Business 5039 Managerial Finance Lakehead University

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1 Business 5039 Managerial Finance Lakehead University Midterm Exam Philippe Grégoire Fall 2004 Time allowed: 2 hours. Instructions: Good luck! Calculators are permitted. No cheat sheet allowed. Please answer all questions in the exam booklets provided. Please hand in your exam booklets only. The marks awarded for each question are in parentheses. Part I: Short Answer Questions (40 points) 1. (10 points) Using the information in Table 1, form (i) a market-value-weighted index, (ii) a price-weighted index and (iii) an equally-weighted index. What was the value of each index on January 1st, 2000? What was the value of each index on January 1st, 2004? Nb. of Shares Outstanding Stock Price Company Jan. 1, 2000 Jan. 1, 2004 Jan. 1, 2000 Jan. 1, 2004 A 10,000 10,000 $10.00 $12.00 B 10,000 12,000 $10.00 $8.00 C 1,000 1,000 $5.00 $10.00 D 1,000 1,000 $30.00 $31.00 Table 1: Data for Question (10 points) Consider the financial statements in Table 2. Assuming that both firms always pay 1/3 of net income as dividends, which firm do you think has the highest internal growth rate? Which firm has the highest sustainable rate? Explain your answers. 1

2 Balance Sheets Assets Liabilities and Owners Equity Firm A Firm B Firm A Firm B Cash Accounts payable Accounts receivable Notes payable Inventory Total current liabilities Total current assets Long-term debt 0 1,100 Net fixed assets 2,100 2,100 Common stock 1, Accum. retained earnings 1,000 1,000 Total assets 3,000 3,000 Total liabilities and equity 3,000 3,000 Income Statements Firm A Firm B Sales 2,000 2,000 COGS 1,000 1,000 Depreciation EBIT Interest Taxable income Taxes (40%) Net income Dividends Earnings retained Table 2: Financial statements for Question (10 points) A firm pays $50,000 for an asset that depreciates at the rate of 24% per annum. In how many years will this asset be worth $25,000? What will be the value of the asset after 4 years? 4. True or False (2 point)? Explain (8 points). Consider the ratios in Table 3. If cost of goods sold is $100 for both firms, then Firm 1 has more current assets than Firm 2. Current Quick Average Age of Ratio Ratio Inventory (in Days) Firm Firm Table 3: Ratios for question (10 points) Arnold wants to borrow $100 from Bryenna today and repay the loan as follows: $.01 tomorrow (Friday), $.02 Saturday, $.04 Sunday, $.08 Monday next week, 2

3 and so on over the next 15 days. That is, Arnold will make 15 payments, one per day, each payment being always twice the preceding payment and the first payment being one cent. How long will it take for Bryenna to get her $100 back? Will Bryenna accept this deal if she can earn an annual return of 18.25% on her $100? Part II: Problems (60 points) 1. Financial Ratios Using the 2002 financial statements for Track Software, Inc., depicted in Table 4, and the industry figures in Table 5, Answer the following questions. (a) (5 points) Compute at least two (2) liquidity ratios for Track Software and compare them with industry averages whenever possible. Comment these ratios. (b) (5 points) Compute at least two (2) leverage ratios for Track Software and compare them with industry averages whenever possible. Comment these ratios. (c) (5 points) Compute at least two (2) activity ratios for Track Software and compare them with industry averages whenever possible. Comment these ratios. (d) (5 points) Compute at least four (4) profitability ratios for Track Software and compare each of them with the industry average whenever possible. Comment these ratios. 2. Financial Planning Using the financial statements for Dalton s Enterprises in Table 6, answer the following questions. (a) (10 points) Construct Dalton s pro forma financial statements using the following assumptions and guidelines: Sales are expected to increase by 20%. Expected COGS is estimated with the equation COGS t = S t. All current liabilities are constant fractions of sales. Depreciation is a constant fraction of net fixed assets. Net fixed assets are a constant fraction of total assets. The capital intensity ratio (total assets/sales) is not expected to change. 3

4 The interest rate on long-term debt is not expected to change. The tax rate and the dividend payout ratio are not expected to change. The total debt ratio must not exceed its 2002 level. Carefully explain each step of your answer. (b) (5 points) Suppose the firm was operating at 90% capacity in 2002 and it wants to invest as little as possible in net fixed assets. That is, if net fixed assets increase, it is because the firm operates at full capacity in If expected sales are as in (a), what would then be the level of net fixed assets on the pro forma balance sheet? (Just answer this question; you don t have to construct a new set of pro forma financial statements.) (c) (5 points) Suppose that sales in 2003 happen to be 1,600 instead of the predicted level. Construct Dalton s 2003 income statement in this case if the firm s net fixed assets and long-term debt have been determined at the beginning of the year, i.e. using the assumptions in (a). Which of the company s ratios are affected by this forecasting error? How does these ratios compare with their expected values? 3. Discounted Cash Flow Valuation Bill Lesuk plans to retire in exactly 30 years. His retirement goal is to create a fund that will pay $100,000 per year for 30 years. During his retirement years, Bill s money will be in an account expected to return, on average, 5% annually. (a) (5 points) How large must Bill s fund be when he retires in order to make the desired payments throughout his retirement? (b) (5 points) Suppose Bill makes equal contributions to his retirement fund at the end of each year until the day he retires. What must each contribution be for Bill to meet his retirement goal if the annual return on his fund is 10%? (c) (5 points) Suppose Bill contributes to his retirement fund at the end of each year until the day he retires and each contribution is always 10% greater than the previous one. What must the first contribution be for Bill to meet his retirement goal if the annual return on his fund is 10%? (d) (5 points) Suppose Bill makes growing contributions to his fund as in (c) and that his employer always matches Bill s contribution. That is, if Bill deposits $100 dollars in his fund in a given year, then his employer also deposits $100 4

5 into the fund. In this case, What must Bill s first contribution be to meet his retirement goal if the annual return on his fund is 10%? Track Software, Inc. Balance Sheet as of December 31, 2002 ($000) Assets Liabilities and Owners Equity Cash 12 Accounts payable 136 Marketable securities 66 Line of credit 200 Accounts receivable 152 Accruals 27 Inventories 191 Total current liabilities 363 Total current assets 421 Long-term debt 38 Gross fixed assets 195 Total liabilities 401 Accumulated amortization (63) Common shares 50 Net fixed assets 132 Retained earnings 102 Total assets 553 Total liabilities and equity 553 Track Software, Inc Income Statement ($000) Sales 1,550 COGS 1,030 Selling expense 150 General and administrative expense 270 Amortization expense 11 EBIT 89 Interest expense 29 Earnings before taxes 60 Taxes (20%) 12 Net income after taxes 48 Table 4: Financial statements for Problem 1. 5

6 Ratio Industry Ratios Average Current ratio 1.8 Quick ratio 1.1 Average age of inventory (days) 47.4 Average collection period (days) 20.5 Average payment period (days) 38.1 Fixed asset turnover 14.1 Total asset turnover 3.9 Total Debt ratio 0.5 Times interest earned 5.6 Gross profit margin (%) 42.3 Net profit margin (%) 8.2 Return on total assets (%) 15.6 Return on equity (%) 34.7 Table 5: Industry ratios for Problem 1. Dalton Enterprises Balance Sheet as of December 31, 2002 Assets Liabilities and Owners Equity Cash 200 Accounts payable 400 Accounts receivable 400 Taxes payable 100 Inventory 400 Total current liabilities 500 Total current assets 1,000 Long-term debt 1,000 Net fixed assets 2,000 Common stock 500 Accum. retained earnings 1,000 Total assets 3,000 Total liabilities and equity 3,000 Dalton Enterprises 2002 Income Statement Sales 1,500 COGS 750 Depreciation 500 EBIT 250 Interest 100 Taxable income 150 Taxes 60 Net income 90 Dividends 30 Earnings retained 60 Table 6: Financial statements for Problem 2. 6