FA 7 - Forecasting and Valuation
Which of the following statements is NOT true in relation to the Gordon Growth Model?
A higher discount rate results in a higher terminal value. is correct This statement is not true. A higher discount rate results in a lower terminal value. Terminal value is the present value of infinite cash flows expected in the future. The Gordon Growth Model assumes that the growth rate will remain fixed. A higher growth rate results in a higher terminal value.
Metropolis had net sales of ₹120 million in 2003 related to pathology services. They expect sales of pathology services to grow by 75% in 2004. Metropolis also plans to introduce a new service, Home Healthcare Blood Draws, which will generate sales of ₹10 million in 2004. What will be the forecasted net sales for 2004?
Pathology revenue is expected to increase by 75% and Home Healthcare Blood Draws revenue is expected to add ₹10 million. In order to calculate, multiply the prior year's revenue by 175% and add ₹10 million. Calculation: (120.0 * 1.75) +10 = 220.0
Metropolis expects sales of pathology services to grow by 75% in 2005. Home Healthcare Blood Draws will generate sales of ₹20 million in 2005. What will be the forecasted net sales for 2005? HINT: You must compound the 2003 sales (₹120 million) twice rather than simply multiplying the 2004 revenue by 175% because the 2004 revenue includes ₹10 million of Home Healthcare Blood Draws revenue.
Pathology revenue is expected to increase by 75% and Home Healthcare Blood Draws revenue is expected to add ₹20 million. In order to calculate, multiply the 2003 revenue by 175% compounded twice and add ₹20 million. Calculation: (120.0 * 1.75 * 1.75) + 20 = 387.5
Which of the following statements is NOT true regarding Payback Period?
Payback Period is impacted by cash flows that occur after the initial cost is recovered. is correct This is the correct answer! This statement is NOT true. Payback Period only considers cash flows that occur before the initial cost is recovered and ignores any cash flows that occur after the payback period.
Which of the following statements are true? Select all that apply.
EBIAT re-applies the tax rate to a pretax amount that excludes the cost of interest.
When projecting financial statements, which of the following accounts is difficult to forecast using the percent of sales method?
Interest Expense is correct Normally, Accounts Receivable, Accounts Payable, and Cost of Sales will trend in a direct relationship with sales. However, Interest Expense is more dependent upon the level of borrowings which does not necessarily track with sales.
What is free cash flow?
It is the amount of cash that a business could be expected to generate from its normal operations.
An automotive parts company that sells to automotive manufacturers is forecasting revenue as part of its internal budgeting and planning process. Which of the following is LEAST likely to be important in its forecasting assumptions?
Level of long-term debt is correct The level of long-term debt would not likely impact the revenue forecast.
On which financial statements would you be most likely to find information about capital expenditures related to the purchase of equipment during the past year?
Look at the investing section in the statement of cash flows
A CFO of a start-up company is evaluating the timing of a significant capital expenditure. He was previously at a mature company that used a discount rate of 8% so he used the same rate at the start-up company. Which of the following would be impacted if the discount rate were raised to reflect the risk of the start-up company?
Net present value is correct NPV is the only one of the answer choices that is impacted by the discount rate.
Which of the following options is true in regards to financial forecasts?
Odds are, forecasts will differ from actual results. is correct Because of the assumptions that need to be made when creating forecasts and the subjectivity involved in making those assumptions, a financial forecast may be good base idea of the company's future operations, but they will most likely not be exactly correct.
A project has a negative Net Present Value. Which of the following statements is true regarding this project?
The IRR of the project is less than the WACC. is correct This is the correct answer! IRR is the discount rate at which the net present value of an investment equals zero. Therefore: When NPV < 0, IRR < WACC. When NPV = 0, IRR = WACC. When NPV > 0, IRR > WACC.
Which of the following cash flows should be used in an NPV calculation to determine which project to pursue? (Select all that apply.)
The cash inflows expected as a result of the pro The cash inflows expected as a result of the pro
A company is considering buying a diagnostic piece of equipment for $250,000. The machine will be depreciated on a straight-line basis for 10 years with a salvage value of $40,000. The company expects the machine to be able to generate after-tax revenues of $33,000 in each of the 10 years, and then it will sell the machine for $40,000 at the end of 10 years. The sum of the undiscounted cash flows is $370,000. The discount rate is 7%. The net present value is calculated to be $2,112. Which of the following statements is true?
The company should buy the equipment because the NPV is positive. is correct As long as the NPV is positive, even if it is a very small positive number, it means the company will earn a return greater than its discount rate, so it is a good investment.
Which of the following would NOT have an impact on the IRR of a project?
Weighted average cost of capital is correct This is the correct answer! IRR is the discount rate at which the net present value of an investment equals zero. Weighted average cost of capital does not impact IRR.
Adele's Deli had the following account balances as of December 31, 2006: Accounts Receivable $500 Inventory $1,250 Accounts Payable $200 Salaries/Wages Payable $225 and the following account balances as of December 31, 2007: Accounts Receivable $900 Inventory $1,000 Accounts Payable $400 Salaries/Wages Payable $100 Which of the following represents the Change in Net Working Capital from 2006 to 2007?
Adele's Deli had the following account balances as of December 31, 2006: Accounts Receivable $500 Inventory $1,250 Accounts Payable $200 Salaries/Wages Payable $225 and the following account balances as of December 31, 2007: Accounts Receivable $900 Inventory $1,000 Accounts Payable $400 Salaries/Wages Payable $100 Which of the following represents the Change in Net Working Capital from 2006 to 2007?
The primary costs that make up the cost of sales for Metropolis are employee costs, chemical costs, and supplies costs. Employee costs are forecast to be 20% of revenue, chemical costs are forecast to be 20% of revenue, and supplies costs are forecast to be 5% of revenue, for a total of 45%. With forecasted sales revenue of ₹220 for 2004, what will be the forecasted cost of sales for 2004?
Cost of sales is forecast to be 45% of net sales (sum of employee cost, 20% + chemical cost, 20% + supplies cost, 5%). In order to calculate, multiply 2004 sales by 45%. Calculation: (220.0 * 0.45) = 99.0
Adele's Deli had the following account balances as of December 31, 2004: Accounts Receivable $1,200 Accumulated Depreciation $200 Inventory $500 Building $2,000 Equipment $500 Accounts Payable $300 Salaries/Wages Payable $900 Which of the following represents the Net Working Capital for the business?
Current assets (excluding cash) less current liabilities equals Net Working Capital. In this case, currents assets total $1,700 (accounts receivable and inventory) and current liabilities total $1,200. The difference, NWC, is $500.
A company is considering which of four mutually exclusive projects it should take. The projects are described as below: NPV IRR (%) Payback Period (yrs) Project 1 $60,800 25.3% 6.5 Project 2 -$5,000 9.6% 1.8 Project 3 $29.100 18.7% 2.4 Project 4 $34,600 21.8% 3.9 The company's maximum acceptable payback period is 6 years. The discount rate is 10%. Which project should it select?
Project 4 is correct This is the correct answer! As Project 1 and Project 2 are excluded, we just need to compare the two projects left. Project 4 has a higher NPV and a higher IRR than Project 3. Consequently, among the four mutually exclusive projects, Project 4 is the optimal choice.
Which of the following is INCORRECT in determining free cash flows?
Subtract depreciation is correct This is the correct answer! It is NOT true. You ADD BACK depreciation in determining free cash flows.
Which of the following statements is true regarding the calculation of Terminal Value under the Gordon Growth model?
Terminal Value is the present value of cash flows expected in the indefinite future. A major assumption of Terminal Value model is that the growth rate will remain fixed. Gordon Growth Model: P = CF / (r - g) P - Present value of the future cash flows CF - Cash flow expected in the last year projected r - Discount rate g - Expected growth rate According to the Gordon Growth Model, the higher the discount rate, the smaller the Terminal Value is. The higher the growth rate, the greater the Terminal Value is.
A company is considering investing in a new project with an infinite life. The estimated cash flows of first three years of the project are shown as below: 2014 2015 2016 Cash Flows $12,000 $15,000 $21,000 After 2016, annual cash flow of the project is expected to stabilize at about 1% growth. The discount rate is 6%. What is the Present Value of the project on January 1, 2014? Present value of $1 for 1 year at 6% is 0.94340 Present value of $1 for 2 years at 6% is 0.89000 Present value of $1 for 3 years at 6% is 0.83962
The correct answer is $398,470. Because cash flow is expected to grow at a stable rate of 1% after 2016, the cash of 2017, the first period of stabilized period, is $21,000 * 1.01 = $21,210. According to the Gordon Growth Model, Terminal Value = CF / (r - g) = $21,210 / (6% - 1%) = $424,200 Present Value on 1/1/2014 = ($12,000 * 0.94340) + ($15,000 * 0.89000) + ($21,000 * 0.83962) + ($424,200 * 0.83962) = $398,470
A company is considering which of four mutually exclusive projects it should take. The projects are described as below: NPV IRR Project 1 -$12,600 8.2% Project 2 $41,500 13.5% Project 3 $28,960 11.7% Project 4 $34,900 12.4% Each project involves an initial investment of $500,000 and has a 10-year life. The company's Weighted Average Cost of Capital (WACC) is 9%. Which project should it select?
The correct answer is Project 2. Among the four mutually exclusive projects, Project 2 has the highest NPV and the highest IRR, so it should be selected.
Company A estimates that it needs 30% of sales in net working capital. In year 1, sales were $1 million and in year 2, sales were $2 million. Associated with the change in net working capital from year 1 to year 2 is a cash:
The correct answer is an outflow of $300,000. The company would need to make a cash investment (outflow) of $300,000 to increase their net working capital from the $300,000 needed to support $1 million of sales to the $600,000 needed to support $2 million of sales.
A company is considering investing in a new project with an infinite life. The estimated cash flows of first five years of the project are shown as below: 2014 2015 2016 2017 2018 Cash Flows $650 $1,240 $2,250 $3,670 $4,200 After 2018, annual cash flow of the project is expected to stabilize at about 3% growth. The discount rate is 7%. What is the Terminal Value of the project on January 1, 2019?
The correct answer is: $108,150 Because cash flow is expected to grow at a stable rate of 3% after 2018, the cash of 2019, the first period of stabilized period, is $4,200 * 1.03 = $4,326. According to the Gordon Growth Model, Terminal Value = CF / (r - g) = $4,326 / (7% - 3%) = $108,150
Cybertrex, a manufacturing facility, rented a new piece of equipment on January 1st and agreed to pay an annual rental fee of $18,000 at the end of each of the next 10 years. The weighted average cost of capital of the company is 8%. The present value of $1 for 10 years at 8% is 0.46319 The present value of an ordinary annuity of $1 for 10 years at 8% is 6.71008 What is the Present Value of the rental payments over 10 years?
The correct answer is: $120,781 It is calculated by multiplying the annual payment by the present value of an annuity factor. $18,000 * 6.71008 = $120,781
A project's estimated net cash flows are shown as below. The discount rate is 6%. Time (t) 0 1 2 3 4 5 6 7 Net Cash Flows ($40,000) $12,000 $12,000 $12,000 $12,000 $12,000 $12,000 $18,000 What is the Net Present Value of the project? Present value of $1 for 7 years at 6% is 0.66506 Present value of an annuity of $1 for 6 years at 6% is 4.91732 Present value of an annuity of $1 for 7 years at 6% is 5.58238
The correct answer is: $30,979 NPV = (-$40,000) + ($12,000 * 4.91732) + ($18,000 * 0.66506) = $30,979 Or NPV = (-$40,000) + ($12,000 * 5.58238) + ($6,000 * 0.66506) = $30,979
Company X is considering investing in a new project. The new project requires an initial investment of $180,000, and is expected to generate annual after-tax net cash inflow of $25,000 for 15 years. The discount rate is 8%. What is the Net Present Value of the project? Present value of $1 for 15 years at 8% is 0.31524 Present value of an annuity of $1 for 15 years at 8% is 8.55948
The correct answer is: $33,987 NPV = (Initial investment) + Present value of operating cash flows = (-$180,000) + ($25,000 * 8.55948) = $33,987
Company Y is considering purchasing a new machine. The new machine has a cost of $50,000, and is expected to generate annual after-tax net cash inflow of $10,000. The useful life of the machine is 8 years. NPV at 9% = $5,348 NPV at 10% = $3,349 NPV at 11% = $1,461 NPV at 12% = -$324 NPV at 13% = -$2,012 Which of the following numbers is closest to the Internal Rate of Return?
The correct answer is: 11.5% IRR is the discount rate at which the NPV of an investment equals zero. Because NPV at 11% is positive while NPV at 12% is negative, IRR must fall between 11% and 12%.
Which of the following would NOT be considered a relevant cash flow in determining if a company should invest in a new project?
The cost already incurred to have a consulting firm do market research is correct This is the correct answer! This is NOT a relevant cash flow. Because the cost has already been incurred, it is considered a sunk cost. This cost is not incremental to the project and is not a relevant cash flow.
Which of the following would NOT be considered a relevant cash flow in determining if a company should invest in a new project?
The cost of office space already owned with capacity to house the new project is correct This is the correct answer! This is NOT a relevant cash flow. Because the office space is already owned, this cost is not incremental to the project and will be incurred regardless of the investment. Thus, it is not a relevant cash flow.
A company has retained earnings of $94,000 as of December 31, 2014. The Pro-forma income statement projects net income of $22,000 for 2015. The company expects to declare their annual dividend on March 15, 2015 of $0.70 per share and has a total of 100,000 shares outstanding. What will the projected retained earnings account be as of December 31, 2015?
To calculate the projected retained earnings, you add the projected 2015 net income of $22,000 to the beginning balance of $94,000 carried over from 2014. Then you must subtract $70,000 for the dividend of $0.70 per share times the 100,000 shares outstanding. $94,000 + $22,000 - $70,000 = $46,000
Suppose a company has a piece of machinery and the company spends money on maintenance to extend the useful life of the machine. The company is considering the decision of whether to capitalize the cost of maintenance to increase the asset's book value, or to record the cost of maintenance immediately as an expense. Does this decision affect free cash flow?
Yes - because EBIT will be affected by depreciation expense, which will be different depending on the decision. is correct This is the correct answer! Even though depreciation is added back in the free cash flow calculation, there is a tax effect that will be picked up by the difference in depreciation that is included in EBIT.
