TEST BANK For Analysis for Financial Management 10th Edition By Robert Higgins | Complete Chapters 1 by digitaldownload87

ch 1 Student: ___________________________________________________________________________

Which of the following statements concerning the cash flow production cycle is true? A. The profits reported in a given time period equal the cash flows generated. B. A company's operations and finances are independent of each other. C. Financial statements have nothing to do with reality. D. The movement of cash to inventory, to accounts receivable, and back to cash is known as the firm's working capital cycle. E. A profitable company will always have sufficient cash to meet its obligations.

Which of the following statements concerning a firm's cash flows and profits is false? A. Managers must be at least as concerned with cash flows as with profits. B A company that sells merchandise at a profit will generate cash soon enough to replenish cash flows . required for continued production. C. The cash flows generated in a given time period can differ from the profits reported. D. Profits are no assurance that cash flow will be sufficient to maintain solvency. E. Due to required cash investments in current assets, fast-growing and profitable companies can literally "grow broke".

Which one of the following is the financial statement that shows a financial snapshot, taken at a point in time, of all the assets the company owns and all the claims against those assets? A. income statement B. creditor's statement C. balance sheet D. cash flow statement E. sources and uses statement

Which one of the following is the financial statement that summarizes a firm's revenue and expenses over a period of time? A. income statement B. balance sheet C. cash flow statement D. sources and uses statement E. market value statement

Which one of the following is the financial statement that summarizes changes in the company's cash balance over a period of time? A. income statement B. balance sheet C. cash flow statement D. shareholders' equity statement E. market value statement

The sources and uses of cash over a stated period of time are reflected on the: A. income statement. B. balance sheet. C. shareholders' equity statement. D. cash flow statement. E. statement of operating position.

Which one of the following is a source of cash? A. increase in accounts receivable B. decrease in notes payable C. decrease in common stock D. increase in inventory E. increase in accounts payable

Which one of the following is a use of cash? A. increase in notes payable B. increase in inventory C. increase in long-term debt D. decrease in accounts receivable E. increase in common stock

Which one of the following is a source of cash? A. decrease in accounts receivable B. decrease in common stock C. decrease in long-term debt D. decrease in accounts payable E. increase in inventory

10. Noncash items refer to: A. sales which are made on a credit basis. B. inventory items purchased using credit. C. intangible assets such as patents. D. expenses, like depreciation, which do not directly affect cash flows. E. administrative expenses. 11. Which of the following tends to cause differences between market values and book values? I. Accounting often creates a dichotomy between realized and unrealized income. II. Accountants allocate goodwill when a firm is acquired for more than book value. III. Many accounting values are transactions-based and hence backward-looking. IV. The use of fair-value accounting. V. Accountants refuse to assign a cost to equity capital. A. I and II only B. I and III only C. II and IV only D. I, III, and IV only E. I, III, and V only F. I, III, IV, and V only 12. The book value of a firm is: A. equivalent to the firm's market value provided that the firm has some fixed assets. B. based on historical cost. C. generally greater than the market value when fixed assets are included. D. more of a financial than an accounting valuation. E. adjusted to the market value whenever the market value exceeds the stated book value. 13. Depreciation expense: A. reduces both taxes and net income. B. increases the net fixed assets as shown on the balance sheet. C. reduces both the net fixed assets and the costs of a firm. D. is a noncash item that increases net income. E. decreases current assets, net income, and operating cash flows.

Selected information about South, Inc., a restaurant chain, follows.

14. During 2011, how much cash (in $ millions) did South collect from sales? A. 364 B. 277 C. 404 D. 324 E. 451 F. None of the above. 15. During 2011, what was the cost of goods (in $ millions) produced by the company? A. 223 B. 194 C. 252 D. 228 E. 218 F. None of the above. 16. Assuming the company neither sold nor salvaged any assets during the year, what were the company's capital expenditures during 2011? A. 482 B. 78 C. 421 D. 61 E. 139 F. None of the above. 17. Assuming that there were no financing cash flows during 2011 and basing your answer solely on the information provided, what were the cash flows from operations (in $ millions) for 2011? A. 45 B. 106 C. 15 D. 76 E. 31 F. None of the above. 18. JM Case Inc. has a market value of $5 million with 500,000 shares outstanding. The book value of its equity is $1,750,000. What is JM Case's price per share? A. $3.50 B. $5 C. $10 D. $25 E. $50 F. None of the above.

19. JM Case Inc. has a market value of $5 million with 500,000 shares outstanding. The book value of its equity is $1,750,000. What is JM Case's book value per share? A. $3.50 B. $5 C. $10 D. $25 E. $50 F. None of the above. 20. JM Case Inc. has a market value of $5 million with 500,000 shares outstanding. The book value of its equity is $1,750,000. If the company repurchases 20 percent of its shares in the stock market, what will be the book value of equity if all else remains the same? A. $750,000 B. $1,250,000 C. $1,000,000 D. $1,400,000 E. $4,000,000 F. None of the above. 21. JM Case Inc. has a market value of $5 million with 500,000 shares outstanding. The book value of its equity is $1,750,000. If the company repurchases 20 percent of its shares in the stock market and there are no taxes or transactions costs and all else remains the same, what should the market value of the firm be after the repurchase? A. $1,000,000 B. $1,750,000 C. $3,250,000 D. $4,000,000 E. $5,000,000 F. None of the above. 22. The book value of Little Statistic's total assets is $400,000. Suppose Number Crunching Inc. acquires Little Statistic's assets for $1 million and finances the purchase by selling $600,000 in new stock, $300,000 in new debt, and reducing cash by $100,000. Describe how the acquisition affects Number Crunching's balance sheet.

23. Playdough Products earned net income of $400,000 in 2011. The firm increased its accounts receivable during the year by $250,000. The book value of its assets declined by the year's depreciation charge, which was $180,000, and the market value of its assets increased by $20,000. Based only on this information, how much cash did Playdough Products generate during the year? Please ignore taxes for this problem.

24. During 2011, Lele Design earned net income of $250,000. The firm neither bought nor sold any capital assets. The book value of its assets declined by the year's depreciation charge of $200,000. The firm's operating cash flow for the year was $450,000. The market value of its assets increased by $300,000. What was Lele Design's economic income for the year? Why is this figure different from its accounting income? Please ignore taxes for this problem.

ch 1 Key 1. A 2. B 3. C 4. A 5. C 6. D 7. E 8. B 9. A 10. D 11. E 12. B 13. A 14. D 15. E 16. E 17. D 18. C 19. A 20. A 21. D 22. First, let us account for Number Crunching's $1 million expenditure. Cash will fall $100,000, liabilities will rise $300,000, and owners' equity will rise $600,000. Next, let us account for the assets acquired. The accountants will write up the value of fixed assets and possibly inventory to their estimated replacement value; they will then add the difference between the acquisition price and the replacement value of the assets acquired to a goodwill account appearing in the long-term assets section of Number Crunching's balance sheet; and lastly, they will consolidate the two companies' balance sheets by adding like accounts together.

23. Playdough Products generated $330,000 of cash during the year. The $400,000 net income ignores the fact that accounts receivable rose $250,000, a use of cash. It also treats $180,000 depreciation as an expense, whereas it is a noncash charge. The $20,000 increase in market value of assets adds to the value of the business, but is not a cash flow. Summary:

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

ch 1 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Difficulty: 3 Hard Higgins - Chapter 01

# of Questions 12 10 2 25

ch 2 Student: ___________________________________________________________________________

The most popular yardstick of financial performance among investors and senior managers is the: A. profit margin. B. return on equity. C. return on assets. D. times burden covered ratio. E. earnings yield. F. None of the above.

Which of these ratios, or levers of performance, are the determinants of ROE? I. profit margin II. financial leverage III. times interest earned IV. asset turnover A. I and IV only B. II and IV only C. I, II, and IV only D. I, II, and III only E. I, III, and IV only F. I, II, III, and IV

Ratios that measure how efficiently a firm manages its assets and operations to generate net income are referred to as _____ ratios. A. asset turnover and control B. financial leverage C. coverage D. profitability E. None of the above.

Which of the following ratios are measures of a firm's liquidity? I. fixed asset turnover ratio II. current ratio III. debt-equity ratio IV. acid test A. I and III only B. II and IV only C. III and IV only D. I, II, and III only E. I, III, and IV only

Ptarmigan Travelers had sales of $420,000 in 2010 and $480,000 in 2011. The firm's current accounts remained constant. Given this information, which one of the following statements must be true? A. The total asset turnover rate increased. B. The days' sales in receivables increased. C. The inventory turnover rate increased. D. The fixed asset turnover decreased. E. The collection period decreased.

Which one of the following ratios identifies the amount of assets a firm needs in order to generate $1 in sales? A. current ratio B. debt-to-equity C. retention D. asset turnover E. return on assets

Assume you are a banker who has loaned money to a firm, but that firm is now facing increased competition and reduced cash flows. Which one of the following ratios would you most closely monitor to evaluate the firm's ability to repay its loan? A. current ratio B. debt-to-equity ratio C. times interest earned ratio D. times burden covered ratio E. None of the above.

Breakers Bay Inc. has succeeded in increasing the amount of goods it sells while holding the amount of inventory on hand at a constant level. Assume that both the cost per unit and the selling price per unit also remained constant. All else held constant, how will this accomplishment be reflected in the firm's financial ratios? A. decrease in the fixed asset turnover rate B. decrease in the financial leverage ratio C. increase in the inventory turnover rate D. increase in the day's sales in inventory E. no change in the total asset turnover rate

Which one of the following statements is correct? A. If the debt-to-assets ratio is greater than 0.50, then the debt-to-equity ratio must be less than 1.0. B. Long-term creditors would prefer the times interest earned ratio be 1.4 rather than 1.5. C. The assets-to-equity ratio can be computed as 1 plus the debt-to-equity ratio. D. To realize the best risk and reward profile, financial leverage should be maximized. E. None of the above is correct.

10. On a common-size balance sheet, all accounts are expressed as a percentage of: A. sales for the period. B. the base year sales. C. total equity for the base year. D. total assets for the current year. E. total assets for the base year. 11. Which one of the following statements does NOT describe a problem with using ROE as a performance measure? A. ROE measures return on accounting book value, and this problem is not solved by using market value. B. ROE is a forward-looking, one-period measure, while business decisions span the past and present. C. ROE measures only return, while financial decisions involve balancing risk against return. D. None of these describe problems with ROE. E. All of these describe problems with ROE.

Selected financial data for Link, Inc. follows: ($ in thousands)

12. The current ratio at the end of 2012 is: A. 10.21 B. 2.31 C. 2.76 D. 10.30 E. None of the above. 13. Which of the following statements best describes how the company's short-term liquidity changed from 2011 to 2012? A. Link's short-run liquidity has improved modestly. B. Link's short-run liquidity has deteriorated very little, but from a low initial base. C. Link's short-run liquidity has improved considerably, but from a low initial base. D. Link's short-run liquidity has deteriorated considerably, but from a high initial base. E. None of the above. 14. Assume a 365-day year for your calculations. The collection period in days, based on sales, at the end of 2012 is: A. 24.3 B. 219.6 C. 35.7 D. 28.8 E. None of the above. 15. Assume a 365-day year for your calculations. The inventory turnover, based on cost of goods sold, at the end of 2012 is: A. 5.2 B. 24.3 C. 28.8 D. 35.7 E. None of the above. 16. Assume a 365-day year for your calculations. The payables period in days, based on cost of goods sold, at the end of 2012 is: A. 5.2 B. 24.3 C. 28.8 D. 35.7 E. None of the above.

17. Assume a 365-day year for your calculations. The days' sales in cash at the end of 2012 is: A. 24.3 B. 28.8 C. 35.7 D. 219.6 E. None of the above. 18. The gross margin for 2012 is: A. -94% B. 13% C. 26% D. 31% E. None of the above. 19. The profit margin for 2012 is: A. -94% B. -57% C. 13% D. 31% E. None of the above. 20. Answer the questions below based on the following information. Taxes are 35% and all dollars are in millions.

a) Calculate each company's ROE, ROA, and ROIC. b) Why is Runrun's ROE so much higher than Suunto's? Does this mean Runrun is a better company? Why or why not? c) Why is Suunto's ROA higher than Runrun's? What does this tell you about the two companies? d) How do the two companies' ROICs compare? What does this suggest about the two companies?

The financial statements for Limited Brands, Inc. follow (fiscal years ending January):

21. Use Limited Brands, Inc.'s financial statements, above, to answer the following question. Use the company's operating profit as an approximation of its EBIT, and assume a 40% tax rate for your calculations. For the fiscal years ending in January of 2006 and 2007, calculate: a) Limited Brands' total liabilities-to-equity ratio; b) Times interest earned ratio; and c) Times burden covered.

22. Use Limited Brands, Inc.'s financial statements, above, to answer the following question. Use the company's operating profit as an approximation of its EBIT, and assume a 40% tax rate for your calculations. What percentage decline in earnings before interest and taxes could Limited Brands have sustained in fiscal years 2006 and 2007 before failing to cover: a) Interest and principal repayment requirements; b) Interest, principal and common dividend payments?

23. Use Limited Brands, Inc.'s financial statements, above, to prepare common-size financial statements for Limited Brands, Inc. for 2006 - 2007.

ch 2 Key 1. B 2. C 3. A 4. B 5. E 6. D 7. D 8. C 9. C 10. D 11. B 12. C 13. D 14. D 15. A 16. B 17. D 18. E 19. A d. ROIC abstracts from differences in leverage to provide a direct comparison of the earning power of the two companies' assets. On this metric, Suunto is the superior performer. Before drawing any firm conclusions, however, it is important to ask how the business risks faced by the companies compare and whether the observed ratios reflect long-run capabilities or transitory events. c. This is also due to Runrun's higher leverage. ROA penalizes levered companies by comparing the net income available to equity to the capital provided by owners and creditors. It does not mean that Runrun is a worse company than Suunto. b. Runrun's higher ROE is a natural reflection of its higher financial leverage. It does not mean that Runrun is the better company.

20. a.

21.

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

22.

23.

ch 2 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Higgins - Chapter 02

# of Questions 9 14 25

ch 3 Student: ___________________________________________________________________________

You are estimating your company's external financing needs for the next year. At the end of the year you expect that owners' equity will be $80 million, total assets will amount to $170 million, and total liabilities will be $70 million. How much will your firm need to borrow, or otherwise acquire, from outside sources during the year? A. $20 million B. $70 million C. $150 million D. $160 million E. $180 million F. None of the above.

To estimate Missed Places, Inc.'s (MP) external financing needs, the CFO needs to figure out how much equity her firm will have at the end of next year. At the end of the most recent fiscal year, MP's retained earnings were $158,000. The Controller has estimated that over the next year, gross profits will be $360,700, earnings after tax will total $23,400, and MP will pay $12,400 in dividends. What are the estimated retained earnings at the end of next year? A. $169,000 B. $170,400 C. $181,400 D. $506,300 E. $518,700 F. None of the above.

The most common approach to developing pro forma financial statements is called the: A. cash budget method. B. financial planning method. C. seasonality approach. D. percent-of-sales method. E. market-oriented approach. F. None of the above.

Which of the following are viable techniques to cope with the uncertainty inherent in realistic financial projections? I. Simulation II. Ad hoc adjustments III. Scenario analysis IV. Sensitivity analysis A. II and IV only B. III and IV only C. II, III, and IV only D. I, II, and III only E. I, III, and IV only F. I, II, III, and IV

Which one of the following statements is correct concerning the cash balance of a firm? A. Most firms attempt to maintain a zero cash balance at all times. B.The cumulative cash surplus shown on a cash budget is equal to the ending cash balance plus the minimum desired cash balance. C. Most firms attempt to maximize the cash balance at all times. D. A cumulative cash deficit indicates a borrowing need. E. The ending cash balance must equal the minimum desired cash balance.

Assume each month has 30 days and AmDocs has a 60-day accounts receivable period. During the second calendar quarter of the year (April, May and June), AmDocs will collect payment for the sales it made during which of the months listed below? A. October, November, and December B. November, December, and January C. December, January, and February D. January, February, and March E. February, March, and April

The Limited collects 25 percent of sales in the month of sale, 60 percent of sales in the month following the month of sale, and 15 percent of sales in the second month following the month of sale. During the month of April, the firm will collect: A. 60 percent of February sales. B. 15 percent of April sales. C. 60 percent of March sales. D. 15 percent of March sales. E. 25 percent of February sales.

Steve has estimated the cash inflows and outflows for his sporting goods store for next year. The report that he has prepared summarizing these cash flows is called a: A. pro forma income statement. B. sales projection. C. cash budget. D. receivables analysis. E. credit analysis. F. None of the above.

You are developing a financial plan for a corporation. Which of the following questions will be considered as you develop this plan? I. How much will our sales grow? II. Will additional fixed assets be required? III. Will dividends be paid to shareholders? IV. How much new debt must be obtained? A. I and IV only B. II and III only C. I, III, and IV only D. II, III, and IV only E. I, II, III, and IV

10. Financial planning: A. focuses solely on the short-term outlook for a firm. B. is a process that firms employ only when major changes to a firm's operations are anticipated. C. is a process that firms undergo once every five years. D. considers multiple options and scenarios for the next two to five years. E. provides minimal benefits for firms that are highly responsive to economic changes. 11. Ruff Wear expects sales of $560, $650, $670, and $610 for the months of May through August, respectively. The firm collects 20 percent of sales in the month of sale, 70 percent in the month following the month of sale, and 8 percent in the second month following the month of sale. The remaining 2 percent of sales is never collected. How much money does the firm expect to collect in the month of August? A. $621 B. $628 C. $633 D. $639 E. $643

12. On May 1, Vaya Corp. had a beginning cash balance of $175. Vaya's sales for April were $430 and May sales were $480. During May, the firm had cash expenses of $110 and made payments on accounts payable of $290. Vaya's accounts receivable period is 30 days. What is the firm's beginning cash balance on June 1? A. $145 B. $155 C. $205 D. $215 E. $265

13. Please refer to Oscar's financial statements. What was the increase in retained earnings of Oscar's during 2012? A. $450 B. $1,380 C. $1,830 D. $2,280 E. None of the above. 14. Please refer to Oscar's financial statements. Sales are projected to increase by 3 percent next year. The profit margin and the dividend payout ratio are projected to remain constant. What is the projected addition to retained earnings for next year? A. $1,309.19 B. $1,421.40 C. $1,884.90 D. $2,667.78 E. $3,001.40 F. None of the above.

15. Please refer to Oscar's financial statements. All of Oscar's costs and net working capital vary directly with sales. Sales are projected to increase by 10 percent. What is the pro forma accounts receivable balance for next year? A. $949 B. $1,034 C. $1,113 D. $1,730 E. $2,670 F. None of the above. 16. Please refer to Oscar's financial statements. Assume a constant net profit margin and dividend payout ratio, and further assume all of Oscar's assets and current liabilities vary directly with sales. Assume longterm debt and common stock remain unchanged. Sales are projected to increase by 10 percent. What is the external financing need for next year? A. -$410 B. -$260 C. $235 D. $1,320 E. $7,240 F. None of the above. 17. Please refer to Oscar's financial statements. Assume a constant debt-equity ratio, net profit margin and dividend payout ratio, and further assume all of Oscar's costs, assets and current liabilities vary directly with sales. What is the pro forma net fixed asset value for next year if sales are projected to increase by 7.5 percent? A. $10,857.50 B. $10,931.38 C. $11,663.75 D. $15,587.50 E. $18,987.50 F. None of the above. 18. Pro forma financial statements, by definition, are predictions of a company's financial statements at a future point in time. So, why is it important to analyze the historical performance of the company before constructing pro forma financial statements?

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

20. Preston Fencing Company's sales, half of which are for cash and the other half sold on credit, over the past three months were:

a. Estimate Preston's cash receipts in October if the company's collection period is 30 days. b. Estimate Preston's cash receipts in October if the company's collection period is 45 days. c. What would be the October balance of accounts receivable for Preston Fencing if the company's collection period is 30 days? 45 days?

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

ch 3 Key 1. A 2. A 3. D 4. E 5. D 6. E 7. C 8. C 9. E 10. D 11. E 12. C 13. B 14. B 15. B 16. B 17. C 18. Historical analysis helps decide for which financial statement items a percent-of-sales forecast might be appropriate. For example, a stable trend in the collection period would tell you that, unless you expect changes in the management of the accounts receivable, future collection periods should continue along this trend. 19. A negative value implies that the company has excess cash above its desired minimum. With a negative external financing need, the firm has a surplus of funds that it can use to reduce current liabilities, reduce long-term debt, buy back common stock, or increase dividends. If acceptable opportunities exist, the firm might also use the extra funds to purchase fixed assets, thereby increasing its potential growth, should that action be warranted. c. If the collection period is 30 days, then the October accounts receivable balance should be the last 30 days' worth of credit sales. October credit sales were $40,000, thus the accounts receivable balance would be $40,000. If the collection period is 45 days, then the balance would be October's credit sales and half of September's credit sales, or 40,000 + 60,000/2 = $70,000. b. With a 45-day collection period, cash collected during the first half of October is from credit sales made from the middle until the end of August; and collections during the second half of October are from credit sales made from the beginning until the middle of September. Therefore, cash receipts from credit sales (which are half of total sales) are from the period mid-August through mid-September, or (70,000/2 + 120,000/2)/2 = $47,500. Adding sales for cash of $40,000 in October, the total is $87,500. 20. a. If the collection period is 30 days, October cash receipts from September sales will equal half of September sales or $60,000. In addition, the company will receive cash from half of October sales, which were for cash of $40,000. The total is $100,000.

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

ch 3 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Higgins - Chapter 03

# of Questions 15 6 22

ch 4 Student: ___________________________________________________________________________

Which one of the following will increase the sustainable rate of growth a corporation can achieve? A. avoidance of external equity financing B. increase in corporate tax rates C. reduction in the retention ratio D. decrease in the dividend payout ratio E. decrease in sales given a positive profit margin F. None of the above.

Which of these ratios are the determinants of a firm's sustainable growth rate? I. Assets-to-equity ratio II. Profit margin III. Retention ratio IV. Asset turnover ratio A. I and III only B. II and III only C. II, III, and IV only D. I, II, and III only E. I, II, III, and IV F. None of the above.

The retention ratio is: A. equal to net income divided by the change in total equity. B. the percentage of net income available to the firm to fund future growth. C. equal to one minus the asset turnover ratio. D. the change in retained earnings divided by the dividends paid. E. the dollar increase in net income divided by the dollar increase in sales. F. None of the above.

Which of the following statements is true? A. Rapid growth spurs increases in market share and profits and thus, is always a blessing. B. Firms that grow rapidly only very rarely encounter financial problems. C. The cash flows generated in a given time period are equal to the profits reported. D. Profits provide assurance that cash flow will be sufficient to maintain solvency. E. Due to required cash investments in current assets, fast-growing and profitable companies can literally "grow broke". F. None of the above.

Which one of the following correctly defines the retention ratio? A. one plus the dividend payout ratio B. additions to retained earnings divided by net income C. additions to retained earnings divided by dividends paid D. net income minus additions to retained earnings E. net income minus cash dividends F. None of the above.

Which one of the following policies most directly affects the projection of the retained earnings balance to be used on a pro forma statement? A. net working capital policy B. capital structure policy C. dividend policy D. capital budgeting policy E. capacity utilization policy F. None of the above.

Which of the following questions are appropriate to address upon conducting sustainable growth analysis and the financial planning process? I. Should the firm merge with a competitor? II. Should additional equity be sold? III. Should a particular division be sold? IV. Should a new product be introduced? A. I, II, and III only B. I, II, and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, III, and IV F. None of the above.

The sustainable growth rate of a firm is best described as the: A. minimum growth rate achievable assuming a 100 percent retention ratio. B. minimum growth rate achievable if the firm maintains a constant equity multiplier. C. maximum growth rate achievable excluding external financing of any kind. D. maximum growth rate achievable excluding any external equity financing while maintaining a constant debt-equity ratio. E. maximum growth rate achievable with unlimited debt financing. F. None of the above.

The sustainable growth rate: A. assumes there is no external financing of any kind. B. assumes no additional long-term debt is available. C. assumes the debt-equity ratio is constant. D. assumes the debt-equity ratio is 1.0. E. assumes all income is retained by the firm. F. None of the above.

10. Which of the following can affect a firm's sustainable rate of growth? I. Asset turnover ratio II. Profit margin III. Dividend policy IV. Financial leverage A. III only B. I and III only C. II, III, and IV only D. I, II, and IV only E. I, II, III, and IV F. None of the above.

11. Wax Music expects sales of $437,500 next year. The profit margin is 4.8 percent and the firm has a 30 percent dividend payout ratio. What is the projected increase in retained earnings? A. $14,700 B. $17,500 C. $18,300 D. $20,600 E. $21,000 F. None of the above. 12. Komatsu has a 4.5 percent profit margin and a 15 percent dividend payout ratio. The asset turnover ratio is 1.6 and the assets-to-equity ratio (using beginning-of-period equity) is 1.77. What is the sustainable rate of growth? A. 1.91 percent B. 6.12 percent C. 10.83 percent D. 11.26 percent E. 12.74 percent F. None of the above. 13. A firm has a retention ratio of 40 percent and a sustainable growth rate of 6.2 percent. The asset turnover ratio is 0.85 and the assets-to-equity ratio (using beginning-of-period equity) is 1.80. What is the profit margin? A. 3.79 percent B. 5.69 percent C. 6.75 percent D. 10.13 percent E. 18.24 percent 14. Westcomb, Inc. had equity of $150,000 at the beginning of the year. At the end of the year, the company had total assets of $195,000. During the year, the company sold no new equity. Net income for the year was $72,000 and dividends were $44,640. What is the sustainable growth rate? A. 15.32 percent B. 15.79 percent C. 17.78 percent D. 18.01 percent E. 18.24 percent The following table presents financial information for Boss Stores, Inc., a retail chain store in the U.S.

15. Use the information from Boss's annual financial statements. What is the retention ratio for 2009? A. 0.32 B. 0.68 C. 0.97 D. 1.00 E. None of the above.

16. Use the information from Boss's annual financial statements. What is the actual sales growth rate for 2010? A. - 17.6% B. - 7.9% C. 8.51% D. 21.4% E. None of the above. 17. Use the above information from Boss's annual financial statements. What is the sustainable sales growth rate for 2010? A. - 17.6% B. - 7.9% C. 9.07% D. 10.27% E. 12.23% F. 21.4% 18. Use the information from Boss's annual financial statements. What is the difference between the sustainable growth and actual growth rates for 2011? A. - 11.40% B. - 7.09% C. -3.04% D. 5.47% E. 13.98% F. 21.40% 19. Which of the following actions might a firm take if its actual sales growth exceeds its sustainable rate of growth? I. Increase prices II. Decrease financial leverage III. Decrease dividends IV. Prune away less marginal products A. I and II only B. I and III only C. I, II, and IV only D. I, III, and IV only E. I, II, III, and IV F. None of the above. 20. Why do financial managers need to understand the implications of the sustainable rate of growth?

Law Dog, Inc. is a provider of temporary and permanent personnel in legal services. The following are selected financial data for the company for the period 2000 - 2004.

21. Use Law Dog's selected information to answer the following questions: a. Calculate Law Dog's sustainable growth rate in each year. b. Comparing the company's sustainable growth rate with its actual growth rate in sales, what growth problems did the company face over this period? c. Considering economic conditions over the period, what appears a likely cause of these problems?

22. Law Dog paid its first dividends in 2004. As an analyst, assess the company's decision to pay dividends.

Selected financial information for Hard Knock Doors is presented below:

Use the information from Hard Knock's annual financial statements to answer the following questions: 23. Calculate the actual and sustainable growth rate for each year.

24. Do you think Hard Knock Doors is having a problem financing its growth?

25. Is the increase in dividends a good idea for Hard Knock?

ch 4 Key 1. D 2. E 3. B 4. E 5. B 6. C 7. E 8. D 9. C 10. E 11. A 12. C 13. D 14. E 15. C 16. D 17. C 18. C 19. D 20. Working capital, fixed assets, and external financing must coordinate with and be able to support a firm's sales growth. If, for example, a projected increase in sales requires external financing when no such financing is available, then the firm cannot grow at the desired rate. Understanding the implications of the sustainable growth rate helps managers understand the need to manage growth so that the firm does not attempt to outgrow its resources. c. In the 2000-2002 period, commensurate with declining business conditions, the company's sales decreased substantially. Despite deteriorating profit margins and asset turnover, and modest decreases in leverage, the sustainable growth rate remained above the large actual decreases in sales. Law Dog's growth rebounded in the improving business conditions of 2003-2004. b. From 2000 through 2002, Law Dog's actual growth (or decline) in sales was well below its sustainable growth rate. In 2003 and 2004, the company's growth problems reversed, with actual growth modestly exceeding sustainable growth in 2003, and double that of 2004.

21. a. Law Dog's sustainable growth rates (these are the product of the first four rows of financial information):

22. Dividends are typically the hallmark of a maturing industry. In the five years before 2000, the company's annual sales growth averaged more than 50%; the more recent experience shown indicates slowing growth for the staffing services business. In this context, the company's decision makes sense. However, in 2004 the company resumed rapid growth, in part attributable to the acquisition of an audit and risk-consulting unit in 2002. Persistent growth rates above sustainable growth could jeopardize its ability to pay dividends on an ongoing basis.

23. Sustainable growth calculation:

24. Hard Knock's actual growth has exceeded its sustainable growth rate every year. The company has financed its rapid growth by aggressively increasing its asset turnover, and in 2008, its financial leverage. 25. The initiation and increase in dividend payments, although modest, have exacerbated its sustainable growth problems by decreasing the retention ratio.

ch 4 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Difficulty: 3 Hard Higgins - Chapter 04

# of Questions 11 11 3 28

ch 5 Student: ___________________________________________________________________________

Which one of the following statements is false? A. Financial executives must design financial securities to meet the needs of the firm and its investors. B. Financial instruments are subject to full disclosure requirements. C. Financial instruments are greatly constrained by law and regulation. D. Financial instruments are claims against a company's cash flows and assets. E. None of the above.

Which of the following securities has a purely fixed claim against a firm's cash flows? A. preferred stock B. options C. common stock D. bonds E. None of the above.

Which of the following securities has a purely residual claim against a firm's cash flows? A. preferred stock B. callable bonds C. common stock D. non-callable bonds E. None of the above.

Mike just purchased a bond which pays $40 each year in interest. The $40 interest payment is also called the: A. coupon. B. par value. C. discount. D. call premium. E. yield. F. None of the above.

Zack owns a bond that will pay him $35 each year in interest plus a $1,000 principal payment at maturity. The $1,000 principal payment is called the: A. coupon. B. par value. C. discount. D. yield. E. call premium. F. None of the above.

Which one of the following statements is true? A. Debt instruments offer residual claims to future cash payouts. B. Bonds with call provisions will have lower coupon rates than otherwise identical bonds. C. Bondholders enjoy a direct voice in company decisions. D. Bonds are low-risk investments that do well in inflationary periods. E. Preferred shareholders are the first investors to be repaid in bankruptcy liquidation. F. None of the above.

Which one of the following accurately orders the rate of return on financial securities from highest to lowest over most of recorded market history (the 1900-2010 period)? A. Short-term government bills, long-term corporate bonds, long-term government bonds, common stocks B. Long-term corporate bonds, long-term government bonds, common stocks, short-term government bills C. Common stocks, long-term government bonds, long-term corporate bonds, short-term government bills D. Common stocks, long-term corporate bonds, long-term government bonds, short-term government bills E. Long-term corporate bonds, common stocks, short-term government bills, long-term government bonds F. None of the above.

Which one of the following statements is true? A. Equity securities offer fixed claims on future cash payouts. B. Unlike bondholders, for their returns, shareholders rely entirely on price appreciation. C. In theory, common shareholders exercise very little control over company decisions. D.Historically, common shareholders have earned a risk premium as compensation for risk borne in excess of government bonds. E. Preferred shareholders are the first investors to be repaid in bankruptcy liquidation. F. None of the above.

You bought a yen-denominated corporate bond at the beginning of the year for ×100,000. The bond paid 3 percent annual interest and was trading for ×110,000 at year-end. The exchange rate was $1 = ×100 at the beginning of the year and $1 = ×122 at year-end. What was your U.S. dollar holding period return on the bond? A. 3% B. 7% C. 10% D. 13% E. 30% F. None of the above.

10. You bought a yen-denominated corporate bond at the beginning of the year for ×100,000. The bond paid 3 percent annual interest and was trading for ×110,000 at year-end. The exchange rate was $1 = ×100 at the beginning of the year and $1 = ×122 at year-end. What holding period return, measured in yen, did you earn on the bond? A. -18.03% B. -7.38% C. -5.03% D. 3.0% E. 10.0% F. None of the above. 11. You bought a yen-denominated corporate bond at the beginning of the year for ×100,000. The bond paid 3 percent annual interest and was trading for ×110,000 at year-end. The exchange rate was $1 = ×100 at the beginning of the year and $1 = ×97 at year-end. What would be your U.S. dollar holding return on the bond? A. 3.09% B. 6.09% C. 13% D. 16.49% E. 30% F. None of the above.

12. Which of the following statements are true? I. Underwriters help private companies access public stock markets through IPOs. II. Shelf registrations and private placements are examples of seasoned security issues. III. Issue costs for debt are typically greater than issue costs for equity. IV. Private equity financing is a common source of financing for startup firms. A. I and II only B. I and III only C. I, II, and IV only D. I, III, and IV only E. I, II, III, and IV F. None of the above. 13. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What rate of return did the common stock owners earn in fiscal year 2012? A. 1.79% B. 4.33% C. 13.43% D. 15.22% E. 17.76% F. None of the above. 14. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What was the dividend yield in fiscal year 2012? A. 1.79% B. 4.33% C. 13.43% D. 15.22% E. 17.76% F. None of the above. 15. At the end of fiscal year 2011, Crane Industries, Inc.'s stock price was $30.75. A year later it was $34.88. Per share dividends over the year were $0.55, while earnings per share were $1.33. What was the percentage change in the share price in fiscal year 2012? A. 1.79% B. 4.33% C. 13.43% D. 15.22% E. 17.76% F. None of the above. 16. Which of the following statements related to market efficiency tends to be supported by current evidence? I. Markets tend to respond quickly to new information. II. It is difficult for the typical investor to earn above-average returns without taking above-average risks. III. Short-run prices are difficult to predict accurately based on public information. IV. Markets are most likely weak form efficient. A. I and III only B. II and IV only C. I and IV only D. I, III, and IV only E. I, II, and III only F. None of the above.

17. Individuals who continually monitor the financial markets seeking mispriced securities: A. earn excess profits over the long-term. B. make the markets increasingly more efficient. C. are never able to find a security that is temporarily mispriced. D. are overwhelmingly successful in earning abnormal profits. E. are always quite successful using only historical price information as their basis of evaluation. F. None of the above. 18. Which of the following are the most likely reasons for why a stock price might not react at all on the day that new information related to the stock issuer is released? I. Insiders knew the information prior to the announcement II. Investors need time to digest the information prior to reacting III. The information has no bearing on the value of the firm IV. The information was anticipated A. I and II only B. I and III only C. II and III only D. II and IV only E. III and IV only F. None of the above. 19. Chapter 5 presents evidence that the average annual rate of return on common stocks over many years has exceeded the return on government bonds in the United States, while returns on common stocks have also exhibited more volatility than returns on U.S. government bonds. Suppose that last year, the realized rate of return on government bonds exceeded the return on common stocks. Your colleague suggests that "last year shows us that investors are now willing to settle for lower returns on stocks than on bonds." How would you interpret this result?

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

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

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

ch 5 Key 1. C 2. D 3. C 4. A 5. B 6. F 7. D 8. D 9. D 10. B 11. D 12. C 13. D 14. A 15. C 16. E 17. B 18. E 19. The fact that government bonds earned a higher rate of return than common stocks in one year is not evidence that investors are suddenly willing to settle for lower returns on stocks than bonds. It means that investors' expectations were not met or, alternatively, that investors were surprised. To take on additional risk, risk-averse investors require additional expected return. But expected returns are not the same as realized returns. Because stocks and bonds are risky, their returns will fluctuate from year to year, and bonds will earn higher returns than stocks in some years. But the expected returns of common stocks should always be higher than the expected returns of government bonds. c. Underpricing is not a cash flow. It is, however, an opportunity cost to current owners because it means that more shares must be sold to raise $100 million and each share will represent a smaller ownership interest in the company. b. Investment bankers' revenue = $3.08 x 2.444 million = $7.528 million.

20. a.

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

c. My answer would change. As an investor, I would want to hold a floating-rate bond because interest income will rise as interest rates rise. Equivalently, the price of the fixed-income bond will fall as rates rise, while that of the floating-rate bond will not. b. My answer would change. I would rather issue a floating-rate bond now because future interest payments will fall as rates decline. 22. a. I would rather own a fixed-rate bond because the interest income I receive from a floating-rate bond will fall as interest rates decline. Equivalently, the market value of the fixed-rate bond will rise as rates fall, but that of the floating-rate bond will not. (This presumes the fixed-rate bond is not callable.)

ch 5 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Difficulty: 3 Hard Higgins - Chapter 05

# of Questions 8 11 3 22

ch 6 Student: ___________________________________________________________________________

Financial leverage: I. increases expected ROE but does not affect its variability. II. increases breakeven, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners. A. I and II only B. I and III only C. II and IV only D. II, III, and IV only E. I, II, III, and IV F. None of the above.

The best financing choice is the one that: A. sets the debt-to-assets ratio equal to 1. B. trades off the tax disadvantage of debt against the signaling effects of equity. C. maximizes expected cash flows. D. ignores the false comfort of financial flexibility. E. results in the lowest possible financial distress costs.

Homemade leverage is: A. the incurrence of debt by a corporation in order to pay dividends to shareholders. B. the exclusive use of debt to fund a corporate expansion project. C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. D. best defined as an increase in a firm's debt-equity ratio. E. the term used to describe the capital structure of a levered firm. F. None of the above.

The basic lesson of the M&M theory is that the value of a firm is dependent upon: A. the firm's capital structure. B. the total cash flow of the firm. C. minimizing the marketed claims. D. the amount of marketed claims to that firm. E. the size of the stockholders' claims. F. None of the above.

The term "financial distress costs" includes which of the following? I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed, but not bankrupt IV. Indirect costs related to being financially distressed, but not bankrupt A. I only B. III only C. I and II only D. III and IV only E. I, II, III, and IV F. None of the above.

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns? I. Estimated pro forma coverage ratios II. The recognition that financing decisions do not affect firm or shareholder value III. A range of earnings chart and proximity of expected EBIT to the breakeven value IV. A conservative debt policy that obviates the need to evaluate risk A. I only B. III only C. I and III only D. II and III only E. IV only F. None of the above.

In general, the capital structures used by non-financial U.S. firms: A. typically result in debt-to-asset ratios between 60 and 80 percent. B. tend to converge to the same proportions of debt and equity. C. tend to be those that maximize the use of the firm's available tax shelters. D. vary significantly across industries. E. None of the above.

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Tax benefits IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. I, II, and III only E. I, II, and IV only F. None of the above.

Which of the following factors favor the issuance of equity in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. II, III, and IV only E. I, II, and IV only F. None of the above.

10. Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. I, II, and III only E. I, II, and IV only F. None of the above.

11. Which of the following is NOT a likely financing policy for a rapidly growing business? A. Adopt a modest dividend payout policy that enables the company to finance most of its growth externally. B. Borrow funds rather than limit growth, thereby limiting growth only as a last resort. C. Maintain a conservative leverage ratio to ensure continuous access to financial markets. D. If external financing is necessary, use debt to the point it does not affect financial flexibility. E. None of the above. 12. According to the pecking-order theory proposed by Stewart Myers of MIT, which of the following are correct? I. For financing needs, firms prefer to first tap internal sources such as retained profits and excess cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms prefer to issue new equity rather than source external debt. IV. A firm's capital structure is dictated by its need for external financing. A. I and III only B. II and IV only C. I, III, and IV only D. I, II, and IV only E. I, II, III, and IV F. None of the above. As the financial vice president for Squamish Equipment, you have the following information:

13. For next year, calculate Squamish's times burden covered ratio if Squamish sells 2 million new shares at $20 a share. A. 1.03 B. 1.38 C. 1.60 D. 1.89 E. 2.10 F. None of the above. 14. For next year, calculate Squamish's earnings per share if Squamish sells 2 million new shares at $20 a share. A. 1.28 B. 1.39 C. 2.00 D. 2.22 E. 4.00 F. None of the above. 15. Calculate Squamish's times interest earned ratio for next year assuming the firm raises $40 million of new debt at an interest rate of 7 percent. A. 2.00 B. 3.09 C. 3.66 D. 4.35 E. None of the above.

16. Calculate Squamish's times burden covered ratio for the next year assuming annual sinking fund payments on the new debt will equal $8 million. A. 1.01 B. 1.08 C. 1.38 D. 1.49 E. 1.95 F. None of the above. 17. Calculate Squamish's earnings per share next year assuming Squamish raises $40 million of new debt at an interest rate of 7 percent. A. 1.28 B. 2.00 C. 2.12 D. 2.22 E. 3.06 F. None of the above. 18. The interest tax shield has no value when a firm has: I. no taxable income. II. debt-equity ratio of 1. III. zero debt. IV. no leverage. A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, and IV only F. None of the above. 19. "A firm can't use interest tax shields unless it has (taxable) income to shield." What does this statement imply for capital structure? Explain briefly, comparing the following two examples: a start-up biotech firm and an electric utility company.

As CFO of Nile Holdings, a carpet wholesaler, you have the following information as of December 2011:

Nile has an attractive investment opportunity, and to finance it, must decide whether to issue $100 million in new debt or new equity.

20. Assume Nile raises $100 million of new debt at the end of 2011, at an interest rate of 7%. a. Calculate the firm's pro forma 2012 times interest earned (TIE) ratio. b. Calculate the percentage EBIT can fall (below expected EBIT) before interest coverage dips below 1.0.

21. Assume Nile raises $100 million of new debt at the end of 2011, at an interest rate of 7%. a. Assuming Nile must make a $20 million payment on the new debt next year, calculate the firm's times burden covered ratio and times common covered (including debt payments) ratio. b. As Nile's banker, would you be comfortable loaning the company this new debt? Briefly explain why, or for what reasons you'd be comfortable or uncomfortable.

22. Calculate next year's earnings per share assuming Nile raises the $100 million of new debt.

23. Calculate next year's times burden covered ratio and earnings per share if Nile sells 2 million new shares at $50 a share instead of raising new debt.

24. Suppose Nile expects $4.52 in EPS next year if it does not go through with the investment and associated financing. As a shareholder, to satisfy its funding needs for the investment opportunity, do you prefer the company issues $100 million in new debt at an interest rate of 7%, or issues 2 million shares of equity at a target price of $50? Show supporting calculations, and provide arguments and potential counterarguments for your recommendation.

25. Can a company incur costs of financial distress without ever going bankrupt? Explain. What is the nature of these costs?

ch 6 Key 1. D 2. C 3. C 4. B 5. E 6. C 7. D 8. D 9. C 10. B 11. B 12. D 13. E 14. C 15. D 16. D 17. C 18. C (Note that the current tax code allows firms to carryforward and carryback their income/losses, for purposes of computing taxes. The argument given above still holds, with "taxable income" incorporating carryforwards or carrybacks.) 19. The corporate tax shield of debt is only valuable to a company that has taxable income to shield. This implies that companies that do not have a lot of taxable income (i.e. startups), or companies that have highly variable taxable income (e.g., younger tech or biotech firms) should not have as much debt, because the benefits of the corporate tax shield are less. The statement also implies that if a company has a lot of debt, it may exhaust its taxable income. At this stage, the marginal benefit of additional debt is zero, and the probability of financial distress grows. The (typical) utility's more stable cash flows and profitability imply greater tax benefits, and lower costs of financial distress.

b. % EBIT can fall to 77.34% ((189.8 - 43) / 189.8 = 77.34%) before interest coverage dips below 1.0. Pro forma TIE = EBIT/Int. Exp. = 189.8/43 = 4.414x 20. a. Interest exp. = $36 + 0.07($100) = $43.

b. Debt (both principal and interest) coverage is relatively strong at 1.5x, but if the company continues to pay its dividend, its expected ability to pay its pro forma fixed financing charges (or burden) including dividends is right at the edge. Although EBIT can fall 33.6% before TBC falls below 1, Nile has a quite low TCC (1.01) including the burden. There is risk here, and a prudent lender will require covenants that restrict dividend payouts to certain situations, if at all. Covenants (restrictions set in the debt contract) impose additional costs on the firm; this fact should be considered by management as they weigh the costs and benefits of new debt. Nile's banker will compare Nile's coverage ratios to the industry's average of these ratios. If the company has strong and relatively stable CFs, and the ratios are above or within industry averages, the banker will be more comfortable with the added debt.

21. a.

22.

23.

● Equity issuance retains more future financing flexibility. ● In fact, debt issuance often has positive signaling and managerial incentive effects. ● The issuance of equity has a negative signaling effect. Evidence indicates that the stock market on average reacts negatively to announcements of secondary, or seasoned public stock offerings (SEOs). Debt avoids this result. As indicated in Chapter 6, debt can increase shareholders' returns in good times, but decrease them in bad times; i.e., the increase in expected return comes at the cost of higher risk. Management must weigh these trade-offs. Other considerations: Shareholders often prefer that debt is raised instead of equity because of the adverse signaling effects on the stock price of issuing equity. Moreover, the EPS calculations above indicate that, while both debt and equity issuances are expected to increase EPS compared to no issuance and subsequent investment, the debt issuance results in the highest EPS. However, depending on the volatility of the company's EBIT, the issuance of debt presents risk to the shareholders. If the company issues debt and its EBIT falls below $126M, then the company defaults on its borrowings. On the other hand, if financing needs were met with equity, EBIT could fall to $88.3 [ = $36 + (34/1 - .35)] and Nile could still make the interest and loan payments. Defaulting on its loans would cause a catastrophic decrease in Nile's stock price. Raising equity poses much less risk of financial distress in this case. The issuance of debt also presents the risk that the company will be forced to miss (or reduce) future dividend payments, causing the stock price to fall.

24. First compare Nile's EPS and coverage ratios under the two scenarios.

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

ch 6 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Difficulty: 3 Hard Higgins - Chapter 06

# of Questions 9 12 4 27

ch 7 Student: ___________________________________________________________________________

Which of the following is not an important step in the financial evaluation of an investment opportunity? A. Calculate a figure of merit for the investment. B. Estimate the accounting rate of return for the investment. C. Estimate the relevant cash flows. D. Compare the figure of merit to an acceptance criterion. E. All of the above are important steps.

Which of the following figures of merit might not use all possible cash flows in its calculations? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Accounting rate of return A. III only B. I & III only C. II & III only D. I & IV only E. III & IV only F. I, II, III, and IV

Which of the following figures of merit does not directly take into consideration the time value of money? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Accounting rate of return A. IV only B. I & III only C. II & III only D. I & II only E. I & IV only F. I, II, III, and IV

Ian is going to receive $20,000 six years from now. Sunny is going to receive $20,000 nine years from now. Which one of the following statements is correct if both Ian and Sunny apply a 7 percent discount rate to these amounts? A. The present values of Ian and Sunny's monies are equal. B. In future dollars, Sunny's money is worth more than Ian's money. C. In today's dollars, Ian's money is worth more than Sunny's. D. Twenty years from now, the value of Ian's money will be equal to the value of Sunny's money. E. Sunny's money is worth more than Ian's money given the 7 percent discount rate. F. None of the above.

You plan to buy a new Mercedes four years from now. Today, a comparable car costs $82,500. You expect the price of the car to increase by an average of 4.8 percent per year over the next four years. How much will your dream car cost by the time you are ready to buy it? A. $98,340.00 B. $98,666.67 C. $99,517.41 D. $99,818.02 E. $100,023.16 F. None of the above.

Your grandmother invested a lump sum 26 years ago at 4.25 percent interest. Today, she gave you the proceeds of that investment which totaled $51,480.79. How much did she originally invest? A. $15,929.47 B. $16,500.00 C. $17,444.86 D. $17,500.00 E. $17,999.45 F. None of the above.

Naomi plans on saving $3,000 a year and expects to earn an annual rate of 10.25 percent. How much will she have in her account at the end of 45 years? A. $1,806,429 B. $1,838,369 C. $2,211,407 D. $2,333,572 E. $2,508,316 F. None of the above.

You are the beneficiary of a life insurance policy. The insurance company informs you that you have two options for receiving the insurance proceeds. You can receive a lump sum of $200,000 today or receive payments of $1,400 a month for 20 years. You can earn a 6 percent annual rate on your money, compounded monthly. Which option should you take and why? A. You should accept the monthly payments because they are worth $209,414 to you. B. You should accept the $200,000 lump sum because the monthly payments are only worth $16,057 to you today. C. You should accept the monthly payments because they are worth $336,000 to you. D. You should accept the $200,000 lump sum because the monthly payments are only worth $189,311 to you today. E. You should accept the $200,000 lump sum because the monthly payments are only worth $195,413 to you today. F. None of the above.

Your brother will borrow $17,800 to buy a car. The terms of the loan call for monthly payments for 5 years at an 8.6 percent annual interest rate, compounded monthly. What is the amount of each payment? A. $287.71 B. $296.67 C. $301.12 D. $342.76 E. $366.05 F. None of the above.

10. EAC Nutrition offers a 9.5 percent coupon bond with annual payments, maturing 11 years from today. Your required return is 11.2 percent. What price are you willing to pay for this bond if the face (or par) value is $1,000? A. $895.43 B. $896.67 C. $941.20 D. $946.18 E. $953.30 F. None of the above. 11. A project will produce after-tax operating cash inflows of $3,200 a year for 5 years. The after-tax salvage value of the project is expected to be $2,500 in year 5. The project's initial cost is $9,500. What is the net present value of this project if the required rate of return is 16 percent? A. -$311.02 B. $2,168.02 C. $4,650.11 D. $9,188.98 E. $21,168.02 F. None of the above. 12. Which of the following should be included in the analysis of a new product? I. Money already spent for research and development of the new product II. Reduction in sales for a current product once the new product is introduced III. Increase in working capital needed to finance sales of the new product IV. Interest expense on the loan used to finance the new product launch A. II and III only B. II and IV only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV F. None of the above. 13. Pro forma free cash flows for a proposed project should: I. exclude the cost of employing existing assets that could be sold anyway. II. exclude interest expense. III. include the depreciation tax shield related to the project. IV. exclude any required increase in operating current assets. A. I and II only B. II and III only C. II and IV only D. I, III, and IV only E. I, II, III, and IV F. None of the above. 14. Which of the following statements related to the internal rate of return (IRR) are correct? I. The IRR is the discount rate at which an investment's NPV equals zero. II. An investment should be undertaken if the discount rate exceeds the IRR. III. The IRR tends to be used more than net present value simply because its results are easier to comprehend. IV. The IRR is the best tool available for deciding between mutually exclusive investments. A. I and II only B. I and III only C. II and III only D. I, II, and IV only E. I, II, III, and IV F. None of the above.

15. You plan to pay $50 for a share of preferred stock that pays a $2.40 dividend per year forever. What annual rate of return will you realize? A. 0.48 percent B. 2.40 percent C. 4.80 percent D. 5.10 percent E. 20.83 percent F. None of the above. 16. Sol's Sporting Goods is expanding, and as a result expects additional operating cash flows of $26,000 a year for 4 years. This expansion requires $39,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires an additional $3,000 of net working capital throughout the life of the project; Sol expects to recover this amount at the end of the project. What is the net present value of this expansion project at a 16 percent required rate of return? A. $18,477.29 B. $21,033.33 C. $28,288.70 D. $29,416.08 E. $32,409.57 F. None of the above. 17. What is the benefit-cost ratio for an investment with the following cash flows at a 14.5 percent required return?

A. 0.94 B. 0.98 C. 1.02 D. 1.06 E. 1.11 F. None of the above. 18. When making a capital budgeting decision, which of the following is/are NOT relevant? I. The size of a cash flow. II. The risk of a cash flow. III. The accounting earnings from a cash flow. IV. The timing of a cash flow. A. I only B. II only C. III only D. II and III only E. III and IV only F. They are all relevant.

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

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

21. Ten years ago you invested $1,000 for 10 shares of Steeze, Inc. common stock. You sold the shares recently for $2,000. While you owned the stock it paid $10.08 per share in annual dividends. What was your rate of return on Steeze stock?

22. Consider the following investment opportunity.

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

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

At the end of the useful life of whatever equipment is chosen the product will be discontinued. The company's tax rate is 50 percent and its cost of capital is 10 percent. a. Calculate the net present value of each alternative. b. Calculate the benefit cost ratio for each alternative. c. Calculate the internal rate of return for each alternative. d. If the company is not under capital rationing, which alternative should be chosen? Why?

24. Given the following information about a possible average-risk, new product investment, calculate the investment's net present value.

25. Your brother, age 40, is the regional manager at an office supply company. He thinks he might want to leave his job to go back to school for an MBA. He expects that his current job, if he were to stay at it, would pay him a real income stream of $75,000 per year until retirement at age 65. If he goes back to school, he would forego two years of income, but his real income after graduation would be $110,000 per year until retirement at age 65. He has been accepted to an MBA program that costs a real $22,000 per year. If his real opportunity cost is 8 percent, would leaving his job to get an MBA be a smart financial decision?

ch 7 Key 1. B 2. D 3. E 4. C 5. C 6. C 7. D 8. E 9. E 10. A 11. B 12. A 13. B 14. B 15. C 16. E 17. C 18. C e. The NPV, PI, and IRR all indicate unambiguously that the investment is worthwhile. The accounting rate of return suggests the same, but is not a reliable indicator of investment value, nor is it comparable to the 15 percent required rate of return on the investment. Because there is no reliable way to transform a 15 percent required rate of return into a maximum acceptable payback period, it is not clear whether a 2.778 year payback period is short enough. d. NPV = 0 = - 100 + 36(PVAF, r%, 6 yrs); (PVAF, r%, 6 yrs) = 2.7778, where PVAF is a present value annuity factor from Appendix B. Consulting Appendix B and interpolating, or using a financial calculator (inputs: 36 = PMT, - 100 = PV, 6 = N, I =?), IRR = 27.698%. c. BCR, or PI = 36(3.784)/100 = 1.3622 b. NPV = - 100 + 36(3.784) = $36,224 The payback period = 100/36 = 2.778 years 19. a. The accounting rate of return = 36/100 = 36%

Alternatively, the calculator inputs are: - 1196.8 = PV, 100 = PMT, 1000 = FV, 20 = N, I =? and the output indicates a yield = 7.996%. 0 = 100(9.818) + 1,000(0.215) - 1,196.8 = 0. Therefore, the yield to maturity = 8 percent. 20. NPV = 0 = 100(PVAF, r%, 20yrs) + 1,000(PVF, r%, 20th yr.) - 1,196.80. Unless we use a financial calculator or spreadsheet program, we must use trial-and-error to search for the discount rate which makes the NPV zero. Because the price of the bond exceeds its maturity value, we know the yield to maturity must be less than the coupon rate. Let's try 8 percent.

Alternatively, the calculator inputs are: - 1000 = PV, 100.8 = PMT, 2000 = FV, 10 = N, I =? and the output indicates an annual return = 15.004%. Using trial-and-error, let's try 15%: - 1,000 + 2,000(0.247) + 100.8(5.019) = - .08. Therefore, IRR equals approximately 15 percent. NPV = - 1,000 + 2,000(PVF, r%, 10th yr) + 100.8(PVAF, r%, 10 yrs) = 0. 21. Total dividends per year = 10 shares x $10.08 per share = $100.80.

Using a financial calculator or Excel, IRR = 23.979%. The investment is clearly attractive at a hurdle rate of 12%. Alternatively, calculate the NPV at a discount rate of 12%; the NPV is positive and therefore the investment opportunity is an attractive one. NPV = - 850,000 + 206,500(4.870) + 40,000(.026) = + 156,695. Interpolating, IRR = about 24.1 percent. Using trial-and-error, let's try 20%: NPV = - 850,000 + 206,500(PVAF, r%, 20yrs) + 40,000(PVF, r%, 20th yr) = 0.

22.

d. The company should choose II because II has the higher NPV and NPV is a direct measure of increase in shareholder wealth. IRRII => NPV = 34(PVAF, r%, 6 yrs.) - 120 = 0. PVAF, r%, 6 yrs. = 120/34 = 3.529. Consulting Appendix B for 6 years, the PVAF for 17% is 3.589 and the value for 16% is 3.685. Interpolating, IRR is about equal to 17.7 percent. Using a financial calculator or Excel, IRR = 17.6% c. IRRI => NPV = 23(PVAF, r%, 4 yrs) - 64 = 0. PVAF, r%, 4 yrs. = 64/23 = 2.782. Consulting Appendix B for 4 yrs, the PVAF for 16% = 2.798, hence, IRR = about 16 percent. Using a financial calculator or Excel, IRR = 16.3%. b. BCRI = 23(3.17)/64 = 1.14; BCRII = 34(4.355)/120 = 1.23 NPVII = 34(4.355) - 120 = $28,000. NPVI = 23(3.17) - 64 = $9,000

23. a.

NPV at 8% cost of capital = $77,658 Cash Flows: Accounts receivable = 45(200,000/365) = 25,000 Ending inventory = production cost/4 = $27,500

24.

The net present value of your brother's MBA real income stream is the difference, or $1,022,523.82 - $39,231.82 = $983,292. This is greater than the value of his current income stream, so the correct financial decision is to return to school for an MBA.

The present value of the cost of the MBA program is $39,231.82.

The value of the MBA real income stream, discounted back 2 years, is $1,022,523.82. For school, the present value of your brother's real income stream is the present value of the 23-year real income from the new job, discounted back 2 years at the real discount rate, minus the present value of the cost of the MBA program.

25. To begin, calculate the present value of the real income stream from his current position. This results in a present value of $800,608.21.

ch 7 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Difficulty: 3 Hard Higgins - Chapter 07

# of Questions 11 11 3 25

ch 8 Student: ___________________________________________________________________________

Total risk is measured by _____ and systematic risk is measured by ____. A. beta; alpha B. beta; standard deviation C. WACC; beta D. standard deviation; beta E. standard deviation; variance F. None of the above.

When investment returns are less than perfectly positively correlated, the resulting diversification effect means that: A. making an investment in two or three large stocks will eliminate all of the unsystematic risk. B. making an investment in three companies all within the same industry will greatly reduce the systematic risk. C. spreading an investment across five diverse companies will not lower the total risk. D. spreading an investment across many diverse assets will eliminate all of the systematic risk. E. spreading an investment across many diverse assets will eliminate some of the total risk. F. None of the above.

Unsystematic risk: A. can be effectively eliminated by portfolio diversification. B. is compensated for by the risk premium. C. is measured by beta. D. is measured by standard deviation. E. is related to the overall economy. F. None of the above.

Which of the following are examples of diversifiable risk? I. An earthquake damages Oakland, California. II. The federal government imposes an additional $1,000 fee on all business entities. III. Employment taxes increase nationally. IV. Toymakers are required to improve their safety standards. A. I and III only B. II and IV only C. II and III only D. I and IV only E. I, III, and IV only F. None of the above.

Which of the following statements are correct concerning diversifiable, or unsystematic, risks? I. Diversifiable risks can be largely eliminated by investing in thirty unrelated securities. II. There is no reward for accepting diversifiable risks. III. Diversifiable risks are generally associated with an individual firm or industry. IV. Beta measures diversifiable risk. A. I and III only B. II and IV only C. I and IV only D. I, II, and III only E. I, II, III, and IV F. None of the above.

Which of the following statements concerning risk are correct? I. Systematic risk is measured by beta. II. The risk premium increases as unsystematic risk increases. III. Systematic risk is the only part of total risk that should affect asset prices and returns. IV. Diversifiable risks are market risks you cannot avoid. A. I and III only B. II and IV only C. I and II only D. III and IV only E. I, II, and III only F. None of the above.

Which one of the following is an example of systematic risk? A. The Federal Reserve unexpectedly announces an increase in target interest rates. B. A flood washes away a firm's warehouse. C. A city imposes an additional one percent sales tax on all products. D. A toymaker has to recall its top-selling toy. E. Corn prices increase due to increased demand for alternative fuels. F. None of the above.

The excess return earned by a risky asset, for example with a beta of 1.4, over that earned by a risk-free asset is referred to as a: A. market risk premium. B. risk premium. C. systematic return. D. total return. E. real rate of return. F. None of the above.

The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations? I. Firms that have a 100 percent retention ratio II. Firms that pay an unchanging dividend III. Firms that pay a constantly increasing dividend IV. Firms that pay an erratically growing dividend A. I and II only B. I and IV only C. II and III only D. I, II, and III only E. I, III, and IV only F. None of the above.

10. The cost of equity for a firm: A. tends to remain static for firms with increasing levels of risk. B. increases as the unsystematic risk of the firm increases. C. ignores the firm's risks when that cost is based on the dividend growth model. D. equals the risk-free rate plus the market risk premium. E. equals the firm's pretax weighted average cost of capital. F. None of the above. 11. The pre-tax cost of debt: A. is based on the current yield to maturity of the firm's outstanding bonds. B. is equal to the coupon rate on the latest bonds issued by a firm. C. is equivalent to the average current yield on all of a firm's outstanding bonds. D. is based on the original yield to maturity on the latest bonds issued by a firm. E. has to be estimated as it cannot be directly observed in the market. F. None of the above.

12. The after-tax cost of debt generally increases when: I. a firm's bond rating increases. II. the market-required rate of interest for the company's bonds increases. III. tax rates decrease. IV. bond prices rise. A. I and III only B. II and III only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV F. None of the above. Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below.

13. Estimate FM's after-tax cost of equity capital. A. 4.50% B. 6.92% C. 7.93% D. 12.20% E. 17.48% F. None of the above. 14. Estimate FM's after-tax cost of debt capital. A. 2.21% B. 4.10% C. 4.55% D. 6.30% E. 7.00% F. None of the above. 15. Estimate the appropriate weight of equity to be used when calculating FM's weighted average cost of capital. A. 11.5% B. 19.3% C. 80.7% D. 88.5% E. 100.0% F. None of the above.

16. Estimate the appropriate weight of debt to be used when calculating FM's weighted average cost of capital. A. 11.5% B. 19.3% C. 80.7% D. 88.5% E. 100.0% F. None of the above. 17. Estimate FM's weighted-average cost of capital. A. 6.46% B. 6.58% C. 11.27% D. 11.32% E. 11.52% F. None of the above. 18. FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in perpetuity. Which of the following statements is/are correct? I. FM should reject the project because the IRR is greater than the firm's WACC. II. FM should accept the project because the IRR is greater than the firm's WACC. III. FM should accept the project because the NPV is greater than zero. IV. FM should reject the project because the NPV is less than zero. A. I only B. II only C. IV only D. I and IV only E. II and III only F. None of the above. 19. Which of the following statements are correct? I. Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more risky than cash flows occurring sooner. II. If you can borrow all of the money you need for a project at 5%, the cost of capital for this project is 5%. III. The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds. IV. The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a firm. A. I and III only B. II and IV only C. I and II only D. I and IV only E. I, II, and III only F. None of the above 20. The capital structure weights used in computing the weighted average cost of capital: A. are based on the book values of total debt and total equity. B. are based on the market value of the firm's debt and equity securities. C. are computed using the book value of the long-term debt and the book value of equity. D. remain constant over time unless the firm issues new securities. E. are restricted to the firm's debt and common stock. F. None of the above.

21. The discount rate assigned to an individual project should be based on: A. the firm's weighted average cost of capital. B. the actual sources of funding used for the project. C. an average of the firm's overall cost of capital for the past five years. D. the current risk level of the overall firm. E. the risks associated with the use of the funds required by the project. F. None of the above. 22. The weighted average cost of capital for a firm is the: A. discount rate which the firm should apply to all of the projects it undertakes. B. rate of return a firm must earn on its existing assets to maintain the current value of its stock. C. coupon rate the firm should expect to pay on its next bond issue. D. minimum discount rate the firm should require on any new project. E. rate of return shareholders should expect to earn on their investment in this firm. F. None of the above. 23. Blue Diamond Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent. The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm's weighted average cost of capital? A. 10.39 percent B. 10.64 percent C. 11.18 percent D. 11.30 percent E. 11.56 percent F. None of the above. 24. Honest Abe's is a chain of furniture retail stores. Integral Designs is a furniture maker and a supplier to Honest Abe's. Honest Abe's has a beta of 1.38 as compared to Integral Designs' beta of 1.12. Both firms carry no debt, i.e., are 100% equity-financed. The risk-free rate of return is 3.5 percent and the market risk premium is 8 percent. What discount rate should Honest Abe's use if it considers a project that involves the manufacturing of furniture? A. 12.46 percent B. 12.92 percent C. 13.50 percent D. 14.08 percent E. 14.54 percent F. None of the above. Key facts and assumptions concerning Costco Company, at December 31, 2011, appear below.

25. Use the above information to answer the following questions. a. Estimate Costco's cost of equity capital. b. Estimate Costco's weighted-average cost of capital.

26. Explain the difference between systematic and unsystematic risk, and why one of these types of risks is rewarded with a risk premium while the other type is not.

27. Suppose that your company's weighted-average cost of capital is 9 percent. Your company is planning to undertake a project with an internal rate of return of 12%, but you believe that this project is not a good investment for the firm. What logical arguments might you use to convince your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your company's cost of capital will destroy value? If so, how?

28. The standard deviation of returns on Wildcat Oil Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is a high-risk investment when investors hold diversified portfolios? Explain why or why not.

29. Investments A and B both cost $100,000 and each promises a single payoff in one year. The distribution of payoffs for each investment appears below.

Ignoring possible differences in nondiversifiable risk, which investment would a risk-averse investor prefer, and why?

30. What is the present value of a cash flow stream of $10,000 per year annually for 11 years that then grows at 2 percent per year forever? Assume the appropriate discount rate is 12 percent.

ch 8 Key 1. D 2. E 3. A 4. D 5. D 6. A 7. A 8. B 9. C 10. C 11. A 12. B 13. D 14. B 15. D 16. A 17. C 18. E 19. D 20. B 21. E 22. B 23. A 24. A

b. The table below presents the weighted-average cost of capital for Costco: KE = 3.28 + 0.80 (6.10) = 8.16% 25. a. KE = gov't borrowing rate + equity beta*market risk premium

26. Unsystematic, or diversifiable, risk affects a limited number of securities and can be eliminated by investing in securities from various industries and geographic regions. Unsystematic risk is not rewarded because it can be eliminated by investors. Systematic risk is risk that affects most, or all, securities and cannot be diversified away. Since systematic risk cannot be eliminated by investors it is rewarded with a risk premium. Systematic risk is measured by beta.

27. If the investment is above the company's average risk, the company's cost of capital is not an appropriate benchmark. Equivalently, you might argue that the high risk of the investment places it below the security market line. Such investments destroy value because they promise returns that, while greater than the company's WACC, are still below those available on similar-risk investments available. Other possible arguments include: the investment is not consistent with the strategic plan; and, the cash flow estimates are too optimistic. 28. The equation for beta in chapter 8 shows that the nondiversifiable risk of an asset is the product of its standard deviation of returns and the correlation of those returns with those on a well-diversified portfolio. Wildcat Oil Drilling may have a high standard deviation of returns, but if those returns are poorly correlated with those on a well-diversified portfolio, as is likely the case, nondiversifiable risk may be low. These investments have the same expected outcome but different dispersions of possible outcomes. Risk-averse investors will prefer investment B because it has the same return as A but at lower risk.

29.

$59,376.99. The value of the growing perpetuity (using the formula provided in the chapter for a growing dividend into perpetuity) at time 11 is $10,000(1 + .02)/(.12-.02) = $102,000. Its value at time zero is $102,000/(1.12)11 = $29,322.56. Adding these present values, $29,322.56 + $59,376.99 = $88,699.55.

30. Divide the cash flows into two periods: An 11-year annuity of $10,000, and a growing perpetuity beginning in the 11th year. The value of the 11-year annuity is

ch 8 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Difficulty: 3 Hard Higgins - Chapter 08

# of Questions 20 9 1 32

ch 9 Student: ___________________________________________________________________________

Which of the following statements are correct? I. Liquidation value of a firm is equal to the present worth of expected future cash flows from operating activities. II. When an acquiring firm purchases a target firm's equity, the acquirer must assume the target's liabilities. III. The market value of a public company reflects the worth of the business to minority investors. IV. The fair market value of a business is usually the lower of its liquidation value and its going-concern value. A. I and III only B. II and IV only C. II and III only D. I, II, and III only E. II, III, and IV only F. None of the above.

Ginormous Oil entered into an agreement to purchase all of the outstanding shares of Slick Company for $60 per share. The number of outstanding shares at the time of the announcement was 82 million. The book value of liabilities on the balance sheet of Slick Co. was $1.46 billion. What was the cost of this acquisition to the shareholders of Ginormous Oil? A. $1.46 billion B. $3.46 billion C. $4.92 billion D. $6.38 billion E. $8.38 billion F. None of the above.

Ginormous Oil entered into an agreement to purchase all of the outstanding shares of Slick Company for $60 per share. The number of outstanding shares at the time of the announcement was 82 million. The book value of liabilities on the balance sheet of Slick Co. was $1.46 billion. Immediately prior to the Ginormous Oil bid, the shares of Slick Co. traded at $33 per share. What value did Ginormous Oil place on the control of Slick Co.? A. $2.21 billion B. $2.71 billion C. $4.17 billion D. $6.38 billion E. None of the above.

Which of the following statements is/are correct? I. Going-concern value of a firm is equal to the present value of expected net income. II. When a buyer values a target firm, the appropriate discount rate is the buyer's weighted-average cost of capital. III. The liquidation value estimate of terminal value usually vastly understates a healthy company's terminal value. IV. The value of a firm's equity equals the discounted cash flow value of the firm minus all liabilities. A. II only B. III only C. I and II only D. II and III only E. II, III, and IV only F. None of the above.

Which of the following statements are correct? I. Going-concern value of a firm is equal to the present value of expected future cash flows to owners and creditors. II. When an acquiring firm purchases a target firm's equity, the acquirer need not assume the target's liabilities. III. The market value of a public company reflects the worth of the business to minority investors. IV. The fair market value of a business is usually the lower of its liquidation value and its going-concern value. A. I and III only B. II and IV only C. II and III only D. I, II, and III only E. II, III, and IV only F. None of the above.

The following table presents forecasted financial and other information for Scott's Miracle-Gro Co.:

What is an appropriate estimate of Scott's terminal value as of the end of 2014, using the perpetualgrowth equation as your estimate? A. $161 million B. $363 million C. $3,690 million D. $3,833 million E. $5,357 million F. None of the above. 7.

The following table presents forecasted financial and other information for Scott's Miracle-Gro Co.:

What is an appropriate estimate of Scott's terminal value of equity as of the end of 2014? A. $225 million B. $3,833.0 million C. $4,207.5 million D. $4,365.0 million E. $6,788.1 million F. None of the above.

The following table presents forecasted financial and other information for Scott's Miracle-Gro Co.:

What is an appropriate estimate of Scott's terminal value as of the end of 2014, using a warranted multiple of free cash flow as your estimate? A. $155 million B. $2,898.5 million C. $3,007.0 million D. $4,365.0 million E. $7,042.2 million F. None of the above. 9.

Atmosphere, Inc. has offered $860 million cash for all of the common stock in ACE Corporation. Based on recent market information, ACE is worth $710 million as an independent operation. For the merger to make economic sense for Atmosphere, what would the minimum estimated value of the enhancements from the merger have to be? A. $0 B. $75 million C. $150 million D. $710 million E. $860 million F. None of the above.

10. Consider the following premerger information about a bidding firm (Buyitall Inc.) and a target firm (Tarjay Corp.). Assume that neither firm has any debt outstanding.

Buyitall has estimated that the present value of any enhancements that Buyitall expects from acquiring Tarjay is $2,600. What is the NPV of the merger assuming that Tarjay is willing to be acquired for $28 per share in cash? A. $400 B. $600 C. $1,800 D. $2,200 E. $2,600 F. None of the above.

Figure 9.1 In March of 2011, Macklemore Corp. considered an acquisition of Blue Scholar Learning, Inc. (BSL), a privately-held educational software firm. As a first step in deciding what price to bid for BSL, Macklemore's CFO, Ryan Lewis, has prepared a five-year financial projection for the company assuming the acquisition takes place. Use this projection and BSL's 2010 actual financial figures to answer the questions below.

11. What is BSL's free cash flow (in $ millions) for 2011? A. - $938 B. - $792 C. - $7 D. $122 E. $1,091 F. None of the above. 12. Estimate the present value of BSL's free cash flow (in $ millions) for the years 2011 - 2015. Macklemore's WACC is 8.0 percent. BSL's WACC is 11.5 percent, and the average of the two companies' WACCs, weighted by sales, is 8.2 percent. A. - $1.29 B. $628.24 C. $720.58 D. $726.68 E. $743.94 F. None of the above.

13. Estimate BSL's value (in $ millions) at the end of 2010 assuming it is worth the book value of its assets at the end of 2015. Macklemore's WACC is 8.0 percent. BSL's WACC is 11.5 percent, and the average of the two companies' WACCs, weighted by sales, is 8.2 percent. A. $628.24 B. $3,669.01 C. $4,297.25 D. $4,412.94 E. $4,984.28 F. $6,951.24 G. None of the above. 14. Assume BSL is worth the book value of its assets at the end of 2015. Macklemore's WACC is 8.0 percent. BSL's WACC is 11.5 percent, and the average of the two companies' WACCs, weighted by sales, is 8.2 percent. What is the maximum acquisition price (in $ millions) Macklemore should pay to acquire BSL's equity? A. $1,702.25 B. $2,227.25 C. $2,342.94 D. $2,383.94 E. $2,603.25 F. $4,297.25 G. None of the above. 15. Estimate BSL's value (in $ millions) at the end of 2010 assuming that in the years after 2015 the company's free cash flow grows 4 percent per year in perpetuity. Macklemore's WACC is 8.0 percent. BSL's WACC is 11.5 percent, and the average of the two companies' WACCs, weighted by sales, is 8.2 percent. A. $4,297.25 B. $4,571.09 C. $4,686.78 D. $6,181.09 E. $5,351.19 F. $7,423.16 G. None of the above. 16. Assume that in the years after 2015 the company's free cash flow grows 4 percent per year in perpetuity. Macklemore's WACC is 8.0 percent. BSL's WACC is 11.5 percent, and the average of the two companies' WACCs, weighted by sales, is 8.2 percent. What is the maximum acquisition price (in $ millions) Macklemore should pay to acquire BSL's equity at the end of 2010? A. $1,976.09 B. $2,501.09 C. $2,877.09 D. $4,195.09 E. $4,571.09 F. None of the above. 17. Estimate BSL's value (in $ millions) at the end of 2010 assuming that at year-end 2015 the company's equity is worth 15 times earnings after tax and its debt is worth book value. Macklemore's WACC is 8.0 percent. BSL's WACC is 11.5 percent, and the average of the two companies' WACCs, weighted by sales, is 8.2 percent. A. $628.24 B. $3,669.01 C. $7,429.74 D. $6,343.26 E. $6,755.83 F. $7,008.06 G. None of the above.

18. Assume that at year-end 2015 the company's equity is worth 15 times earnings after tax and its debt is worth book value. Macklemore's WACC is 8.0 percent. BSL's WACC is 11.5 percent, and the average of the two companies' WACCs, weighted by sales, is 8.2 percent. What is the maximum acquisition price (in $ millions) Macklemore should pay to acquire BSL's equity at the end of 2010? A. $3,484.68 B. $4,723.26 C. $4,938.06 D. $5,554.68 E. $6,343.26 F. None of the above. 19. The following information is available about Chiantivino Corp. (CC):

An activist investor is confident that by terminating CC's money-losing fortified wine division, she can increase free cash flow by $4 million annually for the next decade. In addition, she estimates that an immediate, special dividend of $10 million can be financed by the sale of the division. a. Assuming these actions do not affect CC's cost of capital, what is the maximum price per share the investor would be justified in bidding for control of CC? What percentage premium does this represent? b. Show your answer if you conduct a sensitivity analysis by assuming the cost of capital is 15 percent and the increased cash flow is only $3.5 million per year.

20. Below is a recent income statement for Gatlin Camera:

Calculate Gatlin's free cash flow in this year assuming it spent $510 on new capital equipment and increased current assets net of noninterest-bearing current liabilities $340.

The following table presents a four-year forecast for Kenmore Air, Inc.:

21. Estimate the fair market value of Kenmore Air at the end of 2012. Assume that after 2016, earnings before interest and tax will remain constant at $200 million, depreciation will equal capital expenditures in each year, and working capital will not change. Kenmore Air's weighted-average cost of capital is 11 percent and its tax rate is 40 percent.

22. Estimate the fair market value per share of Kenmore Air's equity at the end of 2016 if the company has 40 million shares outstanding and the market value of its interest-bearing liabilities on the valuation date equals $250 million.

23. Estimate the fair market value of Kenmore Air's equity per share at the end of 2012 under the following assumptions: a. EBIT in year 2016 is $200 million, and then grows at 5 percent per year forever. b. To support the perpetual growth in EBIT, capital expenditures in year 2017 exceed depreciation by $30 million, and this difference grows 5 percent per year forever. c. Similarly, working capital investments are $15 million in 2017, and this amount grows 5 percent per year forever.

24. Estimate the fair market value of Kenmore Air's equity per share at the end of 2012 under the following assumptions: a. EBIT in year 2016 will be $200 million. b. At year-end 2016, Kenmore Air has reached maturity, and analysts expect its equity will sell for 12 times year 2016 net income. c. At year-end 2016, Kenmore Air has $250 million of interest-bearing liabilities outstanding at an average interest rate of 10 percent.

25. Ametek, Inc. is a billion dollar manufacturer of electronic instruments and motors headquartered in Paoli, Pennsylvania. Use the following information on Ametek and five other similar companies to value Ametek, Inc. on December 31, 2010.

*American Power Conversion has no interest-bearing debt outstanding. MV = Market value; BV = Book value. Market value is estimated as book value of interest-bearing debt + market value of equity. Earnings are fiscal year earnings.

26. Rainy City Coffee's (RCC) free cash flow next year will be $100 million and it is expected to grow at a 4 percent annual rate indefinitely. The company's weighted average cost of capital is 10 percent, the market value of its liabilities is $1 billion, and it has 20 million shares outstanding. a. Estimate the price per share of RCC's common stock. b. A hedge fund believes that by selling the company's private jet and instituting other cost savings, it can increase RCC's free cash flow next year to $110 million and can add a full percentage point to RCC's growth rate without affecting its cost of capital. What is the maximum price per share the hedge fund can justify bidding for control of RCC?

27. Empirical evidence indicates that the returns to shareholders of the target firm vary significantly from the returns to the shareholders of the acquiring firm. Identify the shareholders that tend to realize the smaller return. Does your answer depend on the way the acquisition is financed?

ch 9 Key 1. C 2. D 3. A 4. B 5. A 6. D 7. C 8. C 9. C 10. A 11. C 12. B 13. C 14. B 15. B 16. B 17. D 18. B Fair market value of the firm assuming a 15 percent discount rate and a $3.5 million annuity = 155 + 3.5(5.019) + 10 = $182.57 million. Value of equity = 182.57 - 75 = 107.57. Value per share = 107.57/10 = $10.76. This is a 34.5% premium over the existing price. b. Fair market value = $155 million + $4 million x 5.216 + $10 million = $185.86. Fair market value of equity = $185.86 - 75 = $110.86. Fair market of equity per share = $110.86/10 = $11.09. This is a 38.6% premium over the existing $8 share price. Fair market value under new management = $155 million + present value of enhancements = $155 million + present value of a $4 million annuity for 10 years at 14% + $10 million from sale of the division. 19. a. The maximum justifiable premium = the fair market value of CC under new management - the fair market value of CC under existing management. A plausible estimate of CC's fair market value under existing management is its standalone value = current market value of firm = $8 x 10 million + 75 million = $155 million.

Free cash flow = 2,370(1 - .34) + 800 - 510 - 340 = $1,514.20. Tax rate = 612/1,800 = .34 EBIT = Income before tax + Interest = 1,800 + 570 = $2,370. 20. Free cash flow = EBIT(1 - Tax rate) + Depreciation - Fixed investment - Working capital investment.

21. FMV = PV{FCF, 2013 - 16} + PV{Terminal value}. Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2013 - 16} = $155.9 million. Terminal value = EBIT(1 - Tax rate)/0.11 = $120/0.11 = $1090.9 million. PV{Terminal value} = $1090.9 million/(1 + 0.11)4 = $718.6 million. Summing, FMV = $874.5 million. FMV of equity = ($874.5 - $250)/40 = $15.61 per share. 22. FMV = PV{FCF, 2013 - 16} + PV{Terminal value}. Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2013 - 16} = $155.9 million. Terminal value = EBIT(1 - Tax rate)/0.11 = $120/0.11 = $1090.9 million. PV{Terminal value} = $1090.9 million/(1 + 0.11)4 = $718.6 million. Summing, FMV = $874.5 million.

23. FMV = PV{FCF, 2013 - 16} + PV{Terminal value}. Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2013 - 16} = $155.9 million. Terminal value = FCF in 2017/(0.11 - 0.05). FCF in 2017 = $200(1.05)(1 - .4) - 30 - 15 = $81. So, terminal value = $81/(.11 - .05) = $1,350. Present value of terminal value = $889.3. FMV of company = $155.9 + $889.3 = $1,045.2 million. FMV of equity per share = ($1,045.2 $250)/40 = $19.88 24. FMV = PV{FCF, 2013 - 16} + PV{Terminal value}. Discounting the FCFs at an 11 percent cost of capital, PV{FCF, 2013 - 16} = $155.9 million. Terminal value = Value of equity + Value of interest-bearing liabilities. Value of equity = 12 x Net income in 2012 = 12 x (200 - 0.10 x 250)(1 - .40) = $1,260 million. Terminal value = $1,260 million + $250 million = $1,510. Present value of terminal value = $994.7. Therefore, the FMV of company on valuation date = $155.8 + $994.7 = $1,150.6 million. Value per share = ($1,150.6 million - $250 million)/40 = $22.51.

A best guess of a fair price for Ametek, Inc.'s shares at year-end 2010 is $36.00. Many other estimates are, of course, possible.

The implied value of AI common stock per share for each indicator of value is:

Here are estimated indicators of value for Ametek, Inc. The company's higher-than-average leverage suggests that its firm value ratios will be particularly key, as equity value ratios can be distorted by Ametek's higher leverage. Since the firm value ratios abstract from differences in financing, values for these ratios are selected that are closer to the sample averages. Turning to equity value ratios, AI's modest growth and higher financial leverage suggest a 10 to 20 percent discount from the group average for its price/earnings and price/sales indicators. The following estimates require subjective reasoning. In coming to these estimates, Ametek, Inc. (AI) is judged as exhibiting representative earnings per share growth, but considerably higher financial leverage, and a below-average five-year growth rate in sales.

25. The median and mean values for Ametek's peers are presented below:

Fair market value of equity per share after change in ownership = (110/(.10 - .05) - 1,000)/20 = $60.00. 26. Price per share of RCC stock = (100/(.10 - .04) - 1,000)/20 = $33.33.

The empirical evidence also suggests that leveraged buyouts lead to sizeable improvements in operating performance and attractive returns to buyers. Hence, financing policy does appear to change the outcome for buyers. 27. The empirical evidence strongly indicates that the shareholders of the target firm realize large wealth gains (premiums of 20 - 40 percent) as a result of a takeover bid but the shareholders in the acquiring firm gain little or nothing. While a definitive answer is elusive, the following have been offered as possible explanations for these low returns to acquiring shareholders: size differentials, competition in the takeover market, lack of achieving expected synergy gains, management goals other than the best interests of the shareholders, and early announcements of corporate acquisition intent.

ch 9 Summary Category Difficulty: 1 Easy Difficulty: 2 Medium Difficulty: 3 Hard Higgins - Chapter 09

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