value and keeps the others. d) The company sells the properties that have risen in value and keeps the others.

Accounting income recognizes income only through transaction while economic income recognizes income even without a transaction. a) Accounting: (17*5) + (9.2 *5) - (11.2 *5) = 19 Economic: (17*5) + (9.2 *5) - (11.2 *5) = 19 b) Accounting: 0 since no transaction Economic: (17*5) + (9.2 *5) - (11.2 *5) = 19 c) Accounting: (9.2 *5) - (11.2 *5) = -10 Economic: (17*5) + (9.2 *5) - (11.2 *5) = 19 d) Accounting: (17*5) - (11.2 *5) = 29 Economic: (17*5) + (9.2 *5) - (11.2 *5) = 19

Please refer to the financial information for Foodtek, Inc. above. During 2014, how much cash (in $ millions) did Foodtek collect from sales?

Cash collected from sales = Net Sales - Change in AR = 364-40 = 324

Which of the following is NOT a major category on the cash flow statement?

Cash flows from selling activities

Please refer to the financial information for Foodtek, Inc. above. Assuming that there were no financing cash flows during 2017 and basing your answer solely on the information provided, what were Foodtek's cash flows from operations (in millions of dollars) for 2017?

Cash from operations = Net income - increase in A/R - increase in inventory + increase in A/P + depreciation = 45 - (87-47) - (29-34) + (44-39) +65 = 80

A company sells used equipment with a book value of $100,000 for $250,000 cash. How would this transaction affect the company's balance sheet?

Cash rises $250,000; net plant and equipment falls $100,000; equity rises $150,000. This is because any cash earned in excess of the purchase value is recorded as equity.

Westcomb, Inc. had equity of $150,000 at the beginning of the year. At the end of the year, the company had total assets of $195,000. During the year, the company sold no new equity. Net income for the year was $72,000, and dividends were $44,640. What is Westcomb's sustainable growth rate?

Change in Equity = Retained earnings = $72,000 − $44,640 = $27,360 Sustainable growth rate = g* = Change in Equity/Equitybop = $27,360/$150,000 = 18.24%

Scenario analysis involves changing one input to a financial forecast, whereas sensitivity analysis involves changing multiple inputs.

False

A decline in the Net fixed assets account between year-end 2016 and year-end 2017 is a clear indication that fixed assets were sold during 2017.

False, it could just be depreciation

Pro forma financial statements, by definition, are predictions of a company's financial statements at a future point in time. So, why is it important to analyze the historical performance of the company before constructing pro forma financial statements?

Historical analysis helps decide for which financial statement items a percent-of-sales forecast might be appropriate. For example, a stable trend in the collection period would tell you that, unless you expect changes in the management of the accounts receivable, future collection periods should continue along this trend.

Which of the following questions are appropriate to address upon conducting sustainable growth analysis and the financial planning process?

I. Should the firm merge with a competitor? II. Should additional equity be sold? III. Should a particular division be sold? IV. Should a new product be introduced?

In comparison to industry averages, Okra Corp. has a low inventory turnover, a high current ratio, and an average quick ratio. Which of the following would be the most reasonable inference about Okra Corp.?

Its inventory level is too high.

Which one of the following statements is correct?

The assets-to-equity ratio can be computed as 1 plus the debt-to-equity ratio.

Under Armour, Inc. is an American supplier of sportswear and casual apparel. Following are selected financial data for the company for the period 2009-2013. a) Calculate Under Armour's annual sustainable growth rate for the years 2009 through 2013

a) 0.057 * 1.8 * 1.9 * 100% = 19.5% b) 0.066 * 1.8 * 1.9 * 100% = 22.6% c) 0.068 * 1.8 * 2.1 * 100% = 25.7% d) 0.072 * 1.8 * 2.1 * 100% = 25.9% e) 0.072 * 1.7 * 2.1 * 100% = 25.7%

Chapter 5 presents evidence that the average annual rate of return on common stocks over many years has exceeded the return on government bonds in the United States, while returns on common stocks have also exhibited more volatility than returns on U.S. government bonds. Suppose that last year, the realized rate of return on government bonds exceeded the return on common stocks. Your colleague suggests that "last year shows us that investors are now willing to settle for lower returns on stocks than on bonds." How would you interpret this result?

The fact that government bonds earned a higher rate of return than common stocks in one year is not evidence that investors are suddenly willing to settle for lower returns on stocks than bonds. It means that investors' expectations were not met or, alternatively, that investors were surprised. To take on additional risk, risk-averse investors require additional expected return. But expected returns are not the same as realized returns. Because stocks and bonds are risky, their returns will fluctuate from year to year, and bonds will earn higher returns than stocks in some years. But the expected returns of common stocks should always be higher than the expected returns of government bonds.

Suppose you purchase a call option on XYZ stock when the stock price is $81. The option premium is $3, and the strike price is $85. What is your net profit on the call option if the stock price is $89 at maturity?

The gain on the call is 89 − 85 = $4; less the option premium of $3 gives a net profit of $1.

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, III, and IV only

The IRR and NPV always yield the same investment recommendations.

False

Which of the following statements are correct? I. Liquidation value of a firm is equal to the present worth of expected future cash flows from operating activities. II. When an acquiring firm purchases a target firm's equity, the acquirer must assume the target's liabilities. III. The market value of a public company reflects the worth of the business to minority investors. IV. The fair market value of a business is usually the lower of its liquidation value and its going-concern value.

II and III only

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 and III only

Which of the following statements are true? I. Underwriters help private companies access public stock markets through IPOs. II. Shelf registrations and private placements are examples of seasoned security issues. III. Issue costs for debt are typically greater than issue costs for equity. IV. Bearer bonds make it easier for investors to avoid paying taxes on interest income.

I, II, and IV only

Which of the following actions would help a firm's growth problem if its actual sales growth exceeds its sustainable rate of growth? I. Increase prices II. Decrease financial leverage III. Decrease dividends IV. Prune away less-profitable products

I, III, and IV only

Which of the following are viable techniques to cope with the uncertainty inherent in realistic financial projections? I. Simulation II. Ad hoc adjustments III. Scenario analysis IV. Sensitivity analysis

I, III, and IV only

Pro forma free cash flows for a proposed project should I. exclude the cost of employing existing assets that could be sold anyway. II. exclude interest expense. III. include the depreciation tax shield related to the project. IV. exclude any required increase in operating current assets.

II and III only

The after-tax cost of debt generally increases when I. a firm's bond rating improves. II. the market-required rate of interest for the company's bonds increases. III. tax rates decrease. IV. bond prices rise.

II and III only

Which of the following ratios are measures of a firm's liquidity? I. fixed asset turnover ratio II. current ratio III. debt-equity ratio IV. acid test

II and IV only

Which of the following are the most likely reasons for why a stock price might not react at all on the day that new information related to the stock issuer is released? I. Insiders knew the information prior to the announcement. II. Investors need time to digest the information prior to reacting. III. The information has no bearing on the value of the firm. IV. The information was anticipated.

III and IV only

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?

In Excel: = FV(0.1025, 45, −3000) = 2,333,572

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?

In Excel: = PV(0.112, 11, 95, 1000) = −895.43

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.

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

Which of the following formulas describes the calculation of cash flow from operating activities

Net income + Noncash items +/− Changes in current assets and liabilities

A company purchases a new $10 million building financed half with cash and half with a bank loan. How would this transaction affect the company's balance sheet?

Net plant and equipment rises $10 million; cash falls $5 million; bank debt rises $5 million.

Why do financial managers need to understand the implications of the sustainable rate of growth?

Working capital, fixed assets, and external financing must coordinate with and be able to support a firm's sales growth. If, for example, a projected increase in sales requires external financing when no such financing is available, then the firm cannot grow at the desired rate. Understanding the implications of the sustainable growth rate helps managers understand the need to manage growth so that the firm does not attempt to outgrow its resources.

Please refer to the selected financial information for Boss Stores above. What is the difference between Boss's sustainable growth rate and its actual growth rate for 2017?

SGR, g* = Change in Equity/Equitybop = (222.57 − 211.03)/211.03 = 5.47% Actual growth = g = Change in Sales/Salesbop = (446.84 − 411.78)/411.78 = 8.51% g* − g = 5.47% − 8.51% = − 3.04%

A $1,000 par value bond with a fixed 10% rate of interest pays coupons semiannually. What amount will the bondholder receive on the bond's maturity date?

Semiannually = 2 payments each year 1000 * 0.1 * 0.5 = $50 Maturity date = $1,000 + $50 = $1,050

Information about three securities appears next. a) Assuming interest and dividends are paid annually, calculate the annual holding period return on each security

Stock 1($2.70 + $47.95 − $43.70)/$43.70=15.9% Stock 2($0 + $2.63 − $2.45)/$2.45=7.3% Bond 1($53.00 + $1,168 − $1,140)/$1,140=7.1%

Komatsu has a 4.5 percent profit margin and a 15 percent dividend payout ratio. The asset turnover ratio is 1.6, and the assets-to-equity ratio (using beginning-of-period equity) is 1.77. What is Komatsu's sustainable rate of growth?

Sustainable growth = PRAT = 0.045 × (1 − 0.15) × 1.6 × 1.77 = 10.83%

Please refer to the income statement for VGA Associates below. If VGA had a principal repayment of $8,000 due in 2017, what was its times-burden-covered ratio in 2017?

TBC = 30,000/((5000) + (8000/(1-0.2))) = 2.00 None of the above

The following table presents forecasted financial and other information for Havasham Industries: What is an appropriate estimate of Havasham's terminal value as of the end of 2017 using a warranted price-to-earnings multiple as your estimate?

Terminal value (2017) = 18.7 × $225 million = $4,207.5 million.

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.

You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000. The bond paid 3 percent annual interest and was trading for ¥110,000 at year-end. What holding period return, measured in yen, did you earn on the bond?

The holding period return in yen was (3% × 100,000 + 10,000)/100,000 = 13%.

Playdough Products earned net income of $500,000 in 2017. The firm increased its accounts receivable during the year by $220,000. The book value of its assets declined by the year's depreciation charge, which was $140,000, and the market value of its assets increased by $50,000. Based only on this information, how much cash did Playdough Products generate during the year? Please ignore taxes for this problem.

The net income of $500,000 is reduced by $220,000 due to the addition to accounts receivables and increased by $140,000 due to the depreciation charge, which is not a cash charge. The change in market value does not affect cash. Thus, the company's net cash flow is +$420,000.

Below are summary cash flow statements for three roughly equal-sized companies. Calculate each company's cash balance at the end of the year.

a) -319 + -919 + 1390 + 169 = 321 b) -319 + -49 + 248 + 169 = 49 c) 338 + -109 + -259 + 169 = 139

Magenta Corporation wants to raise $50.9 million in a seasoned equity offering, net of all fees. Magenta stock currently sells for $15 per share. The underwriters will require a spread of $0.6 per share, and indicate that the issue must be underpriced by 6 percent. In addition to the underwriter's fee, the firm will incur $1,900,000 in legal, accounting, and other costs. How many shares must Magenta sell?

The price will be set at 6% below the current price, or at 0.94 × 15 = $14.10. The underwriters will take $0.6 per share, leaving $13.5/share for Magenta. Magenta needs to earn $52.8 million (in order to have $50.9 million net of all fees), and it gets $13.5/share, so it must sell $52.8 million/$13.5 = 3.911 million shares.

Carbon8 Corporation wants to raise $120 million in a seasoned equity offering, net of all fees. Carbon8 stock currently sells for $28.00 per share. The underwriters will require a fee of $1.25 per share, and indicate that the issue must be underpriced by 7.5%. In addition to the underwriter's fee, the firm will incur $785,000 in legal, administrative, and other costs. How many shares must Carbon8 sell in order to raise the desired amount of capital?

The price will be set at 7.5% below the current price, or at 0.925 × 28.00 = $25.90. The underwriters will take $1.25 per share, leaving $24.65/share for Carbon8. Carbon8 needs to earn $120,785,000 at $24.65/share, so it must sell 120.785mil/24.65 = 4.9 million shares.

Assume you are a banker who has loaned money to a firm, but that firm is now facing increased competition and reduced cash flows. Which one of the following ratios would you most closely monitor to evaluate the firm's ability to repay its loan?

The times-burden-covered ratio is the best answer, as it indicates how well the firm's cash flows cover both debt principal and interest payments. The times-interest-earned ratio applies most appropriately when we are confident the firm can roll over existing debt; this is not the case here.

Please refer to the financial information for Nile Holdings above. Nile must decide how to finance a $100 million investment. Assume Nile raises $100 million of new debt at the end of 2017 at an interest rate of 7%. 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). 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.

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 b) 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.

The following table shows the projected free cash flows of an acquisition target. The potential acquirer wants to estimate its maximum acquisition price at an 8 percent discount rate and a terminal value in year 5 based on the perpetual growth equation with a 4 percent perpetual growth rate. a) Estimate the target's maximum acquisition price. b) Estimate the target's maximum acquisition price when the discount rate is 7 percent and the perpetual growth rate is 5 percent.

a) The terminal value = 700 × (1 + 0.04)/(0.08 − 0.04) = $18,200. Discounting the annual free cash flows plus the terminal value at 8 percent, the MAP = $11,926. b) The terminal value = 700 × (1 + 0.05)/(0.07 − 0.05) = $36,750. Discounting the annual free cash flow plus the terminal value at 7 percent, the MAP = $25,757.

The capital structure weights used in computing the weighted-average cost of capital

are based on the market value of the firm's debt and equity securities.

Which of the following would allow a corporation to issue a bond at a lower coupon rate, all else equal? a) The addition of a call provision to the bond b) None of the options are correct. c) The removal of protective covenants from the bond d) An increase in the expected inflation rate e) A deterioration in the corporation's credit quality

b) none of the above

Unsystematic risk

can be effectively eliminated by portfolio diversification.

The sustainable growth rate

can never be greater than the return on equity.

Depreciation expense

reduces both taxes and net income.

When investment returns are less than perfectly positively correlated, the resulting diversification effect means that

spreading an investment across many diverse assets will eliminate some of the total risk.