FIN 470 Exam1 - KEY

1. What is the primary disadvantage of the orporate form of organi!ation" Name at #east t$o advantages of orporate organi!ation. The primary disadvantage of the corporate form is the double taxation to shareholders of distributed earnings and dividends. Some advantages include: limited liability, ease of transferability, ability to raise capital, and unlimited life. %. Eva#&ate the fo##o$ing statement' (anagers sho&#d not fo &s on the &rrent sto ) va#&e *e a&se doing so $i## #ead to an overemphasis on short-term profits at the expense of #ongterm profits. Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows, both short-term and long-term. f this is correct, then the statement is false. +. ,o&#d a ompany-s ash f#o$ to sto )ho#ders *e negative in a given year" Exp#ain ho$ this might ome a*o&t. f a company raises more money from selling stock than it pays in dividends in a particular period its cash flow to stockholders will be negative. f a company borrows more than it pays in interest, its cash flow to creditors will be negative. 4. .etson /pa e raft ,orp. sho$s the fo##o$ing information on its %000 in ome statement' sa#es 1 10230004 osts 1 10430004 other expenses 1 235004 depre iation expense 1 031004 interest expense 1 1435004 taxes 1 %134664 dividends 1 103400. In addition3 yo&-re to#d that the firm iss&ed 1 63700 in ne$ e7&ity d&ring %000 and redeemed 1 73+00 in o&tstanding #ong- term de*t. a. What is the %000 operating ash f#o$" *. What is the %000 ash f#o$ to reditors" . What is the %000 ash f#o$ to sto )ho#ders" To find the !"#, we first calculate net income. ncome Statement Sales $%&',((( "osts %(),((( !ther expenses ',*(( +epreciation &,%(( ,- T $.',%(( nterest %),*(( Taxable income $'%,/(( Taxes 0%,)11 2et income $/&,*)1
+ividends $%(,)((

3dditions to 4,

$0&,))1

a. !"# 5 ,- T 6 +epreciation 7 Taxes 5 $.',%(( 6 &,%(( 7 0%,)11 5 $'/,.)1 b. "#" 5 nterest 7 2et new 8T+ 5 $%),*(( 7 97.,/((: 5 $00,%(( 2ote that the net new long-term debt is negative because the company repaid part of its longterm debt.

c. "#S 5 +ividends 7 2et new e;uity 5 $%(,)(( 7 1,.(( 5 $),.(( 6. In re ent years3 8ixie ,o. has great#y in reased its &rrent ratio. 9t the same time3 the 7&i ) ratio has fa##en. What has happened" :as the #i7&idity of the ompany improved" The firm has increased inventory relative to other current assets< therefore, assuming current liability levels remain unchanged, li;uidity has potentially decreased. 2. Y+K3 In .3 has sa#es of 1 63%723 tota# assets of 1 +31063 and a de*t; e7&ity ratio of 1.40. If its ret&rn on e7&ity is 16 per ent3 $hat is its net in ome" This is a multi-step problem involving several ratios. The ratios given are all part of the +uPont dentity. The only +uPont dentity ratio not given is the profit margin. f we know the profit margin, we can find the net income since sales are given. So, we begin with the +uPont dentity: 4!, 5 (.%1 5 9P=:9T3T:9,=: 5 9P=:9S > T3:9% 6 +>,: Solving the +uPont dentity for profit margin, we get: P= 5 ?94!,:9T3:@ > ?9% 6 +>,:9S:@ P= 5 ?9(.%1:9$/,%(1:@ > ?9% 6 %.):9 $1,0.':@ 5 .(//& 2ow that we have the profit margin, we can use this number and the given sales figure to solve for net income: P= 5 .(//& 5 2 > S 2 5 .(//&9$1,0.': 5 $%&).(' 7. Why do yo& thin) most #ong- term finan ia# p#anning *egins $ith sa#es fore asts" <&t different#y3 $hy are f&t&re sa#es the )ey inp&t" The reason is that, ultimately, sales are the driving force behind a business. 3 firmAs assets, employees, and, in fact, Bust about every aspect of its operations and financing exist to directly or indirectly support sales. Put differently, a firmAs future need for things like capital assets, employees, inventory, and financing are determined by its future sales level. 5. =he most re ent finan ia# statements for >oso3 In .3 are sho$n here ?ass&ming no in ome taxes@' In ome /tatement Aa#an e /heet /a#es 1 23+00 9ssets 1 153+00 8e*t 1 1%3400 ,osts +3500 E7&ity 63000 Net in ome 1 %3410 =ota# 1 153+00 =ota# 1 153+00 9ssets and osts are proportiona# to sa#es. 8e*t and e7&ity are not. No dividends are paid. Next year-s sa#es are proBe ted to *e 1 734+4. What is the externa# finan ing needed" 3n increase of sales to $.,)0) is an increase of: Sales increase 5 9$.,)0) 7 ',/((: > $',/(( Sales increase 5 .%* or %*C 3ssuming costs and assets increase proportionally, the pro forma financial statements will look like this: Pro forma income statement Sales $ "osts 2et income $ .,)/) ),1&( 0,*)) 3ssets Total Pro forma balance sheet $ 0%,1&) $ 0%,1&) +ebt ,;uity Total $ %0,)(( *,.)) $ 0%,%))

f no dividends are paid, the e;uity account will increase by the net income, so:

,;uity 5 $1,&(( 6 0,*)) ,;uity 5 $*,.)) So the ,#2 is: ,#2 5 Total assets 7 Total liabilities and e;uity ,#2 5 $0%,1&) 7 0%,%)) 5 $)1( 0. Wo&#d yo& *e $i##ing to pay 1 %43000 today in ex hange for 1 1003000 in +0 years" What $o&#d *e the )ey onsiderations in ans$ering yes or no" Wo&#d yo&r ans$er depend on $ho is ma)ing the promise to repay" The key considerations would be: 9%: s the rate of return implicit in the offer attractive relative to other, similar risk investmentsD and 90: Eow risky is the investment< i.e., how certain are we that we will actually get the $%((,(((D Thus, our answer does depend on who is making the promise to repay. 10. Yo& are s hed&#ed to re eive 1 %03000 in t$o years. When yo& re eive it3 yo& $i## invest it for six more years at 5.4 per ent per year. :o$ m& h $i## yo& have in eight years" Fe need to find the #G of a lump sum. Eowever, the money will only be invested for six years, so the number of periods is six. #G 5 PG9% 6 r:t #G 5 $0(,(((9%.(*):' 5 $/0,))&.// 11. /&ppose t$o ath#etes sign 10-year ontra ts for 1 50 mi##ion. In one ase3 $e-re to#d that the 1 50 mi##ion $i## *e paid in 10 e7&a# insta##ments. In the other ase3 $e-re to#d that the 1 50 mi##ion $i## *e paid in 10 insta##ments3 *&t the insta##ments $i## in rease *y 6 per ent per year. Who got the *etter dea#" -ecause if the time-value-of-money the better deal is the one with e;ual installments. 1%. 9 6- year ann&ity of ten 1 73000 semiann&a# payments $i## *egin 5 years from no$3 $ith the first payment oming 5.6 years from no$. If the dis o&nt rate is 10 per ent ompo&nded month#y3 $hat is the va#&e of this ann&ity five years from no$" What is the va#&e three years from no$" What is the &rrent va#&e of the ann&ity" The cash flows in this problem are semiannual, so we need the effective semiannual rate. The interest rate given is the 3P4, so the monthly interest rate is: =onthly rate 5 .%( > %0 5 .((*// To get the semiannual interest rate, we can use the ,34 e;uation, but instead of using %0 months as the exponent, we will use ' months. The effective semiannual rate is: Semiannual rate 5 9%.((*//:' 7 % 5 .(1%% or 1.%%C Fe can now use this rate to find the PG of the annuity. The PG of the annuity is: PG3 H year *: $.,(((I?% 7 9% > %.(1%%:%(@ > .(1%%J 5 $1/,..'..0 2ote, this is the value one period 9six months: before the first payment, so it is the value at year *. So, the value at the various times the ;uestions asked for uses this value * years from now. PG H year 1: $1/,..'..0 > %.(1%%' 5 $/&,***.//

2ote, you can also calculate this present value 9as well as the remaining present values: using the number of years. To do this, you need the ,34. The ,34 is: ,34 5 9% 6 .((*/:%0 7 % 5 .%(). or %(.).C So, we can find the PG at year 1 using the following method as well: PG H year 1: $1/,..'..0 > %.%()./ 5 $/&,***.// The value of the annuity at the other times in the problem is: PG H year /: $1/,..'..0 > %.(1%%%( 5 $/0,'*).** PG H year /: $1/,..'..0 > %.%().1 5 $/0,'*).** PG H year (: $1/,..'..0 > %.(1%%%' 5 $0),0)/.'. PG H year (: $1/,..'..0 > %.%().* 5 $0),0)/.'. 1+. Is it tr&e that a C. /. =reas&ry se &rity is ris)- free" 2o. 3s interest rates fluctuate, the value of a Treasury security will fluctuate. 8ong-term Treasury securities have substantial interest rate risk. 14. /ay yo& o$n an asset that had a tota# ret&rn #ast year of 11.4 per ent. If the inf#ation rate #ast year $as 4.5 per ent3 $hat $as yo&r rea# ret&rn" The #isher e;uation, which shows the exact relationship between nominal interest rates, real interest rates, and inflation is: 9% 6 R: 5 9% 6 r:9% 6 h: r 5 ?9% 6 .%%): > 9%.()*:@ 7 % 5 .('/( or './(C 16. 9 s&*stantia# per entage of the ompanies #isted on the NY/E and N9/89D don-t pay dividends3 *&t investors are nonethe#ess $i##ing to *&y shares in them. :o$ is this possi*#e given the *e#ief that the pri e of a share of sto ) is the <resent Ea#&e of f&t&re dividends" nvestors believe the company will eventually start paying dividends 9or be sold to another company:. 12. (ar e# ,o. is gro$ing 7&i )#y. 8ividends are expe ted to gro$ at a +0 per ent rate for the next three years3 $ith the gro$th rate fa##ing off to a onstant 2 per ent thereafter. If the re7&ired ret&rn is 1+ per ent and the ompany B&st paid a 1 1.50 dividend3 $hat is the &rrent share pri e" Fith supernormal dividends, we find the price of the stock when the dividends level off at a constant growth rate, and then find the PG of the futures stock price, plus the PG of all dividends during the supernormal growth period. The stock begins constant growth in Kear ), so we can find the price of the stock in Kear /, one year before the constant dividend growth begins as: P/ 5 +/ 9% 6 g: > 9R 7 g: 5 +( 9% 6 g1:/ 9% 6 g2: > 9R 7 g: P/ 5 $%.*(9%./(:/9%.(': > 9.%/ 7 .(': P/ 5 $1&.** The price of the stock today is the PG of the first three dividends, plus the PG of the Kear / stock price. The price of the stock today will be:

P( 5 $%.*(9%./(: > %.%/ 6 $%.*(9%./(:0 > %.%/0 6 $%.*(9%./(:/ > %.%// 6 $1&.** > %.%// P( 5 $)*..( Fe could also use the two-stage dividend growth model for this problem, which is: P( 5 ?+(9% 6 g%:>94 7 g%:@I% 7 ?9% 6 g%:>9% 6 4:@TJ6 ?9% 6 g%:>9% 6 4:@T?+(9% 6 g%:>94 7 g%:@ P( F ?$%.*(9%./(:>9.%/ 7 ./(:@?% 7 9%./(>%.%/:/@ 6 ?9% 6 ./(:>9% 6 .%/:@/?$%.*(9%.(':>9.%/ 7 .(':@ P( F $)*..( 17. /&ppose a proBe t has onventiona# ash f#o$s and a positive N<E. What do yo& )no$ a*o&t its pay*a )" Its dis o&nted pay*a )" Its profita*i#ity index" Its IGG" Exp#ain. f a proBect has a positive 2PG for a certain discount rate, then it will also have a positive 2PG for a Lero discount rate< thus, the payback period must be less than the proBect life. Since discounted payback is calculated at the same discount rate as is 2PG, if 2PG is positive, the discounted payback period must be less than the proBectAs life. f 2PG is positive, then the present value of future cash inflows is greater than the initial investment cost< thus P must be greater than %. f 2PG is positive for a certain discount rate 4, then it will be Lero for some larger discount rate 4M< thus the 44 must be greater than the re;uired return. 15. 9 proBe t that provides ann&a# ash f#o$s of 1 %53600 for nine years osts 1 1+53000 today. Is this a good proBe t if the re7&ired ret&rn is 5 per ent" What if it-s %0 per ent" 9t $hat dis o&nt rate $o&#d yo& *e indifferent *et$een a epting the proBe t and reBe ting it" The 2PG of a proBect is the PG of the outflows minus the PG of the inflows. Since the cash inflows are an annuity, the e;uation for the 2PG of this proBect at an * percent re;uired return is: 2PG 5 7$%/*,((( 6 $0*,1((9PG #3*C, &: 5 $)(,(/'./% 3t an * percent re;uired return, the 2PG is positive, so we would accept the proBect. The e;uation for the 2PG of the proBect at a 0( percent re;uired return is: 2PG 5 7$%/*,((( 6 $0*,1((9PG #30(C, &: 5 7$0/,%%..)1 3t a 0( percent re;uired return, the 2PG is negative, so we would reBect the proBect. Fe would be indifferent to the proBect if the re;uired return was e;ual to the 44 of the proBect, since at that re;uired return the 2PG is Lero. The 44 of the proBect is: ( 5 7$%/*,((( 6 $0*,1((9PG #3 44, &: 44 5 %).1&C 10. =he <resent Ea#&e of a perpet&ity e7&a#s e7&ation red& es to PV =
C . R
C C C + + + . /ho$ ho$ this 0 % + R 9% + R : 9% + R : /

8et: a 5 ">9% 6 4:, and x 5 %>9% 6 4: Then: PG 5 a 6 ax 6 ax0 6 ax/ 6 NNN =ultiply both sides of the e;uation by x to get: PGx 5 ax 6 ax0 6 ax/ 6 NNN #ind the difference: PG 7 PGx 5 a 4earrange to get: PG9% 7 x: 5 a O PG 5 a>9% 7 x:

C %+ R Substitute back into the e;uation to get: PG 5 % % %+ R =ultiply the top and bottom by % 6 4 to get: PG 5 ">9% 7 % 6 4: 5 ">4

%0. ,WC re eives f&nding from the state for ea h st&dent &p to a ertain #imit. If enro##ment goes a*ove that #imit the on#y f&nding for ea h additiona# st&dent omes from t&ition and fees. In determining $hether or not it is profita*#e to a##o$ enro##ment to ex eed the #imit $hi h is more important3 average ost per st&dent or margina# ost per st&dent" 9rg&e yo&r ase. The ;uestion here boils down to whether or not the university is operating at full capacity. f the university is operating at full capacity then the average cost is more important, but if it is operating at less than full capacity then the marginal cost is more important.