Essay Questions Chapter 1

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1 Essay Questions Chapter 1 1. Meese Paper Distributors, Inc. has before-tax earnings of $1,900,000. Calculate the amount of the total tax liability. Answer: Meese Paper Distributors Tax Liability 0.15 $50,000 $ 7, $25,000 6, $25,000 8, ($335,000 $100,000) 91, (1,900,000 $335,000) $532,100 Total tax liability $646,000 Learning Goal: 6 Topic: Business Taxes 2. During 2002, a firm has sold 5 assets described below. Calculate the tax liability on the assets. The firm pays a 40 percent tax rate on ordinary income. Asset Purchase Price Sale Price 1 $10,000 $12,000 2 $50,000 $40,000 3 $37,500 $50,000 4 $ 3,000 $ 3,500 5 $15,000 $12,000 Answer: Asset Tax Liability 1 $ 2,000(0.40) $ $12,500(0.40) $5,000 4 $ 500(0.40) $ Learning Goal: 6 Topic: Business Taxes

2 Chapter 1 The Role and Environment of Managerial Finance 2 3. Consider two firms, Go Debt corporation and No Debt corporation. Both firms are expected to have earnings before interest and taxes of $100,000 during the coming year. In addition, Go Debt is expected to incur $40,000 in interest expenses as a result of its borrowings whereas No Debt will incur no interest expense because it does not use debt financing. However, No Debt will have to pay stockholders $40,000 in dividend income. Both firms are in the 40 percent tax bracket. Calculate the Earnings after tax for both firms. Which firm has the higher after-tax earnings? Which firm appears to have the higher cash flow? How do you account for the difference? Answer: Earnings before interest and taxes Go Debt No Debt $100,000 $100,000 Less: Interest expense 40,000 0 Earnings before taxes $ 60,000 $100,000 Less: Taxes (40%) 24,000 40,000 Earnings after taxes $ 36,000 $ 60,000 Less: Dividends paid 0 40,000 Go Debt has lower earnings after taxes compared to No Debt. However, from a cash outflow perspective, Go Debt paid out a total of only $64,000 ($40,000 in interest expenses plus $24,000 in taxes) while No debt paid out a total of $ ($40,000 in taxes and $40,000 in dividends). The difference between the two is $16,000 which is exactly the difference in taxes paid between the two firms ($24,000 compared to $40,000). This difference results from the fact that interest expense is a tax deductible expense. Level of Difficulty: 4 Learning Goal: 6 Topic: Business Taxes Essay Questions Chapter 2 1. Ag Silver Mining, Inc. has $500,000 of earnings before interest and taxes at the year end. Interest expenses for the year were $10,000. The firm expects to distribute $100,000 in dividends. Calculate the earnings after taxes for the firm assuming a 40 percent tax on ordinary income. Answer: Earnings before interest and taxes $500,000 Less: Interest 10,000 Earnings before taxes $490,000 Less: Taxes (40%) 196,000 Earnings after taxes $294,000 Level of Difficulty: 2 Learning Goal: 1 Topic: Income Statement

3 Chapter 1 The Role and Environment of Managerial Finance 3 2. At the end of 2005, the Long Life Light Bulb Company announced it had produced a gross profit of $1 million. The company has also established that over the course of this year it has incurred $345,000 in operating expenses and $125,000 in interest expenses. The company is subject to a 30 percent tax rate and has declared $57,000 total preferred stock dividends. (a) How much is the earnings available for common stockholders? (b) Compute the increased retained earnings for 2005 if the company were to declare a $4.25 common stock dividend. The company has 15,000 shares of common stock outstanding. Answers: (a) Gross Profits $1,000,000 Less: Operating expenses (345,000) Operating Profits $ 655,000 Less: Interest (125,000) Net Profits before taxes $ 530,000 Less: Taxes (30%) (159,000) Net Profits After Taxes $ 371,000 Less: Preferred Stock Dividend (57,000) Earnings Available for Common Stock $ 314,000 (b) Earnings Available for Common Stock $ 314,000 Learning Goal: 1 Topic: Income Statement Dividend (4.25)(15,000 shares) (63,750) Increased Retained Earnings $ 250, Reliable Auto Parts has 5,000 shares of common stock outstanding. The company also has the following amounts in revenue and expense accounts. Sales revenue $ 85,000 General and administrative expense 7,500 Interest expense 3,500 Depreciation expense 5,000 Preferred stock dividends 500 Selling expense 4,000 Cost of goods sold 50,000 Calculate (a) gross profits. (b) operating profits. (c) net profits before taxes. (d) net profits after taxes (assume a 40 percent tax rate). (e) cash flow from operations. (f) earnings available to common stockholders. (g) earnings per share.

4 Chapter 1 The Role and Environment of Managerial Finance 4 Answers: (a) Sales revenue $85,000 cost of goods sold 50,000 Gross profits $35,000 (b) Gross profits $35,000 operating expenses Selling expense 4,000 General & adm. expense 7,500 Depreciation expense 5,000 $16,500 Operating profits $18,500 (c) Operating profits $18,500 interest expense 3,500 Net profits before taxes $15,000 (d) Net profits before taxes $15,000 taxes (40%) 6,000 Net profits after taxes $9,000 (e) Net profits after taxes $9,000 depreciation expense 5,000 Cash flow from operations $14,000 (f) Net profits after taxes $9,000 preferred dividends 500 earnings available for C.S. $8,500 (g) Earnings available for C.S. $8,500 = Learning Goal: 1 Topic: Income Statement # of common shares outstanding 5,000 $1.70/share

5 Chapter 1 The Role and Environment of Managerial Finance 5 4. Colonial Furniture s net profits before taxes for 2002 totaled $354,000. The company s total retained earnings were $338,000 for 2004 year end and $389,000 for 2005 year end. Colonial is subject to a 26 percent tax rate. How large was the cash dividend declared by Colonial Furniture in 2005? Answer: Net Profits Before Taxes $354,000 Less: Taxes (26%) 92,040 Net Profits After Taxes $261,960 Retained Earnings (2004) $338,000 Net Profits After Taxes (2005) 261,960 Dividends Retained Earnings (2005) $389,000 Dividends $210,960 Learning Goal: 1 Topic: Statement of Retained Earnings 5. On December 31, 2004, the Bradshaw Corporation had $485,000 as an ending balance for its retained earnings account. During 2005, the corporation declared a $3.50/share dividend to its stockholders. The Bradshaw Corporation has 35,000 shares of common stock outstanding. When the books were closed for 2005 year end, the corporation had a final retained earnings balance of $565,000. What was the net profit earned by Bradshaw Corporation during 2005? Answer: Dividends ($3.50/share)(35,000 shares) $122,500 Retained Earnings (2004) $485,000 Net Profits After Taxes (2005) Dividends 122, Retained Earnings (2005) $565,000 Net Profits After Taxes $202,500 Learning Goal: 1 Topic: Statement of Retained Earnings X X

6 Chapter 1 The Role and Environment of Managerial Finance 6 6. The Sunshine Company had a retained earnings balance of $850,000 at the beginning of By the end of 2005, the company s retained earnings balance was $950,000. During 2005, the company earned $245,000 as net profits after paying its taxes. The company was then able to pay its preferred stockholders $45,000. Compute the common stock dividend per share in 2005 assuming 10,000 shares of common stock outstanding. Answer: Retained Earnings (2004) $850,000 Net Profits After Taxes (2005) 245,000 Preferred Stock Dividend (45,000) Common Stock Dividend Retained Earnings (2005) $950,000 Total common stock dividend $100,000 Common stock dividend per share 100,000/10,000 $10 Learning Goal: 1 Topic: Statement of Retained Earnings 7. Discuss the limitations of ratio analysis and the cautions which must be taken when reviewing a cross-sectional and time-series analysis. Answer: In summarizing a large number of ratios, all aspects of the firm s activities can be assessed. However, limitations of ratio analysis must be recognized. A comparison of current and past ratios may reveal mismanagement. But, the ratio does not give definitive cause to the problem. Additional investigation is necessary to confirm the possible problem. The analyst must be cautious of the following points: 1) a single ratio does not provide sufficient information to judge the overall performance of the firm, 2) the dates of the financial statements should be the same, 3) audited statements should be used, 4) similar accounting treatment of comparative data is essential, and 5) inflation and differing asset ages can distort ratio comparisons. Learning Goal: 2 Topic: Ratio Analysis Basics X

7 Chapter 1 The Role and Environment of Managerial Finance 7 8. Key Financial Data Dreamscape, Inc. Industry Average Ratio For the Year Ended For the Year Ended (% of Sales) December 31, 2004 December 31, 2005 Cost of goods sold 74.5% 70.0% Gross profits Selling expense Gen. & admin. expense Depreciation expense Total operating expense Operating profits Interest expense Net profits before taxes Taxes Net profits after taxes Income Statement, Dreamscape, Inc. For the Year Ended December 31, 2005 Sales revenue $1,000,000 Less: Cost of goods sold 750,000 Gross profits $ 250,000 Less: Operating expenses Selling Expense $70,000 Gen. & admin. expense 48,000 Depreciation expense 20,000 Total operating expense $ 138,000 Operating profits $ 112,000 Less: Interest expense $ 20,000 Net profits before taxes $ 92,000 Less: Taxes $ 36,800 Net profits after taxes $ 55,200 Prepare a common-size income statement for Dreamscape, Inc. for the year ended December 31, Evaluate the company s performance against industry average ratios and against last year s results.

8 Chapter 1 The Role and Environment of Managerial Finance 8 Answer: Common-Size Income Statement Dreamscape, Inc. For the Year Ended December 31, 2005 Sales revenue 100% Less: Cost of goods sold 75% Gross profits 25% Less: Operating expenses Selling Expense 7.0% Gen. & admin. expense 4.8% Depreciation expense 2.0% Total operating expense 13.8% Operating profits 11.2% Less: Interest expense 2.0% Net profits before taxes 9.2% Less: Taxes 3.68% Net profits after taxes 5.52% Dreamscape, Inc. performs significantly below industry average. All profitability ratios (gross profit margin, operating profit margin, and net profit margin) trail the industry norms. In 2004 expenses as a percent of sales were high. Dreamscape, Inc. improved the management of operating expenses in 2005 meeting industry averages. However, cost of goods sold as a percent of sales increased and is a full 5 percent above the industry average, further reducing the gross profit margin. Interest expense is two times the average indicating high cost of debt or a high debt level. The firm must concentrate on reducing the cost of goods sold and interest expense to improve performance. Level of Difficulty: 4 Learning Goal: 6 Topic: Common Size Statement Analysis 9. In an effort to analyze Clockwork Company finances, Jim realized that he was missing the company s net profits after taxes for the current year. Find the company s net profits after taxes using the following information. Return on total assets 2% Total Asset Turnover 0.5 Cost of Goods Sold $105,000 Gross Profit Margin 0.30 Answer: Sales CGS/(1 GPM) 105,000/(1 0.30) $150,000 Total Assets Sales/(Total Asset Turnover) 150,000/0.50 $300,000 Net Profits After Taxes (ROA) (Total Assets) Level of Difficulty: 4 Learning Goal: 6 Topic: Ratio and Financial Statement Analysis (0.02) (300,000) $6,000

9 Chapter 1 The Role and Environment of Managerial Finance Construct the DuPont system of analysis using the following financial data for Key Wahl Industries and determine which areas of the firm need further analysis. Key Wahl Industries: Key Financial Data Sales $4,500,000 Net profits after taxes 337,500 Total assets 6,750,000 Total liabilities 3,375,000 Industry Averages: Total asset turnover 0.71 Debt ratio 33.00% Financial leverage multiplier 1.50 Return on total assets 6.75% Return on equity 10.00% Net profit margin 9.50% Answer: Ratios for Key Wahl Industries 4,500,000 Total asset turnover ,750,000 3,375,000 Debt ratio 50% 6,750,000 1 Financial leverage multiplier ,500 ROA 5% 6,750,000 ROE ROA Financial leverage multiplier 10% 337,500 Net profit margin 7.5% 4,500, 000 DuPont System of Analysis: Key Wahl Industries performs equally to industry averages according to the return on equity. However, when dissecting the financial data further into the three key components of the DuPont system (a profit-on-sale, efficiency-of-asset use, and a use-of-leverage component), some areas of improvement may be highlighted. Key Wahl Industries has a lower net profit margin and return on total assets than industry averages. Nevertheless, the firm makes up for the low profit margin through excessive use of leverage (a 50 percent debt ratio versus 33 percent for the industry). Financial risk could be reduced resulting in the same return on equity by increasing the net profit margin and reducing debt. Level of Difficulty: 4 Learning Goal: 6 Topic: Dupont System Analysis

10 Chapter 1 The Role and Environment of Managerial Finance Given the following balance sheet, income statement, historical ratios and industry averages, calculate the Pulp, Paper, and Paperboard, Inc. financial ratios for the most recent year. Analyze its overall financial situation for the most recent year. Analyze its overall financial situation from both a cross-sectional and time-series viewpoint. Break your analysis into an evaluation of the firm s liquidity, activity, debt, and profitability. Income Statement Pulp, Paper and Paperboard, Inc. For the Year Ended December 31, 2005 Sales Revenue $2,080,976 Less: Cost of Goods Sold 1,701,000 Gross Profits $379,976 Less: Operating Expenses 273,846 Operating Profits $106,130 Less: Interest Expense 19,296 Net Profits Before Taxes $86,834 Less: Taxes (40%) 34,810 Net Profits After Taxes $52,024 Balance Sheet Pulp, Paper and Paperboard, Inc. December 31, 2005 Assets Cash $ 95,000 Accounts receivable 237,000 Inventories 243,000 Total current assets $ 575,000 Gross fixed assets 500,000 Less: Accumulated depreciation 75,000 Net fixed assets $ 425,000 Total assets $1,000,000 Current liabilities Liabilities and stockholders equity Accounts payable $ 89,000 Notes payable 169,000 Accruals 87,000 Total current liabilities $ 345,000 Long-term debt 188,000 Total liabilities $ 533,000 Stockholders equity Common stock 255,000 Retained earnings 212,000 Total stockholders equity $ 467,000 Total liabilities and stockholders equity $1,000,000

11 Chapter 1 The Role and Environment of Managerial Finance 11 Historical and Industry Average Ratios Pulp, Paper and Paperboard, Inc. Ratio Industry 2005 Current Ratio Quick Ratio Inventory Turnover Average Collection Period 33 days 37 days 39 days Total Asset Turnover Debt Ratio 60% 56% 58% Times Interest Earned Gross Profit Margin 21% 19.7% 20.4% Operating Profit Margin 4.7% 4.8% 4.7% Net Profit Margin 1.8% 1.6% 1.4% Return on total assets 4.1% 3.5% 3.08% Return on Equity 10.3% 7.9% 7.3% Answer: Historical and Industry Average Ratios Pulp, Paper and Paperboard, Inc. Ratio Current Ratio Quick Ratio Inventory Turnover Industry 2005 Average Collection Period 33 days 37 days 41 days 39 days Total Asset Turnover Debt Ratio 60% 56% 53% 58% Times Interest Earned % 2.3 Gross Profit Margin 21% 19.7% 18.0% 20.4% Operating Profit Margin 4.7% 4.8% 5.1% 4.7% Net Profit Margin 1.8% 1.6% 2.5% 1.4% Return on total assets 4.1% 3.5% 5.2% 3.08% Return on Equity 0.3% 7.9% 11.1% 7.3% LIQUIDITY: The liquidity of 3P is on target with the industry standard in 2005 and shows no trend since ACTIVITY: Inventory and accounts receivable management has deteriorated since 2004 and is inferior when compared to the industry standard. The low inventory turnover may be caused by overstocking and/or obsolete inventories. The high average collection period may have resulted from poor collections procedures. Further investigation is necessary to determine the cause of the variances. DEBT: 3P has less debt than the industry average. The trend since 2003 has been toward reducing the debt ratio. The firm, therefore, is subject to less financial risk than the average firm in the industry.

12 Chapter 1 The Role and Environment of Managerial Finance 12 PROFITABILITY: Although the gross profit margin is inferior to the industry average, the operating and net profit margin far exceed the standards, boosting return on total assets and return on equity. The trend in the gross profit margin is unfavorable and may either be caused by a slide in product prices or an escalation in cost of sales. The cause of the poor gross profit margin should be investigated. Overall, the firm needs to focus attention on inventory and accounts receivable management and the cause of the poor gross profit margin. In general, the firm is in good financial condition. Level of Difficulty: 4 Learning Goal: 6 Topic: Complete Ratio Analysis 12. Complete the balance sheet for General Aviation, Inc. based on the following financial data. Balance Sheet General Aviation, Inc. December 31, 2005 Assets Cash $ 8,005 Marketable securities Accounts receivable Inventories Total current assets Gross fixed assets Less: Accumulated depreciation $50,000 Net fixed assets Total assets Liabilities and Stockholders Equity Accounts payable $28,800 Notes payable Accruals $18,800 Total current liabilities Long-term debts Total liabilities Stockholders equity Preferred stock 2,451 Common stock at par 30,000 Paid-in capital in excess of par 6,400 Retained earnings 90,800 Total stockholders equity Total liabilities and stockholders equity

13 Chapter 1 The Role and Environment of Managerial Finance 13 Key Financial Data (2005) 1. Sales totaled $720, The gross profit margin was 38.7 percent. 3. Inventory turned 6 times. 4. There are 360 days in a year. 5. The average collection period was 31 days. 6. The current ratio was The total asset turnover was The debt ratio was 49.4 percent. 9. Total current assets equal $159,565. Answer: Balance Sheet General Aviation, Inc. December 31, 2005 Assets Cash $ 8,005 Marketable securities 16,000 Accounts receivable 62,000 Inventories 73,560 Total current assets $159,565 Gross fixed assets 146,663 Less: Accumulated depreciation $50,000 Net fixed assets $ 96,663 Total assets $256,228 Current liabilities Liabilities and Stockholders Equity Accounts payable $28,800 Notes payable 20,300 Accruals $18,800 Total current liabilities $67,900 Long-term debts 58,677 Total liabilities $126,577 Stockholders equity Preferred stock 2,451 Common stock at par 30,000 Paid-in capital in excess of par 6,400 Retained earnings 90,800 Total stockholders equity $129,651 Total liabilities and stockholders equity $256,228 Level of Difficulty: 4 Learning Goal: 6 Topic: Ratio and Financial Statement Analysis

14 Chapter 1 The Role and Environment of Managerial Finance 14 Essay Questions Chapter 3 1. Darling Paper Container, Inc. purchased several machines at a total cost of $300,000. The installation cost for this equipment was $25,000. The firm plans to depreciate the equipment using the MACRS 5-year normal recovery period. Prepare a depreciation schedule showing the depreciation expense for each year. Answer: Year Depreciation Schedule Depreciation Expense 1 ($300,000 $25,000) 0.20 $ 65,000 2 $325, ,000 3 $325, ,750 4 $325, ,000 5 $325, ,000 6 $325, ,250 Level of Difficulty: 2 Learning Goal: 1 Topic: Depreciation and Cash Flows 2. Given the financial data for New Electronic World, Inc. (NEW), compute the following measures of cash flows for the NEW for the year ended December 31, 2005 (a) Operating Cash Flow. (b) Free Cash Flow. For the year ended December 31, Depreciation $ 3,000 EBIT 30,000 Interest Expenses 3,000 Taxes 8,000 Cash $21,000 24,000 Accounts Receivable 39,000 45,000 Inventory 27,000 30,000 Net fixed assets 22,000 24,000 Accounts payable 25,000 30,000 Notes payable 50,000 40,000 Accruals 1,000 2,000

15 Chapter 1 The Role and Environment of Managerial Finance 15 Answers: (a) OCF EBIT Taxes Depreciation OCF $30,000 $8,000 $3,000 $35,000 (b) FCF OCF Net fixed asset investment (NFAI) Net current asset investment (NCAI) NFAI Change in net fixed assets Depreciation (24,000 22,000) 3,000 $5,000 NCAI Change in current assets - change in (Accounts payable Accurals) (99,000 87,000) (32,000 26,000) $6,000 FCF 35,000 5,000 6,000 $24,000 Level of difficulty: 4 Learning Goal: 2 Topic: Operating Cash Flows and Free Cash Flows (Equation 3.4 and 3.5) 3. Identify each expense or revenue as a cash flow from operating activities (O), a cash flow from investment activities (I), or a cash flow from financing activities (F). Administrative expenses Rent payment Interest on a note payable Interest on a note receivable Sale of equipment Dividend payment Stock repurchase Sale of finished goods Labor expense Sale of a bond issue Repayment of a long-term debt Selling expenses Depreciation expense Sale of common stock Purchase of fixed assets

16 Chapter 1 The Role and Environment of Managerial Finance 16 Answer: Administrative expenses... Rent payment... Interest on a note payable... Interest on a note receivable... Sale of equipment... Dividend payment... Stock repurchase... Sale of finished goods... Labor expense... Sale of a bond issue... Repayment of a long-term debt... Selling expenses... Depreciation expense... Sale of common stock... Purchase of fixed assets... O O F F I F F O O F F O O F I Level of difficulty: 4 Learning Goal: 2 Topic: Statement of Cash Flows 4. Calculate the change in the key balance sheet accounts between 2002 and 2003 and classify each as a source (S), a use (U), or neither (N), and indicate which type of cash flow it is: an operating cash flow (O), and investment cash flow (I) or a financing cash flow (F). ABC Corp. Balance Sheet Changes and Classification of Key Accounts between 2004 and 2005 Account Change Classification Type Long-term debts $ 960 $ 800 Accounts receivable Common stock Cash Retained earnings Accruals Inventory Accounts payable 1,150 1,000 Net fixed assets 1,800 2,000

17 Chapter 1 The Role and Environment of Managerial Finance 17 Answer: ABC Corp. Balance Sheet Changes and Classification of Key Accounts between 2004 and 2005 Account Chng. Classif. Type Long-term debts $ 960 $ S F Accounts receivable U O Common stock N F Cash U O Retained earnings S O/F Accruals U O Inventory U O Accounts payable 1,150 1, S O Net fixed assets 1,800 2, S I Level of difficulty: 4 Learning Goal: 2 Topic: Statement of Cash Flows Table 3.5 Magna Fax, Inc. Income Statement For the Year Ended December 31, 2005 Sales revenue $150,000 Cost of goods sold 117,500 Gross Profits $32,500 Selling expense 4,500 General and administrative expense 4,000 Depreciation expense 4,000 Operating profits $ 20,000 Interest expense 2,500 Net profit before taxes $ 17,500 Taxes (40%) 7,000 Net profit after taxes $ 10,500

18 Chapter 1 The Role and Environment of Managerial Finance 18 Magna Fax, Inc. Balance Sheet For the Years Ended December 31, 2004 and Assets Cash $24,000 $21,000 Accounts receivable 45,000 39,000 Inventory 30,000 27,000 Gross fixed assets $42,000 $40,000 Acc. Depreciation 22,000 18,000 Net fixed assets 20,000 22,000 Total assets $119,000 $109,000 Liabilities and Equity Accounts payable $25,000 $30,000 Notes payable 50,000 40,000 Accruals 1,000 2,000 Long-term debts 10,000 8,000 Common stock at par 1,000 1,000 Paid-in capital in excess of par 4,000 4,000 Retained earnings 28,000 24,000 Total liabilities and equity $119,000 $109, The credit manager at First National Bank has just received the income statement and balance sheet for Magna Fax, Inc. for the year ended December 31,2005. (See Table 3.5.) The bank requires the firm to report its earnings performance and financial position quarterly as a condition of a loan agreement. The bank s credit manager must prepare two key financial statements based on the information sent by Magna Fax, Inc. This will be passed on to the commercial loan officer assigned to this account, so that he may review the financial condition of the firm. (a) Prepare a statement of retained earnings for the year ended December 31, (b) Prepare a summary of cash inflows and cash outflows for the year ended December 31, (c) Prepare a statement of cash flows for the year ended December 31, 2005, organized by cash flow from operating activities, cash flow from investment activities, and cash flow from financing activities. Answers: (a) Magna Fax, Inc. Statement of Retained Earnings For the Year Ended December 31, 2005 Retained Earnings Balance (December 31, 2004) $24,000 Net profits after taxes 10,500 Dividends 6,500 Retained Earnings Balance (December 31, 2005) $28,000

19 Chapter 1 The Role and Environment of Managerial Finance 19 (b) Cash Inflows Magna Fax, Inc. Statement of Cash Flows For the Year Ended December 31, 2005 Cash Outflows Net profits Dividends paid $6,500 after taxes $10,500 Inc. in cash 3,000 Depreciation 4,000 Inc. in acct. Rec 6,000 Inc. in Notes Payable 10,000 Inc. in Inventory 3,000 Inc. in LT debts 2,000 Inc. in Fixed Asset 2,000 Dec. in Acct Pay. 5,000 Dec. in accruals 1,000 Total Inflows $26,500 Total Outflows $26,500 (c) Cash flow from operating activities: Magna Fax, Inc. Statement of Cash Flows For the Year Ended December 31, 2005 Net profits after taxes $10,500 Depreciation 4,000 Inc. in Accounts Receivable 6,000 Inc. in Inventory 3,000 Dec. in Accounts Payable 5,000 Dec. in Accruals 1,000 Cash flow from investment activities: Inc. in gross fixed assets 2,000 Changes in business interest 0 Cash flow from financing activities: Inc. in notes payable $10,000 Inc. in long-term debts 2,000 Changes in S.E. 0 Dividends paid 6,500 $ 500 $2,000 $5,500 Net increase in cash & marketable sec. $3,000 Level of difficulty: 4 Learning Goal: 2 Topic: Statement of Cash Flows

20 Chapter 1 The Role and Environment of Managerial Finance Gerry Jacobs, a financial analyst for Best Valu Supermarkets, has prepared the following sales and cash disbursement estimates for the period August through December of the current year. Month Sales Cash Disbursements August $400 $300 September October November December percent of sales are for cash, the remaining 10 percent are collected one month later. All disbursements are on a cash basis. The firm wishes to maintain a minimum cash balance of $50. The beginning cash balance in September is $25. Prepare a cash budget for the months of October, November, and December, noting any needed financing or excess cash available. Answer: Cash receipts A Cash Budget for Best Valu Supermarkets Sept. Oct. Nov. Dec. Sales (cash 90%) $450 $450 $540 $630 Sales Collected (1 mo. lag 10%) Total cash receipts $490 $500 $590 $690 Total cash disbursements Net cash flow (10) (200) Beg. cash balance (185) 5 Ending cash balance 15 (185) Minimum balance Required financing excess cash 145 Best Valu Supermarkets should arrange for a line of credit for at least $235 during the four month period. Level of difficulty: 3 Learning Goal: 4 Topic: Cash Flow Analysis 7. Terrel Manufacturing expects stable sales through the summer months of June, July, and August of $500,000 per month. The firm will make purchases of $350,000 per month during these months. Wages and salaries are estimated at $60,000 per month plus 7 percent of sales. The firm must make a principal and interest payment on an outstanding loan in June of $100,000. The firm plans a purchase of a fixed asset costing $75,000 in July. The second quarter tax payment of $20,000 is also due in June. All sales are for cash.

21 Chapter 1 The Role and Environment of Managerial Finance 21 (a) Construct a cash budget for June, July, and August, assuming the firm has a beginning cash balance of $100,000 in June. (b) The sales projections may not be accurate due to the lack of experience by a newly-hired sales manager. If the sales manager believes the most optimistic and pessimistic estimates of sales are $600,000 and $400,000, respectively, what are the monthly net cash flows and required financing or excess cash balances? Answers: Multiple Cash Budgets June Pessimistic Most Likely Optimistic Sales (cash) $400,000 $500,000 $600,000 Less: Cash Disbursements Purchases 350, , ,000 Wages & Salaries 60,000 60,000 60,000 Variable portion (W&S) 28,000 35,000 42,000 Principal & Interest 100, , ,000 Purchase of fixed assets Tax payment 20,000 20,000 20,000 Total cash disbursement $558,000 $565,000 $572,000 Net cash flow (158,000) (65,000) 28,000 Add: Beg. cash 100, , ,000 Ending cash (58,000) 35, ,000 Less: Min cash Required financing 58,000 Excess cash 35, ,000 July Pessimistic Most Likely Optimistic Sales (cash) $400,000 $500,000 $600,000 Less: Cash Disbursements Purchases 350, , ,000 Wages & Salaries 60,000 60,000 60,000 Variable portion (W&S) 28,000 35,000 42,000 Principal & Interest Purchase of fixed assets 75,000 75,000 75,000 Tax payment Total cash disbursement $513,000 $520,000 $527,000 Net cash flow (113,000) (20,000) 73,000 Add: Beg. cash (58,000) 35, ,000 Ending cash (171,000) 15, ,000 Less: Min cash Required financing 171,000 Excess cash 15, ,000

22 Chapter 1 The Role and Environment of Managerial Finance 22 August Pessimistic Most Likely Optimistic Sales (cash) $400,000 $500,000 $600,000 Less: Cash Disbursements Purchases 350, , ,000 Wages & Salaries 60,000 60,000 60,000 Variable portion (W&S) 28,000 35,000 42,000 Principal & Interest Purchase of fixed assets Tax payment Total cash disbursement $438,000 $445,000 $452,000 Net cash flow (38,000) (55,000) 148,000 Add: Beg. cash 171,000 15, ,000 Ending cash (209,000) 70, ,000 Less: Min cash Required financing 209,000 Excess cash 70, ,000 If the most pessimistic sales figure ($400,000) materializes, the financial manager should expect a financing requirement of $209,000 and should arrange for a line of credit to cover the firm s cash deficit. However, if the most optimistic estimate materializes, the financial manager will need to arrange for investing a total of $349,000 over the three month period. Level of difficulty: 4 Learning Goal: 4 Topic: Cash Flow Analysis 8. In preparation for the quarterly cash budget, the following revenue and cost information have been compiled. Prepare and evaluate a cash budget for the months of October, November, and December based on the information shown below. Month Sales Purchases August (actual) $3,000,000 $3,500,000 September (actual) $4,500,000 $2,000,000 October (forecast) $1,000,000 $ 500,000 November (forecast) $1,500,000 $ 750,000 December (forecast) $2,000,000 $1,000,000 The firm collects 60 percent of sales for cash and 40 percent of its sales one month later. Interest income of $50,000 on marketable securities will be received in December. The firm pays cash for 40 percent of its purchases. The firm pays for 60 percent of its purchases the following month. Salaries and wages amount to 15 percent of the preceding month s sales. Sales commissions amount to 2 percent of the preceding month s sales. Lease payments of $100,000 must be made each month. A principal and interest payment on an outstanding loan is due in December of $150,000. The firm pays dividends of $50,000 at the end of the quarter. Fixed assets costing $600,000 will be purchased in December.

23 Chapter 1 The Role and Environment of Managerial Finance 23 Depreciation expense each month of $45,000. The firm has a beginning cash balance in October of $100,000 and maintains a minimum cash balance of $200,000. Answer: Cash Budget Month August September October November December Sales $3,000,000 4,500,000 1,000,000 1,500,000 2,000,000 Cash (60%) 1,800,000 2,700, , ,000 1,200,000 1 mo. (40%) 1,200,000 1,800, , ,000 Interest 50,000 Total Receipts 3,900,000 2,400,000 1,300,000 1,850,000 Purchase 3,500,000 2,000, , ,000 1,000,000 Cash(40%) 1,400, , , , ,000 1 mo.(60%) 2,100,000 1,200, , ,000 Salaries & Wages 450, , , ,000 Sales Commission 60,000 90,000 20,000 30,000 Lease Payments 100, , , ,000 Princ & Interest Pay 150,000 Cash dividends 50,000 Fixed assets purchase 600,000 Total Disbursements 3,510,000 2,265, ,000 2,005,000 Net cash flow 390, , ,000 (155,000) Add: Beg. Cash 100, , ,000 Ending cash 235, , ,000 Less: Min Cash 200, , ,000 Required Fin. Excess Cash 35, , ,000 The firm has excess cash during the three month period and can invest the excess cash in marketable securities. Level of difficulty: 4 Learning Goal: 4 Topic: Cash Flow Analysis 9. Harry s House of Hamburgers (HHH) wants to prepare a cash budget for months of September through December. Using the following information, prepare the cash budget schedule and interpret the results. Sales were $50,000 in June and $60,000 in July. Sales have been forecasted to be $65,000, $72,000, $63,000, $59,000, and $56,000 for months of August, September, October, November, and December, respectively. In the past, 10 percent of sales were on cash basis, and the collection were 50 percent in the first month, 30 percent in the second month, and 10 percent in the third month following the sales.

24 Chapter 1 The Role and Environment of Managerial Finance 24 Every four months (three times a year) $500 of dividends from investments are expected. The first dividend payment was received in January. Purchases are 60 percent of sales, 15 percent of which are paid in cash, 65 percent are paid one month later, and the rest is paid two months after purchase. $8,000 dividends are paid twice a year (in March and September). The monthly rent is $2,000. Taxes are $6,500 payable in December. A new hamburger press will be purchased in October for $2,300. $1,500 interest will be paid in November. $1,000 loan payments are paid every month. Wages and salaries are $1,000 plus 5 percent of sales in each month. August s ending cash balance is $3,000. HHH would like to maintain a minimum cash balance of $10,000. Answer: Cash Budget Month June July Aug. Sept. Oct. Nov. Dec. Sales $50,000 60,000 65,000 72,000 63,000 59,000 56,000 Cash 5,000 6,000 6,500 7,200 6,300 5,900 5,600 sales(10%) Collections of A/R: 1 mon(50%) 25,000 30,000 32,500 36,000 31,500 29,500 2 mon(30%) 15,000 18,000 19,500 21,600 18,900 3 mon(10%) 5,000 6,000 6,500 7,200 Dividend income 500 Total cash recpts $63,200 67,800 65,500 61,200 Purch. $30,000 36,000 39,000 43,200 37,800 35,400 33,600 Cash 4,500 5,400 5,850 6,480 5,670 5,310 5,040 purchases(15%) Payments of A/P: 1 mon(65%) 19,500 23,400 25,350 28,080 24,570 23,010 2 mon(20%) 6,000 7,200 7,800 8,640 7,560 Dividend Payment 8,000 Rent 2,000 2,000 2,000 2,000 Taxes 6,500 New Asset 2,300 Interest 1,500 Loan Payment 1,000 1,000 1,000 1,000 Wages & Salaries 4,600 4,150 3,950 3,800 Total cash $54,630 51,000 46,970 48,910 disbursements

25 Chapter 1 The Role and Environment of Managerial Finance 25 Net cash flow $ 8,570 16,800 18,530 12,290 Add: Beg. cash 3,000 11,570 28,370 46,900 Ending cash 11,570 28,370 46,900 59,190 Less: Min. cash 10,000 10,000 10,000 10,000 Required total financing Excess cash 1,570 18,370 36,900 49,190 No financing required. The company may invest the excess cash in marketable securities. Level of difficulty: 4 Learning Goal: 4 Topic: Cash Flow Analysis 10. Income Statement Huddleston Manufacturing Company For the Year Ended December 31, 2005 Sales $2,800,000 Less: Cost of goods sold 1,820,000 Gross profits $ 980,000 Less: Operating expenses 240,000 Operating Profits $ 740,000 Less: Interest expense 70,000 Net profits before taxes $ 670,000 Less: Taxes (40%) 268,000 Net profits after taxes $ 402,000 Less: Cash Dividends 132,000 To: Retained earnings $ 270,000 Huddleston Manufacturing estimates its sales in 2006 will be $3 million. Interest expense is expected to remain unchanged at $70,000, and the firm plans to pay cash dividends of $140,000 during Use the percent-of-sales method to prepare a pro forma income statement for the year ended December 31, 2006, based on the 2005 income statement shown above.

26 Chapter 1 The Role and Environment of Managerial Finance 26 Answer: Pro Forma Income Statement Huddleston Manufacturing Company For the Year Ended December 31, 2006 Sales $3,000,000 Less: Cost of goods sold (65%) 1,950,000 Gross profits $1,050,000 Less: Operating expenses (8.57%) 257,142 Operating Profits $ 792,858 Less: Interest expense 70,000 Net profits before taxes $ 722,858 Less: Taxes (40%) 289,143 Net profits after taxes $ 433,714 Less: Cash Dividends 140,000 To: Retained earnings $ 293,714 Level of difficulty: 3 Learning Goal: 5 Topic: Pro Forma Analysis Table 3.6 Income Statement Ace Manufacturing, Inc. For the Year Ended December 31, 2005 Sales $2,000,000 Less: Cost of goods sold 1,200,000 Gross profit $800,000 Less: Selling expense 200,000 General & administrative expense 60,000 Less: Depreciation 40,000 Operating profit $ 500,000 Less: Interest 80,000 Earnings before taxes $ 420,000 Less: Taxes (40%) 168,000 Net profit after taxes/eacs $ 252,000 Common stock dividends $ 100, Ace Manufacturing, Inc., is preparing pro forma financial statements for The firm utilized the percent-of-sales method to estimate costs for the next year. Sales in 2005 were $2 million and are expected to increase to $2.4 million in The firm has a 40 per cent tax rate. (a) Given the 2005 income statement in Table 3.6, estimate net profit and retained earnings for (b) If $200,000 of the cost of goods sold and $40,000 of selling expense are fixed costs; and the interest expense and dividends are not expected to change, what is the dollar effect on net income and retained earnings? What is the significance of this effect?

27 Chapter 1 The Role and Environment of Managerial Finance 27 Answers: (a) Pro forma income statement: December 31, 2006 Sales $2,400,000 Less: Cost of goods sold 1,440,000 Gross profit 960,000 Less: Selling expense 240,000 General & administrative expense 72,000 Less: Depreciation 48,000 Operating profit $ 600,000 Less: Interest 96,000 Earnings before taxes $ 504,000 Less: Taxes (40%) 201,600 Net profit after taxes/eacs $ 302,400 Common stock dividends 120,000 Retained earnings $ 182,400 (b) Sales $2,400,000 Less: Cost of goods sold (0.50) 1,200,000 fixed 200,000 Gross profit 1,000,000 Less: Selling expense (0.08) 192,000 fixed 40,000 General & administrative expense 72,000 Less: Depreciation 48,000 Operating profit $ 648,000 Less: Interest 80,000 Earnings before taxes $ 568,000 Less: Taxes (40%) 227,200 Net profit after taxes/eacs $ 340,800 Common stock dividends 100,000 Retained earnings $ 240,800

28 Chapter 1 The Role and Environment of Managerial Finance 28 Net profit after tax is understated by $38,400 and retained earnings by $58,400, using the percent-of-sales method. In planning the addition of assets (current or fixed) and the financing of those assets, the straight percent-of-sales method understates net profit and retained earnings. This, therefore, overstates additional financing needed to add those assets. The judgmental approach allows the firm to obtain a more accurate estimate of the line of credit or long-term financing that will be necessary in the next planning period. Level of difficulty: 4 Learning Goal: 5 Topic: Pro Forma Analysis The income statement and balance sheet for the ZZZ Mattress Co. for the year ended December 31, 2005 follow. Table 3.7 Income Statement ZZZ Mattress Company For the Year Ended December 31, 2005 Sales $300,000 Less: Cost of goods sold 195,000 Gross profit $105,000 Less: Selling expense 40,000 General and administrative expense 11,000 Less: Depreciation 10,000 Operating profit $ 44,000 Less: Interest 12,000 Net profit before taxes $ 32,000 Less: Taxes (40%) 12,800 $ 19,200 Balance Sheet ZZZ Mattress Company December 31, 2005 Assets Cash $1,500 Accounts receivable 60,000 Inventory 95,000 Total current assets $156,500 Net plant and equipment 150,000 Total assets $306,500

29 Chapter 1 The Role and Environment of Managerial Finance 29 Liabilities and Equities Accounts payable $ 45,500 Notes payable 55,000 Accruals 5,000 Total current liabilities $105,500 Long-term debt $55,000 Stockholders equity: Common stock $71,000 Retained earnings 75,000 Total liabilities and equities $306, The ZZZ Mattress Co. has been requested by the 1st National Bank, a major creditor, to prepare a pro forma balance sheet for the year ending, December 31, Using the percent-of-sales method and the following financial data, prepare the pro forma income statement and balance sheet and discuss the resulting external financing required. (See Table 3.7) 2006 sales are estimated at $330,000. Accounts receivable represent 20 percent of sales. A minimum cash balance of $1,650 is maintained. Inventory represents 32 percent of sales. Fixed-asset outlays in 2006 are $20,000. Total depreciation expense for 2006 will be $15,000. Accounts payable represents 15 percent of sales. Notes payable and accruals will remain the same. No long-term debt will be retired in No common stock will be repurchased in The firm will pay dividends equal to 50 percent of its earnings after taxes. Answer: Income Statement ZZZ Mattress Company For the Year Ended December 31, 2006 Sales $330,000 Less: Cost of goods sold (65%) 214,500 Gross profit $115,500 Less: Selling expense (13.3%) 44,000 General and administrative expense (3.67%) 12,100 Less: Depreciation 15,000 Operating profit $ 44,400 Less: Interest (4%) 13,200 Net profit before taxes $ 31,200 Less: Taxes (40%) 12,480 $ 18,720

30 Chapter 1 The Role and Environment of Managerial Finance 30 Balance Sheet ZZZ Mattress Company December 31, 2006 Assets Cash $ 1,650 Accounts receivable 66,000 Inventory 105,600 Total current assets $173,250 Net plant and equipment 155,000 Total assets $328,250 Liabilities and Equities Accounts payable $ 49,500 Notes payable 55,000 Accruals 5,000 Total current liabilities $109,500 Long-term debt 55,000 Stockholders equity: Common stock 71,000 Retained earnings 84,360 Total liabilities and equities $328,250 A 10 percent growth rate in sales cannot be supported by the firm s internally generated funds. A larger line of credit or a request for a long-term loan for the additional $8,390 is necessary to finance operations. Level of difficulty: 4 Learning Goal: 5 Topic: Pro Forma Analysis Table 3.8 Income Statement Wirl Wind Company Sales revenue $3,028,500 Less: Cost of goods sold Fixed costs 1,350,000 Variable costs 1,260,600 Gross profits $417,900 Less: Operating expenses Fixed expenses 4,500 Variable expenses 85,840 Operating profits $327,560 Less: Interest expense 82,150 Net profits before taxes $245,410 Less: Taxes (40%) 98,164 Net profits after taxes $147,246 Less: Dividend 50,000 Increased retained earnings $ 97,246

31 Chapter 1 The Role and Environment of Managerial Finance 31 Current assets Balance Sheet Wirl Wind Company Assets Cash $625,000 Marketable securities 298,000 Accounts receivable 580,000 Inventories 496,000 Total current assets $1,999,000 Land and building $625,000 Machinery & equip 765,000 Fixtures & Furn 110,000 Total gross fixed assets $1,500,000 Less: Accumulated Depreciation 30,000 Net fixed assets $1,470,000 Total assets $3,469,000 Current liabilities Liabilities and Stockholders Equity Accounts payable $267,000 Notes payable 135,000 Accruals 288,000 Total current liabilities $690,000 Total Long-term debt 1,200,000 Total liabilities $1,890,000 Stockholders equity Preferred stock 79,000 Common stock 750,000 Paid-in-capital 601,000 Retained earnings 149,000 Total stockholders equity $1,579,000 Total liabilities and stockholders equity $3,469, The Wirl-Wind Company of America is trying to plan for the next year. Using the current income statement and balance sheet given in Table 3.8, and the additional information provided, prepare the company s pro forma statements. Sales are projected to increase by 15 percent. Total of $75,000 in dividend will be paid. A minimum cash balance of $650,000 is desired. A new asset for $50,000 will be purchased.

32 Chapter 1 The Role and Environment of Managerial Finance 32 Depreciation expense for next year is $50,000. Marketable securities will remain the same. Accounts receivable, inventory, accounts payable, notes payable, and accruals will increase by 15 percent. $30,000 new issue of bond will be sold. No new stock will be issued. Answer: Pro Forma Income Statement Wirl Wind Company Sales revenue $3,482,775 Less: Cost of goods sold Fixed costs 1,350,000 Variable costs (42%) 1,462,766 Gross profits $670,009 Less: Operating expenses Fixed expenses 4,500 Variable expenses (2.8%) 97,518 Operating profits $567,991 Less: Interest expense (2.7%) 94,035 Net profits before taxes $ 473,956 Less: Taxes (40%) 189,582 Net profits after taxes $ 284,374 Less: Dividend 75,000 Increased retained earnings $ 209,374 Current assets Pro Forma Balance Sheet Wirl Wind Company Assets Cash $ 650,000 Marketable securities 298,000 Accounts receivable 667,000 Inventories 570,400 Total current assets $2,185,400 Land and building Machinery & equip. Fixtures & Furn. Total gross fixed assets Less: Accumulated Depreciation Net fixed assets $1,470,000 Total assets $3,655,400

33 Chapter 1 The Role and Environment of Managerial Finance 33 Current liabilities Liabilities and Stockholders Equity Accounts payable $ 307,050 Notes payable 155,250 Accruals 331,200 Total current liabilities $793,500 Long-term debts 1,230,000 Total liabilities $2,023,500 Stockholders equity Preferred stock 79,000 Common stock 750,000 Paid-in-capital 601,000 Retained earnings 358,374 Total stockholders equity $1,788,374 Excess cash 156,474 Total liabilities and stockholders $3,655,400 equity The Wirl Wind Company of America will have an excess cash of $156,474 which can be used to pay debt. Level of difficulty: 4 Learning Goal: 5 Topic: Pro Forma Analysis Essay Questions Chapter 4 1. Calculate the future value of $4,600 received today if it is deposited at 9 percent for three years. Answer: FV $4,600(1.295) $5,957 Level of Difficulty: 1 Learning Goal: 2 Topic: Future Value (Equation 4.4, 4.5, and 4.6) 2. Calculate the present value of $89,000 to be received in 15 years, assuming an opportunity cost of 14 percent. Answer: PV 89,000(1.40) $12,460 Level of Difficulty: 1 Learning Goal: 2 Topic: Future Value (Equation 4.9, 4.11, and 4.12) 3. Jeanie has deposited $33,000 today in an account which will earn 10 percent annually. She plans to leave the funds in this account for seven years earning interest. If the goal of this deposit is to cover a future obligation of $65,000, what recommendation would you make to Jeanie? Answer: FV 33,000(1.949) $64,317 Jeanie will only have $64,317 at the end of seven years under the stated arrangement. She must find an account with a higher interest rate or deposit a larger sum today. Level of Difficulty: 2 Learning Goal: 2

34 Chapter 1 The Role and Environment of Managerial Finance 34 Topic: Future Value (Equation 4.4, 4.5, and 4.6) 4. EcoSystems, Inc. is preparing a five-year plan. Today, sales are $1,000,000. If the growth rate in sales is projected to be 10 percent over the next five years, what will the dollar amount of sales be in year five? Answer: FV 1,000,000(1.611) $1,611,000 Level of Difficulty: 2 Learning Goal: 2 Topic: Future Value (Equation 4.4, 4.5, and 4.6) 5. Fred has inherited $6,000 from the death of Barney. He would like to use this money to buy Wilma a new rockmobile costing $7,000 for their 10th anniversary celebration which will take place in 2 years from now. Will Fred have enough money to buy the gift if he deposits his money in an account paying 8 percent compounded semi-annually? Answer: n 2, m 2, i 8% FV PV(FVIF4%,4) 6,000(1.170) $7,020 Yes, Fred will have enough money to buy the rockmobile. Level of Difficulty: 2 Learning Goal: 2 Topic: Future Value (Equation 4.4, 4.5, and 4.6)

35 Chapter 1 The Role and Environment of Managerial Finance Kay and Arthur are newlyweds and have just purchased a condominium for $70,000. Since the condo is very small, they hope to move into a single-family house in 5 years. How much will their condo worth in 5 years if inflation is expected to be 8 percent? Answer: PV $70,000, i 8%, n 5 FV PV(FVIF) 70,000(1.469) $102,830. Level of Difficulty: 2 Learning Goal: 2 Topic: Future Value (Equation 4.4, 4.5, and 4.6) 7. Calculate the present value of a $10,000 perpetuity at a 6 percent discount rate. Answer: PV 10,000/0.06 $166,667 Level of Difficulty: 1 Learning Goal: 3 Topic: Perpetuities (Equation 4.19) 8. Calculate the future value of an annuity of $5,000 each year for eight years, deposited at 6 percent. Answer: FV 5,000(9.897) $49,485 Level of Difficulty: 2 Learning Goal: 3 Topic: Future Value of an Annuity (Equation 4.13, 4.14) 9. Calculate the present value of an annuity of $3,900 each year for four years, assuming an opportunity cost of 10 percent. Answer: PV 3,900(3.170) $12,363 Level of Difficulty: 2 Learning Goal: 3 Topic: Present Value of an Annuity (Equation 4.15, 4.16) 10. Linda has decided to set up an account that will pay her granddaughter (Janice) $5,000 a year indefinitely. How much should Linda deposit in an account paying 8 percent annual interest? Answer: PV 5,000/0.08 $62,500 Level of Difficulty: 2 Learning Goal: 3 Topic: Present Value of an Annuity (Equation 4.13, 4.14) 11. A wealthy industrialist wishes to establish a $2,000,000 trust fund which will provide income for his grandchild into perpetuity. He stipulates in the trust agreement that the principal may not be distributed. The grandchild may only receive the interest earned. If the interest rate earned on the trust is expected to be at least 7 percent in all future periods, how much income will the grandchild receive each year? Answer: $2,000, $140,000 Level of Difficulty: 2 Learning Goal: 3 Topic: Perpetuities (Equation 4.19)

36 Chapter 1 The Role and Environment of Managerial Finance Cara establishes a seven-year, 8 percent loan with a bank requiring annual end-of-year payments of $ Calculate the original principal amount. Answer: PVA (5.206) $5,000 Level of Difficulty: 2 Learning Goal: 3 Topic: Present Value of an Annuity (Equation 4.15, 4.16) 13. A lottery administrator has just completed the state s most recent $50 million lottery. Receipts from lottery sales were $50 million and the payout will be $5 million at the end of each year for 10 years. The expenses of running the lottery were $800,000. The state can earn an annual compound rate of 8 percent on any funds invested. (a) Calculate the gross profit to the state from this lottery. (b) Calculate the net profit to the state from this lottery (no taxes). Answers: Lottery revenue $50,000,000 Less: Cost of payout $5,000, ,550,000 Gross profi $16,450,000 (a) Less: operating expenses 800,000 (b) Net profit $15,650,000 Learning Goal: 3 Topic: Present Value of an Annuity (Equation 4.15, 4.16) 14. Kimberly has just won a $20 million lottery, which will pay her $1 million at the end of each year for 20 years. An investor has offered her $10 million for this annuity. She estimates that she can earn 10 percent interest, compounded annually, on any amounts she invests. She asks your advice on whether to accept or reject the offer. What will you tell her? (Ignore Taxes) Answer: P $1,000, $8,514,000 $10,000,000 > $8,514,000 Accept the offer. Learning Goal: 3 Topic: Present Value of an Annuity (Equation 4.15, 4.16) 15. Mr. Handyman has been awarded a bonus for his outstanding work. His employer offers him a choice of a lump-sum of $5,000 today, or an annuity of $1,250 a year for the next five years. Which option should Mr. Handyman choose if his opportunity cost is 9 percent? Answer: PVA $1,250(PVIFA) 1,250(3.890) $4, Mr. Handyman should choose a lump-sum of $5,000 today. Learning Goal: 3 Topic: Present Value of an Annuity (Equation 4.15, 4.16)

37 Chapter 1 The Role and Environment of Managerial Finance In their meeting with their advisor, Mr. & Mrs. Smith concluded that they would need $40,000 per year during their retirement years in order to live comfortably. They will retire 10 years from now and expect a 20-year retirement period. How much should Mr. & Mrs. Smith deposit now in a bank account paying 9 percent to reach financial happiness during retirement? Answer: The amount of money required at the beginning of the retirement period is: n 20, i 9% PVA PMT(PVIFA) 40,000(9.129) $365,160 n 10, i 9% PV 365,160(0.422) $154, Learning Goal: 3 Topic: Complex Time Value Problems (Equation 4.13, 4.14, and 4.15, 4.16) 17. Jay is 30 years old and will retire at age 65. He will receive retirement benefits but the benefits are not going to be enough to make a comfortable retirement life for him. Jay has estimated that an additional $25,000 a year over his retirement benefits will allow him to have a satisfactory life. How much should Jay deposit today in an account paying 6 percent interest to meet his goal? Assume Jay will have 15 years of retirement. Answer: PMT $25,000, n 15, i 6% P(65) 25,000(PVIFA) 25,000(9.712) $242,800 FV $242,800, n 35, i 6% P(30) 242,800(PVIF) 242,800(0.130) $31,564 Level of Difficulty: 4 Learning Goal: 3 Topic: Complex Time Value Problems (Equation 4.4, 4.5, 4.6 and 4.15, 4.16) 18. You have been given a choice between two retirement policies as described below. Policy A: You will receive equal annual payments of $10,000 beginning 35 years from now for 10 years. Policy B: You will receive one lump-sum of $100,000 in 40 years from now. Which policy would you choose? Assume rate of interest is 6 percent. Answer: Policy A: present value of the annuity at the beginning of the 35 years from now: PVA PMT(PVIFA) 10,000(7.360) $73,600 Policy B: present value of the lump-sum at the beginning of the 35 years from now: PV FV(PVIF) 100,000(0.747) $74,700 I will choose policy B. Level of Difficulty: 4 Learning Goal: 3 Topic: Complex Time Value Problems (Equation 4.9, 4.11, 4.12 and 4.15, 4.16)

38 Chapter 1 The Role and Environment of Managerial Finance Joie is planning to attend college when she graduates from high school 7 years from now. She anticipates that she will need $10,000 at the beginning of each college year to pay for tuition and fees, and have some spending money. Joie has made an arrangement with her father to do the household chores if her dad deposits $3,500 at the end of each year for the next 7 years in a bank account paying 8 percent interest. Will there be enough money in the account for Joie to pay for her college expenses? Assume the rate of interest stays at 8 percent during the college years. Answer: At the beginning of the first year of college: PV 10,000 10,000(PVIFA 12%,3 ) 10,000 10,000(2.577) $35,770 PMT $3,500, i 8%, n 7 FVA 3,500(FVIFA) 3,500(8.923) $31,230 Joie will need $4,539( 35,770 31,230) additional money to pay for her college education. Level of Difficulty: 4 Learning Goal: 3 Topic: Complex Time Value Problems (Equation 4.13, 4.14 and 4.15, 4.16) 20. During her four years at college, Rose received the following amounts of money at the end of each year from her grandmother. She deposited her money in a saving account paying 6 percent rate of interest. How much money will Rose have on graduation day? Year $ Answer: Year $ n FVIF FV 1 $ $ Level of Difficulty: 2 Learning Goal: 4 Topic: Mixed Streams (Equation 4.4, 4.5, 4.6) $1,061.90

39 Chapter 1 The Role and Environment of Managerial Finance You have provided your friend with a service worth $8,500. Your friend offers you the following cash flow instead of paying $8,500 today. Should you accept his offer if your opportunity cost is 8 percent? Year Cash Flow 1 $4, , , ,000 Answer: Year Cash Flow PVIF PV 1 $4, $3, , , , , , Accept the offer. Level of Difficulty: 2 Learning Goal: 4 Topic: Mixed Streams (Equation 4.9, 4.11, 4.12) $8, Calculate the present value of $5,800 received at the end of year 1, $6,400 received at the end of year 2, and $8,700 at the end of year 3, assuming an opportunity cost of 13 percent. Answer: PV 5,800(0.885) 6,400(0.783) 8,700(0.693) $16, Level of Difficulty: 2 Learning Goal: 4 Topic: Mixed Streams (Equation 4.9, 4.11, 4.12) 23. Calculate the present value of $800 received at the beginning of year 1, $400 received at the beginning of year 2, and $700 received at the beginning of year 3, assuming an opportunity cost of 9 percent. Answer: PV (0.917) 700(0.842) $1, Level of Difficulty: 2 Learning Goal: 4 Topic: Mixed Streams (Equation 4.9, 4.11, 4.12) 24. Calculate the combined future value at the end of year 3 of $1,000 received at the end of year 1, $3,000 received at the end of year 2, and $5,000 received at the end of year 3, all sums deposited at 5 percent. Answer: FV 1000(1.102) 3000(1.050) 5000 $9,252 Level of Difficulty: 2 Learning Goal: 4 Topic: Mixed Streams (Equation 4.4, 4.5, 4.6)

40 Chapter 1 The Role and Environment of Managerial Finance You are considering the purchase of new equipment for your company and you have narrowed down the possibilities to two models which perform equally well. However, the method of paying for the two models is different. Model A requires $5,000 per year payment for the next five years. Model B requires the following payment schedule. Which model should you buy if your opportunity cost is 8 percent? Year Payment (Model B) 1 $7, , , , ,000 Answer: Model A: PV PMT (PVIFA) 5,000 (3.993) $19,965 Model B Year Payment PVIF PV 1 $7, $6, , , , , , , , ,043 Buy Model A. Learning Goal: 4 Topic: Mixed Streams (Equation 4.9, 4.11, 4.12 and 4.15, 4.16) $20, Last Christmas, Larry received an annual bonus of $1,500. These annual bonuses are expected to grow by 5 percent for the next 5 years. How much will Larry have at the end of the fifth year if he invests his Christmas bonuses (including the most recent bonus) in a project paying 8 percent per year? Answer: Year Bonus 0 FVIF (5%,t ) Bonus(t) n FVIF (8%,n) FV 0 $1, $1, $2, , , , , , , , , , , , , , , , Level of Difficulty: 4 Learning Goal: 4 Topic: Complex Time Value Problems (Equation 4.4, 4.5, 4.6) $12,337.54

41 Chapter 1 The Role and Environment of Managerial Finance Calculate the present value of the following stream of cash flows, assuming that the firm s opportunity cost is 15 percent. Years Amount 1 7 $12, ,000 Answer: PV 12,000(4.160) 14,000( ) $61,946 Level of Difficulty: 4 Learning Goal: 4 Topic: Mixed Streams (Equation 4.9, 4.11, 4.12 and 4.15, 4.16) 28. Calculate the future value of $6,490 received today and deposited for five years in an account which pays interest of 14 percent compounded semiannually. Answer: FV 6,490(1.967) $12,766 Level of Difficulty: 2 Learning Goal: 5 Topic: Future Value (Equation 4.4, 4.5, 4.6) 29. Calculate the future value of $10,000 received today and deposited for six years in an account which pays interest of 12 percent compounded quarterly. Answer: FV 10,000(2.033) $20,330 Learning Goal: 5 Topic: Future Value (Equation 4.4, 4.5, 4.6) 30. Jeanne has just graduated from high school and has received an award for $5,000. She would like to deposit the money in an interest earning account until she graduates from college (i.e., four years from now). In her search for the highest interest earning account, she has narrowed the list down to the following two accounts: 1) bank A pays 9 percent interest compounded annually, and 2) bank B pays 8 percent interest compounded semi-annually. Which is the better offer, and how much will Jeanne have upon graduation from college? Answer: Bank A: n 4, i 9%, m 1 FV 5,000(1.412) $7,060 Bank B: n 4, i 8%, m 2 FV 5,000(1.369) $6,845 Jeanne should deposit her money in Bank A and she will have $7,060 upon her graduation from college. Learning Goal: 5 Topic: Nominal and Effective Interest Rates (Equation 4.23) 31. Janice borrows $25,000 from the bank at 15 percent to be repaid in 10 equal annual installments. Calculate the end-of-year payment. Answer: PMT 25,000/5.019 $4, Level of Difficulty: 2 Learning Goal: 6 Topic: Present Value of an Annuity (Equation 4.15, 4.16)

42 Chapter 1 The Role and Environment of Managerial Finance The following table presents the Sally s Silly Service Company s net earnings for the past six years. Compute the growth rate in the company s earnings. Year Return 2002 $2, , , , , ,728 Answer: FVIF FV/PV 2,659/1, n 5, i 9% Level of Difficulty: 2 Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.4, 4.5, 4.6 or 4.9, 4.11, 4.12) 33. Marc has purchased a new car for $15,000. He paid $2,500 as down payment and he paid the balance by a loan from his hometown bank. The loan is to be paid on a monthly basis for two years charging 12 percent interest. How much are the monthly payments? Answer: PV 15,000 2,500 $12,500, i 12%, n 2, m 12 PMT PVA/PVIFA 12,500/ $ Level of Difficulty: 2 Learning Goal: 6 Topic: Present Value of an Annuity (Equation 4.15, 4.16) 34. You have been given the opportunity to earn $20,000 five years from now if you invest $9,524 today. What will be the rate of return to your investment? Answer: FVIF 20,000/9, i 16%. Level of Difficulty: 2 Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.4, 4.5, 4.6 or 4.9, 4.11, 4.12) 35. Ten years ago, Tom purchased a painting for $300. The painting is now worth $1,020. Tom could have deposited $300 in a savings account paying 12 percent interest compounded annually. Which of these two options would have provided Tom with a higher return? Answer: PV $300, FV $1,020, n 10 FVIF 1,020/ i 13% Painting has a higher return (13 percent) in comparison to the 12 percent rate of return from the savings account. Level of Difficulty: 2 Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.4, 4.5, 4.6 or 4.9, 4.11, 4.12) 36. Find the equal annual end-of-year payment on $50,000, 15 year, and 10 percent loan. Answer: PMT PVA/PVIFA 50,000/7.606 $6, Level of Difficulty: 2 Learning Goal: 6 Topic: Present Value of an Annuity (Equation 4.15, 4.16)

43 Chapter 1 The Role and Environment of Managerial Finance A firm wishes to establish a fund which, in 10 years, will accumulate to $10,000,000. The fund will be used to repay an outstanding bond issue. The firm plans to make deposits, which will earn 12 percent, to this fund at the end of each of the 10 years prior to maturity of the bond. How large must these deposits be to accumulate to $10,000,000? Answer: PMT 10,000,000/ $569, Learning Goal: 6 Topic: Future Value of an Annuity (Equation 4.13, 4.14) 38. John borrowed $12,000 to buy a new car and expects to pay $ per month for the next 2 years to pay off the loan. What is the loan s rate of interest? Answer: PVA $12,000, PMT $564.87, n 2, m 12 PVIFA PVA/PMT 12,000/ i/m 1% i 12% Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.15, 4.16) 39. The New York Soccer Association would like to accumulate $10,000 by the end of 4 years from now to finance a big soccer weekend for its members. The Association currently has $2,500 and wishes to raise the balance by arranging annual fund-raising events. How much money should they raise at each annual fund-raising event assuming 8 percent rate of interest? Answer: Future value of $2,500 at the end of fourth year: FV 2,500(1.360) $3,400 Balance 10,000 3,400 $6,600 PMT FVA/FVIFA 6,600/4.506 $1, Learning Goal: 6 Topic: Complex Time Value Problems (Equation 4.4, 4.5, 4.6 and 4.13, 4.14) 40. Ms. Day needs $20,000 to buy her dream car. In her search for the best (low cost) loan, she has gathered the following information from three local banks. Which bank would you recommend Ms. Day borrow from? Bank Annual Payment Term (years) A $8, B 6, C 5, Answer: A: PVIFA 20,000/8, i 12% B: PVIFA 20,000/6, i 10% C: PVIFA 20,000/5, i 11% Ms. Day should borrow from Bank B. Bank B has the lowest rate. Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.15, 4.16)

44 Chapter 1 The Role and Environment of Managerial Finance A deep-discount bond can be purchased for $312 and in 20 years it will be worth $1,000. What is the rate of interest on the bond? Answer: FVIF 1,000/ i 6% Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.4, 4.5, 4.6 or 4.9, 4.11, 4.12) 42. Timothy borrows $6,930 from the bank. For a four-year loan, the bank requires annual end-of-year payments of $2, Calculate the interest rate on the loan. Answer: PVIFA 6,930/2, , i 12% Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.15, 4.16) 43. Tom is evaluating the growth rate in dividends of a company over the past 6 years. What is the annual compound growth rate if the dividends are as follows: Year Dividends 1997 $ Answer: $2.15/$ FVIF5years or $1.38/$ PVIF5years approximately 9 percent. Learning Goal: 6 Topic: Finding Interest or Growth Rates (Equation 4.4, 4.5, 4.6 or 4.9, 4.11, 4.12) 44. To expand its operation, the International Tools Inc. (ITI) has applied for a $3,500,000 loan from the International Bank. According to ITI s financial manager, the company can only afford a maximum yearly loan payment of $1,000,000. The bank has offered ITI, 1) a 3-year loan with a 10 percent interest rate, 2) a 4-year loan with a 11 percent interest rate, or 3) a 5-year loan with a 12 percent interest rate. (a) Compute the loan payment under each option. (b) Which option should the company choose? Answers: (a) 1) PMT 3,500,000/2.487 $1,407, ) PMT 3,500,000/3.102 $1,128, ) PMT 3,500,000/3.605 $ 970, (b) The company should choose option #3. Learning Goal: 6 Topic: Present Value of an Annuity (Equation 4.15, 4.16)

45 Chapter 1 The Role and Environment of Managerial Finance To buy his favorite car, Larry is planning to accumulate money by investing his Christmas bonuses for the next five years in a security which pays a 10 percent annual rate of return. The car will cost $20,000 at the end of the fifth year and Larry s Christmas bonus is $3,000 a year. Will Larry accumulate enough money to buy the car? Answer: FVA PMT (FVIFA) 3,000(6.105) $18,315 Larry will not have enough money to buy the car. He should either invest more money or deposit his christmas bonuses in a security paying a higher rate of return. Learning Goal: 6 Topic: Future Value of an Annuity (Equation 4.13, 4.14) 46. Mr. & Mrs. Pribel wish to purchase a boat in 8 years when they retire. They are planning to purchase the boat using proceeds from the sale of their property which is currently worth $90,000 and its value is growing at 7 percent a year. The boat is currently worth $200,000 increasing at 5 percent per year. In addition to the value of their property, how much additional money should they deposit at the end of each year in an account paying 9 percent annual interest in order to be able to buy the boat upon retirement? Answer: Value of the property upon retirement: PV $90,000, i 7%, n 8 FV PV(FVIF) 90,000(1.718) $154,620 Value of the boat upon retirement: PV $200,000, i 5%, n 8 FV PV(FVIF) 200,000(1.477) $295,400 Additional money needed upon retirement: $295,400 $154,620 $140,780 Amount of money needed to deposit at the end of each year: FV $140,780, n 8, i 9%, PMT? PMT FV/FVIFA 140,780/ $12, Level of Difficulty: 4 Learning Goal: 6 Topic: Complex Time Value Problems (Equation 4.4, 4.5, 4.6 and 4.13, 4.14) 47. Herbert has opened a retirement fund account which pays 7 percent interest and requires $5,000 annual deposits. Herbert will retire in 15 years and expects 10 years of retirement life. What is the maximum annual retirement benefit Herbert can get during his retirement years? Answer: i 7%, PMT $5,000, n 15 At the beginning of retirement: FVA 5,000(FVIFA) 5,000(25.129) $125,645 Annual retirement benefit: i 7%, n 10, P $125,645 PMT PVA/PVIFA 125,645/7.024 $17, Level of Difficulty: 4 Learning Goal: 6 Topic: Complex Time Value Problems (Equation 4.13, 4.14 and 4.15, 4.16)

46 Chapter 1 The Role and Environment of Managerial Finance Brian borrows $5,000 from a bank at 8 percent annually compounded interest to be repaid in five annual installments. Calculate the principal paid in the third year. Answer: PMT 5,000/3.993 $1, Year Payment Principal Interest Balance 0 0 $5, $1, $ $ , , , , The principal paid in the third year is $ Level of Difficulty: 4 Learning Goal: 6 Topic: Loan Amortization (Equation 4.15, 4.16) 49. Nancy would like to accumulate $10,000 by the end of 3 years from now to buy a sports car from her friend, Jim. She has $2,500 now and would like to save equal annual end-of-year deposits to pay for the car. How much should she deposit at the end of each year in an account paying 8 percent interest to buy the car? Answer: Future value of $2,500 at the end of year 3: FV 2,500(FVIF) 2,500(1.260) $3,150 Balance 10,000 3,150 $6,850 PMT FVA/FVIFA 6,850/3.246 $2, Level of Difficulty: 4 Learning Goal: 6 Topic: Complex Time Value Problems (Equation 4.4, 4.5, 4.6 and 4.13, 4.14) 50. To expand its operation, International Tools Inc. has applied to the International Bank for a 3-year, $3,500,000 loan. Prepare a loan amortization table assuming 10 percent rate of interest. Answer: PMT 3,500,000/2.487 $1,407, Year Payment Principal Interest Balance 0 0 $3,500, $1,407, $1,057, $ 350, ,442, ,407, ,163, , ,279, ,407, ,279, , Level of Difficulty: 4 Learning Goal: 6 Topic: Loan Amortization (Equation 4.15, 4.16)

47 Chapter 1 The Role and Environment of Managerial Finance Ken borrows $15,000 from a bank at 10 percent annually compounded interest to be repaid in six equal installments. Calculate the interest paid in the second year. Answer: PMT 15,000/4.355 $3, Year Payment Principal Interest Balance 0 0 $ 15,000 1 $3, $1, $1, , , , The interest paid in the second year is $1, Level of Difficulty: 4 Learning Goal: 6 Topic: Loan Amortization (Equation 4.15, 4.16) 52. Suzy wants to buy a house but does not want to get a loan. The average price of her dream house is $500,000 and its price is growing at 5 percent per year. How much should Suzy invest in a project at the end of each year for the next 5 years in order to accumulate enough money to buy her dream house with cash at the end of the fifth year? Assume the project pays 12 percent rate of return. Answer: FV 500,000(1.276) $638,000 PMT 638,000/6.353 $100,425 Level of Difficulty: 4 Learning Goal: 6 Topic: Complex Time Value Problems (Equation 4.4, 4.5, 4.6 and 4.13, 4.14) 53. Assume you have a choice between two deposit accounts. Account X has an annual percentage rate of percent but with interest compounded monthly. Account Y has an annual percentage rate of percent with interest compounded continuously. Which account provides the highest effective annual return? Answer: Account X EAR [1 (0.1225/12) % Account Y EAR e % Choose X Level of Difficulty: 4 Learning Goal: 5 Topic: Continuous Compounding and Effective Annual Rate (Equation 4.21, 4.22, 4.23)

48 Chapter 1 The Role and Environment of Managerial Finance Congratulations! You have just won the lottery! However, the lottery bureau has just informed you that you can take your winnings in one of two ways. Choice X pays $1,000,000. Choice Y pays $1,750,000 at the end of five years from now. Using a discount rate of 5 percent, based on present values, which would you choose? Using the same discount rate of 5 percent, based on future values, which would you choose? What do your results suggest as a general rule for approaching such problems? (Make your choices based purely on the time value of money.) Answer: The PV of A $1,000,000; The PV of B $1,371,000; The FV of A $1,276,000; The FV of B $1,500,000. Based on both present values and future values, B is the better choice. The student should recognize that finding present values and finding future values are simply reverse processes of one another, and that choosing between two lump sums based on PV will always give the same result as choosing between the same two lump sums based on FV. Level of Difficulty: 2 Learning Goal: 2 Topic: Present Value and Future Value (Equation 4.4, 4.5, 4.6, 4.9, 4.11, 4.12) 55. Nico is the new assistant branch manager of a larger Florida-based bank and the branch manager has asked him a question to test his knowledge. The question he asked is which rate should the bank advertise on monthly-compounded loans, the nominal annual percentage rate or the effective annual percentage rate? Which rate should the bank advertise on quarterly-compounded savings accounts? Explain. As a consumer, which would you prefer to see and why? Answer: A bank would rather advertise the annual percentage rate on loans since this rate appears to be lower and the effective annual rate. With respect to savings accounts, the bank would rather advertise the effective rate since this rate will be higher than the annual percentage rate with compounding frequency greater than annually. As a consumer, the effective rate is the more important rate since it represents the rate actually paid or earned. Learning Goal: 5 Topic: Nominal and Effective Interest Rates (Equation 4.23) Essay Questions Chapter 5 1. Jeremy Irons purchased 100 shares of Ferro, Inc. common stock for $25 per share one year ago. During the year, Ferro, Inc. paid cash dividends of $2 per share. The stock is currently selling for $30 per share. If Jeremy sells all of his shares of Ferro, Inc. today, what rate of return would he realize? Answer: $30 $25 $2 Realized return 28% $25 Level of Difficulty: 2 Learning Goal: 1 Topic: Holding Period Return (Equation 5.1) 2. Ralph s Ratchets Corporation purchased ratchets rotator one year ago for $6,500. During the year it generated $4,000 in cash flow. If Ralph sells it, he could receive $6,100 for it. What is ratchets rotator s rate of return? Answer: $6,100 $6, 500 $4, 000 Realized return 55% $6, 500 Level of Difficulty: 2 Learning Goal: 1 Topic: Holding Period Return (Equation 5.1)

49 Chapter 1 The Role and Environment of Managerial Finance Asset A was purchased six months ago for $25,000 and has generated $1,500 cash flow during that period. What is the asset s rate of return if it can be sold for $26,750 today? Answer: $26, 750 $25, 000 $1, 500 Realized return 13% $25, 000 Annual rate of return 13% 2 26% Level of Difficulty: 2 Learning Goal: 1 Topic: Holding Period Return (Equation 5.1)

50 Chapter 1 The Role and Environment of Managerial Finance Given the following information about the two assets A and B, determine which asset is preferred. Initial Investment $5,000 $5,000 Annual rate of return Pessimistic 9% 7% Most Likely Optimistic Range 4 8 A Answer: Asset A is preferred because it has a lower range for the same expected return. Level of Difficulty: 2 Learning Goal: 2 Topic: Expected Return and Standard Deviation (Equation 5.2 and Equation 5.3) 5. Assuming the following returns and corresponding probabilities for asset A, compute its standard deviation and coefficient of variation. Rate of Return Answer: Asset A Probability 10% 30% K P KP (K K)^2 P 10% 30% 5.0 ( )^ ( )^ ( )^ % 15.25% SD 3.91% CV SD/K 3.91/ Learning Goal: 2 Topic: Expected Return, Standard Deviation and Coefficient of Variation (Equation 5.2, Equation 5.3 and Equation 5.4) B

51 Chapter 1 The Role and Environment of Managerial Finance Champion Breweries must choose between two asset purchases. The annual rate of return and related probabilities given below summarize the firm s analysis. Asset A Asset B Rate of Return Probability Rate of Return Probability 10% 30% 5% 40% For each asset, compute (a) the expected rate of return. (b) the standard deviation of the expected return. (c) the coefficient of variation of the return. (d) Which asset should Champion select? Answers: (a) Asset A Asset B Return Pr Return Pr 10% % 5% % Expected Return 15% Expected Return 15% (b) Asset A (10% 15%)^ % (15% 15%)^ % (20% 15%)^ % 15% Standard Deviation of A 3.87% Asset B ( 5% 15%)^ % (15% 15%)^ % (25% 15%)^ % 80% Standard Deviation of B 8.94% (c) CVA 3.87/ CVB 8.94/ (d) Asset A; for 15% rate of return and lesser risk. Level of Difficulty: 4 Learning Goal: 2 Topic: Expected Return, Standard Deviation and Coefficient of Variation (Equation 5.2, Equation 5.2 and Equation 5.4)

52 Chapter 1 The Role and Environment of Managerial Finance The College Copy Shop is in process of purchasing a high-tech copier. In their search, they have gathered the following information about two possible copiers A and B. A Initial Investment $10,000 $10,000 Annual rate of return Return Prob. Return Prob. Pessimistic 11% % 0.30 Most Likely Optimistic (a) Compute expected rate of return for each copier. (b) Compute variance and standard deviation of rate of return for each copier. (c) Which copier should they purchase? Answer: a and b. COPIER A B COPIER B K P KP K^2 P K P KP K^2 P 11% % % % % % Expected value 16.9% Expected value 17.05% Variance ^ Variance ^ SD 4.18% SD 5.97% (c) CV SD / k Copier A: CV 4.18/ Copier B: CV 5.97/ The College Copy Shop should buy copier A. Level of Difficulty: 4 Learning Goal: 2 Topic: Expected Return and Standard Deviation (Equation 5.2 and Equation 5.3)

53 Chapter 1 The Role and Environment of Managerial Finance Given the following probability distribution for assets X and Y, compute the expected rate of return, variance, standard deviation, and coefficient of variation for the two assets. Which asset is a better investment? X Return Prob. Return Prob. 8% % Answer: Asset X Y Asset Y K P KP K^2 P K P KP K^2 P 8% % % % % % Expected value 10.7% Expected value 11.15% Variance ^ Variance ^ SD 1.42% SD 0.79% CV SD/k Asset X: CV 1.42/ Asset Y: CV 0.79/ Asset Y is preferred. Level of Difficulty: 4 Learning Goal: 2 Topic: Expected Return, Standard Deviation and Coefficient of Variation (Equation 5.2, Equation 5.3 and Equation 5.4) 9. Russo has a portfolio of three assets. Find the expected rate of return for the portfolio assuming he invests 50 percent of its money in asset A with 10 percent rate of return, 30 percent in asset B with a rate of return of 20 percent, and the rest in asset C with 30 percent rate of return. Answer: Asset Rate of Return Weight (W) K W A 10% B C Expected rate of return Learning Goal: 3 Topic: Portfolio Return (Equation 5.5) 17 percent.

54 Chapter 1 The Role and Environment of Managerial Finance Russo s Gas Distributor, Inc. wants to determine the required return on a stock portfolio with a beta coefficient of 0.5. Assuming the risk-free rate of 6 percent and the market return of 12 percent, compute the required rate of return. Answer: K RF b(km - RF) ( ) % The company should expect at least 9 percent return on the stock portfolio. Level of Difficulty: 2 Learning Goal: 6 Topic: Capital Asset Pricing Model (CAPM) (Equation 5.8) 11. Assuming a risk-free rate of 8 percent and a market return of 12 percent, would a wise investor acquire a security with a Beta of 1.5 and a rate of return of 14 percent given the facts above? Answer: K RF b(km RF) ( ) % Yes, a security with a beta of 1.5 should yield 14 percent rate of return. Learning Goal: 6 Topic: Capital Asset Pricing Model (CAPM) (Equation 5.8) 12. Mr. Thomas is considering investment in a project with beta coefficient of What would you recommend him to do if this investment has an 11.5 percent rate of return, risk-free rate is 5.5 percent, and the rate of return on the market portfolio of assets is 8.5 percent? Answer: K RF b(km RF) ( ) % Mr. Thomas should invest in the project because the project s actual rate of return (11.5 percent) is greater than the project s required rate of return (10.8 percent). Learning Goal: 6 Topic: Capital Asset Pricing Model (CAPM) (Equation 5.8) 13. Nico bought 100 shares of Cisco Systems stock for $24.00 per share on January 1, He received a dividend of $2.00 per share at the end of 2002 and $3.00 per share at the end of At the end of 2004, Nico collected a dividend of $4.00 per share and sold his stock for $18.00 per share. What was Nico s realized return during the three year holding period? What was Nico s compound annual rate of return? Explain the difference? Answer: Realized return $24 $18 $9 $ % Compound Return: $24 $2/(1 R) 1 $3/(1 R) 2 ($4 18)/(1 R) 3 Solve for R either with a calculator or through trial and error. The calculator is approximately 4.4 percent. The reason the realized holding period return is so much larger than the compound rate of return is that the realized return does not account for the time value of money. Learning Goal: 2 Topic: Measuring Single Asset Return (Equation 5.1)

55 Chapter 1 The Role and Environment of Managerial Finance 55 Essay Questions Chapter 6 1. A record collector has agreed to sell her entire collection to a historical museum in three years at a price of $100,000. The current risk-free rate is 7 percent. At what price should she value her collection today? Answer: $100,000(0.816) $81,600 Level of Difficulty: 1 Learning Goal: 4 Topic: Valuation Fundamentals (Equation 6.5 and Equation 6.6) 2. A corporate financial analyst must calculate the value of an asset which produces year-end annual cash flows of $0 the first year, $2,000 the second year, $3,000 the third year, and $2,500 the fourth year. Assuming a discount rate of 15 percent, what is the value of this asset? Answer: Using PVIF(15,n): $0(0.870) $2,000(0.756) $3,000(0.658) $2,500(0.572) $0 $1,512 $1,974 $1,430 $4,916 Level of Difficulty: 2 Learning Goal: 4 Topic: Valuation Fundamentals (Equation 6.5 and Equation 6.6) 3. What is the value of an asset which pays $200 a year for the next 5 years and can be sold for $1,500 at the end of five years from now? Assume that the opportunity cost is 10 percent. Answer: P 200(PVIFA) 1,500(PVIF) 200(3.791) 1,500(0.621) $1, Learning Goal: 4 Topic: Valuation Fundamentals (Equation 6.5 and Equation 6.6) Table 6.2 Bond Par Value ($) Annual Coupon Interest Rate (%) Years to Maturity Required Return (%) L M N (a) Calculate the current value of Bond L. (See Table 6.2) (b) What will happen to the value/price as the bond approaches maturity? Answers: (a) $90(4.212) $1,000(0.747) $1, (b) The bond price will decrease and come closer to par. Level of Difficulty: 2 Learning Goal: 5 Topic: Bond Pricing (Equation 6.7 and Equation 6.7a) 5. Calculate the current value of Bond M. (See Table 6.2) Answer: Annual coupon interest rate Therefore, value par value $100 required rate of return Level of Difficulty: 2 Learning Goal: 5 Topic: Bond Pricing (Equation 6.7 and Equation 6.7a)

56 Chapter 1 The Role and Environment of Managerial Finance Calculate the current value of Bond M if the time of maturity is six years. (See Table 6.2) Answer: The bond is at par, or $100, because the annual coupon interest rate is equal to the required rate of return. Level of Difficulty: 2 Learning Goal: 5 Topic: Bond Pricing (Equation 6.7 and Equation 6.7a) 7. (a) Calculate the current value of Bond N. (See Table 6.2) (b) What will happen to value/price as the bond approaches maturity? Answers: (a) $90(6.047) $500(0.093) $ (b) The bond price will decrease and come closer to par. Level of Difficulty: 2 Learning Goal: 5 Topic: Bond Pricing (Equation 6.7 and Equation 6.7a) 8. Hewitt Packing Company has an issue of $1,000 par value bonds with a 14 percent coupon interest rate outstanding. The issue pays interest semiannually and has 10 years remaining to its maturity date. Bonds of similar risk are currently selling to yield a 12 percent rate of return. What is the value of these Hewitt Packing Company bonds? Answer: B $70(11.470) $1,000(.312) $1, Learning Goal: 5 Topic: Bond Pricing (Equation 6.8 and Equation 6.8a) 9. To expand its business, the Kingston Outlet factory would like to issue a bond with par value of $1,000, coupon rate of 10 percent, and maturity of 10 years from now. What is the value of the bond if the required rate of return is 1) 8 percent, 2) 10 percent, and 3) 12 percent? Answers: Coupon payment 1, $100 1) B 100(PVIFA 8%, 10) 1,000(PVIF 8%, 10) 100(6.710) 1,000(0.463) $1, ) B $1,000 since coupon rate and required rate of return are equal. 3) B 100(PVIFA 12%, 10) 1,000(PVIF 12%, 10) 100(5.650) 1,000(0.322) $887 Learning Goal: 5 Topic: Bond Pricing (Equation 6.7 and Equation 6.7a) 10. To finance a new line of product, the Westchester Company has issued $1,000,000 bond with a par value of $1,000, coupon rate of 8 percent, and maturity of 30 years. Compute the price of the bond if the opportunity cost is 11 percent. Answer: Coupon payment 1, $80 B 80(PVIFA 11%, 30) 1,000(PVIF 11%, 30) 80(8.694) 1,000(0.044) $ Learning Goal: 5 Topic: Bond Pricing (Equation 6.7 and Equation 6.7a)

57 Chapter 1 The Role and Environment of Managerial Finance Peter has recently inherited $10,000 and is considering purchasing 10 bonds of the Lucky Corporation. The bond has a par value of $1,000 with 10 percent coupon rate and will mature in 10 years. Does Peter have enough money to buy 10 bonds if the required rate of return is 9 percent? Answer: No. Since the required rate of return (9 percent) is less than the bond s coupon rate (10 percent), the bond s price is greater than its par value ($1,000). Thus, the total price of 10 bonds is greater than $10,000. Learning Goal: 5 Topic: Bond Pricing (Equation 6.7 and Equation 6.7a) 12. Fancy Food, Inc. has issued a bond with par value of $1,000, a coupon rate of 9 percent that is paid semi-annually, and that matures in 10 years. What is the value of the bond if the required rate of return is 12 percent? Answer: Coupon payment 1, $90 Semi-annual coupon payment 90/2 $45 P 45(PVIFA 6%, 20) 1,000(PVIF 6%, 20) 45(11.470) 1,000(0.312) $ Learning Goal: 5 Topic: Bond Pricing (Equation 6.8 and Equation 6.8a) 13. The H&H Computer Company has an outstanding issue of bond with a par value of $1,000, paying 12 percent coupon rate semi-annually. The bond was issued 25 years ago and has 5 years to maturity. What is the value of the bond assuming 14 percent rate of interest? Answer: Coupon payment 1, $120 Semi-annual coupon payment 120/2 $60 P 60(PVIFA 7%, 10) 1,000(PVIF 7%, 10) 60(7.024) 1,000(0.508) $ Learning Goal: 5 Topic: Bond Pricing (Equation 6.8 and Equation 6.8a) 14. Dell Camping Equipment, Inc. just issued a 10 percent, 25-year bond with a $1,000 par value that pays interest semiannually. (a) How much can the investor expect in annual interest (in dollars)? (b) How much can the investor expect in interest every six months (in dollars)? (c) How much can the investor expect in par value at the end of the 25th year? Answers: (a) $100 (b) $50 (c) $1,000 Level of Difficulty: 1 Learning Goal: 6 Topic: Bond Pricing (Equation 6.8 and Equation 6.8a)

58 Chapter 1 The Role and Environment of Managerial Finance Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape. Answer: The student should draw a normal, upward-sloping yield curve as shown in the text. Factors impacting the shape of the yield curve are the risk free rate, the inflation premium, and the interest rate risk premium. Level of Difficulty: 2 Learning Goal: 1 Topic: Term Structure of Interest Rates 16. Explain liquidity, default risk, and maturity risk premiums. Answer: Liquidity problems exist in thinly traded bonds, default risk is the likelihood the corporation will default on its bond obligations, and the maturity premium reflects the fact that longer-term bonds possess greater interest rate risk and sensitivity than shorter term bonds.. If any of these exist, investors will demand to be compensated for the risk by demanding a yield premium to own the bonds. Learning Goal: 2 Topic: Risk Premiums

59 Chapter 1 The Role and Environment of Managerial Finance 59 Essay Questions Chapter 7 1. Sopp Accounting Services has an outstanding issue of 1,000 shares preferred stock with a $100 par value, an 8 percent annual dividend, and 5,000 shares of common stock outstanding. If the stock is cumulative and the board of directors has passed the preferred dividend for the last two years, how much must preferred stockholders be paid prior to paying dividends to common stockholders? Answer: $8,000 2 $16,000 for the two prior years plus $8,000 for the current year. Learning Goal: 2 Topic: Features of Preferred Stock 2. Identify whether the key characteristic describes common stock (CS) or preferred stock (PS). 1. Source of financing which places minimum constraints on the firm. 2. Used often in mergers. 3. Potential dilution of earnings and voting power. 4. Fixed financial obligation. 5. Increases the firm s borrowing power. 6. May have cumulative and participating features. 7. May be convertible into another type of security. 8. Last to receive earnings or distribution of assets in the event of bankruptcy. 9. Frequently includes a call feature. Answers: 1. CS 2. PS 3. CS 4. PS 5. CS 6. PS 7. PS 8. CS 9. PS Learning Goal: 3 Topic: Features of Preferred and Common Stock 3. Fish n Chips Restaurants, Inc. had earnings before interest and taxes of $4,000,000 last year. The firm has a marginal tax rate of 40 percent and currently has the following capital structure: Source of Capital Amount Percentage of Total Capital Long-term Debt at 12% $8,000,000 25% Preferred Stock at 14% 8,000, Common Stock Equity (2,000,000 shares outstanding) 16,000, $32,000, % (a) Calculate the firm s after-tax return on equity (ROE) and earnings per share (EPS).

60 Chapter 1 The Role and Environment of Managerial Finance 60 (b) If the firm retires $4,000,000 of preferred stock using the proceeds from an equal increase in long-term debt, what would have been the after-tax return on equity (ROE) and earnings per share (EPS)? (c) If the firm retires $4,000,000 of preferred stock using the proceeds from the sale of 500,000 shares of common stock, what would have been the after-tax return on equity (ROE) and earnings per share (EPS)? Answers: (a) (b) (c) EBIT $4,000,000 ROE** 1,824,000/24,000,000 Interest* 960, % EBT $3,040,000 EPS*** 704,000/2,000,000 Taxes (40%) 1,216,000 $ EAT $1,824,000 Preferred Div 1,120,000 EAC $ 704,000 * $8,000, $960,000 ** ROE Net Profits after Taxes/Stockholders Equity (where stockholders equity includes preferred stock). *** EPS EAC/Common share outstanding EBIT $4,000,000 ROE 1,536,000/20,000,000 Interest 1,440, % EBT $2,560,000 EPS 976,000/2,000,000 Taxes (40%) 1,024,000 $0.49 EAT $1,536,000 Preferred Div 560,000 EAC $ 976,000 EBIT $4,000,000 ROE 1,824,000/24,000,000 Interest 960, % EBT $3,040,000 EPS 1,264,000/2,500,000 Taxes (40%) 1,216,000 $0.51 EAT $1,824,000 Preferred Div 560,000 EAC $1,264,000 Level of Difficulty: 4 Learning Goal: 3 Topic: ROE and EPS

61 Chapter 1 The Role and Environment of Managerial Finance The board of directors of the National Computer Company has declared $5.00 common stock dividend and accepted a plan to freeze the dividend at $5 per year indefinitely. What is the value of the National Computer Company s common stock if the required rate of interest is 15 percent? Answer: P D/k 5/0.15 $33.33 Level of Difficulty: 1 Learning Goal: 4 Topic: Zero Growth Valuation Model (Equation 7.3) 5. Kingston Kitchen Stuff has recently sold 1,000 shares of $6.75 preferred stock. What is the value of the stock assuming 10 percent required rate of return? Answer: P D/k 6.75/0.10 $67.50 Level of Difficulty: 1 Learning Goal: 4 Topic: Preferred Stock Valuation (Equation 7.3) 6. The Fur Company has been experiencing several years of financial difficulty and, thus, has considered maintaining its dividend payment at $2.50 indefinitely. What is the value of its common stock if the required rate of return is 8.5 percent? Answer: P D/k 2.50/0.085 $29.41 Level of Difficulty: 1 Learning Goal: 4 Topic: Zero Growth Valuation Model (Equation 7.3) 7. In response to the stock market s reaction to its dividend policy, the Paper Company has decided to increase its dividend payment at a rate of 4 percent per year. The firm s most recent dividend is $3.25 and the required rate of interest is 9 percent. What is the maximum you would be willing to pay for a share of the stock? Answer: P D1/(k g) 3.25(1 0.04)/( ) $67.60 Level of Difficulty: 2 Learning Goal: 4 Topic: Constant Growth Valuation Model (Equation 7.4 and Equation 7.5) 8. A firm has an expected dividend next year of $3.60 and a required return of 12 percent. Calculate the value of a share of common stock assuming a zero growth rate of dividends. Answer: $ $30 Level of Difficulty: 2 Learning Goal: 4 Topic: Zero Growth Valuation Model (Equation 7.3) 9. Smith Juggling Equipment has an outstanding preferred issue of stock with a par value of $100 and an annual dividend of 10 percent (of par). Similar risk preferred stocks are yielding an 11.5 percent annual rate of return. (a) What is the current value of the outstanding preferred stock? (b) What will happen to price as the risk-free rate increases? Explain.

62 Chapter 1 The Role and Environment of Managerial Finance 62 Answers: (a) $10/0.115 $86.96 (b) As the risk-free rate increases, the required rate of return will increase and the price will drop. Level of Difficulty: 2 Learning Goal: 4 Topic: Preferred Stock Valuation (Equation 7.3) 10. Ted has 10 shares of the Men s Underwear Company. Based on the company s dividend policy, Ted will receive a total of $450 a year in perpetuity. What is the value of each share if the rate of interest is 8 percent? Answer: Dividend per share 450/10 $45 P D/k 45/0.08 $ Level of Difficulty: 2 Learning Goal: 4 Topic: Zero Growth Valuation Model (Equation 7.3) 11. The Bradshaw Company s most recent dividend was $6.75. The historical dividend payment by the company shows a constant growth rate of 5 percent per year. What is the maximum you would be willing to pay for a share of its common stock if your required rate of return is 8 percent? Answer: D (1 0.05) $7.09 P D1/(k g) 7.09/( ) $ Level of Difficulty: 2 Learning Goal: 4 Topic: Constant Growth Valuation Model (Equation 7.4 and Equation 7.5) 12. The Medical Equipment Company paid $2.25 common stock dividend last year. The company s policy is to allow its dividend to grow at 5 percent per year indefinitely. What is the value of the stock if the required rate of return is 8 percent? Answer: P D1/(k g) 2.25 (1 0.05)/( ) $78.67 Level of Difficulty: 2 Learning Goal: 4 Topic: Constant Growth Valuation Model (Equation 7.4 and Equation 7.5) 13. Mr. Arthur recently purchased a block of 100 shares of Bingham Corporation common stock for $6,000. The stock is expected to provide an annual cash flow of dividends of $400 indefinitely. Assuming a discount rate of 8 percent, how does the price Mr. Arthur paid compare to the value of the stock? $400 Answer: The value of the stock is $5, Mr. Arthur paid $1,000 more than the value of the stock. Learning Goal: 4 Topic: Zero Growth Valuation Model (Equation 7.3) 14. The Central Heating Company has been very successful in the past four years. Over these years, it paid common stock dividend of $4 in the first year, $4.20 in the second year, $4.41 in the third year, and its most recent dividend was $4.63. The company wishes to continue this dividend growth indefinitely. What is the value of the company s stock if the required rate of return is 12 percent? Answer: FVIFg, / g 5% P D5/(k g) 4.63 (1 0.05)/( ) $69.46

63 Chapter 1 The Role and Environment of Managerial Finance 63 Learning Goal: 4 Topic: Constant Growth Valuation Model (Equation 7.4 and Equation 7.5) Table 7.2 Year Dividends($) Charlene owns stock in a company which has paid the annual dividends shown in Table 7.2. Calculate the growth rate of these dividends. Answer: PVIF growth rate 14% Learning Goal: 4 Topic: Constant Growth Valuation Model (Equation 7.4 and Equation 7.5) 16. Calculate the estimated dividend for (See Table 7.2.) Answer: ($2.89)(1.14) $3.29 Learning Goal: 4 Topic: Constant Growth Valuation Model (Equation 7.4 and Equation 7.5) 17. The required return is assumed to be 17 percent. Using the Gordon model, calculate the per share value of the stock. (See Table 7.2.) Answer: $ $ Learning Goal: 4 Topic: Constant Growth Valuation Model (Equation 7.4 and Equation 7.5)

64 Chapter 1 The Role and Environment of Managerial Finance Diamond House Exporting has a beta of 1.50, the risk-free rate of interest is currently 12 percent, and the required return on the market portfolio is 18 percent. The company plans to pay a dividend of $2.45 per share in the coming year and anticipates that its future dividends will increase at an annual rate consistent with that experienced over the period Year Dividend Estimate the value of Diamond House Exporting stock. Answer: ks ( ) 0.21 growth rate of dividends: 2.23/2.10 FVIF % $2.45 Po $ Level of Difficulty: 4 Learning Goal: 4 Topic: CAPM and Constant Growth Valuation Model (Equation 7.4, Equation 7.5 and Equation 7.9) 19. The National X-Ray Company paid $2.00 per share in common stock dividends last year. The company s policy is to allow its dividend to grow at 5 percent for 4 years and then the rate of growth changes to 3 percent per year from year five and on. What is the value of the stock if the required rate of return is 8 percent? Answer: t Do FVIF5%,t Dt PVIF8%,t PV 1 $ $ $ D (1 0.03) $ P2 $ (1 0.08) ^ 4 Value of stock $36.75 $7.46 $44.21 Level of Difficulty: 4 Learning Goal: 4 Topic: Variable Growth Valuation Model (Equation 7.6) P1 $7.46

65 Chapter 1 The Role and Environment of Managerial Finance Compute the value of a share of common stock of a company whose most recent dividend was $2.50 and is expected to grow at 3 percent per year for the next 5 years, after which the dividend growth rate will increase to 6 percent per year indefinitely. Assume 10 percent required rate of return. Answer: t Do FVIF5%,t Dt PVIF8%,t PV 1 $ $ $ D (1 0.06) $ P2 $ (1 0.10) ^ 5 Value of stock $47.66 $10.32 $57.98 Level of Difficulty: 4 Learning Goal: 4 Topic: Variable Growth Valuation Model (Equation 7.6) P1 $ Newmarket Industries currently has 2,000 shares of common stock outstanding. The firm has assets of $200,000 and total liabilities including preferred stock of $75,000. Calculate the book value per share of Newmarket common stock. Answer: $200, 000 $75, 000 2,000 $62.50/share Level of Difficulty: 1 Learning Goal: 5 Topic: Book Value of Common Stock 22. Based on analysis of the company and expected industry and economic conditions, Newmarket Industries is expected to earn $4.60 per share of common stock next year. The average price/earnings ratio for firms in the same industry is 8. Calculate the estimated value of a share of Newmarket common stock. Answer: $4.60(8) $36.80/share Level of Difficulty: 1 Learning Goal: 5 Topic: P/E Multiple Valuation Model 23. Due to growing demand for computer software, the LetterPerfect Company has had a very successful year and expects its earnings per share to grow by 25 percent to reach $5.50 for this year. Estimate the price of the company s common stock assuming the industry s price/earning ratio is 12. Answer: P (P/E)(E) $66 Level of Difficulty: 1 Learning Goal: 5 Topic: P/E Multiple Valuation Model

66 Chapter 1 The Role and Environment of Managerial Finance International Tools Inc. (ITI) s total assets as recorded on its balance sheet are $1,500,000. What is the value of the ITI s common stock if it has $950,000 in liabilities, and 7,500 shares of common stock outstanding? Answer: P (1,500, ,000)/7,500 $73.33 Level of Difficulty: 1 Learning Goal: 5 Topic: Book Value of Common Stock 25. International Tools Inc. (ITI) has estimated the market value of its assets to be $1,250,000. What is the value of ITI s common stock if it has $900,000 in liabilities, $50,000 in preferred stock, and 7,500 shares of common stock outstanding? Answer: P (1,250, ,000 50,000)/7,500 $40 Level of Difficulty: 1 Learning Goal: 5 Topic: Book Value of Common Stock 26. A firm s common stock currently sells for $75 per share. The firm has total assets of $1,000,000 and total liabilities, including preferred stock, of $350,000. If the firm has 10,000 shares of common stock outstanding, (a) what is the book value of each share of common stock? (b) is the stock overvalued or undervalued in the marketplace? (c) what might be the reason(s) for your answer in (b). Answers: (a) $1, 000, 000 $350, , 000 $65/share (b) overvalued (c) market value of the assets is greater than the book value. Level of Difficulty: 2 Learning Goal: 5 Topic: Book Value of Common Stock 27. A firm has current assets of $800,000, which can be liquidated at 90 percent of book value. Total liabilities, including preferred stock, equal $270,000. The firm has 15,000 shares of common stock outstanding. What is the liquidation value per share of common stock? Answer: $800, 000(0.90) $270, , 000 $30/share Level of Difficulty: 2 Learning Goal: 5 Topic: Liquidation Value of Common Stock

67 Chapter 1 The Role and Environment of Managerial Finance Antique Replicas, Inc., has a beta of 1.40, the annual risk-free rate of interest is currently 10 percent, and the required return on the market portfolio is 16 percent. The firm estimates that its future dividends will continue to increase at an annual compound rate consistent with that experienced over the period. Year Dividend 2000 $ (a) Estimate the value of Antique Replicas, Inc., stock. (b) A lawsuit has been filed against the company by a competitor, and the potential loss has increased risk, which is reflected in the company s beta, increasing it to 1.6. What is the estimated price of the stock following the filing of the lawsuit. Answers: (a) ks ( ) growth rate of dividends $3.40/$ FVIF3, k 8% Po $3.40(1.08)/( ) $35.31 (b) ks ( ) Po $3.40(1.08)/( ) $31.66 Level of Difficulty: 4 Learning Goal: 6 Topic: CAPM and Constant Growth Valuation Model (Equation 7.4, Equation 7.5 and Equation 7.9) 29. Tangshan China s stock is currently selling for $ per share and the firm s dividends are expected to grow at 5 percent indefinitely. In addition, Tangshan China s most recent dividend was $5.50. The expected risk free rate of return is 3 percent, the expected market return is 8 percent, and Tangshan has a beta of (a) What is the expected return based on the dividend valuation model? (b) What is the required return based on the CAPM? (c) Would Tangshan China be a good investment at this time? Explain Answers: (a) ks [$5.50(1.05)]/$ % (b) ks ( ) 9% (c) The expected return is 8.6 percent but the required return is 9 percent. Based on this information, Tangshan is overvalued and would not be a good investment at this time. Level of Difficulty: 4 Learning Goal: 6 Topic: CAPM and Constant Growth Valuation Model (Equation 7.4, Equation 7.5 and Equation 7.9)

68 Chapter 1 The Role and Environment of Managerial Finance 68 Essay Questions Chapter 8 1. Compute the initial purchase price for an asset with book value of $34,800 and total accumulated depreciation of $85,200. Answer: Initial purchase price book value accumulated depreciation 34,800 85,200 $120,000 Level of Difficulty: 2 Learning Goal: 4 Topic: Depreciation (Equation 8.1) 2. A mixer was purchased two years ago for $120,000 and can be sold for $125,000 today. The mixer has been depreciated using the MACRS 5-year recovery period and the firm pays 40 percent taxes on both ordinary income and capital gain. (a) Compute recaptured depreciation and capital gain (loss), if any. (b) Find the firm s tax liability.

69 Chapter 1 The Role and Environment of Managerial Finance 69 Answers: (a) Book Value 120,000 ( ) $57,600 Recaptured depreciation 120,000 57,600 $62,400 Capital gain 125, ,000 5,000 $67,400 (b) Tax liability 67, $26,960 Learning Goal: 4 Topic: MACRS Depreciation and Taxes (Equation 8.1) 3. An asset was purchased three years ago for $100,000 and can be sold for $40,000 today. The asset has been depreciated using the MACRS 5-year recovery period and the firm pays 40 percent taxes on both ordinary income and capital gain. (a) Compute recaptured depreciation and capital gain (loss), if any. (b) Find the firm s tax liability. Answers: (a) Book Value 100,000 ( ) $29,000 Recaptured depreciation 40,000 29,000 $11,000 Capital gain 0 $11,000 (b) Tax liability 11, $4,400 Learning Goal: 4 Topic: MACRS Depreciation and Taxes (Equation 8.1) 4. A machine was purchased two years ago for $120,000 and can be sold for $50,000 today. The machine has been depreciated using the MACRS 5-year recovery period and the firm pays 40 percent taxes on both ordinary income and capital gains. (a) Compute recaptured depreciation and capital gain (loss), if any. (b) Find the firm s tax liability. Answers: (a) Book Value 120,000 ( ) $57,600 Recaptured depreciation $0 Capital loss 57,600 50,000 7,600 (b) Tax benefit 7, $3,040 Learning Goal: 4 Topic: MACRS Depreciation and Taxes (Equation 8.1)

70 Chapter 1 The Role and Environment of Managerial Finance Compute the depreciation values for an asset which costs $55,000 and requires $5,000 in installation costs using MACRS 5-year recovery period. Answer: Depreciable Value 55,000 5,000 $60,000 Year Depreciable Value Percentages Depreciation Values 1 $60,000 20% $12, , , , , , , , , , ,000 $60,000 Learning Goal: 4 Topic: MACRS Depreciation (Equation 8.1) Table 8.5 Fine Press is considering replacing the existing press with a more efficient press. The new press costs $55,000 and requires $5,000 in installation costs. The old press was purchased 2 years ago for an installed cost of $35,000 and can be sold for $20,000 net of any removal costs today. Both presses are depreciated under the MACRS 5-year recovery schedule. The firm is in 40 percent marginal tax rate. 6. Calculate the book value of the existing press being replaced. (See Table 8.5.) Answer: Book value of existing press $35,000 [1 ( )] 16,800 Learning Goal: 4 Topic: Initial Investment, MACRS Depreciation and Taxes (Equation 8.1) 7. Calculate the tax effect from the sale of the existing asset. (See Table 8.5.) Answer: Tax: $20,000 16,800 $3,200 recaptured depreciation $3, $1,280 tax Learning Goal: 4 Topic: Initial Investment, MACRS Depreciation and Taxes (Equation 8.1) 8. Calculate the initial investment of the new asset. (See Table 8.5.) Answer: Cost of new press $55,000 Installation Cost 5,000 Proceeds from the sale of existing press 20,000 Tax effect on sale of existing press 1,280 Initial investment $41,280 Learning Goal: 4 Topic: Initial Investment, MACRS Depreciation and Taxes (Equation 8.1) Degnan Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given. Table 8.6 Existing Machine Facts Proposed Machine

71 Chapter 1 The Role and Environment of Managerial Finance 71 Cost $100,00 Cost $150,000 Purchased 2 years ago Installation $20,000 Depreciation using MACRS over Depreciation the MACRS a 5-year 5-year recovery schedule recover schedule will be used. Current market value $105,000 Five year usable life remaining Five year usable life expected Earnings before Depreciation and Taxes Existing Machine Proposed Machine Year 1 $160,000 Year 1 $170, , , , , , , , ,000 The firm pays 40 percent taxes on ordinary income and capital gains. 9. Calculate the book value of the existing asset being replaced. (See Table 8.6.) Answer: Book value of existing equipment $100,000 [1 ( )] 48,000 Learning Goal: 5 Topic: MACRS Depreciation (Equation 8.1) 10. Calculate the tax effect from the sale of the existing asset. (See Table 8.6.) Answer: Tax: $105,000 $100,000 $5,000 capital gain 0.4 $2,000 $ 52,000 recaptured depreciation ,800 Total tax liability $22,800 Learning Goal: 5 Topic: MACRS Depreciation and Taxes (Equation 8.1)

72 Chapter 1 The Role and Environment of Managerial Finance Calculate the initial investment required for the new asset. (See Table 8.6.) Answer: Cost of new equipment $150,000 Installation cost 20,000 Proceeds from the sale of existing equipment (105,000) Tax effect on sale of existing equipment 22,800 Initial investment $ 87,800 Learning Goal: 5 Topic: Initial Investment 12. Calculate the incremental earnings before depreciation and taxes. (See Table 8.6.) Answer: Year 1 $10, , , , ,000 Learning Goal: 5 Topic: Incremental EBDT 13. Calculate the incremental depreciation. (See Table 8.6.) Answer: Year 1 $15, , , , , ,500 Learning Goal: 5 Topic: Incremental Depreciation

73 Chapter 1 The Role and Environment of Managerial Finance Summarize the incremental after-tax cash flow (relevant cash flows) for years t 0 through t 5. (See Table 8.6.) Answer: Calculation of Operating Cash Flows Profits before Depreciation and Taxes Net Profits before Taxes Net Profits After Taxes Cash Flow Year Depreciation Taxes Existing Machine 1 $160,000 $19,000 $141,000 $56,400 $84,600 $103, ,000 12, ,000 55,200 82,800 94, ,000 12, ,000 51,200 76,800 88, ,000 5, ,000 54,000 81,000 86, , ,000 56,000 84,000 84, Proposed Machine 1 $170,000 $34,000 $136,000 $54,400 $81,600 $115, ,000 54, ,600 46,240 69, , ,000 32, ,700 55,080 82, , ,000 20, ,600 59,840 89, , ,000 20, ,600 59,840 89, , ,500 8,500 3,400 5,100 3,400 Calculation of Incremental Cash Flows Year Proposed Existing Incremental 1 $115,600 $103,600 $12, ,760 94,800 28, ,920 88,800 26, ,160 86,000 24, ,160 84,000 26, , ,400 Learning Goal: 5 Topic: Incremental Cash Flows

74 Chapter 1 The Role and Environment of Managerial Finance Should financing costs such as the returns paid to bondholders and stockholders be considered in computing after tax operating cash flows? Why or why not? Answer: Financing costs are not an incremental cash flow for capital budgeting purposes. Financing costs are a direct consequence of how the project is financed, not whether the project is economically viable. Financing costs are embedded in the required rate of return used to discount project cash flows. Level of Difficulty: 2 Learning Goal: 3 Topic: Relevant Cash Flows 16. Please explain the difference between a sunk cost and an opportunity cost and give an example of each type of cost Answer: There is no one correct answer to this question. A correct answer depends upon the student s response. Level of Difficulty: 2 Learning Goal: 3 Topic: Sunk Costs versus Opportunity Costs Essay Questions Chapter 9 Table 9.4 Operating Cash Inflows $1,000 $1,000 $1,000 $1,000 $1,000 $2,500 (Initial outlay) 1. Given the information in Table 9.4 and 15 percent cost of capital, (a) compute the net present value. (b) should the project be accepted? Answers: (a) NPV 1,000 (PVIFA15%,5) 2,500 1,000 (3.352) 2,500 $852 (b) Since NPV > 0, the project should be accepted. Learning Goal: 3 Topic: Net Present Value

75 Chapter 1 The Role and Environment of Managerial Finance 75 Table 9.5 Operating Cash Inflows $25,000 $10,000 $50,000 $10,000 $10,000 $60,000 $100,000 (Initial outlay) 2. Given the information in Table 9.5 and 15 percent cost of capital, (a) compute the net present value. (b) should the project be accepted? Answers: (a) Year CF PVIF 15%,t PV 1 $25, $21, , , , , , , , , , ,920 $98,820 NPV 98, ,000 $1,180 < 0 (b) Since NPV < 0, the project should be rejected. Learning Goal: 3 Topic: Net Present Value (Equation 9.1 and Equation 9.1a)

76 Chapter 1 The Role and Environment of Managerial Finance 76 Degnan Dance Company, Inc., a manufacturer of dance and exercise apparel, is considering replacing an existing piece of equipment with a more sophisticated machine. The following information is given. Table 9.6 Facts Existing Machine Proposed Machine Cost $100,00 Cost $150,000 Purchased 2 years ago Installation $20,000 Depreciation using MACRS over Depreciation the MACRS a 5-year recover schedule 5-year recovery schedule will be used Current market value $105,000 Five year usable life remaining Five year usable life expected Earnings before Depreciation and Taxes Existing Machine Proposed Machine Year 1 $160,000 Year 1 $170, , , , , , , , ,000 The firm pays 40 percent taxes on ordinary income and capital gains. 3. Given the information in Table 9.6, compute the initial investment. Answer: Cost of new equipment $150,000 Installation cost 20,000 Proceeds from sale of existing equip. 105,000 Tax effect on sale of existing equip. 22,800 Initial Investment $87,800 Level of Difficulty: 4 Learning Goal: 3 Topic: Initial Investment

77 Chapter 1 The Role and Environment of Managerial Finance Given the information in Table 9.6, compute the incremental annual cash flows. Answer: Profits before Depreciation and Taxes Calculation of Operating Cash Flows Net Profits before Depreciation Taxes Taxes Net Profits after Taxes Cash Flow Year Existing Machine 1 $160,000 $19,000 $141,000 $56,400 $84,600 $103, ,000 12, ,000 55,200 82,800 94, ,000 12, ,000 51,200 76,800 88, ,000 5, ,000 54,000 81,000 86, , ,000 56,000 84,000 84, Proposed Machine 1 $170,000 $34,000 $136,000 $54,400 $81,600 $115, ,000 54, ,600 46,240 69, , ,000 32, ,700 55,080 82, , ,000 20, ,600 59,840 89, , ,000 20, ,600 59,840 89, , ,500 8,500 3,400 5,100 3,400 Calculation of Incremental Cash Flows Year Proposed Machine Existing Machine Incremental Cash Flows 1 $115,600 $103,600 $12, ,760 94,800 28, ,920 88,800 26, ,160 86,000 24, ,160 84,000 26, , ,400 Level of Difficulty: 4 Learning Goal: 3 Topic: Incremental Operating Cash Flows

78 Chapter 1 The Role and Environment of Managerial Finance Given the information in Table 9.6, compute the payback period. Answer: Year Incremental Cash Flows Cumulative Cash Flow 1 $12,000 $12, ,960 40, ,120 67, ,160 91, , , , ,800 PP 3 [(87,800 67,080)/24,160] 3.86 years. Level of Difficulty: 4 Learning Goal: 3 Topic: Payback Method 6. Given the information in Table 9.6 and 15 percent cost of capital, (a) compute the net present value. (b) Should the project be accepted? Answers: (a) Year ICF PVIF15%,t PV 1 $12, $10, , , , , , , , , , $77,812 NPV 77,812 87,800 $9,988 (b) Since NPV < 0, the project should be rejected. Level of Difficulty: 4 Learning Goal: 3 Topic: Net Present Value (Equation 9.1 and Equation 9.1a)

79 Chapter 1 The Role and Environment of Managerial Finance 79 Galaxy Satellite Co. is attempting to select the best group of independent projects competing for the firm s fixed capital budget of $10,000,000. Any unused portion of this budget will earn less than its 20 percent cost of capital. A summary of key data about the proposed projects follows. Table 9.7 Project Initial Investment IRR PV of Inflows at 20% A $3,000,000 21% $3,050,000 B 9,000, ,320,000 C 1,000, ,060,000 D 7,000, ,350, Use the NPV approach to select the best group of projects. (See Table 9.7) Answer: Choose Projects C and D, since this combination maximizes NPV at $410,000 and only requires $8,000,000 initial investment. Learning Goal: 6 Topic: NPV and Capital Rationing 8. Use the IRR approach to select the best group of projects. (See Table 9.7) Answer: IRR Approach Project IRR Initial Investment NPV B 25% $9,000,000 $320,000 C 24 1,000,000 60,000 D 23 7,000, ,000 A 21 3,000,000 50,000 Choose Projects B and C, resulting in a NPV of $380,000. Learning Goal: 6 Topic: IRR and Capital Rationing 9. Which projects should the firm implement? (See Table 9.7) Answer: Projects C and D Learning Goal: 6 Topic: NPV versus IRR and Capital Rationing

80 Chapter 1 The Role and Environment of Managerial Finance Consider the following projects, X and Y where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project B also costs $600, and generates cash flows of $500 and $275 for the next 2 years, respectively. Sketch a net present value profile for each of these projects. Which project should the firm choose if the cost of capital is 10 percent? What if the cost of capital is 25 percent? Show all work. Answer: Cost of Capital Project X Project Y 0% $200 $175 5% $144 $126 10% $94 $86 15% $50 $43 20% $11 $8 25% $(24) $(24) At a cost of capital of 10 percent, the firm would choose Project X. At a cost of capital of 25 percent, the firm would choose neither. Learning Goal: 6 Topic: Net Present Value Profiles (Equation 9.1 and Equation 9.1a)