Business Finance Mid-term Exam 2

In general, the capital structures used by non-financial U.S. firms

vary significantly across industries.

Giant Corp. is considering a project that requires a $1,500 initial cost for a new machine that will be depreciated straight line to a salvage value of 0 on a 5-year schedule. The project will require a one-time increase in the level of net working capital of $300. The project will generate an additional $1,600 in revenues and $700 in operating expenses each year. The project will end at the end of year 2, at which time the machinery is expected to be sold for $800. Giant's tax rate is 50%. In a discounted cash flow analysis of this project, what would be the projected Year 0 free cash flow?

−$1,800

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 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.

The basic lesson of the M&M theory is that the value of a firm is dependent upon

the total cash flow of the firm.

In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected Year 2 free cash flow?

$1,750

Your grandmother invested a lump sum 26 years ago at 4.25-percent interest. Today, she gave you the proceeds of that investment which totaled $51,480.79. How much did she originally invest?

$17,444.86

A project will produce after-tax operating cash inflows of $3,200 a year for 5 years. The after-tax salvage value of the project is expected to be $2,500 in year 5. The project's initial cost is $9,500. What is the net present value of this project if the required rate of return is 16 percent?

$2,168.02

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?

$2,333,572

What is the difference in the value of a $5,000 annual perpetuity and an annuity of $5,000 for 100 years? Assume that the discount rate is 8% and that cash flows are received at the end of the year.

$28

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?

$32,409.57

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?

$366.05

You are to receive an annuity of $1,000 per year for 10 years. You will receive the first payment two years from today. At a discount rate of 10%, what is the present value of this annuity?

$5,585.97

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?

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

Given the spreadsheet below, what value would Excel return if you entered the following formula? = NPV(B2,B5:D5)

$577.57

In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected Year 1 free cash flow?

$600

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?

$895.43

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?

$99,517.41

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

1.02 PVinflows = (12,200/1.145) + (38,400/1.145 2 ) + (11,300/1.145 3 ) = $47,472.78 BCR = $47,472.78/$46,500 = 1.02

Please refer to the financial information for Squamish Equipment above. Calculate Squamish's times-burden-covered ratio for the next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent, and that annual sinking fund payments on the new debt will equal $8 million.

1.49 EBIT = 40/(1 − 0.36) + 15 = $77.5 Interest = $15 + 0.07(40) = $17.8 Burden of interest and sinking fund before tax = 17.8 + (14 + 8)/(1 − 0.36) = $52.175 Times burden covered = 77.5/52.175 = 1.49 times

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

2.00 EPS = 40/(18 + 2) = $2.00

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.

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

Please refer to the financial information for Squamish Equipment above. Calculate Squamish's earnings per share next year assuming Squamish raises $40 million of new debt at an interest rate of 7 percent.

2.12 EBIT = 40/(1 − 0.36) + 15 = $77.5 Interest = $15 + 0.07(40) = $17.8 EPS = (77.5 − 17.8)(1 - 0.36)/18 = $2.12

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.

4.35 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

TTT Corporation reported earnings per share of $2.52 in 2012 and $3.15 in 2017. At what compound annual rate did earnings per share grow over this period?

4.56%

You plan to pay $50 for a share of preferred stock that pays a $2.40 dividend per year forever. What annual rate of return will you realize?

4.80% r = A/P = $2.40/$50 = 4.80%

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?

75% % EBIT can fall = (4.0 − 1)/4.0 = 0.75

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.

According to the pecking order theory of capital structure, why do firms avoid issuing equity?

Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall

Which of the following is NOT likely to be a prudent financing policy for a rapidly growing business?

Borrow funds rather than limit growth, thereby limiting growth only as a last resort.

Which of the following is NOT an important step in the financial evaluation of an investment opportunity?

Estimate the accounting rate of return for the investment.

Which of the following figures of merit does not directly take into consideration the time value of money? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Accounting rate of return

I & IV only

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

I and III only

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 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 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

According to the pecking order theory proposed by Steward Myers of MIT, which of the following are correct? I. For financing needs, firms prefer to first tap internal sources, such as retained profits and excess cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms prefer to issue new equity rather than source external debt. IV. A firm's capital structure is dictated by its need for external financing.

I, II, and IV only

The interest tax shield has no value when a firm has: I. no taxable income. II. debt-equity ratio of 1. III. zero debt. IV. no leverage.

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

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

Which of the following factors favor the issuance of equity in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility

II and IV only

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.11.

II,III, and IV only

When making a capital budgeting decision, which of the following is/are NOT relevant? I. The size of a cash flow II. The risk of a cash flow III. The accounting earnings from a cash flow IV. The timing of a cash flow

III only

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.

Which of the following would NOT be considered a cost of financial distress?

Lack of interest tax shields

Which of the following is NOT an implication of the pecking order theory of capital structure?

More-profitable firms (all else equal) should have higher debt ratios.

A divisional manager submitted a project proposal to the chief financial officer, complete with a calculated NPV for the project. The chief financial officer studied the proposal and pointed out that the divisional manager had failed to account for a one-time increase in net working capital of $60,000 that will be required over the life of the seven-year project. Assuming the full value of net working capital will be recovered at the end of the project, how will the project's NPV change after making the chief financial officer's adjustment? Assume a discount rate of 9%.

None of the options are correct.

Which of the following statements regarding interest tax shields is correct?

Taxable income is reduced by the amount of the interest on a firm's debt.

Which of the following is NOT a reason why a dollar today is worth more than a dollar in the future?

The value of a dollar in the future will be compounded more than the value of a dollar today.

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.