Finance - Example Exam

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Examination2
MultipleChoice:True/False
(142)BusinessriskFQAnswer:bEASY
.Afirm'sbusinessriskislargelydeterminedbythefinancialcharacteristicsofitsindustry,especiallyby
theamountofdebttheaveragefirmintheindustryuses.
a.True
b.False
(142)FinancialriskFQAnswer:aEASY
.Financialriskreferstotheextrariskstockholdersbearasaresultofafirm'suseofdebtascompared
withtheirriskifthefirmhadusednodebt.
a.True
b.False
(142)FinancialriskFQAnswer:aEASY
.Afirmscapitalstructuredoesnotaffectitsfreecashflowsasdiscussedinthetext,becauseFCFreflects
onlyoperatingcashflows,whichareavailabletoservicedebt,topaydividendstostockholders,andfor
otherpurposes.
a.True
b.False
(142)FinancialleverageFQAnswer:aEASY
.Ifafirmborrowsmoney,itisusingfinancialleverage.
a.True
b.False
(142)FinancialleverageFQAnswer:aEASY
.Otherthingsheldconstant,anincreaseinfinancialleveragewillincreaseafirm'smarket(orsystematic)
riskasmeasuredbyitsbetacoefficient.
a.True
b.False
(142)UseoffinancialleverageFQAnswer:bEASY
.ThegraphicalprobabilitydistributionofROEforafirmthatusesfinancialleveragewouldtendtobemore
peakedthanthedistributionifthefirmusednoleverage,otherthingsheldconstant.
https://sites.google.com/site/exam2finance2/
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a.True
b.False
(142)Operatingandfin.leverageFQAnswer:bEASY
.Providedafirmdoesnotuseanextremeamountofdebt,operatingleveragetypicallyaffectsonlyEPS,
whilefinancialleverageaffectsbothEPSandEBIT.
a.True
b.False
(144)TradeofftheoryFQAnswer:aEASY
.Thetradeofftheorystatesthatcapitalstructuredecisionsinvolveatradeoffbetweenthecostsand
benefitsofdebtfinancing.
a.True
b.False
(144)BankruptcycostsFQAnswer:aEASY
.Differentborrowershavedifferentrisksofbankruptcy,andifaborrowergoesbankrupt,itslenderswill
probablynotgetbackthefullamountoffundsthattheyloaned.Therefore,lenderschargehigherratesto
borrowersjudgedtobemorelikelytogobankrupt.
a.True
b.False
(144)MMFQAnswer:aEASY
.ModiglianiandMiller(MM)wonNobelPrizesfortheirworkoncapitalstructuretheory.
a.True
b.False
(144)MMFQAnswer:aEASY
.ModiglianiandMiller'sfirstarticleledtotheconclusionthatcapitalstructureis"irrelevant"becauseithas
noeffectonafirm'svalue.
a.True
b.False
(144)MMFQAnswer:bEASY
.ModiglianiandMiller'sfirstarticleledtotheconclusionthatcapitalstructureisextremelyimportant,and
thateveryfirmhasanoptimalcapitalstructurethatmaximizesitsvalueandminimizesitscostofcapital.
a.True
b.False
(142)OperatingandfinancialleverageFQAnswer:aMEDIUM
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.ItispossibleforFirmsAandBtohaveidenticalfinancialandoperatingleverage,yetforFirmAtohave
moreriskasmeasuredbythevariabilityofEPS.ThiswouldoccurifFirmAhasmorebusinessriskthan
FirmB.
a.True
b.False
(142)FinancialriskFQAnswer:bMEDIUM
.Asthetextindicates,afirm'sfinancialriskcanandshouldbedividedintoseparatemarketand
diversifiableriskcomponents.
a.True
b.False
(142)BusinessriskFQAnswer:bMEDIUM
.Iftwofirmshavethesameexpectedearningspershare(EPS)andthesamestandarddeviationof
expectedEPS,thentheymusthavethesameamountofbusinessrisk.
a.True
b.False
(144)MMFQAnswer:aMEDIUM
.Inaworldwithnotaxes,ModiglianiandMiller(MM)showthatafirm'scapitalstructuredoesnotaffectits
value.However,whentaxesareconsidered,MMshowapositiverelationshipbetweendebtandvalue,
i.e.,thefirm'svaluerisesasitusesmoreandmoredebt,otherthingsheldconstant.
a.True
b.False
(144)MMFQAnswer:bMEDIUM
.AccordingtoModiglianiandMiller(MM),inaworldwithouttaxestheoptimalcapitalstructureforafirmis
approximately100%debtfinancing.
a.True
b.False
.AccordingtoModiglianiandMiller(MM),inaworldwithcorporateincometaxestheoptimalcapital
structurecallsforapproximately100%debtfinancing.
a.True
b.False
.AccordingtoModiglianiandMiller(MM),inaworldwithoutcorporateincometaxestheuseofdebthas
noeffectonthefirm'svalue.
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a.True
b.False
.ModiglianiandMiller'sfirstarticleledtotheconclusionthatcapitalstructureis"irrelevant"becauseithas
noeffectonafirm'svalue.However,thatarticlewascriticizedbecauseitassumedthatnotaxesexisted.
MMthenrevisedtheiroriginalarticletoincludecorporatetaxes,andthismodelledtotheconclusionthat
afirm'svaluewouldbemaximizedifitused(almost)100%debt.
a.True
b.False
.ModiglianiandMiller'ssecondarticle,whichassumedtheexistenceofcorporateincometaxes,ledtothe
conclusionthatafirm'svaluewouldbemaximized,anditscostofcapitalminimized,ifitused(almost)
100%debt.However,thismodeldidnottakeaccountofbankruptcycosts.Theexistenceofbankruptcy
costsleadstotheassumptionofanoptimalcapitalstructurewherethedebtratioislessthan100%.
a.True
b.False
(144)MillermodelFQAnswer:aMEDIUM
.TheMillermodelbeginswiththeModiglianiandMiller(MM)modelwithcorporatetaxesandthenadds
personaltaxes.
a.True
b.False
(144)MillermodelFQAnswer:bMEDIUM
.TheMillermodelbeginswiththeModiglianiandMiller(MM)modelwithoutcorporatetaxesandthen
addspersonaltaxes.
a.True
b.False
(144)TradeofftheoryFQAnswer:aMEDIUM
.TheModiglianiandMiller(MM)articlesimplicitlyassumedthatbankruptcydidnotexist.Thatledtothe
developmentofthe"tradeoff"model,wherethefirm'svaluefirstriseswiththeuseofdebtduetothetax
shelterofdebt,butlaterfallsasmoredebtisaddedbecausethepotentialcostsofbankruptcybeginto
morethanoffsetthetaxshelterbenefits.Underthetradeofftheory,anoptimalcapitalstructureexists.
a.True
b.False
(144)TradeofftheoryFQAnswer:bMEDIUM
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.ModiglianiandMiller(MM),intheirsecondarticle,tookaccountoftaxes,bankruptcy,andotherfactors
thatwereassumedawayintheiroriginalarticle.Oncetheytookaccountofalltheseassumptions,they
concludedthateveryfirmhasauniqueoptimalcapitalstructure.Moreover,amanagercanusethe
secondMMmodeltodeterminehisorherfirm'soptimaldebtratio.
a.True
b.False
(144)TradeofftheoryFQAnswer:aMEDIUM
.SomepeopleincludingthecurrentchairmanoftheFederalReserveBoardofGovernorshaveargued
thatoneadvantageofcorporatedebtfromthestockholders'standpointisthattheexistenceofdebtforces
managerstofocusoncashflowandtorefrainfromspendingtoomuchofthefirm'smoneyonprivate
planeandother"perks."ThisisoneofthefactorsthatledtotheriseofLBOsandprivateequityfirms.
a.True
b.False
(144)SignalingtheoryFQAnswer:aMEDIUM
.TheModiglianiandMiller(MM)articlesimplicitlyassumed,amongotherthings,thatoutsidestockholders
havethesameinformationaboutafirm'sfutureprospectsasitsmanagers.Thatwascalled"symmetric
information,"anditisquestionable.Theintroductionof"asymmetricinformation"ledtothedevelopmentof
the"signaling"theoryofcapitalstructure,whichpostulatedthatfirmsarereluctanttoissuenewstock
becauseinvestorswillinterpretsuchanactasasignalthatthefirm'smanagersareworriedaboutits
future.Otheractionsgiveoffdifferentsignals,andtheendresultisthatcapitalstructureisaffectedby
managers'perceptionsabouthowtheirfinancingdecisionswillaffectinvestors'viewsofthefirmandthus
itsvalue.
a.True
b.False
(144)SignalingtheoryFQAnswer:bMEDIUM
.Accordingtothesignalingtheoryofcapitalstructure,firmsfirstusecommonequityfortheircapital,then
usedebtifandonlyiftheycanraisenomoreequityon"reasonable"terms.Thisoccursbecausetheuse
ofdebtfinancingsignalstoinvestorsthatthefirm'smanagersthinkthatthefuturedoesnotlookgood.
a.True
b.False
(145)CapitalstructureFQAnswer:aMEDIUM
.Otherthingsheldconstant,firmswithmorestableandpredictablesalestendtousemoredebtthanfirms
withlessstablesales.
a.True
b.False
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.Otherthingsheldconstant,firmsthatuseassetsthatcanbesoldeasily(liketrucks)tendtousemore
debtthanfirmswhoseassetsarehardertosell(likethoseengagedinR&D").
a.True
b.False
(145)CapitalstructureFQAnswer:bMEDIUM
.Otherthingsheldconstant,thelowerafirm'staxrate,themorelogicalitisforthefirmtousedebt.
a.True
b.False
.Afirm'streasurerlikestobeinapositiontoraisefundstosupportoperationswheneversuchfundsare
needed,evenin"badtimes".Thisiscalled"financialflexibility,"andthelowerthefirm'sdebtratio,the
greateritsfinancialflexibility,otherthingsheldconstant.
a.True
b.False
(142)UseofdebtinfinancingFQAnswer:aHARD
.Ifafirmutilizesdebtfinancing,a10%declineinearningsbeforeinterestandtaxes(EBIT)willresultina
declineinearningspersharethatislargerthan10%,andthehigherthedebtratio,thelargerthis
differencewillbe.
a.True
b.False
MultipleChoice:Conceptual
(142)BusinessriskCQAnswer:aEASY
.Anincreaseinthedebtratiowillgenerallyhavenoeffectonwhichoftheseitems?
a.Businessrisk.
b.Totalrisk.
c.Financialrisk.
d.Marketrisk.
e.Thefirm'sbeta.
(142)BusinessriskCQAnswer:dEASY
.Businessriskisaffectedbyafirm'soperations.WhichofthefollowingisNOTdirectlyassociatedwith
(ordoesnotdirectlycontributeto)businessrisk?
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a.Demandvariability.
b.Salespricevariability.
c.Theextenttowhichoperatingcostsarefixed.
d.Theextenttowhichinterestratesonthefirm'sdebtfluctuate.
e.Inputpricevariability.
(143)CapitalstructureandWACCCQAnswer:dEASY
.WhichofthefollowingstatementsisCORRECT?
a.Sincedebtfinancingraisesthefirm'sfinancialrisk,increasingthetargetdebtratiowillalwaysincrease
theWACC.
b.Sincedebtfinancingischeaperthanequityfinancing,raisingacompanysdebtratiowillalwaysreduce
itsWACC.
c.Increasingacompanysdebtratiowilltypicallyreducethemarginalcostsofbothdebtandequity
financing.However,thisactionstillmayraisethecompanysWACC.
d.Increasingacompanysdebtratiowilltypicallyincreasethemarginalcostsofbothdebtandequity
financing.However,thisactionstillmaylowerthecompanysWACC.
e.Sinceafirm'sbetacoefficientisnotaffectedbyitsuseoffinancialleverage,leveragedoesnotaffectthe
costofequity.
(143)OptimalcapitalstructureCQAnswer:dEASY
a.ThecapitalstructurethatmaximizesexpectedEPSalsomaximizesthepricepershareofcommon
stock.
b.ThecapitalstructurethatminimizestheinterestrateondebtalsomaximizestheexpectedEPS.
c.Thecapitalstructurethatminimizestherequiredreturnonequityalsomaximizesthestockprice.
d.ThecapitalstructurethatminimizestheWACCalsomaximizesthepricepershareofcommonstock.
e.Thecapitalstructurethatgivesthefirmthebestbondratingalsomaximizesthestockprice.
(143)OptimalcapitalstructureCQAnswer:cEASY
.Basedontheinformationbelow,whatisthefirm'soptimalcapitalstructure?
a.Debt=40%Equity=60%EPS=$2.95Stockprice=$26.50.
b.Debt=50%Equity=50%EPS=$3.05Stockprice=$28.90.
c.Debt=60%Equity=40%EPS=$3.18Stockprice=$31.20.
d.Debt=80%Equity=20%EPS=$3.42Stockprice=$30.40.
e.Debt=70%Equity=30%EPS=$3.31Stockprice=$30.00.
(143)OptimalcapitalstructureCQAnswer:bEASY
.Whichofthefollowingstatementsbestdescribestheoptimalcapitalstructure?
a.Theoptimalcapitalstructureisthemixofdebt,equity,andpreferredstockthatmaximizesthe
companysearningspershare(EPS).
b.Theoptimalcapitalstructureisthemixofdebt,equity,andpreferredstockthatmaximizesthe
companysstockprice.
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c.Theoptimalcapitalstructureisthemixofdebt,equity,andpreferredstockthatminimizesthecompanys
costofequity.
d.Theoptimalcapitalstructureisthemixofdebt,equity,andpreferredstockthatminimizesthecompanys
costofdebt.
e.Theoptimalcapitalstructureisthemixofdebt,equity,andpreferredstockthatminimizesthecompanys
costofpreferredstock.
(145)Leverageandcap.struct.CQAnswer:aEASY
.Whichofthefollowingeventsislikelytoencourageacompanytoraiseitstargetdebtratio,otherthings
heldconstant?
a.Anincreaseinthecorporatetaxrate.
b.Anincreaseinthepersonaltaxrate.
c.Anincreaseinthecompanysoperatingleverage.
d.TheFederalReservetightensinterestratesinanefforttofightinflation.
e.Thecompany'sstockpricehitsanewhigh.
(145)Leverageandcap.struct.CQAnswer:bEASY
.Whichofthefollowingwouldtendtoincreaseafirm'stargetdebtratio,otherthingsheldconstant?
a.Thecostsassociatedwithfilingforbankruptcyincrease.
b.Thecorporatetaxrateisincreased.
c.Thepersonaltaxrateisincreased.
d.TheFederalReservetightensinterestratesinanefforttofightinflation.
e.Thecompany'sstockpricehitsanewlow.
(143)OptimalcapitalstructureCQAnswer:eEASY/MEDIUM
a.Asarule,theoptimalcapitalstructureisfoundbydeterminingthedebtequitymixthatmaximizes
expectedEPS.
b.TheoptimalcapitalstructuresimultaneouslymaximizesEPSandminimizestheWACC.
c.Theoptimalcapitalstructureminimizesthecostofequity,whichisanecessaryconditionformaximizing
thestockprice.
d.Theoptimalcapitalstructuresimultaneouslyminimizesthecostofdebt,thecostofequity,andthe
WACC.
e.TheoptimalcapitalstructuresimultaneouslymaximizesthestockpriceandminimizestheWACC.
(143)TargetcapitalstructureCQAnswer:eEASY/MEDIUM
.Thefirmstargetcapitalstructureshoulddowhichofthefollowing?
a.Maximizetheearningspershare(EPS).
b.Minimizethecostofdebt(rd).
c.Obtainthehighestpossiblebondrating.
d.Minimizethecostofequity(rs).
e.Minimizetheweightedaveragecostofcapital(WACC).
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(Comp.)CapitalstructureconceptsCQAnswer:bEASY/MEDIUM
a.Afirmsbusinessriskisdeterminedsolelybythefinancialcharacteristicsofitsindustry.
b.Thefactorsthataffectafirmsbusinessriskincludeindustrycharacteristicsandeconomicconditions,
bothofwhicharegenerallybeyondthefirm'scontrol.
c.Oneofthebenefitstoafirmofbeingatornearitstargetcapitalstructureisthatthisgenerallyminimizes
theriskofbankruptcy.
d.Afirmsfinancialriskcanbeminimizedbydiversification.
e.TheamountofdebtinitscapitalstructurecanundernocircumstancesaffectacompanysEBITand
businessrisk.
(142)OperatingleverageCQAnswer:eMEDIUM
.WhichofthefollowingstatementsisCORRECT?Asafirmincreasestheoperatingleverageusedto
produceagivenquantityofoutput,this
a.normallyleadstoanincreaseinitsfixedassetsturnoverratio.
b.normallyleadstoadecreaseinitsbusinessrisk.
c.normallyleadstoadecreaseinthestandarddeviationofitsexpectedEBIT.
d.normallyleadstoadecreaseinthevariabilityofitsexpectedEPS.
e.normallyleadstoareductioninitsfixedassetsturnoverratio.
(142)FinancialleverageandEPSCQAnswer:aMEDIUM
.Afirm'sCFOisconsideringincreasingthetargetdebtratio,whichwouldalsoincreasethecompanys
interestexpense.Newbondswouldbeissuedandtheproceedswouldbeusedtobuybacksharesof
commonstock.Neithertotalassetsnoroperatingincomewouldchange,butexpectedearningspershare
(EPS)wouldincrease.AssumingtheCFOsestimatesarecorrect,whichofthefollowingstatementsis
CORRECT?
a.Sincetheproposedplanincreasesthefirmsfinancialrisk,thestockpricemightfallevenifEPS
increases.
b.IftheplanreducestheWACC,thestockpriceislikelytodecline.
c.SincetheplanisexpectedtoincreaseEPS,thisimpliesthatnetincomeisalsoexpectedtoincrease.
d.IftheplandoesincreasetheEPS,thestockpricewillautomaticallyincreaseatthesamerate.
e.Undertheplantherewillbemorebondsoutstanding,andthatwillincreasetheirliquidityandthuslower
theinterestrateonthecurrentlyoutstandingbonds.
(145)Leverageandcap.struct.CQAnswer:cMEDIUM
.Yourfirmiscurrently100%equityfinanced.TheCFOisconsideringarecapitalizationplanunderwhich
thefirmwouldissuelongtermdebtwithayieldof9%andusetheproceedstorepurchasesomeofits
commonstock.Therecapitalizationwouldnotchangethecompanystotalassets,norwoulditaffectthe
firmsbasicearningpower,whichis15%.TheCFObelievesthatthisrecapitalizationwouldreducethe
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firm'sWACCandincreaseitsstockprice.Whichofthefollowingwouldbelikelytooccurifthecompany
goesaheadwiththerecapitalizationplan?
a.Thecompanysnetincomewouldincrease.
b.Thecompanysearningspersharewoulddecline.
c.Thecompanyscostofequitywouldincrease.
d.ThecompanysROAwouldincrease.
e.ThecompanysROEwoulddecline.
(142)Cap.struct.,ROA,andROECQAnswer:eMEDIUM
.Yourfirmhas$500millionoftotalassets,itsbasicearningpoweris15%,anditcurrentlyhasnodebtin
itscapitalstructure.TheCFOiscontemplatingarecapitalizationwhereitwouldissuedebtatacostof
10%andusetheproceedstobuybacksomeofitscommonstock,payingbookvalue.Ifthecompany
goesaheadwiththerecapitalization,itsoperatingincome,totalassets,andtaxratewouldremain
unchanged.Whichofthefollowingismostlikelytooccurasaresultoftherecapitalization?
a.TheROAwouldincrease.
b.TheROAwouldremainunchanged.
c.Thebasicearningpowerratiowoulddecline.
d.Thebasicearningpowerratiowouldincrease.
e.TheROEwouldincrease.
(142)FinancialleverageandEPSCQAnswer:cMEDIUM
a.Increasingitsuseoffinancialleverageisonewaytoincreaseafirmsbasicearningpower(BEP).
b.Ifafirmlowereditsfixedcostsbutincreaseditsvariablecostsbyjustenoughtoholdtotalcostsatthe
presentlevelofsalesconstant,thiswouldincreaseitsoperatingleverage.
c.ThedebtratiothatmaximizesexpectedEPSgenerallyexceedsthedebtratiothatmaximizesshare
price.
d.Ifacompanyweretoissuedebtandusethemoneytorepurchasecommonstock,thiswouldreduceits
basicearningpowerratio.(Assumethattherepurchasehasnoimpactonthecompanysoperating
income.)
e.Ifachangeinthebankruptcycodemadebankruptcylesscostlytocorporations,thiswouldtendto
reducecorporations'debtratios.
(142)Fin.leverageandratiosCQAnswer:bMEDIUM
.CompaniesHDandLDhaveidenticaltaxrates,totalassets,andbasicearningpowerratios,andtheir
basicearningpowerexceedstheirbeforetaxcostofdebt,rd.However,CompanyHDhasahigherdebt
ratioandthusmoreinterestexpensethanCompanyLD.WhichofthefollowingstatementsisCORRECT?
a.CompanyHDhasahighernetincomethanCompanyLD.
b.CompanyHDhasalowerROAthanCompanyLD.
c.CompanyHDhasalowerROEthanCompanyLD.
d.ThetwocompanieshavethesameROA.
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e.ThetwocompanieshavethesameROE.
(142)Fin.leverageandratiosCQAnswer:bMEDIUM
.FirmsUandLeachhavethesameamountofassets,andbothhaveabasicearningpowerratioof20%.
FirmUisunleveraged,i.e.,itis100%equityfinanced,whileFirmLisfinancedwith50%debtand50%
equity.FirmLsdebthasabeforetaxcostof8%.Bothfirmshavepositivenetincome.Whichofthe
followingstatementsisCORRECT?
a.Thetwocompanieshavethesametimesinterestearned(TIE)ratio.
b.FirmLhasalowerROAthanFirmU.
c.FirmLhasalowerROEthanFirmU.
d.FirmLhasthehighertimesinterestearned(TIE)ratio.
e.FirmLhasahigherEBITthanFirmU.
(142)Fin.leverageandratiosCQAnswer:cMEDIUM
.CompaniesHDandLDhavethesametotalassets,operatingincome(EBIT),taxrate,andbusinessrisk.
CompanyHD,however,hasamuchhigherdebtratiothanLD.Also,bothcompanies'basicearning
power(BEP)ratiosexceedtheircostofdebt(rd).WhichofthefollowingstatementsisCORRECT?
a.HDshouldhaveahigherreturnonassets(ROA)thanLD.
b.HDshouldhaveahighertimesinterestearned(TIE)ratiothanLD.
c.HDshouldhaveahigherreturnonequity(ROE)thanLD,butitsrisk,asmeasuredbythestandard
deviationofROE,shouldalsobehigherthanLD's.
d.GiventhatBEP>rd,HD'sstockpricemustexceedthatofLD.
e.GiventhatBEP>rd,LD'sstockpricemustexceedthatofHD.
(144)MillermodelCQAnswer:bMEDIUM
.AmajorcontributionoftheMillermodelisthatitdemonstrates,otherthingsheldconstant,that
a.personaltaxesincreasethevalueofusingcorporatedebt.
b.personaltaxeslowerthevalueofusingcorporatedebt.
c.personaltaxeshavenoeffectonthevalueofusingcorporatedebt.
d.financialdistressandagencycostsreducethevalueofusingcorporatedebt.
e.debtcostsincreasewithfinancialleverage.
(145)Leverageandcap.struct.CQAnswer:eMEDIUM
.WhichofthefollowingstatementsisCORRECT,holdingotherthingsconstant?
a.Firmswhoseassetsarerelativelyliquidtendtohaverelativelylowbankruptcycosts,hencetheytendto
userelativelylittledebt.
b.Anincreaseinthepersonaltaxrateislikelytoincreasethedebtratiooftheaveragecorporation.
c.Ifchangesinthebankruptcycodemakebankruptcylesscostlytocorporations,thenthiswouldlikely
leadtolowerdebtratiosforcorporations.
d.Anincreaseinthecompanysdegreeofoperatingleveragewouldtendtoencouragethefirmtouse
moredebtinitscapitalstructuresoastokeepitstotalriskunchanged.
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e.Anincreaseinthecorporatetaxratewouldintheoryencouragecompaniestousemoredebtintheir
capitalstructures.
(145)Leverageandcap.struct.CQAnswer:eMEDIUM
.Otherthingsheldconstant,whichofthefollowingeventswouldbemostlikelytoencourageafirmto
increasetheamountofdebtinitscapitalstructure?
a.Itssalesareprojectedtobecomelessstableinthefuture.
b.Thebankruptcylawsarechangedinawaythatwouldmakebankruptcymorecostlytothefirmandits
stockholders.
c.Managementbelievesthatthefirmsstockiscurrentlyovervalued.
d.Thefirmdecidestoautomateitsfactorywithspecializedequipmentandthusincreaseitsuseof
operatingleverage.
e.Thecorporatetaxrateisincreased.
(Comp.)Capitalstruct.conceptsCQAnswer:bMEDIUM
a.Afirmcanuseretainedearningswithoutpayingaflotationcost.Therefore,whilethecostofretained
earningsisnotzero,itscostisgenerallylowerthantheaftertaxcostofdebt.
b.Thecapitalstructurethatminimizesafirmsweightedaveragecostofcapitalisalsothecapitalstructure
thatmaximizesitsstockprice.
c.Thecapitalstructurethatminimizesthefirmsweightedaveragecostofcapitalisalsothecapital
structurethatmaximizesitsearningspershare.
d.Ifafirmfindsthatthecostofdebtislessthanthecostofequity,increasingitsdebtratiomustreduceits
WACC.
e.Otherthingsheldconstant,ifcorporatetaxratesdeclined,thentheModiglianiMillertaxadjustedtheory
wouldsuggestthatfirmsshouldincreasetheiruseofdebt.
(Comp.)Capitalstruct.conceptsCQAnswer:dMEDIUM
a.Thecapitalstructurethatmaximizesthestockpriceisalsothecapitalstructurethatminimizesthecost
ofequityfromretainedearnings(rs).
b.Thecapitalstructurethatmaximizesthestockpriceisalsothecapitalstructurethatmaximizesearnings
pershare.
c.Thecapitalstructurethatmaximizesthestockpriceisalsothecapitalstructurethatmaximizesthefirms
timesinterestearned(TIE)ratio.
d.Ifacompanyincreasesitsdebtratio,thiswilltypicallyincreasethemarginalcostsofbothdebtand
equity,butitstillmayreducethecompanysWACC.
e.IfCongressweretopasslegislationthatincreasesthepersonaltaxratebutdecreasesthecorporatetax
rate,thiswouldencouragecompaniestoincreasetheirdebtratios.
(142)Capitalstruct.conceptsCQAnswer:aMEDIUM/HARD
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a.Ingeneral,afirmwithlowoperatingleveragealsohasasmallproportionofitstotalcostsintheformof
fixedcosts.
b.Thereisnoreasontothinkthatchangesinthepersonaltaxratewouldaffectfirmscapitalstructure
decisions.
c.Afirmwitharelativelyhighbusinessriskismorelikelytoincreaseitsuseoffinancialleveragethana
firmwithlowbusinessrisk,assumingallelseequal.
d.Ifafirm'saftertaxcostofequityexceedsitsaftertaxcostofdebt,itcanalwaysreduceitsWACCby
increasingitsuseofdebt.
e.Supposeafirmhaslessthanitsoptimalamountofdebt.Increasingitsuseofdebttothepointwhereit
isatitsoptimalcapitalstructurewilldecreasethecostsofbothdebtandequity.
(142)Fin.leverageandratiosCQAnswer:cMEDIUM/HARD
.CompaniesHDandLDhaveidenticalamountsofassets,operatingincome(EBIT),taxrates,and
businessrisk.CompanyHD,however,hasahigherdebtratiothanLD.CompanyHDsbasicearning
powerratio(BEP)exceedsitscostofdebt(rd).WhichofthefollowingstatementsisCORRECT?
a.CompanyHDhasahigherreturnonassets(ROA)thanCompanyLD.
b.CompanyHDhasahighertimesinterestearned(TIE)ratiothanCompanyLD.
c.CompanyHDhasahigherreturnonequity(ROE)thanCompanyLD,anditsriskasmeasuredbythe
standarddeviationofROEisalsohigherthanLDs.
d.ThetwocompanieshavethesameROE.
e.CompanyHDsROEwouldbehigherifithadnodebt.
(Comp.)Capitalstruct.conceptsCQAnswer:aMEDIUM/HARD
a.IfCongressloweredcorporatetaxrateswhileotherthingswereheldconstant,andiftheModigliani
Millertaxadjustedtheoryofcapitalstructurewerecorrect,thiswouldtendtocausecorporationsto
decreasetheiruseofdebt.
b.Achangeinthepersonaltaxrateshouldnotaffectfirmscapitalstructuredecisions.
c.Businessriskisdifferentiatedfromfinancialriskbythefactthatfinancialriskreflectsonlytheuseof
debt,whilebusinessriskreflectsboththeuseofdebtandsuchfactorsassalesvariability,costvariability,
andoperatingleverage.
d.Theoptimalcapitalstructureistheonethatsimultaneously(1)maximizesthepriceofthefirmsstock,
(2)minimizesitsWACC,and(3)maximizesitsEPS.
e.Ifchangesinthebankruptcycodemadebankruptcylesscostlytocorporations,thiswouldlikelyreduce
theaveragecorporation'sdebtratio.
(Comp.)Leverageandcap.struct.CQAnswer:cMEDIUM/HARD
a.Whenacompanyincreasesitsdebtratio,thecostsofequityanddebtbothincrease.Therefore,the
WACCmustalsoincrease.
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b.Thecapitalstructurethatmaximizesthestockpriceisgenerallythecapitalstructurethatalsomaximizes
earningspershare.
c.Allelseequal,anincreaseinthecorporatetaxratewouldtendtoencouragecompaniestoincrease
theirdebtratios.
d.Sincedebtfinancingraisesthefirmsfinancialrisk,increasingacompanysdebtratiowillalways
increaseitsWACC.
e.Sincethecostofdebtisgenerallyfixed,increasingthedebtratiotendstostabilizenetincome.
(146)Variationsincap.struct.CQAnswer:dHARD
a.Generally,debttototalassetsratiosdonotvarymuchamongdifferentindustries,althoughtheydovary
amongfirmswithinagivenindustry.
b.Electricutilitiesgenerallyhaveveryhighcommonequityratiosbecausetheirrevenuesaremorevolatile
thanthoseoffirmsinmostotherindustries.
c.Airlinecompaniestendtohaveveryvolatileearnings,andasaresulttheygenerallyhavehightarget
debttoequityratios.
d.Widevariationsincapitalstructuresexistbothbetweenindustriesandamongindividualfirmswithin
givenindustries.Thesedifferencesarecausedbydifferingbusinessrisksandalsomanagerialattitudes.
e.Sincemoststockssellatorveryclosetotheirbookvalues,bookvaluecapitalstructuresaretypically
adequateforuseinestimatingfirms'costsofcapital.
Problems
Someoftheseproblemsareconceptuallydifficult,andtheyaredesignatedasHARD.Othersarenot
conceptuallydifficult,buttheyrequireagoodbitofarithmetic.Pleasetakethisintoaccountwhenmaking
uptimedtests.
(142)BreakevenanalysisCQAnswer:aEASY
.LongstreetInc.hasfixedoperatingcostsof$470,000,variablecostsof$2.80perunitproduced,andits
productsellsfor$4.00perunit.Whatisthecompany'sbreakevenpoint,i.e.,atwhatunitsalesvolume
wouldincomeequalcosts?
a.391,667
b.411,250
c.431,813
d.453,403
e.476,073
(142)BreakevenanalysisCQAnswer:cEASY
.Youruncleisconsideringinvestinginanewcompanythatwillproducehighqualitystereospeakers.The
salespricewouldbesetat1.5timesthevariablecostperunitthevariablecostperunitisestimatedtobe
$75.00andfixedcostsareestimatedat$1,200,000.Whatsalesvolumewouldberequiredtobreakeven,
i.e.,tohaveEBIT=zero?
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a.28,880
b.30,400
c.32,000
d.33,600
e.35,280
(142)BreakevenanalysisCQAnswer:dEASY
.SouthwestU'scampusbookstoresellscoursepacksfor$15each,thevariablecostperpackis$9,fixed
coststoproducethepacksare$200,000,andexpectedannualsalesare50,000packs.Whatarethepre
taxprofitsfromsalesofcoursepacks?
a.$72,900
b.$81,000
c.$90,000
d.$100,000
e.$110,000
(142)Breakeven:FCCQAnswer:dEASY
.SouthwestU'scampusbookstoresellscoursepacksfor$16each.Thevariablecostperpackis$10,
andatcurrentannualsalesof50,000packs,thestoreearns$75,000beforetaxesoncoursepacks.How
mucharethefixedcostsofproducingthecoursepacks?
a.$164,025
b.$182,250
c.$202,500
d.$225,000
e.$247,500
(142)Breakeven:operatingplansCQAnswer:dEASY
.Assumethatyouandyourbrotherplantoopenabusinessthatwillmakeandsellanewlydesignedtype
ofsandal.Tworoboticmachinesareavailabletomakethesandals,MachineAandMachineB.Theprice
perpairwillbe$20.00regardlessofwhichmachineisused.Thefixedandvariablecostsassociatedwith
thetwomachinesareshownbelow.WhatisthedifferencebetweenthebreakevenpointsforMachinesA
andB?(Hint:FindBEBBEA)
MachineAMachineB
Priceperpair(P)$20.00$20.00
Fixedcosts(F)$25,000$100,000
Variablecost/unit(V)$7.00$4.00
a.3,154
b.3,505
c.3,894
d.4,327
e.4,760
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(142)Breakeven:operatingplansCQAnswer:dEASY
.Yourcompanyplanstoproduceanewproduct,awirelesscomputermouse.Twomachinescanbeused
tomakethemouse,MachinesAandB.Thepricepermousewillbe$25.00regardlessofwhichmachine
isused.Thefixedandvariablecostsassociatedwiththetwomachinesareshownbelow.Attheexpected
saleslevelof75,000units,howmuchhigherorlowerwillthefirm'sexpectedEBITbeifituseshighfixed
costMachineBratherthanlowfixedcostMachineA,i.e.,whatisEBITBEBITA?
MachineAMachineB
Pricepermouse(P)$25.00$25.00
Fixedcosts(F)$100,000$400,000
Exp.unitsales(Q)75,00075,000
a.$123,019
b.$136,688
c.$151,875
d.$168,750
e.$185,625
(142)ROEsandoperatingplansCQAnswer:bMEDIUM
.Yourcompany,whichisfinancedentirelywithcommonequity,planstomanufactureanewproduct,acell
phonethatcanbewornlikeawristwatch.Tworoboticmachinesareavailabletomakethephone,
MachineAandMachineB.Thepriceperphonewillbe$250.00regardlessofwhichmachineisusedto
makeit.Thefixedandvariablecostsassociatedwiththetwomachinesareshownbelow,alongwiththe
capital(allequity)thatmustbeinvestedtopurchaseeachmachine.Theexpectedsaleslevelis25,000
units.Yourcompanyhastaxlosscarryforwardsthatwillcauseitstaxratetobezeroforthelifeofthe
project,soT=0.Howmuchhigherorlowerwilltheproject'sROEbeifyouselectthemachinethat
producesthehigherROE,i.e.,whatisROEBROEA?(Hint:Sincethefirmusesnodebtanditstaxrate
iszero,ROE=EBIT/Requiredinvestment.)
MachineAMachineB
Priceperphone(P)$250.00$250.00
Fixedcosts(F)$1,000,000$2,000,000
Expectedunitsales(Q)25,00025,000
Requiredequityinvestment$2,500,000$3,000,000
a.6.00%
b.6.67%
c.7.00%
d.7.35%
e.7.72%
(142)ROEsandfinancingplansCQAnswer:aMEDIUM
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.YouworkfortheCEOofanewcompanythatplanstomanufactureandsellanewproduct,awatchthat
hasanembeddedTVsetandamagnifyingglasscrystal.Theissuenowishowtofinancethecompany,
withonlyequityorwithamixofdebtandequity.Expectedoperatingincomeis$400,000.Otherdatafor
thefirmareshownbelow.Howmuchhigherorlowerwillthefirm'sexpectedROEbeifitusessomedebt
ratherthanallequity,i.e.,whatisROELROEU?
0%Debt,U60%Debt,L
Oper.income(EBIT)$400,000$400,000
Requiredinvestment$2,500,000$2,500,000
%Debt0.0%60.0%
$ofDebt$0.00$1,500,000
$ofCommonequity$2,500,000$1,000,000
InterestrateNA10.00%
Taxrate35%35%
a.5.85%
b.6.14%
c.6.45%
d.6.77%
e.7.11%
(142)EPSandfinancingplansCQAnswer:dMEDIUM
.YouworkfortheCEOofanewcompanythatplanstomanufactureandsellanewtypeoflaptop
computer.Theissuenowishowtofinancethecompany,withonlyequityorwithamixofdebtandequity.
Expectedoperatingincomeis$600,000.Otherdataforthefirmareshownbelow.Howmuchhigheror
lowerwillthefirm'sexpectedEPSbeifitusessomedebtratherthanonlyequity,i.e.,whatisEPSL
EPSU?
0%Debt,U60%Debt,L
Oper.income(EBIT)$600,000$600,000
%Debt0.0%60.0%
$ofDebt$0.00$1,500,000
$ofCommonequity$2,500,000$1,000,000
Sharesissued,$10/share250,000100,000
Taxrate35%35%
a.$1.00
b.$1.11
c.$1.23
d.$1.37
e.$1.50
(142)DebtandROECQAnswer:aMEDIUM
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.ConfuInc.expectstohavethefollowingdataduringthecomingyear.Whatisthefirm'sexpectedROE?
Assets$200,000Interestrate8%
Debt/Assets,bookvalue65%Taxrate40%
EBIT$25,000
a.12.51%
b.13.14%
c.13.80%
d.14.49%
e.15.21%
(142)OperatingincomeCQAnswer:bMEDIUM
.SenateInc.isconsideringtwoalternativemethodsforproducingplayingcards.Method1involvesusing
amachinewithafixedcost(mainlydepreciation)of$12,000andvariablecostsof$1.00perdeckofcards.
Method2wouldusealessexpensivemachinewithafixedcostofonly$5,000,butitwouldrequirea
variablecostof$1.50perdeck.Thesalepriceperdeckwouldbethesameundereachmethod.Atwhat
unitoutputlevelwouldthetwomethodsprovidethesameoperatingincome(EBIT)?
a.12,600
b.14,000
c.15,400
d.16,940
e.18,634
(142)RequiredunitsalesCQAnswer:cMEDIUM
.AgroupofventureinvestorsisconsideringputtingmoneyintoLemmaBooks,whichwantstoproducea
newreaderforelectronicbooks.Thevariablecostperunitisestimatedat$250,thesalespricewouldbe
setattwicetheVC/unit,or$500,andfixedcostsareestimatedat$750,000.Theinvestorswillputupthe
fundsiftheprojectislikelytohaveanoperatingincomeof$500,000ormore.Whatsalesvolumewould
berequiredinordertomeettheminimumprofitgoal?(Hint:Usethebreakevenformula,butincludethe
requiredprofitinthenumerator.)
a.4,513
b.4,750
c.5,000
d.5,250
e.5,513
(143)CalculatingunleveredbetaCQAnswer:eMEDIUM
.ElCapitanFoodshasacapitalstructureof40%debtand60%equity,itstaxrateis35%,anditsbeta
(leveraged)is1.25.BasedontheHamadaequation,whatwouldthefirm'sbetabeifitusednodebt,i.e.,
whatisitsunleveredbeta?
a.0.71
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b.0.75
c.0.79
d.0.83
e.0.87
(143)WACCandrecapitalizationCQAnswer:aMEDIUM
.GatorFabricsInc.currentlyhaszerodebt.Itisazerogrowthcompany,andithasthedatashown
below.Nowthecompanyisconsideringusingsomedebt,movingtothenewdebt/assetsratioindicated
below.Themoneyraisedwouldbeusedtorepurchasestockatthecurrentprice.Itisestimatedthatthe
increaseinriskresultingfromtheadditionalleveragewouldcausetherequiredrateofreturnonequityto
risesomewhat,asindicatedbelow.Ifthisplanwerecarriedout,byhowmuchwouldtheWACCchange,
i.e.,whatisWACCOldWACCNew?
NewDebt/Assets55%Orig.costofequity,rs10.0%
NewEquity/Assets45%Newcostofequity=rs11.0%
Interestratenew=rd7.0%Taxrate40%
a.2.74%
b.3.01%
c.3.32%
d.3.65%
e.4.01%
(Comp.)Cap.struct.&firmvalueCQAnswer:eMEDIUM
.AsaconsultanttoFirstResponderInc.,youhaveobtainedthefollowingdata(dollarsinmillions).The
companyplanstopayoutallofitsearningsasdividends,henceg=0.Also,nonetnewinvestmentin
operatingcapitalisneededbecausegrowthiszero.TheCFObelievesthatamovefromzerodebtto
20.0%debtwouldcausethecostofequitytoincreasefrom10.0%to12.0%,andtheinterestrateonthe
newdebtwouldbe8.0%.Whatwouldthefirm'stotalmarketvaluebeifitmakesthischange?Hints:Find
theFCF,whichisequaltoNOPAT=EBIT(1T)becausenonewoperatingcapitalisneeded,andthen
divideby
(WACCg).
Oper.income(EBIT)$800Taxrate40.0%
Newcostofequity(rs)12.00%Newdebtratio20.0%
Interestrate(rd)8.00%
a.$2,982
b.$3,314
c.$3,682
d.$4,091
e.$4,545
(143)EPS&capitalstructureCQAnswer:cMEDIUM/HARD
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.Youplantoinvestinoneoftwohomedeliverypizzacompanies,HighandLow,thatwererecently
foundedandareabouttocommenceoperations.Theyareidenticalexceptfortheiruseofdebtandthe
interestratesontheirdebtHighusesmoredebtandthusmustpayahigherinterestrate.Basedonthe
datagivenbelow,howmuchhigherorlowerwillHigh'sexpectedEPSbeversusthatofLow,i.e.,whatis
EPSHighEPSLow?
ApplicabletoBothFirmsFirmHigh'sDataFirmLow'sData
Assets$3,000,000Debtratio70%Debtratio20%
EBIT$500,000Shares90,000Shares240,000
Taxrate35%Int.rate12%Int.rate10%
a.$0.49
b.$0.54
c.$0.60
d.$0.66
e.$0.73
(143)ROE&capitalstructureCQAnswer:cMEDIUM/HARD
.FirmsHDandLDareidenticalexceptfortheiruseofdebtandtheinterestratestheypayHDhasmore
debtandthusmustpayahigherinterestrate.Basedonthedatagivenbelow,howmuchhigherorlower
willHD'sROEbeversusthatofLD,i.e.,whatisROEHDROELD?
ApplicabletoBothFirmsFirmHD'sDataFirmLD'sData
Assets$3,000,000Debtratio70%Debtratio20%
EBIT$500,000Int.rate12%Int.rate10%
Taxrate35%
a.5.41%
b.5.69%
c.5.99%
d.6.29%
e.6.61%
.FirmAisveryaggressiveinitsuseofdebttoleverageupitsearningsforcommonstockholders,
whereasFirmNAisnotaggressiveandusesnodebt.Thetwofirms'operationsareidenticaltheyhave
thesameassets,sales,operatingcosts,andEBIT.Thus,theydifferonlyintheiruseoffinancialleverage.
Basedonthefollowingdata,howmuchhigherorlowerisA'sROEthanthatofNA,i.e.,whatisROEA
ROENA?
ApplicabletoBothFirmsFirmA'sDataFirmNA'sData
Assets$150,000Debtratio50%Debtratio0%
EBIT$40,000Int.rate12%Int.rate10%
Taxrate35%
a.8.60%
b.9.06%
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c.9.53%
d.10.01%
e.10.51%
.Yourfirm'sdebtratioisonly5.00%,butthenewCFOthinksthatmoredebtshouldbeemployed.She
wantstosellbondsandusetheproceedstobuybackandretiresomestock,whichsellsatitsbookvalue.
Otherthingsheldconstant,andbasedonthedatabelow,ifthefirmincreasesitsdebtratioto60.0%,by
howmuchwouldtheROEchange,i.e.,whatisROENewROEOld?
OperatingDataOtherData
Assets$150,000Newdebtratio60%
EBIT/Assets=BEP20.00%Olddebtratio5%
Taxrate35%Newinterestrate12%
Oldinterestrate10%
a.6.73%
b.7.09%
c.7.46%
d.7.83%
e.8.22%
.Youhavebeenhiredbyanewfirmthatisjustbeingstarted.TheCFOwantstofinancewith60%debt,
butthepresidentthinksitwouldbebettertoholdthedebtratiotoonly10%.Otherthingsheldconstant,
andbasedonthedatabelow,ifthefirmusesthehigherdebtratio,byhowmuchwouldtheROEchange,
i.e.,whatisROENewROEOld?
OperatingDataOtherData
Assets$4,000Higherdebtratio60%
EBIT/Assets=BEP20.00%Lowerdebtratio10%
Taxrate35%Higherinterestrate13%
Lowerinterestrate9%
a.5.44%
b.5.73%
c.6.03%
d.6.33%
e.6.65%
(142)EPS&financingplansCQAnswer:eHARD
.Yourgirlfriendplanstostartanewcompanytomakeanewtypeofcatlitter.Herfatherwillfinancethe
operation,butshewillhavetopayhimback.Youarehelpingher,andtheissuenowishowtofinancethe
company,withequityonlyorwithamixofdebtandequity.Thepriceperunitwillbe$5.00regardlessof
howthefirmisfinanced.Theexpectedfixedandvariableoperatingcosts,alongwithotherinformation,
areshownbelow.Howmuchhigherorlowerwillthefirm'sexpectedEPSbeifitusessomedebtrather
thanonlyequity,i.e.,whatisEPSLEPSU?
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0%Debt,U60%Debt,L
Expectedunitsales225,000225,000
Priceperunit$10.00$10.00
Fixedcosts$1,000,000$1,000,000
Variablecost/unit$3.50$3.50
Sharesissuedat$10/share250,000100,000
%Debt0.00%60.00%
Debt,$$0$1,500,000
Equity,$$2,500,000$1,000,000
Taxrate35.00%35.00%
a.$0.54
b.$0.60
c.$0.67
d.$0.75
e.$0.83
(142)BreakevenanalysisCQAnswer:dHARD
.SoutheastU'scampusbookstoresellscoursepacksfor$15.00each,thevariablecostperpackis
$11.00,fixedcostsforthisoperationare$300,000,andannualsalesare100,000packs.Theunitvariable
costconsistsofa$4.00royaltypayment,VR,perpacktoprofessorsplusothervariablecostsofVO=
$7.00.Theroyaltypaymentisnegotiable.Thebookstore'sdirectorsbelievethatthestoreshouldearna
profitmarginof10%onsales,andtheywantthestore'smanagerstopayaroyaltyratethatwillproduce
thatprofitmargin.Whatroyaltyperpackwouldpermitthestoretoearna10%profitmarginoncourse
packs,otherthingsheldconstant?
a.$2.55
b.$2.84
c.$3.15
d.$3.50
e.$3.85
(143)LeveredbetaandrsCQAnswer:bHARD
.DyeIndustriescurrentlyusesnodebt,butitsnewCFOisconsideringchangingthecapitalstructureto
40.0%debtbyissuingbondsandusingtheproceedstorepurchaseandretiresomecommonstockat
bookvalue.Giventhedatashownbelow,byhowmuchwouldthisrecapitalizationchangethefirm'scost
ofequity,i.e.,whatisrLrU?
Riskfreerate,rRF6.00%Taxrate,T40%
Marketriskpremium,RPM4.00%Currentdebtratio0%
Currentbeta,bU1.15Targetdebtratio40%
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a.1.66%
b.1.84%
c.2.02%
d.2.23%
e.2.45%
(143)LeveredbetaandrsCQAnswer:bHARD
.DysonInc.currentlyfinanceswith20.0%debt,butitsnewCFOisconsideringchangingthecapital
structureto60.0%debtbyissuingadditionalbondsandusingtheproceedstorepurchaseandretiresome
commonstockatbookvalue.Giventhedatashownbelow,byhowmuchwouldthisrecapitalization
changethefirm'scostofequity?(Hint:Youmustunleverthecurrentbetaandthenusetheunleveredbeta
tosolvetheproblem.)
Riskfreerate,rRF5.00%Taxrate,T40%
Marketriskpremium,RPM6.00%Currentdebtratio20%
Currentbeta,bL1.15Targetdebtratio60%
a.4.05%
b.4.50%
c.4.95%
d.5.45%
e.5.99%
(143)RecapitalizationCQAnswer:bHARD
.MonroeInc.isanallequityfirmwith500,000sharesoutstanding.Ithas$2,000,000ofEBIT,andEBITis
expectedtoremainconstantinthefuture.Thecompanypaysoutallofitsearnings,soearningspershare
(EPS)equaldividendspershares(DPS),anditstaxrateis40%.Thecompanyisconsideringissuing
$5,000,000of9.00%bondsandusingtheproceedstorepurchasestock.Theriskfreerateis4.5%,the
marketriskpremiumis5.0%,andthefirm'sbetaiscurrently0.90.However,theCFObelievesthebeta
wouldriseto1.10iftherecapitalizationoccurs.Assumingthesharescouldberepurchasedattheprice
thatexistedpriortotherecapitalization,whatwouldthepricepersharebefollowingtherecapitalization?
(Hint:P0=EPS/rsbecauseEPS=DPS.)
a.$28.27
b.$29.76
c.$31.25
d.$32.81
e.$34.45
(143)ROE&financingplansCQAnswer:eHARD
.YouwerehiredastheCFOofanewcompanythatwasfoundedbythreeprofessorsatyouruniversity.
Thecompanyplanstomanufactureandsellanewproduct,acellphonethatcanbewornlikeawrist
watch.Theissuenowishowtofinancethecompany,withequityonlyorwithamixofdebtandequity.
Thepriceperphonewillbe$250.00regardlessofhowthefirmisfinanced.Theexpectedfixedand
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variableoperatingcosts,alongwithotherdata,areshownbelow.Howmuchhigherorlowerwillthefirm's
expectedROEbeifituses60%debtratherthanonlyequity,i.e.,whatisROELROEU?
0%Debt,U60%Debt,L
Expectedunitsales(Q)28,50028,500
Priceperphone(P)$250.00$250.00
Fixedcosts(F)$1,000,000$1,000,000
%Debt0.00%60.00%
Debt,$$0$1,500,000
Equity,$$2,500,000$1,000,000
Taxrate35.00%35.00%
a.5.68%
b.5.94%
c.6.22%
d.6.52%
e.6.83%
.(151)OptimaldistributionpolicyFRAnswer:aEASY
.(151)TargetpayoutratioFRAnswer:bEASY
Thehigherthepayoutratio,thelessofitsearningsthefirmreinvestsinthebusiness,andthelowerthe
reinvestmentrate,thelowerthegrowthrate.
.(151)DividendirrelevanceFRAnswer:aEASY
.(151)DividendirrelevanceFRAnswer:bEASY
.(151)Investors'div.preferencesFRAnswer:aEASY
.(156)StockdividendsandsplitsFRAnswer:aEASY
.(156)ReversesplitFRAnswer:aEASY
.(151)DividendsandstockpricesFRAnswer:bMEDIUM
.(151)DividendsandstockpricesFRAnswer:aMEDIUM
.(151)DividendirrelevanceFRAnswer:aMEDIUM
.(151)DividendgrowthtradeoffFRAnswer:aMEDIUM
MMwoulddisagree.Theywouldsaythatinvestorstookthedividendincreaseasasignalthatthefirm's
managementexpectedhigherearningsinthefuture.MMsaydividendshaveinformationcontent
regardingfutureearnings.
.(152)SignalinghypothesisFRAnswer:aMEDIUM
.(153)ResidualdividendmodelFRAnswer:aMEDIUM
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.(153)ResidualdividendmodelFRAnswer:bMEDIUM
Thehigherthedebtratio,themoredollarsofdebtwillbeusedtofundagivencapitalbudget.So,the
higherthedebtratio,thelessequitywillbeneeded,andthisresultsinahigherdividendpayoutratio.
.(153)ResidualdividendmodelFRAnswer:bMEDIUM
.(153)DividendpaymentproceduresFRAnswer:bMEDIUM
Thisisfalse.Thestockpricewilldropontheexdividenddate,whichistwodayspriortotheholderof
recorddate,whichiswellbeforetheactualJanuary31paymentdate.Also,becausethedividendis
taxable,thepricedeclineisgenerallysomewhatlessthanthefullamountofthedividend.
.(153)DividendpaymentproceduresFRAnswer:aMEDIUM
Thisistrue.Thestockpricewilldropontheexdividenddate,whichistwodayspriortotheholderof
recorddate,whichiswellbeforetheactualJanuary31paymentdate.Note,though,thatbecausethe
dividendistaxable,thepricedeclinemaybesomewhatlessthanthefullamountofthedividend.
.(154)DividendreinvestmentplansFRAnswer:bMEDIUM
.(154)DividendreinvestmentplansFRAnswer:aMEDIUM
.(154)DividendreinvestmentplansFRAnswer:aMEDIUM
Thisistrue,becauseifthecompanyretainsitsearningsratherthanpayingthemout,investorsshouldget
capitalgainsratherthandividendincome,andthetaxesonthosegainswillbedeferreduntilthestockis
sold.Notethatthemoneywillbereinvestedbythecompanyineithercase,sotherisktostockholders
underdividendreinvestmentandretainedearningsshouldbethesame.
.(156)StocksplitsFRAnswer:aMEDIUM
.(153)ResidualdividendmodelFRAnswer:aHARD
(1)Thefirm'sWACCwouldincrease,(2)thiswouldcausefewerprojectstobeaccepted,(3)thiswould
leadtoasmallercapitalbudget,(4)thuslessmoneywouldbeneededtofundthecapitalbudget,(5)thus
lessequitywouldbeneeded,so(6)thedividendpayoutratiowouldincrease.
.(155)WACCanddividendpolicyFRAnswer:bHARD
FirmUcouldfunditscapitalbudgetwithvaryingamountsofdebtwithoutcausinglargechangesinits
WACCandthusinitsvalueandstockprice.FirmVcouldnotvaryitsdebtratiowithoutincreasingits
WACC.Thus,FirmVwouldhavetoraiseandloweritspayoutinordertoobtaintheequityitneededto
supportitscapitalbudget.FirmU,ontheotherhand,couldmaintainastable,steadydividend,andletthe
debtratiovarywithoutcausingmuchharmtoitsstockprice.
.(153)DividendpayoutCRAnswer:aEASY
.(156)StocksplitsCRAnswer:bEASY
.(151)Investors'div.preferencesCRAnswer:dMEDIUM
.(153)ResidualdividendpolicyCRAnswer:aMEDIUM
.(153)ResidualdividendpolicyCRAnswer:bMEDIUM
.(153)ResidualdividendpolicyCRAnswer:cMEDIUM
.(155)Factorsindiv.policyCRAnswer:dMEDIUM
.(155)Factorsindiv.policyCRAnswer:cMEDIUM
.(156)StockdividendsandsplitsCRAnswer:eMEDIUM
.(Comp.)DividendtheoriesCRAnswer:eMEDIUM
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.(Comp.)RepurchasesandDRIPSCRAnswer:cMEDIUM
.(Comp.)Divs.,DRIPs,andrepurch.CRAnswer:dMEDIUM
.(Comp.)Div.policyandrepurchasesCRAnswer:dMEDIUM
.(Comp.)DividendconceptsCRAnswer:cMEDIUM
.(Comp.)DividendconceptsCRAnswer:eMEDIUM
.(Comp.)DividendconceptsCRAnswer:bMEDIUM
.(Comp.)DividendconceptsCRAnswer:bMEDIUM
.(Comp.)DividendconceptsCRAnswer:aMEDIUM
.(Comp.)DividendconceptsCRAnswer:eMEDIUM
.(Comp.)RepurchasesandsplitsCRAnswer:eMEDIUM
.(Comp.)DividendconceptsCRAnswer:aMEDIUM/HARD
.(Comp.)DividendconceptsCRAnswer:dMEDIUM/HARD
.(153)ResidualdividendmodelCRAnswer:dEASY
Capitalbudget$12,500
Netincome(NI)$11,500
%Debt40%
%Equity=1.0%Debt=60%
Equityneededtosupportthecapitalbudget=%EquityCapitalbudget$7,500
Dividendspaid=NIEquityneededifpositive,otherwise$0.0.$4,000
Payoutratio=Dividendspaid/NI=34.78%
.(156)StocksplitsCRAnswer:cEASY
Numberofnewshares2
Numberofoldshares1
Old(presplit)price$80
Newprice=Oldprice(Oldshares/Newshares)=$40.00
.(156)StocksplitsCRAnswer:aEASY
Numberofnewshares3
Numberofoldshares1
Presplitstockprice$90.00
Postsplitstockprice:P0/Newperold=$30.00
.(156)StocksplitsCRAnswer:cEASY
Numberofnewshares7
Numberofoldshares2
Old(presplit)price$80.00
Newprice=Oldprice(Oldshares/Newshares)=$22.86
.(153)ResidualdividendmodelCRAnswer:bEASY/MEDIUM
%Equity60%
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Dividendstobepaid$225,000
Requirednetincome=Dividends+(Capitalbudget%Equity)=$615,000
.(153)ResidualdividendmodelCRAnswer:bMEDIUM
Equityratio65%
Dividendstobepaid$400,000
Requirednetincome=Dividends+(Capitalbudget%Equity)=$952,500
.(153)ResidualdividendmodelCRAnswer:aMEDIUM
Equityratio55%
Dividendspaid$500,000
NI=Dividends+(Equity%Capitalbudget)=$898,750
Payout=Dividends/NI=55.63%
.(153)ResidualdividendmodelCRAnswer:dMEDIUM
%Debt30%
%Equity70%
Netincome$550,000
Max.capitalbudget=NI/%Equity$785,714
Check:IscalculatedMax.capitalbudget%Equity=NI?$550,000=Netincome
EBIT$2,000,000Capitalbudget$850,000
Interestrate10%%Debt40%
Debtoutstanding$5,000,000%Equity60%
Sharesoutstanding5,000,000Taxrate40%
EBIT$2,000,000
Interestexpense=InterestrateDebt500,000
Taxableincome$1,500,000
Taxes=TaxrateIncome600,000
Equityneededforcapitalbudget=%Equity(Capitalbudget)510,000
Dividends=NIEquityneeded$390,000
Payoutratio=Dividends/NI=43.33%
.(153)ResidualdividendmodelCRAnswer:cMEDIUM
%Debt30%
%Equity70%
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Netincome$400,000
Equityrequirement=capitalbudget%Equity$350,000
Dividends=NIEquityrequirement=$50,000
.(153)ResidualdividendmodelCRAnswer:eMEDIUM
Capitalbudget$1,000,000
%Debt60%
%Equity=1.0%Debt40%
Dividendspaid=NIEquityneededifpositive(otherwise,$0.0)=$225,000
.(153)ResidualdividendmodelCRAnswer:eMEDIUM
%Debt65%
%Equity=1.0%Debt35%
Dividendspaid=NIEquityneededifpositive(otherwise,$0.0)=$25,000
Capitalbudget$5,000
Netincome(NI)$5,300
%Debt45%
%Equity=1.0%Debt55%
Dividendspaid=NIEquityneededifpositive(otherwise,$0.0)$2,550
Capitalbudget$5,000
Netincome(NI)$7,000
%Debt45%
%Equity=1.0%Debt55%
Capitalbudget$7,500
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Netincome(NI)$6,500
%Debt35%
%Equity=1.0%Debt65%
.(156)StocksplitCRAnswer:cMEDIUM
Currentprice$0.50
Targetprice$25.00
Oldsharessurrenderedper1newshare=Targetprice/Oldprice=50.00
.(156)StocksplitCRAnswer:bMEDIUM
Currentprice$175.00
Targetprice$25.00
No.ofnewsharesper1oldshare=Currentprice/Targetprice=7.00
.(156)StocksplitCRAnswer:bMEDIUM
Newsharesper1oldshare4
Presplitstockprice$120
%valueincrease5%
Postsplitstockprice=(P0/[Newsharesperoldshares)(1+%Valueincrease)]=$31.50
.(153)ResidualdividendmodelCRAnswer:cMEDIUM/HARD
OldNew
%Debt15%60%
%Equity=1.0%Debt85%40%
Capitalbudget$3,000,000$3,000,000
Netincome(NI)$3,500,000$3,500,000
Equityneededtosupportthecapitalbudget=%EquityCapitalbudget$2,550,000$1,200,000
Dividendspaid=NIEquityneededifpositive(otherwise,$0.0)$950,000$2,300,000
Increaseindividendspaid=$1,350,000
.(153)ResidualdividendmodelCRAnswer:aMEDIUM/HARD
OldNew
%Debt15%60%
Capitalbudget$3,000,000$3,000,000
Netincome(NI)$3,500,000$3,500,000
Dividendspaid=NIEquityneededifpositive(otherwise,$0.0)$950,000$2,300,000
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Dividendpayoutratio27.1%65.7%
Increaseindividendpayoutratio=38.6%
.(153)ResidualdividendmodelCRAnswer:cMEDIUM/HARD
OldNew
%Debt40%40%
Capitalbudget$3,000,000$2,000,000
Netincome(NI)$3,500,000$3,500,000
Dividendspaid=NIEquityneededifpositive(otherwise,$0.0)$1,700,000$2,300,000
Increaseindividendspaid=$600,000
.(153)ResidualdividendmodelCRAnswer:eMEDIUM/HARD
%Equity60%
Equityrequiredforcapitalbudget=%EquityCapitalbudget$1,200,000
Dividends=NIEquityrequiredif>0(otherwise,0)=$0
Requirednewstock=NIEquityrequiredif<0(otherwise,0)=$300,000
Dividends:ornewstock:
Dividendspaid=NI[%Equity(Cap.bud.)],stockissuedifdividendszeroorneg.$0$300,000
.(156)StocksplitCRAnswer:bMEDIUM/HARD
Numberofnewshares7
Numberofoldshares3
Old(presplit)price$75.00
%Increaseinvalue5%
Newpricebeforevalueincrease=Oldprice/(Newshares/Oldshares)$32.14
Newpriceaftervalueincrease=Prior(1+%Valueincrease)=$33.75
.(153)ResidualdividendmodelCRAnswer:cHARD
OldNew
Netincome(NI)$3,500,000$3,500,000
%Debt35%35%
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Newtargetpayoutratio70%
Targetdividend=TargetpayoutNI$2,450,000
Targetretainedearnings(RE)=NIDividends$1,050,000
Max.capitalbudget=RE/%Equity$1,615,385
Check:%EquityCapitalbudgetconsistent=CalculatedRE?Yes$1,050,000
NewcapitalbudgetOldcapitalbudget=$1,615,385$5,000,000=$3,384,615
.(153)ResidualdividendmodelCRAnswer:eHARD
EPS$3.00
Sharesoutstanding500,000
DPS$2.00
Netincome=EPSSharesoutstanding$1,500,000
Dividendspaid=DPSSharesoutstanding$1,000,000
Retainedearningsavailable$500,000
CapitalbudgetRetainedearnings=Debtneeded$300,000
Debtneeded/Capitalbudget=%Debtfinancing=37.5%
.(153)ResidualdividendmodelCRAnswer:eHARD
NewMaximums:
CurrentIfIncreaseIflowerIfDo
Foundas:MaximumDebtPayoutBoth
NIGiven$175.0$175.0$175.0$175.0
%Debt"25.0%75.0%25.0%75.0%
%Equity"75.0%25.0%75.0%25.0%
%Payout"65.0%65.0%20.0%20.0%
DividendsPayout%NI$113.8$113.8$35.0$35.0
Ret.earnings,RENIDividends$61.3$61.3$140.0$140.0
Max.cap.budgetRE/%Equity$81.7$245.0$186.7$560.0
Increase:Newmax.Currentmax.=$163.3$105.0$478.3
Percentageincrease:Newmax./Currentmax.1.0=200.0%128.6%585.7%
.(157)Repurchasesvs.dividendsCRAnswer:cHARD
NI$625,000
No.ofsharesoutstanding100,000
ExpectedEPS$6.25
Currentstockprice$40.00
P/Eratio6.40
ExpectedDPSifpaydividend=EPS$6.25
Expectedstockpriceendofyear=Currentprice+ExpectedDPS$46.25
Sharesrepurchasedifuserepurchaseplan=NI/Expectedprice13,514
Newsharesoutstandingafterrepurchase86,486
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NewEPSifuserepurchaseplan=NI/Newshares$7.227
Newprice=P/ENewEPS$46.25
Gain,100shareowner,dividends=100DPS$625.00
Gain,100shareowner,repurchase=100(newpricecurrentprice)=$625.00
(161)NetworkingcapitalFSAnswer:bEASY
.Networkingcapital,definedascurrentassetsminusthesumofpayablesandaccruals,isequaltothe
currentratiominusthequickratio.
a.True
b.False
(161)NetworkingcapitalFSAnswer:bEASY
.Networkingcapitalisdefinedascurrentassetsdividedbycurrentliabilities.
a.True
b.False
(161)WorkingcapitalFSAnswer:bEASY
.Anincreaseinanycurrentassetmustbeaccompaniedbyanequalincreaseinsomecurrentliability.
a.True
b.False
(162)WorkingcapitalpolicyFSAnswer:aEASY
.Determiningafirm'soptimalinvestmentinworkingcapitalanddecidinghowthatinvestmentshouldbe
financedareelementsofworkingcapitalpolicy.
a.True
b.False
(163)PermanentcurrentassetsFSAnswer:aEASY
.Theconceptofpermanentcurrentassetsreflectsthefactthatsomecomponentsofcurrentassetsdonot
shrinktozeroevenwhenabusinessisatitsseasonalorcyclicallow.Thus,permanentcurrentassets
representaminimumlevelofcurrentassetsthatmustbefinanced.
a.True
b.False
(163)ConservativefinancingFSAnswer:aEASY
.Aconservativefinancingapproachtoworkingcapitalwillresultinpermanentcurrentassetsandsome
seasonalcurrentassetsbeingfinancedusinglongtermsecurities.
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a.True
b.False
(163)CurrentassetfinancingFSAnswer:aEASY
.Althoughshortterminterestrateshavehistoricallyaveragedlessthanlongtermrates,theheavyuseof
shorttermdebtisconsideredtobeanaggressivecurrentassetfinancingstrategybecauseoftheinherent
risksofusingshorttermfinancing.
a.True
b.False
(164)CashconversioncycleFSAnswer:bEASY
.Ifafirmtakesactionsthatreduceitsdayssalesoutstanding(DSO),then,otherthingsheldconstant,this
willlengthenitscashconversioncycle(CCC).
a.True
b.False
(164)CashconversioncycleFSAnswer:bEASY
.Otherthingsheldconstant,ifafirm"stretches"(i.e.,delayspaying)itsaccountspayable,thiswill
lengthenitscashconversioncycle(CCC).
a.True
b.False
(165)CashbudgetFSAnswer:aEASY
.Shortertermcashbudgetssayadailycashbudgetforthenextmontharegenerallyusedforactual
cashcontrolwhilelongertermcashbudgetssaymonthlycashbudgetsforthenextyeararegenerally
usedforplanningpurposes.
a.True
b.False
(166)LockboxFSAnswer:aEASY
.Settingupalockboxarrangementisonewayforafirmtospeedupthecollectionofpaymentsfromits
customers.
a.True
b.False
(167)InventorymanagementFSAnswer:bEASY
.Inventorymanagementislargelyselfcontainedinthesensethatverylittlecoordinationamongthesales,
purchasing,andproductionpersonnelisrequiredforsuccessfulinventorymanagement.
a.True
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b.False
(168)ReceivablesbalanceFSAnswer:aEASY
.Theaverageaccountsreceivablesbalanceisafunctionofboththevolumeofcreditsalesandthedays
salesoutstanding.
a.True
b.False
(168)CreditpolicyFSAnswer:aEASY
.Thefourprimaryelementsinafirm'screditpolicyare(1)creditstandards,(2)discountsoffered,(3)
creditperiod,and(4)collectionpolicy.
a.True
b.False
(169)TakingdiscountsFSAnswer:aEASY
.Nottakingcashdiscountsiscostly,andasaresult,firmsthatdonottakethemareusuallythosethatare
performingpoorlyandhaveinadequatecashbalances.
a.True
b.False
(169)TradecreditFSAnswer:bEASY
.Ifafirmbuysontermsof2/10,net30,itshouldpayasearlyaspossibleduringthediscountperiod.
a.True
b.False
(169)TradecreditFSAnswer:bEASY
.Tradecreditcanbeseparatedintotwocomponents:freetradecredit,whichiscreditreceivedafterthe
discountperiodends,andcostlytradecredit,whichisthecostofdiscountsnottaken.
a.True
b.False
(169)TradecreditFSAnswer:aEASY
.Asarule,managersshouldtrytoalwaysusethefreecomponentoftradecreditbutshouldusethe
costlycomponentonlyifthecostofthiscreditislowerthanthecostofcreditfromothersources.
a.True
b.False
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.Ifafirm'ssuppliersstopofferingdiscounts,thenitsuseoftradecreditismorelikelytoincreasethanto
decreaseotherthingsheldconstant.
a.True
b.False
.Whendecidingwhetherornottotakeatradediscount,thecostofborrowingfromabankorothersource
shouldbecomparedtothecostoftradecredittodetermineifthecashdiscountshouldbetaken.
a.True
b.False
(169)CostoftradecreditFSAnswer:aEASY
.Thecalculatedcostoftradecreditcanbereducedbypayinglate.
a.True
b.False
(169)CostoftradecreditCSAnswer:aEASY
.Thecalculatedcostoftradecreditforafirmthatbuysontermsof2/10,net30,islower(otherthingsheld
constant)ifthefirmplanstopayin40daysthanin30days.
a.True
b.False
(169)CostoftradecreditFSAnswer:aEASY
.Oneoftheeffectsofceasingtotaketradecreditdiscountsisthatthefirm'saccountspayablewillrise,
otherthingsheldconstant.
a.True
b.False
(169)StretchingpayablesFSAnswer:bEASY
."Stretching"accountspayableisawidelyaccepted,entirelyethical,andcostlessfinancingtechnique.
a.True
b.False
(1610)BankloansFSAnswer:bEASY
.Aninformallineofcreditandarevolvingcreditagreementaresimilarexceptthatthelineofcredit
createsalegalobligationforthebankandthusisamorereliablesourceoffundsfortheborrower.
a.True
b.False
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(1610)BankloansFSAnswer:aEASY
.Thematurityofmostbankloansisshortterm.Bankloanstobusinessesarefrequentlymadeas90day
noteswhichareoftenrolledover,orrenewed,ratherthanrepaidwhentheymature.However,ifthe
borrower'sfinancialsituationdeteriorates,thenthebankmayrefusetorollovertheloan.
a.True
b.False
(1610)LineofcreditFSAnswer:aEASY
.Alineofcreditcanbeeitheraformaloraninformalagreementbetweenaborrowerandabank
regardingthemaximumamountofcreditthebankwillextendtotheborrowerduringsomefutureperiod,
assumingtheborrowermaintainsitsfinancialstrength.
a.True
b.False
(1610)RevolvingcreditFSAnswer:aEASY
.Ifafirmhassetuparevolvingcreditagreementwithabank,therisktothefirmofbeingunabletoobtain
fundswhenneededislowerthanifithadaninformallineofcredit.
a.True
b.False
(1612)AccrualsFSAnswer:aEASY
.Accrualsare"free"capitalinthesensethatnoexplicitinterestmustnormallybepaidonaccrued
liabilities.
a.True
b.False
(1612)AccrualsFSAnswer:aEASY
.Accrualsare"spontaneous,"butunfortunately,duetolawandeconomicforces,firmshavelittlecontrol
overtheleveloftheseaccounts.
a.True
b.False
(1612)AccrualsFSAnswer:bEASY
.Thefacts(1)thatnoexplicitinterestispaidonaccrualsand(2)thatthefirmcanvarythelevelofthese
accountsatwillmakesthemanattractivesourceoffundingtomeetworkingcapitalneeds.
a.True
b.False
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(163)MaturitymatchingFSAnswer:aMEDIUM
.Uncertaintyabouttheexactlivesofassetspreventsprecisematuritymatchinginanexpost(i.e.,after
thefact)senseeventhoughitispossibletomatchmaturitiesonanexante(expected)basis.
a.True
b.False
(163)MaturitymatchingFSAnswer:bMEDIUM
.Thematuritymatching,or"selfliquidating,"approachtofinancinginvolvesobtainingthefundsfor
permanentcurrentassetswithacombinationoflongtermcapitalandshorttermcapitalthatvaries
dependingonthelevelofinterestrates.Whenshorttermratesarerelativelyhigh,shorttermassetswill
befinancedwithlongtermdebttoreducecosts.
a.True
b.False
(163)AggressivefinancingFSAnswer:aMEDIUM
.Afirmthatfollowsanaggressiveworkingcapitalfinancingapproachusesprimarilyshorttermcreditand
thusismoreexposedtoanunexpectedincreaseininterestratesthanisafirmthatuseslongtermcapital
andthusfollowsaconservativefinancingpolicy.
a.True
b.False
(163)AggressivefinancingFSAnswer:bMEDIUM
.Therelativeprofitabilityofafirmthatemploysanaggressiveworkingcapitalfinancingpolicywillimprove
iftheyieldcurvechangesfromupwardslopingtodownwardsloping.
a.True
b.False
(163)ShorttermfinancingFSAnswer:aMEDIUM
.Iftheyieldcurveisupwardsloping,thenshorttermdebtwillbecheaperthanlongtermdebt.Thus,ifa
firm'sCFOexpectstheyieldcurvetocontinuetohaveanupwardslope,thiswouldtendtocausethe
currentratiotoberelativelylow,otherthingsheldconstant.
a.True
b.False
(163)ShorttermfinancingFSAnswer:aMEDIUM
.Therisktothefirmofborrowingusingshorttermcreditisusuallygreaterthanifitusedlongtermdebt.
Addedriskstemsfrom(1)thegreatervariabilityofinterestcostsonshorttermthanlongtermdebtand(2)
thefactthatevenifitslongtermprospectsaregood,thefirm'slendersmaynotbewillingtorenewshort
termloansifthefirmistemporarilyunabletorepaythoseloans.
a.True
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b.False
(163)ShorttermfinancingFSAnswer:bMEDIUM
.Longtermloanagreementsalwayscontainprovisions,orcovenants,thatconstrainthefirm'sfuture
actions.Shorttermcreditagreementsarejustasrestrictiveinordertoprotecttheinterestofthelender.
a.True
b.False
(163)ShorttermfinancingCSAnswer:aMEDIUM
.Afirmconstructinganewmanufacturingplantandfinancingitwithshorttermloans,whichare
scheduledtobeconvertedtofirstmortgagebondswhentheplantiscompleted,wouldwanttoseparate
theconstructionloanfromitscurrentliabilitiesassociatedwithworkingcapitalwhencalculatingnet
workingcapital.
a.True
b.False
(164)CashconversioncycleFSAnswer:aMEDIUM
.Thelongeritscustomersnormallyholdinventory,thelongerthecreditperiodsupplierfirmsnormally
offer.Still,suppliershavesomeflexibilityinthecredittermstheyoffer.Ifasupplierlengthensthecredit
periodoffered,thiswillshortenthecustomer'scashconversioncyclebutlengthenthesupplierfirm'sown
CCC.
a.True
b.False
(164)CashconversioncycleFSAnswer:aMEDIUM
.Thecashconversioncycle(CCC)combinesthreefactors:Theinventoryconversionperiod,the
receivablescollectionperiod,andthepayablesdeferralperiod,anditspurposeistoshowhowlongafirm
mustfinanceitsworkingcapital.Otherthingsheldconstant,theshortertheCCC,themoreeffectivethe
firm'sworkingcapitalmanagement.
a.True
b.False
(165)SeasonalcashpatternsFSAnswer:bMEDIUM
.Thetargetcashbalanceistypically(andlogically)setsothatitdoesnotneedtobeadjustedforeither
seasonalpatternsorunanticipatedrandomfluctuations.
a.True
b.False
(165)CashbudgetFSAnswer:bMEDIUM
.Afirm'speakborrowingneedswillprobablybeoverstatedifitbasesitsmonthlycashbudgetonthe
assumptionthatbothcashreceiptsandcashpaymentsoccuruniformlyoverthemonthbutinreality
paymentsareconcentratedatthebeginningofeachmonth.
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a.True
b.False
(165)CashbudgetFSAnswer:aMEDIUM
.Afirm'speakborrowingneedswillprobablybeoverstatedifitbasesitsmonthlycashbudgetonthe
assumptionthatbothcashreceiptsandcashpaymentsoccuruniformlyoverthemonthbutinreality
receiptsareconcentratedatthebeginningofeachmonth.
a.True
b.False
(165)CashandcapitalbudgetsFSAnswer:bMEDIUM
.Thecashbudgetandthecapitalbudgetarehandledseparately,andalthoughtheyarebothimportant,
theyaredevelopedcompletelyindependentlyofoneanother.
a.True
b.False
(165)CashbudgetanddepreciationFSAnswer:bMEDIUM
.Sincedepreciationisanoncashcharge,itneitherappearsonnorhasanyeffectonthecashbudget.
Thus,ifthedepreciationchargeforthecomingyeardoubledorhalved,thiswouldhavenoeffectonthe
cashbudget.
a.True
b.False
(165)CashflowsynchronizationFSAnswer:aMEDIUM
.Synchronizationofcashflowsisanimportantcashmanagementtechnique,aspropersynchronization
canreducetherequiredcashbalanceandincreaseafirm'sprofitability.
a.True
b.False
(166)LockboxCSAnswer:bMEDIUM
.Onaverage,afirmcollectscheckstotaling$250,000perday.Ittakesthefirmapproximately4days
fromthedaythechecksweremaileduntiltheyresultinusablecashforthefirm.Assumethat(1)a
lockboxsystemcouldbeemployedwhichwouldreducethecashconversionprocedureto21/2daysand
(2)thefirmcouldinvestanyadditionalcashgeneratedat6%aftertaxes.Thelockboxsystemwouldbea
goodbuyifitcosts$25,000annually.
a.True
b.False
(168)ReceivablesbalanceFSAnswer:bMEDIUM
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.Sincereceivablesandpayablesbothresultfromsalestransactions,afirmwithahighreceivablesto
salesratiomustalsohaveahighpayablestosalesratio.
a.True
b.False
(168)ReceivablesandgrowthCSAnswer:bMEDIUM
.DimonProducts'salesareexpectedtobe$5millionthisyear,with90%oncreditand10%forcash.
Salesareexpectedtogrowatastable,steadyrateof10%annuallyinthefuture.Dimon'saccounts
receivablebalancewillremainconstantatthecurrentlevel,becausethe10%cashsalescanbeusedto
supportthe10%growthrate,otherthingsheldconstant.
a.True
b.False
(168)ReceivablesandgrowthCSAnswer:aMEDIUM
.Forazerogrowthfirm,itispossibletoincreasethepercentageofsalesthataremadeoncreditandstill
keepaccountsreceivableattheircurrentlevel,providedthefirmcanshortenthelengthofitscollection
periodsufficiently.
a.True
b.False
(168)CollectionpolicyFSAnswer:aMEDIUM
.Afirm'scollectionpolicy,i.e.,theproceduresitfollowstocollectaccountsreceivable,playsanimportant
roleinkeepingitsaveragecollectionperiodshort,althoughtoostrictacollectionpolicycanreduceprofits
duetolostsales.
a.True
b.False
(168)CollectionpolicyFSAnswer:aEASY
.Changesinafirm'scollectionpolicycanaffectsales,workingcapital,andprofits.
a.True
b.False
(168)Cashvs.creditsalesFSAnswer:bMEDIUM
.Becausemoneyhastimevalue,acashsaleisalwaysmoreprofitablethanacreditsale.
a.True
b.False
(168)DSOandpastdueaccountsCSAnswer:bMEDIUM
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.Ifafirmsellsontermsof2/10,net30days,anditsDSOis28days,thenthefactthatthe28dayDSOis
lessthanthe30daycreditperiodtellusthatthecreditdepartmentisfunctioningefficientlyandthereare
nopastdueaccounts.
a.True
b.False
(169)TradecreditFSAnswer:bMEDIUM
.Ifafirmswitchedfromtakingtradecreditdiscountstopayingonthenetduedate,thismightcostthefirm
somemoney,butsuchapolicywouldprobablyhaveonlyanegligibleeffectontheincomestatementand
noeffectwhateveronthebalancesheet.
a.True
b.False
(169)StretchingpayablesFSAnswer:aMEDIUM
.Ifaprofitablefirmfindsthatitsimplymust"stretch"itsaccountspayable,thenthissuggeststhatitis
undercapitalized,i.e.,thatitneedsmoreworkingcapitaltosupportitsoperations.
a.True
b.False
(169)StretchingpayablesFSAnswer:bMEDIUM
.Ifoneofyourfirm'scustomersis"stretching"itsaccountspayable,thismaybeanuisancebutitdoesnot
representarealfinancialcosttoyourfirmaslongasthecustomerperiodicallypaysoffitsentirebalance.
a.True
b.False
(1610)PrimerateFSAnswer:bMEDIUM
.Theprimeratechargedbybigmoneycenterbanksatanyonetimeislikelytovarygreatly(forexample,
asmuchas2to4percentagepoints)acrossbanksduetobanks'abilitytodifferentiatethemselvesand
becausedifferentbanksoperateindifferentpartsofthecountry.
a.True
b.False
(1610)RevolvingcreditFSAnswer:aMEDIUM
.Arevolvingcreditagreementisaformallineofcredit.Thefirmmustgenerallypayafeeontheunused
balanceofthecommittedfundstocompensatethebankforthecommitmenttoextendthosefunds.
a.True
b.False
(1610)PromissorynoteFSAnswer:bHARD
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.Apromissorynoteisthedocumentsignedwhenabankloanisexecuted,anditspecifiesfinancial
aspectsoftheloan.Thebankcanholdthenoteinitsloanportfolio,sellittoapermanentinvestorlikea
lifeinsurancecompanyorpensionfund,orbundleitwithothernotespayableanduseitascollateralforan
assetbackedsecuritythattradesontheopenmarket.
a.True
b.False
(161)WorkingcapitalCSAnswer:cEASY
.Otherthingsheldconstant,whichofthefollowingwillcauseanincreaseinnetworkingcapital?
a.Cashisusedtobuymarketablesecurities.
b.Acashdividendisdeclaredandpaid.
c.Merchandiseissoldataprofit,butthesaleisoncredit.
d.Longtermbondsareretiredwiththeproceedsofapreferredstockissue.
e.Missinginventoryiswrittenoffagainstretainedearnings.
(163)CurrentassetfinancingCSAnswer:aEASY
.Firmsgenerallychoosetofinancetemporarycurrentassetswithshorttermdebtbecause
a.matchingthematuritiesofassetsandliabilitiesreducesriskundersomecircumstances,andalso
becauseshorttermdebtisoftenlessexpensivethanlongtermcapital.
b.shortterminterestrateshavetraditionallybeenmorestablethanlongterminterestrates.
c.afirmthatborrowsheavilyonalongtermbasisismoreapttobeunabletorepaythedebtthanafirm
thatborrowsshortterm.
d.theyieldcurveisnormallydownwardsloping.
e.shorttermdebthasahighercostthanequitycapital.
(164)CashconversioncycleCSAnswer:bEASY
.HelenaFurnishingswantstoreduceitscashconversioncycle.Whichofthefollowingactionsshouldit
take?
a.Increasesaverageinventorywithoutincreasingsales.
b.TakestepstoreducetheDSO.
c.Startpayingitsbillssooner,whichwouldreducetheaverageaccountspayablebutnotaffectsales.
d.Sellcommonstocktoretirelongtermbonds.
e.Sellanissueoflongtermbondsandusetheproceedstobuybacksomeofitscommonstock.
(166)LockboxCSAnswer:dEASY
.Alockboxplanis
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a.usedtoprotectcash,i.e.,tokeepitfrombeingstolen.
b.usedtoidentifyinventorysafetystocks.
c.usedtoslowdownthecollectionofchecksourfirmwrites.
d.usedtospeedupthecollectionofchecksreceived.
e.usedprimarilybyfirmswherecurrencyisusedfrequentlyintransactions,suchasfastfoodrestaurants,
andlessfrequentlybyfirmsthatreceivepaymentsaschecks.
(166)LockboxCSAnswer:eEASY
.Alockboxplanismostbeneficialtofirmsthat
a.havesupplierswhooperateinmanydifferentpartsofthecountry.
b.havewidelydisbursedmanufacturingfacilities.
c.havealargemarketablesecuritiesportfolio,andcash,toprotect.
d.receivepaymentsintheformofcurrency,suchasfastfoodrestaurants,ratherthanintheformof
checks.
e.havecustomerswhooperateinmanydifferentpartsofthecountry.
(168)CreditpolicyCSAnswer:eEASY
.WhichofthefollowingisNOTcommonlyregardedasbeingacreditpolicyvariable?
a.Creditperiod.
b.Collectionpolicy.
c.Creditstandards.
d.Cashdiscounts.
e.Paymentsdeferralperiod.
(163)CurrentassetfinancingCSAnswer:cMEDIUM
.SwimSuitsUnlimitedisinahighlyseasonalbusiness,andthefollowingsummarybalancesheetdata
showitsassetsandliabilitiesatpeakandoffpeakseasons(inthousandsofdollars):
PeakOffPeak
Cash$50$30
Marketablesecurities020
Accountsreceivable4020
Inventories10050
Netfixedassets500500
Totalassets$690$620
Payablesandaccruals$30$10
Shorttermbankdebt500
Longtermdebt300300
Commonequity310310
Totalclaims$690$620
Fromthisdatawemayconcludethat
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a.SwimSuits'currentassetfinancingpolicycallsforexactlymatchingassetandliabilitymaturities.
liabilitymaturities
b.SwimSuits'currentassetfinancingpolicyisrelativelyaggressivethatis,thecompanyfinancessomeof
itspermanentassetswithshorttermdiscretionarydebt.
c.SwimSuitsfollowsarelativelyconservativeapproachtocurrentassetfinancingthatis,someofits
shorttermneedsaremetbypermanentcapital.
d.Withoutincomestatementdata,wecannotdeterminetheaggressivenessorconservatismofthe
company'scurrentassetfinancingpolicy.
e.Withoutcashflowdata,wecannotdeterminetheaggressivenessorconservatismofthecompany's
currentassetfinancingpolicy.
(163)CurrentassetfinancingCSAnswer:bMEDIUM
a.Networkingcapitalisdefinedascurrentassetsminusthesumofpayablesandaccruals,andany
increaseinthecurrentratioautomaticallyindicatesthatnetworkingcapitalhasincreased.
b.Althoughshortterminterestrateshavehistoricallyaveragedlessthanlongtermrates,theheavyuseof
shorttermdebtisconsideredtobeanaggressivestrategybecauseoftheinherentrisksassociatedwith
usingshorttermfinancing.
c.Ifacompanyfollowsapolicyof"matchingmaturities,"thismeansthatitmatchesitsuseofcommon
stockwithitsuseoflongtermdebtasopposedtoshorttermdebt.
d.Networkingcapitalisdefinedascurrentassetsminusthesumofpayablesandaccruals,andany
decreaseinthecurrentratioautomaticallyindicatesthatnetworkingcapitalhasdecreased.
e.Ifacompanyfollowsapolicyof"matchingmaturities,"thismeansthatitmatchesitsuseofshortterm
debtwithitsuseoflongtermdebt.
(164)CashconversioncycleCSAnswer:dMEDIUM
.Otherthingsheldconstant,whichofthefollowingwouldtendtoreducethecashconversioncycle?
a.Carryaconstantamountofreceivablesassalesdecline.
b.Placelargerordersforrawmaterialstotakeadvantageofpricebreaks.
c.Takealldiscountsthatareoffered.
d.Continuetotakealldiscountsthatareofferedandpayonthenetdate.
e.Offerlongerpaymenttermstocustomers.
(164)CashconversioncycleCSAnswer:aMEDIUM
.Whichofthefollowingactionswouldbelikelytoshortenthecashconversioncycle?
a.Adoptanewmanufacturingprocessthatspeedsuptheconversionofrawmaterialstofinishedgoods
from20daysto10days.
b.Changethecredittermsofferedtocustomersfrom3/10,net30to1/10,net50.
c.Begintotakediscountsoninventorypurchaseswebuyontermsof2/10,net30.
d.Adoptanewmanufacturingprocessthatsavessomelaborcostsbutslowsdowntheconversionofraw
materialstofinishedgoodsfrom10daysto20days.
e.Changethecredittermsofferedtocustomersfrom2/10,net30to1/10,net60.
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(165)CashbudgetCSAnswer:eMEDIUM
.WhichofthefollowingisNOTdirectlyreflectedinthecashbudgetofafirmthatisinthezerotax
bracket?
a.Paymentslags.
b.Paymentforplantconstruction.
c.Cumulativecash.
d.Repurchasesofcommonstock.
e.Writingoffbaddebts.
(165)CashbudgetCSAnswer:bMEDIUM
.WhichofthefollowingisNOTdirectlyreflectedinthecashbudgetofafirmthatisinthezerotax
bracket?
a.Paymentslags.
b.Depreciation.
c.Cumulativecash.
d.Repurchasesofcommonstock.
e.Paymentforplantconstruction.
(165)CashbudgetCSAnswer:aMEDIUM
.WhichofthefollowingstatementsconcerningthecashbudgetisCORRECT?
a.Depreciationexpenseisnotexplicitlyincluded,butdepreciation'seffectsarereflectedintheestimated
taxpayments.
b.Cashbudgetsdonotincludefinancialitemssuchasinterestanddividendpayments.
c.Cashbudgetsdonotincludecashinflowsfromlongtermsourcessuchastheissuanceofbonds.
d.ChangesthataffecttheDSOdonotaffectthecashbudget.
e.Capitalbudgetingdecisionshavenoeffectonthecashbudgetuntilprojectsgointooperationandstart
producingrevenues.
(165)CashbudgetCSAnswer:bMEDIUM
.Whichofthefollowingitemsshouldacompanyreportdirectlyinitsmonthlycashbudget?
a.Itsmonthlydepreciationexpense.
b.Cashproceedsfromsellingoneofitsdivisions.
c.Accruedinterestonzerocouponbondsthatitissued.
d.Newsharesissuedinastocksplit.
e.Newsharesissuedinastockdividend.
(165)CashbudgetCSAnswer:eMEDIUM
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a.Shortertermcashbudgets,ingeneral,areusedprimarilyforplanningpurposes,whilelongerterm
budgetsareusedforactualcashcontrol.
b.Thecashbudgetandthecapitalbudgetaredevelopedseparately,andalthoughtheyarebothimportant
tothefirm,onedoesnotaffecttheother.
c.Sincedepreciationisanoncashcharge,itneitherappearsonnorhasanyeffectonthecashbudget.
d.Thetargetcashbalanceshouldbesetsuchthatitneednotbeadjustedforseasonalpatternsand
unanticipatedfluctuationsinreceipts,althoughitshouldbechangedtoreflectlongtermchangesinthe
firm'soperations.
e.Thetypicalcashbudgetreflectsinterestpaidonloansaswellasincomefromtheinvestmentofsurplus
cash.Thesenumbers,aswellasotheritemsonthecashbudget,areexpectedvalueshence,actual
resultsmightvaryfromthebudgetedamounts.
(166)MarketablesecuritiesCSAnswer:cMEDIUM
.WhichofthefollowingisNOTasituationthatmightleadafirmtoincreaseitsholdingsofshortterm
marketablesecurities?
a.Thefirmmustmakeaknownfuturepayment,suchaspayingforanewplantthatisunderconstruction.
b.Thefirmisgoingfromitspeaksalesseasontoitsslackseason,soitsreceivablesandinventorieswill
experienceaseasonaldecline.
c.Thefirmisgoingfromitsslackseasontoitspeaksalesseason,soitsreceivablesandinventorieswill
experienceseasonalincreases.
d.Thefirmhasjustsoldlongtermsecuritiesandhasnotyetinvestedtheproceedsinoperatingassets.
e.Thefirmjustwonaproductliabilitysuitoneofitscustomershadbroughtagainstit.
(166)MarketablesecuritiesCSAnswer:dMEDIUM
.WhichofthefollowingstatementcompletionsisCORRECT?Iftheyieldcurveisupwardsloping,then
themarketablesecuritiesheldinafirm'sportfolio,assumedtobeheldforemergencies,should
a.consistmainlyoflongtermsecuritiesbecausetheypayhigherrates.
b.consistmainlyofshorttermsecuritiesbecausetheypayhigherrates.
c.consistmainlyofU.S.Treasurysecuritiestominimizeinterestraterisk.
d.consistmainlyofshorttermsecuritiestominimizeinterestraterisk.
e.bebalancedbetweenlongandshorttermsecuritiestominimizetheadverseeffectsofeitheran
upwardoradownwardtrendininterestrates.
(167)InventorymanagementCSAnswer:bMEDIUM
.Whichofthefollowingstatementsismostconsistentwithefficientinventorymanagement?Thefirmhas
a
a.belowaverageinventoryturnoverratio.
b.lowincidenceofproductionscheduledisruptions.
c.belowaveragetotalassetsturnoverratio.
d.relativelyhighcurrentratio.
e.relativelylowDSO.
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(168)ReceivablesmanagementCSAnswer:bMEDIUM
a.Afirmthatmakes90%ofitssalesoncreditand10%forcashisgrowingataconstantrateof10%
annually.Suchafirmwillbeabletokeepitsaccountsreceivableatthecurrentlevel,sincethe10%cash
salescanbeusedtofinancethe10%growthrate.
b.Inmanagingafirm'saccountsreceivable,itispossibletoincreasecreditsalesperdayyetstillkeep
accountsreceivablefairlysteady,providedthefirmcanshortenthelengthofitscollectionperiod(itsDSO)
sufficiently.
c.Becauseofthecostsofgrantingcredit,itisnotpossibleforcreditsalestobemoreprofitablethancash
sales.
d.Sincereceivablesandpayablesbothresultfromsalestransactions,afirmwithahighreceivablesto
salesratiomustalsohaveahighpayablestosalesratio.
e.Otherthingsheldconstant,ifafirmcanshortenitsDSO,thiswillleadtoahighercurrentratio.
(168)Dayssalesoutstanding(DSO)CSAnswer:cMEDIUM
a.Otherthingsheldconstant,thehigherafirm'sdayssalesoutstanding(DSO),thebetteritscredit
department.
b.Ifafirmthatsellsontermsofnet30changesitspolicyto2/10,net30,andifnochangeinsalesvolume
occurs,thenthefirm'sDSOwillprobablyincrease.
c.Ifafirmsellsontermsof2/10,net30,anditsDSOis30days,thenthefirmprobablyhassomepastdue
accounts.
d.Ifafirmsellsontermsofnet60,andifitssalesarehighlyseasonal,withasharppeakinDecember,
thenitsDSOasitistypicallycalculated(withsalesperday=Salesforpast12months/365)would
probablybelowerinJanuarythaninJuly.
e.Ifafirmchangedthecredittermsofferedtoitscustomersfrom2/10,net30to2/10,net60,thenits
salesshouldincrease,andthisshouldleadtoanincreaseinsalesperday,andthatshouldleadtoa
decreaseintheDSO.
(Comp.)CurrentassetfinancingCSAnswer:bMEDIUM
a.Tradecreditisprovidedonlytorelativelylarge,strongfirms.
b.Commercialpaperisaformofshorttermfinancingthatisprimarilyusedbylarge,strong,financially
stablecompanies.
c.Shorttermdebtisfavoredbyfirmsbecause,whileitisgenerallymoreexpensivethanlongtermdebt,it
exposestheborrowingfirmtolessriskthanlongtermdebt.
d.Commercialpapercanbeissuedbyvirtuallyanyfirmsolongasitiswillingtopaythegoinginterest
rate.
e.Commercialpaperistypicallyofferedatalongtermmaturityofatleastfiveyears.
(Comp.)CurrentassetfinancingCSAnswer:aMEDIUM
.WhichofthefollowingstatementsisNOTCORRECT?
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a.Commercialpapercanbeissuedbyvirtuallyanyfirmsolongasitiswillingtopaythegoinginterest
rate.
b.Accrualsare"free"inthesensethatnoexplicitinterestispaidonthesefunds.
c.Aconservativeapproachtoworkingcapitalmanagementwillresultinmostifnotallpermanentassets
beingfinancedwithlongtermcapital.
d.Therisktoafirmthatborrowswithshorttermcreditisusuallygreaterthanifitborrowedusinglongterm
debt.Thisaddedriskstemsfromthegreatervariabilityofinterestcostsonshorttermdebtandpossible
difficultieswithrollingovershorttermdebt.
e.Bankloansgenerallycarryahigherinterestratethancommercialpaper.
(Comp.)ShorttermfinancingCSAnswer:aMEDIUM
a.Undernormalconditions,afirm'sexpectedROEwouldprobablybehigherifitfinancedwithshortterm
ratherthanwithlongtermdebt,butusingshorttermdebtwouldprobablyincreasethefirm'srisk.
b.Conservativefirmsgenerallyusenoshorttermdebtandthushavezerocurrentliabilities.
c.Ashorttermloancanusuallybeobtainedmorequicklythanalongtermloan,butthecostofshortterm
debtisnormallyhigherthanthatoflongtermdebt.
d.Ifafirmthatcanborrowfromitsbankata6%interestratebuysmaterialsontermsof2/10,net30,and
ifitmustpaybyDay30orelsebecutoff,thenwewouldexpecttoseezeroaccountspayableonits
balancesheet.
e.Ifoneofyourfirm'scustomersis"stretching"itsaccountspayable,thismaybeanuisancebutitwillnot
haveanadversefinancialimpactonyourfirmifthecustomerperiodicallypaysoffitsentirebalance.
(Comp.)WorkingcapitalpolicyCSAnswer:dMEDIUM
.WhichofthefollowingstatementsisNOTCORRECT?
a.Acompanymayholdarelativelylargeamountofcashandmarketablesecuritiesifitisuncertainabout
itsvolumeofsales,profits,andcashflowsduringthecomingyear.
b.Creditpolicyhasanimpactonworkingcapitalbecauseitinfluencesbothsalesandthetimebefore
receivablesarecollected.
c.Thecashbudgetisusefultohelpestimatefuturefinancingneeds,especiallytheneedforshortterm
workingcapitalloans.
d.Ifafirmwantstogeneratemorecashflowfromoperationsinthenextmonthortwo,itcouldchangeits
creditpolicyfrom2/10,net30tonet60.
e.Managingworkingcapitalisimportantbecauseitinfluencesfinancingdecisionsandthefirm's
profitability.
(Comp.)WorkingcapitalconceptsCSAnswer:bMEDIUM
a.Depreciationisincludedintheestimateofcashflows(Cashflow=Netincome+Depreciation),hence
depreciationissetforthonaseparatelineinthecashbudget.
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b.Ifcashinflowsfromcollectionsoccurinequaldailyamountsbutmostpaymentsmustbemadeonthe
10thofeachmonth,thenaregularmonthlycashbudgetwillbemisleading.Theproblemcanbecorrected
byusingadailycashbudget.
c.Soundworkingcapitalpolicyisdesignedtomaximizethetimebetweencashexpendituresonmaterials
andthecollectionofcashonsales.
d.Ifafirmwantstogeneratemorecashflowfromoperationsinthenextmonthortwo,itcouldchangeits
creditpolicyfrom2/10,net30tonet60.
e.Ifafirmsellsontermsofnet90,andifitssalesarehighlyseasonal,with80%ofitssalesinSeptember,
thenitsDSOasitistypicallycalculated(withsalesperday=Salesforpast12months/365)would
probablybelowerinOctoberthaninAugust.
(Comp.)WorkingcapitalconceptsCSAnswer:cMEDIUM
a.Accrualsareanexpensivebutcommonlyusedwaytofinanceworkingcapital.
b.Aconservativefinancingpolicyisonewherethefirmfinancespartofitsfixedassetswithshortterm
capitalandallofitsnetworkingcapitalwithshorttermfunds.
c.Ifacompanyreceivestradecreditundertermsof2/10,net30,thisimpliesthatthecompanyhas10
daysoffreetradecredit.
d.Onecannottellifafirmhasaconservative,aggressive,ormoderatecurrentassetfinancingpolicy
withoutanexaminationofitscashbudget.
e.Ifafirmhasarelativelyaggressivecurrentassetfinancingpolicyvisvisotherfirmsinitsindustry,then
itscurrentratiowillprobablyberelativelyhigh.
Problems
(163)MaturitymatchingCSAnswer:eEASY
.HalkaCompanyisanogrowthfirm.Itssalesfluctuateseasonally,causingtotalassetstovaryfrom
$320,000to$410,000,butfixedassetsremainconstantat$260,000.Ifthefirmfollowsamaturity
matching(ormoderate)workingcapitalfinancingpolicy,whatisthemostlikelytotaloflongtermdebtplus
equitycapital?
a.$260,642
b.$274,360
c.$288,800
d.$304,000
e.$320,000
(164)CashconversioncycleCSAnswer:dEASY
.Cass&Companyhasthefollowingdata.Whatisthefirm'scashconversioncycle?
Inventoryconversionperiod=50days
Receivablescollectionperiod=17days
Payablesdeferralperiod=25days
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a.31days
b.34days
c.38days
d.42days
e.46days
(164)CashconversioncycleCSAnswer:bEASY
.RomanoInc.hasthefollowingdata.Whatisthefirm'scashconversioncycle?
a.33days
b.37days
c.41days
d.45days
e.49days
(164)CashconversioncycleCSAnswer:eEASY
.WhittingtonInc.hasthefollowingdata.Whatisthefirm'scashconversioncycle?
a.31days
b.34days
c.37days
d.41days
e.45days
(164)CashconversioncycleCSAnswer:dEASY
.InmooCompanysaverageageofaccountsreceivableis45days,theaverageageofaccountspayable
is40days,andtheaverageageofinventoryis69days.Assuminga365dayyear,whatisthelengthofits
cashconversioncycle?
a.63days
b.67days
c.70days
d.74days
e.78days
(165)CashbudgetCSAnswer:dEASY
.SingalInc.ispreparingitscashbudget.Itexpectstohavesalesof$30,000inJanuary,$35,000in
February,and$35,000inMarch.If20%ofsalesareforcash,40%arecreditsalespaidinthemonthafter
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thesale,andanother40%arecreditsalespaid2monthsafterthesale,whataretheexpectedcash
receiptsforMarch?
a.$24,057
b.$26,730
c.$29,700
d.$33,000
e.$36,300
(168)AccountsreceivablebalanceCSAnswer:aEASY
.DylPickleInc.hadcreditsalesof$3,500,000lastyearanditsdayssalesoutstandingwasDSO=35
days.Whatwasitsaveragereceivablesbalance,basedona365dayyear?
a.$335,616
b.$352,397
c.$370,017
d.$388,518
e.$407,944
(162)ROEandWCpolicyCSAnswer:cMEDIUM
.EdwardsEnterprisesfollowsamoderatecurrentassetinvestmentpolicy,butitisnowconsideringa
change,perhapstoarestrictedormaybetoarelaxedpolicy.Thefirmsannualsalesare$400,000its
fixedassetsare$100,000itstargetcapitalstructurecallsfor50%debtand50%equityitsEBITis
$35,000theinterestrateonitsdebtis10%anditstaxrateis40%.Witharestrictedpolicy,current
assetswillbe15%ofsales,whileunderarelaxedpolicytheywillbe25%ofsales.Whatisthedifference
intheprojectedROEsbetweentherestrictedandrelaxedpolicies?
a.4.25%
b.4.73%
c.5.25%
d.5.78%
e.6.35%
(164)DayssalesoutstandingCSAnswer:cMEDIUM
.DataonShickInc.for2008areshownbelow,alongwiththedayssalesoutstandingofthefirmsagainst
whichitbenchmarks.Thefirm'snewCFObelievesthatthecompanycouldreduceitsreceivablesenough
toreduceitsDSOtothebenchmarks'average.Ifthisweredone,byhowmuchwouldreceivables
decline?Usea365dayyear.
Sales$110,000
Accountsreceivable$16,000
Dayssalesoutstanding(DSO)53.09
Benchmarks'dayssalesoutstanding(DSO)20.00
a.$8,078
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b.$8,975
c.$9,973
d.$10,970
e.$12,067
(164)Inventoryconv.periodCSAnswer:dMEDIUM
.Yourfirm'scostofgoodssold(COGS)average$2,000,000permonth,anditkeepsinventoryequalto
50%ofitsmonthlyCOGSonhandatalltimes.Usinga365dayyear,whatisitsinventoryconversion
period?
a.11.7days
b.13.0days
c.14.4days
d.15.2days
e.16.7days
(164)Inventoryconv.periodCSAnswer:eMEDIUM
.DataonShinIncfor2008areshownbelow,alongwiththeinventoryconversionperiod(ICP)ofthefirms
againstwhichitbenchmarks.Thefirm'snewCFObelievesthatthecompanycouldreduceitsinventory
enoughtoreduceitsICPtothebenchmarks'average.Ifthisweredone,byhowmuchwouldinventories
decline?Usea365dayyear.
Costofgoodssold=$85,000
Inventory=$20,000
Inventoryconversionperiod(ICP)=85.88
Benchmarkinventoryconversionperiod(ICP)=38.00
a.$7,316
b.$8,129
c.$9,032
d.$10,036
e.$11,151
(164)PayablesdeferralperiodCSAnswer:eMEDIUM
.DataonWentzInc.for2008areshownbelow,alongwiththepayablesdeferralperiod(PDP)forthe
firmsagainstwhichitbenchmarks.Thefirm'snewCFObelievesthatthecompanycoulddelaypayments
enoughtoincreaseitsPDPtothebenchmarks'average.Ifthisweredone,byhowmuchwouldpayables
increase?Usea365dayyear.
Costofgoodssold=$75,000
Payables=$5,000
Payablesdeferralperiod(PDP)=24.33
Benchmarkpayablesdeferralperiod=30.00
a.$764
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b.$849
c.$943
d.$1,048
e.$1,164
(164)CashconversioncycleCSAnswer:eMEDIUM
.YourconsultingfirmwasrecentlyhiredtoimprovetheperformanceofShinSoenenInc,whichishighly
profitablebuthasbeenexperiencingcashshortagesduetoitshighgrowthrate.Asonepartofyour
analysis,youwanttodeterminethefirmscashconversioncycle.Usingthefollowinginformationanda
365dayyear,whatisthefirmspresentcashconversioncycle?
Averageinventory=$75,000
Annualsales=$600,000
Annualcostofgoodssold=$360,000
Averageaccountsreceivable=$160,000
Averageaccountspayable=$25,000
a.120.6days
b.126.9days
c.133.6days
d.140.6days
e.148.0days
.DeweyCorporationhasthefollowingdata,inthousands.Assuminga365dayyear,whatisthefirm's
cashconversioncycle?
Annualsales=$45,000
Inventory=$4,000
Accountsreceivable=$2,000
Accountspayable=$2,400
a.25days
b.28days
c.31days
d.35days
e.38days
.DesaiInc.hasthefollowingdata,inthousands.Assuminga365dayyear,whatisthefirm'scash
conversioncycle?
Annualsales=$45,000
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Inventory=$4,500
Accountsreceivable=$1,800
Accountspayable=$2,500
a.28days
b.32days
c.35days
d.39days
e.43days
(164)CashconversioncycleCSAnswer:aMEDIUM
.ZervosInc.hadthefollowingdatafor2008(inmillions).ThenewCFObelieves(1)thatanimproved
inventorymanagementsystemcouldlowertheaverageinventoryby$4,000,(2)thatimprovementsinthe
creditdepartmentcouldreducereceivablesby$2,000,and(3)thatthepurchasingdepartmentcould
negotiatebettercredittermsandtherebyincreaseaccountspayableby$2,000.Furthermore,shethinks
thatthesechangeswouldnotaffecteithersalesorthecostsofgoodssold.Ifthesechangesweremade,
byhowmanydayswouldthecashconversioncyclebelowered?
OriginalRevised
Annualsales:unchanged$110,000$110,000
Costofgoodssold:unchanged$80,000$80,000
Averageinventory:loweredby$4,000$20,000$16,000
Averagereceivables:loweredby$2,000$16,000$14,000
Averagepayables:increasedby$2,000$10,000$12,000
Daysinyear365365
a.34.0
b.37.4
c.41.2
d.45.3
e.49.8
(164)CashconversioncycleCSAnswer:bMEDIUM
.EdisonInc.hasannualsalesof$36,500,000,or$100,000adayona365daybasis.Thefirm'scostof
goodssoldis75%ofsales.Onaverage,thecompanyhas$9,000,000ininventoryand$8,000,000in
accountsreceivable.Thefirmislookingforwaystoshortenitscashconversioncycle.ItsCFOhas
proposednewpoliciesthatwouldresultina20%reductioninbothaverageinventoriesandaccounts
receivable.Shealsoanticipatesthatthesepolicieswouldreducesalesby10%,whilethepayables
deferralperiodwouldremainunchangedat35days.Whateffectwouldthesepolicieshaveonthe
company'scashconversioncycle?Roundtothenearestwholeday.
a.26days
b.22days
c.18days
d.14days
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e.11days
(164)CashconversioncycleCSAnswer:eMEDIUM
.VanDenBorshCorp.hasannualsalesof$50,735,000,anaverageinventorylevelof$15,012,000,and
averageaccountsreceivableof$10,008,000.Thefirm'scostofgoodssoldis85%ofsales.Thecompany
makesallpurchasesoncreditandhasalwayspaidonthe30thday.However,itnowplanstotakefull
advantageoftradecreditandtopayitssuppliersonthe40thday.TheCFOalsobelievesthatsalescan
bemaintainedattheexistinglevelbutinventorycanbeloweredby$1,946,000andaccountsreceivableby
$1,946,000.Whatwillbethenetchangeinthecashconversioncycle,assuminga365dayyear?
a.26.6days
b.29.5days
c.32.8days
d.36.4days
e.40.5days
(165)CashbudgetCSAnswer:cMEDIUM
.NogueirasCorpsbudgetedmonthlysalesare$5,000,andtheyareconstantfrommonthtomonth.40%
ofitscustomerspayinthefirstmonthandtakethe2%discount,whiletheremaining60%payinthemonth
followingthesaleanddonotreceiveadiscount.Thefirmhasnobaddebts.Purchasesfornextmonths
salesareconstantat50%ofprojectedsalesforthenextmonth.Otherpayments,whichincludewages,
rent,andtaxes,are25%ofsalesforthecurrentmonth.Constructacashbudgetforatypicalmonthand
calculatetheaveragecashgainorlossduringthemonth.
a.$1,092
b.$1,150
c.$1,210
d.$1,271
e.$1,334
(166)LockboxCSAnswer:dMEDIUM
.WhitmerInc.sellstocustomersallovertheU.S.,andallreceiptscomeintoitsheadquartersinNew
YorkCity.Thefirm'saverageaccountsreceivablebalanceis$2.5million,andtheyarefinancedbyabank
loanatan11%annualinterestrate.Thefirmisconsideringsettinguparegionallockboxsystemtospeed
upcollections,anditbelievesthiswouldreducereceivablesby20%.Iftheannualcostofthesystemis
$15,000,whatpretaxnetannualsavingswouldberealized?
a.$29,160
b.$32,400
c.$36,000
d.$40,000
e.$44,000
(169)Tradecredit:nom.costCSAnswer:aMEDIUM
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.Afirmbuysontermsof3/15,net45.Itdoesnottakethediscount,anditgenerallypaysafter60days.
Whatisthenominalannualpercentagecostofitsnonfreetradecredit,basedona365dayyear?
a.25.09%
b.27.59%
c.30.35%
d.33.39%
e.36.73%
(169)Tradecredit:nom.costCSAnswer:eMEDIUM
.AtlantaCement,Inc.buysontermsof2/15,net30.Itdoesnottakediscounts,andittypicallypays60
daysaftertheinvoicedate.Netpurchasesamountto$720,000peryear.Whatisthenominalannual
percentagecostofitsnonfreetradecredit,basedona365dayyear?
a.10.86%
b.12.07%
c.13.41%
d.14.90%
e.16.55%
(169)Tradecredit:nom.costCSAnswer:bMEDIUM
.Yourcompanyhasbeenofferedcredittermsof4/30,net90days.Whatwillbethenominalannual
percentagecostofitsnonfreetradecreditifitpays120daysafterthepurchase?(Assumea365day
year.)
a.16.05%
b.16.90%
c.17.74%
d.18.63%
e.19.56%
(169)Tradecredit:EARcostCSAnswer:dMEDIUM
.BumpasEnterprisespurchases$4,562,500ingoodsperyearfromitssolesupplierontermsof2/15,net
50.Ifthefirmchoosestopayontimebutdoesnottakethediscount,whatistheeffectiveannual
percentagecostofitsnonfreetradecredit?(Assumea365dayyear.)
a.20.11%
b.21.17%
c.22.28%
d.23.45%
e.24.63%
(169)Tradecredit:EARcostCSAnswer:cMEDIUM
.Afirmbuysontermsof2/8,net45days,itdoesnottakediscounts,anditactuallypaysafter58days.
Whatistheeffectiveannualpercentagecostofitsnonfreetradecredit?(Usea365dayyear.)
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a.14.34%
b.15.10%
c.15.89%
d.16.69%
e.17.52%
(169)FreetradecreditCSAnswer:aMEDIUM
.BuskirkConstructionbuysontermsof2/15,net60days.Itdoesnottakediscounts,andittypicallypays
ontime,60daysaftertheinvoicedate.Netpurchasesamountto$450,000peryear.Onaverage,how
muchfreetradecreditdoesthefirmreceiveduringtheyear?(Assumea365dayyear,andnotethat
purchasesarenetofdiscounts.)
a.$18,493
b.$19,418
c.$20,389
d.$21,408
e.$22,479
(169)CostlytradecreditCSAnswer:aMEDIUM
.IngramOfficeSupplies,Inc.,buysontermsof2/15,net50days.Itdoesnottakediscounts,andit
typicallypaysontime,50daysaftertheinvoicedate.Netpurchasesamountto$450,000peryear.On
average,whatisthedollaramountofcostlytradecredit(totalcreditfreecredit)thefirmreceivesduring
theyear?(Assumea365dayyear,andnotethatpurchasesarenetofdiscounts.)
a.$43,151
b.$45,308
c.$47,574
d.$49,952
e.$52,450
(169)CostlytradecreditCSAnswer:aMEDIUM
.RotonInc.purchasesmerchandiseontermsof2/15,net40,anditsgrosspurchases(i.e.,purchases
beforetakingoffthediscount)are$800,000peryear.Whatisthemaximumdollaramountofcostlytrade
creditthefirmcouldget,assumingitabidesbythesupplierscreditterms?(Assumea365dayyear.)
a.$53,699
b.$56,384
c.$59,203
d.$62,163
e.$65,271
(169)TotaltradecreditCSAnswer:aMEDIUM
.KirkDevelopmentbuysontermsof2/15,net60days.Itdoesnottakediscounts,andittypicallypayson
time,60daysaftertheinvoicedate.Netpurchasesamountto$550,000peryear.Onaverage,whatisthe
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dollaramountoftotaltradecredit(costly+free)thefirmreceivesduringtheyear,i.e.,whatareitsaverage
accountspayable?(Assumea365dayyear,andnotethatpurchasesarenetofdiscounts.)
a.$90,411
b.$94,932
c.$99,678
d.$104,662
e.$109,895
(169)StretchingacctspayableCSAnswer:eMEDIUM
.AffleckInc.'sbusinessisbooming,anditneedstoraisemorecapital.Thecompanypurchasessupplies
ontermsof1/10,net20,anditcurrentlytakesthediscount.Onewayofgettingtheneededfundswould
betoforgothediscount,andthefirm'sownerbelievesshecoulddelaypaymentto40dayswithout
adverseeffects.Whatwouldbetheeffectiveannualpercentagecostoffundsraisedbythisaction?
(Assumea365dayyear.)
a.10.59%
b.11.15%
c.11.74%
d.12.36%
e.13.01%
(1610)RevolvingcreditagreementCSAnswer:bMEDIUM
.WeissInc.arrangeda$9,000,000revolvingcreditagreementwithagroupofbanks.Thefirmpaidan
annualcommitmentfeeof0.5%oftheunusedbalanceoftheloancommitment.Ontheusedportionofthe
revolver,itpaid1.5%aboveprimeforthefundsactuallyborrowedonasimpleinterestbasis.Theprime
ratewas9%duringtheyear.Ifthefirmborrowed$6,000,000immediatelyaftertheagreementwassigned
andrepaidtheloanattheendofoneyear,whatwasthetotaldollarannualcostoftherevolver?
a.$612,750
b.$645,000
c.$677,250
d.$711,113
e.$746,668
(164)CashconversioncycleCSAnswer:aHARD
.SoenenInc.hadthefollowingdatafor2008(inmillions).ThenewCFObelievesthatthecompanycould
improveitsworkingcapitalmanagementsufficientlytobringitsNWCandCCCuptothebenchmark
companies'levelwithoutaffectingeithersalesorthecostsofgoodssold.Soenenfinancesitsnetworking
capitalwithabankloanatan8%annualinterestrate,anditusesa365dayyear.Ifthesechangeshad
beenmade,byhowmuchwouldthefirm'spretaxincomehaveincreased?
OriginalBenchmarks
DataRelatedCCCCCC
Sales$100,000
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Costofgoodssold$80,000
Inventory(ICP)$20,00091.2538.00
Receivables(DSO)$16,00058.4020.00
Payables(PDP)$5,00022.8130.00
126.8428.00
a.1,901
b.2,092
c.2,301
d.2,531
e.2,784
(164)CashconversioncycleCSAnswer:cHARD
.MargetisInc.carriesanaverageinventoryof$750,000.Itsannualsalesare$10million,itscostof
goodssoldis75%ofannualsales,anditsreceivablescollectionperiodistwiceaslongasitsinventory
conversionperiod.Thefirmbuysontermsofnet30days,anditpaysontime.ItsnewCFOwantsto
decreasethecashconversioncycleby10days,basedona365dayyear.Hebelieveshecanreducethe
averageinventoryto$647,260withnoeffectonsales.Byhowmuchmustthefirmalsoreduceits
accountsreceivabletomeetitsgoalinthereductionofthecashconversioncycle?
a.$123,630
b.$130,137
c.$136,986
d.$143,836
e.$151,027
(169)Tradecredit:EARcostCSAnswer:bHARD
.Supposethecredittermsofferedtoyourfirmbyitssuppliersare2/10,net30days.Yourfirmisnot
takingdiscounts,butispayingafter25daysinsteadofwaitinguntilDay30.Youpointoutthatthenominal
costofnottakingthediscountandpayingonDay30isapproximately37%.Butsinceyourfirmisneither
takingdiscountsnorpayingontheduedate,whatistheeffectiveannualpercentagecost(notthenominal
cost)ofitscostlytradecredit,usinga365dayyear?
a.60.3%
b.63.5%
c.66.7%
d.70.0%
e.73.5%
(169)AccountspayablebalanceCSAnswer:eHARD
.AggarwalInc.buysontermsof2/10,net30,anditalwayspaysonthe30thday.TheCFOcalculates
thattheaverageamountofcostlytradecreditcarriedis$375,000.Whatisthefirm'saverageaccounts
payablebalance?Assumea365dayyear.
a.$458,160
b.$482,273
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c.$507,656
d.$534,375
e.$562,500
(169)Fin.stmts.andtradecreditCSAnswer:dHARD
.GonzalesCompanycurrentlyusesmaximumtradecreditbynottakingdiscountsonitspurchases.The
standardindustrycredittermsofferedbyallitssuppliersare2/10,net30days,andthefirmpaysontime.
ThenewCFOisconsideringborrowingfromitsbank,usingshorttermnotespayable,andthentaking
discounts.Thefirmwantstodeterminetheeffectofthispolicychangeonitsnetincome.Itsnet
purchasesare$11,760perday,usinga365dayyear.Theinterestrateonthenotespayableis10%,and
thetaxrateis40%.Ifthefirmimplementstheplan,whatistheexpectedchangeinnetincome?
a.$32,964
b.$34,699
c.$36,526
d.$38,448
e.$40,370
(Comp.)InventoryturnoverandDSOCSAnswer:cHARD
.ZarrukConstructionsDSOis50days(ona365daybasis),accountsreceivableare$100million,andits
balancesheetshowsinventoryof$125million.Whatistheinventoryturnoverratio?
a.4.73
b.5.26
c.5.84
d.6.42
e.7.07
(Comp.)Workingcapital,FCFCSAnswer:bHARD
.MaduraInc.wantstoincreaseitsfreecashflowby$180millionduringthecomingyear,whichshould
resultinahigherEVAandstockprice.TheCFOhasmadetheseprojectionsfortheupcomingyear:
EBITisprojectedtoequal$850million.
Grosscapitalexpendituresareexpectedtototalto$360millionversusdepreciationof$120million,soits
netcapitalexpendituresshouldtotal$240million.
Thetaxrateis40%.
Therewillbenochangesincashormarketablesecurities,norwilltherebeanychangesinnotespayable
oraccruals.
Whatincreaseinnetworkingcapital(inmillionsofdollars)wouldenablethefirmtomeetitstargetincrease
inFCF?
a.$72
b.$90
c.$108
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d.$130
e.$156
MultiplePart:
(ThefollowingdataapplytoProblems126128.)
ZornCorporationisdecidingwhethertopursuearestrictedorrelaxedworkingcapitalinvestmentpolicy.
Thefirm'sannualsalesareexpectedtototal$3,600,000,itsfixedassetsturnoverratioequals4.0,andits
debtandcommonequityareeach50%oftotalassets.EBITis$150,000,theinterestrateonthefirm's
debtis10%,andthetaxrateis40%.Ifthecompanyfollowsarestrictedpolicy,itstotalassetsturnoverwill
be2.5.Underarelaxedpolicyitstotalassetsturnoverwillbe2.2.
(163)WCinvestmentpolicyCSAnswer:dMEDIUM
.Ifthefirmadoptsarestrictedpolicy,howmuchlowerwoulditsinterestexpensebethanunderthe
relaxedpolicy?
a.$8,418
b.$8,861
c.$9,327
d.$9,818
e.$10,309
(163)WCinvestment,ROECSAnswer:bMEDIUM
.What'sthedifferenceintheprojectedROEsundertherestrictedandrelaxedpolicies?
a.1.20%
b.1.50%
c.1.80%
d.2.16%
e.2.59%
(163)WCinvestment,ROECSAnswer:aMEDIUM
.Assumenowthatthecompanybelievesthatifitadoptsarestrictedpolicy,itssaleswillfallby15%and
EBITwillfallby10%,butitstotalassetsturnover,debtratio,interestrate,andtaxratewillallremainthe
same.Inthissituation,what'sthedifferencebetweentheprojectedROEsundertherestrictedandrelaxed
policies?
a.2.24%
b.2.46%
c.2.70%
d.2.98%
e.3.27%
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CHAPTER17
FINANCIALPLANNINGANDFORECASTING
(DifficultyLevels:Easy,Easy/Medium,Medium,Medium/Hard,andHard)
PleaseseetheprefaceforinformationontheAACSBletterindicators(F,M,etc.)onthesubjectlines.
MultipleChoice:True/False
(172)SalesforecastFKAnswer:aEASY
.Thefirst,andmostcritical,stepinconstructingasetofforecastedfinancialstatementsisthesales
forecast.
a.True
b.False
(172)SalesforecastFKAnswer:aEASY
.Atypicalsalesforecast,thoughconcernedwithfutureevents,willusuallybebasedonrecenthistorical
trendsandeventsaswellasonforecastsofeconomicprospects.
a.True
b.False
(172)SalesforecastFKAnswer:bEASY
.Errorsinthesalesforecastcanbeoffsetbysimilarerrorsincostsandincomeforecasts.Thus,aslong
astheerrorsarenotlarge,salesforecastaccuracyisnotcriticaltothefirm.
a.True
b.False
(173)Spontaneouslygen.fundsFKAnswer:aEASY
.Asafirm'ssalesgrow,itscurrentassetsalsotendtoincrease.Forinstance,assalesincrease,the
firm'sinventoriesgenerallyincrease,andpurchasesofinventoriesresultinmoreaccountspayable.Thus,
spontaneouslygeneratedfundsarisefromtransactionsbroughtonbysalesincreases.
a.True
b.False
(173)Spontaneouslygen.fundsFKAnswer:bEASY
.Theterm"spontaneouslygeneratedfunds"generallyreferstoincreasesinthecashaccountthatresult
fromgrowthinsales,assumingthefirmisoperatingwithapositiveprofitmargin.
a.True
b.False
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(173)AssetincreaseFKAnswer:aEASY
.Arapidbuildupofinventoriesnormallyrequiresadditionalfinancing,unlesstheincreaseismatchedby
anequallylargedecreaseinsomeotherasset.
a.True
b.False
(173)AdditionalfundsneededFKAnswer:bEASY
.Ifafirmwantstomaintainitsratiosattheirexistinglevels,thenifithasapositivesalesgrowthrateof
anyamount,itwillrequiresomeamountofexternalfunding.
a.True
b.False
(173)AdditionalfundsneededFKAnswer:bEASY
.Todeterminetheamountofadditionalfundsneeded(AFN),youmaysubtracttheexpectedincreasein
liabilities,whichrepresentsasourceoffunds,fromthesumoftheexpectedincreasesinretainedearnings
andassets,bothofwhichareusesoffunds.
a.True
b.False
(174)ForecastedstatementsFKAnswer:aEASY
.Oneofthekeystepsinthedevelopmentoftheforecastedbalancesheetistoidentifythoseassetsand
liabilitiesthatincreaseatthesamerateassales.
a.True
b.False
(173)AdditionalfundsneededFKAnswer:aMEDIUM
.Ifafirmwithapositivenetworthisoperatingitsfixedassetsatfullcapacity,ifitsdividendpayoutratiois
100%,andifitwantstoholdallfinancialratiosconstant,thenforanypositivegrowthrateinsales,itwill
requireexternalfinancing.
a.True
b.False
(173)AdditionalfundsneededFKAnswer:bMEDIUM
.Afirm'sprofitmarginis5%,itsdebt/assetsratiois56%,anditsdividendpayoutratiois40%.Ifthefirm
isoperatingatlessthanfullcapacity,thensalescouldincreasetosomeextentwithouttheneedfor
externalfunds,butifitisoperatingatfullcapacitywithrespecttoallassets,includingfixedassets,then
anypositivegrowthinsaleswillrequiresomeexternalfinancing.
a.True
b.False
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(173)CapitalintensityratioFKAnswer:aMEDIUM
.Twofirmswithidenticalcapitalintensityratiosaregeneratingthesameamountofsales.However,Firm
Aisoperatingatfullcapacity,whileFirmBisoperatingbelowcapacity.Ifthetwofirmsexpectthesame
growthinsalesduringthenextperiod,thenFirmAislikelytoneedmoreadditionalfundsthanFirmB,
otherthingsheldconstant.
a.True
b.False
(173)CapitalintensityratioFKAnswer:bMEDIUM
.Ifafirm'scapitalintensityratio(A*0/S0)decreasesassalesincrease,useoftheAFNformulaislikelyto
understatetheamountofadditionalfundsrequired,otherthingsheldconstant.
a.True
b.False
(174)FinancialforecastingFKAnswer:bMEDIUM
.Thefactthatlongtermdebtandcommonstockareraisedinfrequentlyandinlargeamountslessensthe
needforthefirmtoforecastthoseaccountsonacontinualbasis.
a.True
b.False
(175)AFNformulaandlinearreg.FKAnswer:aMEDIUM
.WhenweusetheAFNformulatoforecasttheadditionalfundsneeded(AFN),weareimplicitlyassuming
thatallfinancialratiosareconstant.Iffinancialratiosarenotconstant,regressiontechniquescanbeused
toimprovethefinancialforecast.
a.True
b.False
(171)StrategicplanningCKAnswer:cEASY
.WhichofthefollowingisNOTakeyelementinstrategicplanningasitisdescribedinthetext?
a.Themissionstatement.
b.Thestatementofthecorporationsscope.
c.Thestatementofcashflows.
d.Thestatementofcorporateobjectives.
e.Theoperatingplan.
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(173)AFNformulamethodCKAnswer:bEASY
.WhichofthefollowingassumptionsisembodiedintheAFNformula?
a.Allbalancesheetaccountsaretieddirectlytosales.
b.Accountspayableandaccrualsaretieddirectlytosales.
c.Commonstockandlongtermdebtaretieddirectlytosales.
d.Fixedassets,butnotcurrentassets,aretieddirectlytosales.
e.Lastyearstotalassetswerenotoptimalforlastyearssales.
(173)AdditionalfundsneededCKAnswer:aEASY/MEDIUM
.JeffersonCityComputershasdevelopedaforecastingmodeltoestimateitsAFNfortheupcomingyear.
Allelsebeingequal,whichofthefollowingfactorsismostlikelytoleadtoanincreaseoftheadditional
fundsneeded(AFN)?
a.Asharpincreaseinitsforecastedsales.
b.Asharpreductioninitsforecastedsales.
c.Thecompanyreducesitsdividendpayoutratio.
d.Thecompanyswitchesitsmaterialspurchasestoasupplierthatsellsontermsof1/5,net90,froma
supplierwhosetermsare3/15,net35.
e.Thecompanydiscoversthatithasexcesscapacityinitsfixedassets.
(173)AdditionalfundsneededCKAnswer:bEASY/MEDIUM
.Thetermadditionalfundsneeded(AFN)isgenerallydefinedasfollows:
a.Fundsthatareobtainedautomaticallyfromroutinebusinesstransactions.
b.Fundsthatafirmmustraiseexternallyfromnonspontaneoussources,i.e.,byborrowingorbyselling
newstock,tosupportoperations.
c.Theamountofassetsrequiredperdollarofsales.
d.Theamountofinternallygeneratedcashinagivenyearminustheamountofcashneededtoacquire
thenewassetsneededtosupportgrowth.
e.Aforecastingapproachinwhichtheforecastedpercentageofsalesforeachbalancesheetaccountis
heldconstant.
(173)CapitalintensityratioCKAnswer:eEASY/MEDIUM
.Thecapitalintensityratioisgenerallydefinedasfollows:
a.Salesdividedbytotalassets,i.e.,thetotalassetsturnoverratio.
b.Thepercentageofliabilitiesthatincreasespontaneouslyasapercentageofsales.
c.Theratioofsalestocurrentassets.
d.Theratioofcurrentassetstosales.
e.Theamountofassetsrequiredperdollarofsales,orA*0/S0.
(171)FinancialplanningCKAnswer:eMEDIUM
.WhichofthefollowingisNOToneofthestepstakeninthefinancialplanningprocess?
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a.Assumptionsaremadeaboutfuturelevelsofsales,costs,andinterestratesforuseintheforecast.
b.Theentirefinancialplanisreexamined,assumptionsarereviewed,andthemanagementteam
considershowadditionalchangesinoperationsmightimproveresults.
c.Projectedratiosarecalculatedandanalyzed.
d.Developasetofprojectedfinancialstatements.
e.Consultwithkeycompetitorsabouttheoptimalsetofpricestocharge,i.e.,thepricesthatwillmaximize
profitsforourfirmanditscompetitors.
(173)Spontaneouslygen.fundsCKAnswer:dMEDIUM
.Spontaneouslygeneratedfundsaregenerallydefinedasfollows:
a.Assetsrequiredperdollarofsales.
b.Aforecastingapproachinwhichtheforecastedpercentageofsalesforeachitemisheldconstant.
c.Fundsthatafirmmustraiseexternallythroughborrowingorbysellingnewcommonorpreferredstock.
d.Fundsthatariseoutofnormalbusinessoperationsfromitssuppliers,employees,andthegovernment,
andtheyincludespontaneousincreasesinaccountspayableandaccruals.
e.Theamountofcashraisedinagivenyearminustheamountofcashneededtofinancetheadditional
capitalexpendituresandworkingcapitalneededtosupportthefirmsgrowth.
(173)AdditionalfundsneededCKAnswer:bMEDIUM
.Acompanyexpectssalestoincreaseduringthecomingyear,anditisusingtheAFNequationto
forecasttheadditionalcapitalthatitmustraise.WhichofthefollowingconditionswouldcausetheAFNto
increase?
a.Thecompanypreviouslythoughtitsfixedassetswerebeingoperatedatfullcapacity,butnowitlearns
thatitactuallyhasexcesscapacity.
b.Thecompanyincreasesitsdividendpayoutratio.
c.Thecompanybeginstopayemployeesmonthlyratherthanweekly.
d.Thecompanysprofitmarginincreases.
e.Thecompanydecidestostoptakingdiscountsonpurchasedmaterials.
(Comp.)ForecastingconceptsCKAnswer:bMEDIUM
a.Perhapsthemostimportantstepwhendevelopingforecastedfinancialstatementsistodeterminethe
breakdownofcommonequitybetweencommonstockandretainedearnings.
b.Thefirst,andperhapsthemostcritical,stepinforecastingfinancialrequirementsistoforecastfuture
sales.
c.Forecastedfinancialstatements,asdiscussedinthetext,areusedprimarilyasapartofthemanagerial
compensationprogram,wheremanagementshistoricalperformanceisevaluated.
d.Thecapitalintensityratiogivesusanideaofthephysicalconditionofthefirmsfixedassets.
e.TheAFNequationproducesmoreaccurateforecaststhantheforecastedfinancialstatementmethod,
especiallyiffixedassetsarelumpyandeconomiesofscaleexist.
(171)StrategicplanningCKAnswer:cMEDIUM/HARD
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a.Onceafirmhasdefineditspurpose,scope,andobjectives,itmustdevelopastrategyorstrategiesfor
achievingitsgoals.Thestatementofcorporatestrategiessetsforthdetailedplansratherthanbroad
approachesforachievingafirm'sgoals.
b.Afirmscorporatepurposestatesthegeneralphilosophyofthebusinessandprovidesmanagerswith
specificoperationalobjectives.
c.Operatingplansprovidemanagementwithdetailedimplementationguidance,consistentwiththe
corporatestrategy,tohelpmeetthecorporateobjectives.Theseoperatingplanscanbedevelopedforany
timehorizon,butmanycompaniesusea5yearhorizon.
d.Afirmsmissionstatementdefinesitslinesofbusinessandgeographicareaofoperations.
e.Thecorporatescopeisacondensedversionoftheentiresetofstrategicplans.
(173)AdditionalfundsneededCKAnswer:dMEDIUM/HARD
a.Sinceaccountspayableandaccruedliabilitiesmusteventuallybepaidoff,astheseaccountsincrease,
AFNascalculatedbytheAFNequationmustalsoincrease.
b.Supposeafirmisoperatingitsfixedassetsatbelow100%ofcapacity,butithasnoexcesscurrent
assets.BasedontheAFNequation,itsAFNwillbelargerthanifithadbeenoperatingwithexcess
capacityinbothfixedandcurrentassets.
c.Ifafirmretainsallofitsearnings,thenitcannotrequireanyadditionalfundstosupportsalesgrowth.
d.Additionalfundsneeded(AFN)aretypicallyraisedusingacombinationofnotespayable,longterm
debt,andcommonstock.Suchfundsarenonspontaneousinthesensethattheyrequireexplicitfinancing
decisionstoobtainthem.
e.Ifafirmhasapositivefreecashflow,thenitmusthaveeitherazerooranegativeAFN.
(173)AdditionalfundsneededCKAnswer:dMEDIUM/HARD
a.Anyforecastoffinancialrequirementsinvolvesdetermininghowmuchmoneythefirmwillneed,andthis
needisdeterminedbyaddingtogetherincreasesinassetsandspontaneousliabilitiesandthensubtracting
operatingincome.
b.TheAFNequationforforecastingfundsrequirementsrequiresonlyaforecastofthefirmsbalance
sheet.Althoughaforecastedincomestatementmayhelpclarifytheresults,incomestatementdataare
notessentialbecausefundsneededrelateonlytothebalancesheet.
c.Dividendsarepaidwithcashtakenfromtheaccumulatedretainedearningsaccount,hencedividend
policydoesnotaffecttheAFNforecast.
d.AnegativeAFNindicatesthatretainedearningsandspontaneouscapitalarefarmorethansufficientto
financetheadditionalassetsneeded.
e.Ifassetsandspontaneouslygeneratedliabilitiesarenotprojectedtogrowatthesamerateassales,
thentheAFNmethodwillprovidemoreaccurateforecaststhantheprojectedfinancialstatementmethod.
(173)AFNequationCKAnswer:aMEDIUM/HARD
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a.Thesustainablegrowthrateisthemaximumachievablegrowthratewithoutthefirmhavingtoraise
externalfunds.Inotherwords,itisthegrowthrateatwhichthefirm'sAFNequalszero.
b.Ifafirmsassetsaregrowingatapositiverate,butitsretainedearningsarenotincreasing,thenitwould
beimpossibleforthefirmsAFNtobenegative.
c.Ifafirmincreasesitsdividendpayoutratioinanticipationofhigherearnings,butsalesandearnings
actuallydecrease,thenthefirmsactualAFNmust,mathematically,exceedthepreviouslycalculatedAFN.
d.Highersalesusuallyrequirehigherassetlevels,andthisleadstowhatwecallAFN.However,theAFN
willbezeroifthefirmchoosestoretainallofitsprofits,i.e.,tohaveazerodividendpayoutratio.
e.DividendpolicydoesnotaffecttherequirementforexternalfundsbasedontheAFNequation.
(175)Forecastingfinancialreqs.CKAnswer:cMEDIUM/HARD
a.WhenweusetheAFNequation,weassumethattheratiosofassetsandliabilitiestosales(A*0/S0and
L*0/S0)varyfromyeartoyearinastable,predictablemanner.
b.Whenfixedassetsareaddedinlarge,discreteunitsasacompanygrows,theassumptionofconstant
ratiosismoreappropriatethanifassetsarerelativelysmallandcanbeaddedinsmallincrementsassales
grow.
c.Firmswhosefixedassetsarelumpyfrequentlyhaveexcesscapacity,andthisshouldbeaccountedfor
inthefinancialforecastingprocess.
d.Forafirmthatuseslumpyassets,itisimpossibletohavesmallincreasesinsaleswithoutexpanding
fixedassets.
e.Regressiontechniquescannotbeusedinsituationswhereexcesscapacityoreconomiesofscaleexist.
Problems
(173)ExcesscapacityCKAnswer:aEASY
.LastyearGodinhoCorp.had$250millionofsales,andithad$75millionoffixedassetsthatwerebeing
operatedat80%ofcapacity.Inmillions,howlargecouldsaleshavebeenifthecompanyhadoperatedat
fullcapacity?
a.$312.5
b.$328.1
c.$344.5
d.$361.8
e.$379.8
(175)Forecastinginv.regressionCKAnswer:dEASY
.KamathMeierCorporation'sCFOusesthisequation,whichwasdevelopedbyregressinginventorieson
salesoverthepast5years,toforecastinventoryrequirements:Inventories=$22.0+0.125(Sales).The
companyexpectssalesof$400millionduringthecurrentyear,anditexpectssalestogrowby30%next
year.Whatistheinventoryforecastfornextyear?Alldollarsareinmillions.
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exam2
a.$74.6
b.$78.5
c.$82.7
d.$87.0
e.$91.4
(173)ExcesscapacityCKAnswer:cMEDIUM
.LastyearWeiGuanInc.had$350millionofsales,andithad$270millionoffixedassetsthatwereused
at65%ofcapacity.Inmillions,byhowmuchcouldWeiGuan'ssalesincreasebeforeitisrequiredto
increaseitsfixedassets?
a.$170.09
b.$179.04
c.$188.46
d.$197.88
e.$207.78
(173)ExcesscapacityCKAnswer:eMEDIUM
.LastyearHandorfZhuInc.had$850millionofsales,andithad$425millionoffixedassetsthatwere
usedatonly60%ofcapacity.Whatisthemaximumsalesgrowthratethecompanycouldachievebefore
ithadtoincreaseitsfixedassets?
a.54.30%
b.57.16%
c.60.17%
d.63.33%
e.66.67%
(173)FindingtargetFA/SratioCKAnswer:bMEDIUM
.LastyearJainTechnologieshad$250millionofsalesand$100millionoffixedassets,soitsFA/Sales
ratiowas40%.However,itsfixedassetswereusedatonly75%ofcapacity.Nowthecompanyis
developingitsfinancialforecastforthecomingyear.Aspartofthatprocess,thecompanywantstosetits
targetFixedAssets/Salesratioatthelevelitwouldhavehadhaditbeenoperatingatfullcapacity.What
targetFA/Salesratioshouldthecompanyset?
a.28.5%
b.30.0%
c.31.5%
d.33.1%
e.34.7%
(175)Forecastinginv.turnoverCKAnswer:aMEDIUM
.FairchildGardenSupplyexpects$600millionofsalesthisyear,anditforecastsa15%increasefornext
year.TheCFOusesthisequationtoforecastinventoryrequirementsatdifferentlevelsofsales:
Inventories=$30.2+0.25(Sales).Alldollarsareinmillions.Whatistheprojectedinventoryturnover
ratioforthecomingyear?
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a.3.40
b.3.57
c.3.75
d.3.94
e.4.14
(173)PositiveAFNCKAnswer:dMEDIUM/HARD
.ClaytonIndustriesisplanningitsoperationsfornextyear,andRonnieClayton,theCEO,wantsyouto
forecastthefirm'sadditionalfundsneeded(AFN).Dataforuseinyourforecastareshownbelow.Based
ontheAFNequation,whatistheAFNforthecomingyear?Dollarsareinmillions.
Lastyearssales=S0$350Lastyearsaccountspayable$40
Salesgrowthrate=g30%Lastyearsnotespayable$50
Lastyearstotalassets=A*0$500Lastyearsaccruals$30
Lastyearsprofitmargin=M5%Targetpayoutratio60%
a.$102.8
b.$108.2
c.$113.9
d.$119.9
e.$125.9
(173)NegativeAFNCKAnswer:cMEDIUM/HARD
.ChuaChang&WuInc.isplanningitsoperationsfornextyear,andtheCEOwantsyoutoforecastthe
firm'sadditionalfundsneeded(AFN).Dataforuseinyourforecastareshownbelow.BasedontheAFN
equation,whatistheAFNforthecomingyear?
Lastyearssales=S0$200,000Lastyear'saccountspayable$50,000
Salesgrowthrate=g40%Lastyear'snotespayable$15,000
Lastyearstotalassets=A*0$135,000Lastyear'saccruals$20,000
Lastyearsprofitmargin=M20.0%Targetpayoutratio25.0%
a.$14,440
b.$15,200
c.$16,000
d.$16,800
e.$17,640
(173)AFNchangingdiv.payoutCKAnswer:bMEDIUM/HARD
.Howton&HowtonWorldwide(HHW)isplanningitsoperationsforthecomingyear,andtheCEOwants
youtoforecastthefirm'sadditionalfundsneeded(AFN).Dataforuseintheforecastareshownbelow.
However,theCEOisconcernedabouttheimpactofachangeinthepayoutratiofromthe10%thatwas
usedinthepastto50%,whichthefirm'sinvestmentbankershaverecommended.BasedontheAFN
equation,byhowmuchwouldtheAFNforthecomingyearchangeifHHWincreasedthepayoutfrom10%
tothenewandhigherlevel?Alldollarsareinmillions.
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exam2
Lastyearssales=S0$300.0Lastyearsaccountspayable$50.0
Salesgrowthrate=g40%Lastyearsnotespayable$15.0
Lastyearstotalassets=A0$500.0Lastyearsaccruals$20.0
Lastyearsprofitmargin=M20.0%Initialpayoutratio10.0%
a.$31.9
b.$33.6
c.$35.3
d.$37.0
e.$38.9
(173)FindingtargetFA/SratioCKAnswer:bHARD
.LastyearEmeryIndustrieshad$450millionofsalesand$225millionoffixedassets,soitsFA/Sales
ratiowas50%.However,itsfixedassetswereusedatonly65%ofcapacity.Ifthecompanyhadbeen
abletoselloffenoughofitsfixedassetsatbookvaluesothatitwasoperatingatfullcapacity,withsales
heldconstantat$450million,howmuchcash(inmillions)wouldithavegenerated?
a.$74.81
b.$78.75
c.$82.69
d.$86.82
e.$91.16
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