Test Bank for Analysis For Financial Management 13th Edition Robert Higgins, Jennifer Koski, Todd M

Test Bank for Analysis For Financial Management 13th Edition Robert Higgins, Jennifer Koski, Todd Mitton Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) Current liabilities are defined as liabilities with a maturity of less than one year. ⊚ true ⊚ false

2) A decline in the Net Property, Plant, and Equipment account between year-end 2020 and year-end 2021 is a clear indication that fixed assets were sold during 2021. ⊚ true ⊚ false

3) When reporting financial performance for tax purposes, U.S. companies prefer to use accelerated depreciation methods over the straight-line method. ⊚ true ⊚ false

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

5) You can construct a sources and uses statement for 2021 if you have a company’s yearend balance sheets for 2021 and 2022. ⊚ true ⊚ false

6)

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

7) The accrual principle requires that revenue not be recognized until payment from a sale is received. ⊚ true ⊚ false

8) An increase in cash and cash equivalents should appear as a use of cash on the sources and uses statement. ⊚ true ⊚ false

9) A cash flow statement places each source or use of cash into one of three broad categories: operating activities, investing activities, or financing activities. ⊚ true ⊚ false

10) The cost of equity is usually reported on the income statement right below interest expense. ⊚ true ⊚ false

11) The United States was one of the first countries to adopt International Financial Reporting Standards. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

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

A) Managers must be at least as concerned with cash flows as with profits.

B) A company that sells merchandise at a profit can be assured of generating cash soon enough to replenish cash flows required for continued production.

C) The cash flows generated in a given time period can differ from the profits reported.

D) Profits are no assurance that cash flow will be sufficient to maintain solvency.

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

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

A) Goodwill B) Depreciation expense C) Changes in accounts receivable D) Accrual accounting practices

14) Which one of the following is the financial statement that shows a financial snapshot, taken at a point in time, of all the assets the company owns and all the claims against those assets?

A) Income statement B) Creditor’s statement C) Balance sheet D) Cash flow statement E) Sources and uses statement

15)

A balance sheet reports the value of a firm’s assets, liabilities, and equity A) over an annual period.

B) over any period of time.

C) at any point in time.

D) at the end of the year only.

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

A) Equity rises $250,000; net plant and equipment falls $250,000.

B) Cash rises $250,000; net plant and equipment falls $100,000; equity rises $150,000.

C) Cash rises $250,000; accounts receivable falls $100,000; goodwill rises $150,000.

D) Cash rises $250,000; net plant and equipment falls $250,000.

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

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

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

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

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

18) Which one of the following is the financial statement that summarizes a firm’s revenue and expenses over a period of time?

A) Income statement B) Balance sheet C) Cash flow statement D) Sources and uses statement E) Market value statement

19)

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

A) income statement.

B) balance sheet.

C) shareholders’ equity statement.

D) cash flow statement.

E) statement of operating position.

20)

Which one of the following is a source of cash?

A) Increase in accounts receivable B) Decrease in notes payable C) Decrease in common stock D) Increase in inventory E) Increase in accounts payable

21)

Which one of the following is a use of cash?

A) Increase in notes payable B) Increase in inventory C) Increase in long-term debt D) Decrease in accounts receivable E) Increase in common stock

22)

Which one of the following is a source of cash?

A) Decrease in accounts receivable B) Decrease in common stock C) Decrease in long-term debt D) Decrease in accounts payable E) Increase in inventory

23)

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

A) Dividends paid B) A decrease in accounts payable C) Depreciation D) An increase in the cash and marketable securities account

24) Which one of the following is the financial statement that summarizes changes in the company’s cash balance over a period of time?

A) Income statement B) Balance sheet C) Cash flow statement D) Shareholders’ equity statement E) Market value statement

25)

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

A) Cash flows from selling activities B) Cash flows from operating activities C) Cash flows from financing activities D) Cash flows from investing activities

26)

The book value of an asset A) is always equal to its market value.

B) is always less than or equal to its market value.

C) is always greater than or equal to its market value.

D) could be greater than, equal to, or less than its market value.

27) Which of the following is a reason why a company’s market value of equity can differ from its book value of equity?

A) Shareholders are keenly aware of book values but have little interest in market values.

B) Accountants’ charges for the cost of equity are often higher than they should be.

C) The value of some assets on the balance sheet are marked to market.

D) The value of some assets on the balance sheet reflect historical cost, adjusted for depreciation.

28)

Depreciation expense A) decreases both taxes and net income.

B) increases net fixed assets.

C) increases net income.

D) increases both current assets and net income.

E) decreases both current assets and net income.

29) Suppose an acquiring firm pays $100 million for a target firm, and the target’s assets have a book value of $60 million and an estimated replacement value of $70 million. What amount would be allocated to the acquiring firm’s goodwill account?

A) $0 million B) $20 million C) $30 million D) $70 million E) $80 million F) None of the options are correct.

30) JM Case Incorporation has a market value of $5 million with 500,000 shares outstanding.

The book value of its equity is $1,750,000. What is JM Case’s price per share?

A) $3.50 B) $5.00 C) $10.00 D) $25.00 E) $50.00 F) None of the options are correct.

31) JM Case Incorporation has a market value of $5 million with 500,000 shares outstanding.

The book value of its equity is $1,750,000. What is JM Case’s book value per share?

A) $3.50 B) $5.00 C) $10.00 D) $25.00 E) $50.00 F) None of the options are correct.

32) JM Case Incorporation has a market value of $5 million with 500,000 shares outstanding.

The book value of its equity is $1,750,000. If the company repurchases 20% of its shares in the stock market at the current market price, what will be the book value of equity after the repurchase if all else remains the same? (Assume there are no taxes, no transactions costs, and that investors do not change their perceptions of the firm.)

A) $750,000 B) $1,000,000 C) $1,250,000 D) $1,400,000 E) $4,000,000 F) None of the options are correct.

33) JM Case Incorporation has a market value of $5 million with 500,000 shares outstanding.

The book value of its equity is $1,750,000. If the company repurchases 20% of its shares in the stock market at the current market price, what will be the market value of equity after the repurchase if all else remains the same? (Assume there are no taxes, no transactions costs, and that investors do not change their perceptions of the firm.)

A) $1,000,000 B) $1,750,000 C) $3,250,000 D) $4,000,000 E) $5,000,000 F) None of the options are correct.

34) ZZZ Corporation’s income statement shows a provision for income taxes of $65 million in 2021. At the end of 2020, ZZZ’s balance sheet reported income taxes payable of $12 million and deferred taxes of $18 million. At the end of 2021, their balance sheet shows income taxes payable of $13 million and deferred taxes of $17 million. What were ZZZ’s taxes paid in 2021?

A) $61 million B) $63 million C) $65 million D) $67 million E) $69 million

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

A) Net income + Noncash charges − Net increase in current assets + Net increase in current liabilities B) Net income + Capital expenditures − Dividends paid C) Net income − Capital expenditures − Dividends paid D) Net income + Net increase in current assets − Net increase in current liabilities E) Net income + Noncash charges − Capital expenditures

36) true?

Which of the following statements regarding the practice of reporting adjusted earnings is

A) It is uncommon for large public U.S. corporations to report adjusted earnings.

B) A company’s adjusted earnings are typically lower than official earnings.

C) U.S. corporations are required to explain differences between adjusted earnings and official earnings.

D) Managers must follow all generally accepted accounting principles when calculating adjusted earnings.

37)

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

A) The profits reported in a given time period equal the cash flows generated.

B) A company’s operations and finances are independent of each other.

C) Financial statements have nothing to do with reality.

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

E) A profitable company will always have sufficient cash to meet its obligations.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

38) The estimated replacement value of Little Rock, Incorporation’s total assets is $400,000.

Suppose Big Rock Incorporation acquires Little Rock’s assets for $1 million and finances the purchase with $600,000 in new stock, $300,000 in new debt, and existing cash of $100,000.

Describe how the acquisition affects Big Rock’s balance sheet.

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

40) During the past year, Lele Design earned net income of $250,000. The firm neither bought nor sold any capital assets. The book value of its assets declined by the year’s depreciation charge of $200,000. The firm’s operating cash flow for the year was $450,000. The market value of its assets increased by $300,000. Based only on this information, what was Lele Design’s economic income for the year? Why is this figure different from its accounting income?

Please ignore taxes for this problem.

41) Identify the sources and uses of cash for Blackhurst Corporation for 2021 based on the following year-end balance sheets.

2020

2021

Cash Accounts receivable Inventory Net fixed assets

40 100 135 200

30 150 125 240

Total assets

475

545

Bank loan Long-term debt Equity

40 200 235

100 180 265

Total liabilities & equity

475

545

ASSETS

LIABILITIES & EQUITY

SECTION BREAK. Answer all the part questions.

42) [The following information applies to the questions displayed below.]

Foodtek, Incorporation

Selected financial information ($ millions) 2020 Net sales Cost of goods sold Depreciation Net income Finished goods inventory Accounts receivable Accounts payable Net fixed assets Year-end cash balance

296 168 51 32 34 47 39 310 186

2021 364 223 65 45 29 87 44 415 123

42.1) Please refer to the financial information for Foodtek, Incorporation above. During 2021, how much cash (in millions of dollars) did Foodtek collect from sales?

A) 277 B) 324 C) 364 D) 404 E) 451 F) None of the options are correct.

42.2) Please refer to the financial information for Foodtek, Incorporation above. During 2021, what was the cost of merchandise (in millions of dollars) produced by Foodtek?

A) 194 B) 218 C) 223 D) 228 E) 252 F) None of the options are correct.

42.3) Please refer to the financial information for Foodtek, Incorporation above.

Assuming the company neither sold nor salvaged any assets during the year, what were Foodtek’s capital expenditures (in millions of dollars) during 2021?

A) 40 B) 105 C) 170 D) 310 E) 415 F) None of the options are correct.

42.4) Please refer to the financial information for Foodtek, Incorporation above.

Assuming that there were no financing cash flows during 2021 and basing your answer solely on the information provided, what were Foodtek’s cash flows from operations (in millions of dollars) for 2021?

A) 35 B) 45 C) 70 D) 90 E) 110 F) None of the options are correct.

Answer Key Test name: chapter 1 1) TRUE 2) FALSE 3) TRUE 4) FALSE 5) FALSE 6) TRUE 7) FALSE 8) TRUE 9) TRUE 10) FALSE 11) FALSE 12) B 13) A 14) C 15) C 16) B 17) D 18) A 19) D 20) E 21) B 22) A 23) C 24) C 25) A 26) D

27) D 28) A 29) C 30) C Stock price per share = $5 million/500,000 shares = $10 per share 31) A Book value per share = $1,750,000/500,000 shares = $3.50 per share 32) A JM Case will pay $10 per share for the 100,000 shares (= 0.20 × 500,000) it repurchases. This reduces the book value by $1 million (= $10 × 100,000). Assuming all else remains the same, the new book value should be $750,000.

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

34) C Taxes paid = Provision for income taxes − Increase in taxes payable − Increase in deferred taxes = 65 − 1 + 1 = $65 million 35) A 36) C 37) D

38)First, let us account for Big Rock’s $1 million expenditure. Cash will fall $100,000, liabilities will rise $300,000, and owners’ equity will rise $600,000. Next, let us account for the assets acquired. The difference between the acquisition price and the replacement value of the assets acquired will be allocated to the goodwill account ($600,000). Finally, other asset accounts will rise by $400,000 in total as the two companies’ balance sheets are consolidated by adding like accounts together.

39)Playtime Products generated $420,000 of cash during the year. The $500,000 net income ignores the fact that accounts receivable rose $220,000, a use of cash. It also treats $140,000 depreciation as an expense, whereas it is a noncash charge. The $50,000 increase in market value of assets adds to the value of the business, but is not a cash flow.

Summary: Accounting Income Depreciation, a non-cash charge Increase in Accounts Receivable

$ 500,000 + $ 140,000 − $ 220,000

Cash generated

$ 420,000

40)Lele Design generated economic income equal to $750,000, comprised of $450,000 in operating cash flow ($250,000 net income plus $200,000 depreciation) plus a $300,000 increase in the market value of its assets. The $500,000 difference between economic income and accounting income consists of the $200,000 noncash charge of depreciation, and the $300,000 appreciation in the market value of assets, which accounting income does not include.

41) 2020

2021

Cash

40

30

Accounts receivable

100

150

Sources

Uses

ASSETS 10 50

Inventory

135

125

Net fixed assets

200

240

Total assets

475

545

Bank loan

40

100

Long-term debt

200

180

Equity

235

265

Total liabilities & equity

475

545

10 40

LIABILITIES & EQUITY 60 20 30

110

110

42) Section Break 42.1) B In 2021, sales were $364 million, but account receivable rose $40 million, indicating that the company only received $324 million in cash. (This ignores possible changes in bad debt reserves.) Letting bop stand for beginning of period, eop for end of period, and AR for accounts receivable, the equation is AReop = ARbop + Sales − Collections Collections = Sales + ARbop − AReop Collections = 364 + 47 − 87 = $324 million 42.2) B

During 2021, the company sold $223 million of merchandise at cost, but finished goods inventory fell $5 million, indicating that the company only produced $218 million of merchandise. Letting bop stand for beginning of period, and eop for end of period, the equation is Inventoryeop = Inventorybop+ Production − Cost of goods sold Production = Cost of goods sold + Inventoryeop − Inventorybop Production = 223 + 29 − 34 = $218 million 42.3) C Net fixed assets rose $105 million, depreciation reduced net fixed assets by $65 million, so capital expenditures must have been $170 million (ignoring asset sales or write-offs). Letting bop stand for beginning of period, and eop for end of period, the equation is Net fixed assetseop = Net fixed assetsbop + Capital expenditures − Depreciation Capital expenditures = Net fixed assetseop − Net fixed assetsbop + Depreciation Capital expenditures = 415 − 310 + 65 = $170 million 42.4) F Cash flow from operations can be calculated directly from items in the table. Start with net income, remove any noncash items (such as depreciation), and add any cash transactions that are not captured by the income statement (such as changes to working capital accounts).

Cash flow from operations = Net income − increase in accounts receivable + decrease in inventory + increase in accounts payable + depreciation Cash flow from operations = 45 − 40 + 5 + 5 + 65 = $80 million

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) An inventory turnover ratio of 10 means that, on average, items are held in inventory for 10 days. ⊚ true ⊚ false

2)

All else equal, an increase in a company’s asset turnover will decrease its ROE. ⊚ true ⊚ false

3)

A company’s return on assets will always equal or exceed its profit margin. ⊚ true ⊚ false

4)

A company’s price-to-earnings ratio is always equal to one minus its earnings yield. ⊚ true ⊚ false

5)

Return on assets can be calculated as profit margin times asset turnover. ⊚ true ⊚ false

6)

All else equal, a firm would prefer to have a lower gross margin. ⊚ true ⊚ false

7)

The times-interest-earned ratio always equals or exceeds the times-burden-covered ratio. ⊚ true ⊚ false

8) If a firm increases its accounts payable period, all else equal, it increases its cash conversion cycle. ⊚ true ⊚ false

9)

Across companies, ROA and financial leverage tend to be inversely related. ⊚ true ⊚ false

10)

One advantage of ROE is that it is a risk-adjusted measure of performance. ⊚ true ⊚ false

11)

A firm’s operating cycle is never longer than its cash conversion cycle. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

12) Which of these ratios, or levers of performance, are the determinants of ROE? 1.Profit margin 2.Financial leverage 3.Times interest earned 4.Asset turnover A) I and IV only B) II and IV only C) I, II, and IV only D) I, II, and III only E) I, III, and IV only F) I, II, III, and IV

13) Ratios that measure how efficiently a firm manages its assets and operations to generate net income are referred to as

A) asset turnover and control ratios.

B) financial leverage ratios.

C) coverage ratios.

D) profitability ratios.

E) liquidity ratios.

14) Which of the following ratios are measures of a firm’s liquidity?

1.Fixed asset turnover ratio 2.Current ratio 3.Debt-equity ratio 4.Acid test A) I and III only B) II and IV only C) III and IV only D) I, II, and III only E) I, III, and IV only

15) Ptarmigan Travelers had sales of $420,000 in 2020 and $480,000 in 2021. The firm’s current asset accounts remained constant. Given this information, which one of the following statements about the change in Ptarmigan’s ratios between 2020 and 2021 must be true?

A) The asset turnover ratio increased.

B) The collection period increased.

C) The inventory turnover ratio decreased.

D) The fixed-asset turnover ratio decreased.

E) None of the options are correct.

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

A) Its current liabilities are too low.

B) Its cost of goods sold is too low.

C) Its cash and securities balance is too low.

D) Its inventory level is too high.

17) Which one of the following ratios identifies the amount of sales a firm generates for every $1 in assets?

A) Current ratio B) Gross margin C) Retention ratio D) Asset turnover ratio E) Return on assets

18)

A times-interest-earned ratio of 4.3 indicates that the firm A) pays 4.3 times its earnings in interest expense.

B) has EBIT equal to 4.3 times its interest expense.

C) has interest expense equal to 4.3% of EBIT. D) has interest expense equal to 4.3% of net income.

19) At the end of 2021, Stacky Corporation had $500,000 in liabilities and a debt-to-assets ratio of 0.5. For 2021, Stacky had an asset turnover of 3.0. What were annual sales for Stacky in 2021?

A) $333,333 B) $1,200,000 C) $1,800,000 D) $3,000,000

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

A) 8.7% B) 9.1% C) 18.2% D) Insufficient information is provided to answer the question.

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

A) Current ratio B) Debt-to-equity ratio C) Times-interest-earned ratio D) Times-burden-covered ratio

22) Breakers Bay Incorporation has succeeded in increasing the amount of goods it sells while holding the amount of inventory on hand at a constant level. The firm’s cost per unit and selling price per unit also remained constant. All else equal, how will this accomplishment be reflected in the firm’s financial ratios?

A) Decrease in the fixed-asset turnover ratio B) Decrease in the times-interest-earned ratio C) Increase in the inventory turnover ratio D) Increase in days’ sales in inventory E) Decrease in the total asset turnover ratio

23)

Which one of the following statements is correct?

A) If the debt-to-assets ratio is greater than 0.50, then the debt-to-equity ratio must be less than 1.0.

B) Long-term creditors would prefer the times-interest-earned ratio be 1.4 rather than 2.4.

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

D) To realize the best risk and reward profile, financial leverage should be maximized.

E) None of the options are correct.

24)

On a common-size balance sheet, all accounts are expressed as a percentage of A) sales.

B) profits.

C) equity.

D) total assets.

E) None of the options are correct.

25) Primavera Holdings has a profit margin of 25%, an asset turnover of 0.5, and financial leverage (assets to equity) of 1.5. Primavera has $20 billion in assets, half of which is in cash and marketable securities. Assume that Primavera earns a 3% after-tax return on cash and securities.

What would Primavera’s return on equity be if it paid out 90% of its cash and marketable securities as a dividend to shareholders?

A) Negative B) Between 0% and 20% C) Between 20% and 40% D) between 40% and 60% E) Greater than 60%

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

A) ROE measures return on accounting book value.

B) ROE is a forward-looking measure that ignores past performance.

C) ROE measures only return, not risk.

D) None of these describe problems with ROE. E) All of these describe problems with ROE.

27) Please refer to the income statement for VGA Associates below. Assuming that cost of goods sold are variable and operating expenses are fixed, what was VGA Associates’ breakeven sales volume in 2021?

VGA Associates Income statement for 2021

Sales Cost of goods sold Gross profit Operating expenses Operating income Interest expense Pre-tax income Taxes

$ 200,000 150,000 50,000 20,000 30,000 5,000 25,000 5,000

Net income

$ 20,000

A) $20,000 B) $80,000 C) $150,000 D) $180,000 E) None of the options are correct.

28) Please refer to the income statement for VGA Associates below. If VGA had a principal repayment of $8,000 due in 2021, what was its times-burden-covered ratio in 2021?

VGA Associates Income statement for 2021 Sales Cost of goods sold Gross profit Operating expenses Operating income Interest expense Pre-tax income Taxes

$ 200,000 150,000 50,000 20,000 30,000 5,000 25,000 5,000

Net income

$ 20,000

A) 0.67 B) 1.33 C) 2.31 D) 6.00 E) None of the options are correct.

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

A) Ellsbury changes the credit terms it offers to customers, allowing them to pay in 45 days instead of 30 days.

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

C) Ellsbury starts paying off all outstanding invoices to suppliers twice a month instead of once a month.

D) Ellsbury increases its cash/assets ratio from 12% to 15%.

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

A) 34.0 days B) 51.2 days C) 70.4 days D) 131.2 days E) None of the options are correct.

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

A) profit margin.

B) return on equity.

C) return on assets.

D) times-burden-covered ratio.

E) earnings yield.

F) None of the options are correct.

32)

Which of the following statements regarding common-size financial statements is true?

A) Items on a common-size income statement are presented as a percentage of total assets.

B) Items on a common-size balance sheet are presented as a percentage of net sales.

C) On a common-size income statement, the sum of sales, cost of goods sold, and all expenses is 100%.

D) On a common-size balance sheet, the sum of all items under liabilities and equity is 100%.

E) None of the options are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

33) Answer the questions below based on the following information. The tax rate is 35%, and all dollars are in millions. Assume that the companies have no liabilities other than the debt shown below.

Earnings before interest and taxes Debt (at 10% interest) Equity

Suunto Incorporation $ 280 $ 140 $ 560

Runrun Corporation $ 294 $ 840 $ 210

a. Calculate each company’s ROE, ROA, and ROIC. b. Why is Runrun’s ROE higher than Suunto’s? Does this mean Runrun is a better company?

Why or why not? c. Why is Suunto’s ROA higher than Runrun’s? What does this tell you about the two companies? d. How do the two companies’ ROICs compare? What does this suggest about the two companies?

34) Please refer to the financial statements for Roxbury Corporation. Estimate the length of Roxbury’s cash conversion cycle in 2021.

Roxbury Corporation

2020 and 2021, ($ millions) INCOME STATEMENT BALANCE SHEET 2020 2021 2020 Net sales

$ 47,616 Cost of goods 40,718 sold GS&A expense 6,171 EBIT 727 Interest 215 expense Earnings 512 before tax Tax 154

$ 52,378 44,790

Net income

$ 358

6,788 800 255

Cash & securities Accounts receivable Inventories Net fixed assets Total assets

2021

$ 951

$ 1,046

6,666

7,333 5,760 2,253 $ 16,392 $ 547

545

Bank loan

5,236 2,048 $ 14,901 $ 392

164

Accounts payable

7,419

8,161

$ 382

Long-term debt

2,148

2,551

Total liabilities Common stock

9,959

11,259

1,293

1,293

Retained earnings Total equity

3,649

3,840

4,942

5,133

Total liabilities & equity

$ 14,901

$ 16,392

SECTION BREAK. Answer all the part questions.

35) [The following information applies to the questions displayed below.]

Link, Incorporation Selected financial data ($ thousands) 2020

2021

Income statement and related items Sales Cost of goods sold

$ 160,835 141,829

$ 274,219 209,628

Net income Cash flow from operations Balance sheet items Cash Marketable securities Accounts receivable Inventory Total current assets Accounts payable Accrued liabilities Total current liabilities

(91,432) (35,831)

(257,981) (12,538)

$ 236,307 209,670 12,645 3,971 462,593 17,735 27,184

$ 164,952 22,638 21,655 40,556 249,801 13,962 76,596

44,919

90,558

35.1) Please refer to the financial data for Link, Incorporation above. What is the current ratio for Link at the end of 2021?

A) 2.31 B) 2.76 C) 10.21 D) 10.30 E) None of the options are correct.

35.2) Please refer to the financial data for Link, Incorporation above. Which of the following statements best describes how the Link's short-term liquidity changed from 2020 to 2021?

A) Link’s short-term liquidity has improved modestly.

B) Link’s short-term liquidity has deteriorated very little, but from a low initial base.

C) Link’s short-term liquidity has improved considerably, but from a low initial base.

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

E) None of the options are correct.

35.3) Please refer to the financial data for Link, Incorporation above. What is Link’s collection period in days, based on sales, for 2021?

A) 24.3 B) 28.8 C) 35.7 D) 219.6

35.4) Please refer to the financial data for Link, Incorporation above. What is Link’s inventory turnover for 2021?

A) 5.2 B) 24.3 C) 28.8 D) 35.7 E) None of the options are correct.

35.5) Please refer to the financial data for Link, Incorporation above. What is Link’s payables period in days, based on cost of goods sold, for 2021?

A) 5.2 B) 24.3 C) 28.8 D) 35.7

35.6) Please refer to the financial data for Link, Incorporation above. What is Link’s days’ sales in cash for 2021?

A) 24.3 B) 28.8 C) 219.6 D) 249.7 E) None of the options are correct.

35.7) Please refer to the financial data for Link, Incorporation above. What is Link’s gross margin for 2021?

A) −94% B) 13% C) 26% D) 31% E) None of the options are correct.

35.8) Please refer to the financial data for Link, Incorporation above. What is Link’s profit margin for 2021?

A) −94%.

B) −57%.

C) 13%.

D) 31%.

E) None of the options are correct.

36) [The following information applies to the questions displayed below.]

Financial statements for Limited Brands, Incorporation follow (fiscal years ending January): Limited Brands, Incorporation Balance Sheets ($ Millions) 2007 2006

2005

Total Assets Liabilities

7,093.000

6,346.000

6,089.000

Long-Term Debt Due in One Year Payables and Accrued Expenses Total Current Liabilities Long-Term Debt Deferred Taxes Minority Interest Other Liabilities Total Liabilities Total Equity Total Liabilities & Equity

8.000 1,701.000 1,709.000 1,665.000 173.000 71.000 520.000 4,138.000 2,955.000 7,093.000

7.000 1,568.000 1,575.000 1,669.000 146.000 33.000 452.000 3,875.000 2,471.000 6,346.000

0.000 1,451.000 1,451.000 1,646.000 177.000 33.000 447.000 3,754.000 2,335.000 6,089.000

398.000

395.000

407.000

Common Shares Outstanding

Income Statements ($ Millions)

2007

2006

10,671.000 6,342.000 4,329.000 2,837.000

9,669.000 5,920.000 3,749.000 2,502.500

1,492.000

1,246.500

316.000

299.000

1,176.000 102.000 23.000 0.000 1,097.000 422.000 675.000 1.000

947.500 94.000 25.000 78.500 957.000 291.000 666.000 17.000

Adjusted Net Income

676.000

683.000

Dividends per share

$ 0.60

$ 0.61

Sales Cost of Goods Sold Gross Profit Selling, General, & Administrative Expenses Operating Income Before Depreciation Depreciation, Depletion, & Amortization Operating Profit Interest Expense Non-Operating Income/Expense Special Items Pre-tax Income Total Income Taxes Adjusted Available for Common Extraordinary Items

36.1) Please refer to Limited Brands, Incorporation’s financial statements above. Use the company’s operating profit as an approximation of its EBIT, and assume a 40% tax rate for your calculations. For 2006 and 2007, calculate: a. Debt-to-equity ratio b. Times-interest-earned ratio c. Times burden covered

36.2) Please refer to Limited Brands, Incorporation’s financial statements above. Use the company’s operating profit as an approximation of its EBIT, and assume a 40% tax rate for your calculations. What percentage decline in EBIT could Limited Brands have sustained in 2006 and 2007 before failing to cover: a. Interest and principal repayment requirements? b. Interest, principal, and common dividend payments?

36.3) Please refer to Limited Brands, Incorporation’s financial statements above.

Prepare common-size financial statements for Limited Brands, Incorporation for 2006– 2007.

Answer Key Test name: chapter 2 1) FALSE 2) FALSE 3) FALSE 4) FALSE 5) TRUE 6) FALSE 7) TRUE 8) FALSE 9) TRUE 10) FALSE 11) FALSE 12) C 13) A 14) B 15) E 16) D 17) D 18) B 19) D Liabilities/Assets = 0.5 = $500,000/Assets So Assets = $1,000,000 Then, Sales/$1,000,000 = 3 So sales = $3,000,000 20) D 21) D

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

22) C 23) C 24) D 25) D Currently, equity = $13.33 billion (20/13.33 = 1.5) and net income = $2.5 billion (2.5/10 = 25%).

Paying a $9 billion dividend would reduce equity to $4.33 billion. Net income would fall by 3% × $9 billion = $0.27 billion, to $2.23 billion.

ROE would then be 2.23/4.33 = 51.5% 26) B 27) B Gross margin = 50,000/200,000 = 25%.

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

28) E TBC = EBIT/(Interest expenses + Principal Repay/1−t) TBC = 30000/(5000 + 8000/1 − 0.2) = 2.00 29) B A would increase the cash conversion cycle, because accounts receivable would increase.

B would reduce the cash conversion cycle, because inventory would decrease.

C would increase the cash conversion cycle, because accounts payable would decrease.

D would not affect the cash conversion cycle.

30) C Cash conversion cycle = Days inventory outstanding + Collection period − Payables period = Inventory/(COGS/365) + Receivables/(Sales/365) − Payables/(COGS/365) = 3/(18/365) + 40 − 1.5/(18/365) = 60.8 + 40 − 30.4 = 70.4 days 31) B 32) D 33)a.

Net income ROE ROA ROIC

Suunto Incorporation $ 172.9 31% 25% 26%

Runrun Corporation $ 136.5 65% 13% 18%

b. Runrun’s higher ROE is a natural reflection of its higher financial leverage. It does not mean that Runrun is the better company. c. This is also due to Runrun’s higher leverage. ROA penalizes levered companies by comparing the net income available to equity to the capital provided by owners and creditors. It does not mean that Runrun is a worse company than Suunto. d. ROIC abstracts from differences in leverage to provide a direct comparison of the earning power of the two companies’ assets. On this metric, Suunto is the superior performer. Before drawing any firm conclusions, however, it is important to ask how the business risks faced by the companies compare and whether the observed ratios reflect longrun capabilities or transitory events.

34)Cash conversion cycle = Days inventory outstanding + Collection period − Payables period = Inventory/(COGS/365) + Accounts receivable/(Sales/365) − Accounts payable/(COGS/365) = 5760/(44,790/365) + 7333/(52,378/365) − 8161/(44,790/365) = 46.9 + 51.1 − 66.5 = 31.5 days 35) Section Break 35.1) B 249,801/90,558 = 2.76 35.2) D 35.3) B 21,655/(274,219/365) = 28.8 35.4) A 209,628/40,556 = 5.2 35.5) B 13,962/(209,628/365) = 24.3 35.6) D (164,952 + 22,638)/(274,219/365) = 249.7 35.7) E (274,219 − 209,628)/274,219 = 23.6% 35.8) A −257,981/274,219 = −94% 36) Section Break 36.1)

a. Debt-to-equity ratio b. Times-interest-earned ratio c. Times burden covered

2007

2006

1.40 11.53 10.35

1.57 10.08 10.08

(Note that principal payment in year t equals current portion of long-term debt in year t-1.)

36.2)a. For 2006: Interest expense = $94 Principal repayment = $0 (long-term debt due in one year from 2005) EBIT = $947.5, so it could have fallen (947.5 − 94)/947.5 = 90.1% before failing to cover interest and principal.

For 2007: Interest expense = $102 Principal repayment = $7 (long-term debt due in one year from 2006) EBIT = $1,176, so it could have fallen (1,176 − 102 − 7/0.6)/1,176 = 90.3% before failing to cover interest and principal. b. For 2006: Interest expense = $94 Principal repayment = $0 (long-term debt due in one year from 2005) Common dividends = Shares outstanding × Dividends per share = 395 × 0.61 = $241.0 EBIT = $947.5, so it could have fallen (947.5 − 94 − 241/0.6)/947.5 = 47.7% before failing to cover interest, principal, and dividends.

For 2007: Interest expense = $102 Principal repayment = $7 (long-term debt due in one year from 2006) Common dividends = Shares outstanding × Dividends per share = 398 × 0.60 = $238.8 EBIT = $1,176, so it could have fallen (1,176 − 102 − 245.8/0.6)/1,176 = 56.5% before failing to cover interest, principal, and dividends.

36.3)

BALANCE SHEETS (% of Assets) 2007

2006

2005

100.00%

100.00%

100.00%

Long-Term Debt Due in One Year 0.11% Payables and Accrued Expenses 23.98% Total Current Liabilities 24.09% Long-Term Debt 23.47% Deferred Taxes 2.44% Minority Interest 1.00% Other Liabilities 7.33% TOTAL LIABILITIES 58.34% TOTAL EQUITY 41.66% TOTAL LIABILITIES & EQUITY 100.00% INCOME STATEMENTS (% of Sales) 2007

0.11% 24.71% 24.82% 26.30% 2.30% 0.52% 7.12% 61.06% 38.94% 100.00%

0.00% 23.83% 23.83% 27.03% 2.91% 0.54% 7.34% 61.65% 38.35% 100.00%

Sales Cost of Goods Sold Gross Profit Selling, General, & Administrative Expenses Operating Income Before Depreciation Depreciation, Depletion, & Amortization Operating Profit Interest Expense Non-Operating Income/Expense Special Items Pretax Income Total Income Taxes Adjusted Available for Common Extraordinary Items

100.00% 59.43% 40.57% 26.59%

100.00% 61.23% 38.77% 25.88%

13.98% 2.96% 11.02% 0.96% 0.22% 0.00% 10.28% 3.95% 6.33% 0.01%

12.89% 3.09% 9.80% 0.97% 0.26% 0.81% 9.90% 3.01% 6.89% 0.18%

6.33%

7.06%

TOTAL ASSETS LIABILITIES

Adjusted Net Income

2006

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The percent-of-sales approach to financial forecasting works well for forecasting the income statement but is not useful for forecasting the balance sheet.

⊚ ⊚

true false

2) An advantage of the percent-of-sales approach to financial forecasting is that effective forecasts can be prepared without consulting historical financial statements. ⊚ true ⊚ false

3) The forecast for retained earnings on the year-end 2022 balance sheet can be determined as retained earnings on the year-end 2021 balance sheet plus projected 2022 after-tax earnings less projected 2022 dividends. ⊚ ⊚

true false

4) An annual financial forecast for 2022 showing no external funding required assures a company that no cash shortfalls are likely to occur during 2022. ⊚ ⊚

true false

5) All else equal, increasing the assumed payables period in a financial forecast will decrease external funding required. ⊚ true ⊚ false

6) All else equal, decreasing the assumed collection period in a financial forecast will decrease external funding required. ⊚ ⊚

true false

7) Given the same assumptions, cash flow forecasts and pro forma projections will yield the same need for external funding.

⊚ ⊚

true false

8) A drawback of forecasting using spreadsheets is that typical spreadsheet programs are not equipped to deal with the circularity involving interest expense and debt. ⊚ ⊚

true false

9) Scenario analysis involves changing one input to a financial forecast, whereas sensitivity analysis involves changing multiple inputs. ⊚ true ⊚ false

10)

Cash flow forecasts are less informative than pro forma financial statements. ⊚ true ⊚ false

11)

Cash budgets are based on cash accounting rather than accrual accounting. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

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

A) Increase the sales growth rate B) Increase cost of goods sold as a percentage of sales C) Reduce the collection period D) Increase the dividend payout ratio E) None of the options are correct.

13) To estimate H-32 Corporation’s 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, H-32’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 H-32 will pay $10,400 in dividends. What are the estimated retained earnings at the end of next year?

A) $168,400 B) $171,000 C) $181,400 D) $508,300 E) $518,700 F) None of the options are correct.

14)

The most common approach to developing pro forma financial statements is called the A) cash budget method.

B) financial planning method.

C) seasonality approach.

D) percent-of-sales method.

E) market-oriented approach.

F) None of the options are correct.

15) Which of the following are viable techniques to cope with the uncertainty inherent in realistic financial projections?

1.Simulation 2.Ad hoc adjustments 3.Scenario analysis 4.Sensitivity analysis

A) II and IV only B) III and IV only C) II, III, and IV only D) I, II, and III only E) I, III, and IV only F) I, II, III, and IV

16)

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

A) Most firms attempt to maintain a zero cash balance at all times.

B) The cumulative cash surplus shown on a cash budget is equal to the ending cash balance plus the minimum desired cash balance.

C) Most firms attempt to maximize the cash balance at all times.

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

E) The ending cash balance must equal the minimum desired cash balance.

17) 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?

A) October, November, and December B) November, December, and January C) December, January, and February D) January, February, and March E) February, March, and April

18) The Limited collects 25% of sales in the month of sale, 60% of sales in the month following the month of sale, and 15% of sales in the second month following the month of sale.

During the month of April, the firm will collect

A) 60% of February sales.

B) 15% of April sales.

C) 60% of March sales.

D) 15% of March sales.

E) 25% of February sales.

19) 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

A) pro forma income statement.

B) sales projection.

C) cash budget.

D) receivables analysis.

E) credit analysis.

F) None of the options are correct.

20) You are developing a financial plan for a corporation. Which of the following questions will be considered as you develop this plan?

1.How much will our sales grow?

2.Will additional fixed assets be required?

3.Will dividends be paid to shareholders?

4.How much new debt must be obtained?

A) I and IV only B) II and III only C) I, III, and IV only D) II, III, and IV only E) I, II, III, and IV

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

A) $621 B) $628 C) $633 D) $639 E) $643

22) On May 1, Vaya Corporation 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?

A) $145 B) $155 C) $205 D) $215 E) $265

23) You are preparing pro forma financial statements for 2021 using the percent-of-sales method. Sales were $100,000 in 2020 and are projected to be $120,000 in 2021. Net income was $5,000 in 2020 and is projected to be $6,000 in 2021. Equity was $45,000 at year-end 2019 and $50,000 at year-end 2020. 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 2021?

A) $55,000 B) $56,000 C) $60,000 D) Insufficient information is provided to answer the question.

24) 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?

A) Total assets cannot grow by more than $10,000.

B) Dividends cannot exceed $10,000.

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

D) Long-term debt cannot grow by more than $5,000.

25) You are estimating your company’s external financing needs for the next year. At the end of next year, you project that owners’ equity will be $80 million, total assets will be $170 million, and total liabilities will be $60 million. How much external funding required will be projected for your company at the end of next year?

A) $20 million B) $30 million C) $60 million D) $90 million E) $110 million F) None of the options are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

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

27) Edna’s Laundry Services just completed pro forma statements using the percentage-ofsales approach. The pro forma shows a projected external financing need of –$5,500. Interpret this figure. What are the firm’s options in this case?

28) Preston Fencing Company’s sales, half of which are for cash and the other half sold on credit, over the past three months were: August $ 70,000

September $ 120,000

October $ 80,000

For simplicity, assume for this question that all months are 30 days in length and that Preston’s sales are evenly distributed over the course of each month. a.Estimate Preston’s cash receipts in October if the company’s collection period is 30 days. b.Estimate Preston’s cash receipts in October if the company’s collection period is 45 days. c.What would be Preston’s accounts receivable balance at the end of October if the company’s collection period is 30 days? 45 days?

29) Suppose your colleague constructed a pro forma balance sheet and a cash budget for your company for the same time period, and the external financing required from the pro forma forecast exceeded the cash deficit estimated on the cash budget. How would you interpret this result?

30) Complete the following pro forma financial statements for XYZ Corporation. Use the percent-of-sales method and use long-term debt as the plug figure (balancing item). Assume the following: 20% sales growth, capital expenditures of $200 in 2022, no equity issues or repurchases in 2022, no sale or disposal of fixed assets in 2022, no changes in the tax rate, and a 50% dividend payout ratio. Round figures to the nearest whole dollar.

XYZ Corporation Financial Statements Actual 2021 and Pro Forma 2022 Income Statement Balance Sheet 2021 2022 2021

2022

Sales

Current assets

Cost of goods sold

$ 1,000 700

Net fixed assets

$ 300 500

Operating expense

100

Total assets

800

Depreciation expense EBIT

100

Current liabilities

400

Interest expense

25

Long-term debt

200

Pre-tax income

75

Equity

200

Tax

25

Total liabilities & equity

$ 800

Net income

130

100 20

$ 50

SECTION BREAK. Answer all the part questions.

31) [The following information applies to the questions displayed below.]

Oscar's Incredible Eatery ($ thousands) Income Statement for the year ending December 31, 2021 Net sales 17,300 Cost of goods sold 10,600 Depreciation 3,250 Earnings before interest and 3,450 taxes Interest expense 680 Earnings before tax 2,770 Tax 940 Earnings after tax 1,830 Dividends 450 Oscar's Incredible Eatery ($ thousands) Balance Sheet as of December 31, 2021 Cash 350 Accounts payable Accounts receivable 940 Long-term debt

1,920 3,500

Inventory Total current assets Net fixed assets

2,360 3,650 10,850

Common stock Retained earnings

7,500 1,580

Total assets

14,500

Total liability & equity

14,500

31.1) Please refer to Oscar’s financial statements above. What was Oscar’s increase in retained earnings during 2021?

A) $450 B) $1,380 C) $1,830 D) $2,280 E) None of the options are correct.

31.2) Please refer to Oscar’s financial statements above. Sales are projected to increase by 3% 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?

A) $1,309.19 B) $1,421.40 C) $1,884.90 D) $2,667.78 E) $3,001.40 F) None of the options are correct.

31.3) 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% next year.

What is the pro forma accounts receivable balance for next year?

A) $949 B) $1,034 C) $1,113 D) $1,730 E) $2,670 F) None of the options are correct.

31.4) 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% next year. What is Oscar’s external financing need for next year?

A) − $410 B) − $260 C) $235 D) $1,320 E) $7,240 F) None of the options are correct.

31.5) 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%?

A) $10,857.50 B) $10,931.38 C) $11,663.75 D) $15,587.50 E) $18,987.50 F) None of the options are correct.

32)

[The following information applies to the questions displayed below.]

Financial Statements for Royal Corporation Actual 2020 and Pro Forma 2021 Income Statement Balance Sheet 2020 2021 2020 Net sales

$ 47,616 40,718

$ 52,378 44,790

5,171 1,000

5,688 1,100

727

800

Interest expense Earnings before tax Tax

215

215

512

585

154

176

Net income

$ 359

$ 409

Cost of goods sold Other expenses Depreciation expense EBIT

Dividends paid

90

Additional to retained earnings

$ 269

102

2021

Cash & securities Accounts receivable Inventories Net fixed assets

$ 951

Total assets

14,901

Bank loan (short-term) Accounts payable Long-term debt

$ 392

$ 431

7,419

8,161

Total liabilities Shareholders' equity

9,959

Total liabilities & equity

$ 14,901

5,666 4,236 4,048

$ 1,046 6,233 4,660

2,148

4,942

32.1) In the above financial statements, Royal Corporation has prepared (incomplete) pro forma financial statements for 2021 based on actual financial statements for 2020.

Royal Corp. used the percent-of-sales method, assuming a sales growth rate of 10% for 2021. If capital expenditures are planned to be $1,615 in 2021, and there are no plans to sell or dispose of fixed assets in 2021, what would be the appropriate projection for net fixed assets in 2021?

A) $4,453 B) $4,563 C) $4,663 D) $5,663

32.2) Please refer to the pro forma financial statements for Royal Corporation above. If $100 in new equity is planned to be issued in 2021, and there are no plans to repurchase equity in 2021, what should be the projection for shareholders’ equity for 2021?

A) $5,349 B) $5,436 C) $5,451 D) $5,536

32.3) Please refer to the pro forma financial statements for Royal Corporation above.

Assume that net fixed assets are projected to be $5,000 for 2021 and that shareholders’ equity is projected to be $5,500 for 2021. If long-term debt is the plug figure, what should be the projection for long-term debt for Royal Corporation in 2021?

A) $2,206 B) $2,363 C) $2,455 D) $2,847

33)

[The following information applies to the questions displayed below.]

Selected assumptions for 2022 Sales growth 9% rate Cost of goods 62% sold/Sales Dividends/Net 40% income Income Statement

Balance Sheet

Sales Cost of goods sold Operating expense Depreciation expense EBIT

Actual

Forecast

2021

2022

$ 1,000 600

Actual Forecast 2021 Cash

$ 100

Accounts receivable Inventory

200

800

100

Total Current Assets Net PP&E

1,000

Interest expense

35

Total Assets

1,800

Pre-tax income

65

Tax

26

Accounts payable

300

Bank loan

100

Total Current Liabilities Long-Term Debt

400

Shareholders' Equity

1,000

Net Income

200 100

$ 39

Total Liabilities & Equity

2022

500

400

$ 1,800

33.1) Please refer to the spreadsheet above. Selected assumptions are given for preparing pro forma financial statements for 2022. Which of the following formulas would correctly give the forecast for sales in cell C8?

A) = B8 * B2 B) = B8 + B8 * B2 C) = (1 + B8) * B2 D) = (1/B2) * B8 E) None of the options are correct.

33.2) Please refer to the spreadsheet above. Selected assumptions are given for preparing pro forma financial statements for 2022. When the pro formas are completed, which of the following formulas would correctly give the forecast for cost of goods sold in cell C9?

A) = B9 * B3 B) = B9 + B9 * B3 C) = B8 * B3 D) = B9 * B2 E) None of the options are correct.

33.3) Please refer to the spreadsheet above. Selected assumptions are given for preparing pro forma financial statements for 2022. Assume that no new equity will be issued and that no equity will be repurchased in 2022. When the pro formas are completed, which of the following formulas would correctly give the forecast for shareholders’ equity in cell G19?

A) = F19 * B2 B) = F19 * (1 + B2) C) = F19 + (1 − B4) * C16 D) = F19 + B4 * C16 E) None of the options are correct.

33.4) Please refer to the spreadsheet above. Selected assumptions are given for preparing pro forma financial statements for 2022. Assume that gross property plant and equipment (PP&E) will grow at the sales growth rate in 2022. When the pro formas are completed, which of the following formulas would correctly give the forecast for net PP&E in cell G12?

A) = F12 * B2 B) = F12 * (1+B2) C) = F12 − B11 D) = F12 − C11 E) None of the options are correct.

Answer Key Test name: chapter 3 1) FALSE 2) FALSE 3) TRUE 4) FALSE 5) TRUE 6) TRUE 7) TRUE 8) FALSE 9) FALSE 10) TRUE 11) TRUE 12) C 13) B 158,000 + 23,400 − 10,400 = $171,000 14) D 15) E 16) D 17) E 18) C 19) C 20) E 21) E August collections = 0.20($610) + 0.70($670) + 0.08($650) = $643 22) C Cash balance = $175 − $110 − $290 + $430 = $205

23) B All of net income was added to equity in 2020, so all of net income will be added to equity in 2021. $50,000 + $6,000 = $56,000.

24) C 25) B 26) Historical analysis helps decide for which financial statement items a percent-of-sales forecast might be appropriate. For example, a stable trend in the collection period would tell you that, unless you expect changes in the management of the accounts receivable, future collection periods should continue along this trend. Historical analysis also helps determine the appropriate percentages to apply to financial statement items that are expected to change as a percent of sales.

27)A negative value implies that the company has excess cash above its desired minimum. With a negative external financing need, the firm has a surplus of funds that it can use to reduce current liabilities, reduce long-term debt, buy back common stock, or increase dividends. If acceptable opportunities exist, the firm might also use the extra funds to purchase fixed assets, thereby increasing its potential growth, should that action be warranted.

28)a.If the collection period is 30 days, October cash receipts from September sales will equal half of September sales or $60,000. In addition, the company will receive cash from half of October sales or $40,000. The total is $100,000. b.With a 45-day collection period, cash receipts from credit sales (which are half of total sales) in October are from the period mid-August through mid-September, or (70,000/2 + 120,000/2)/2 = $47,500. Adding sales for cash of $40,000 in October, the total is $87,500. c.If the collection period is 30 days, then the October accounts receivable balance should be the last 30 days’ worth of credit sales.

October credit sales were $40,000, thus the accounts receivable balance would be $40,000. If the collection period is 45 days, then the balance would be October’s credit sales and half of September’s credit sales, or 40,000 + 60,000/2 = $70,000.

29) This would tell you that your colleague had erred in constructing one or both forecasts. Using the same assumptions and avoiding accounting and arithmetic errors, estimated external financing required should equal estimated cash surplus or deficit for the same date.

30) XYZ Corporation Financial Statements Actual 2021 and Pro Forma 2022 Income Statement Balance Sheet 2021 2022 2021 Sales Cost of goods sold Operating expense Depreciation expense EBIT

$ 1,000 700

$ 1,200 840

100

120

100

130

100

110

Current assets Net fixed assets Total assets

Current

2022

$ 300 500

$ 360 570

800

930

400

480

Interest expense Pre-tax income Tax

Net income

25

20

75 25

90 30

$ 50

$ 60

liabilities Long-term debt Equity Total liabilities & equity

200

220

200 $ 800

230 $ 930

Notes: Net fixed assets = 500 + 200 − 130 = 570 Equity = 200 + 0.5 × 60 = 230 31) Section Break 31.1) B 1,830 − 450 = 1,380 31.2) B Projected addition to retained earnings = $1,380 × (1 + 0.03) = $1,421.40 31.3) B Pro forma accounts receivable = $940 × (1 + 0.10) = $1,034 31.4) B Projected total assets = $14,500 × 1.10 = $15,950 Projected total liabilities = $1,920 × 1.10 + $3,500 = $5,612 Projected total equity = $7,500 + ($1,580 + $1,380 × 1.1) = $10,598 External financing needed = $15,950 − ($5,612 + $10,598) = −$260 31.5) C Pro forma net fixed assets = $10,850 × (1 + 0.075) = $11,663.75 32) Section Break 32.1) B 4,048 + 1,615 − 1,100 = $4,563 32.2) A 4,942 + 307 + 100 = $5,349 32.3) D

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 33) Section Break 33.1) B 33.2) E 33.3) C 33.4) E Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The sustainable growth rate is defined as the maximum rate at which company sales can increase. ⊚ ⊚

true false

2) The sustainable growth rate is the only growth rate in sales that is consistent with stable values of the profit margin, retention rate, asset turnover, and leverage (assets/equitybop). ⊚ ⊚

true false

3) A company experiencing balanced growth does not generate cash surpluses or cash deficits. ⊚ true ⊚ false

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

⊚ ⊚

true false

5) The only way a company can grow at a rate above its current sustainable growth rate is by increasing leverage. ⊚ true ⊚ false

6) In recent years, U.S. companies as a whole have issued more equity than they have repurchased. ⊚ ⊚

7)

Share repurchases usually cause a reduction in earnings per share. ⊚ ⊚

8)

true false

true false

Issue costs of equity are higher than issue costs of debt. ⊚ ⊚

true false

9) One way to manage an actual growth rate above the sustainable growth rate is to decrease prices. ⊚ true ⊚ false

10) One way to manage an actual growth rate below the sustainable growth rate is to repurchase shares. ⊚ true ⊚ false

11) The sustainable growth rate can be calculated as the retention ratio times the return on beginning-of-period equity. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

12) Which of these ratios are determinants of a firm’s sustainable growth rate?

1.Assets-to-equity ratio 2.Profit margin 3.Retention ratio 4.Asset turnover ratio A) I and III only B) II and III only C) II, III, and IV only D) I, II, and III only E) I, II, III, and IV F) None of the options are correct

13)

The retention ratio is

A) equal to net income divided by the change in total equity.

B) the percentage of net income available to the firm to fund future growth.

C) equal to one minus the asset turnover ratio.

D) the change in retained earnings divided by the dividends paid.

E) the dollar increase in net income divided by the dollar increase in sales.

F) None of the options are correct.

14)

Which of the following statements is true?

A) As long as they are profitable, companies should always seek to maximize sales growth.

B) Companies that grow rapidly very rarely encounter financial problems.

C) The cash flows generated in a given time period are equal to the profits reported.

D) Profits provide assurance that cash flow will be sufficient to maintain solvency.

E) It is possible for fast-growing companies to run out of cash, even when they are profitable.

F) None of the options are correct.

15)

Which one of the following correctly defines the retention ratio?

A) One plus the dividend payout ratio B) Additions to retained earnings divided by net income C) Additions to retained earnings divided by dividends paid D) Net income minus additions to retained earnings E) Net income minus cash dividends F) None of the options are correct.

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

A) Working capital policy B) Capital structure policy C) Dividend policy D) Capital budgeting policy E) Capacity utilization policy

17) Which of the following actions would help resolve the problem of having actual growth greater than sustainable growth?

1.Increase financial leverage 2.Sell additional equity 3.Decrease prices 4.Outsource production

A) I and II only B) I, II, and IV only C) I, III, and IV only D) II and IV only E) I, II, III, and IV F) None of the options are correct.

18)

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

A) minimum growth rate achievable while maintaining a 100% retention ratio.

B) minimum growth rate achievable if the firm maintains a constant debt-to-equity ratio.

C) maximum growth rate achievable without any new external financing.

D) maximum growth rate achievable without raising new equity or increasing financial leverage.

E) maximum growth rate achievable with unlimited debt financing.

19)

The sustainable growth rate

A) assumes there is no external financing of any kind.

B) assumes no additional long-term debt is available.

C) assumes the debt-equity ratio remains constant.

D) assumes the debt-equity ratio does not exceed 1.0.

E) assumes all income is retained by the firm.

F) None of the options are correct.

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

1.Asset turnover 2.Profit margin 3.Dividend policy 4.Financial leverage

A) III only B) I and III only C) II, III, and IV only D) I, II, and IV only E) I, II, III, and IV F) None of the options are correct.

21) Gujarat Corporation doubled its shareholders’ equity during 2022. 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 2022?

A) 50% B) 100% C) 150% D) 200% E) Insufficient information is given to determine the answer.

22) 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?

A) 3% B) 4% C) 5% D) 6% E) Insufficient information is given to determine the answer.

23) 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?

A) Milano’s leverage has decreased.

B) Milano’s leverage has remained constant.

C) Milano’s leverage has increased.

D) Milano has no debt.

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

A) A decrease in the dividend payout ratio B) A decrease in sales growth C) An increase in profit margin D) A decrease in the collection period E) None of the options are correct.

25) 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?

A) A stock repurchase B) A decrease in accounts payable C) An increase in cash and marketable securities D) An increase in the retention ratio E) None of the options are correct.

26)

The sustainable growth rate

A) is the highest growth rate attainable for a firm that pays no dividends.

B) is the highest growth rate attainable for a firm without issuing new stock.

C) can never be greater than the return on equity.

D) can be increased by decreasing leverage.

E) None of the options are correct.

27) Enterex Corporation expects sales of $437,500 next year. Enterex’s profit margin is 4.8% and its dividend payout ratio is 40%. What is Enterex’s projected increase in retained earnings for next year?

A) $8,400 B) $12,600 C) $14,700 D) $21,000 E) $262,500 F) None of the options are correct.

28) Komatsu Corporation has a 4.5% profit margin and a 15% dividend payout ratio.

Komatsu’s asset turnover ratio is 1.6 and its assets-to-equity ratio (using beginning-of-period equity) is 1.77. What is Komatsu’s sustainable rate of growth?

A) 1.9% B) 6.1% C) 10.8% D) 11.3% E) 12.7% F) None of the options are correct.

29) A firm has a retention ratio of 40% and a sustainable growth rate of 6.2%. Its asset turnover ratio is 0.85, and its assets-to-equity ratio (using beginning-of-period equity) is 1.8.

What is its profit margin?

A) 3.8% B) 5.7% C) 6.7% D) 10.1% E) 18.2%

30) Westcomb, Incorporated 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 did not sell or repurchase any equity. Net income for the year was $72,000, and dividends were $44,640.

What is Westcomb’s sustainable growth rate?

A) 15.3% B) 15.8% C) 17.8% D) 18.0% E) 18.2%

31) In 2021, Santa Fe Corporation had profits of $500,000 on sales of $10,000,000. At the beginning of 2021 Santa Fe’s book equity was $2,500,000, and at the end of 2021 Santa Fe’s total assets were $5,000,000. What is Santa Fe’s sustainable rate of growth for 2021?

A) 5% B) 10% C) 20% D) 25% E) Insufficient information is given to determine the answer.

32) Which of the following actions would help a firm’s growth problem if its actual sales growth exceeds its sustainable rate of growth?

1.Increase prices 2.Decrease financial leverage 3.Decrease dividends 4.Prune away less-profitable products A) I and II only B) I and III only C) I, II, and IV only D) I, III, and IV only E) I, II, III, and IV F) None of the options are correct

33) Which of the following is NOT a reason why U.S. corporations haven’t issued more equity in recent years?

A) Managers usually believe that their stock is overvalued.

B) Companies in the aggregate had sufficient funds through profits and new debt.

C) Equity is relatively expensive to issue.

D) Managers try to avoid dilution of earnings per share.

E) Managers perceive the stock market to be an unreliable funding source.

34) Which one of the following will increase the sustainable rate of growth a corporation can achieve?

A) Avoidance of external equity financing B) An increase in corporate tax rates C) A decrease in the retention ratio D) A decrease in the dividend payout ratio E) A decrease in leverage F) None of the options are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

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

SECTION BREAK. Answer all the part questions.

36) [The following information applies to the questions displayed below.]

Boss Stores, Incorporated Selected financial information ($ millions) 2018 2019 2020 Sales Net income

287.31 11.22

339.19 16.48

411.78 19.70

2021 446.84 12.23

Total assets Equity Dividends

268.58 180.63 0.00

275.30 191.90 5.21

318.43 211.03 0.58

451.32 222.57 0.69

36.1) Please refer to the selected financial information for Boss Stores above. What is the retention ratio for 2020?

A) 0.32 B) 0.68 C) 0.97 D) 1.00 E) None of the options are correct.

36.2) Please refer to the selected financial information for Boss Stores above. What is the actual sales growth rate for 2020?

A) −17.6% B) −7.9% C) 8.5% D) 21.4% E) None of the options are correct.

36.3) Please refer to the selected financial information for Boss Stores above. What is the sustainable growth rate for 2020?

A) −17.6% B) −7.9% C) 9.97% D) 10.27% E) 12.23% F) 21.40%

36.4) 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 2021?

A) −11.40% B) −7.09% C) −3.04% D) 5.47% E) 13.98% F) 21.40%

37)

[The following information applies to the questions displayed below.]

Law Specialists, Incorporated Selected financial information 2017 2018 2019

Profit margin (%) Retention ratio (%) Asset turnover (X) Financial leverage (X) Growth rate in sales (%)

2020

2021

6.89 100.00 2.78 1.69

4.94 100.00 2.47 1.38

0.11 100.00 2.03 1.16

0.32 100.00 2.00 1.32

5.25 78.27 2.23 1.52

22.89

-10.05

-28.76

3.55

26.19

37.1) Use Law Specialists’ selected financial information above to answer the following questions: a.Calculate Law Specialists’ sustainable growth rate in each year. b.Comparing the company’s sustainable growth rate with its actual growth rate in sales, what growth problems did the company face over this period?

37.2) Please refer to the selected financial information for Law Specialists, Inc. above.

Law Specialists paid its first dividends in 2021. As an analyst, assess the company’s decision to pay dividends.

38)

[The following information applies to the questions displayed below.]

Hard Knock Doors Selected financial information ($ thousands) 2015 2016 2017 2018 2019

Sales Net income Total assets Equity Dividends

477.84 – – – –

491.62 43.27 477.06 346.32 –

706.52 26.31 648.42 372.63 –

792.01 28.58 664.26 400.41 0.80

876.52 34.84 697.16 433.60 1.65

2020 1,088.46 25.76 982.63 457.14 2.22

38.1) Please refer to the selected financial information for Hard Knock Doors above.

Calculate the actual and sustainable growth rates for Hard Knock Doors for each year, 2017–2020.

38.2) Please refer to the selected financial information for Hard Knock Doors above.

Do you think Hard Knock Doors is having a problem financing its growth? If so, what is it doing to address the problem?

38.3) Please refer to the selected financial information for Hard Knock Doors above. Is the increase in dividends between 2017 and 2020 a good idea for Hard Knock Doors?

Answer Key Test name: chapter 4 1) FALSE 2) TRUE 3) TRUE 4) FALSE 5) FALSE 6) FALSE 7) FALSE 8) TRUE 9) FALSE 10) TRUE 11) TRUE 12) E 13) B 14) E 15) B 16) C 17) B 18) D 19) C 20) E 21) B If equity doubled, then g* = change in equity/equitybop = 100%.

22) D g* = ROEbop × Retention ratio = (5/50) × 0.6 = 6% 23) C

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.

24) E 25) D 26) C 27) B Change in retained earnings = $437,500 × 0.048 × (1 − 0.40) = $12,600 28) C Sustainable growth = PRAT = 0.045 × (1 − 0.15) × 1.6 × 1.77 = 10.8% 29) D 0.062 = PRAT = Profit margin × 0.40 × 0.85 × 1.8 Profit margin = 0.062/(0.40 × 0.85 × 1.8) = 10.1% 30) E Change in Equity = Retained earnings = $72,000 − $44,640 = $27,360 Sustainable growth rate = g* = Change in Equity/Equitybop= $27,360/$150,000 = 18.2% Alternatively: g* = R × ROEbop = (72,000 − 44,640)/72,000 × 72,000/150,000 = 0.38 × 0.48 = 0.182 31) E 32) D 33) A 34) D

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

36) Section Break 36.1) C 1 − (0.58/19.70) = 0.97 36.2) D (411.78 − 339.19)/339.19 = 0.214 36.3) C Sustainable growth = g* = Change in Equity/Equitybop = (211.03 − 191.90)/191.90 = 9.97% 36.4) C Sustainable growth = g* = PRAT = 0.0274 × 0.94 × 0.99 × 2.14 = 5.47% (with no rounding of intermediate values) 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% 37) Section Break 37.1)a. Law Specialists’ sustainable growth rates (these are the product of the first four rows of financial information): Sustainable growth rate (%)

2017

2018

2019

2020

2021

32.37

16.84

0.26

0.84

13.93

b.From 2017 through 2019, Law Specialists’ actual growth (or decline) in sales was well below its sustainable growth rate. In 2020 and 2021, the company’s growth problems reversed, with actual growth modestly exceeding sustainable growth in 2020, and doubling sustainable growth in 2021.

37.2) Dividends are typically the hallmark of a maturing company.

The growth rates between 2018 and 2020 indicate slowing growth for Law Specialists’ business. In this context, the company’s decision makes sense. However, in 2021 the company resumed rapid growth. Persistent growth rates above sustainable growth could jeopardize its ability to pay dividends on an ongoing basis.

38) Section Break 38.1) Hard Knock Doors 2017 2018 Profit margin Retention ratio Asset turnover Financial leverage Sustainable growth (g* = PRAT) OR g* = ΔEquity/Equitybop Actual growth

2019

2020

3.72% 1.00 1.09 1.87 7.60%

3.61% 0.97 1.19 1.78 7.46%

3.97% 0.95 1.26 1.74 8.29%

2.37% 0.91 1.11 2.27 5.43%

7.60% 43.71%

7.46% 12.10%

8.29% 10.67%

5.43% 24.18%

38.2) Hard Knock’s actual growth has exceeded its sustainable growth rate every year. The company has financed its rapid growth by increasing its asset turnover, and in 2020, its financial leverage.

38.3) The initiation and increase in dividend payments, although modest, have exacerbated its sustainable growth problems by decreasing the retention ratio.

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) In the steps a company takes to prepare for an IPO, the “bake-off” precedes the “roadshow”. ⊚ true ⊚ false

2) The only reason why the price would fall on a corporate bond is if market interest rates increase. ⊚ true ⊚ false

3) After issue, the market price of a fixed-rate bond can differ substantially from its par value. ⊚ true ⊚ false

4)

Bond investors should be more concerned with real returns than with nominal returns. ⊚ true ⊚ false

5)

Investment-grade bonds are usually defined as bonds with ratings of BBB−or higher. ⊚ true ⊚ false

6)

Private equity firms comprise a relatively insignificant portion of the American economy. ⊚ true ⊚ false

7)

Shelf registration is possible for both debt and equity issues. ⊚ true ⊚ false

8)

In a strong-form efficient market, insider trading is not profitable. ⊚ true ⊚ false

9) A private equity firm that charges 20% carried interest would receive $400 million when a $1 billion portfolio is subsequently liquidated for $2 billion. ⊚ true ⊚ false

10)

Principal is exchanged in interest rate swaps but not in currency swaps. ⊚ true ⊚ false

11) Valuing a call option requires an accurate estimate of the future value of the underlying asset. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

12) Which of the following securities has a purely fixed claim against a firm’s cash flows?

A) Bonds B) Options C) Common stock D) None of the options are correct.

13)

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

A) Preferred stock B) Callable bonds C) Common stock D) Non-callable bonds E) None of the options are correct.

14) Maria just purchased a bond which pays $40 in interest every six months. The $40 interest payment is also called the A) coupon.

B) par value.

C) discount.

D) call premium.

E) yield.

F) None of the options are correct.

15) A $1,000 par value bond with a fixed 10% rate of interest pays coupons semiannually.

What amount will the bondholder receive on the bond’s maturity date?

A) $50 B) $100 C) $500 D) $1,000 E) $1,050 F) $1,100

16) Zilu owns a bond that will pay her $25 in interest each year plus a $1,000 principal payment at maturity. The $1,000 principal payment is called the

A) coupon.

B) par value.

C) discount.

D) yield.

E) call premium.

F) None of the options are correct.

17)

Which one of the following statements is true?

A) Debt instruments offer residual claims to future cash payouts.

B) Bonds with call provisions will have lower coupon rates than otherwise identical

bonds.

C) Bondholders enjoy a direct voice in company decisions.

D) Bonds are low-risk investments that do well in inflationary periods.

E) Preferred stockholders are the first investors to be repaid in bankruptcy liquidation.

F) None of the options are correct.

18) Which one of the following accurately orders the average rate of return on financial securities from highest to lowest over most of recorded market history (the 1928–2020 period)?

A) Short-term government bills, long-term corporate bonds, long-term government bonds, common stocks B) Long-term corporate bonds, long-term government bonds, common stocks, short-term government bills C) Common stocks, long-term government bonds, long-term corporate bonds, short-term government bills D) Common stocks, long-term corporate bonds, long-term government bonds, short-term government bills E) Long-term corporate bonds, common stocks, short-term government bills, long-term government bonds F) None of the options are correct.

19)

Which one of the following statements is true?

A) Equity securities offer fixed claims on future cash payouts.

B) Unlike bondholders, stockholders rely entirely on price appreciation for their returns.

C) In theory, common stockholders exercise very little control over company decisions.

D) Historically, common stockholders have earned a risk premium as compensation for risk borne in excess of government bonds.

E) Common stockholders are the first investors to be repaid in bankruptcy liquidation.

F) None of the options are correct.

20) You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.

The bond paid 2.5% annual interest and was trading for ¥105,000 at year-end. What holding period return, measured in yen, did you earn on the bond?

A) 2.5% B) 5.0% C) 7.5% D) 10.0% E) 12.5% F) None of the options are correct.

21) You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.

The bond paid 3% annual interest and was trading for ¥110,000 at year-end. The exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥122 at year-end. What holding period return, measured in U.S. dollars, did you earn on the bond?

A) −18.03% B) −7.38% C) −5.03% D) 3.0% E) 10.0% F) None of the options are correct.

22) You bought a yen-denominated corporate bond at the beginning of the year for ¥100,000.

The bond paid 3% annual interest and was trading for ¥110,000 at year-end. The exchange rate was $1 = ¥100 at the beginning of the year and $1 = ¥97 at year-end. What holding period return, measured in U.S. dollars, did you earn on the bond?

A) 3.09% B) 6.09% C) 13.0% D) 16.49% E) 30.0% F) None of the options are correct.

23) What is the holding period return for the year on a bond with a par value of $1,000 and a coupon rate of 8.5% if its price at the beginning of the year was $1,215 and its price at the end of the year was $1,020? Assume interest is paid annually.

A) −11.00% B) −10.78% C) −9.05% D) 10.50%

24)

Which of the following statements regarding junk bonds is true?

A) Junk bonds typically offer lower yields to maturity than investment-grade bonds.

B) Junk bonds have higher priority in bankruptcy than preferred stock.

C) Junk bonds offer no coupon payments to investors.

D) Junk bonds are typically defined as bonds with default probabilities of 25% or higher.

25)

Which of the following statements regarding preferred stock is true?

A) Holders of preferred stock have the same voting rights as common stockholders.

B) Preferred stock dividend payments are a deductible expense for corporate tax purposes.

C) Almost all public corporations are at least partly financed with preferred stock.

D) None of the options are correct.

26) What would be the carried interest (at 20%) on a private equity portfolio with an initial value of $500 million that was subsequently liquidated for $750 million?

A) $50 million B) $100 million C) $150 million D) $250 million

27) Which of the following statements are true?

1.Underwriters help private companies access public stock markets through IPOs. 2.Shelf registrations and private placements are examples of seasoned security issues.

3.Issue costs for debt are typically greater than issue costs for equity.

4.Bearer bonds make it easier for investors to avoid paying taxes on interest income.

A) I and II only B) I and III only C) I, II, and IV only D) I, III, and IV only E) I, II, III, and IV F) None of the options are correct.

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

A) 4.3 million B) 4.5 million C) 4.6 million D) 4.9 million

29) At the end of 2020, Crane Industries, Incorporated stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33.

What rate of return did the common stockholders earn in 2021?

A) 1.79% B) 4.33% C) 13.43% D) 15.22% E) 17.76% F) None of the options are correct.

30) At the end of 2020, Crane Industries, Incorporated stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33.

What was Crane's dividend yield in 2021?

A) 1.79% B) 4.33% C) 13.43% D) 15.22% E) 17.76% F) None of the options are correct.

31) At the end of 2020, Crane Industries, Incorporated stock price was $30.75. A year later, it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33.

What was the percentage change in the share price in 2021?

A) 1.79% B) 4.33% C) 13.43% D) 15.22% E) 17.76% F) None of the options are correct.

32) Which of the following would allow a corporation to issue a bond at a lower coupon rate, all else equal?

A) The addition of a call provision to the bond B) The removal of protective covenants from the bond C) A deterioration in the corporation’s credit quality D) An increase in the expected inflation rate E) None of the options are correct.

33) Which of the following statements related to market efficiency tend to be supported by current evidence?

1.Markets tend to respond quickly to new information.

2.It is difficult for the typical investor to earn above-average returns without taking aboveaverage risks.

3.Short-run prices are difficult to predict accurately based on public information.

4.Markets are most likely strong-form efficient.

A) I and III only B) II and IV only C) I and IV only D) I, III, and IV only E) I, II, and III only F) I, II, III, and IV

34)

Individuals who continually monitor the financial markets seeking mispriced securities

A) earn excess profits over the long term.

B) make the markets increasingly more efficient.

C) are never able to find a security that is temporarily mispriced.

D) are overwhelmingly successful in earning abnormal profits.

E) are always quite successful using only historical price information as their basis of evaluation.

F) None of the options are correct.

35) Which of the following are the most likely reasons for why a stock price might not react at all on the day that new information related to the stock issuer is released?

1.Insiders knew the information prior to the announcement.

2.Investors need time to digest the information prior to reacting.

3.The information has no bearing on the value of the firm.

4.The information was anticipated.

A) I and II only B) I and III only C) II and III only D) II and IV only E) III and IV only F) None of the options are correct.

36) Assume that financial markets are semistrong-form efficient and that no private information is available. Which of the following statements is false?

A) Publicly available information is not helpful in forecasting future prices.

B) The best forecast of future price is current price, perhaps adjusted for a long-term trend.

C) A firm cannot get better prices for its securities by trying to select the optimal time to sell them.

D) Unless they accept above-average risk, investors should not expect to consistently earn above-average returns.

E) All of the statements are true.

37)

Which one of the following statements is false?

A) Financial executives must design financial securities to meet the needs of the firm and its investors.

B) Financial instruments are subject to full disclosure requirements.

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

D) Financial instruments are claims against a company’s cash flows and assets.

E) None of the options are correct.

38) In March, with the spot price of wheat at $5.75 per bushel, Hollywood Bakery longs 100 July wheat futures contracts (5,000 bushels each) on the CME at a futures price of $5.90 per bushel. In June, Hollywood Bakery closes out its futures contracts when the futures price is $5.80 per bushel. What is Hollywood Bakery’s gain (or loss) on the futures contracts?

A) A loss of $50,000 B) A loss of $25,000 C) A gain of $25,000 D) A gain of $50,000 E) None of the options are correct.

39)

Which of the following variables does NOT affect the value of a stock option?

A) The predicted future price of the underlying stock B) The current price of the underlying stock C) The option’s time to maturity D) The option’s strike price E) The interest rate

40)

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

A) Forward sale B) Forward purchase C) Call option D) Put option

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

A) The expected volatility of the underlying stock B) The price of the underlying stock C) The time to maturity D) The strike price E) None of the options are correct.

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

A) The expected volatility of the underlying stock B) The price of the underlying stock C) The time to maturity D) The strike price E) None of the options are correct.

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

A) −$7 B) −$3 C) $1 D) $4 E) $5

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

A) −$2 B) −$1 C) $0 D) $1 E) $2

45)

Principal amounts are usually exchanged A) in currency swaps.

B) in interest rate swaps.

C) in both currency swaps and interest rate swaps.

D) in neither currency swaps nor interest rate swaps.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

46) Chapter 5 presents evidence that the average annual rate of return on common stocks over many years has exceeded the return on government bonds in the United States, while returns on common stocks have also exhibited more volatility than returns on U.S. government bonds.

Suppose that last year, the realized rate of return on government bonds exceeded the return on common stocks. Your colleague suggests that “last year shows us that investors are now willing to settle for lower returns on stocks than on bonds.” How would you interpret this result?

47) Himmel Corporation. wants to raise $100 million in a new stock issue. Its investment banker indicates that the sale of new stock will require 12% underpricing and a 7% spread. a.Assuming Himmel’s stock price does not change from its current price of $50 per share, how many shares must the company sell and at what price to the public? b.How much money will the investment banking syndicate earn on the sale? c.Is the 12% underpricing a cash flow? Is it a cost? If so, to whom?

48) If the stock market in the United States is efficient, how do you explain the fact that some people make very high returns? Would it be more difficult to reconcile very high returns with efficient markets if the same people made extraordinary returns year after year?

49) You believe interest rates will soon fall. a.Would you rather own a three-year, 6% coupon, fixed-rate bond or an equivalent-risk, threeyear, floating-rate bond currently paying 6% interest? b.Would your answer to (a) change if you were contemplating issuing a bond rather than owning one? If so, how? c.Would your answer to (a) change if, as an investor, you believed interest rates would soon rise?

If so, why?

50) Houston Corporation., an American company, has a payment of ¥500 million due to Osaka Corporation. one year from today. At the prevailing spot rate of 100 ¥/$, this would cost Houston $5 million, but Houston faces the risk that the ¥/$ rate will fall in the coming year, so that it will end up paying a higher amount in dollar terms. To hedge this risk, Houston has two possible strategies. The first strategy is to buy ¥500 million forward today at a one-year forward rate of 98 ¥/$. The second strategy is to pay a premium of $100,000 for a one-year call option on ¥500 million at an exchange rate of 96 ¥/$. a.Suppose that in one year, the spot exchange rate is 95 ¥/$. What would be Houston’s net dollar cost for the payable under each strategy? b.Suppose that in one year, the spot exchange rate is 105 ¥/$. What would be Houston’s net dollar cost for the payable under each strategy? c.Which hedging strategy would you recommend to Houston Corporation., if any? Why?

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

Answer Key Test name: chapter 5 1) TRUE 2) FALSE 3) TRUE 4) TRUE 5) TRUE 6) FALSE 7) TRUE 8) TRUE 9) FALSE 10) FALSE 11) FALSE 12) A 13) C 14) A 15) E 16) B 17) F 18) D 19) D 20) C The holding period return in yen was (2.5% × 100,000 + 5,000)/100,000 = 7.5%.

21) B

You paid $1,000 for the bond (¥100,000/100). At the end of the year, you had interest income and a yen bond worth a total of $926.23 (¥113,000/122). Your dollar return was ($926.23 − $1,000)/$1,000 = −7.38%.

22) D You paid $1,000 for the bond (¥100,000/100). At the end of the year, you had interest income and a yen bond worth a total of $1,164.95 (¥113,000/97). The U.S. dollar holding period return would be ($1,164.95 − $1,000)/$1,000 = 16.49%.

23) C (85 + 1,020 − 1,215)/1,215 = −0.0905 24) B 25) D 26) A 27) C 28) D The price will be set at 7.5% below the current price, or at 0.925 × 28.00 = $25.90. The underwriters will take $1.25 per share, leaving $24.65/share for Carbon8. Carbon8 needs to earn $120,785,000 at $24.65/share, so it must sell 120.785mil/24.65 = 4.9 million shares.

29) D Rate of return = (34.88 + 0.55 − 30.75)/30.75 = 15.22% 30) A Dividend yield = 0.55/30.75 = 1.79% 31) C Percentage change in share price = (34.88 − 30.75)/30.75 = 4.13/30.75 = 13.43%.

32) E 33) E 34) B

35) E 36) E 37) C 38) A Gain on futures = ($5.80 − $5.90) × 500,000 bushels = −$50,000 39) A 40) C 41) D 42) B 43) C The gain on the call is 89 − 85 = $4; less the option premium of $3 gives a net profit of $1.

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

45) A 46)The fact that government bonds earned a higher rate of return than common stocks in one year is not evidence that investors are suddenly willing to settle for lower returns on stocks than bonds. It means that investors’ expectations were not met or, alternatively, that investors were surprised. To take on additional risk, risk-averse investors require additional expected return. But expected returns are not the same as realized returns. Because stocks and bonds are risky, their returns will fluctuate from year to year, and bonds will earn higher returns than stocks in some years. But the expected returns of common stocks should always be higher than the expected returns of government bonds.

47)a.

Stock Price − 12% underpricing Issue price − 7% spread

$ 50.00 6.00 44.00 3.08

Net to company

$ 40.92

Desired revenue (millions) Number of shares (millions)

$ 100 $ 2.444

b.Investment bankers’ revenue = $3.08 × 2.444 million = $7.528 million. c.Underpricing is not a cash flow. It is, however, an opportunity cost to current owners because it means that more shares must be sold to raise $100 million and each share will represent a smaller ownership interest in the company.

48)Earning high returns in an efficient market is like winning at roulette.

In any random process, there will be winners and losers, and some winners might win big. Earning consistently high returns over time is also possible in an efficient market, just like a gambler on a lucky streak might win repeatedly at roulette. The relevant question is whether the very high returns or the length of the winning streak is inconsistent with blind luck or not.

49)a.I would rather own a fixed-rate bond because the interest income I receive from a floating-rate bond will fall as interest rates decline.

Equivalently, the market value of the fixed-rate bond will rise as rates fall, but that of the floating-rate bond will not. (This presumes the fixedrate bond is not callable.) b.My answer would change. I would rather issue a floating-rate bond now because future interest payments will fall as rates decline. c.My answer would change. As an investor, I would want to hold a floating-rate bond because interest income will rise as interest rates rise.

Equivalently, the price of the fixed-income bond will fall as rates rise, while that of the floating-rate bond will not.

50)a.In the first strategy, the net cost in dollars is ¥500 million/98 = $5.102 million. In the second strategy, Houston Corporation. exercises its option to exchange at 96 ¥/$ for a cost of ¥500 million/96 = $5.208 million. Including the cost of the option, the net cost is $5.308 million. b.In the first strategy, the net cost in dollars is again ¥500 million/98 = $5.102 million. In the second strategy, Houston Corporation. allows its option to expire and exchanges at the spot rate of 105 ¥/$ for a cost of ¥500 million/105 = $4.762 million. Including the cost of the option, the net cost is $4.862 million. c.The first strategy allows Houston to lock in an exact cost without paying a premium up front. The second strategy requires a premium payment, but Houston retains the possibility of having a much lower net dollar cost if the dollar strengthens enough relative to the yen. The correct strategy for Houston depends on its risk tolerance, its expectations for exchange rate movements, and its cash availability.

51)The table below shows ABC’s net interest payments for years 1 through 3. Negative signs indicate cash flows paid by ABC and positive signs indicate cash flows received by ABC, all in dollars.

Year 0 1 2 3

LIBOR 4.2%

Debt payment

4.3% 4.4%

-2,000,000 -2,000,000 -2,000,000

Fixed leg

-1,900,000 -1,900,000 -1,900,000

Floating leg

Net payment

-2,100,000 -2,150,000 -2,200,000

-2,200,000 -2,250,000 -2,300,000

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The evidence indicates that, on average, a company’s stock price declines when it announces a new issue of equity. ⊚ true ⊚ false

2)

Debt financing results in higher after-tax earnings relative to equity financing. ⊚ true ⊚ false

3)

The interest tax shield reduces a firm’s taxes by the amount of interest on its debt. ⊚ true ⊚ false

4) If the return on invested capital is greater than the after-tax interest rate, then a higher debt-to-equity ratio increases return on equity. ⊚ true ⊚ false

5) The M&M irrelevance proposition assures financial managers that their choice between equity and debt financing will ultimately have no impact on firm value. ⊚ true ⊚ false

6) In some instances, additional debt financing can encourage managers to act more in the interests of owners. ⊚ true ⊚ false

7) If the maturity of a company’s liabilities is less than that of its assets, the company incurs a refinancing risk. ⊚ true ⊚ false

8)

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

9) When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments. ⊚ true ⊚ false

10)

Inflation benefits borrowers only if the inflation is unexpected. ⊚ true ⊚ false

11) When a company declares Chapter 11 bankruptcy, it typically shuts down operations at the same time. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

12) The best capital structure is the one that A) sets the debt-to-equity ratio equal to 1.

B) trades off the tax disadvantage of debt against the signaling effects of equity.

C) maximizes expected cash flows.

D) ignores the false comfort of financial flexibility.

E) results in the lowest possible financial distress costs.

13)

“Homemade leverage” refers to

A) the incurrence of debt by a corporation in order to pay dividends to shareholders.

B) the exclusive use of debt to fund a corporate expansion project.

C) shareholders using personal debt to replicate the leverage effects of corporate borrowing.

D) an increase in debt arising naturally from company growth.

E) None of the options are correct.

14)

The basic lesson of the M&M theory is that the value of a firm is dependent upon A) the firm’s capital structure.

B) the total cash flows of the firm.

C) minimizing paper claims on the firm.

D) the riskiness of the firm’s cash flows.

E) the size of the stockholders’ claims.

F) None of the options are correct.

15) The term “financial distress costs” includes which of the following?

1.Direct bankruptcy costs 2.Indirect bankruptcy costs 3.Direct costs related to being financially distressed but not bankrupt 4.Indirect costs related to being financially distressed but not bankrupt A) I only B) III only C) I and II only D) III and IV only E) I, II, III, and IV F) None of the options are correct.

16) Which of the following 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 IV. A conservative debt policy that obviates the need to evaluate risk A) I only B) III only C) I and III only D) II and III only E) IV only F) None of the options are correct.

17)

In general, the capital structures used by non-financial U.S. firms A) typically result in debt-to-asset ratios between 50% and 70%.

B) vary significantly across industries.

C) tend to converge to the same proportions of debt and equity.

D) tend to be those that maximize the use of the firm’s available tax shelters.

E) None of the options are correct.

18) Which of the following factors favor the issuance of debt in the financing decision?

1.Market signaling 2.Distress costs 3.Tax benefits 4.Financial flexibility A) I and II only B) I and III only C) II and IV only D) I, II, and III only E) I, II, and IV only F) None of the options are correct.

19) Which of the following factors favor the issuance of equity in the financing decision?

1.Market signaling 2.Distress costs 3.Management incentives 4.Financial flexibility A) I and II only B) I and III only C) II and IV only D) II, III, and IV only E) I, II, and IV only F) None of the options are correct.

20) 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 A) I and II only B) I and III only C) II and IV only D) I, II, and III only E) I, II, and IV only F) None of the options are correct.

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

A) Adopt a modest dividend payout policy that enables the company to finance most of its growth internally.

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

C) Maintain a conservative leverage ratio to ensure continuous access to financial markets.

D) If external financing is necessary, use debt to the point that it does not affect financial flexibility.

E) None of the options are correct.

22) According to the pecking order theory of capital structure, which of the following are correct?

I. For financing needs, firms prefer to first tap internal sources.

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 results from its profitability relative to investment needs over time.

A) I and III only B) II and IV only C) I, III, and IV only D) I, II, and IV only E) I, II, III, and IV F) None of the options are correct.

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

A) On average, a firm’s stock price drops when it announces an equity issue.

B) Firms may want to maintain a reserve of cash or unused borrowing capacity.

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

D) Firms may fail to undertake attractive investments if they would have to be financed with a new issue of equity.

24) 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 Corporation. currently faces an effective tax rate of 20%. What would be the annual interest tax shield to Salinas Corporation. if it goes through with the debt issuance?

A) $280,000 B) $1,400,000 C) $4,000,000 D) $20,000,000

25)

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

A) Taxes are reduced by the amount of a firm’s interest-bearing debt.

B) Taxable income is reduced by the amount of a firm’s interest-bearing debt.

C) Taxes are reduced by the amount of the interest on a firm’s debt.

D) Taxable income is reduced by the amount of the interest on a firm’s debt.

26)

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

A) Lack of interest tax shields B) Bankruptcy costs C) Excessive risk-taking by shareholders D) Loss of customers or suppliers

27) 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)?

A) ABC’s cash flows from operations are less volatile than XYZ’s.

B) ABC is a computer software firm, and XYZ is an electric utility.

C) ABC operates in a more competitive industry than XYZ. D) ABC’s assets have lower resale values than XYZ’s assets.

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

A) Because fees associated with issuing new equity are so high B) Because they want to avoid dilution of earnings per share C) Because they do not want to commit to paying dividends on the new equity D) Because equity issuance signals negative information about the firm

29) Under the simplifying assumptions of Modigliani and Miller, an increase in a firm’s financial leverage will A) increase the variability in earnings per share.

B) reduce the operating risk of the firm.

C) increase the value of the firm.

D) decrease the value of the firm.

30) JJ Corporation has a projected times-interest-earned ratio of 5.0 for next year. What percentage could EBIT decline next year before JJ’s times-interest-earned ratio would fall below 1.0?

A) 4% B) 40% C) 75% D) 80% E) 400% F) Insufficient information is provided to answer the question.

31) The interest tax shield has no value when a firm has 1.no taxable income.

2.a debt-to-equity ratio of 1.

3.no interest-bearing debt.

4.a negative growth rate.

A) I and II only B) I and IV only C) I, III, and IV only D) II, III, and IV only E) I, II, and IV only F) None of the options are correct.

32) To aid in her decision of whether to issue bonds or stock, a CFO has prepared a range of earnings chart for her company, as shown below. Which of the following changes (holding all else equal) would increase the crossover EBIT in the range of earnings chart?

A) An increase in the interest rate on the bonds to be issued.

B) A decrease in the company’s stock price.

C) Increased uncertainty about the company’s future earnings.

D) An increase in cash dividends paid on the company’s common stock.

E) None of the options are correct.

33) Financial leverage 1.increases expected ROE but does not affect its variability.

2.increases breakeven sales, but increases the rate of earnings per share growth once breakeven is achieved.

3.is a fundamental financial variable affecting sustainable growth.

4.increases expected return and risk to owners.

A) I and II only B) I and III only C) II and IV only D) II, III, and IV only E) I, II, III, and IV F) None of the options are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

34) “A firm can’t use interest tax shields unless it has taxable income to shield.” What does this statement imply for capital structure? Explain briefly, comparing the following two examples: a start-up biotech firm and an electric utility company.

35) Can a company incur costs of financial distress without ever going bankrupt? Explain.

What is the nature of these costs?

36) Kahuku Corporation has 100 million shares outstanding trading at $20 per share. The company announces its intention to raise $150 million by selling new shares. a.What do market signaling studies suggest will happen to Kahuku’s stock price on the announcement date? Why? b.Suppose that Kahuku stock loses 30% of the value of the equity issue when it is announced.What percentage of the value of Kahuku’s existing equity prior to the announcement is this loss? c.Given this loss, at what price should Kahuku expect its existing shares to sell immediately after the announcement?

37) An all-equity business has 200 million shares outstanding selling for $30 a share.

Management believes that interest rates are unreasonably low and decides to execute a leveraged recapitalization (a recap). It will raise $750 million in debt and repurchase 25 million shares. a.What is the market value of the firm prior to the recap? What is the market value of equity? b.Assuming that the recap has no effect on operating cash flows (or shareholders’ perception of them), what is the market value of the firm after the recap? What is the market value of equity? c.Again assuming that the recap has no effect on operating cash flows, do equity shareholders gain or lose as a result of the recap? Please explain. d.Eliminating the assumption that the recap has no effect on operating cash flows, what are some possible ways in which the recap could provide additional value to shareholders?

SECTION BREAK. Answer all the part questions.

38) [The following information applies to the questions displayed below.]

Squamish Equipment Selected financial information Expected net income after tax next year before new financing Sinking-fund payments due next year on existing debt Interest due next year on existing debt Company tax rate Common stock price, per share Common shares outstanding

$ 40 million $ 14 million $ 15 million 36% 20.00 18 million

38.1) 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.

A) 1.03 B) 1.38 C) 1.60 D) 1.89 E) 2.10 F) None of the options are correct.

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

A) 1.28 B) 1.39 C) 2.00 D) 2.22 E) 4.00 F) None of the options are correct.

38.3) Please refer to the financial information for Squamish Equipment above.

Calculate Squamish’s times-interest-earned ratio for next year assuming the firm issues $40 million of new debt at an interest rate of 7%.

A) 2.00 B) 3.09 C) 3.66 D) 4.35 E) None of the options are correct.

38.4) Please refer to the financial information for Squamish Equipment above.

Calculate Squamish’s times-burden-covered ratio for the next year assuming the firm issues $40 million of new debt at an interest rate of 7%, and that annual sinking fund payments on the new debt will equal $8 million.

A) 1.01 B) 1.08 C) 1.38 D) 1.49 E) 1.95 F) None of the options are correct.

38.5) Please refer to the financial information for Squamish Equipment above.

Calculate Squamish’s earnings per share next year assuming Squamish issues $40 million of new debt at an interest rate of 7%.

A) 1.28 B) 2.00 C) 2.12 D) 2.22 E) 3.06 F) None of the options are correct.

39)

[The following information applies to the questions displayed below.]

Nile Holdings Selected financial information as of December 31, 2021 Last year’s EBIT (2021) $ 175.0 million Expected EBIT (2022) $ 189.8 million Current portion of existing long-term debt, due $ 34 million 2022 Interest due in 2022 on existing debt $ 36 million Tax rate 35% Common stock price per share

$ 50.00

Common shares outstanding Dividends per share

20 million $ 2.00

39.1) Please refer to the financial information for Nile Holdings above. Nile must decide how to finance a $100 million investment. Assume Nile raises $100 million of new debt at the end of 2021 at an interest rate of 7%. a.Calculate the firm’s pro forma 2022 times-interest-earned (TIE) ratio. b.Calculate the percentage EBIT can fall (below expected EBIT) before interest coverage dips below 1.0.

39.2) Please refer to the financial information for Nile Holdings above. Nile must decide how to finance a $100 million investment. Assume Nile raises $100 million of new debt at the end of 2021 at an interest rate of 7%. a.Assuming Nile must make a $20 million payment on the new debt next year, calculate the firm’s times-burden-covered ratio and times-common-covered ratio (i.e., the number of times EBIT could cover interest, principal payments, and dividends). b.As Nile’s banker, would you be comfortable loaning the company this new debt? Briefly explain why, or for what reasons you would be comfortable or uncomfortable.

39.3) Please refer to the financial information for Nile Holdings above. Nile must decide how to finance a $100 million investment. Calculate next year’s earnings per share assuming Nile raises $100 million of new debt at an interest rate of 7%.

39.4) Please refer to the financial information for Nile Holdings above. Nile must decide how to finance a $100 million investment. Calculate next year’s times-burdencovered ratio and earnings per share if Nile sells 2 million new shares at $50 a share instead of raising new debt.

39.5) Please refer to the financial information for Nile Holdings above. Nile must decide how to finance a $100 million investment. Suppose Nile expects $4.52 in EPS next year if it does not go through with the investment and associated financing. As a shareholder, to satisfy its funding needs for the investment opportunity, do you prefer the company issue $100 million in new debt (at an interest rate of 7% with a payment of $20 million due on the debt next year) or issue 2 million shares of equity at a target price of $50? Show supporting calculations and provide arguments and potential counterarguments for your recommendation.

Answer Key Test name: chapter 6 1) TRUE 2) FALSE 3) FALSE 4) TRUE 5) FALSE 6) TRUE 7) TRUE 8) FALSE 9) TRUE 10) TRUE 11) FALSE 12) C 13) C 14) B 15) E 16) C 17) B 18) B 19) C 20) B 21) B 22) D 23) C 24) A Interest tax shield = interest rate × amount of debt × tax rate = 0.07 × 20,000,000 × 0.20 = $280,000

25) D 26) A 27) A 28) D 29) A 30) D % EBIT can fall = (5.0 − 1)/5.0 = 0.80 31) F 32) A 33) D 34)The corporate tax shield of debt is only valuable to a company that has taxable income to shield. This implies that companies that do not have a lot of taxable income (i.e. startups), or companies that have highly variable taxable income (e.g., younger tech or biotech firms) should not have as much debt, because the benefits of the corporate tax shield are less. The statement also implies that if a company has a lot of debt, it may exhaust its taxable income. At this stage, the marginal benefit of additional debt is zero, and the probability of financial distress grows. The (typical) utility’s more stable cash flows and profitability imply greater tax benefits, and lower costs of financial distress.

(Note that the even when the tax code allows firms to carry forward and carry back their income/losses, the statement still holds, with “taxable income” incorporating carryforwards or carrybacks.)

35)Yes. There are costs of financial distress even before the company actually defaults on the debt. These costs arise as the company, customers, and suppliers become aware that there is a possibility the company may default soon. These costs may include managers’ time and effort, disruption of supplies and customer service, drastic sales decreases for sellers of durable goods, and delay of research or capital improvement projects. The firm’s competitors can also sense a firm in trouble and could engage in predatory pricing to weaken or eliminate the firm as a competitor. Moreover, detrimental conflicts of interest among owners, creditors, and managers can also arise when a company gets into financial difficulty.

36)a.Market signaling studies suggest that the price of existing Kahuku shares will fall. One explanation for the decline is that managers know more about their company than outsiders do, and that the announcement of an equity sale signals they are worried about the company’s prospects. Alternatively, they believe the company’s stock is overvalued at the current price. b.Expected loss = 0.3 × ($150 million) = $45 million 45/($20 × 100) = 2.25% c.Price per share = $20 × (1 − 0.0225) = $19.55

37)a.Because there is no debt outstanding, Firm value = Equity value = 200 million × $30 = $6 billion. b.If operating cash flows are unaffected, then the M&M theory tells us that firm value is unchanged at $6 billion. Debt outstanding is $0.75 billion, so equity value is $5.25 billion. (Equity value = firm value − debt value.) c.Equity investors neither gain nor lose from the recap. Before the recap, equity value is $6 billion for 200 million shares, or $30 per share. After the recap, equity value is $5.25 billion for 175 million remaining shares, or $30 per share. (Equity investors that sold shares in the repurchase also received $30 cash for each share.) d.If the company has taxable income, shareholders could benefit from interest tax shields. The repurchase of shares could increase the stock price through a positive signaling effect. The increase in debt could have positive effects on managerial incentives to increase shareholder value.

38) Section Break 38.1) E EBIT = 40/(1 − 0.36) + 15 = $77.5 Times burden covered = 77.5/[15 + 14/(1 − 0.36)] = 2.10 38.2) C EPS = 40/(18 + 2) = $2.00 38.3) D EBIT = 40/(1 − 0.36) + 15 = $77.5 Interest = 15 + 0.07(40) = $17.8 Times interest earned = 77.5/17.8 = 4.35 38.4) D EBIT = 40/(1 − 0.36) + 15 = $77.5 Interest = $15 + 0.07(40) = $17.8 Times burden covered = 77.5/[17.8 + (14 + 8)/(1 − 0.36)] = 1.49 38.5) C

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 39) Section Break 39.1)a.Interest expense = $36 + 0.07($100) = $43 Pro forma TIE = EBIT/Int. Exp. = 189.8/43 = 4.41 b.EBIT can fall (189.8 − 43)/189.8 = 77.3% before interest coverage dips below 1.0.

39.2)a. Interest expense = $36 + 0.07($100) = $43 Upcoming payments on debt = existing + new = 34 + 20 = 54 Times burden covered = EBIT/(interest + debt pmts./(1 − t)) = 189.8/(43 + 54/(1 − 0.35)) = 1.51 Times common covered = EBIT/(interest + (debt pmts. + dividends)/(1 − t)) = 189.8/(43 + (54 + 40)/(1 − 0.35)) = 1.01 b.Debt (both principal and interest) coverage is relatively strong at 1.5 times, but if the company continues to pay its dividend, its expected ability to pay its pro forma fixed financing charges (or burden) including dividends is right at the edge. Although EBIT can fall 33.6% ((189.8 − 126.08)/189.8 = 33.6%) before TBC falls below 1, Nile has a quite low TCC (1.01) including the burden.

There is risk here, and a prudent lender will require covenants that restrict dividend payouts to certain situations, if at all. Covenants (restrictions set in the debt contract) impose additional costs on the firm; this fact should be considered by management as they weigh the costs and benefits of new debt. Nile’s banker will compare Nile’s coverage ratios to the industry’s average of these ratios. If the company has strong and relatively stable cash flows, and the ratios are above or within industry averages, the banker will be more comfortable with the added debt.

39.3) EBIT Interest expense Pre-tax income Tax Net income Shares outstanding EPS

189.80 43.00 146.80 51.38 95.42 20.00 4.77

39.4)Times burden covered = EBIT/(interest + debt payments./(1 − t)) = 189.8/(36 + 34/(1 − 0.35)) = 2.15 EBIT Interest expense Pre−tax income Tax Net income Shares outstanding EPS

189.80 36.00 153.80 53.83 99.97 22.00 4.54

39.5)First compare Nile’s EPS and coverage ratios under the two scenarios.

Debt Issuance: EBIT Interest expense Pre−tax income Tax Net income Shares outstanding EPS

189.80 43.00 146.80 51.38 95.42 20.00 4.77

Upcoming payments on debt = existing + new = 34 + 20 = 54 Times burden covered = EBIT/(interest + debt pmts./(1 − t)) = 189.8/(43 + 54/(1 − 0.35)) = 1.51 Times common covered = EBIT/(interest + (debt pmts. + dividends)/(1 − t)) = 189.8/(43 + (54 + 40)/(1 − 0.35)) = 1.01 Equity issuance: EBIT Interest expense

189.80 36.00

Pre−tax income Tax Net income Shares outstanding EPS

153.80 53.83 99.97 22.00 4.54

Times burden covered = EBIT/(interest + debt pmts./(1 − t)) = 189.8/(36 + 34/(1 − 0.35)) = 2.15 Times common covered = EBIT/(interest + (debt pmts. + dividends)/(1 − t)) = 189.8/(36 + (34 + 44)/(1 − 0.35)) = 1.22 The EPS calculations above indicate that, while both debt and equity issuances are expected to increase EPS compared to no issuance and subsequent investment, the debt issuance results in the highest EPS, although the higher EPS is accompanied by a higher level or risk. Depending on the volatility of the company’s EBIT, the issuance of debt presents risk to the shareholders. If the company issues debt and its EBIT falls below $126 million [$43 + 54/(1 − 0.35)], then the company could default on its borrowings.

On the other hand, if financing needs were met with equity, EBIT could fall to $88 million [$36 + 34/(1 − 0.35)] and Nile could still make the interest and loan payments. Defaulting on its debt would likely cause a severe decline in Nile’s stock price. Raising equity poses much less risk of financial distress in this case. The issuance of debt also presents the risk that the company will be forced to miss (or reduce) future dividend payments, which could cause the stock price to fall.

As indicated in Chapter 6, debt can increase shareholders’ returns in good times, but decrease them in bad times, i.e., the increase in expected return comes at the cost of higher risk. Management must weigh these trade-offs. Other considerations: ● The issuance of equity has a negative signaling effect. Evidence indicates that stock prices on average fall upon announcements of stock offerings. Debt avoids this problem. ● Debt issuance may offer positive managerial incentive effects. ● Equity issuance retains more future financing flexibility.

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) The accounting rate of return is deficient as a figure of merit because it is insensitive to the timing of cash flows. ⊚ ⊚

true false

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

3)

Inflation is one reason why a dollar today is worth more than a dollar in the future. ⊚ ⊚

4)

true false

true false

The IRR and NPV always yield the same investment recommendations. ⊚ ⊚

true false

5) Under capital rationing, when evaluating investments that are independent and can be acquired fractionally, ranking by the BCR is the appropriate technique. ⊚ ⊚

true false

6) 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. ⊚ ⊚

true false

7)

The IRR is the discount rate at which an investment’s NPV equals its initial cost. ⊚ ⊚

true false

8) The present value of a perpetuity can be calculated as the annual cash flow multiplied by the discount rate. ⊚ ⊚

true false

9) As a noncash expense, depreciation is irrelevant in the determination of a project’s cash flows. ⊚ ⊚

true false

10) Sunk costs should be included in the cash flows for valuing a project only if they are directly attributable to that specific project. ⊚ ⊚

true false

11) If the tax rate were zero, depreciation would not affect an investment’s after-tax cash flow. ⊚ ⊚

true false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

12) Which of the following figures of merit might not use all possible cash flows in its calculation?

1.Payback period 2.Internal rate of return 3.Net present value (NPV) 4.Benefit-cost ratio A) III only B) I & III only C) II & III only D) I only E) III & IV only F) I, II, III, and IV

13) Which of the following figures of merit does not directly take into consideration the time value of money?

1.Payback period 2.Internal rate of return 3.Net present value (NPV) 4.Accounting rate of return A) IV only B) I & III only C) II & III only D) I & II only E) I & IV only F) I, II, III, and IV

14) Liam is going to receive $50,000 five years from now. Sydney is going to receive $50,000 ten years from now. Which one of the following statements is correct if both Liam and Sydney apply a 6% discount rate to these amounts?

A) The present values of Liam’s money and Sydney’s money are equal.

B) In future dollars, Sydney’s money is worth more than Liam's money.

C) In today’s dollars, Liam’s money is worth more than Sydney’s money.

D) Fifteen years from now, the value of Liam’s money will be equal to the value of Sydney’s money.

E) Sydney’s money is worth more than Liam’s money given the 6% discount rate.

F) None of the options are correct.

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

A) Inflation reduces the purchasing power of future dollars.

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

C) There is more uncertainty of receiving dollars further into the future.

D) A dollar today can be productively invested in the time before receiving a dollar in the future.

16) 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 4.8% per year over the next four years.

How much will your dream car cost by the time you are ready to buy it?

A) $98,340.00 B) $98,666.67 C) $99,517.41 D) $99,818.02 E) $100,023.16 F) None of the options are correct.

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

A) $15,929.47 B) $16,500.00 C) $17,444.86 D) $17,500.00 E) $17,999.45 F) None of the options are correct.

18) Naomi plans on saving $3,000 a year and expects to earn an annual interest rate of 10.25%. How much will she have in her account at the end of 45 years?

A) $1,806,429 B) $1,838,369 C) $2,211,407 D) $2,333,572 E) $2,508,316 F) None of the options are correct.

19) 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% annual rate on your money, compounded monthly. Which option should you take and why?

A) You should accept the monthly payments because they are worth $209,414 to you.

B) You should accept the $200,000 lump sum because the monthly payments are only worth $16,057 to you today.

C) You should accept the monthly payments because they are worth $336,000 to you.

D) You should accept the $200,000 lump sum because the monthly payments are only worth $189,311 to you today.

E) You should accept the $200,000 lump sum because the monthly payments are only worth $195,413 to you today.

F) None of the options are correct.

20) 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% annual interest rate, compounded monthly. What is the amount of each payment?

A) $287.71 B) $296.67 C) $301.12 D) $342.76 E) $366.05

21) EAC Nutrition offers a 9.5% coupon bond with annual payments maturing 11 years from today. Your required return is 11.2%. What price are you willing to pay for this bond if the face (or par) value is $1,000?

A) $895.43 B) $896.67 C) $941.20 D) $946.18 E) $953.30 F) None of the options are correct.

22) 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%?

A) −$311.02 B) $2,168.02 C) $4,650.11 D) $9,188.98 E) $21,168.02 F) None of the options are correct.

23) Which of the following should be included in the cash flow projections for a new product?

1.Money already spent for research and development of the new product 2.Capital expenditures for equipment to produce the new product 3.Increase in working capital needed to finance sales of the new product 4.Interest expense on the loan used to finance the new product launch A) II and III only B) II and IV only C) I, II, and III only D) II, III, and IV only E) I, II, III, and IV F) None of the options are correct.

24) Projected free cash flows for a proposed project should 1.exclude the cost of employing existing assets that could be sold anyway.

2.exclude interest expense.

3.include the depreciation tax shield related to the project.

4.exclude any required increase in operating current assets.

A) I and II only B) II and III only C) II and IV only D) I, III, and IV only E) I, II, III, and IV F) None of the options are correct.

25) Which of the following statements related to the internal rate of return (IRR) are correct?

1.The IRR is the discount rate at which an investment’s NPV equals zero.

2.An investment should be undertaken if the discount rate exceeds the IRR. 3.In most cases, the IRR yields the same investment recommendation as the NPV. 4.The IRR is the best tool available for deciding between mutually exclusive investments.

A) I and II only B) I and III only C) II and III only D) I, II, and IV only E) I, II, III, and IV F) None of the options are correct.

26) You plan to pay $60 for a share of preferred stock that pays a $3.00 dividend per year forever. What annual rate of return will you realize?

A) 2.0% B) 3.0% C) 5.0% D) 6.0% E) 20.0%

27) 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% required rate of return?

A) $18,477.29 B) $21,033.33 C) $28,288.70 D) $29,416.08 E) $32,409.57 F) None of the options are correct.

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

Year 0

Cash Flow ($46,500)

1 2 3

$12,200 $38,400 $11,300

A) 0.94 B) 0.98 C) 1.02 D) 1.06 E) 1.11 F) None of the options are correct.

29) When making a capital budgeting decision, which of the following are NOT relevant?

1.The size of a cash flow 2.The risk of a cash flow 3.The accounting earnings from a cash flow 4.The timing of a cash flow A) I only B) II only C) III only D) II and III only E) III and IV only F) They are all relevant.

30) Giant Corporation is considering a project that requires a $1,500 initial cost for a new machine that will be depreciated by $300 per year. The project will require a one-time increase in the level of net working capital of $300 which is expected to be fully recovered at the end of the project. 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?

A) −$2,100 B) −$1,800 C) −$1,500 D) −$1,200

31) Giant Corporation is considering a project that requires a $1,500 initial cost for a new machine that will be depreciated by $300 per year. The project will require a one-time increase in the level of net working capital of $300 which is expected to be fully recovered at the end of the project. 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 1 free cash flow?

A) $300 B) $600 C) $750 D) $900

32) Giant Corporation is considering a project that requires a $1,500 initial cost for a new machine that will be depreciated by $300 per year. The project will require a one-time increase in the level of net working capital of $300 which is expected to be fully recovered at the end of the project. 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 2 free cash flow?

A) $1,300 B) $1,450 C) $1,700 D) $1,750

33) 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%.

A) The NPV will decrease by $16,411.

B) The NPV will decrease by $32,822.

C) The NPV will decrease by $60,000.

D) The NPV will not be affected.

E) None of the options are correct.

34) 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?

A) $5,078.15 B) $5,585.97 C) $6,144.57 D) $6,759.03

35) TTT Corporation reported earnings per share of $2.52 in 2016 and $3.15 in 2021. At what compound annual rate did earnings per share grow over this period?

A) 3.79% B) 4.00% C) 4.56% D) 5.00% E) None of the options are correct.

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

A) $28 B) $656 C) $1,656 D) $5,000

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

A) $577.57 B) $629.56 C) $750.00 D) #VALUE!

38) What is the effective annual interest rate on a credit card loan charging 15%, compounded monthly?

A) 14.06% B) 15.00% C) 15.12% D) 16.08% E) 16.18%

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

A) Calculate a figure of merit for the investment.

B) Estimate the accounting rate of return for the investment.

C) Estimate the relevant cash flows.

D) Compare the figure of merit to an acceptance criterion.

E) All of the options are important steps.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

40) An investment costing $100,000 promises an after-tax cash flow of $36,000 per year for 6 years. a.Find the investment’s accounting rate of return and its payback period. b.Find the investment’s net present value at a 15% discount rate. c.Find the investment’s benefit-cost ratio (profitability index) at a 15% discount rate. d.Find the investment’s internal rate of return. e.Assuming the required rate of return on the investment is 15%, which of the above figures of merit indicate the investment is attractive? Which indicate it is unattractive?

41) At $1,000 par value, a 10% coupon bond matures in 20 years. If the price of the bond is $1,196.80, what is the yield to maturity on the bond? Assume interest is paid annually.

42) Ten years ago, you invested $1,000 for 10 shares of Providien, Incorporated common stock. You sold the shares recently for $2,000. While you owned the stock, it paid $10.08 per share in annual dividends. Assume that the dividends were paid at the end of each year and that you received a dividend just prior to selling your shares. What was your rate of return on Providien stock?

43)

Consider the following investment opportunity.

Initial cost Annual revenues Annual operating costs, excluding depreciation Expected life (years) Salvage value after taxes Annual depreciation for tax purposes Tax rate

$ 850,000 $ 500,000 $ 200,000 20 $ 40,000 $ 25,000 34%

Assume the annual figures are unchanged for the expected life of the investment. What is the rate of return on this investment? Assuming the investor wants to earn at least 12%, is this investment an attractive one?

44) A company is considering two alternative methods of producing a new product. The relevant data concerning the alternatives are presented below.

Initial investment Annual receipts Annual disbursements Annual depreciation Expected life (years) Salvage value

Alternative I

Alternative II

$ 64,000 $ 50,000 $ 20,000 $ 16,000 4 $ 0

$ 120,000 $ 60,000 $ 12,000 $ 20,000 6 $ 0

At the end of the useful life of whatever equipment is chosen, the product will be discontinued.

The company’s tax rate is 50%, and its cost of capital is 10%. a.Calculate the net present value of each alternative. b.Calculate the benefit-cost ratio for each alternative. c.Calculate the internal rate of return for each alternative. d.If the company is not under capital rationing, which alternative should be chosen? Why?

45) Given the following information about a possible average-risk, new product investment, calculate the investment’s net present value. Assume that investments in working capital (inventory and accounts receivable) will be fully recovered at the end of the project.

Initial cost Expected life (years) Salvage value Annual depreciation Incremental annual sales Incremental annual production costs Incremental annual selling and administrative costs Tax rate Expected inventory turnover (Product cost/Ending inventory) Expected collection period (assume a 360-day year) Required rate of return

$ 200,000 10 $ 0 $ 20,000 $ 200,000 $ 110,000 $ 20,000 50% 4 45 8%

46) Your brother, age 40, is the regional manager at an office supply company. He thinks he might want to leave his job to go back to school for an MBA. He expects that his current job, if he were to stay at it, would pay him a real income stream of $75,000 per year until retirement at age 65. If he goes back to school, he would forego two years of income, but his real income after graduation would be $115,000 per year until retirement at age 65. He has been accepted to an MBA program that costs a real $22,000 per year. If his real discount is 8%, would leaving his job to get an MBA be a smart financial decision?

Answer Key Test name: chapter 7 1) TRUE 2) TRUE 3) TRUE 4) FALSE 5) TRUE 6) FALSE 7) FALSE 8) FALSE 9) FALSE 10) FALSE 11) TRUE 12) D 13) E 14) C 15) B 16) C Future value = $82,500 × (1 + 0.048)4 = $99,517.41 Input: Output:

n

i

PV

PMT

FV

4

4.8

−82,500

0

?

99,517.41

In Excel: =FV(0.048,4,0,−82500) =99,517.41 17) C Present value = $51,480.79 ÷ (1 + 0.0425)26 = $17,444.86

Input: Output:

n

i

PV

PMT

FV

26

4.25

? −17,444.86

0

51,480.79

In Excel: =PV(0.0425,26,0,51480.79) =−17,444.86 18) D Input: Output:

n

i

PV

PMT

FV

45

10.25

0

−3,000

?

2,333,572

In Excel: =FV(0.1025,45,−3000) =2,333,572 19) E The number of monthly periods = 20 × 12 = 240 The monthly interest rate = 6%/12 = 0.5% Input: Output:

n

i

PV

PMT

FV

240

0.5

? −195,413

1,400

0

In Excel: =PV(0.005,240,1400) =−195,413 20) E The number of monthly periods = 5 × 12 = 60 The monthly interest rate = 8.6%/12 = 0.71667% Input: Output:

n

i

PV

PMT

FV

60

0.71667

17,800

? −366.05

0

In Excel: =PMT(0.0071667,60,17800) =−366.05 21) A Price = present value of coupons and face value Coupon payment = 0.095 × 1000 = $95 per year Input: Output:

n

i

PV

PMT

FV

11

11.2

? −895.43

95

1,000

In Excel: =PV(0.112,11,95,1000) =−895.43 22) B Solve for the PV of the cash inflows, and then subtract the initial investment: Input: Output:

n

i

PV

PMT

FV

5

16

? −11,668.02

3,200

2,500

In Excel: =PV(0.16,5,3200,2500) =−11,668.02 NPV = 11668.02 − 9,500 = $2,168.02 23) A 24) B 25) B 26) C r = A/P = $3.00/$60 = 5.0% 27) E

The initial investment consists of the fixed assets and incremental working capital: $39,000 + $3000 = $42,000. The working capital amount is recovered at the end of year 4. Solve for the PV of the cash inflows, and then subtract the initial investment: Input: Output:

n

i

PV

PMT

FV

4

16

? −74,409.57

26,000

3,000

In Excel: =PV(0.16,4,26000,3000) =−74,409.57 NPV = 74,409.57 − 42,000 = $32,409.57 28) C PVinflows = (12,200/1.145) + (38,400/1.1452) + (11,300/1.1453) = $47,472.78 In Excel: =NPV(0.145,12200,38400,11300) =47,472.78 BCR = $47,472.78/$46,500 = 1.02 29) C 30) B 0

1

2

Revenue

$ 1,600

$ 1,600

Expense

700

700

Depreciation

300

300

Pre-tax profit

600

600

Taxes

300

300

After-tax profit

300

300

Plant and equipment

$ 1,500

−850

Increased working capital Free cash flow

300

−300

−$ 1,800

$ 600

$ 1,750

0

1

2

Revenue

$ 1,600

$ 1,600

Expense

700

700

Depreciation

300

300

Pre-tax profit

600

600

Taxes

300

300

After-tax profit

300

300

31) B

Plant and equipment

$ 1,500

−850

300

−300

Increased working capital Free cash flow

−$ 1,800

$ 600

$ 1,750

0

1

2

Revenue

$ 1,600

$ 1,600

Expense

700

700

Depreciation

300

300

Pre-tax profit

600

600

Taxes

300

300

After-tax profit

300

300

32) D

Plant and equipment Increased working capital Free cash flow

$ 1,500

−850

300

−300

−$ 1,800

$ 600

$ 1,750

(Note that the salvage value from the equipment includes the $800 resale value plus $50 tax savings from the $100 loss on the equipment relative to book value.)

33) E In Year 0 there is a $60,000 outflow.

In Year 5 there is a $60,000 inflow, which has a present value of 60,000/1.097 = $32,822.

The decrease in NPV is 60,000 − 32,822 = $27,178.

34) B Input: Output:

n

i

PV

PMT

FV

10

10

? −6,144.57

1,000

0

In Excel: =PV(0.1,10,1000) =−6,144.57 The PV = $6,144.57. But the first payment is received in two years, not one year, so discount the PV by one more year: 6,144.57/1.1 = $5,585.97 35) C Input: Output:

n

i

PV

PMT

FV

5

?

4.56

−2.52

0

3.15

In Excel: =RATE(5,0,−2.52,3.15) =4.56% 36) A The present value of the perpetuity is 5,000/0.08 = $62,500. For the annuity: Input:

n

i

PV

PMT

FV

100

8

?

5,000

0

Output:

−62,472

In Excel: =PV(0.08,100,5000) =−62,472 The difference = 62,500 − 62,472 = $28 37) A −250/1.09 + 500/1.092 + 500/1.093 = $577.57

38) D EAR = (1 + 0.15/12)12 − 1 = 0.1608 39) B 40)a.The accounting rate of return = 36/100 = 36% The payback period = 100/36 = 2.78 years b. NPV = −100,000 + 136,241 = $36,241 Input: Output:

n

i

PV

PMT

FV

6

15

? −136,241

36,000

0

In Excel: =PV(0.15,6,36000) =−136,241 c. BCR, or PI = 136,241/100,000 = 1.36 d. IRR = 27.70% Input: Output:

n

i

PV

PMT

FV

6

?

27.70

−100,000

36,000

0

In Excel: =RATE(6,36000,−100000) =27.7% e.The NPV, PI, and IRR all indicate unambiguously that the investment is worthwhile. The accounting rate of return suggests the same, but is not a reliable indicator of investment value, nor is it comparable to the 15% required rate of return on the investment. Because there is no reliable way to transform a 15% required rate of return into a maximum acceptable payback period, it is not clear whether a 2.78 year payback period is short enough.

41)

Input: Output:

n

i

PV

PMT

FV

20

?

8.00

−1,196.80

100

1,000

In Excel: =RATE(20,100,−1196.8,1000) =8.00% 42)Total dividends per year = 10 shares × $10.08 per share = $100.80.

Rate of return = 15.00%, as shown below.

Input: Output:

n

i

PV

PMT

FV

10

?

−1,000 15.00

100.80

2,000

In Excel: =RATE(10,100.8,−1000,2000) =15.00% 43)The annual cash flows for the investment are: Revenues Operating costs Depreciation

$ 500,000 200,000 25,000

Profit before tax Taxes Profit after tax Depreciation

275,000 93,500 181,500 25,000

Cash flow after tax

$ 206,500

And the rate of return = 23.96% as shown below.

Input: Output:

n

i

PV

PMT

FV

20

?

23.96

−850,000

206,500

0

In Excel: =RATE(20,206500,−850000,,,0.2) =23.96% The investment is clearly attractive at a hurdle rate of 12%. (Note that Excel requires a guess to be entered in order to solve for the IRR in this case.)

44)a. The annual cash flows for each alternative are as follows: Alternative I Receipts Disbursements Depreciation Income before tax Taxes Income after tax Depreciation Cash flow after tax

$ 50,000 20,000 16,000 14,000 7,000 7,000 16,000 $ 23,000

Alternative II $ 60,000 12,000 20,000 28,000 14,000 14,000 20,000 $ 34,000

Alternative I PV: Input: Output:

n

i

PV

PMT

FV

4

10

? −72,906.91

23,000

0

In Excel: =PV(0.1,4,23000) =−72,906.91 Alternative II PV: Input: Output:

n

i

PV

PMT

FV

6

10

? −148,078.86

34,000

0

In Excel: =PV(0.1,6,34000) =−148,078.86 NPVI = −64,000 + 72,907 = $8,907 NPVII = −120,000 + 148,079 = $28,079 b. BCRI = 72,907/64,000 = 1.14 BCRII = 148,079/120,000 = 1.23 c. IRRI = 16.3% as shown below: Input: Output:

n

i

PV

PMT

FV

4

?

16.3

−64,000

23,000

0

In Excel: =RATE(4,23000,−64000) =16.3% IRRII = 17.6% as shown below: Input: Output:

n

i

PV

PMT

FV

6

?

17.6

−120,000

34,000

0

In Excel: =RATE(6,34000,−120000) =17.6% d.The company should choose Alternative II because II has the higher NPV and NPV is a direct measure of increase in shareholder wealth.

45)Inventory = Production cost/Inventory turnover = 110,000/4 = $27,500 Accounts receivable = Collection period × Sales per day = 45(200,000/360) = $25,000 Working capital required = 27,500 + 25,000 = $52,500 Total Year 0 cost = 200,000 + 52,500 = $252,500 Annual after-tax cash flow: Revenue Production costs Selling and administrative expense Depreciation Profit before tax Tax Profit after tax Depreciation Cash flow after tax

Input: Output:

$ 200,000 110,000 20,000 20,000 50,000 25,000 25,000 20,000 $ 45,000 n

i

PV

PMT

FV

10

8

? −326,271

45,000

52,500

In Excel: =PV(0.08,10,45000,52500) =−326,271 NPV = −252,500 + 326,271 = $73,771 46)To begin, calculate the present value of the real income stream from his current position. This results in a present value $800,608.

Input: Output:

n

i

PV

PMT

FV

25

8

? −800,608

75,000

0

In Excel: =PV(0.08,25,75000) =−800,608 For school, the present value of your brother’s real income stream is the present value of the 23-year real income from the new job, discounted back 2 years at the real discount rate, minus the present value of the cost of the MBA program.

The value of the MBA real income stream, discounted back 2 years, is 1,192,672/1.082 = $1,022,524.

Input: Output:

n

i

PV

PMT

FV

23

8

? −1,192,672

115,000

0

In Excel: =PV(0.08,23,115000) =−1,192,672 The present value of the cost of the MBA program is $39,232.

Input: Output:

n

i

PV

PMT

FV

2

8

? −39,232

22,000

0

In Excel: =PV(0.08,2,22000) =−39,232 The net present value of your brother’s MBA real income stream is the difference, or 1,022,524 − 39,232 = $983,292. This is greater than the value of his current income stream, so the correct financial decision is to return to school for an MBA.

Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

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

2) All else equal, if two competing firms in industry X are valuing the same plant in industry Y for a potential acquisition, the firm with the more volatile stock should arrive at a lower valuation for the plant. ⊚ true ⊚ false

3) A beta greater than 1 is indicative of an above-average level of diversifiable (unsystematic) risk. ⊚ true ⊚ false

4) Failing to include real options in a project valuation could cause the NPV of the project to be overestimated. ⊚ true ⊚ false

5) The adjusted present value (APV) method of valuation is superior to the standard WACC method of valuation because the WACC method makes no adjustment for interest tax shields. ⊚ true ⊚ false

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

7)

Asset betas measure financial risk and business risk. ⊚ true ⊚ false

8) When projected cash flows are in nominal dollars, they should be discounted with a real discount rate. ⊚ true ⊚ false

9) A firm’s WACC is the appropriate discount rate to value a project undertaken by the firm only if the project has the same risk as the firm’s existing assets. ⊚ true ⊚ false

10) If a firm’s cost of debt is lower than its cost of equity, shifting the firm’s financing toward more debt will always reduce the firm’s WACC. ⊚ true ⊚ false

11) If a new project will be funded entirely by debt, then the cost of capital for the project is simply the after-tax cost of debt. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

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

A) making an investment in two or three large stocks will eliminate all of the unsystematic risk.

B) making an investment in three companies all within the same industry will greatly reduce the systematic risk.

C) spreading an investment across five diverse companies will not lower the total risk.

D) spreading an investment across many diverse assets will eliminate all of the systematic risk.

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

F) None of the options are correct.

13)

Unsystematic risk A) can be effectively eliminated by portfolio diversification.

B) is compensated for by the risk premium.

C) is measured by beta.

D) is measured by standard deviation.

E) is related to the overall economy.

F) None of the options are correct.

14) Which of the following are examples of diversifiable risk?

1.An earthquake damages Oakland, California.

2.The federal government imposes an additional $1,000 fee on all business entities.

3.Employment taxes increase nationally.

4.Toymakers are required to improve their safety standards.

A) I and III only B) II and IV only C) II and III only D) I and IV only E) I, III, and IV only F) None of the options are correct.

15) Which of the following statements concerning diversifiable risk are correct?

1.Diversifiable risk can be largely eliminated by investing in 50 unrelated securities.

2.There is no reward for accepting diversifiable risk.

3.Diversifiable risk is generally associated with an individual firm or industry.

4.Beta measures diversifiable risk.

A) I and III only B) II and IV only C) I and IV only D) I, II, and III only E) I, II, III, and IV F) None of the options are correct.

16) Which of the following statements concerning risk are correct?

1.Systematic risk is measured by beta.

2.The risk premium increases as unsystematic risk increases.

3.Systematic risk is the only part of total risk that should affect asset prices and returns.

4.Diversifiable risks are market risks you cannot avoid.

A) I and III only B) II and IV only C) I and II only D) III and IV only E) I, II, and III only F) None of the options are correct.

17)

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

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

B) A flood washes away a firm’s warehouse.

C) A city imposes an additional 1% sales tax on all products.

D) A toymaker has to recall its top-selling toy.

E) Corn prices increase due to increased demand for alternative fuels.

F) None of the options are correct.

18) The excess return earned by a risky asset over that earned by a risk-free asset is referred to as a A) market risk premium.

B) risk premium.

C) systematic return.

D) total return.

E) real rate of return.

F) None of the options are correct.

19) The dividend growth model yields a plausible estimate the cost of equity for a firm in which of the following situations?

1.A firm that has a 100% retention ratio 2.A firm that pays an unchanging dividend 3.A firm that pays a constantly increasing dividend 4.A firm with unpredictable dividend payments A) I and II only B) III only C) II and III only D) I, II, and III only E) I, III, and IV only F) None of the options are correct.

20)

The cost of equity for a firm A) tends to remain static for firms with increasing levels of risk.

B) increases as the unsystematic risk of the firm increases.

C) can be estimated from the capital asset pricing model or the dividend growth model.

D) equals the risk-free rate plus the market risk premium.

E) equals the firm’s pre-tax weighted-average cost of capital.

F) None of the options are correct.

21)

A firm’s pre-tax cost of debt

A) can be estimated from the yield to maturity of the firm’s outstanding bonds.

B) is equal to the coupon rate on the latest bonds issued by the firm.

C) is equal to the average coupon rate on all of the firm’s outstanding bonds.

D) is multiplied by the firm’s tax rate to get the after-tax cost of debt.

E) None of the options are correct.

22) The after-tax cost of debt generally increases when 1.a firm’s bond rating declines.

2.a firm’s probability of bankruptcy increases.

3.tax rates decrease.

4.bond prices rise.

A) I and III only B) II and III only C) I, II, and III only D) II, III, and IV only E) I, II, III, and IV F) None of the options are correct.

23) Celebrity Auto Parts, Incorporation Facts and assumptions Company equity beta Stock price Number of shares outstanding (millions) Book value of equity (millions) Book value of interest-bearing debt (millions) Yield to maturity on long-term government bonds Historical excess return on common stocks Yield to maturity on outstanding bonds Tax rate

1.20 $ 30 200 $ 3,500 $ 1,500 3.4% 6.6% 9% 25%

Please refer to the information for Celebrity Auto Parts above. What is Celebrity’s WACC?

A) 9.9% B) 10.4% C) 10.8% D) 11.3% E) None of the options are correct.

24) Which of the following statements are correct?

1.Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often riskier than cash flows occurring sooner.

2.If you can borrow all of the money you need for a project at 5%, the cost of capital for the project is 5%.

3.The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds.

4.A firm’s weighted-average cost of capital is the correct discount rate to use for all projects undertaken by the firm.

A) I only B) II and IV only C) I and II only D) I and IV only E) I, II, and III only F) None of the options are correct.

25)

The capital structure weights used in computing the weighted-average cost of capital A) are based on the book values of total debt and total equity.

B) are based on the book values of long-term debt and total equity.

C) are based on the market value of total debt and the book value of total equity.

D) remain constant over time unless the firm issues new securities.

E) should always sum to one.

F) None of the options are correct.

26) The discount rate assigned to a project in an industry outside the firm’s existing business should be based on

A) the firm’s weighted-average cost of capital.

B) the actual sources of funding used for the project.

C) an average of the firm’s overall cost of capital for the past five years.

D) the current risk level of the overall firm.

E) the risks associated with the use of the funds required by the project.

F) None of the options are correct.

27)

The weighted-average cost of capital for a firm is the A) discount rate which the firm should apply to all of the projects it undertakes.

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

stock.

C) coupon rate the firm should expect to pay on its next bond issue.

D) minimum discount rate the firm should require on any new project.

E) rate of return shareholders should expect to earn on their investment in the firm.

F) None of the options are correct.

28) Honest Abe is a chain of furniture retail stores. Integral Designs is a furniture maker and a supplier to Honest Abe. Honest Abe has a beta of 1.38 and Integral Designs has a beta of 1.12.

The risk-free rate of return is 3.5% and the market risk premium is 8%. Based only on this information, what cost of equity should Honest Abe use when calculating the weighted-average cost of capital for a project that involves the manufacturing of furniture?

A) 12.46% B) 12.92% C) 13.50% D) 14.08% E) 14.54% F) None of the options are correct.

29) A firm is considering an average-risk project with an IRR of 6%. The firm’s pre-tax cost of debt is 5%, its cost of equity is 12%, and its tax rate is 20%. The firm’s debt ratio ( D/( D+ E)), in market values, is 0.5. The firm should

A) accept the project only if it can be completely financed with equity.

B) accept the project only if it can be completely financed with debt.

C) accept the project regardless of the financing method.

D) reject the project regardless of the financing method.

30) Unitron Corporation is considering project Z, which costs $50 million and offers an annual after-tax cash flow of $7.5 million in perpetuity. The project is in an industry that has greater market risk than Unitron’s typical projects. Unitron’s company weighted-average cost of capital, based on its typical projects, is 15%. Should Unitron Corporation accept project Z? A) Yes, because the NPV of the project is positive.

B) Yes, because a zero-NPV project is marginally acceptable.

C) No, because a zero-NPV project is a waste of resources.

D) No, because the NPV of the project is negative.

31) Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock trades for $3 per share. It also has $2 million in face value of debt that trades at 90% of par. What is the appropriate debt ratio ( D/( D+ E)) to use for calculating Company X’s weighted-average cost of capital?

A) 23.1% B) 25.0% C) 31.0% D) 33.3%

32) JKL Corporation, a company devoted primarily to paper products, is estimating the cost of equity appropriate for a vegetable processing plant it is planning to build. JKL has an equity beta of 1.0. JKL has a debt ratio ( D/( D+ E)) of 0.3 and believes this is also the appropriate debt ratio for the vegetable processing plant. A comparable vegetable processing firm has an equity beta of 0.8 and a debt ratio of 0.2. Assume a risk-free rate of 5% and a market risk premium of 8%. What cost of equity should JKL use in this situation?

A) 7.7% B) 11.4% C) 12.3% D) 13.0%

33) Georgia Corporation is calculating the appropriate rate for discounting cash flows on a project valued using the APV method. Georgia’s debt ratio ( D/( D+ E)) in market value terms is 50%, and the yield-to-maturity on its outstanding debt is 6%. A comparable firm has an equity beta of 1.4 and a debt ratio of 40%. Assume a risk-free rate of 4% and a market risk premium of 8%. Georgia’s tax rate is 30%. What discount rate should Georgia use?

A) 6.66% B) 10.02% C) 10.72% D) 16.44% E) 17.44%

34)

Total risk is measured by _____, and systematic risk is measured by ____.

A) beta; alpha B) beta; standard deviation C) WACC; beta D) standard deviation; beta E) standard deviation; variance F) None of the options are correct.

35) Liverpool Corporation is evaluating a potential project that promises $100,000 in free cash flow in each of the next three years. The project will be partially funded by a constant $1 million dollars in debt at a 6% interest rate over the three-year period. Liverpool’s all-equity cost of capital (KA) is 10%, and its tax rate is 25%. Assuming that interest tax shields are the only important side effect of financing and that they should be discounted at the after-tax cost of debt, what is the APV of this project?

A) $263,039 B) $274,440 C) $288,780 D) $289,920 E) $293,685

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

36) Key facts and assumptions concerning Alpine Corporation appear below.

Yield to maturity on long-term government bonds Yield to maturity on company long-term bonds Coupon rate on company long-term bonds Historical excess return on common stocks Company equity beta Stock price Number of shares outstanding (millions) Book value of equity (millions) Book value of interest-bearing debt (millions) Tax rate

3.28% 4.62% 5.50% 6.10% 0.80 $ 75.08 449.5 $ 11,585 $ 2,524 35.00%

Use the above information to answer the following questions. a.Estimate Alpine’s cost of equity capital. b.Estimate Alpine’s weighted-average cost of capital.

37) Explain the difference between systematic and unsystematic risk and why one of these types of risks is rewarded with a risk premium while the other type is not.

38) Suppose that your company’s weighted-average cost of capital is 9%. Your company is planning to undertake a project with an internal rate of return of 12%, but you believe that this project is not a good investment for the firm. What logical arguments might you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your company’s cost of capital will destroy value?

If so, how?

39) The standard deviation of returns on Wildcat Oil Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

40) What is the present value of a cash flow stream of $10,000 per year annually for 11 years that then grows at 2% per year forever? Assume the appropriate discount rate is 12%.

41) Kilborn Corporation’s balance sheet is shown below. The current rate on treasury bonds is 7%. The yield to maturity on Kilborn’s bonds is 10%. Assume a market risk premium of 8%.

Kilborn’s tax rate is 40%. Kilborn’s stock price is $45, and it has 2 million shares outstanding.

Kilborn’s beta is unknown because it only recently went public, but it is known that a comparable firm’s stock has a beta of 1.2 and that the comparable firm’s debt ratio ( D/( D+ E)) is 0.4. What is the weighted-average cost of capital for Kilborn Corporation?

Assets Cash and securities Accounts receivable Inventory

Kilborn Corporation Balance Sheet ($ millions) Liabilities and Equity 10 50 50

Bonds Common stock Retained earnings

20 50 80

Net fixed assets

40

Total assets

150

Total liabilities and equity

150

SECTION BREAK. Answer all the part questions.

42) [The following information applies to the questions displayed below.]

FM Foods, Incorporation Facts and assumptions as of Dec. 31, 2021 Yield to maturity on long-term government bonds Yield to maturity on company long-term bonds Coupon rate on company long-term bonds Historical excess return on common stocks Company equity beta Stock price Number of shares outstanding (millions) Book value of equity (millions) Book value of interest-bearing debt (millions) Tax rate

4.4% 6.3% 7.0% 6.5% 1.20 $ 40.00 240 $ 5,240 $ 1,250 35.0%

42.1) Please refer to the information for FM Foods above. Estimate FM’s after-tax cost of equity capital.

A) 4.5% B) 6.9% C) 7.9% D) 12.2% E) 17.5% F) None of the options are correct.

42.2) Please refer to the information for FM Foods above. Estimate FM’s after-tax cost of debt.

A) 2.2% B) 4.1% C) 4.5% D) 6.3% E) 7.0% F) None of the options are correct.

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

A) 11.5% B) 19.3% C) 80.7% D) 88.5% E) 100.0% F) None of the options are correct.

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

A) 11.5% B) 19.3% C) 80.7% D) 88.5% E) 100.0% F) None of the options are correct.

42.5) Please refer to the information for FM Foods above. Estimate FM’s weightedaverage cost of capital.

A) 6.5% B) 6.6% C) 11.3% D) 11.4% E) 11.5% F) None of the options are correct.

42.6) Please refer to the information for FM Foods above. FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in perpetuity. Which of the following statements are correct?

1.FM should reject the project because the IRR is greater than the firm’s WACC. 2.FM should accept the project because the IRR is greater than the firm’s WACC. 3.FM should accept the project because the NPV is greater than zero.

4.FM should reject the project because the NPV is less than zero.

A) I only B) II only C) IV only D) I and IV only E) II and III only F) None of the options are correct.

Answer Key Test name: chapter 8 1) TRUE 2) FALSE 3) FALSE 4) FALSE 5) FALSE 6) FALSE 7) FALSE 8) FALSE 9) TRUE 10) FALSE 11) FALSE 12) E 13) A 14) D 15) D 16) A 17) A 18) B 19) C 20) C 21) A 22) C 23) B KE = 3.4% + 1.2(6.6%) = 11.3% D/(D+E) = 1500/(1500 + (200)(30)) = 0.2 KW = (1 − 0.25)0.09(0.2) + 0.113(0.8) = 0.104

24) A 25) E 26) E 27) B 28) A KE = risk-free rate + equity beta × market risk premium = 0.035 + 1.12(0.08) = 0.1246 or 12.46% 29) D KW = (1 − t) KD (D/(D+E)) + KE (E/(D+E)) KW = (1 − 0.2)0.05(0.5) + 0.12(0.5) KW = 0.08 = 8% The project should be rejected because the IRR of 6% does not meet the hurdle of 8%.

30) D Use the equation for a perpetuity to solve for the IRR: 7.5/IRR = 50 IRR = 15% Since the IRR is 15%, it would have an NPV of zero at a WACC of 15%. However, this project is riskier than the firm’s average projects, so the WACC would be higher than 15%, which would make the NPV negative.

31) A D = 0.9 × $2 million = $1.8 million E = $3 ×2 million = $6 million D/( D+ E) = 1.8/(1.8 + 6) = 0.231 32) C Unlever the comparable firm’s beta: βA = (E/V) βE = (0.8)0.8 = 0.64 Then relever at JKL’s debt ratio: βE = βA/(E/V) = 0.64/(0.7) = 0.91 Cost of Equity: KE = 5% + 0.91(8%) = 12.3% 33) C

βA = (E/V) βE = (0.6)1.4 = 0.84 K A = 4% + 0.84(8%) = 10.72% 34) D 35) D PV(FCF) = 100,000/(1 + 0.1) + 100,000/(1 + 0.1)2 + 100,000/(1 + 0.1)3 = $248,685.20 Input: Output:

n

i

PV

PMT

FV

3

10

?

-248,685.20

100,000

0

In Excel: =PV(0.1,3,100000) =−248,685.20 Annual tax shield = $1,000,000 × 6% × 25% = $15,000 After-tax cost of debt = 6%(1 − 0.25) = 4.5% PV(Tax shields) = 15,000/(1 + 0.045) + 15,000/(1 + 0.045)2 + 15,000/(1 + 0.045)3 = $41,234.47 Input: Output:

n

i

PV

PMT

FV

3

4.5

?

-41,234.47

15,000

0

In Excel: =PV(0.045,3,15000) =−41,234,47 APV = 248,685.20 + 41,234.47 = $289,919.67

36)a. KE = government bond rate + equity beta × market risk premium KE = 3.28 + 0.80 × 6.10 = 8.16% b. Market value of equity = 449.5 × 75.08 = $33,748 Weight for debt = 2,524/(2,524 + 33,748) = 0.070 KW = (1 − t) KD (D/(D+E)) + KE (E/(D+E)) KW = (1 − 0.35)0.0462(0.07) + 0.0816(0.93) KW = 0.078 = 7.8% 37)Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated by investing in securities from various industries and geographic regions. Unsystematic risk is not rewarded because it can be eliminated by investors. Systematic risk is risk that affects most, or all, securities and cannot be diversified away. Since systematic risk cannot be eliminated by investors it is rewarded with a risk premium. Systematic risk is measured by beta.

38)If the risk of the investment is above the company’s average risk, the company’s cost of capital is not an appropriate benchmark. Equivalently, you might argue that the high risk of the investment places it below the security market line. Such investments destroy value because they promise returns that, while greater than the company’s WACC, are still below those available on similar-risk investments available. Other possible arguments include that the investment is not consistent with the strategic plan or that the cash flow estimates are too optimistic.

39)The equation for beta in Chapter 8 shows that the nondiversifiable risk of an asset is the product of its standard deviation of returns and the correlation of those returns with those on a well-diversified portfolio.

Wildcat Oil Drilling may have a high standard deviation of returns, but if those returns are poorly correlated with those on a well-diversified portfolio, as is likely the case, nondiversifiable risk may be low. In other words, if investors can diversify away most of Wildcat’s risk, then it is not truly a high-risk investment.

40)Divide the cash flows into two periods: An 11-year annuity of $10,000, and a growing perpetuity beginning in the 11th year. The value of the 11-year annuity is $59,377, as shown below: Input: Output:

n

i

PV

PMT

FV

11

12

? −59,377

10,000

0

In Excel: = PV(0.12,11,10000) = −59,377 The value of the growing perpetuity (using the formula provided in Chapter 8 for a growing dividend into perpetuity) at time 11 is $10,000(1 + 0.02)/(0.12 − 0.02) = $102,000. Its value at time zero is $102,000/(1.12)11 = $29,323. Adding these values, 29,323 + 59,377 = $88,700.

41)Note that for Kilborn: D = 20; E = 45 ×2 = 90; V = D + E = 110 Unlever the comparable firm’s beta: βA = ( E/ V) βE = (0.6)1.2 = 0.72 Then relever at Kilborn’s debt ratio: βE = βA/( E/ V) = 0.72/(90/110) = 0.88 Cost of Equity: KE = 7% + 0.88(8%) = 14.04% Cost of Debt: KD = 10% KW = (1 − t) KD (D/(D+E)) + KE (E/(D+E)) KW = (1 − 0.4) 0.1 (20/110) + 0.1404 (90/110) KW = 0.126 = 12.6% 42) Section Break 42.1) D KE = government bond rate + equity beta × market risk premium = 0.044 + 1.2 × 0.065 = 0.122 42.2) B The correct approach is to use the YTM on the firm’s bonds for the before-tax cost. Thus, after-tax cost = 6.3% × (1 − 0.35) = 4.10%.

42.3) D Market value of equity = $40 × 240 million = $9,600 million Weight of equity = 9,600/(9,600 + 1,250) = 0.8848 or 88.5% 42.4) A Market value of equity = $40 × 240 million = $9,600 million Weight of debt = 1,250/(9,600 + 1,250) = 0.1152 or 11.5% 42.5) C KW = (1 − t) KD (D/(D+E)) + KE (E/(D+E)) KW = (1 − 0.35) 0.063 (0.115) + 0.122 (0.885) KW = 0.113 42.6) E

The IRR of the investment is 15/100 = 15%. FM’s WACC of 11.3% is shown in the calculations below. The NPV of the investment at the WACC = −100 + 15/0.113 = $32.7 million.

KW = (1 − t) KD (D/(D+E)) + KE (E/(D+E)) KW = (1 − 0.35) 0.063 (0.115) + 0.122 (0.885) KW = 0.113 Student name:__________ TRUE/FALSE - Write 'T' if the statement is true and 'F' if the statement is false.

1) On average, mergers create value for shareholders of acquired firms. ⊚ true ⊚ false

2) When an acquirer purchases all of a target firm’s equity, it must assume the target’s liabilities. ⊚ true ⊚ false

3) An acquirer should be willing to pay a higher control premium for a poorly managed company than for a well-managed company. ⊚ true ⊚ false

4) When an acquirer values a potential target, it should discount the target’s cash flows at the acquirer’s cost of capital. ⊚ true ⊚ false

5)

Rational investors would never value a company’s stock below its liquidation value. ⊚ true ⊚ false

6)

In business valuation, a typical discount for lack of marketability is about 10%. ⊚ true ⊚ false

7) Terminal value estimates based on book value tend to understate a company’s terminal value. ⊚ true ⊚ false

8) All else equal, a terminal value based on a no-growth perpetuity would be higher than a terminal value based on a perpetuity with 2% growth. ⊚ true ⊚ false

9) An acquirer should never consider a target that would reduce the acquirer’s earnings per share. ⊚ true ⊚ false

10) In venture-capital valuation, the post-money valuation is equal to the pre-money valuation minus the amount of the venture capitalist’s investment. ⊚ true ⊚ false

11) Studies show that activist investing has very little impact on the companies targeted by activist investors. ⊚ true ⊚ false

MULTIPLE CHOICE - Choose the one alternative that best completes the statement or answers the question.

12) Ginormous Oil entered into an agreement to purchase all of the outstanding shares of Slick Company for $60 per share. The number of outstanding shares at the time of the announcement was 82 million. The book value of liabilities on the balance sheet of Slick Company was $1.46 billion. What was the cost of this acquisition to the shareholders of Ginormous Oil? A) $1.46 billion B) $3.46 billion C) $4.92 billion D) $6.38 billion E) $8.38 billion F) None of the options are correct.

13) Ginormous Oil entered into an agreement to purchase all of the outstanding shares of Slick Company for $60 per share. The number of outstanding shares at the time of the announcement was 82 million. The book value of liabilities on the balance sheet of Slick Company was $1.46 billion. Immediately prior to the Ginormous Oil bid, the shares of Slick Company traded at $33 per share. What value did Ginormous Oil place on control of Slick Company.?

A) $2.21 billion B) $2.71 billion C) $4.17 billion D) $6.38 billion E) None of the options are correct.

14) Which of the following statements are correct?

1.Going-concern value of a firm is equal to the present value of expected net income.

2.When a buyer values a target firm, the appropriate discount rate is the buyer’s weightedaverage cost of capital.

3.The liquidation value estimate of terminal value usually vastly understates a healthy company’s terminal value.

4.The value of a firm’s equity equals the discounted cash flow value of the firm minus all liabilities.

A) II only B) III only C) I and II only D) II and III only E) II, III, and IV only F) None of the options are correct.

15) Which of the following statements are correct?

1.Going-concern value of a firm is equal to the present value of expected future cash flows to owners and creditors.

2.When an acquiring firm purchases a target firm’s equity, the acquirer need not assume the target’s liabilities.

3.The market value of a public company reflects the worth of the business to minority investors.

4.The fair market value of a business is always the higher of its liquidation value and its goingconcern value.

A) I and III only B) II and IV only C) II and III only D) I, II, and III only E) II, III, and IV only F) None of the options are correct.

16) The following table presents forecasted financial and other information for Havisham Industries: 2019 Projected EBIT Earnings after tax Free cash flow Havisham's WACC

2020

$ 317 197 135 8.2%

Expected growth rate in FCFs after 2021

4.0%

Warranted MV firm/FCF in 2021

19.4

Warranted P/E in 2021

18.7

$ 339 210 144

2021 $ 363 225 155

What is an appropriate estimate of Havisham’s terminal value as of the end of 2021 using the perpetual-growth equation as your estimate?

A) $161 million B) $363 million C) $3,690 million D) $3,889 million E) $5,357 million F) None of the options are correct.

17) The following table presents forecasted financial and other information for Havisham Industries: 2019 Projected EBIT Earnings after tax Free cash flow Havisham's WACC

$ 317 197 135 8.2%

Expected growth rate in FCFs after 2021

4.0%

Warranted MV firm/FCF in 2021

19.4

Warranted P/E in 2021

18.7

2020 $ 339 210 144

2021 $ 363 225 155

What is an appropriate estimate of Havisham’s terminal value as of the end of 2021 using a warranted price-to-earnings multiple as your estimate?

A) $225 million B) $3,833.0 million C) $4,207.5 million D) $4,365.0 million E) $6,788.1 million F) None of the options are correct.

18) The following table presents forecasted financial and other information for Havisham Industries: 2019

2020

2021

Projected EBIT Earnings after tax Free cash flow Havisham's WACC

$ 317 197 135 8.2%

Expected growth rate in FCFs after 2021

4.0%

Warranted MV firm/FCF in 2021

19.4

Warranted P/E in 2021

18.7

$ 339 210 144

$ 363 225 155

What is an appropriate estimate of Havisham’s terminal value as of the end of 2021 using a warranted multiple of free cash flow as your estimate?

A) $155 million B) $2,898.5 million C) $3,007.0 million D) $4,365.0 million E) $7,042.2 million F) None of the options are correct.

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

A) $0 B) $75 million C) $150 million D) $710 million E) $860 million F) None of the options are correct.

20) Consider the following premerger information about a bidding firm (Buyitall Incorporated) and a target firm (Tarjay Corporation). Assume that neither firm has any debt outstanding.

Buyitall Shares outstanding

1,500

Tarjay 1,100

Price per share

$ 32

$ 26

Buyitall has estimated that the present value of enhancements that Buyitall expects from acquiring Tarjay is $2,600. What is the NPV of the merger assuming that Tarjay is willing to be acquired for $28 per share in cash?

A) $400 B) $600 C) $1,800 D) $2,200 E) $2,600 F) None of the options are correct.

21) Based on the actual financial data for 2010 and projections for 2011 for Blue Scholar Learning (BSL), as shown below, what is BSL’s projected free cash flow (in $ millions) for 2011?

Blue Scholar Learning, Incorporated (BSL) 5-year Financial Projection ($ millions) Actual 2011 2012 2013 2014 2010 Income Statement

2015

Net sales Cost of sales Gross income Depreciation Interest expense Operating expenses Net income before tax Provision for taxes Net income after tax Balance sheet

1,996 644 1,352 492 171 212 477 186 291

2,267 742 1,525 785 178 239 323 126 197

2,508 830 1,678 1,061 191 270 156 61 95

2,827 959 1,868 1,301 175 306 86 34 52

3,138 1,087 2,051 1,009 142 334 566 221 345

3,571 1,241 2,330 917 110 374 929 363 566

Total current assets Gross property and equipment Accumulated depreciation Net property and equipment Goodwill

1,121 4,180

1,234 5,149

1,412 6,410

1,650 7,449

1,923 8,200

2,179 9,016

868 3,312

1,654 3,495

2,714 3,696

4,015 3,434

5,024 3,176

5,941 3,075

1,069

1,069

1,069

1,069

1,069

1,069

Total assets Accounts payable Short-term debt Current portion long-term debt Accrued expenses Total current liabilities Long-term debt Deferred taxes Shareholders' equity Total liabilities and equity

5,502 104 335 41

5,798 77 482 140

6,177 91 842 165

6,153 110 814 200

6,168 117 585 223

6,323 135 393 267

86 566

97 796

120 1,218

134 1,258

174 1,099

168 963

1,694 335 2,907 5,502

1,554 334 3,104 5,798

1,389 370 3,200 6,177

1,189 454 3,252 6,153

966 505 3,598 6,168

699 496 4,165 6,323

A) −$938 B) −$792 C) −$7 D) $122 E) $1,091 F) None of the options are correct.

22)

A recent annual income statement for Stonehenge Roofing is shown below.

Net sales

$ 5,000

Cost of sales

3,200

Gross profit

1,800

Operating expense

800

Depreciation expense

200

Operating income

800

Interest expense

100

Income before tax

700

Tax

175

Income after tax

$ 525

Assume that during the year, Stonehenge spent $180 on new capital equipment and increased current assets net of non-interest-bearing current liabilities by $150. What was Stonehenge’s free cash flow in this year?

A) $270 B) $395 C) $470 D) $545 E) $650 F) None of the options are correct.

23) STU Corporation has $3 million in earnings on $20 million in sales and has 1 million shares outstanding. Earnings per share of comparable firm 1 is $5, and earnings per share of comparable firm 2 is $2. Comparable firm 1’s stock is trading for $50, and comparable firm 2’s stock is trading for $28. What is the estimated stock price of STU using the method of comparables? (Use average multiples of the comparable firms when doing the calculations.)

A) $33.43 B) $36.00 C) $39.00 D) $40.00

24) Tutter Corporation is being valued using discounted cash flow methodology with terminal value calculated as a growing perpetuity. Not including the terminal value, the present value of projected free cash flows for years 1 through 5 is $200 million (total). In year 5, projections show free cash flow of $60 million. What is the estimated fair market value of Tutter Corporation? Assume a WACC of 10% and a growth rate of 2%.

A) $666 million B) $675 million C) $950 million D) $965 million

25) Which of the following is NOT a reason why venture capitalists apply high discount rates to proposed investments?

A) The risk level of venture capital investing is high B) Venture capitalists provide services in addition to funding C) Realized rates of return in venture capital are typically even higher than the discount rates applied D) Business plans provided to venture capitalists tend to be overly optimistic

26) Which of the following statements are correct?

1.Liquidation value of a firm is equal to the present worth of expected future cash flows from operating activities.

2.When an acquiring firm purchases a target firm’s equity, the acquirer must assume the target’s liabilities.

3.The market value of a public company reflects the worth of the business to minority investors.

4.The fair market value of a business is usually the lower of its liquidation value and its goingconcern value.

A) I and III only B) II and IV only C) II and III only D) I, II, and III only E) II, III, and IV only F) None of the options are correct.

SHORT ANSWER. Write the word or phrase that best completes each statement or answers the question.

27) The following information is available about Chiantivino Corporation (CC): Stock price per share Common shares outstanding (millions) Market value of interest-bearing debt (millions) Weighted-average cost of capital

$ 8.00 10 $ 75 14%

An activist investor is confident that by terminating CC’s money-losing fortified wine division, she can increase free cash flow by $4 million annually for the next decade. In addition, she estimates that an immediate, special dividend of $10 million can be financed by the sale of the division. a.Assuming these actions do not affect CC’s cost of capital, what is the maximum price per share the investor would be justified in bidding for control of CC? What percentage premium does this represent? b.Show your answer if you conduct a sensitivity analysis by assuming the cost of capital is 15% and the increased cash flow is only $3.5 million per year.

28)

Below is a recent income statement for Gatlin Camera:

Net sales Cost of sales (including depreciation of $800) Gross profit Selling and administation expenses (including interest expense of $570) Income before tax Tax Income after tax

$ 8,000 4,700 3,300 1,500 1,800 612 $ 1,188

Calculate Gatlin’s free cash flow in this year assuming it spent $510 on new capital equipment and increased current assets net of non-interest-bearing current liabilities by $340.

29) Given the forecast below, estimate the fair market value of Kenmore Air at the end of 2017. Assume that after 2021, earnings before interest and tax will remain constant at $220 million, depreciation will equal capital expenditures in each year, and working capital will not change. Kenmore Air’s weighted-average cost of capital is 11% and its tax rate is 40%.

Forecast for Kenmore Air, Incorporated Year 2018 2019 Free cash flow ($ millions) −40 85

2020 97

2021 112

30) Given the forecast below, estimate the fair market value per share of Kenmore Air’s equity at the end of 2017 if the company has 50 million shares outstanding and the market value of its interest-bearing liabilities on the valuation date equals $300 million. Assume that after 2021, earnings before interest and tax will remain constant at $220 million, depreciation will equal capital expenditures in each year, and working capital will not change. Kenmore Air’s weighted-average cost of capital is 11% and its tax rate is 40%.

Forecast for Kenmore Air, Incorporated Year 2018 2019 Free cash flow ($ millions) −40 85

2020 97

2021 112

31) Given the forecast below, estimate the fair market value of Kenmore Air’s equity per share at the end of 2017 under the following assumptions: ● EBIT in year 2021 is $210 million and then grows at 4% per year forever. ● To support the perpetual growth in EBIT, capital expenditures in year 2022 exceed depreciation by $25 million, and this difference grows 4% per year forever. ● Similarly, working capital investments are $10 million in 2022, and this amount grows 4% per year forever. ● Kenmore Air’s weighted-average cost of capital is 11%, and its tax rate is 40%. ● Kenmore Air has 50 million shares outstanding, and the market value of its interest-bearing liabilities on the valuation date equals $300 million.

Forecast for Kenmore Air, Incorporated Year 2018 2019 Free cash flow ($ millions) −40 85

2020 97

2021 112

32) Given the forecast below, estimate the fair market value of Kenmore Air’s equity per share at the end of 2017 under the following assumptions: ● EBIT in year 2021 will be $210 million. ● At year-end 2021, Kenmore Air has reached maturity, and analysts expect its equity will sell for 15 times year 2021 net income. ● At year-end 2021, Kenmore Air has $300 million book value of interest-bearing liabilities outstanding at an average interest rate of 10%. ● Kenmore Air’s weighted-average cost of capital is 11%, and its tax rate is 40%. ● Kenmore Air has 50 million shares outstanding, and the market value of its interest-bearing liabilities on the valuation date equals $300 million.

Forecast for Kenmore Air, Incorporated Year 2018 2019 Free cash flow ($ millions) −40 85

2020 97

2021 112

33) Ketema, Incorporated is a manufacturer of electronic instruments. Use the following information on Ketema and five other similar companies to value Ketema, Incorporated on December 31, 2021.

Ketema, Incorporated, 2021 ($ millions) Net income $ 66.10 Number of common 32.82 shares (millions) Earnings before $ interest and tax 112.30 Tax rate 22% Book value of $ equity 335.10 Book value of $ interest-bearing 470.80 debt Comparison of Ketema, Incorporated with Comparable Companies Ketema Aloha Butler AJ Baker National Electric Electric Smith Modesto Power Growth Rates, Financial Risks, Size

5-year growth rate in sales (%) 5-year growth rate in EPS (%) Interest coverage ratio (X) Total liabilities to assets (X) Total assets ($ millions) Indicators of Value

3.3

6.8

1.4

8.1

10.2

15.2

5.1

1.3

9.2

(5.4)

19.6

3.4

4.8

8.0

38.0

3.0

12.3

*

0.7

0.6

0.4

0.7

0.5

0.1

1,029

15,046

196 1,294

585

1,421

Price/earnings (X)

23.2

16.1

32.0

12.4

25.0

MV firm/EBIT(1−Tax rate) (X) MV equity/BV equity (X) MV firm/BV firm (X)

23.3

16.2

34.7

13.2

25.0

3.9

3.5

1.0

2.1

2.3

2.7

3.3

1.0

1.8

2.3

Price/sales (X)

1.5

1.4

0.4

1.0

2.0

MV firm/sales (X)

1.9

1.4

0.8

1.1

2.0

*National Power has no interest-bearing debt outstanding.

MV = Market value; BV = Book value. MV firm is estimated as book value of interest-bearing debt + market value of equity.

34) Rainy City Coffee’s (RCC) free cash flow next year will be $100 million, and it is expected to grow at a 4% annual rate indefinitely. The company’s weighted average cost of capital is 10%, the market value of its liabilities is $1 billion, and it has 20 million shares outstanding. a.Estimate the price per share of RCC’s common stock. b.A hedge fund believes that by selling the company’s private jet and instituting other cost savings, it can increase RCC’s free cash flow next year to $110 million and can add a full percentage point to RCC’s growth rate without affecting its cost of capital. What is the maximum price per share the hedge fund can justify bidding for control of RCC?

35) Empirical evidence indicates that the returns to shareholders of the target firm vary significantly from the returns to the shareholders of the acquiring firm. Which shareholders tend to realize lower returns? Why is this the case?

36) Estimate a current stock price for Montana Corporation using the following information.

Projected free cash flows for the next three years are shown in the table below. Assume the growth rate in years 1 through 3 continues into the future. Calculate terminal value as a growing perpetuity. Montana’s WACC is 18%, the market value of its debt is $5 million, and it has 1.2 million shares of stock outstanding.

Year Free cash flow

1 $ 1,000,000

2 $ 1,050,000

3 $ 1,102,500

37) A venture capital firm wants to invest $5 million in Artichoke Corporation, a startup biotech firm. Artichoke is expected to go public in 4 years. Earnings will be negligible until year 4 but are projected to be $4 million in year 4. Comparable biotech firms are trading at P/E ratios of 18 on average. Artichoke has 3 million shares of stock outstanding. The VC firm will apply a discount rate of 40% to the investment. How many shares of stock should the VC firm be given for its $5 million investment?

SECTION BREAK. Answer all the part questions.

38) [The following information applies to the questions displayed below.]

Blue Scholar Learning, Incorporated (BSL) 5-year Financial Projection

($ millions) Actual 2011 2012 2010

2013

2014

2015

Income Statement Net sales 1,996 Cost of sales 644 Gross income 1,352 Depreciation 492 Interest expense 171 Operating expenses 212 Net income before 477 tax Provision for taxes 186 Net income after tax 291 Balance sheet

2,267 742 1,525 785 178 239 323

2,508 830 1,678 1,061 191 270 156

2,827 959 1,868 1,301 175 306 86

3,138 1,087 2,051 1,009 142 334 566

3,571 1,241 2,330 917 110 374 929

126 197

61 95

34 52

221 345

363 566

Total current assets Gross property and equipment Accumulated depreciation Net property and equipment Goodwill Total assets Accounts payable Short-term debt Current portion longterm debt Accrued expenses Total current liabilities Long-term debt Deferred taxes Shareholders' equity Total liabilities and equity Free cash flow

1,121 4,180

1,234 5,149

1,412 6,410

1,650 7,449

1,923 8,200

2,179 9,016

868

1,654

2,714

4,015

5,024

5,941

3,312

3,495

3,696

3,434

3,176

3,075

1,069 5,502 104 335 41

1,069 5,798 77 482 140

1,069 6,177 91 842 165

1,069 6,153 110 814 200

1,069 6,168 117 585 223

1,069 6,323 135 393 267

86 566

97 796

120 1,218

134 1,258

174 1,099

168 963

1,694 335 2,907 5,502

1,554 334 3,104 5,798

1,389 370 3,200 6,177

1,189 454 3,252 6,153

966 505 3,598 6,168

699 496 4,165 6,323

(7)

(130)

215

464

490

38.1) At the beginning of 2011, Macklemore Corporation is considering the acquisition of Blue Sky Learning (BSL), based on BSL’s actual financial data for 2010 and its projections for 2011 to 2015, as shown above Macklemore’s WACC is 8.0%, BSL’s WACC is 11.5%, and the average of the two companies’ WACCs, weighted by sales, is 8.2%. What is the present value of BSL’s free cash flow (in $ millions) for the years 2011 to 2015?

A) −$1.29 B) $628.79 C) $720.58 D) $726.68 E) $743.94 F) None of the options are correct.

38.2) At the beginning of 2011, Macklemore Corporation is considering the acquisition of Blue Sky Learning (BSL), based on BSL’s actual financial data for 2010 and its projections for 2011 to 2015, as shown above. Macklemore’s WACC is 8.0%, BSL’s WACC is 11.5%, and the average of the two companies’ WACCs, weighted by sales, is 8.2%. What is the firm value of BSL (in $ millions) at the beginning of 2011, assuming it is worth the book value of its assets at the end of 2015?

A) $628.24 B) $3,669.01 C) $4,297.80 D) $4,412.94 E) $4,984.28 F) $6,951.24 G) None of the options are correct.

38.3) At the beginning of 2011, Macklemore Corporation is considering the acquisition of Blue Sky Learning (BSL), based on BSL’s actual financial data for 2010 and its projections for 2011 to 2015, as shown above. Macklemore’s WACC is 8.0%, BSL’s WACC is 11.5%, and the average of the two companies’ WACCs, weighted by sales, is 8.2%. What is the value of BSL’s equity (in $ millions) at the beginning of 2011, assuming it is worth the book value of its assets at the end of 2015?

A) $1,702.80 B) $2,227.80 C) $2,342.94 D) $2,383.94 E) $2,603.80 F) $4,297.80 G) None of the options are correct.

38.4) At the beginning of 2011, Macklemore Corporation is considering the acquisition of Blue Sky Learning (BSL), based on BSL’s actual financial data for 2010 and its projections for 2011 to 2015, as shown above. Macklemore’s WACC is 8.0%, BSL’s WACC is 11.5%, and the average of the two companies’ WACCs, weighted by sales, is 8.2%. What is the firm value of BSL (in $ millions) at the beginning of 2011, assuming the company’s free cash flow grows 4% per year in perpetuity after 2015?

A) $4,297.25 B) $4,571.49 C) $4,686.78 D) $6,181.49 E) $5,351.19 F) $7,423.16 G) None of the options are correct.

38.5) At the beginning of 2011, Macklemore Corporation is considering the acquisition of Blue Sky Learning (BSL), based on BSL’s actual financial data for 2010 and its projections for 2011 to 2015, as shown above. Macklemore’s WACC is 8.0%, BSL’s WACC is 11.5%, and the average of the two companies’ WACCs, weighted by sales, is 8.2%. What is the value of BSL’s equity (in $ millions) at the beginning of 2011, assuming the company’s free cash flow grows 4% per year in perpetuity after 2015?

A) $1,976.49 B) $2,501.49 C) $2,877.49 D) $4,195.49 E) $4,571.49 F) None of the options are correct.

38.6) At the beginning of 2011, Macklemore Corporation is considering the acquisition of Blue Sky Learning (BSL), based on BSL’s actual financial data for 2010 and its projections for 2011 to 2015, as shown above. Macklemore’s WACC is 8.0%, BSL’s WACC is 11.5%, and the average of the two companies’ WACCs, weighted by sales, is 8.2%. What is the firm value of BSL (in $ millions) at the beginning of 2011, assuming that at year-end 2015, the company’s equity is worth 15 times earnings after tax and its debt is worth book value.

A) $628.24 B) $3,669.01 C) $6,343.81 D) $6,755.83 E) $7,008.06 F) $7,429.74 G) None of the options are correct.

38.7) At the beginning of 2011, Macklemore Corporation is considering the acquisition of Blue Sky Learning (BSL), based on BSL’s actual financial data for 2010 and its projections for 2011 to 2015, as shown above. Macklemore’s WACC is 8.0%, BSL’s WACC is 11.5%, and the average of the two companies’ WACCs, weighted by sales, is 8.2%. What is the value of BSL’s equity (in $ millions) at the beginning of 2011, assuming that at year-end 2015, the company’s equity is worth 15 times earnings after tax and its debt is worth book value.

A) $3,484.68 B) $4,723.81 C) $4,938.06 D) $5,554.68 E) $6,343.81 F) None of the options are correct.

Answer Key Test name: chapter 9 1) TRUE 2) TRUE 3) TRUE 4) FALSE 5) FALSE 6) FALSE 7) TRUE 8) FALSE 9) FALSE 10) FALSE 11) FALSE 12) D The value of the bid to Ginormous’s shareholders is the value of the assets acquired in the merger. This would include the value of the equity acquired and the liabilities that accompany the equity. Therefore, the cost of the acquisition was ($60 × 82 million shares) + $1.46 billion = $6.38 billion.

13) A Ginormous paid $60 per share for a firm that minority shareholders valued at $33 per share, so they placed a value of 60 – 33 = $27 per share on control of Slick. $27 × 82 million = $2.21 billion.

14) B 15) A 16) F

FCF2022 = 155 × (1 + 0.04) = $161.2 million.

Terminal value2021 = FCF2022/(KW − g ) = $161.2 million/(0.082 − 0.04) = $3,838 million.

17) C Terminal value2021 = 18.7 × $225 million = $4,207.5 million.

18) C Terminal value2021 = 19.4 × $155 million = $3,007.0 million.

19) C Minimum economic value in PV terms = $860 million − $710 million = $150 million 20) A The NPV of the merger is the market value of the target firm, plus the value of the enhancements, minus the acquisition costs: NPV = 1,100 ($26) + $2,600 − 1,100($28) = $400.

21) C FCF = EBIT(1 − Tax rate) + Depreciation − Capital expenditures − Working capital investment EBIT = Income before tax + Interest = 323 + 178 = $501 Tax rate = 126/323 = 0.390 or 39.0% Capital expenditures = change in gross property and equipment = 5,149 − 4,180 = 969 Change in working capital: working capital is current assets less operating current liabilities (this excludes short-term debt and the current portion of long-term debt.) Hence, the working capital balance is 1,234 − (77 + 97) = 1,060 in 2011, and 931 in 2010. The change in working capital is 1,060 − 931 = 129.

2011 Free Cash Flow = 501(1 − 0.39) + 785 − 969 − 129 = −$7 22) C

FCF = EBIT(1 − t) + Depreciation − Fixed investment − Working capital investment FCF = 800(1 − 0.25) + 200 − 180 – 150 = $470 23) B Comparable 1 P/E = 10, Comparable 2 P/E = 14, Average P/E = 12 STU = 12 × $3.00 (EPS) = $36.00 24) B FMV = PV{FCF, 1−5} + PV{Terminal value} Terminal value = FCF(1 + g)/(KW −g) = $61.2/0.08 = $765 million PV of Terminal value = $765 million/1.15 = $475 million FMV = 200 million + 475 million = $675 million 25) C 26) C 27)a. The maximum justifiable premium = the fair market value of CC under new management − the fair market value of CC under existing management. A plausible estimate of CC’s fair market value under existing management is its standalone value = current market value of firm = $8 × 10 million + 75 million = $155 million.

Fair market value under new management = $155 million + present value of enhancements = $155 million + present value of a $4 million annuity for 10 years at 14% + $10 million from sale of the division.

Input: Output:

n

i

PV

PMT

FV

10

14

? −20.86

4

0

In Excel: =PV(0.14,10,4) =-20.86 Fair market value = 155 million + 20.86 million + 10 million = $185.86 million.

Fair market value of equity = $185.86 − 75 = $110.86 million.

Fair market of equity per share = $110.86/10 = $11.09.

This is a 38.6% premium over the existing $8 share price. b. The fair market value of the firm assuming a 15% discount rate and a $3.5 million annuity = 155 + 17.57 + 10 = $182.57 million.

Value of equity = 182.57 − 75 = 107.57.

Value per share = 107.57/10 = $10.76.

This is a 34.5% premium over the existing price.

Input: Output:

n

i

PV

PMT

FV

10

15

? −17.57

3.5

0

In Excel: =PV(0.15,10,3.5) =-17.57 28)Free cash flow = EBIT(1 − Tax rate) + Depreciation − Fixed investment − Working capital investment.

EBIT = Income before tax + Interest = 1,800 + 570 = $2,370 Tax rate = 612/1,800 = 0.34 Free cash flow = 2,370(1 − 0.34) + 800 − 510 − 340 = $1,514.20

29)FMV = PV{FCF, 2018-2021} + PV{Terminal value}.

Discounting the FCFs at an 11% cost of capital, PV{FCF, 2018–2021} = $177.7 million Terminal value = EBIT(1 − Tax rate)/0.11 = $132/0.11 = $1,200 million PV{Terminal value} = $1,200 million/(1 + 0.11)4 = $790.5 million FMV = 177.7 million + 790.5 million = $968.2 million 30)FMV = PV{FCF, 2018–2021} + PV{Terminal value} Discounting the FCFs at an 11% cost of capital, PV{FCF, 2018–2021} = $177.7 million Terminal value = EBIT(1 − Tax rate)/0.11 = $132/0.11 = $1,200 million PV{Terminal value} = $1,200 million/(1 + 0.11)4 = $790.5 million FMV = 177.7 million + 790.5 million = $968.2 million FMV of equity per share = ($968.2 − $300)/50 = $13.36 31)FMV = PV{FCF, 2018–2021} + PV{Terminal value} Discounting the FCFs at an 11% cost of capital, PV{FCF, 2018–2021} = $177.7 million Terminal value = FCF in 2022/(0.11 − 0.04) FCF in 2022 = $210(1.04)(1 − 0.4) − 25 − 10 = $96.0 million So, terminal value = $96/(0.11 − 0.04) = $1,371.4 million PV{Terminal value} = $1,371.4/(1 + 0.11)4 = $903.4 million FMV of company = $177.7 + $903.4 = $1,081.1 million FMV of equity per share = ($1,081.1 − $300)/50 = $15.62

32)FMV = PV{FCF, 2018−2021} + PV{Terminal value} Discounting the FCFs at an 11% cost of capital, PV{FCF, 2018−2021} = $177.7 million Terminal value = Value of equity + Value of interest-bearing liabilities Value of equity = 15 × Net income in 2021 = 15 × (210 − 0.10 × 300)(1 − 0.40) = $1,620 million Terminal value = $1,620 + $300 = $1,920 million PV{Terminal value} = $1,920/(1 + 0.11)4 = $1,264.8 million FMV of company on valuation date = $177.7 + $1,264.8 = $1,442.5 million FMV of equity per share = ($1,442.5 − $300)/50 = $22.85 33)The median and mean values for Ketema’s peers are presented below: (Excluding Ketema) Median 5-year growth rate in sales (%) 5-year growth rate in eps (%) Interest coverage ratio (X) Total liabilities to assets (X) Total assets ($ millions) Price/earnings (X) MV firm/EBIT(1−Tax rate) (X) MV equity/BV equity (X) MV firm/BV firm (X) Price/sales (X) MV firm/sales (X)

8.1 3.4 10.1 0.5 1,294 23.2 23.3 2.3 2.3 1.4 1.4

Mean 8.3 5.6 15.3 0.4 3,708 21.7 22.5 2.6 2.2 1.3 1.4

The following estimates require subjective reasoning. In coming to these estimates, Ketema, Incorporated is judged as exhibiting representative earnings per share growth, but considerably higher financial leverage, and a below-average five-year growth rate in sales. The company’s higher-than-average leverage suggests that its firm value ratios will be particularly key, as equity value ratios can be distorted by Ketema’s higher leverage. Since the firm value ratios abstract from differences in financing, values for these ratios are selected that are closer to the sample averages. Turning to equity value ratios, Ketema’s modest growth and higher financial leverage suggest a 10% to 20% discount from the group average for its price/earnings and price/sales indicators.

Estimated Indicators for Ketema, Incorporated Price/earnings (X) MV firm/EBIT(1−Tax rate) (X) Price/sales (X) MV firm/sales (X) MV equity/BV equity MV firm/BV firm

18.0 20.0 1.1 1.3 2.7 2.1

And here are associated implied values of Ketema stock: Implied Value of Ketema Stock Price/earnings (X) $ 36.26 = 18 × Net income / # shares MV firm/EBIT(1−Tax rate) (X) $ 39.26 = [20 × EBIT(1 − Tax rate) − Debt] / # shares Price/sales (X) $ 34.35 = 1.1 × Sales / # shares MV firm/sales (X) $ 26.25 = (1.3 × Sales − Debt) / # shares MV equity/BV equity $ 27.57 = 2.7 × BV equity / # shares MV firm/BV firm $ 37.23 = (2.1 × BV firm − Debt) / # shares

Based on these numbers, a reasonable estimate of a fair price for Ketema, Incorporated’s shares at year-end 2021 is $36.00. Many other estimates are, of course, possible.

34)a.Price per share of RCC stock = (100/(0.10 − 0.04) − 1,000)/20 = $33.33 b.Fair market value of equity per share after change in ownership = (110/(0.10 − 0.05) − 1,000)/20 = $60.00 35)The empirical evidence strongly indicates that the shareholders of the target firm realize large wealth gains (premiums of 20% to 40%) as a result of a takeover bid but the shareholders in the acquiring firm gain little or nothing. While a definitive answer is elusive, the following have been offered as possible explanations for these low returns to acquiring shareholders: size differentials, competition in the takeover market, lack of achieving expected synergy gains, management goals other than the best interests of the shareholders, and early announcements of corporate acquisition intent.

36)PV of cash flows, years 1 to 3 = 1,000,000/1.18 + 1,050,000/1.182 + 1,102,500/1.183 = $2,272,567 Terminal value = 1,102,500(1.05)/(0.18 − 0.05) = $8,904,808 PV(Terminal value) = 8,904,808/1.183 = $5,419,741 Firm value = 2,272,567 + 5,419,741 = $7,692,308 Equity value = 7,692,308 − 5,000,000 = $2,692,308 Stock price = 2,692,308/1,200,000 = $2.24 37)Terminal value = $4 million × 18 = $72 million PV(Terminal value) = $72 million/1.44 = $18,742,191 Required ownership percentage = 5,000,000/18,742,191 = 26.7% Number of new shares = (New owners% / Existing owners%) × Current shares = (0.267/0.733) × 3,000,000 = 1,092,769 38) Section Break 38.1) B

PV@ 11.5% {FCFs, 2011–2015} = $628.79 The fundamental principle is that the discount rate should reflect the risks of the cash flows discounted. Here, the cash flows are BSL’s, so BSL’s WACC is the appropriate discount rate. Some argue incorrectly that because BSL will disappear in the merger, the cash flows will become Macklemore’s, so Macklemore’s WACC is the appropriate discount rate. However, the relevant criterion is the risk of the cash flows, not who owns them or what we call them.

38.2) C PV@ 11.5% {FCFs, 2011–2015} = $628.79 Terminal value in 2015 = $6,323 PV of terminal value = 6,323/1.1155 = 3,669.01 Estimated firm value = $628.79 + 3,669.01 = $4,297.80 38.3) B PV@ 11.5% {FCFs, 2011–2015} = $628.79 Terminal value in 2015 = $6,323 PV of terminal value = 6,323/1.1155 = 3,669.01 Estimated firm value = $628.79 + 3,669.01 = $4,297.80 Equity value = firm value − existing interest-bearing debt = $4,297.80 − (335 + 41 + 1,694) = $2,227.80 38.4) B PV@ 11.5% {FCFs, 2011–2015} = $628.79 Terminal value in 2015 = (490 × (1 + 0.04))/(0.115 − 0.04) = $6,794.67 PV of terminal value = 6,794.67/1.1155 = 3,942.70 Estimated firm value = $628.79 + 3,942.70 = $4,571.49 38.5) B

PV@ 11.5% {FCFs, 2011–2015} = $628.79 Terminal value in 2015 = (490 × (1 + 0.04))/(0.115 − 0.04) = $6,794.67 PV of terminal value = 6,794.67/1.1155 = 3,942.70 Estimated firm value = $628.79 + 3,942.70 = $4,571.49 Equity value = firm value − existing interest-bearing debt = $4,571.49 − (335 + 41 + 1,694) = $2,501.49 38.6) C PV@ 11.5% {FCFs, 2011–2015} = $628.79 Terminal value in 2015 = value of equity + value of debt = 15 × 566 + (393 + 267 + 699) = 8,490 + 1,359 = $9,849 PV of terminal value = 9,849/1.1155 = $5,715.02 Estimated firm value = $628.79 + $5,715.02 = $6,343.81 38.7) B PV@ 11.5% {FCFs, 2011–2015} = $628.79 Terminal value in 2015 = value of equity + value of debt = 15 × 566 + (393 + 267 + 699) = 8,490 + 1,359 = $9,849 PV of terminal value = 9,849/1.1155 = $5,715.02 Estimated firm value = $628.79 + $5,715.02 = $6,343.81 Equity value = firm value − existing interest-bearing debt = $6,343.81 − (335 + 41 + 1,694) = $4,723.81