FINA 4300 Exam 3
In general, the capital structures used by non-financial U.S. firms:
vary significantly across industries.
Which of the following are viable techniques to cope with the uncertainty inherent in realistic financial projections? I. Simulation II. Ad hoc adjustments III. Scenario analysis IV. Sensitivity analysis
E. I, III, and IV only
Which one of the following policies most directly affects the projection of the retained earnings balance to be used on a pro forma statement?
dividend policy
Under the simplifying assumptions of Modigliani and Miller, an increase in a firm's financial leverage will:
increase the variability in earnings per share.
The best financing choice is the one that:
maximizes expected cash flows.
The sustainable growth rate of a firm is best described as the:
maximum growth rate achievable excluding any external equity financing while maintaining a constant debt-equity ratio.
The most common approach to developing pro forma financial statements is called the:
percent-of-sales method.
Homemade leverage is:
the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.
The retention ratio is:
the percentage of net income available to the firm to fund future growth.
The basic lesson of the M&M theory is that the value of a firm is dependent upon:
the total cash flow of the firm.
Issue costs of equity are high relative to those of debt.
True
When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments.
True
Please refer to Oscar's financial statements above. Sales are projected to increase by 3 percent next year. The profit margin and the dividend payout ratio are projected to remain constant. What is the projected addition to retained earnings for next year?
$1,380 × (1 + 0.03) = $1,421.40
A project will produce after-tax operating cash inflows of $3,200 a year for 5 years. The after- tax salvage value of the project is expected to be $2,500 in year 5. The project's initial cost is $9,500. What is the net present value of this project if the required rate of return is 16 percent?
$2,168.02 NPV = 11668.02 - 9,500 = $2,168.02
Naomi plans on saving $3,000 a year and expects to earn an annual rate of 10.25 percent. How much will she have in her account at the end of 45 years?
$2,333,572
You are estimating your company's external financing needs for the next year. At the end of the year you expect that owners' equity will be $80 million, total assets will amount to $170 million, and total liabilities will be $70 million. How much will your firm need to borrow, or otherwise acquire, from outside sources during the year?
$20 million
Your brother will borrow $17,800 to buy a car. The terms of the loan call for monthly payments for 5 years at an 8.6 percent annual interest rate, compounded monthly. What is the amount of each payment?
$366.05
You are to receive an annuity of $1,000 per year for 10 years. You will receive the first payment two years from today. At a discount rate of 10%, what is the present value of this annuity?
$5,585.97 0 for future value solve for pv
You plan to buy a new Mercedes four years from now. Today, a comparable car costs $82,500. You expect the price of the car to increase by an average of 4.8 percent per year over the next four years. How much will your dream car cost by the time you are ready to buy it?
$99,517.41
Giant Corp. is considering a project that requires a $1,500 initial cost for a new machine that will be depreciated straight line to a salvage value of 0 on a 5-year schedule. The project will require a one-time increase in the level of net working capital of $300. The project will generate an additional $1,600 in revenues and $700 in operating expenses each year. The project will end at the end of year 2, at which time the machinery is expected to be sold for $800. Giant's tax rate is 50%. In a discounted cash flow analysis of this project, what would be the projected Year 0 free cash flow?
-$1,800
Please refer to Oscar's financial statements above. Assume a constant profit margin and dividend payout ratio, and further assume all of Oscar's assets and current liabilities vary directly with sales. Assume long-term debt and common stock remain unchanged. Sales are projected to increase by 10 percent. What is Oscar's external financing need for next year?
-$260
A firm has a retention ratio of 40 percent and a sustainable growth rate of 6.2 percent. Its asset turnover ratio is 0.85 and its assets-to-equity ratio (using beginning-of-period equity) is 1.80. What is its profit margin?
0.062 = PRAT = profit margin × 0.40 × 0.85 × 1.80 profit margin = 0.062/(0.40 × 0.85 × 1.80) = 10.13%
Please refer to the selected financial information for Boss Stores above. What is the retention ratio for 2013?
1 - (0.58/19.70) = 0.97
Please refer to Oscar's financial statements above. What was Oscar's increase in retained earnings during 2014?
1,830 - 450 = 1,380
What is the benefit-cost ratio for an investment with the following cash flows at a 14.5 percent required return?
1.02
Please refer to the financial information for Squamish Equipment above. Calculate Squamish's times-burden-covered ratio for the next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent and that annual sinking fund payments on the new debt will equal $8 million.
1.49 EBIT = 40/(1 - 0.36) + 15 = $77.5 Interest = $15 + 0.07(40) = $17.8 Burden of interest and sinking fund before tax = 17.8 + (14 + 8)/(1 - 0.36) = $52.175 Times burden covered = 77.5/52.175 = 1.49 times
Gujarat Corporation doubled its shareholders' equity during the year 2014. Gujarat did not issue any new equity, repurchase any equity, or pay out any dividends during the year. What is Gujarat's sustainable growth rate for 2014?
100%
Please refer to the financial information for Squamish Equipment above. For next year, calculate Squamish's times-burden-covered ratio if Squamish sells 2 million new shares at $20 a share.
2.10
In the above financial statements, Royal Corporation has prepared (incomplete) pro forma financial statements for 2014, based on actual financial statements for 2013. Royal Corp. used the percent-of-sales method assuming a sales growth rate of 10% for 2014. If capital expenditures are planned to be $1,615 in 2014, then what would be the appropriate projection for net fixed assets in 2014?
4,048 + 1,615 - 1,100 = $4,563
Please refer to the pro forma financial statements for Royal Corporation above. If Royal Corporation plans to issue $100 in new equity in 2014, what should be the projection for shareholders' equity for 2014?
4,942 + 307 + 100 = $5,349
Please refer to the financial information for Squamish Equipment above. Calculate Squamish's times-interest-earned ratio for next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent.
4.35 EBIT = 40/(1 - 0.36) + 15 = $77.5 Interest = 15 + 0.07(40) = $17.8 Times interest earned = 77.5/17.8 = 4.35 times
The Limited collects 25 percent of sales in the month of sale, 60 percent of sales in the month following the month of sale, and 15 percent of sales in the second month following the month of sale. During the month of April, the firm will collect:
60 percent of March sales.
In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected Year 1 free cash flow?
600
Please refer to the spreadsheet above. Selected assumptions are given for preparing pro forma financial statements for 2015. Assume that no new equity will be issued in 2015. When the pro formas are completed, which of the following formulas would correctly give the forecast for shareholders' equity in cell G19?
=F19 + (1 - B4)*C16
Which one of the following statements is correct concerning the cash balance of a firm?
A cumulative cash deficit on a cash budget indicates the need to acquire additional funds.
Westcomb, Inc. had equity of $150,000 at the beginning of the year. At the end of the year, the company had total assets of $195,000. During the year, the company sold no new equity. Net income for the year was $72,000 and dividends were $44,640. What is Westcomb's sustainable growth rate?
E. 18.24 percent
To estimate Missed Places Inc.'s (MP) external financing needs, the CFO needs to figure out how much equity her firm will have at the end of next year. At the end of the most recent fiscal year, MP's retained earnings were $158,000. The Controller has estimated that over the next year, gross profits will be $360,700, earnings after tax will total $23,400, and MP will pay $12,400 in dividends. What are the estimated retained earnings at the end of next year?
A. $169,000
Given the spreadsheet below, what value would Excel return if you entered the following formula? =NPV(B2,B5:D5)
A. $577.57 lowest
EAC Nutrition offers a 9.5 percent coupon bond with annual payments, maturing 11 years from today. Your required return is 11.2 percent. What price are you willing to pay for this bond if the face (or par) value is $1,000?
A. $895.43
Which of the following would increase a company's need for external finance, all else equal?
A. An increase in the dividend payout ratio
When considering the impact of distress costs on capital structure, which of the following facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all else equal)?
ABC's cash flows from operations are less volatile than XYZ's.
Assume each month has 30 days and AmDocs has a 60-day accounts receivable period. During the second calendar quarter of the year (April, May, and June), AmDocs will collect payment for the sales it made during which of the months listed below?
E. February, March, and April
You are preparing pro forma financial statements for 2014 using the percent-of-sales method. Sales were $100,000 in 2013 and are projected to be $120,000 in 2014. Net income was $5,000 in 2013 and is projected to be $6,000 in 2014. Equity was $45,000 at year-end 2012 and $50,000 at year-end 2013. Assuming that this company never issues new equity, never repurchases equity, and never changes its dividend payout ratio, what would be projected for equity at year-end 2014?
All of net income was added to equity in 2013, so all of net income will be added to equity in 2014. $50,000 + $6,000 = $56,000.
Ruff Wear expects sales of $560, $650, $670, and $610 for the months of May through August, respectively. The firm collects 20 percent of sales in the month of sale, 70 percent in the month following the month of sale, and 8 percent in the second month following the month of sale. The remaining 2 percent of sales is never collected. How much money does the firm expect to collect in the month of August?
August collections = 0.20($610) + 0.70($670) + 0.08($650) = $643
Please refer to the spreadsheet above. Selected assumptions are given for preparing pro forma financial statements for 2015. Which of the following formulas would correctly give the forecast for sales in cell C8?
B. =B8 + B8*B2
Which of the following statements related to the internal rate of return (IRR) are correct? I. The IRR is the discount rate at which an investment's NPV equals zero. II. An investment should be undertaken if the discount rate exceeds the IRR. III. The IRR tends to be used more than net present value simply because its results are easier to comprehend. IV. The IRR is the best tool available for deciding between mutually exclusive investments.
B. I and III only
According to the pecking order theory of capital structure, why do firms avoid issuing equity?
Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall
Which of the following is NOT a likely financing policy for a rapidly growing business?
Borrow funds rather than limit growth, thereby limiting growth only as a last resort.
Your grandmother invested a lump sum 26 years ago at 4.25 percent interest. Today, she gave you the proceeds of that investment which totaled $51,480.79. How much did she originally invest?
C. $17,444.86
Please refer to the financial information for Squamish Equipment above. Calculate Squamish's earnings per share next year assuming Squamish raises $40 million of new debt at an interest rate of 7 percent.
C. 2.12 EBIT = 40/(1 - 0.36) + 15 = $77.5 Interest = $15 + 0.07(40) = $17.8 EPS = (77.5 - 17.8)(1 - 0.36)/18 = $2.12
You plan to pay $50 for a share of preferred stock that pays a $2.40 dividend per year forever. What annual rate of return will you realize?
C. 4.80% r = A/P = $2.40/$50 = 4.80%
Ian is going to receive $20,000 six years from now. Sunny is going to receive $20,000 nine years from now. Which one of the following statements is correct if both Ian and Sunny apply a 7 percent discount rate to these amounts?
C. In today's dollars, Ian's money is worth more than Sunny's.
Which of the following statements is correct if a firm's pro forma financial statements project net income of $12,000 and external financing required of $5,000?
C. Retained earnings cannot grow by more than $12,000.
Which of these ratios are the determinants of a firm's sustainable growth rate? I. Assets-to-equity ratio II. Profit margin III. Retention ratio IV. Asset turnover ratio
E. I, II, III, and IV
On May 1, Vaya Corp. had a beginning cash balance of $175. Vaya's sales for April were $430 and May sales were $480. During May, the firm had cash expenses of $110 and made payments on accounts payable of $290. Vaya's accounts receivable period is 30 days. What is the firm's beginning cash balance on June 1?
Cash balance = $175 - $110 - $290 + $430 = $205
Wax Music expects sales of $437,500 next year. The profit margin is 4.8 percent and the firm has a 30 percent dividend payout ratio. What is the projected increase in retained earnings?
Change in retained earnings = $437,500 × 0.048 × (1 - 0.30) = $14,700 A. $14,700
In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected Year 2 free cash flow?
D. $1,750
Please refer to the selected financial information for Boss Stores above. What is the actual sales growth rate for 2013?
D. 21.4%
You constructed a pro forma balance sheet for next year and found that external financing required was negative (i.e., the company projected a financing surplus). Which of the following options, all else equal, would NOT correct the projected imbalance?
D. An increase in the retention ratio
Which of the following figures of merit might not use all possible cash flows in its calculations? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Benefit-cost ratio
D. I only
Which of the following actions would help a firm's growth problem if its actual sales growth exceeds its sustainable rate of growth? I. Increase prices II. Decrease financial leverage III. Decrease dividends IV. Prune away less-profitable products
D. I, III, and IV only
Which of the following statements is true?
Due to required cash investments in current assets, fast-growing and profitable companies can literally "grow broke".
Sol's Sporting Goods is expanding, and as a result expects additional operating cash flows of $26,000 a year for 4 years. This expansion requires $39,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires an additional $3,000 of net working capital throughout the life of the project; Sol expects to recover this amount at the end of the project. What is the net present value of this expansion project at a 16 percent required rate of return?
E. $32,409.57
A divisional manager submitted a project proposal to the chief financial officer, complete with a calculated NPV for the project. The chief financial officer studied the proposal and pointed out that the divisional manager had failed to account for a one-time increase in net working capital of $60,000 that will be required over the life of the seven-year project. Assuming the full value of net working capital will be recovered at the end of the project, how will the project's NPV change after making the chief financial officer's adjustment? Assume a discount rate of 9%.
E. None of the above.
Which of the following is NOT an important step in the financial evaluation of an investment opportunity?
Estimate the accounting rate of return for the investment.
As a noncash expense, depreciation is irrelevant in the determination of a project's cash flows.
FALSE
The IRR is the discount rate at which an investment's NPV equals its initial cost.
FALSE
A drawback of forecasting using spreadsheets is that typical spreadsheet programs are not equipped to deal with the circularity involving interest expense and debt.
False
An annual financial forecast for 2013 showing no external funding required assures a company that no cash shortfalls are likely to occur during 2013.
False
If a company seeks to maximize firm value, it should never grow at a rate above its sustainable growth rate.
False
One way to manage an actual growth rate above a sustainable growth rate is to decrease prices.
False
Scenario analysis involves changing one input to a financial forecast, whereas sensitivity analysis involves changing multiple inputs.
False
Share repurchases usually decrease earnings per share.
False
The IRR and NPV always yield the same investment recommendations.
False
The M&M irrelevance proposition assures financial managers that their choice between equity or debt financing will ultimately have no impact on firm value.
False
The only way a company can grow at a rate above its current sustainable growth rate is by increasing leverage.
False
When conducting a discounted cash flow analysis of a project, it is important to always include a careful estimate of financing costs in the project's cash flows.
False
Which of the following figures of merit does not directly take into consideration the time value of money? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Accounting rate of return
I & IV only
Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility
I and III only
Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Tax benefits IV. Financial flexibility
I and III only
Which one of the following will increase the sustainable rate of growth a corporation can achieve?
decrease in the dividend payout ratio
Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns? I. Estimated pro forma coverage ratios II. The recognition that financing decisions do not affect firm or shareholder value III. A range of earnings chart and proximity of expected EBIT to the breakeven value IV. A conservative debt policy that obviates the need to evaluate risk
I and III only
The term "financial distress costs" includes which of the following? I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed, but not bankrupt IV. Indirect costs related to being financially distressed, but not bankrupt
I, II, III, and IV
Which of the following can affect a firm's sustainable rate of growth? I. Asset turnover ratio II. Profit margin III. Dividend policy IV. Financial leverage
I, II, III, and IV
Which of the following questions are appropriate to address upon conducting sustainable growth analysis and the financial planning process? I. Should the firm merge with a competitor? II. Should additional equity be sold? III. Should a particular division be sold? IV. Should a new product be introduced?
I, II, III, and IV
You are developing a financial plan for a corporation. Which of the following questions will be considered as you develop this plan? I. How much will our sales grow? II. Will additional fixed assets be required? III. Will dividends be paid to shareholders? IV. How much new debt must be obtained?
I, II, III, and IV
According to the pecking order theory proposed by Stewart Myers of MIT, which of the following are correct? I. For financing needs, firms prefer to first tap internal sources such as retained profits and excess cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms prefer to issue new equity rather than source external debt. IV. A firm's capital structure is dictated by its need for external financing.
I, II, and IV only
The interest tax shield has no value when a firm has: I. no taxable income. II. debt-equity ratio of 1. III. zero debt. IV. no leverage.
I, III, and IV only
Pro forma free cash flows for a proposed project should: I. exclude the cost of employing existing assets that could be sold anyway. II. exclude interest expense. III. include the depreciation tax shield related to the project. IV. exclude any required increase in operating current assets.
II and III only
Which of the following should be included in the cash flow projections for a new product? I. Money already spent for research and development of the new product II. Capital expenditures for equipment to produce the new product III. Increase in working capital needed to finance sales of the new product IV. Interest expense on the loan used to finance the new product launch
II and III only
Which of the following factors favor the issuance of equity in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility
II and IV only
Financial leverage: I. increases expected ROE but does not affect its variability. II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners.
II, III, and IV only
When making a capital budgeting decision, which of the following is/are NOT relevant? I. The size of a cash flow. II. The risk of a cash flow. III. The accounting earnings from a cash flow. IV. The timing of a cash flow.
III only
Salinas Corporation has net income of $15 million per year on net sales of $90 million per year. It currently has no long-term debt, but is considering a debt issue of $20 million. The interest rate on the debt would be 7%. Salinas Corp. currently faces an effective tax rate of 40%. What would be the annual interest tax shield to Salinas Corp. if it goes through with the debt issuance?
Interest tax shield = interest rate × amount of debt × tax rate = 0.07 × 20,000,000 × 0.40= $560,000
Which of the following would not be considered a cost of financial distress?
Lack of interest tax shields
Milano Corporation has experienced growth of 20% for each of the last 5 years. Over this 5- year period, Milano's return on equity has never exceeded 15%, its profit margin has held steady at 5%, and its total asset turnover has not changed. Over the 5-year period, Milano paid no dividends and issued no new equity. Based on this information, which of the following can you most likely infer about Milano's performance over the past 5 years?
Milano's leverage has increased. Note first that g > g* because g = 20% and g*<15%. With g > g* one of PRAT must increase. P has held steady at 5%, R has remained at 100%, A has not changed. Thus T (leverage) must have increased.
Which of the following is NOT an implication of the pecking order theory of capital structure?
More-profitable firms (all else equal) should have higher debt ratios.
Please refer to the spreadsheet above. Selected assumptions are given for preparing pro forma financial statements for 2015. When the pro formas are completed, which of the following formulas would correctly give the forecast for cost of goods sold in cell C9?
None of the above.
Please refer to Oscar's financial statements above. All of Oscar's costs and current asset accounts vary directly with sales. Sales are projected to increase by 10 percent. What is the pro forma accounts receivable balance for next year?
Pro forma accounts receivable = $940 × (1 + 0.10) = $1,034
The sustainable growth rate:
can never be greater than the return on equity.
Please refer to Oscar's financial statements above. Assume a constant debt-equity ratio, net profit margin and dividend payout ratio, and further assume all of Oscar's expenses, assets and current liabilities vary directly with sales. What is the pro forma net fixed asset value for next year if sales are projected to increase by 7.5 percent?
Pro forma net fixed assets = $10,850 × (1 + 0.075) = $11,663.75
Hayesville Corporation had net income of $5 million this year on net sales of $125 million per year. At the beginning of this year, its debt-to-equity ratio was 1.5 and it held $75 million in total liabilities. It paid out $2 million in dividends for the year. What is Hayesville Corporation's sustainable growth rate?
ROEbop × Retention ratio = (5/50) × 0.6 = 6%
Komatsu has a 4.5 percent profit margin and a 15 percent dividend payout ratio. The asset turnover ratio is 1.6 and the assets-to-equity ratio (using beginning-of-period equity) is 1.77. What is Komatsu's sustainable rate of growth?
Sustainable growth = PRAT = 0.045 × (1 - 0.15) × 1.6 × 1.77 = 10.83%
Please refer to the selected financial information for Boss Stores above. What is the sustainable growth rate for 2013?
Sustainable growth = g* = Change in Equity/Equitybop = (211.03 - 191.90)/191.90 = 9.97%
Please refer to the selected financial information for Boss Stores above. What is the difference between Boss's sustainable growth rate and its actual growth rate for 2014?
Sustainable growth = g* = PRAT = 0.0274 × 0.94 × 0.99 × 2.14 = 5.47% Alternatively, g* = Change in Equity/Equitybop = (222.57 - 211.03)/211.03 = 5.47% Actual growth = g = Change in Sales/Salesbop = (446.84 - 411.78)/411.78 = 8.51% g* - g = 5.47% - 8.51% = -3.04%
Debt financing results in lower after-tax earnings relative to equity financing.
TRUE
The accounting rate of return is deficient as a figure of merit because it is insensitive to the timing of cash flows.
TRUE
The evidence indicates that, on average, a company's stock price declines when it announces a new issue of equity.
TRUE
When evaluating investments under capital rationing that are independent and can be acquired fractionally, ranking by the BCR is the appropriate technique.
TRUE
Which of the following statements regarding interest tax shields is correct?
Taxable income is reduced by the amount of the interest on a firm's debt.
Which of the following is NOT a reason why a dollar today is worth more than a dollar in the future?
The value of a dollar in the future will be compounded more than the value of a dollar today.
Please refer to the pro forma financial statements for Royal Corporation above. Assume that net fixed assets are projected to be 5,000 for 2014 and that shareholders' equity is projected to be 5,500 for 2014. If long-term debt is the plug figure, what should be the projection for long-term debt for Royal Corporation in 2014?
Total assets would be 1,046 + 6,233 + 4,660 + 5,000 = $16,939 Total liabilities and equity, without long-term debt, would be 431 + 8,161 + 5,500 = $14,092 Long-term debt must make up the difference = 16,939 - 14,092 = $2,847
All else equal, increasing the assumed payables period in a financial forecast will decrease external funding required.
True
Cash budgets are less informative than pro forma financial statements.
True
Given the same assumptions, cash flow forecasts and pro forma projections will yield the same need for external funding.
True
If the maturity of a company's liabilities is less than that of its assets, the company incurs a refinancing risk.
True
In recent years, U.S. companies as a whole have repurchased more equity than they have issued.
True
In some instances, additional debt financing can encourage managers to act more in the interests of owners.
True
You are the beneficiary of a life insurance policy. The insurance company informs you that you have two options for receiving the insurance proceeds. You can receive a lump sum of $200,000 today or receive payments of $1,400 a month for 20 years. You can earn a 6 percent annual rate on your money, compounded monthly. Which option should you take and why?
You should accept the $200,000 lump sum because the monthly payments are only worth $195,413 to you today.
Which one of the following correctly defines the retention ratio?
additions to retained earnings divided by net income
The sustainable growth rate:
assumes the debt-equity ratio is constant.
Steve has estimated the cash inflows and outflows for his sporting goods store for next year. The report that he has prepared summarizing these cash flows is called a:
cash budget.
