Exam 1

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36. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Accounts payable. b. Common stock "raised" by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt.

39. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. re > rs > WACC > rd. b. WACC > re > rs > rd. c. rd > re > rs > WACC. d. WACC > rd > rs > re. e. rs > re > rd > WACC.

Which of the following statements best describes the optimal capital structure? The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's ________. A. stock price. B. cost of equity. C. cost of debt. D. Cost of preferred stock.

A. stock price.

50. Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. e. A change in a company's target capital structure cannot affect its WACC.

ANS: C Statement c is true, because the cost of debt for WACC purposes = rd(1 − T), so if T increases, then rd(1 − T) declines.

61. Which of the following statements is CORRECT? a. Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. b. An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. c. When the WACC is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. d. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. e. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of reinvested earnings.

ANS: D Statement d is true. The firm would receive no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would be able to deduct 70% of the preferred dividends they receive, which would make them willing to accept a lower before-tax yield on preferred stock than on bonds. Put another way, the market yield on this firm's preferred could be lower than the interest rate on its debt because of the 70% exclusion; however, with a zero tax rate there would be no reduction in the firm's cost of debt.

44. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many low-risk projects.

ANS: E Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement e is correct.

Brothers Breads has the following data. What is the firm's cash conversion cycle? Inventory conversion period = 50 days Average collection period = 17 days Payables deferral period = 25 days a. 31 days b. 34 days c. 38 days d. 42 days e. 46 days

Which of the following is NOT commonly regarded as being a credit policy variable? A. Collection policy. B. Credit standards. C. Payments deferral period. D. Credit period.

C. Payments deferral period.

What are some financial institutions?

Commercial banks Investment banks Savings & Loans, mutual savings banks, and credit unions Life insurance companies Mutual funds Exchanged Traded Funds (ETFs) Pension funds Hedge funds and private equity funds

Emerson Inc.'s would like to undertake a policy of paying out 45% of its income. Its latest net income was $1,250,000, and it had 225,000 shares outstanding. What dividend per share should it declare? a. $2.14 b. $2.26 c. $2.38 d. $2.50 e. $2.63

D) $2.50

Debt Management Ratios

Does the company have too much debt? Can the company's earnings meet its debt servicing requirements?

Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming other things are held constant? a. $267.34 b. $281.41 c. $296.22 d. $311.81 e. $328.22

E) $328.22

Orono Corp.'s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm's times interest earned (TIE) ratio? a. 4.72 b. 4.97 c. 5.23 d. 5.51 e. 5.80

E) 5.80

True/False Net working capital is defined as current assets dived by current liabilities

False

Modifying the Forecasting Model

Multi-year projections of financial statements. Maintain target capital structure each year. For examples, see Ch09 Tool Kit.xlsx and look at the worksheet CFO Model.

What four factors affect the cost of money?

Production opportunities Time preferences for consumption Risk Expected inflation

7. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

The DuPont system focuses on

The DuPont system focuses on: Expense control (PM) Asset utilization (TATO) Debt utilization (EM) It shows how these factors combine to determine the ROE.

Over the years, Janjigian Corporation's stockholders have provided $15,250 of capital, part when they purchased new issues of stock and part when they allowed management to retain some of the firm's earnings. The firm now has 1,000 shares of common stock outstanding, and it sells at a price of $42.00 per share. How much value has Janjigian's management added to stockholder wealth over the years, i.e., what is Janjigian's MVA?

Total book value of equity $15,250 Stock price per share $42.00 Shares outstanding 1,000 Market value of equity 42,000 MVA = 26,750

Which of the following statements is CORRECT? a. A conservative financing policy is one where the firm finances part of its fixed assets with short-term capital and all of its net working capital with short-term funds. b. If a company receives trade credit under terms of 2/10 net 30, this implies that the company has 10 days of free trade credit. c. One cannot tell if a firm has a conservative, aggressive, or moderate current asset financing policy without an examination of its cash budget. d. If a firm has a relatively aggressive current asset financing policy vis-à-vis other firms in its industry, then its current ratio will probably be relatively high. e. Accruals are an expensive but commonly used way to finance working capital.

Which of the following statements is CORRECT? a. Commercial paper is a form of short-term financing that is primarily used by large, strong, financially stable companies. b. Short-term debt is favored by firms because, while it is generally more expensive than long-term debt, it exposes the borrowing firm to less risk than long-term debt. c. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. d. Commercial paper is typically offered at a long-term maturity of at least five years. e. Trade credit is provided only to relatively large, strong firms

Which of the following statements is NOT CORRECT? a. Accruals are "free" in the sense that no explicit interest is paid on these funds. b. A conservative approach to working capital management will result in most, if not all, permanent current operating assets being financed with long-term capital. c. The risk to a firm that borrows with short-term credit is usually greater than if it borrowed using long-term debt. This added risk stems from the greater variability of interest costs on short-term debt and possible difficulties with rolling over short-term debt. d. Bank loans generally carry a higher interest rate than commercial paper. e. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate.

The free cash flows (in millions) shown below are forecast by Parker & Sons. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments). Year: 1 2 Free cash flow: −$50 $100 a. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770

a. $1,456

National Advertising just paid a dividend of D0 = $0.75 per share, and that dividend is expected to grow at a constant rate of 6.50% per year in the future. The company's beta is 1.25, the required return on the market is 10.50%, and the risk-free rate is 4.50%. What is the company's current stock price? a. $14.52 b. $14.89 c. $15.26 d. $15.64 e. $16.03

a. $14.52

Atchley Corporation's last free cash flow was $1.55 million. The free cash flow growth rate is expected to be constant at 1.5% for 2 years, after which free cash flows are expected to grow at a rate of 8.0% forever. The firm's weighted average cost of capital (WACC) is 12.0%. Atchley has $2 million in short-term debt and $14 million in debt and 1 million shares outstanding. What is the best estimate of the intrinsic stock price? a. $25.05 b. $26.16 c. $27.30 d. $28.48 e. $29.70

a. $25.05

Dyer Furniture is expected to pay a dividend of D1 = $1.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company's beta is 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is Dyer's current stock price? a. $28.90 b. $29.62 c. $30.36 d. $31.12 e. $31.90

a. $28.90

If D1 = $1.50, g (which is constant) = 6.5%, and P0 = $56, what is the stock's expected capital gains yield for the coming year? a. 6.50% b. 6.83% c. 7.17% d. 7.52% e. 7.90%

a. 6.50%

If D0 = $2.25, g (which is constant) = 3.5%, and P0 = $50, what is the stock's expected dividend yield for the coming year? a. 4.42% b. 4.66% c. 4.89% d. 5.13% e. 5.39%

b. 4.66%

Merrell Enterprises' stock has an expected return of 14%. The stock's dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT? a. The stock's dividend yield is 8%. b. The current dividend per share is $4.00. c. The stock price is expected to be $54 a share one year from now. d. The stock price is expected to be $57 a share one year from now. e. The stock's dividend yield is 7%.

c. The stock price is expected to be $54 a share one year from now.

The preemptive right is important to shareholders because it a. will result in higher dividends per share. b. is included in every corporate charter. c. protects the current shareholders against a dilution of their ownership interests. d. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate. e. allows managers to buy additional shares below the current market price.

c. protects the current shareholders against a dilution of their ownership interests.

Based on the free cash flow valuation model, Bizzaro Co.'s value of operations is $300 million. The balance sheet shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. Bizzaro has 10 million shares of stock outstanding. What is the best estimate of the stock's price per share? a. $13.72 b. $14.44 c. $15.20 d. $16.00 e. $16.80

d. $16.00

. Burke Tires just paid a dividend of D0 = $1.32. Analysts expect the company's dividend to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The required return on this low-risk stock is 9.00%. What is the best estimate of the stock's current market value? a. $41.59 b. $42.65 c. $43.75 d. $44.87 e. $45.99

d. $44.87

Reynolds Construction's value of operations is $750 million based on the free cash flow valuation model. Its balance sheet shows $50 million of short-term investments that are unrelated to operations, $100 million of accounts payable, $100 million of notes payable, $200 million of long-term debt, $40 million of common stock (par plus paid-in-capital), and $160 million of retained earnings. What is the best estimate for the firm's value of equity, in millions? a. $429 b. $451 c. $475 d. $500 e. $525

d. $500

If D1 = $1.25, g (which is constant) = 4.7%, and P0 = $26.00, what is the stock's expected dividend yield for the coming year? a. 4.12% b. 4.34% c. 4.57% d. 4.81% e. 5.05%

d. 4.81%

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $40 Expected growth 7% 9% Expected return 10% 12% a. The two stocks could not be in equilibrium with the numbers given in the question. b. A's expected dividend is $0.50. c. B's expected dividend is $0.75. d. A's expected dividend is $0.75 and B's expected dividend is $1.20. e. The two stocks should have the same expected dividend.

d. A's expected dividend is $0.75 and B's expected dividend is $1.20.

Which of the following statements is CORRECT? a. If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease. b. A reduction in inventories held would have no effect on the current ratio. c. An increase in inventories would have no effect on the current ratio. d. If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. e. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.

d. If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase.

Which of the following statements is CORRECT? a. If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. b. If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president. c. Other things held constant, the higher a firm's expected future growth rate, the lower its P/E ratio is likely to be. d. The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA). e. If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this situation to continue, then its market/book ratio and MVA are both likely to be below average.

d. The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).

If a firm's expected growth rate increased then its required rate of return would a. decrease. b. fluctuate less than before. c. fluctuate more than before. d. possibly increase, possibly decrease, or possibly remain constant. e. increase.

d. possibly increase, possibly decrease, or possibly remain constant.

Heath and Logan Inc. forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions? Year: 1 2 3 Free cash flow: −$15 $10 $40 a. $315 b. $331 c. $348 d. $367 e. $386

e. $386

Connor Publishing's preferred stock pays a dividend of $1.00 per quarter, and it sells for $55.00 per share. What is its effective annual (not nominal) rate of return? a. 6.62% b. 6.82% c. 7.03% d. 7.25% e. 7.47%

e. 7.47%

Companies Heidee and Leaudy are virtually identical in that they are both profitable, and they have the same total assets (TA), Sales (S), return on assets (ROA), and profit margin (PM). However, Company Heidee has the higher debt ratio. Which of the following statements is CORRECT? a. Company Heidee has a lower operating income (EBIT) than Company LD. b. Company Heideehas a lower total assets turnover than Company Leaudy. c. Company Heideehas a lower equity multiplier than Company Leaudy. d. Company Heideehas a higher fixed assets turnover than Company Leaudy. e. Company Heideehas a higher ROE than Company Leaudy.

e. Company Heideehas a higher ROE than Company Leaudy.

A partnership

has roughly the same advantages and disadvantages as a sole proprietorship.

Securitization

is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security.

Additional funds needed (AFN) equation

• Basic idea: o Estimate new assets required o Subtract new spontaneous liabilities (i.e., accounts payable and accruals) o Subtract reinvested profit (i.e., net income minus dividends)

What three aspects of cash flows affect an investment's value?

(1)Amount of expected cash flows (bigger is better) (2)Timing of the cash flow stream (sooner is better) (3)Risk of the cash flows (less risk is better)

.) Working capital policy C S Answer: c MEDIUM . Which of the following statements is NOT CORRECT? a. Credit policy has an impact on working capital because it influences both sales and the time before receivables are collected. b. The cash budget is useful to help estimate future financing needs, especially the need for short-term working capital loans. c. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10 net 30 to net 60. d. Managing working capital is important because it influences financing decisions and the firm's profitability. e. A company may hold a relatively large amount of cash and marketable securities if it is uncertain about its volume of sales, profits, and cash flows during the coming year.

What are the five uses of FCF?

1. Pay interest on debt. 2. Pay back principal on debt. 3. Pay dividends. 4. Buy back stock. 5. Buy nonoperating assets (e.g., marketable securities, investments in other companies, etc.)

Hunter Manufacturing Inc.'s December 31, 2014 balance sheet showed total common equity of $2,050,000 and 100,000 shares of stock outstanding. During 2015, Hunter had $250,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/2015, assuming that Hunter neither issued nor retired any common stock during 2015?

12/31/2014 common equity $2,050,000 2015 net income $250,000 2015 dividends $100,000 2015 addition to retained earnings $150,000 12/31/2015 common equity $2,200,000 Shares outstanding 100,000 12/31/2015 BVPS $22.00

56. Which of the following statements is CORRECT? a. A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. b. No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are "free." c. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. d. If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC. e. The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.

Features of Corporate Taxes

A corporation can: deduct its interest expenses but not its dividend payments; carry back losses for two years, carry forward losses for 20 years.* exclude 70% of dividend income if it owns less than 20% of the company's stock *Losses in 2003 and 2004 can be carried back for five years.

Bostian, Inc. has total assets of $625,000. Its total debt outstanding is $185,000. The Board of Directors has directed the CFO to move towards a debt ratio of 55%. How much debt must the company add or subtract to achieve the target debt ratio? a. $158,750 b. $166,688 c. $175,022 d. $183,773 e. $192,962

A) $158,750

Lindley Corp.'s stock price at the end of last year was $33.50, and its book value per share was $25.00. What was its market/book ratio? a. 1.34 b. 1.41 c. 1.48 d. 1.55 e. 1.63

A) 1.34

Branch Corp.'s total assets at the end of last year were $315,000 and its net income after taxes was $22,750. What was its return on total assets? a. 7.22% b. 7.58% c. 7.96% d. 8.36% e. 8.78%

A) 7.22%

Which of the following assumptions is embodied in the AFN equation? a. Accounts payable and accruals are tied directly to sales. b. Common stock and long-term debt are tied directly to sales. c. Fixed assets, but not current assets, are tied directly to sales. d. Last year's total assets were not optimal for last year's sales. e. None of the firm's ratios will change.

A) Accounts payable and accruals are tied directly to sales

A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase? a. The company increases its dividend payout ratio. b. The company begins to pay employees monthly rather than weekly. c. The company's profit margin increases. d. The company decides to stop taking discounts on purchased materials. e. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity.

A) The company increases its dividend payout ratio

Which of the following statements is CORRECT? a. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. b. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management's historical performance is evaluated. c. The capital intensity ratio gives us an idea of the physical condition of the firm's fixed assets. d. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. e. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings.

A) The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales

The term "additional funds needed (AFN)" is generally defined as follows: a. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock to support operations. b. The amount of assets required per dollar of sales. c. The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth. d. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant. e. Funds that are obtained automatically from routine business transactions.

A) funds that a firm must raise externally from non-spontaneous sources, ie, by borrowing or by selling new stock to support operations

These are the simplified financial statements for Judd Enterprises. Income statement Current Projected Sales n/a 1,000 Costs n/a 700 Profit before tax n/a 300 Taxes n/a 90 Net income n/a 210 Dividends n/a 63 Balance sheets Current Projected Current assets 100 115 Net fixed assets 900 1,080 Current liabilities 70 81 Long-term debt 400 Common stock 300 Retained earnings 230

A. Refer to the Judd Enterprises financial statements. What is Judd's projected retained earnings under this plan? Retained earnings = old retained earnings + new net income - new dividends = 230 + 210 - 63 = 377 B. Refer to the Judd Enterprises financial statements. If Judd does not plan on issuing new stock or additional long-term debt, then what is the additional net financing needed for the projected year? Additional net financing = Projected assets - Projected liabilities and equity = 1,195 - (81 + 400 + 300 + (230 + 210 - 63)) = 37

Which of the following actions should Reece Windows take if it wants to reduce its cash conversion cycle? A. Take steps to reduce the DSO. B. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales. C. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock. D. Increase average inventory without increasing sales.

A. Take steps to reduce the DSO.

Which of the following statements is correct? A. The capital structure that minimizes a firm's WACC is also the capital structure that minimizes its stock price. B. The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. C. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. D.Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted tradeoff theory would suggest that firms should increase their use of debt.

A. The capital structure that minimizes a firm's WACC is also the capital structure that minimizes its stock price.

In the real world, dividends A. are usually more stable than earnings. B. fluctuate more widely than earnings. C. tend to be a lower percentage of earning for mature firms. D. are usually changed every year to reflect earnings changes, and these changes are randomly higher or lower, depending on whether earnings increased or decreased.

A. are usually more stable than earnings.

The major contribution of the Miller model is that it demonstrates that. A. personal taxes decrease the value of using corporate debt. B. Financial distress and agency costs reduce the value of using corporate debt. C. equity costs increase with financial leverage.

A. personal taxes decrease the value of using corporate debt.

The Additional Funds Needed (AFN) Equation

AFN equation forecasts the additional financing needed by the operating plan. Basic idea: Estimate new assets required Subtract new spontaneous liabilities (i.e., accounts payable and accruals) Subtract reinvested profit (i.e., net income minus dividends)

70. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings? a. 12.60% b. 13.10% c. 13.63% d. 14.17% e. 14.74%

ANS: A Bond yield 8.75% Risk premium 3.85% rs = rd + Risk premium 12.60%

37. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the percentage of debt in the target capital structure. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Reduce the percentage of debt in the target capital structure. e. Increase the dividend payout ratio for the upcoming year.

ANS: A Statement a is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.

66. Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72%

ANS: A rRF 5.00% RPM 6.00% b 1.05 rs = rRF + (RPM × b) 11.30%

54. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. b. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time. c. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value. e. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value.

ANS: B By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and too few in the data processing division. As a result, the company will become riskier overall, raising its cost of capital. Investors will discount the firm's cash flows at a higher rate, and the firm's value will fall. Therefore, statement b is true and the other statements are false.

64. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a. 8.72% b. 9.08% c. 9.44% d. 9.82% e. 10.22%

ANS: B Preferred stock price $97.50 Preferred dividend $8.50 Flotation cost 4.00% rp = Dp/(Pp(1 − F)) 9.08%

63. Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings and stock price move counter cyclically with J and other S&P companies. Both J and F estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT? a. J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical. b. If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs. c. Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F merged. d. Since J and F move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs. e. J should have the lower WACC because it is like most other companies, and investors like that fact.

ANS: B Statement b is true. The merged firm would have a beta that is a simple average of J's and F's betas, and that would result in a cost of equity that is an average of the two firms' costs of equity. Since they are financed only with equity, their WACCs could also be averaged to find the merged firm's WACC.

41. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept? a. A Division Y project with a 12% return. b. A Division X project with an 11% return. c. A Division X project with a 9% return. d. A Division Y project with an 11% return. e. A Division Y project with a 13% return.

ANS: B The correct answer is statement b. Division X should accept only projects with returns greater than 10%, while Division Y should accept only projects with returns greater than 14%. Only statement b meets this criterion.

68. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51%

ANS: C D1 $0.67 P0 $27.50 g 8.00% rs = D1/P0 + g 10.44%

45. Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become riskier over time, but its intrinsic value will be maximized.

ANS: C Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement c is correct.

43. Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. b. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. e. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.

ANS: C Statement c is correct. Here is the proof: rs = 5% + 4%(2.0) = 5% + 8% = 13%. Required return for risky projects = 13% + 3% = 16%. Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected.

60. Which of the following statements is CORRECT? a. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. b. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. c. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. d. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. e. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.

ANS: C Statement c is true⎯the WACC will increase if the firm raises more funds than can be supported by reinvested earnings.

40. When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. The expected rate of return on the market, rM. d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM).

ANS: D By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.

69. To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 11.10% b. 11.68% c. 12.30% d. 12.94% e. 13.59%

ANS: D D1 $1.45 P0 $22.50 g 6.50% rs = D1/P0 + g 12.94%

65. A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock? a. 7.81% b. 8.22% c. 8.65% d. 9.10% e. 9.56%

ANS: D Preferred stock price $92.50 Preferred dividend $8.00 Flotation cost 5.00% rp = Dp/(Pp(1 − F)) 9.10%

46. Which of the following statements is CORRECT? a. All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. b. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. c. Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. d. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. e. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.

ANS: D Statement d is true, because the after-tax cost of debt is rd(1 − T). So, if rd remains constant but T increases, rd(1 − T) will decline. The other statements are false.

62. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. b. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. c. Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. d. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital. e. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

ANS: D The fact that A's returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the project's beta versus the market and also with the firm's other assets to be relatively low, denoting a low risk and thus justifying a relatively low cost of capital. This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a "bet the company" project.

42. Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project C, which is of above-average risk and has a return of 11%. b. Project A, which is of average risk and has a return of 9%. c. None of the projects should be accepted. d. All of the projects should be accepted. e. Project B, which is of below-average risk and has a return of 8.5%.

ANS: E Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.

47. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. b. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. c. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock. d. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

ANS: E Statement e is true; interest payments on debt are tax deductible. The other statements are false.

67. You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from reinvested earnings? a. 9.67% b. 9.97% c. 10.28% d. 10.60% e. 10.93%

ANS: E rRF 4.10% RPM 5.25% b 1.30 rs = rRF + (RPM × b) 10.925%

17. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

ANS: F In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case.

34. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

ANS: F Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.

31. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

ANS: F None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the beta that investors are using, we are not totally sure of what rRF to use, and we don't know if the CAPM is truly correct.

33. Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.70)(0.50).

ANS: F The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer; hence, this statement is not true. It actually is just nonsense anyway!

23. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)."

ANS: F This statement is true only if the expected growth rate is zero. Here are some illustrative numbers that show that the statement is true if g = 0 but false otherwise.

24. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 − F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula.

ANS: T This statement is true. Here are some illustrative numbers to demonstrate this point.

27. If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

ANS: T True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms.

Proprietorship

Advantages:Ease of formation,Subject to few regulations, and No corporate income taxes Disadvantages:Limited life,Unlimited liability,Difficult to raise capital to support growth

Some countries have legal system with poor investor protection

Agency costs, such as perquisite consumption and wasteful acquisitions, are harder for investors to prevent. Low dividend payouts make more cash available for these activities.

Albrecht Inc. is a no-growth firm whose sales fluctuate seasonally, causing total assets to vary from $320,000 to $410,000, but fixed assets remain constant at $260,000. If the firm follows a maturity matching (or moderate) working capital financing policy, what is the most likely total of long-term debt plus equity capital? a. $260,642 b. $274,360 c. $288,800 d. $304,000 e. $320,000

An investor is considering starting a new business. The company would require $475,000 of assets, and it would be financed entirely with common stock. The investor will go forward only if she thinks the firm can provide a 13.5% return on the invested capital, which means that the firm must have an ROE of 13.5%. How much net income must be expected to warrant starting the business?

Assets = equity $475,000 Target ROE 13.5% Required net income $64,125

53. Which of the following statements is CORRECT? a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. c. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. d. Higher flotation costs tend to reduce the cost of equity capital. e. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.

59. Which of the following statements is CORRECT? a. If the calculated beta underestimates the firm's true investment risk⎯i.e., if the forward-looking beta that investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high. b. Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified. c. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required. d. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. e. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.

Hutchinson Corporation has zero debt—it is financed only with common equity. Its total assets are $410,000. The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio? a. $155,800 b. $164,000 c. $172,200 d. $180,810 e. $189,851

B) $164,000

Vang Corp.'s stock price at the end of last year was $33.50 and its earnings per share for the year were $2.30. What was its P/E ratio? a. 13.84 b. 14.57 c. 15.29 d. 16.06 e. 16.86

B) 14.57

Which of the following statements is CORRECT? a. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. b. Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be accounted for in the financial forecasting process. c. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. d. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases. The Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. e. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner.

B) Firms whose fixed assets are "lumpy" frequently have excess capacity, and this should be account for in the financial forecasting process

Which of the following is NOT a key element in strategic planning as it is described in the text? a. The statement of the corporation's scope. b. The statement of cash flows. c. The statement of corporate objectives. d. The corporation's strategies. e. The mission statement.

B) Statement of cash flows

Which of the following statements is CORRECT? a. A firm's corporate purpose states the general philosophy of the business and provides managers with specific operational objectives. b. Operating plans provide management with detailed implementation guidance, consistent with the corporate strategy, to help meet the corporate objectives. These operating plans can be developed for any time horizon, but many companies use a 5-year horizon. c. A firm's mission statement defines its lines of business and geographic area of operations. d. The corporate scope is a condensed version of the entire set of strategic plans. e. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy or strategies for achieving its goals. The statement of corporate strategies sets forth detailed plans rather than broad approaches for achieving a firm's goals.

B) operating plans provide management with detailed implementation guidance, consistent with the corporate strategy, to help meet the corporate objectives. These operating plans can be developed for any time horizon, but many companies use a 5-year horizon

Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio? A. Its access to the capital markets increases. B. Its R&D efforts pay off, and it now has more high-return investment opportunities. C. Its accounts receivable decrease due to a change in its credit policy. D. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages.

B. Its R&D efforts pay off, and it now has more high-return investment opportunities.

Which of the following will cause an increase in net working capital, other things held constant? A. A cash dividend is declared and paid. B. Merchandise is sold at a profit, but the sale is on credit. C. Long-term bonds are retired with the proceeds of a preferred stock issue. D. Cash is used to buy marketable securities.

B. Merchandise is sold at a profit, but the sale is on credit.

Which of the following statements is correct? A. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their accounts. B. Stock repurchases can be used by a firm that wants to increase its debt ratio. C. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities. D. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding.

B. Stock repurchases can be used by a firm that wants to increase its debt ratio.

Which of the following is NOT normally regarded as being a good reason to establish an ESOP? A. To enable the firm to borrow at a below-market interest rate. B. To make it easier to grant stock options to employees. C. To help prevent a hostile takeover. D. To help retain valued employees. E. To increase worker productivity.

B. To make it easier to grant stock options to employees.

Baltimore Baking is preparing its cash budget and expects to have sales of $30,000 in January, $35,000 in February, and $35,000 in March. If 20% of sales are for cash, 40% are credit sales paid in the month after the sale, and another 40% are credit sales paid 2 months after the sale, what are the expected cash receipts for March? a. $24,057 b. $26,730 c. $29,700 d. $33,000 e. $36,300

Below are the simplified current and projected financial statements for Decker Enterprises. All of Decker's assets are operating assets. All of Decker's current liabilities are operating liabilities. Income statement Current Projected Sales n/a 1,500 Costs n/a 1,050 Profit before tax n/a 450 Taxes n/a 135 Net income n/a 315 Dividends n/a 95 Balance sheets Current Projected Current assets 100 115 Net fixed assets 1,200 1,440 Current liabilities 70 81 Long-term debt 300 360 Common stock 500 500 Retained earnings 430 650

Based on the projections, will Decker will have a financing surplus or deficit? Financing deficit = additional net financing = projected assets - projected liabilities and equity If financing deficit < 0 then instead, financing surplus = -financing deficit. Financing deficit = 1,555 - (81 + 360 + 500 + 650) = -36 so financing surplus = 36.

Buchholz Corporation follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy. The firm's annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its tax rate is 40%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? a. 4.25% b. 4.73% c. 5.25% d. 5.78% e. 6.35%

What's the difference between business risk (operational leverage) and financial risk?

Business risk does not come from debt.

48. Which of the following statements is CORRECT? a. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. b. The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c. A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock. d. The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.

49. Which of the following statements is CORRECT? a. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. b. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. c. There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." d. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. e. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital.

57. Which of the following statements is CORRECT? a. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. b. Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. c. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. e. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.

58. Which of the following statements is CORRECT? a. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. b. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. d. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. e. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the risk-free rate, and the market risk premium⎯can be estimated with little error.

Northwest Lumber had a profit margin of 5.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE? a. 12.79% b. 13.47% c. 14.18% d. 14.88% e. 15.63%

C) 14.18%

Chambliss Corp.'s total assets at the end of last year were $305,000 and its EBIT was 62,500. What was its basic earning power (BEP)? a. 18.49% b. 19.47% c. 20.49% d. 21.52% e. 22.59%

C) 20.49%

Rappaport Corp.'s sales last year were $320,000, and its net income after taxes was $23,000. What was its profit margin on sales? a. 6.49% b. 6.83% c. 7.19% d. 7.55% e. 7.92%

C) 7.19%

Which of the following statements is CORRECT? a. The AFN equation for forecasting funds requirements requires only a forecast of the firm's balance sheet. Although a forecasted income statement may help clarify the results, income statement data are not essential because funds needed relate only to the balance sheet. b. Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast. c. A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed. d. If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method. e. Any forecast of financial requirements involves determining how much money the firm will need, and this need is determined by adding together increases in assets and spontaneous liabilities and then subtracting operating income.

C) A negative AFN indicates that retained earnings and spontaneous liabilities are far more than sufficient to finance the additional assets needed

Which of the following statements is CORRECT? a. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets. Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets. b. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth. c. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them. d. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN. e. Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase.

C) Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock. Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them

Spontaneous funds are generally defined as follows: a. A forecasting approach in which the forecasted percentage of sales for each item is held constant. b. Funds that a firm must raise externally through short-term or long-term borrowing and/or by selling new common or preferred stock. c. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes. d. The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm's growth. e. Assets required per dollar of sales.

C) funds that arise out of normal business operations from its suppliers, employees, and the government, and they include immediate increases in accounts payable, accrued wages, and accrued taxes

A firm's new president wants to strengthen the company's financial position. Which of the following actions would make it financially stronger? a. Increase inventories while holding sales constant. b. Increase accounts receivable while holding sales constant. c. Increase EBIT while holding sales constant. d. Increase accounts payable while holding sales constant. e. Increase notes payable while holding sales constant.

C) increase EBIT while holding sales constant

Which of the following statements is CORRECT? A. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. B. The capital structure that minimizes the required return on equity also maximizes the stock price. C. The capital structure that minimizes the WACC also maximizes the price per share of common stock. D. The capital structure that gives the firm the best credit rating also maximizes the stock price.

C. The capital structure that minimizes the WACC also maximizes the price per share of common stock.

Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm's operations. A. Sales price variability. B. The extent to which operating cots are fixed. C. The extent to which interest rates on the firm's debt fluctuate. D. Input price variability.

C. The extent to which interest rates on the firm's debt fluctuate.

Myron Gordon and John Lintner believe that they required return on equity increases as the dividend payout ratio is decreased. Their argument is based on the assumption that A. investors require that the dividend yield and capital gains yield equal constant. B. capital gains are taxed at a higher rate than dividends. C. investors view dividends as being less risky than potential future capital gains. D. investors value a dollar of expected capital gains more highly than a dollar of expected dividends because of the lower tax rate on capital gains.

C. investors view dividends as being less risky than potential future capital gains.

A lockbox plan is A. used to identify inventory safety stocks. B. used to slow down the collection of checks our firm writes. C. used to speed up the collection of checks received. D. used primarily by firms where currency is used frequently in transactions, such as fast food restaurants, and less frequently by firms that receive payments as checks.

C. used to speed up the collection of checks received.

Liquidity Ratios

Can the company meet its short-term obligations using the resources it currently has on hand?

WACC is affected by:

Capital structure (the firm's relative use of debt and equity as sources of financing) Interest rates Risk of the firm Investors' overall attitude toward risk

Other Assets Can be Securitized

Car loans Student loans Credit card balances

What two factors lead to exchange rate fluctuations?

Changes in relative inflation will lead to changes in exchange rates. An increase in country risk will also cause that country's currency to fall.

Potential Problems and Limitations of Ratio Analysis

Comparison with industry averages is difficult if the firm operates many different divisions. Seasonal factors can distort ratios. Window dressing techniques can make statements and ratios look better. Different accounting and operating practices can distort comparisons.

Is maximizing stock price good?(2)

Consumer welfare is higher in capitalist free market economies than in communist or socialist economies. Fortune lists the most admired firms. In addition to high stock returns, these firms have: high quality from customers' view employees who like working there

What do we call the price, or cost, of equity capital?

Cost of equity = Required return = dividend yield + capital gain

What international conditions affect the cost of money?

Country risk. Depends on the country's economic, political, and social environment. Exchange rate risk. Non-dollar denominated investment's value depends on what happens to exchange rate. Exchange rates affected by: International trade deficits/surpluses Relative inflation and interest rates Country risk

Swinnerton Clothing Company's balance sheet showed total current assets of $2,250, all of which were required in operations. Its current liabilities consisted of $575 of accounts payable, $300 of 6% short-term notes payable to the bank, and $145 of accrued wages and taxes. What was its net operating working capital that was financed by investors?

Current assets $2,250 Accounts payable $575 Accrued wages and taxes $145 Net operating working capital $1,530

Alternatives to Drawing on LOC

Cut dividends. Add long-term debt. Issue common stock. Cut back on growth in operating plan. Improve operating plan. Financial planning is an iterative process—if plan isn't acceptable, then the company can make changes.

51. Which of the following statements is CORRECT? a. The after-tax cost of debt usually exceeds the after-tax cost of equity. b. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. c. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. d. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. e. The WACC is calculated using before-tax costs for all components.

Nikko Corp.'s total common equity at the end of last year was $305,000 and its net income after taxes was $60,000. What was its ROE? a. 16.87% b. 17.75% c. 18.69% d. 19.67% e. 20.66%

D) 19.67%

Arshadi Corp.'s sales last year were $52,000, and its total assets were $22,000. What was its total assets turnover ratio (TATO)? a. 2.03 b. 2.13 c. 2.25 d. 2.36 e. 2.48

D) 2.36

Which of the following would, generally, indicate an improvement in a company's financial position, holding other things constant? a. The total assets turnover decreases. b. The TIE declines. c. The DSO increases. d. The EBITDA coverage ratio increases. e. The current and quick ratios both decline.

D) The EBITDA coverage ratio

The capital intensity ratio is generally defined as follows: a. The percentage of liabilities that increase spontaneously as a percentage of sales. b. The ratio of sales to current assets. c. The ratio of current assets to sales. d. The amount of assets required per dollar of sales, or A0*/S0. e. Sales divided by total assets, i.e., the total assets turnover ratio.

D) The amount of assets required per dollar of sales or Ao*/So

Which of the following is NOT one of the steps taken in the financial planning process? a. Monitor operations after implementing the plan to spot any deviations and then take corrective actions. b. Determine the amount of capital that will be needed to support the plan. c. Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. d. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors. e. Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised.

D) consult with key competitors about the optimal set of prices to charge, ie, the prices that will maximize profits for our firms and its competitors

Frost Co. has the following data. Assuming a 365-day year, what is the firm's CCC? Annual sales = $45,000 Annual COGS = $31,500 Inventory = $4,000 Accounts receivable = $2,000 Accounts payable = $2,400 A. 25 days B. 28 days C. 31 days D. 35 days

D. 35 days

Other things held constant, which of the following events is most likely to encourage a firm to increase the amount of debt in its capital structure? A. The costs that would be incurred in the event of bankruptcy increase. B. Management believes that the firm's stock has become overvalued. C. Its degree of operating leverage increases. D. The corporate tax rate increases.

D. The corporate tax rate increases.

Firms generally choose finance temporarily current operating assets with short-term debt because A. short-term interest rates have traditionally been more stable than long-term interest rates. B. short-term interest rates have traditionally been more stable than long-term interest rates. C. the yield curve is normally downward sloping. D. matching the maturities of assets and liabilities reduce risk under some circumstances, and also because short-term debt is often less expensive than long-term capital.

D. matching the maturities of assets and liabilities reduce risk under some circumstances, and also because short-term debt is often less expensive than long-term capital.

Data on Liu Inc. for the most recent year are shown below, along with the inventory conversion period (ICP) of the firms against which it benchmarks. The firm's new CFO believes that the company could reduce its inventory enough to reduce its ICP to the benchmarks' average. If this were done, by how much would inventories decline? Use a 365-day year. Cost of goods sold = $85,000 Inventory = $20,000 Inventory conversion period (ICP) = 85.88 Benchmark inventory conversion period (ICP) = 38.00 a. $ 7,316 b. $ 8,129 c. $ 9,032 d. $10,036 e. $11,151

Data on Mertz Co. for the most recent year are shown below, along with the payables deferral period (PDP) for the firms against which it benchmarks. The firm's new CFO believes that the company could delay payments enough to increase its PDP to the benchmarks' average. If this were done, by how much would payables increase? Use a 365-day year. Cost of goods sold = $75,000 Payables = $5,000 Payables deferral period (PDP) = 24.33 Benchmark payables deferral period = 30.00 a. $ 764 b. $ 849 c. $ 943 d. $1,048 e. $1,164

Data on Nathan Enterprises for the most recent year are shown below, along with the days sales outstanding of the firms against which it benchmarks. The firm's new CFO believes that the company could reduce its receivables enough to reduce its DSO to the benchmarks' average. If this were done, by how much would receivables decline? Use a 365-day year. Sales $110,000 Accounts receivable $16,000 Days sales outstanding (DSO) 53.09 Benchmark days sales outstanding (DSO) 20.00 a. $ 8,078 b. $ 8,975 c. $ 9,973 d. $10,970 e. $12,067

During the coming year, Gold & Gold wants to increase its free cash flow by $180 million, which should result in a higher EVA and stock price. The CFO has made these projections for the upcoming year: • EBIT is projected to equal $850 million. • Gross capital expenditures are expected to total to $360 million versus depreciation of $120 million, so its net capital expenditures should total $240 million. • The tax rate is 40%. • There will be no changes in cash or marketable securities, nor will there be any changes in notes payable or accruals. What increase in net working capital (in millions of dollars) would enable the firm to meet its target increase in FCF? a. $ 72 b. $ 90 c. $108 d. $130 e. $156

38. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The flotation costs associated with issuing new common stock increase. b. The company's beta increases. c. Expected inflation increases. d. The flotation costs associated with issuing preferred stock increase. e. The market risk premium declines.

55. Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. b. After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. c. Careco/Audaco's WACC, as a result of the merger, would be 10%. d. After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

E) $64125

F. Marston, Inc. has developed a forecasting model to estimate its AFN for the upcoming year. All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)? a. A switch to a just-in-time inventory system and outsourcing production. b. The company reduces its dividend payout ratio. c. The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35. d. The company discovers that it has excess capacity in its fixed assets. e. A sharp increase in its forecasted sales.

E) A sharp increase in forecasted sales

A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio? a. Use cash to increase inventory holdings. b. Reduce the company's days' sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment. c. Use cash to repurchase some of the company's own stock. d. Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year. e. Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash.

E) Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash

Which of the following statements is CORRECT? a. If a firm's assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm's AFN to be negative. b. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm's actual AFN must, mathematically, exceed the previously calculated AFN. c. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio. d. Dividend policy does not affect the requirement for external funds based on the AFN equation. e. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero.

E) The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero

Considered alone, which of the following would increase a company's current ratio? a. An increase in accounts payable. b. An increase in net fixed assets. c. An increase in accrued liabilities. d. An increase in notes payable. e. An increase in accounts receivable.

E) an increase in accounts receivable

Which of the following is NOT normally regarded as being a barrier to hostile takeovers? A. Targeted share repurchases. B. Shareholder rights provisions. C. Restricted voting rights. D. Poison pills. E. Abnormally high executive compensation.

E. Abnormally high executive compensation.

Jessie's Bobcat Rentals' operations provided a negative net cash flow last year, yet the cash shown on its balance sheet increased. Which of the following statements could explain the increase in cash, assuming the company's financial statements were prepared under generally accepted accounting principles?

E. The company sold some of its fixed assets.

Olivia Hardison, CFO of Impact United Athletic Designs, plans to have the company issue $500 million of new common stock and use the proceeds to pay off some of its outstanding bonds. Assume that the company, which does not pay any dividends, takes this action, and that total assets, operating income (EBIT), and its tax rate all remain constant. Which of the following would occur?

E. The company's net income would increase.

Stewart Inc.'s latest EPS was $3.50, its book value per share was $22.75, it had 215,000 shares outstanding, and its debt-to-assets ratio was 46%. How much debt was outstanding?XXX

EPS $3.50 BVPS $22.75 Shares outstanding 215,000 Debt ratio 46.0% Total equity $4,891,250/1-.46 Total assets $9,057,870 Total debt $4,166,620

Is maximizing stock price good for society, employees, and customers?(1)

Employment growth is higher in firms that try to maximize stock price. On average, employment goes up in: firms that make managers into owners (such as LBO firms) and firms that were owned by the government but that have been sold to private investors

11. For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm.

12. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

13. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

14. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

15. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired.

25. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC).

29. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

30. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice.

4. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC.

6. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

8. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

What is free cash flow (FCF)? Why is it important?

FCF is the amount of cash available from operations for distribution to all investors (including stockholders and debtholders) after making the necessary investments to support operations. A company's value depends on the amount of FCF it can generate.

True/False An informal line of credit and a revolving credit agreement are similar except that the line of credit creates a legal obligation for the bank and thus is a more reliable source of funds for the borrower.

False

True/False The CEO of D'Amico Motors has been granted some stock options that have provisions similar to most other executive stock options. If D'Amico's stock under-performs the market, these options will necessarily be worthless.

False

True/False Two important issues in corporate governance are (1) the rules that cover the board's ability to fire the CEO and (2) the rules that cover the CEO's ability to remove members of the board.

False

Famous Farm's DSO is 50 days (on a 365-day basis), accounts receivable are $100 million, and its balance sheet shows inventory of $125 million. What is the inventory turnover ratio? a. 4.73 b. 5.26 c. 5.84 d. 6.42 e. 7.07

What economic conditions affect the cost of money?

Federal Reserve policies Budget deficits/surpluses Level of business activity (recession or boom) International trade deficits/surpluses

What's the "residual distribution model"?

Find the reinvested earnings needed for the capital budget, pay out any leftover earnings (the residual) as either dividends or stock repurchases, and this policy minimizes flotation and equity signaling costs, hence minimizes the WACC. Also, only works for young companies.

Fireside Inc. has the following data. What is the firm's cash conversion cycle? Inventory conversion period = 38 days Average collection period = 19 days Payables deferral period = 20 days a. 33 days b. 37 days c. 41 days d. 45 days e. 49 days

Firms generally choose to finance temporary current operating assets with short-term debt because a. short-term interest rates have traditionally been more stable than long-term interest rates. b. a firm that borrows heavily on a long-term basis is more apt to be unable to repay the debt than a firm that borrows short term. c. the yield curve is normally downward sloping. d. short-term debt has a higher cost than equity capital. e. matching the maturities of assets and liabilities reduces risk under some circumstances, and also because short-term debt is often less expensive than long-term capital.

Financial Planning Process

Forecast financial statements under alternative operating plans. Forecast the free cash flows to determine the estimated intrinsic stock price. Determine amount of financing needed to support the plan.

Forecasting Operating Items

Forecast sales to grow at chosen growth rates. Forecast many items as a percentage of sales: cash, accounts receivable, inventories, fixed assets, costs (excl. depr.). Forecast depreciation as a percent of fixed assets.

Forecasted Financial Statements: The Basic Approach

Forecast the operating items (e.g., sales, costs, inventory, etc.). Choose a preliminary financial policy and use it to forecast the financial items (e.g., long-term debt, interest expense, etc.). Identify any financing surplus or deficit and eliminate it. Repeat until satisfied that the plan is achievable and is the best possible.

Free Cash Flows (FCF)

Free cash flows are the cash flows that are available (or free) for distribution to all investors (stockholders and creditors). FCF = sales revenues - operating costs - operating taxes - required investments in operating capital.

Frosty Corporation has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle? Annual sales = $45,000 Annual cost of goods sold = $31,500 Inventory = $4,000 Accounts receivable = $2,000 Accounts payable = $2,400 a. 25 days b. 28 days c. 31 days d. 35 days e. 38 days

Asset Management Ratios

How efficiently does the firm use its assets? How much does the firm have tied up in assets for each dollar of sales?

Corporate finance provides the skills managers need to

Identify and select the corporate strategies and individual projects that add value to their firm. Forecast the funding requirements of their company, and devise strategies for acquiring those funds.

Variations on the Percent of Sales

In some situations, it might not be appropriate to model operating ratios as a percent of sales: Economies of scale Nonlinearity Lumpy assets acquisitions.

What determines a firm's fundamental, or intrinsic, value?

Intrinsic value is the sum of all the future expected free cash flows when converted into today's dollars

Ratios are used by

Lenders to determine creditworthiness Stockholders to estimate future cash flows and risk Managers to identify areas of weakness and strength

Market Value Added (MVA)

MVA = Market Value of the Firm - Book Value of the Firm Market Value = (# shares of stock)(price per share) + Value of debt Book Value = Total common equity + Value of debt If the market value of debt is close to the book value of debt, then MVA is: MVA = Market value of equity - book value of equity

Mark's Manufacturing's average age of accounts receivable is 45 days, the average age of accounts payable is 40 days, and the average age of inventory is 69 days. Assuming a 365-day year, what is the length of its cash conversion cycle? a. 63 days b. 67 days c. 70 days d. 74 days e. 78 days

Market Value Ratios

Market value ratios incorporate the: High current levels of earnings and cash flow increase market value ratios High expected growth in earnings and cash flow increases market value ratios High risk of expected growth in earnings and cash flow decreases market value ratios

Marshall Inc. recently hired your consulting firm to improve the company's performance. It has been highly profitable but has been experiencing cash shortages due to its high growth rate. As one part of your analysis, you want to determine the firm's cash conversion cycle. Using the following information and a 365-day year, what is the firm's present cash conversion cycle? Average inventory = $75,000 Annual sales = $600,000 Annual cost of goods sold = $360,000 Average accounts receivable = $160,000 Average accounts payable = $25,000 a. 120.6 days b. 126.9 days c. 133.6 days d. 140.6 days e. 148.0 days

Monar Inc.'s CFO would like to decrease its cash conversion cycle by 10 days (based on a 365 day year). The company carries average inventory of $750,000. Its annual sales are $10 million, its cost of goods sold is 75% of annual sales, and its average collection period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays on time. The CFO believes he can reduce the average inventory to $647,260 with no effect on sales. By how much must the firm also reduce its accounts receivable to meet its goal in the reduction of the cash conversion cycle? a. $123,630 b. $130,137 c. $136,986 d. $143,836 e. $151,027

Tibbs Inc. had the following data for the year ending 12/31/2015: Net income = $300; Net operating profit after taxes (NOPAT) = $400; Total assets = $2,500; Short-term investments = $200; Stockholders' equity = $1,800; Total debt = $700; and Total operating capital = $2,300. What was its return on invested capital (ROIC)?

NOPAT $400 Total operating capital $2,300 ROIC = NOPAT/Total operating capital ROIC = $400/$2,300 ROIC = 17.39%

JBS Inc. recently reported net income of $4,750 and depreciation of $885. How much was its net cash flow, assuming it had no amortization expense and sold none of its fixed assets?

Net income $4,750.00 Depreciation $885.00 NCF $5,635.00

Ratios facilitate comparison of

One company over time One company versus other companies

AFN (Additional Funds Needed) Equation: Key Assumptions

Operating at full capacity in 2015. Sales are expected to increase by 10%. Asset-to-sales ratios remain the same. Spontaneous-liabilities-to-sales ratio remains the same. 2015 profit margin and payout ratio will be maintained

Other things held constant, which of the following would tend to reduce the cash conversion cycle? a. Place larger orders for raw materials to take advantage of price breaks. b. Take all discounts that are offered. c. Continue to take all discounts that are offered and pay on the net date. d. Offer longer payment terms to customers. e. Carry a constant amount of receivables as sales decline

Pascarella Inc. is revising its payables policy. It has annual sales of $50,735,000, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000. The firm's cost of goods sold is 85% of sales. The company makes all purchases on credit and has always paid on the 30th day. However, it now plans to take full advantage of trade credit and to pay its suppliers on the 40th day. The CFO also believes that sales can be maintained at the existing level but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-day year? a. -26.6 days b. -29.5 days c. -32.8 days d. -36.4 days e. -40.5 days

Northwest Lumber had a profit margin of 5.25%, a total assets turnover of 1.5, and an equity multiplier of 1.8. What was the firm's ROE?

Profit margin 5.25% TATO 1.50 Equity multiplier 1.80 ROE 14.18%

Comparison

Profitability ratios lower because of lower operating profits and higher interest expense. Lower asset management ratios due to high levels of receivables, inventory, and fixed assets. Higher leverage than industry.

Features of Corporate Taxation

Progressive rate up until $18.3 million taxable income. Below $18.3 million, the marginal rate is not equal to the average rate. Above $18.3 million, the marginal rate and the average rate are 35%. Dividends are double taxed

Initial Public Offering (IPO) of Stock

Raises cash, Allows founders and pre-IPO investors to "harvest" some of their wealth

What's the difference between relaxed, restrictive, and moderate policy?

Relaxed holds a lot of cash, receivables, and inventories relative to sales, high level of assets, low total assets turnover ratio, low ROE. Restrictive current assets minimized, firm's policy is tight or lean and mean, exposed firm to risk. Moderate fall in between

Alternatives to Paying Special Dividend

Repurchase stock Repay debt Purchase marketable securities

Definitions of Variables in AFN

S0: Most recent sales. g: Growth rate in sales. S1: Projected sales. S: Increase in sales = g(S0). A0*: Assets required to support sales. L0*: Spontaneous liabilities. A0*/S0: Capital intensity ratio. L0*/S0: Spontaneous liabilities ratio. M: Profit margin (Net income/Sales) POR: Payout ratio (Dividends/Net income)

Companies generate income from their "regular" operations and from other sources like interest earned on the securities they hold, which is called non-operating income. Lindley Textiles recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,000 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was Lindley's operating income, or EBIT?

Sales $12,500 Operating costs excluding depr'n $7,250 Depreciation $1,000 Operating income (EBIT) $4,250

Last year National Aeronautics had a FA/Sales ratio of 40%, comprised of $250 million of sales and $100 million of fixed assets. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set?XXX

Sales $250 Fixed assets $100 % of capacity utilized 75% Sales at full capacity = Actual sales/% of capacity used = $333.33 Target FA/Sales ratio = Full capacity FA/Sales = FA Capacity sales = 30% .75 X .4=.3

Last year Vaughn Corp. had sales of $315,000 and a net income of $17,832, and its year-end assets were $210,000. The firm's total-debt-to-total-assets ratio was 42.5%. Based on the DuPont equation, what was Vaughn's ROE?

Sales $315,000 Assets $210,000 Net income $17,832 Debt ratio 42.5% Debt $89,250 Equity $120,750 Profit margin 5.66% TATO 1.50 Equity multiplier 1.74 ROE 14.77%

Rappaport Corp.'s sales last year were $320,000, and its net income after taxes was $23,000. What was its profit margin on sales?

Sales $320,000 Net income $23,000 Profit margin 7.19%

Last year Baron Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity last year. In millions, by how much could Baron's sales increase before it is required to increase its fixed assets?

Sales $350 Fixed assets (not used in calculations) $270 % of capacity utilized 65% Sales at full capacity = Actual sales/% of capacity used = $538.46 Additional sales without adding FA = Full capacity sales − Actual sales = $188.46

Orono Corp.'s sales last year were $435,000, its operating costs were $362,500, and its interest charges were $12,500. What was the firm's times interest earned (TIE) ratio?

Sales $435,000 Operating costs 362,500 Operating income (EBIT) 72,500 Interest charges $ 12,500 TIE ratio 5.80

Arshadi Corp.'s sales last year were $52,000, and its total assets were $22,000. What was its total assets turnover ratio (TATO)?

Sales $52,000 Total assets $22,000 TATO 2.36

What actions reduce agency cost of debt?

Securing the loan with the company's assets, placing restrictive covenants in debt agreements. The borrower must: maintain profitability ratios and retained earnings at a certain level before making any distributions to shareholders, maintain debt ratios at specified levels, and not issue more debt.

Tucker Electronic System's current balance sheet shows total common equity of $3,125,000. The company has 125,000 shares of stock outstanding, and they sell at a price of $52.50 per share. By how much do the firm's market and book values per share differ?

Shares outstanding 125,000 Price per share $52.50 Total book common equity $3,125,000 Book value per share $25.00 Difference between book and market values $27.50

Shulman Inc. has the following data, in thousands. Assuming a 365-day year, what is the firm's cash conversion cycle? Annual sales = $45,000 Annual cost of goods sold = $30,000 Inventory = $4,500 Accounts receivable = $1,800 Accounts payable = $2,500 a. 28 days b. 32 days c. 35 days d. 39 days e. 43 days

52. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity. a. The WACC is calculated on a before-tax basis. b. The WACC exceeds the cost of equity. c. The cost of equity is always equal to or greater than the cost of debt. d. The cost of reinvested earnings typically exceeds the cost of new common stock. e. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet.

Statement c is true, because equity is more risky than debt and hence investors require a higher return on equity. Also, interest on debt is deductible, and this further reduces the cost of debt. The other statements are false.

1. "Capital" is sometimes defined as funds supplied to a firm by investors.

10. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

16. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

18. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.

19. The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle.

2. The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets.

20. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

21. When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs.

22. When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

26. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

28. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 − T).

3. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

32. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.

35. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt.

9. The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm.

What do we call the price, or cost, of debt capital?

The interest rate

Intrinsic Value

The intrinsic value is the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors.

What should be management's primary objective?

The primary objective should be shareholder wealth maximization, which translates to maximizing the fundamental stock price.

Qualitative Factors

There is greater risk if: revenues tied to a single customer revenues tied to a single product reliance on a single supplier? High percentage of business is generated overseas? What is the competitive situation? What products are in the pipeline? What are the legal and regulatory issues?

Thornton Universal Sales's cost of goods sold (COGS) average $2,000,000 per month, and it keeps inventory equal to 50% of its monthly COGS on hand at all times. Using a 365-day year, what is its inventory conversion period? a. 11.7 days b. 13.0 days c. 14.4 days d. 15.2 days e. 16.7 days

Hutchinson Corporation has zero debt⎯it is financed only with common equity. Its total assets are $410,000. The new CFO wants to employ enough debt to bring the debt/assets ratio to 40%, using the proceeds from the borrowing to buy back common stock at its book value. How much must the firm borrow to achieve the target debt ratio?

Total assets $410,000 Target debt ratio 40% Debt to achieve target ratio = amount borrowed $164,000

True/False Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.

True

True/False The less sure a firm is about an idea, the more likely they will go to equity rather than their shareholders.

True

True/False If you're a highly variable cost business, you can essentially pack up shop whenever

True. But, if a highly variable cost business goes down, it goes down worse than if they had a lot of fixed and/or operating costs.

What is the weighted average cost of capital (WACC)?

WACC is the average rate of return required by all of the company's investors.

Economic Value Added (EVA)

WACC is weighted average cost of capital EVA = NOPAT- (WACC)(Capital)

Whaley & Whaley has the following data. What is the firm's cash conversion cycle? Inventory conversion period = 41 days Average collection period = 31 days Payables deferral period = 38 days a. 31 days b. 34 days c. 37 days d. 41 days e. 45 days

Profitability Ratios

What is the company's rate of return on: Sales? Assets?

Which of the following actions should Reece Windows take if it wants to reduce its cash conversion cycle? a. Take steps to reduce the DSO. b. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales. c. Sell common stock to retire long-term bonds. d. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock. e. Increase average inventory without increasing sales

Which of the following actions would be likely to shorten the cash conversion cycle? a. Change the credit terms offered to customers from 3/10 net 30 to 1/10 net 50. b. Begin to take discounts on inventory purchases; we buy on terms of 2/10 net 30. c. Adopt a new manufacturing process that saves some labor costs but slows down the conversion of raw materials to finished goods from 10 days to 20 days. d. Change the credit terms offered to customers from 2/10 net 30 to 1/10 net 60. e. Adopt a new manufacturing process that speeds up the conversion of raw materials to finished goods from 20 days to 10 days.

Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket? a. Depreciation. b. Cumulative cash. c. Repurchases of common stock. d. Payment for plant construction. e. Payments lags.

Which of the following items should a company report directly in its monthly cash budget? a. Cash proceeds from selling one of its divisions. b. Accrued interest on zero coupon bonds that it issued. c. New shares issued in a stock split. d. New shares issued in a stock dividend. e. Its monthly depreciation expense.

Which of the following statements concerning the cash budget is CORRECT? a. Cash budgets do not include financial items such as interest and dividend payments. b. Cash budgets do not include cash inflows from long-term sources such as the issuance of bonds. c. Changes that affect the DSO do not affect the cash budget. d. Capital budgeting decisions have no effect on the cash budget until projects go into operation and start producing revenues. e. Depreciation expense is not explicitly included, but depreciation's effects are reflected in the estimated tax payments.

Which of the following statements is CORRECT? a. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive strategy because of the inherent risks associated with using short-term financing. b. If a company follows a policy of "matching maturities," this means that it matches its use of common stock with its use of long-term debt as opposed to short-term debt. c. Net working capital is defined as current assets minus the sum of payables and accruals, and any decrease in the current ratio automatically indicates that net working capital has decreased. d. If a company follows a policy of "matching maturities," this means that it matches its use of short-term debt with its use of long-term debt. e. Net working capital is defined as current assets minus the sum of payables and accruals, and any increase in the current ratio automatically indicates that net working capital has increased.

Which of the following statements is CORRECT? a. Conservative firms generally use no short-term debt and thus have zero current liabilities. b. A short-term loan can usually be obtained more quickly than a long-term loan, but the cost of short-term debt is normally higher than that of long-term debt. c. If a firm that can borrow from its bank at a 6% interest rate buys materials on terms of 2/10 net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet. d. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it will not have an adverse financial impact on your firm if the customer periodically pays off its entire balance. e. Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but using short-term debt would probably increase the firm's risk.

Which of the following statements is CORRECT? a. If cash inflows from collections occur in equal daily amounts but most payments must be made on the 10th of each month, then a regular monthly cash budget will be misleading. The problem can be corrected by using a daily cash budget. b. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales. c. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10 net 30 to net 60. d. If a firm sells on terms of net 90, and if its sales are highly seasonal, with 80% of its sales in September, then its DSO as it is typically calculated (with sales per day = Sales for past 12 months/365) would probably be lower in October than in August. e. Depreciation is included in the estimate of cash flows (Cash flow = Net income = Depreciation); hence depreciation is set forth on a separate line in the cash budget.

Which of the following statements is CORRECT? a. The cash budget and the capital budget are developed separately, and although they are both important to the firm, one does not affect the other. b. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget. c. The target cash balance should be set such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it should be changed to reflect long-term changes in the firm's operations. d. The typical cash budget reflects interest paid on loans as well as income from the investment of surplus cash. These numbers, as well as other items on the cash budget, are expected values; hence, actual results might vary from the budgeted amounts. e. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual

Which of the following will cause an increase in net working capital, other things held constant? a. A cash dividend is declared and paid. b. Merchandise is sold at a profit, but the sale is on credit. c. Long-term bonds are retired with the proceeds of a preferred stock issue. d. Missing inventory is written off against retained earnings. e. Cash is used to buy marketable securities

Whitson Co. is looking for ways to shorten its cash conversion cycle. It has annual sales of $36,500,000, or $100,000 a day on a 365-day basis. The firm's cost of goods sold is 75% of sales. On average, the company has $9,000,000 in inventory and $8,000,000 in accounts receivable. Its CFO has proposed new policies that would result in a 20% reduction in both average inventories and accounts receivable. She also anticipates that these policies would reduce sales by 10%, while the payables deferral period would remain unchanged at 35 days. What effect would these policies have on the company's cash conversion cycle? Round to the nearest whole day. a. -26 days b. -22 days c. -18 days d. -14 days e. -11 days

Should firms behave ethically? Do firms have any responsibilities to society at large?

YES! YES! Shareholders are also members of society.

. The Jameson Company just paid a dividend of $0.75 per share, and that dividend is expected to grow at a constant rate of 5.50% per year in the future. The company's beta is 1.15, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is Jameson's current stock price, P0? a. $18.62 b. $19.08 c. $19.56 d. $20.05 e. $20.55

a. $18.62

The last dividend paid by Wilden Corporation was $1.55. The dividend growth rate is expected to be constant at 1.5% for 2 years, after which dividends are expected to grow at a rate of 8.0% forever. The firm's required return (rs) is 12.0%. What is the best estimate of the current stock price? a. $37.05 b. $38.16 c. $39.30 d. $40.48 e. $41.70

a. $37.05

Connolly Co.'s expected year-end dividend is D1 = $1.60, its required return is rs = 11.00%, its dividend yield is 6.00%, and its growth rate is expected to be constant in the future. What is Connolly's expected stock price in 7 years, i.e., what is ? a. $37.52 b. $39.40 c. $41.37 d. $43.44 e. $45.61

a. $37.52

Gere Furniture forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5% thereafter. If the weighted average cost of capital is 10% and the cost of equity is 15%, what is the horizon value, in millions at t = 3? a. $840 b. $882 c. $926 d. $972 e. $1,021

a. $840

Which of the following statements is CORRECT? a. An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin. b. The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio. c. If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE. d. An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio. e. An increase in the DSO, other things held constant, could be expected to increase the ROE.

a. An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.

Companies A and C each reported the same earnings per share (EPS), but Company A's stock trades at a higher price. Which of the following statements is CORRECT? a. Company A trades at a higher P/E ratio. b. Company A probably has fewer growth opportunities. c. Company A is probably judged by investors to be riskier. d. Company A must have a higher market-to-book ratio. e. Company A must pay a lower dividend.

a. Company A trades at a higher P/E ratio.

Companies Heidee and Leaudy have the same tax rate, sales, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company Heidee has a lower times interest earned (TIE) ratio. b. Company Heidee has a lower equity multiplier. c. Company Heidee has more net income. d. Company Heidee pays more in taxes. e. Company Heidee has a lower ROE.

a. Company Heidee has a lower times interest earned (TIE) ratio.

Which of the following statements is CORRECT? a. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline. b. If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength. c. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding (DSO) will increase. d. There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things. e. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.

a. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT? a. If one stock has a higher dividend yield, it must also have a lower dividend growth rate. b. If one stock has a higher dividend yield, it must also have a higher dividend growth rate. c. The two stocks must have the same dividend growth rate. d. The two stocks must have the same dividend yield. e. The two stocks must have the same dividend per share.

a. If one stock has a higher dividend yield, it must also have a lower dividend growth rate.

Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company Heidee has a higher debt ratio. Which of the following statements is CORRECT? a. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE. b. Given this information, Leaudy must have the higher ROE. c. Company Leaudy has a higher basic earning power ratio (BEP). d. Company Heidee has a higher basic earning power ratio (BEP). e. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE.

a. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE.

Which of the following statements is CORRECT? a. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock. b. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock. c. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free. d. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer. e. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.

a. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm's common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock.

. Stocks A and B have the following data. The market risk premium is 6.0% and the risk-free rate is 6.4%. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Beta 1.10 0.90 Constant growth rate 7.00% 7.00% a. Stock A must have a higher dividend yield than Stock B. b. Stock B's dividend yield equals its expected dividend growth rate. c. Stock B must have the higher required return. d. Stock B could have the higher expected return. e. Stock A must have a higher stock price than Stock B.

a. Stock A must have a higher dividend yield than Stock B.

. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $25 $25 Expected dividend yield 5% 3% Required return 12% 10% a. Stock X pays a higher dividend per share than Stock Y. b. One year from now, Stock X should have the higher price. c. Stock Y has a lower expected growth rate than Stock X. d. Stock Y has the higher expected capital gains yield. e. Stock Y pays a higher dividend per share than Stock X.

a. Stock X pays a higher dividend per share than Stock Y.

Which of the following would indicate an improvement in a company's financial position, holding other things constant? a. The current and quick ratios both increase. b. The inventory and total assets turnover ratios both decline. c. The debt ratio increases. d. The profit margin declines. e. The EBITDA coverage ratio declines.

a. The current and quick ratios both increase.

Which of the following statements is NOT CORRECT? a. The free cash flow valuation model discounts free cash flows by the required return on equity. b. The free cash flow valuation model can be used to find the value of a division. c. An important step in applying the free cash flow valuation model is forecasting the firm's pro forma financial statements. d. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value. e. The free cash flow valuation model can be used both for companies that pay dividends and those that do not pay dividends.

a. The free cash flow valuation model discounts free cash flows by the required return on equity.

Which of the following statements is CORRECT? a. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock. b. Corporations cannot buy the preferred stocks of other corporations. c. Preferred dividends are not generally cumulative. d. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation. e. Preferred stockholders have a priority over bondholders in the event of bankruptcy to the income, but not to the proceeds in a liquidation.

a. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock.

. Stock X has the following data. Assuming the stock market is efficient and the stock is in equilibrium, which of the following statements is CORRECT? Expected dividend, D1 $3.00 Current Price, P0 $50 Expected constant growth rate 6.0% a. The stock's expected dividend yield and growth rate are equal. b. The stock's expected dividend yield is 5%. c. The stock's expected capital gains yield is 5%. d. The stock's expected price 10 years from now is $100.00. e. The stock's required return is 10%.

a. The stock's expected dividend yield and growth rate are equal.

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Required return 10% 12% Market price $25 $40 Expected growth 7% 9% a. These two stocks must have the same dividend yield. b. These two stocks should have the same expected return. c. These two stocks must have the same expected capital gains yield. d. These two stocks must have the same expected year-end dividend. e. These two stocks should have the same price.

a. These two stocks must have the same dividend yield.

Justus Motor Co.has a WACC of 11.50%, and its value of operations is $25.00 million. Justus's free cash flow is expected to grow at a constant rate of 7.00%. What was the last free cash flow, FCF0 in millions? a. $0.95 b. $1.05 c. $1.16 d. $1.27 e. $1.40

b. $1.05

Kellner Motor Co.'s stock has a required rate of return of 11.50%, and it sells for $25.00 per share. Kellner's dividend is expected to grow at a constant rate of 7.00%. What was the last dividend, D0? a. $0.95 b. $1.05 c. $1.16 d. $1.27 e. $1.40

b. $1.05

Kinkead Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be −$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%, what is the firm's value of operations, in millions? a. $158 b. $167 c. $175 d. $184 e. $193

b. $167

. Hirshfeld Corporation's stock has a required rate of return of 10.25%, and it sells for $57.50 per share. The dividend is expected to grow at a constant rate of 6.00% per year. What is the expected year-end dividend, D1? a. $2.20 b. $2.44 c. $2.69 d. $2.96 e. $3.25

b. $2.44

Judd Corporation has a weighted average cost of capital of 10.25%, and its value of operations is $57.50 million. Free cash flow is expected to grow at a constant rate of 6.00% per year. What is the expected year-end free cash flow, FCF1 in millions? a. $2.20 b. $2.44 c. $2.69 d. $2.96 e. $3.25

b. $2.44

. Based on the free cash flow valuation model, the value of Weidner Co.'s operations is $1,200 million. The company's balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity. If Weidner has 30 million shares of stock outstanding, what is the best estimate of the stock's price per share? a. $24.90 b. $27.67 c. $30.43 d. $33.48 e. $36.82

b. $27.67

Huxley Building Supplies' last free cash flow was $1.75 million. Its free cash flow growth rate is expected to be constant at 25% for 2 years, after which free cash flows are expected to grow at a rate of 6% forever. Its weighted average cost of capital WACC is 12%. Huxley has $5 million in short-term investments and $7 million in debt and has 1 million shares outstanding. What is the best estimate of the current intrinsic stock price? a. $39.58 b. $40.64 c. $41.71 d. $42.80 e. $44.92

b. $40.64

. Orwell Building Supplies' last dividend was $1.75. Its dividend growth rate is expected to be constant at 25% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price? a. $41.58 b. $42.64 c. $43.71 d. $44.80 e. $45.92

b. $42.64

The free cash flows (in millions) shown below are forecast by Simmons Inc. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions? Year: 1 2 3 Free cash flow: −$20 $42 $45 a. $586 b. $617 c. $648 d. $680 e. $714

b. $617

. Barnette Inc.'s free cash flows are expected to be unstable during the next few years while the company undergoes restructuring. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5? a. $719 b. $757 c. $797 d. $839 e. $883

b. $757

Lincoln Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio? a. Use cash to reduce long-term bonds outstanding. b. Borrow using short-term notes payable and use the cash to increase inventories. c. Use cash to reduce accruals. d. Use cash to reduce accounts payable. e. Use cash to reduce short-term notes payable.

b. Borrow using short-term notes payable and use the cash to increase inventories.

Companies Heidee and Leaudy have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company Heidee has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT? a. Company Heidee has more net income. b. Company Heidee pays less in taxes. c. Company Heidee has a lower equity multiplier. d. Company Heidee has a higher ROA. e. Company Heidee has a higher times interest earned (TIE) ratio.

b. Company Heidee pays less in taxes.

You observe that a firm's ROE is above the industry average, but its profit margin and debt ratio are both below the industry average. Which of the following statements is CORRECT? a. Its total assets turnover must equal the industry average. b. Its total assets turnover must be above the industry average. c. Its return on assets must equal the industry average. d. Its TIE ratio must be below the industry average. e. Its total assets turnover must be below the industry average.

b. Its total assets turnover must be above the industry average.

A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio? a. Issue new common stock and use the proceeds to acquire additional fixed assets. b. Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2)lead to an increase in accounts receivable. c. Issue new common stock and use the proceeds to increase inventories. d. Speed up the collection of receivables and use the cash generated to increase inventories. e. Use some of its cash to purchase additional inventories.

b. Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2)lead to an increase in accounts receivable.

. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% a. Stock Y has a higher dividend yield than Stock X. b. One year from now, Stock X's price is expected to be higher than Stock Y's price. c. Stock X has the higher expected year-end dividend. d. Stock Y has a higher capital gains yield. e. Stock X has a higher dividend yield than Stock Y.

b. One year from now, Stock X's price is expected to be higher than Stock Y's price.

Which of the following statements is CORRECT? a. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will decrease. b. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will increase. c. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Without additional information, we cannot tell what will happen to the ROE. d. The modified Du Pont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE. e. Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales.

b. Suppose a firm's total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will increase.

The Cavendish Company recently issued new common stock and used the proceeds to pay off some of its short-term notes payable. This action had no effect on the company's total assets or operating income. Which of the following effects would occur as a result of this action? a. The company's debt ratio increased. b. The company's current ratio increased. c. The company's times interest earned ratio decreased. d. The company's basic earning power ratio increased. e. The company's equity multiplier increased.

b. The company's current ratio increased.

If the CEO of a large, diversified, firm were filling out a fitness report on a division manager (i.e., "grading" the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant. a. The division's DSO (days' sales outstanding) is 40, whereas the average for its competitors is 30. b. The division's basic earning power ratio is above the average of other firms in its industry. c. The division's total assets turnover ratio is below the average for other firms in its industry. d. The division's debt ratio is above the average for other firms in the industry. e. The division's inventory turnover is 6, whereas the average for its competitors is 8.

b. The division's basic earning power ratio is above the average of other firms in its industry.

. Which of the following statements is CORRECT? a. If a company has a WACC = 12% and its free cash flow is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. The free cash flow valuation model for constant growth, Vop = FCF1/(WACC − g), can be used to value firms whose free cash flows are expected to decline at a constant rate, i.e., to grow at a negative rate. c. The value of operations of a stock is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. d. The constant growth model cannot be used for a zero growth stock, where free cash flows are expected to remain constant over time. e. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.

b. The free cash flow valuation model for constant growth, Vop = FCF1/(WACC − g), can be used to value firms whose free cash flows are expected to decline at a constant rate, i.e., to grow at a negative rate.

Which of the following statements is CORRECT? a. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. b. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. c. The free cash flow valuation model, Vops =FCF1/(WACC − g), cannot be used for firms that have negative growth rates. d. The free cash flow valuation model, Vops = FCF1/(WACC − g), can be used only for firms whose growth rates exceed their WACC. e. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights.

b. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock.

Which of the following statements is CORRECT? a. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. b. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock. c. The stock valuation model, P0 = D1/(rs − g), cannot be used for firms that have negative growth rates. d. The stock valuation model, P0 = D1/(rs − g), can be used only for firms whose growth rates exceed their required returns. e. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights.

b. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock.

Which of the following statements is CORRECT? a. If a stock has a required rate of return rs = 12% and its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate. c. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. d. The constant growth model cannot be used for a zero growth stock, where the dividend is expected to remain constant over time. e. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.

b. The stock valuation model, P0 = D1/(rs − g), can be used to value firms whose dividends are expected to decline at a constant rate, i.e., to grow at a negative rate.

You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think a. the stock should be sold. b. the stock is a good buy. c. management is probably not trying to maximize the price per share. d. dividends are not likely to be declared. e. the stock is experiencing supernormal growth.

b. the stock is a good buy.

. Young & Liu Inc.'s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm's value of operations, in millions? a. $948 b. $998 c. $1,050 d. $1,103 e. $1,158

c. $1,050

A company is expected to have free cash flows of $0.75 million next year. The weighted average cost of capital is WACC = 10.5%, and the expected constant growth rate is g = 6.4%. The company has $2 million in short-term investments, $2 million in debt, and 1 million shares. What is the stock's current intrinsic stock price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22

c. $18.29

A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price? a. $17.39 b. $17.84 c. $18.29 d. $18.75 e. $19.22

c. $18.29

The value of Broadway-Brooks Inc.'s operations is $900 million, based on the free cash flow valuation model. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock's price per share? a. $23.00 b. $25.56 c. $28.40 d. $31.24 e. $34.36

c. $28.40

McGaha Enterprises expects earnings and dividends to grow at a rate of 25% for the next 4 years, after the growth rate in earnings and dividends will fall to zero, i.e., g = 0. The company's last dividend, D0, was $1.25, its beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the current price of the common stock? a. $26.77 b. $27.89 c. $29.05 d. $30.21 e. $31.42

c. $29.05

Which of the following statements is CORRECT? a. All else equal, increasing the debt ratio will increase the ROA. b. The use of debt financing will tend to lower the basic earning power ratio, other things held constant. c. A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure. d. If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE. e. Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock.

c. A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure.

Amram Company's current ratio is 1.9. Considered alone, which of the following actions would reduce the company's current ratio? a. Use cash to reduce accounts payable. b. Borrow using short-term notes payable and use the proceeds to reduce accruals. c. Borrow using short-term notes payable and use the proceeds to reduce long-term debt. d. Use cash to reduce accruals. e. Use cash to reduce short-term notes payable.

c. Borrow using short-term notes payable and use the proceeds to reduce long-term debt.

Which of the following statements is CORRECT? a. "Window dressing" is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value. b. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an example of "window dressing." Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is another example of "window dressing." c. Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of "window dressing." d. Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of "window dressing." e. Using some of the firm's cash to reduce long-term debt is an example of "window dressing."

c. Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of "window dressing."

Which of the following statements is CORRECT? a. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same. b. If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same. c. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same. d. If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio. e. If Firm X's P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at a faster rate.

c. If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same.

Other things held constant, which of the following alternatives would increase a company's cash flow for the current year? a. Increase the number of years over which fixed assets are depreciated for tax purposes. b. Pay down the accounts payables. c. Reduce the days' sales outstanding (DSO) without affecting sales or operating costs. d. Pay workers more frequently to decrease the accrued wages balance. e. Reduce the inventory turnover ratio without affecting sales or operating costs.

c. Reduce the days' sales outstanding (DSO) without affecting sales or operating costs.

Lofland's has $20 million in current assets and $10 million in current liabilities, while Smaland's current assets are $10 million versus $20 million of current liabilities. Both firms would like to "window dress" their end-of-year financial statements, and to do so each plans to borrow $10 million on a short-term basis and to then hold the borrowed funds in their cash accounts. Which of the statements below best describes the results of these transactions? a. The transaction would improve both firms' financial strength as measured by their current ratios. b. The transactions would raise Lofland's financial strength as measured by its current ratio but lower Smaland's current ratio. c. The transactions would lower Lofland's financial strength as measured by its current ratio but raise Smaland's current ratio. d. The transaction would have no effect on the firm' financial strength as measured by their current ratios. e. The transaction would lower both firm' financial strength as measured by their current ratios.

c. The transactions would lower Lofland's financial strength as measured by its current ratio but raise Smaland's current ratio.

Sawchuck Consulting has been profitable for the last 5 years, but it has never paid a dividend. Management has indicated that it plans to pay a $0.25 dividend 3 years from today, then to increase it at a relatively rapid rate for 2 years, and then to increase it at a constant rate of 8.00% thereafter. Management's forecast of the future dividend stream, along with the forecasted growth rates, is shown below. Assuming a required return of 11.00%, what is your estimate of the stock's current value? Year 0 1 2 3 4 5 6 Growth rate NA NA NA NA 50.00% 25.00% 8.00% Dividends $0.000 $0.000 $0.000 $0.250 $0.375 $0.469 $0.506 a. $9.94 b. $10.19 c. $10.45 d. $10.72 e. $10.99

d. $10.72

A share of Lash Inc.'s common stock just paid a dividend of $1.00. If the expected long-run growth rate for this stock is 5.4%, and if investors' required rate of return is 11.4%, what is the stock price? a. $16.28 b. $16.70 c. $17.13 d. $17.57 e. $18.01

d. $17.57

. Lance Inc.'s free cash flow was just $1.00 million. If the expected long-run growth rate for this company is 5.4%, if the weighted average cost of capital is 11.4%, Lance has $4 million in short-term investments and $3 million in debt, and 1 million shares outstanding, what is the intrinsic stock price? a. $17.28 b. $17.70 c. $18.13 d. $18.57

d. $18.57

The projected cash flow for the next year for Minesuah Inc. is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company's weighted average cost of capital is 11%, what is the value of its operations? a. $1,714,750 b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000

d. $2,000,000

The last dividend paid by Coppard Inc. was $1.25. The dividend growth rate is expected to be constant at 15% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm's required return (rs) is 11%, what is its current stock price? a. $30.57 b. $31.52 c. $32.49 d. $33.50 e. $34.50

d. $33.50

Decker Tires' free cash flow was just FCF0 = $1.32. Analysts expect the company's free cash flow to grow by 30% this year, by 10% in Year 2, and at a constant rate of 5% in Year 3 and thereafter. The WACC for this company 9.00%. Decker has $4 million in short-term investments and $14 million in debt and 1 million shares outstanding. What is the best estimate of the stock's current intrinsic price? a. $31.59 b. $32.65 c. $33.75 d. $34.87 e. $35.99

d. $34.87

Which of the following statements is CORRECT? a. If two firms differ only in their use of debt—i.e., they have identical assets, sales, operating costs, and tax rates—but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales. b. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. c. A firm's use of debt will have no effect on its profit margin on sales. d. If two firms differ only in their use of debt—i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates—but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales. e. The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.

d. If two firms differ only in their use of debt—i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates—but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales.

If a bank loan officer were considering a company's request for a loan, which of the following statements would you consider to be CORRECT? a. Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm. b. The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm. c. Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm. d. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm. e. The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.

d. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks, regardless of class, must have the same voting rights. b. All firms have several classes of common stock. c. All common stock, regardless of class, must pay the same dividend. d. Some class or classes of common stock are entitled to more votes per share than other classes. e. All common stocks fall into one of three classes: A, B, and C.

d. Some class or classes of common stock are entitled to more votes per share than other classes.

A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = −5%). If the company is in equilibrium and its expected and required rate of return is 15%, which of the following statements is CORRECT? a. The company's dividend yield 5 years from now is expected to be 10%. b. The constant growth model cannot be used because the growth rate is negative. c. The company's expected capital gains yield is 5%. d. The company's expected stock price at the beginning of next year is $9.50. e. The company's current stock price is $20.

d. The company's expected stock price at the beginning of next year is $9.50.

If a company's free cash flows are expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The company's stock's dividend yield is 5%. b. The value of operations is expected to decline in the future. c. The company's WACC must be equal to or less than 5%. d. The company's value of operations one year from now is expected to be 5% above the current price. e. The expected return on the company's stock is 5% a year.

d. The company's value of operations one year from now is expected to be 5% above the current price.

If a stock's dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The stock's dividend yield is 5%. b. The price of the stock is expected to decline in the future. c. The stock's required return must be equal to or less than 5%. d. The stock's price one year from now is expected to be 5% above the current price. e. The expected return on the stock is 5% a year.

d. The stock's price one year from now is expected to be 5% above the current price.

Cordelion Communications is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Cordelion pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue? a. The times interest earned ratio will decrease. b. The ROA will decline. c. Taxable income will decrease. d. The tax bill will increase. e. Net income will decrease.

d. The tax bill will increase.

. Carby Hardware has an outstanding issue of perpetual preferred stock with an annual dividend of $7.50 per share. If the required return on this preferred stock is 6.5%, at what price should the preferred stock sell? a. $104.27 b. $106.95 c. $109.69 d. $112.50 e. $115.38

e. $115.38

. A stock just paid a dividend of D0 = $1.50. The required rate of return is rs = 10.1%, and the constant growth rate is g = 4.0%. What is the current stock price? a. $23.11 b. $23.70 c. $24.31 d. $24.93 e. $25.57

e. $25.57

. A company's free cash flow was just FCF0 = $1.50 million. The weighted average cost of capital is WACC = 10.1%, and the constant growth rate is g = 4.0%. What is the current value of operations? a. $23.11 million b. $23.70 million c. $24.31 million d. $24.93 million e. $25.57 million

e. $25.57 million

$35.50 per share is the current price for Foster Farms' stock. The dividend is projected to increase at a constant rate of 5.50% per year. The required rate of return on the stock, rs, is 9.00%. What is the stock's expected price 3 years from today? a. $37.86 b. $38.83 c. $39.83 d. $40.85 e. $41.69

e. $41.69

Kelly Enterprises' stock currently sells for $35.25 per share. The dividend is projected to increase at a constant rate of 4.75% per year. The required rate of return on the stock, rs, is 11.50%. What is the stock's expected price 5 years from now? a. $40.17 b. $41.20 c. $42.26 d. $43.34 e. $44.46

e. $44.46

The required return for Williamson Heating's stock is 12%, and the stock sells for $40 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00(1.30)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of X% per year forever. What is the stock's expected constant growth rate after t = 4, i.e., what is X? a. 5.17% b. 5.44% c. 5.72% d. 6.02% e. 6.34%

e. 6.34%

. Franklin Corporation is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate? a. 6.01% b. 6.17% c. 6.33% d. 6.49% e. 6.65%

e. 6.65%

If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock's expected total return for the coming year? a. 7.54% b. 7.73% c. 7.93% d. 8.13% e. 8.34%

e. 8.34%

Alcott's preferred stock pays a dividend of $1.00 per quarter. If the price of the stock is $45.00, what is its nominal (not effective) annual rate of return? a. 8.03% b. 8.24% c. 8.45% d. 8.67% e. 8.89%

e. 8.89%

If D0 = $1.75, g (which is constant) = 3.6%, and P0 = $32.00, what is the stock's expected total return for the coming year? a. 8.37% b. 8.59% c. 8.81% d. 9.03% e. 9.27%

e. 9.27%

Heidee Corp. and Leaudy Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, Heidee uses more debt than Leaudy. Which of the following statements is CORRECT? a. Heidee would have the higher net income as shown on the income statement. b. Without more information, we cannot tell if Heidee or Leaudy would have a higher or lower net income. c. Heidee would have the lower equity multiplier for use in the Du Pont equation. d. Heidee would have to pay more in income taxes. e. Heidee would have the lower net income as shown on the income statement.

e. Heidee would have the lower net income as shown on the income statement.

Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? a. Stock B must have a higher dividend yield than Stock A. b. Stock A must have a higher dividend yield than Stock B. c. If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B's. d. Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. e. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's.

e. If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B's.

The required returns of Stocks X and Y are rX = 10% and rY = 12%. Which of the following statements is CORRECT? a. If Stock Y and Stock X have the same dividend yield, then Stock Y must have a lower expected capital gains yield than Stock X. b. If Stock X and Stock Y have the same current dividend and the same expected dividend growth rate, then Stock Y must sell for a higher price. c. The stocks must sell for the same price. d. Stock Y must have a higher dividend yield than Stock X. e. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

e. If the market is in equilibrium, and if Stock Y has the lower expected dividend yield, then it must have the higher expected growth rate.

Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? A B Price $25 $25 Expected growth (constant) 10% 5% Required return 15% 15% a. Stock A has a higher dividend yield than Stock B. b. Currently the two stocks have the same price, but over time Stock B's price will pass that of A. c. Since Stock A's growth rate is twice that of Stock B, Stock A's future dividends will always be twice as high as Stock B's. d. The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist. e. Stock A's expected dividend at t = 1 is only half that of Stock B.

e. Stock A's expected dividend at t = 1 is only half that of Stock B.

. Which of the following statements is CORRECT? a. Two firms with the same expected free cash flows and growth rates must also have the same value of operations. b. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. c. If a company has a weighted average cost of capital WACC = 12%, and if its free cash flows are expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The value of operations is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

Which of the following statements is CORRECT? a. Two firms with the same expected dividend and growth rates must also have the same stock price. b. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. c. If a stock has a required rate of return rs = 12%, and if its dividend is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

Which of the following statements is CORRECT, assuming stocks are in equilibrium? a. Assume that the required return on a given stock is 13%. If the stock's dividend is growing at a constant rate of 5%, its expected dividend yield is 5% as well. b. A stock's dividend yield can never exceed its expected growth rate. c. A required condition for one to use the constant growth model is that the stock's expected growth rate exceeds its required rate of return. d. Other things held constant, the higher a company's beta coefficient, the lower its required rate of return. e. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

e. The dividend yield on a constant growth stock must equal its expected total return minus its expected capital gains yield.

A corporation

is a legal entity separate from its owners and managers. File papers of incorporation with state. Bylaws and Charter Advantages:Unlimited life,Easy transfer of ownership,Limited liability, and Ease of raising capital Disadvantages:Double taxation and Cost of set-up and report filing

Corporate governance

is the set of rules that control a company's behavior towards its directors, managers, employees, shareholders, creditors, customers. Corporate governance can help control agency problems.

Agency problem

managers may act in their own interests and not on behalf of owners (stockholders)

Self-Supporting Growth Rate

o Self-Supporting growth rate is the maximum growth rate the firm could achieve if it had no access to external capital. o The firm's self-supporting growth rate is influenced by the firm's capital intensity ratio. The more assets the firm requires to achieve a certain sales level, the lower its sustainable growth rate will be.

Forecasted financial statements

• Forecast the operating items (e.g., sales, costs, inventory, etc.). • Choose a preliminary financial policy and use it to forecast the financial items (e.g., long-term debt, interest expense, etc.). • Identify any financing surplus or deficit and eliminate it. • Repeat until satisfied that the plan is achievable and is the best possible. • Forecasting Operating Items o Forecast sales to grow at chosen growth rates. o Forecast many items as a percentage of sales: cash, accounts receivable, inventories, fixed assets, costs (excl. depr.). o Forecast depreciation as a percent of fixed assets.

Exam 1

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