The tutorial for the following is available at SoF.
TRUE / FALSE
1. Financing through common stock is the most popular method for corporations.
2. Although maximization of the market value of a firm’s common stock is a valid objective of the firm, it is not without its drawbacks since the effects of financial structure
decisions are not reflected in this term.
3. If a foreign currency is expected to depreciate with respect to the home currency, the
holder of a net liability in foreign currency will profit.
4. The money market is usually thought of as dealing with long-term debt instruments
issued by firms with excellent credit ratings.
5. Sales occurring in the secondary markets increase the total stock of financial assets that exist in the economy.
SIMPLE MULTIPLE CHOICE (only provide answer)
6. Which of the following statements is correct?
a. Firms whose sales are very sensitive to changes in the business cycle are more
likely to rely on debt financing.
b. Firms with large tax loss-carry-forwards are more likely to rely on debt financing.
c. Firms with a high operating leverage are more likely to rely on debt financing.
d. None of the above statements is correct.
7. The break-even quantity of output results in an EBIT level equal to:
a. fixed costs.
b. contribution margin.
c. zero.
d. variable costs.
8. Which of the following could offset the higher risk exposure a company would face if it
were to engage in heavy short-term borrowing?
a. Its inventory would need to be mostly highly liquid consumer impulse items.
b. Its accounts receivable collection policy could increase the average collection
period.
c. It could offer no discounts for early payment by its customers.
d. It could buy back some of its shares in the open market in order to reduce its
equity.
9. Which of the following is a characteristic of an efficient market?
a. Small number of individuals.
b. Opportunities exist for investors to profit from publicly available information.
c. Security prices reflect fair value of the firm.
d. Immediate response occurs for new public information.
10. Which of the following is inconsistent with an optimal capital structure policy?
a. Lower the blended cost of debt and equity.
b. Maximize a firm’s common stock price.
c. Minimize the cost of capital.
d. Maximize EPS.
PROBLEM MULTIPLE CHOICE (must show work)
11. Your company is considering an investment in one of two mutually exclusive projects. Project 1 involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after tax cash flows of $500 per year in years 1-5. Project 2
involves a capital intensive process, requiring an initial outlay of $6,704. After tax cash
flows for Project 2 are expected to be $2,000 per year for years 1-5. Your firm’s discount rate is 10%. If your company is not subject to capital rationing, which project(s) should you take on based on the basic capital budgeting criteria (NPV and IRR)?
a. Project 1
b. Project 2
c. Projects 1 and 2
d. Neither project is acceptable.
12. A friend of yours is trying to determine whether to open a sandwich stand at the local mall based on the following data. She expects total fixed costs per year of $24,000, a sale price per sandwich of $3.00, and variable costs per sandwich of $1.80. What is the breakeven level of output for this endeavor:
a. 12,000.
b. 16,000.
c. 20,000.
d. 24,000.
13. Kimble Carpets, Inc. has asked you to calculate the company’s current ratio for 2001. All you have is a partial balance sheet and some assumptions. Using the information provided, calculate Kimble’s current ratio for 2001.
Gross profit margin = 50%
Inventory turnover (COGS/Inv) = 5
2001 sales = $3,000
Assets Liabilities & Equity
Cash 60 Accounts payable $50
AR $40 Accruals 200
Inventory 300 Long-term debt $400
Net fixed assets $500 Equity $250
Total assets $900 Total liab. & equity 900
a. 0.3
b. 0.8
c. 1.6
d. 2.2
14. Company ABC has a target capital structure of 50% debt and 50% equity. They are
planning to invest in a project which will necessitate raising new capital. New debt will
be issued at a before-tax yield of 12%, with a coupon rate of 10%. The equity will be
provided by internally generated funds. No new outside equity will be issued. If the
required rate of return on the firm’s stock is 15% and its marginal tax rate is 40%,
compute the firm’s cost of capital.
a. 13.5%
b. 12.5%
c. 7.2%
d. 11.1%
.12*(1-.4)*.5+.5*.15=11.1%
Use the following to answer questions 15-16. The information below describes a project with an
initial cash outlay of $10,000 and a required return of 12%.
After-tax cash inflow
Year 1 $6,000
Year 2 $2,000
Year 3 $2,000
Year 4 $2,000
15. Which of the following statements is correct?
a. The project should be accepted since its NPV is $353.87.
b. The project should be rejected since its NPV is -$353.87.
c. The project should be accepted since it has a payback of less than four years.
d. The project should be rejected since its NPV is -$23.91.
16. This project:
a. has an IRR of 9.86%.
b. should be accepted based on the IRR criterion.
c. has an IRR of 12%.
d. both a and b.
This is the only acceptable choice since NPV is negative at 10%, hence IRR is lower than that.
DETAILED PROBLEMS (must show work)
Problem # 1:
Bailey and Brothers has applied for a loan from the Me Too Bank in order to invest in several potential opportunities. In order to evaluate the firm as a potential debtor, the bank would like to compare Bailey and Brothers to the industry. The following are the financial statements given to Trust Us Bank:
Balance Sheet 12/31/2005 12/31/2006
Cash $305 270
Accounts receivable 275 290
Inventory 600 580
Current assets 1,180 1,140
Plant and equipment 1,700 1,940
Less: acc depr (500) (600)
Net plant and equipment 1,200 1,340
Total assets $2,380 $2,480
Liabilities and Owners’ Equity
Accounts payable $150 $200
Notes payable 125 0
Bonds 500 500
Owners’ equity
Common stock 165 305
Paid-in-capital 775 775
Retained earnings 665 700
Total owners’ equity 1,605 1,780
Total liabilities and
owners’ equity $2,380 $2,480
Income Statement
Sales (100% credit) $1,100 $1,330
Cost of goods sold 600 760
Gross profit 500 570
Operating expenses 20 30
Depreciation 160 200
Net operating income 320 340
Interest expense 64 57
Net income before taxes 256 283
Taxes 87 96
Net income $ 169 $ 187
a) Compute the following ratios for 2005 and 2006:
2005 2006 Industry Norms
Current ratio 5.0
Acid test ratio 3.0
Inventory turnover 2.2
Average collection period 90 days
Debt ratio 0.33
Times interest earned 7.0
Total asset turnover 0.75
Fixed asset turnover 1.0
Operating profit margin 20%
Net profit margin 12%
Return on total assets 9.00%
Oper income return on investments 15.00%
Return on equity 10.43%
b) What are the firm’s financial strengths and weaknesses?
• Be sure to discuss each ratio in relation to the industry norm. What does the
comparison mean?
• Be sure to discuss each ratio in relation to the year-to-year trend. What does the trend
indicate?
• What qualitative assessments can you make based on your analysis?
c) Should the bank make the loan? Why or why not?
• The answer to this question should be a thoughtful response.
• In your answer be sure to address trends in liquidity, inventory management,
operating profits and whether or not you believe the loan is needed and why.
• A simple “yes” / “no” type answer will receive ZERO
Problem # 2: (15 pts)
ANSWER: Please see Excel file
Ducker Industries’ projected sales for the first six months of 2004 are given below:
Table 1
Jan. $200,000 April $400,000
Feb. $240,000 May $320,000
March $280,000 June $320,000
• 25% of sales is collected in cash at the time of the sale, 50% is collected in the month
following the sale, and the remaining 25% is collected in the second month following
the sale.
• Cost of goods sold is 75% of sales.
• Purchases are made in the month prior to the sale, and payments for purchases are
made in the month of the sale.
• Total other cash expenses are $60,000/month.
• The company’s cash balance as of February 28, 2004 will be $40,000. Excess cash
will be used to retire short-term borrowing (if any).
• Ducker has no short-term borrowing as of February 28, 2004.
• Assume that the interest rate on short-term borrowing is 1% per month.
• The company must have a minimum cash balance of $25,000 at the beginning of each
month.
• Round all Answers to the nearest $100.
a) Prepare a cash budget for Ducker and highlight (using color, borders or bold) the following:
_ total cash receipts (collections) for April 2004
_ total disbursement in May (not including interest on short-term borrowing)
_ ending cash balance (before borrowing) in March
_ projected cumulative short-term borrowing as of April 30, 2004
_ when Ducker pays off its short-term borrowing
b) Prepare a simple income statement and highlight (using color, borders or bold)
Ducker’s EBIT for March 2004
Problem # 3: (15 pts)
ANSWER: Please see Excel file
Use the following information to answer questions for Problem 3.
Millennium Corp, Inc. has a base level of sales of 150,000 units. Sales price per unit is
$10.00 and variable cost per unit is $6.50. Total annual operating fixed costs are $155,000, and the annual interest expense is $90,000. (For consistency with answers below, carry all calculations to two decimals.)
a) What is base level EBIT?
b) What is Millennium Corp.’s operating leverage? Provide an interpretation to describe
Millennium’s degree of operating leverage.
c) Assume that Millennium expects units sold to increase 20%. What will be the resulting percentage change in EBIT?
d) What will be the new level of EBIT given the expected 20% increase in units sold?
e) Calculate Millennium’s degree of financial leverage. Provide an interpretation to
describe Millennium’s degree of financial leverage.
f) Calculate Millennium’s degree of combined leverage. Provide an interpretation to
describe Millennium’s degree of combined leverage.
g) Assume that Millennium expects units sold to increase 20%. What will be the resulting percentage change in earnings per share?
h) Assume that Millennium’s current level of earnings per share is $2.00. What will be the new level of earnings per share given the expected 20% increase in units sold?
