Examination 2

Multiple Choice:  True/False

(14-2) Business risk F Q Answer: b  EASY
 . A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

a. True
b. False

(14-2) Financial risk F Q Answer: a  EASY
 . Financial risk refers to the extra risk stockholders bear as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

a. True
b. False

(14-2) Financial risk F Q Answer: a  EASY
 . A firm’s capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

a. True
b. False

(14-2) Financial leverage F Q Answer: a  EASY
 . If a firm borrows money, it is using financial leverage.

a. True
b. False

(14-2) Financial leverage F Q Answer: a  EASY
 . Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

a. True
b. False

 
(14-2) Use of financial leverage F Q Answer: b  EASY
 . The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

a. True
b. False

(14-2) Operating and fin. leverage F Q Answer: b  EASY
 . Provided a firm does not use an extreme amount of debt, operating leverage typically affects only EPS, while financial leverage affects both EPS and EBIT.

a. True
b. False

(14-4) Trade-off theory F Q Answer: a  EASY
 . The trade-off theory states that capital structure decisions involve a tradeoff between the costs and benefits of debt financing.

a. True
b. False

(14-4) Bankruptcy costs F Q Answer: a  EASY
 . Different borrowers have different risks of bankruptcy, and if a borrower goes bankrupt, its lenders will probably not get back the full amount of funds that they loaned.  Therefore, lenders charge higher rates to borrowers judged to be more likely to go bankrupt.

a. True
b. False

(14-4) MM F Q Answer: a  EASY
 . Modigliani and Miller (MM) won Nobel Prizes for their work on capital structure theory.  

a. True
b. False

(14-4) MM F Q Answer: a  EASY
 . Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.

a. True
b. False

(14-4) MM F Q Answer: b  EASY
 . Modigliani and Miller's first article led to the conclusion that capital structure is extremely important, and that every firm has an optimal capital structure that maximizes its value and minimizes its cost of capital.

a. True
b. False
 
(14-2) Operating and financial leverage F Q Answer: a  MEDIUM
 . It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS.  This would occur if Firm A has more business risk than Firm B.

a. True
b. False

(14-2) Financial risk F Q Answer: b  MEDIUM
 . As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components.

a. True
b. False

(14-2) Business risk F Q Answer: b  MEDIUM
 . If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk.

a. True
b. False

(14-4) MM F Q Answer: a  MEDIUM
 . In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value.  However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant.

a. True
b. False

(14-4) MM F Q Answer: b  MEDIUM
 . According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

a. True
b. False

(14-4) MM F Q Answer: a  MEDIUM
 . According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing.

a. True
b. False

(14-4) MM F Q Answer: a  MEDIUM
 . According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value.

a. True
b. False
(14-4) MM F Q Answer: a  MEDIUM
 . Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value.  However, that article was criticized because it assumed that no taxes existed.  MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt.

a. True
b. False

(14-4) MM F Q Answer: a  MEDIUM
 . Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt.  However, this model did not take account of bankruptcy costs.  The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.

a. True
b. False

(14-4) Miller model F Q Answer: a  MEDIUM
 . The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes.

a. True
b. False

(14-4) Miller model F Q Answer: b  MEDIUM
 . The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes.

a. True
b. False

(14-4) Trade-off theory F Q Answer: a  MEDIUM
 . The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist.  That led to the development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits.  Under the trade-off theory, an optimal capital structure exists.

a. True
b. False

 
(14-4) Trade-off theory F Q Answer: b  MEDIUM
 . Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article.  Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure.  Moreover, a manager can use the second MM model to determine his or her firm's optimal debt ratio.

a. True
b. False

(14-4) Trade-off theory F Q Answer: a  MEDIUM
 . Some people--including the current chairman of the Federal Reserve Board of Governors--have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks."  This is one of the factors that led to the rise of LBOs and private equity firms.

a. True
b. False

(14-4) Signaling theory F Q Answer: a  MEDIUM
 . The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm's future prospects as its managers.  That was called "symmetric information," and it is questionable.  The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future.  Other actions give off different signals, and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value.

a. True
b. False

(14-4) Signaling theory F Q Answer: b  MEDIUM
 . According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms.  This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good.

a. True
b. False

(14-5) Capital structure F Q Answer: a  MEDIUM
 . Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales.

a. True
b. False

 
 
(14-5) Capital structure F Q Answer: a  MEDIUM
 . Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are harder to sell (like those engaged in R&D").

a. True
b. False

(14-5) Capital structure F Q Answer: b  MEDIUM
 . Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt.

a. True
b. False

(14-5) Capital structure F Q Answer: a  MEDIUM
 . A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times".  This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant.  

a. True
b. False

(14-2) Use of debt in financing F Q Answer: a  HARD
 . If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be.

a. True
b. False


Multiple Choice:  Conceptual

(14-2) Business risk C Q Answer: a  EASY
 . An increase in the debt ratio will generally have no effect on which of these items?

a. Business risk.
b. Total risk.
c. Financial risk.
d. Market risk.
e. The firm's beta.

(14-2) Business risk C Q Answer: d  EASY
 . Business risk is affected by a firm's operations.  Which of the following is NOT directly associated with (or does not directly contribute to) business risk?

a. Demand variability.
b. Sales price variability.
c. The extent to which operating costs are fixed.
d. The extent to which interest rates on the firm's debt fluctuate.
e. Input price variability.
(14-3) Capital structure and WACC C Q Answer: d  EASY
 . Which of the following statements is CORRECT?

a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC.
b. Since debt financing is cheaper than equity financing, raising a company’s debt ratio will always reduce its WACC.
c. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing.  However, this action still may raise the company’s WACC.
d. Increasing a company’s debt ratio will typically increase the marginal costs of both debt and equity financing.  However, this action still may lower the company’s WACC.
e. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.

(14-3) Optimal capital structure C Q Answer: d  EASY
 . Which of the following statements is CORRECT?

a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock.
b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS.
c. The capital structure that minimizes the required return on equity also maximizes the stock price.
d. The capital structure that minimizes the WACC also maximizes the price per share of common stock.
e. The capital structure that gives the firm the best bond rating also maximizes the stock price.

(14-3) Optimal capital structure C Q Answer: c  EASY
 . Based on the information below, what is the firm's optimal capital structure?

a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50.
b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90.
c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.
d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40.
e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

(14-3) Optimal capital structure C Q Answer: b  EASY
 . Which of the following statements best describes the optimal capital structure?

a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS).
b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price.
c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity.
d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt.
e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of preferred stock.

(14-5) Leverage and cap. struct. C Q Answer: a  EASY
 . Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?

a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. An increase in the company’s operating leverage.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company's stock price hits a new high.

(14-5) Leverage and cap. struct. C Q Answer: b  EASY
 . Which of the following would tend to increase a firm's target debt ratio, other things held constant?

a. The costs associated with filing for bankruptcy increase.
b. The corporate tax rate is increased.
c. The personal tax rate is increased.
d. The Federal Reserve tightens interest rates in an effort to fight inflation.
e. The company's stock price hits a new low.

(14-3) Optimal capital structure C Q Answer: e  EASY/MEDIUM
 . Which of the following statements is CORRECT?

a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS.
b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.
c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price.
d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC.
e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.

(14-3) Target capital structure C Q Answer: e  EASY/MEDIUM
 . The firm’s target capital structure should do which of the following?

a. Maximize the earnings per share (EPS).
b. Minimize the cost of debt (rd).
c. Obtain the highest possible bond rating.
d. Minimize the cost of equity (rs).
e. Minimize the weighted average cost of capital (WACC).

 
(Comp.) Capital structure concepts C Q Answer: b  EASY/MEDIUM
 . Which of the following statements is CORRECT?

a. A firm’s business risk is determined solely by the financial characteristics of its industry.
b. The factors that affect a firm’s business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control.
c. One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy.
d. A firm’s financial risk can be minimized by diversification.
e. The amount of debt in its capital structure can under no circumstances affect a company’s EBIT and business risk.

(14-2) Operating leverage C Q Answer: e  MEDIUM
 . Which of the following statements is CORRECT?  As a firm increases the operating leverage used to produce a given quantity of output, this

a. normally leads to an increase in its fixed assets turnover ratio.
b. normally leads to a decrease in its business risk.
c. normally leads to a decrease in the standard deviation of its expected EBIT.
d. normally leads to a decrease in the variability of its expected EPS.
e. normally leads to a reduction in its fixed assets turnover ratio.

(14-2) Financial leverage and EPS C Q Answer: a  MEDIUM
 . A firm's CFO is considering increasing the target debt ratio, which would also increase the company’s interest expense.  New bonds would be issued and the proceeds would be used to buy back shares of common stock.  Neither total assets nor operating income would change, but expected earnings per share (EPS) would increase.  Assuming the CFO’s estimates are correct, which of the following statements is CORRECT?

a. Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases.
b. If the plan reduces the WACC, the stock price is likely to decline.
c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase.
d. If the plan does increase the EPS, the stock price will automatically increase at the same rate.
e. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.

 
(14-5) Leverage and cap. struct. C Q Answer: c  MEDIUM
 . Your firm is currently 100% equity financed.  The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase some of its common stock.  The recapitalization would not change the company’s total assets, nor would it affect the firm’s basic earning power, which is 15%.  The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price.  Which of the following would be likely to occur if the company goes ahead with the recapitalization plan?

a. The company’s net income would increase.
b. The company’s earnings per share would decline.
c. The company’s cost of equity would increase.
d. The company’s ROA would increase.
e. The company’s ROE would decline.

(14-2) Cap. struct., ROA, and ROE C Q Answer: e  MEDIUM
 . Your firm has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure.  The CFO is contemplating a recapitalization where it would issue debt at a cost of 10% and use the proceeds to buy back some of its common stock, paying book value.  If the company goes ahead with the recapitalization, its operating income, total assets, and tax rate would remain unchanged.  Which of the following is most likely to occur as a result of the recapitalization?

a. The ROA would increase.
b. The ROA would remain unchanged.
c. The basic earning power ratio would decline.
d. The basic earning power ratio would increase.
e. The ROE would increase.

(14-2) Financial leverage and EPS C Q Answer: c  MEDIUM
 . Which of the following statements is CORRECT?

a. Increasing its use of financial leverage is one way to increase a firm’s basic earning power (BEP).
b. If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage.
c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.
d. If a company were to issue debt and use the money to repurchase common stock, this would reduce its basic earning power ratio.  (Assume that the repurchase has no impact on the company’s operating income.)
e. If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.

 
(14-2) Fin. leverage and ratios C Q Answer: b  MEDIUM
 . Companies HD and LD have identical tax rates, total assets, and basic earning power ratios, and their basic earning power exceeds their before-tax cost of debt, rd.  However, Company HD has a higher debt ratio and thus more interest expense than Company LD.  Which of the following statements is CORRECT?

a. Company HD has a higher net income than Company LD.
b. Company HD has a lower ROA than Company LD.
c. Company HD has a lower ROE than Company LD.
d. The two companies have the same ROA.
e. The two companies have the same ROE.

(14-2) Fin. leverage and ratios C Q Answer: b  MEDIUM
 . Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%.  Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity.  Firm L’s debt has a before-tax cost of 8%.  Both firms have positive net income.  Which of the following statements is CORRECT?

a. The two companies have the same times interest earned (TIE) ratio.
b. Firm L has a lower ROA than Firm U.
c. Firm L has a lower ROE than Firm U.
d. Firm L has the higher times interest earned (TIE) ratio.
e. Firm L has a higher EBIT than Firm U.

(14-2) Fin. leverage and ratios C Q Answer: c  MEDIUM
 . Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk.  Company HD, however, has a much higher debt ratio than LD.  Also, both companies' basic earning power (BEP) ratios exceed their cost of debt (rd).  Which of the following statements is CORRECT?

a. HD should have a higher return on assets (ROA) than LD.
b. HD should have a higher times interest earned (TIE) ratio than LD.
c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.
d. Given that BEP > rd, HD's stock price must exceed that of LD.
e. Given that BEP > rd, LD's stock price must exceed that of HD.

(14-4) Miller model C Q Answer: b  MEDIUM
 . A major contribution of the Miller model is that it demonstrates, other things held constant, that

a. personal taxes increase the value of using corporate debt.
b. personal taxes lower the value of using corporate debt.
c. personal taxes have no effect on the value of using corporate debt.
d. financial distress and agency costs reduce the value of using corporate debt.
e. debt costs increase with financial leverage.

 
(14-5) Leverage and cap. struct. C Q Answer: e  MEDIUM
 . Which of the following statements is CORRECT, holding other things constant?

a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations.
d. An increase in the company’s degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged.
e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.

(14-5) Leverage and cap. struct. C Q Answer: e  MEDIUM
 . Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?

a. Its sales are projected to become less stable in the future.
b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders.
c. Management believes that the firm’s stock is currently overvalued.
d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage.
e. The corporate tax rate is increased.

(Comp.) Capital struct. concepts C Q Answer: b  MEDIUM
 . Which of the following statements is CORRECT?

a. A firm can use retained earnings without paying a flotation cost.  Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. 
b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price.
c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share.
d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC.
e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.

 
(Comp.) Capital struct. concepts C Q Answer: d  MEDIUM
 . Which of the following statements is CORRECT?

a. The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs).
b. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share.
c. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.
d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC.
e. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.

(14-2) Capital struct. concepts C Q Answer: a  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.
b. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions.
c. A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal.
d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt.
e. Suppose a firm has less than its optimal amount of debt.  Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.

(14-2) Fin. leverage and ratios C Q Answer: c  MEDIUM/HARD
 . Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk.  Company HD, however, has a higher debt ratio than LD.  Company HD’s basic earning power ratio (BEP) exceeds its cost of debt (rd).  Which of the following statements is CORRECT?

a. Company HD has a higher return on assets (ROA) than Company LD.
b. Company HD has a higher times interest earned (TIE) ratio than Company LD.
c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD’s.
d. The two companies have the same ROE.
e. Company HD’s ROE would be higher if it had no debt.

 
(Comp.) Capital struct. concepts C Q Answer: a  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.
b. A change in the personal tax rate should not affect firms’ capital structure decisions.
c. “Business risk” is differentiated from “financial risk” by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage.
d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm’s stock, (2) minimizes its WACC, and (3) maximizes its EPS.
e. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.

(Comp.) Leverage and cap. struct. C Q Answer: c  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. When a company increases its debt ratio, the costs of equity and debt both increase.  Therefore, the WACC must also increase.
b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.
c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios.
d. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC.
e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.

(14-6) Variations in cap. struct. C Q Answer: d  HARD
 . Which of the following statements is CORRECT?

a. Generally, debt-to-total-assets ratios do not vary much among different industries, although they do vary among firms within a given industry.
b. Electric utilities generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries.
c. Airline companies tend to have very volatile earnings, and as a result they generally have high target debt-to-equity ratios.
d. Wide variations in capital structures exist both between industries and among individual firms within given industries.  These differences are caused by differing business risks and also managerial attitudes.
e. Since most stocks sell at or very close to their book values, book value capital structures are typically adequate for use in estimating firms' costs of capital.

 
Problems

Some of these problems are conceptually difficult, and they are designated as HARD.  Others are not conceptually difficult, but they require a good bit of arithmetic.  Please take this into account when making up timed tests.

(14-2) Breakeven analysis C Q Answer: a  EASY
 . Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells for $4.00 per unit.  What is the company's breakeven point, i.e., at what unit sales volume would income equal costs? 

a. 391,667
b. 411,250
c. 431,813
d. 453,403
e. 476,073

(14-2) Breakeven analysis C Q Answer: c  EASY
 . Your uncle is considering investing in a new company that will produce high quality stereo speakers.  The sales price would be set at 1.5 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,200,000.  What sales volume would be required to break even, i.e., to have EBIT = zero?

a. 28,880
b. 30,400
c. 32,000
d. 33,600
e. 35,280

(14-2) Breakeven analysis C Q Answer: d  EASY
 . Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs.  What are the pre-tax profits from sales of course packs? 

a. $72,900
b. $81,000
c. $90,000
d. $100,000
e. $110,000

(14-2) Breakeven: FC C Q Answer: d  EASY
 . Southwest U's campus book store sells course packs for $16 each.  The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs.  How much are the fixed costs of producing the course packs? 

a. $164,025
b. $182,250
c. $202,500
d. $225,000
e. $247,500

(14-2) Breakeven: operating plans C Q Answer: d  EASY
 . Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal.  Two robotic machines are available to make the sandals, Machine A and Machine B.  The price per pair will be $20.00 regardless of which machine is used.  The fixed and variable costs associated with the two machines are shown below.  What is the difference between the breakeven points for Machines A and B?  (Hint:  Find BEB - BEA)

Machine A Machine B
Price per pair (P) $20.00 $20.00
Fixed costs (F) $25,000 $100,000
Variable cost/unit (V) $7.00 $4.00

a. 3,154
b. 3,505
c. 3,894
d. 4,327
e. 4,760

(14-2) Breakeven: operating plans C Q Answer: d  EASY
 . Your company plans to produce a new product, a wireless computer mouse.  Two machines can be used to make the mouse, Machines A and B.  The price per mouse will be $25.00 regardless of which machine is used.  The fixed and variable costs associated with the two machines are shown below.  At the expected sales level of 75,000 units, how much higher or lower will the firm's expected EBIT be if it uses high fixed cost Machine B rather than low fixed cost Machine A, i.e., what is EBITB - EBITA?  

Machine A Machine B
Price per mouse (P) $25.00 $25.00
Fixed costs (F) $100,000 $400,000
Variable cost/unit (V) $15.25 $9.00
Exp. unit sales (Q) 75,000 75,000

a. $123,019
b. $136,688
c. $151,875
d. $168,750
e. $185,625

 
(14-2) ROEs and operating plans C Q Answer: b  MEDIUM
 . Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that can be worn like a wristwatch.  Two robotic machines are available to make the phone, Machine A and Machine B.  The price per phone will be $250.00 regardless of which machine is used to make it.  The fixed and variable costs associated with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each machine.  The expected sales level is 25,000 units.  Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project, so T = 0.  How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE, i.e., what is ROEB - ROEA?  (Hint:  Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.)

Machine A Machine B
Price per phone (P) $250.00 $250.00
Fixed costs (F) $1,000,000 $2,000,000
Variable cost/unit (V) $200.00 $150.00
Expected unit sales (Q) 25,000 25,000
Required equity investment $2,500,000 $3,000,000

a. 6.00%
b. 6.67%
c. 7.00%
d. 7.35%
e. 7.72%

(14-2) ROEs and financing plans C Q Answer: a  MEDIUM
 . You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal.  The issue now is how to finance the company, with only equity or with a mix of debt and equity.  Expected operating income is $400,000.  Other data for the firm are shown below.  How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU?

0% Debt, U 60% Debt, L
Oper. income (EBIT) $400,000 $400,000
Required investment $2,500,000 $2,500,000
% Debt 0.0% 60.0%
$ of Debt $0.00 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Interest rate NA 10.00%
Tax rate 35% 35%

a. 5.85%
b. 6.14%
c. 6.45%
d. 6.77%
e. 7.11%

 
(14-2) EPS and financing plans C Q Answer: d  MEDIUM
 . You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer.  The issue now is how to finance the company, with only equity or with a mix of debt and equity.  Expected operating income is $600,000.  Other data for the firm are shown below.  How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU?

0% Debt, U 60% Debt, L
Oper. income (EBIT) $600,000 $600,000
Required investment $2,500,000 $2,500,000
% Debt 0.0% 60.0%
$ of Debt $0.00 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Shares issued, $10/share 250,000 100,000
Interest rate NA 10.00%
Tax rate 35% 35%

a. $1.00
b. $1.11
c. $1.23
d. $1.37
e. $1.50

(14-2) Debt and ROE C Q Answer: a  MEDIUM
 . Confu Inc. expects to have the following data during the coming year.  What is the firm's expected ROE?

Assets $200,000 Interest rate 8%
Debt/Assets, book value 65% Tax rate 40%
EBIT $25,000

a. 12.51%
b. 13.14%
c. 13.80%
d. 14.49%
e. 15.21%

(14-2) Operating income C Q Answer: b  MEDIUM
 . Senate Inc. is considering two alternative methods for producing playing cards.  Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards.  Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck.  The sale price per deck would be the same under each method.  At what unit output level would the two methods provide the same operating income (EBIT)?

a. 12,600
b. 14,000
c. 15,400
d. 16,940
e. 18,634

 
(14-2) Required unit sales C Q Answer: c  MEDIUM
 . A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books.  The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $750,000.  The investors will put up the funds if the project is likely to have an operating income of $500,000 or more.  What sales volume would be required in order to meet the minimum profit goal?  (Hint: Use the breakeven formula, but include the required profit in the numerator.)

a. 4,513
b. 4,750
c. 5,000
d. 5,250
e. 5,513

(14-3) Calculating unlevered beta C Q Answer: e  MEDIUM
 . El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25.  Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta?

a. 0.71
b. 0.75
c. 0.79
d. 0.83
e. 0.87

(14-3) WACC and recapitalization C Q Answer: a  MEDIUM
 . Gator Fabrics Inc. currently has zero debt.  It is a zero growth company, and it has the data shown below.  Now the company is considering using some debt, moving to the new debt/assets ratio indicated below.  The money raised would be used to repurchase stock at the current price.  It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below.  If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew?

New Debt/Assets 55% Orig. cost of equity, rs 10.0%
New Equity/Assets 45% New cost of equity = rs 11.0%
Interest rate new = rd 7.0% Tax rate 40%

a. 2.74%
b. 3.01%
c. 3.32%
d. 3.65%
e. 4.01%

 
(Comp.) Cap. struct. & firm value C Q Answer: e  MEDIUM
 . As a consultant to First Responder Inc., you have obtained the following data (dollars in millions).  The company plans to pay out all of its earnings as dividends, hence g = 0.  Also, no net new investment in operating capital is needed because growth is zero.  The CFO believes that a move from zero debt to 20.0% debt would cause the cost of equity to increase from 10.0% to 12.0%, and the interest rate on the new debt would be 8.0%.  What would the firm's total market value be if it makes this change?  Hints: Find the FCF, which is equal to NOPAT = EBIT(1 – T) because no new operating capital is needed, and then divide by 
(WACC – g).

Oper. income (EBIT) $800 Tax rate 40.0%
New cost of equity (rs) 12.00% New debt ratio 20.0%
Interest rate (rd) 8.00%

a. $2,982
b. $3,314
c. $3,682
d. $4,091
e. $4,545

(14-3) EPS & capital structure C Q Answer: c  MEDIUM/HARD
 . You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations.  They are identical except for their use of debt and the interest rates on their debt--High uses more debt and thus must pay a higher interest rate.  Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh - EPSLow?

Applicable to Both Firms Firm High's Data Firm Low's Data
Assets $3,000,000 Debt ratio 70% Debt ratio 20%
EBIT $500,000 Shares 90,000 Shares 240,000
Tax rate 35% Int. rate 12% Int. rate 10%

a. $0.49
b. $0.54
c. $0.60
d. $0.66
e. $0.73

(14-3) ROE & capital structure C Q Answer: c  MEDIUM/HARD
 . Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate.  Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD?

Applicable to Both Firms Firm HD's Data Firm LD's Data
Assets $3,000,000 Debt ratio 70% Debt ratio 20%
EBIT $500,000 Int. rate 12% Int. rate 10%
Tax rate 35%

a. 5.41%
b. 5.69%
c. 5.99%
d. 6.29%
e. 6.61%
(14-3) ROE & capital structure C Q Answer: c  MEDIUM/HARD
 . Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt.  The two firms' operations are identical--they have the same assets, sales, operating costs, and EBIT.  Thus, they differ only in their use of financial leverage.  Based on the following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA - ROENA?

Applicable to Both Firms Firm A's Data Firm NA's Data
Assets $150,000 Debt ratio 50% Debt ratio 0%
EBIT $40,000 Int. rate 12% Int. rate 10%
Tax rate 35%

a. 8.60%
b. 9.06%
c. 9.53%
d. 10.01%
e. 10.51%

(14-3) ROE & capital structure C Q Answer: c  MEDIUM/HARD
 . Your firm's debt ratio is only 5.00%, but the new CFO thinks that more debt should be employed.  She wants to sell bonds and use the proceeds to buy back and retire some stock, which sells at its book value.  Other things held constant, and based on the data below, if the firm increases its debt ratio to 60.0%, by how much would the ROE change, i.e., what is ROENew - ROEOld?

Operating Data Other Data
Assets $150,000 New debt ratio 60%
EBIT/Assets = BEP 20.00% Old debt ratio 5%
Tax rate 35% New interest rate 12%
Old interest rate 10%

a. 6.73%
b. 7.09%
c. 7.46%
d. 7.83%
e. 8.22%

(14-3) ROE & capital structure C Q Answer: c  MEDIUM/HARD
 . You have been hired by a new firm that is just being started.  The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the debt ratio to only 10%.  Other things held constant, and based on the data below, if the firm uses the higher debt ratio, by how much would the ROE change, i.e., what is ROENew - ROEOld?

Operating Data Other Data
Assets $4,000 Higher debt ratio 60%
EBIT/Assets = BEP 20.00% Lower debt ratio 10%
Tax rate 35% Higher interest rate 13%
Lower interest rate 9%

a. 5.44%
b. 5.73%
c. 6.03%
d. 6.33%
e. 6.65%
(14-2) EPS & financing plans C Q Answer: e  HARD
 . Your girlfriend plans to start a new company to make a new type of cat litter.  Her father will finance the operation, but she will have to pay him back.  You are helping her, and the issue now is how to finance the company, with equity only or with a mix of debt and equity.  The price per unit will be $5.00 regardless of how the firm is financed.  The expected fixed and variable operating costs, along with other information, are shown below.  How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU?

0% Debt, U 60% Debt, L
Expected unit sales 225,000 225,000
Price per unit $10.00 $10.00
Fixed costs $1,000,000 $1,000,000
Variable cost/unit $3.50 $3.50
Required investment $2,500,000 $2,500,000
Shares issued at $10/share 250,000 100,000
% Debt 0.00% 60.00%
Debt, $ $0 $1,500,000
Equity, $ $2,500,000 $1,000,000
Interest rate NA 10.00%
Tax rate 35.00% 35.00%

a. $0.54
b. $0.60
c. $0.67
d. $0.75
e. $0.83

(14-2) Breakeven analysis C Q Answer: d  HARD
 . Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are 100,000 packs.  The unit variable cost consists of a $4.00 royalty payment, VR, per pack to professors plus other variable costs of VO = $7.00.  The royalty payment is negotiable.  The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin.  What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant?

a. $2.55
b. $2.84
c. $3.15
d. $3.50
e. $3.85

 
(14-3) Levered beta and rs C Q Answer: b  HARD
 . Dye Industries currently uses no debt, but its new CFO is considering changing the capital structure to 40.0% debt by issuing bonds and using the proceeds to repurchase and retire some common stock at book value.  Given the data shown below, by how much would this recapitalization change the firm's cost of equity, i.e., what is rL - rU?

Risk-free rate, rRF 6.00% Tax rate, T 40%
Market risk premium, RPM 4.00% Current debt ratio 0%
Current beta, bU 1.15 Target debt ratio 40%

a. 1.66%
b. 1.84%
c. 2.02%
d. 2.23%
e. 2.45%

(14-3) Levered beta and rs C Q Answer: b  HARD
 . Dyson Inc. currently finances with 20.0% debt, but its new CFO is considering changing the capital structure to 60.0% debt by issuing additional bonds and using the proceeds to repurchase and retire some common stock at book value.  Given the data shown below, by how much would this recapitalization change the firm's cost of equity? (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)

Risk-free rate, rRF 5.00% Tax rate, T 40%
Market risk premium, RPM 6.00% Current debt ratio 20%
Current beta, bL1 .15 Target debt ratio 60%

a. 4.05%
b. 4.50%
c. 4.95%
d. 5.45%
e. 5.99%

(14-3) Recapitalization C Q Answer: b  HARD
 . Monroe Inc. is an all-equity firm with 500,000 shares outstanding.  It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future.  The company pays out all of its earnings, so earnings per share (EPS) equal dividends per shares (DPS), and its tax rate is 40%.  The company is considering issuing $5,000,000 of 9.00% bonds and using the proceeds to repurchase stock.  The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90.  However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs.  Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization?  (Hint:  P0 = EPS/rs because EPS = DPS.)

a. $28.27
b. $29.76
c. $31.25
d. $32.81
e. $34.45

 
(14-3) ROE & financing plans C Q Answer: e  HARD
 . You were hired as the CFO of a new company that was founded by three professors at your university.  The company plans to manufacture and sell a new product, a cell phone that can be worn like a wrist watch.  The issue now is how to finance the company, with equity only or with a mix of debt and equity.  The price per phone will be $250.00 regardless of how the firm is financed.  The expected fixed and variable operating costs, along with other data, are shown below.  How much higher or lower will the firm's expected ROE be if it uses 60% debt rather than only equity, i.e., what is ROEL - ROEU?

0% Debt, U 60% Debt, L
Expected unit sales (Q) 28,500 28,500
Price per phone (P) $250.00 $250.00
Fixed costs (F) $1,000,000 $1,000,000
Variable cost/unit (V) $200.00 $200.00
Required investment $2,500,000 $2,500,000
% Debt 0.00% 60.00%
Debt, $ $0 $1,500,000
Equity, $ $2,500,000 $1,000,000
Interest rate NA 10.00%
Tax rate 35.00% 35.00%

a. 5.68%
b. 5.94%
c. 6.22%
d. 6.52%
e. 6.83%

 . (15-1) Optimal distribution policy F R Answer: a  EASY
 . (15-1) Target payout ratio F R Answer: b  EASY
The higher the payout ratio, the less of its earnings the firm reinvests in the business, and the lower the reinvestment rate, the lower the growth rate.

 . (15-1) Dividend irrelevance F R Answer: a  EASY
 . (15-1) Dividend irrelevance F R Answer: b  EASY
 . (15-1) Investors' div. preferences F R Answer: a  EASY
 . (15-6) Stock dividends and splits F R Answer: a  EASY
 . (15-6) Reverse split F R Answer: a  EASY
 . (15-1) Dividends and stock prices F R Answer: b  MEDIUM
 . (15-1) Dividends and stock prices F R Answer: b  MEDIUM
 . (15-1) Dividends and stock prices F R Answer: b  MEDIUM
 . (15-1) Dividends and stock prices F R Answer: a  MEDIUM
 . (15-1) Dividend irrelevance F R Answer: a  MEDIUM
 . (15-1) Dividend-growth tradeoff F R Answer: a  MEDIUM
 . (15-2) Dividends and stock prices F R Answer: a  MEDIUM
 . (15-2) Dividends and stock prices F R Answer: a  MEDIUM
 . (15-2) Dividends and stock prices F R Answer: b  MEDIUM
MM would disagree. They would say that investors took the dividend increase as a signal that the firm's management expected higher earnings in the future.  MM say dividends have information content regarding future earnings.

 . (15-2) Signaling hypothesis F R Answer: a  MEDIUM
 . (15-3) Residual dividend model F R Answer: a  MEDIUM
 . (15-3) Residual dividend model F R Answer: b  MEDIUM
The higher the debt ratio, the more dollars of debt will be used to fund a given capital budget.  So, the higher the debt ratio, the less equity will be needed, and this results in a higher dividend payout ratio.

 . (15-3) Residual dividend model F R Answer: b  MEDIUM
 . (15-3) Dividend payment procedures F R Answer: b  MEDIUM
This is false.  The stock price will drop on the ex-dividend date, which is two days prior to the holder of record date, which is well before the actual January 31 payment date.  Also, because the dividend is taxable, the price decline is generally somewhat less than the full amount of the dividend.

 . (15-3) Dividend payment procedures F R Answer: a  MEDIUM
This is true.  The stock price will drop on the ex-dividend date, which is two days prior to the holder of record date, which is well before the actual January 31 payment date.  Note, though, that because the dividend is taxable, the price decline may be somewhat less than the full amount of the dividend.

 . (15-4) Dividend reinvestment plans F R Answer: b  MEDIUM
 . (15-4) Dividend reinvestment plans F R Answer: a  MEDIUM
 . (15-4) Dividend reinvestment plans F R Answer: a  MEDIUM
This is true, because if the company retains its earnings rather than paying them out, investors should get capital gains rather than dividend income, and the taxes on those gains will be deferred until the stock is sold.  Note that the money will be reinvested by the company in either case, so the risk to stockholders under dividend reinvestment and retained earnings should be the same.

 . (15-6) Stock splits F R Answer: a  MEDIUM
 . (15-3) Residual dividend model F R Answer: a  HARD
(1) The firm's WACC would increase, (2) this would cause fewer projects to be accepted, (3) this would lead to a smaller capital budget, (4) thus less money would be needed to fund the capital budget, (5) thus less equity would be needed, so (6) the dividend payout ratio would increase.

 . (15-5) WACC and dividend policy F R Answer: b  HARD
Firm U could fund its capital budget with varying amounts of debt without causing large changes in its WACC and thus in its value and stock price.  Firm V could not vary its debt ratio without increasing its WACC.  Thus, Firm V would have to raise and lower its payout in order to obtain the equity it needed to support its capital budget.  Firm U, on the other hand, could maintain a stable, steady dividend, and let the debt ratio vary without causing much harm to its stock price.

 . (15-3) Dividend payout C R Answer: a  EASY
 . (15-6) Stock splits C R Answer: b  EASY
 . (15-1) Investors' div. preferences C R Answer: d  MEDIUM
 . (15-3) Residual dividend policy C R Answer: a  MEDIUM
 . (15-3) Residual dividend policy C R Answer: b  MEDIUM
 . (15-3) Residual dividend policy C R Answer: c  MEDIUM
 . (15-5) Factors in div. policy C R Answer: d  MEDIUM
 . (15-5) Factors in div. policy C R Answer: c  MEDIUM
 . (15-6) Stock dividends and splits C R Answer: e  MEDIUM
 . (Comp.) Dividend theories C R Answer: e  MEDIUM
 . (Comp.) Repurchases and DRIPS C R Answer: c  MEDIUM
 . (Comp.) Divs., DRIPs, and repurch. C R Answer: d  MEDIUM
 . (Comp.) Div. policy and repurchases C R Answer: d  MEDIUM
 . (Comp.) Dividend concepts C R Answer: c  MEDIUM
 . (Comp.) Dividend concepts C R Answer: e  MEDIUM
 . (Comp.) Dividend concepts C R Answer: b  MEDIUM
 . (Comp.) Dividend concepts C R Answer: b  MEDIUM
 . (Comp.) Dividend concepts C R Answer: a  MEDIUM
 . (Comp.) Dividend concepts C R Answer: e  MEDIUM
 . (Comp.) Repurchases and splits C R Answer: e  MEDIUM
 . (Comp.) Dividend concepts C R Answer: a  MEDIUM/HARD
 . (Comp.) Dividend concepts C R Answer: d  MEDIUM/HARD
 . (15-3) Residual dividend model C R Answer: d  EASY
Capital budget $12,500
Net income (NI) $11,500
% Debt 40%
% Equity = 1.0 – %Debt = 60%
Equity needed to support the capital budget = % Equity × Capital budget $7,500
Dividends paid = NI - Equity needed if positive, otherwise $0.0. $4,000

Payout ratio = Dividends paid/NI = 34.78%

 . (15-6) Stock splits C R Answer: c  EASY
Number of new shares 2
Number of old shares 1
Old (pre-split) price $80

New price = Old price × (Old shares/New shares) = $40.00

 . (15-6) Stock splits C R Answer: a  EASY
Number of new shares 3
Number of old shares 1
Pre-split stock price $90.00

Post-split stock price: P0/New per old = $30.00

 . (15-6) Stock splits C R Answer: c  EASY
Number of new shares 7
Number of old shares 2
Old (pre-split) price $80.00

New price = Old price × (Old shares/New shares) = $22.86

 . (15-3) Residual dividend model C R Answer: b  EASY/MEDIUM
Capital budget $650,000
% Equity 60%
Dividends to be paid $225,000

Required net income = Dividends + (Capital budget × % Equity) = $615,000

 . (15-3) Residual dividend model C R Answer: b  MEDIUM
Capital budget $850,000
Equity ratio 65%
Dividends to be paid $400,000

Required net income = Dividends + (Capital budget × % Equity) = $952,500

 . (15-3) Residual dividend model C R Answer: a  MEDIUM
Capital budget $725,000
Equity ratio 55%
Dividends paid $500,000

NI = Dividends + (Equity % × Capital budget) = $898,750
Payout = Dividends/NI = 55.63%

 . (15-3) Residual dividend model C R Answer: d  MEDIUM
% Debt 30%
% Equity 70%
Net income $550,000
Max. capital budget = NI/% Equity $785,714

Check: Is calculated Max. capital budget × % Equity = NI?  $550,000 = Net income

 . (15-3) Residual dividend model C R Answer: d  MEDIUM
EBIT $2,000,000 Capital budget $850,000
Interest rate 10% % Debt 40%
Debt outstanding $5,000,000 % Equity 60%
Shares outstanding 5,000,000 Tax rate 40%

EBIT $2,000,000
  -  Interest expense = Interest rate × Debt     500,000
Taxable income $1,500,000
  -  Taxes = Tax rate × Income     600,000
Net income (NI) $   900,000
  -  Equity needed for capital budget = % Equity(Capital budget)     510,000
Dividends = NI - Equity needed $   390,000

Payout ratio = Dividends/NI = 43.33%

 . (15-3) Residual dividend model C R Answer: c  MEDIUM
% Debt 30%
% Equity 70%
Capital budget $500,000
Net income $400,000
Equity requirement = capital budget × % Equity $350,000

Dividends = NI - Equity requirement = $50,000

 . (15-3) Residual dividend model C R Answer: e  MEDIUM
Capital budget $1,000,000
Net income (NI) $625,000
% Debt 60%
% Equity = 1.0 – % Debt 40%
Equity needed to support the capital budget = % Equity × Capital budget $400,000

Dividends paid = NI - Equity needed if positive (otherwise, $0.0) = $225,000

 . (15-3) Residual dividend model C R Answer: e  MEDIUM
Capital budget $1,500,000
Net income (NI) $550,000
% Debt 65%
% Equity = 1.0 – % Debt 35%
Equity needed to support the capital budget = % Equity × Capital budget $525,000

Dividends paid = NI - Equity needed if positive (otherwise, $0.0) = $25,000

 . (15-3) Residual dividend model C R Answer: a  MEDIUM
Capital budget $5,000
Net income (NI) $5,300
% Debt 45%
% Equity = 1.0 – % Debt 55%
Equity needed to support the capital budget = % Equity × Capital budget $2,750
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $2,550

Payout ratio = Dividends paid/NI = 48.11%

 . (15-3) Residual dividend model C R Answer: a  MEDIUM
Capital budget $5,000
Net income (NI) $7,000
% Debt 45%
% Equity = 1.0 – % Debt 55%
Equity needed to support the capital budget = % Equity × Capital budget $2,750
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $4,250

Payout ratio = Dividends paid/NI = 60.71%

 . (15-3) Residual dividend model C R Answer: d  MEDIUM
Capital budget $7,500
Net income (NI) $6,500
% Debt 35%
% Equity = 1.0 – % Debt 65%
Equity needed to support the capital budget = % Equity × Capital budget $4,875
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $1,625

Payout ratio = Dividends paid/NI = 25.00%

 . (15-6) Stock split C R Answer: c  MEDIUM
Current price $0.50
Target price $25.00

Old shares surrendered per 1 new share = Target price/Old price = 50.00

 . (15-6) Stock split C R Answer: b  MEDIUM
Current price $175.00
Target price $25.00

No. of new shares per 1 old share = Current price/Target price = 7.00

 . (15-6) Stock split C R Answer: b  MEDIUM
New shares per 1 old share 4
Pre-split stock price $120
% value increase 5%

Post-split stock price = (P0/[New shares per old shares)×(1 + % Value increase)] = $31.50

 . (15-3) Residual dividend model C R Answer: c  MEDIUM/HARD
Old New
% Debt 15% 60%
% Equity = 1.0 – % Debt 85% 40%
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity × Capital budget $2,550,000 $1,200,000
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000

Increase in dividends paid = $1,350,000

 . (15-3) Residual dividend model C R Answer: a  MEDIUM/HARD
Old New
% Debt 15% 60%
% Equity = 1.0 – % Debt 85% 40%
Capital budget $3,000,000 $3,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity × Capital budget $2,550,000 $1,200,000
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $950,000 $2,300,000
Dividend payout ratio 27.1% 65.7%

Increase in dividend payout ratio = 38.6%

 . (15-3) Residual dividend model C R Answer: c  MEDIUM/HARD
Old New
% Debt 40% 40%
% Equity = 1.0 – % Debt 60% 60%
Capital budget $3,000,000 $2,000,000
Net income (NI) $3,500,000 $3,500,000
Equity needed to support the capital budget = % Equity × Capital budget $1,800,000 $1,200,000
Dividends paid = NI - Equity needed if positive (otherwise, $0.0) $1,700,000 $2,300,000

Increase in dividends paid = $600,000

 . (15-3) Residual dividend model C R Answer: e  MEDIUM/HARD
Capital budget $2,000,000
% Equity 60%
Net income (NI) $900,000
Equity required for capital budget = % Equity × Capital budget $1,200,000
Dividends = NI – Equity required if > 0 (otherwise, 0) = $0
Required new stock = NI – Equity required if < 0 (otherwise, 0) = $300,000

Dividends: or new stock:
Dividends paid = NI - [% Equity(Cap. bud.)], stock issued if dividends zero or neg. $0 $300,000







 . (15-6) Stock split C R Answer: b  MEDIUM/HARD
Number of new shares 7
Number of old shares 3
Old (pre-split) price $75.00
% Increase in value 5%
New price before value increase = Old price/(New shares/Old shares) $32.14

New price after value increase = Prior × (1 + % Value increase) = $33.75

 . (15-3) Residual dividend model C R Answer: c  HARD
Old New
Net income (NI) $3,500,000 $3,500,000
% Debt 35% 35%
% Equity = 1.0 – % Debt 65% 65%

New target payout ratio 70%
Target dividend = Target payout × NI $2,450,000
Target retained earnings (RE) = NI – Dividends $1,050,000
Max. capital budget = RE/% Equity $1,615,385
Check: % Equity × Capital budget consistent = Calculated RE?  Yes $1,050,000

New capital budget – Old capital budget = $1,615,385 – $5,000,000 = -$3,384,615

 . (15-3) Residual dividend model C R Answer: e  HARD
EPS $3.00
Shares outstanding 500,000
DPS $2.00
Capital budget $800,000
Net income = EPS × Shares outstanding $1,500,000
Dividends paid = DPS × Shares outstanding $1,000,000
Retained earnings available $500,000
Capital budget - Retained earnings = Debt needed $300,000

Debt needed/Capital budget = % Debt financing = 37.5%

 . (15-3) Residual dividend model C R Answer: e  HARD
New Maximums:
Current If Increase If  lower If Do
Found as: Maximum Debt Payout Both
NI Given $175.0 $175.0 $175.0 $175.0
% Debt " 25.0% 75.0% 25.0% 75.0%
% Equity " 75.0% 25.0% 75.0% 25.0%
% Payout " 65.0% 65.0% 20.0% 20.0%
Dividends Payout % × NI $113.8 $113.8 $35.0 $35.0
Ret. earnings, RE NI – Dividends $61.3 $61.3 $140.0 $140.0
Max. cap. budget RE/% Equity $81.7 $245.0 $186.7 $560.0

Increase:  New max. - Current max. = $163.3 $105.0 $478.3
Percentage increase:  New max./Current max. – 1.0 = 200.0% 128.6% 585.7%

 . (15-7) Repurchases vs. dividends C R Answer: c  HARD
NI $625,000
No. of shares outstanding 100,000
Expected EPS $6.25
Current stock price $40.00
P/E ratio 6.40
Expected DPS if pay dividend = EPS $6.25
Expected stock price end of year = Current price + Expected DPS $46.25
Shares repurchased if use repurchase plan = NI/Expected price 13,514
New shares outstanding after repurchase 86,486
New EPS if use repurchase plan = NI/New shares $7.227
New price = P/E × New EPS $46.25

Gain, 100 share owner, dividends = 100 × DPS $625.00
Gain,100 share owner, repurchase = 100 × (new price - current price) = $625.00


(16-1) Net working capital F S Answer: b  EASY
 . Net working capital, defined as current assets minus the sum of payables and accruals, is equal to the current ratio minus the quick ratio.

a. True
b. False

(16-1) Net working capital F S Answer: b  EASY
 . Net working capital is defined as current assets divided by current liabilities.

a. True
b. False

(16-1) Working capital F S Answer: b  EASY
 . An increase in any current asset must be accompanied by an equal increase in some current liability.

a. True
b. False

(16-2) Working capital policy F S Answer: a  EASY
 . Determining a firm's optimal investment in working capital and deciding how that investment should be financed are elements of working capital policy.

a. True
b. False

(16-3) Permanent current assets F S Answer: a  EASY
 . The concept of permanent current assets reflects the fact that some components of current assets do not shrink to zero even when a business is at its seasonal or cyclical low.  Thus, permanent current assets represent a minimum level of current assets that must be financed.

a. True
b. False

 
(16-3) Conservative financing F S Answer: a  EASY
 . A conservative financing approach to working capital will result in permanent current assets and some seasonal current assets being financed using long-term securities.

a. True
b. False

(16-3) Current asset financing F S Answer: a  EASY
 . Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive current asset financing strategy because of the inherent risks of using short-term financing.

a. True
b. False

(16-4) Cash conversion cycle F S Answer: b  EASY
 . If a firm takes actions that reduce its days sales outstanding (DSO), then, other things held constant, this will lengthen its cash conversion cycle (CCC).

a. True
b. False

(16-4) Cash conversion cycle F S Answer: b  EASY
 . Other things held constant, if a firm "stretches" (i.e., delays paying) its accounts payable, this will lengthen its cash conversion cycle (CCC).

a. True
b. False

(16-5) Cash budget F S Answer: a  EASY
 . Shorter-term cash budgets--say a daily cash budget for the next month--are generally used for actual cash control while longer-term cash budgets--say monthly cash budgets for the next year--are generally used for planning purposes.

a. True
b. False

(16-6) Lockbox F S Answer: a  EASY
 . Setting up a lockbox arrangement is one way for a firm to speed up the collection of payments from its customers.

a. True
b. False

 
(16-7) Inventory management F S Answer: b  EASY
 . Inventory management is largely self-contained in the sense that very little coordination among the sales, purchasing, and production personnel is required for successful inventory management.

a. True
b. False

(16-8) Receivables balance F S Answer: a  EASY
 . The average accounts receivables balance is a function of both the volume of credit sales and the days sales outstanding.

a. True
b. False

(16-8) Credit policy F S Answer: a  EASY
 . The four primary elements in a firm's credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy.

a. True
b. False

(16-9) Taking discounts F S Answer: a  EASY
 . Not taking cash discounts is costly, and as a result, firms that do not take them are usually those that are performing poorly and have inadequate cash balances.

a. True
b. False

(16-9) Trade credit F S Answer: b  EASY
 . If a firm buys on terms of 2/10, net 30, it should pay as early as possible during the discount period.

a. True
b. False

(16-9) Trade credit F S Answer: b  EASY
 . Trade credit can be separated into two components:  free trade credit, which is credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken.

a. True
b. False

(16-9) Trade credit F S Answer: a  EASY
 . As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the cost of credit from other sources.

a. True
b. False

 
(16-9) Trade credit F S Answer: a  EASY
 . If a firm's suppliers stop offering discounts, then its use of trade credit is more likely to increase than to decrease other things held constant.

a. True
b. False

(16-9) Trade credit F S Answer: a  EASY
 . When deciding whether or not to take a trade discount, the cost of borrowing from a bank or other source should be compared to the cost of trade credit to determine if the cash discount should be taken.

a. True
b. False

(16-9) Cost of trade credit F S Answer: a  EASY
 . The calculated cost of trade credit can be reduced by paying late.

a. True
b. False

(16-9) Cost of trade credit C S Answer: a  EASY
 . The calculated cost of trade credit for a firm that buys on terms of 2/10, net 30, is lower (other things held constant) if the firm plans to pay in 40 days than in 30 days.

a. True
b. False

(16-9) Cost of trade credit F S Answer: a  EASY
 . One of the effects of ceasing to take trade credit discounts is that the firm's accounts payable will rise, other things held constant.

a. True
b. False

(16-9) Stretching payables F S Answer: b  EASY
 . "Stretching" accounts payable is a widely accepted, entirely ethical, and costless financing technique.

a. True
b. False

(16-10) Bank loans F S Answer: b  EASY
 . An informal line of credit and a revolving credit agreement are similar except that the line of credit creates a legal obligation for the bank and thus is a more reliable source of funds for the borrower.

a. True
b. False

 
(16-10) Bank loans F S Answer: a  EASY
 . The maturity of most bank loans is short term.  Bank loans to businesses are frequently made as 90-day notes which are often rolled over, or renewed, rather than repaid when they mature.  However, if the borrower's financial situation deteriorates, then the bank may refuse to roll over the loan.

a. True
b. False

(16-10) Line of credit F S Answer: a  EASY
 . A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the maximum amount of credit the bank will extend to the borrower during some future period, assuming the borrower maintains its financial strength.

a. True
b. False

(16-10) Revolving credit F S Answer: a  EASY
 . If a firm has set up a revolving credit agreement with a bank, the risk to the firm of being unable to obtain funds when needed is lower than if it had an informal line of credit.

a. True
b. False

(16-12) Accruals F S Answer: a  EASY
 . Accruals are "free" capital in the sense that no explicit interest must normally be paid on accrued liabilities.

a. True
b. False

(16-12) Accruals F S Answer: a  EASY
 . Accruals are "spontaneous," but unfortunately, due to law and economic forces, firms have little control over the level of these accounts.

a. True
b. False

(16-12) Accruals F S Answer: b  EASY
 . The facts (1) that no explicit interest is paid on accruals and (2) that the firm can vary the level of these accounts at will makes them an attractive source of funding to meet working capital needs.

a. True
b. False

 
(16-3) Maturity matching F S Answer: a  MEDIUM
 . Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to match maturities on an ex ante (expected) basis.

a. True
b. False

(16-3) Maturity matching F S Answer: b  MEDIUM
 . The maturity matching, or "self-liquidating," approach to financing involves obtaining the funds for permanent current assets with a combination of long-term capital and short-term capital that varies depending on the level of interest rates.  When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs.

a. True
b. False

(16-3) Aggressive financing F S Answer: a  MEDIUM
 . A firm that follows an aggressive working capital financing approach uses primarily short-term credit and thus is more exposed to an unexpected increase in interest rates than is a firm that uses long-term capital and thus follows a conservative financing policy.

a. True
b. False

(16-3) Aggressive financing F S Answer: b  MEDIUM
 . The relative profitability of a firm that employs an aggressive working capital financing policy will improve if the yield curve changes from upward sloping to downward sloping.

a. True
b. False

(16-3) Short-term financing F S Answer: a  MEDIUM
 . If the yield curve is upward sloping, then short-term debt will be cheaper than long-term debt.  Thus, if a firm's CFO expects the yield curve to continue to have an upward slope, this would tend to cause the current ratio to be relatively low, other things held constant. 

a. True
b. False

(16-3) Short-term financing F S Answer: a  MEDIUM
 . The risk to the firm of borrowing using short-term credit is usually greater than if it used long-term debt.  Added risk stems from (1) the greater variability of interest costs on short-term than long-term debt and (2) the fact that even if its long-term prospects are good, the firm's lenders may not be willing to renew short-term loans if the firm is temporarily unable to repay those loans.

a. True
b. False
(16-3) Short-term financing F S Answer: b  MEDIUM
 . Long-term loan agreements always contain provisions, or covenants, that constrain the firm's future actions.  Short-term credit agreements are just as restrictive in order to protect the interest of the lender.

a. True
b. False
(16-3) Short-term financing C S Answer: a  MEDIUM
 . A firm constructing a new manufacturing plant and financing it with short-term loans, which are scheduled to be converted to first mortgage bonds when the plant is completed, would want to separate the construction loan from its current liabilities associated with working capital when calculating net working capital.

a. True
b. False

(16-4) Cash conversion cycle F S Answer: a  MEDIUM
 . The longer its customers normally hold inventory, the longer the credit period supplier firms normally offer.  Still, suppliers have some flexibility in the credit terms they offer.  If a supplier lengthens the credit period offered, this will shorten the customer's cash conversion cycle but lengthen the supplier firm's own CCC.

a. True
b. False

(16-4) Cash conversion cycle F S Answer: a  MEDIUM
 . The cash conversion cycle (CCC) combines three factors:  The inventory conversion period, the receivables collection period, and the payables deferral period, and its purpose is to show how long a firm must finance its working capital.  Other things held constant, the shorter the CCC, the more effective the firm's working capital management.

a. True
b. False

(16-5) Seasonal cash patterns F S Answer: b  MEDIUM
 . The target cash balance is typically (and logically) set so that it does not need to be adjusted for either seasonal patterns or unanticipated random fluctuations.

a. True
b. False

(16-5) Cash budget F S Answer: b  MEDIUM
 . A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality payments are concentrated at the beginning of each month.

a. True
b. False

 
(16-5) Cash budget F S Answer: a  MEDIUM
 . A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption that both cash receipts and cash payments occur uniformly over the month but in reality receipts are concentrated at the beginning of each month.

a. True
b. False

(16-5) Cash and capital budgets F S Answer: b  MEDIUM
 . The cash budget and the capital budget are handled separately, and although they are both important, they are developed completely independently of one another.

a. True
b. False

(16-5) Cash budget and depreciation F S Answer: b  MEDIUM
 . Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget.  Thus, if the depreciation charge for the coming year doubled or halved, this would have no effect on the cash budget.

a. True
b. False

(16-5) Cash flow synchronization F S Answer: a  MEDIUM
 . Synchronization of cash flows is an important cash management technique, as proper synchronization can reduce the required cash balance and increase a firm's profitability.

a. True
b. False

(16-6) Lockbox C S Answer: b  MEDIUM
 . On average, a firm collects checks totaling $250,000 per day.  It takes the firm approximately 4 days from the day the checks were mailed until they result in usable cash for the firm.  Assume that (1) a lockbox system could be employed which would reduce the cash conversion procedure to 2 1/2 days and (2) the firm could invest any additional cash generated at 6% after taxes.  The lockbox system would be a good buy if it costs $25,000 annually.

a. True
b. False

(16-8) Receivables balance F S Answer: b  MEDIUM
 . Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio.

a. True
b. False

 
(16-8) Receivables and growth C S Answer: b  MEDIUM
 . Dimon Products' sales are expected to be $5 million this year, with 90% on credit and 10% for cash. Sales are expected to grow at a stable, steady rate of 10% annually in the future.  Dimon's accounts receivable balance will remain constant at the current level, because the 10% cash sales can be used to support the 10% growth rate, other things held constant.

a. True
b. False

(16-8) Receivables and growth C S Answer: a  MEDIUM
 . For a zero-growth firm, it is possible to increase the percentage of sales that are made on credit and still keep accounts receivable at their current level, provided the firm can shorten the length of its collection period sufficiently.

a. True
b. False

(16-8) Collection policy F S Answer: a  MEDIUM
 . A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales.

a. True
b. False

(16-8) Collection policy F S Answer: a  EASY
 . Changes in a firm's collection policy can affect sales, working capital, and profits.

a. True
b. False

(16-8) Cash vs. credit sales F S Answer: b  MEDIUM
 . Because money has time value, a cash sale is always more profitable than a credit sale.

a. True
b. False

(16-8) DSO and past due accounts C S Answer: b  MEDIUM
 . If a firm sells on terms of 2/10, net 30 days, and its DSO is 28 days, then the fact that the 28-day DSO is less than the 30-day credit period tell us that the credit department is functioning efficiently and there are no past due accounts.

a. True
b. False

 
(16-9) Trade credit F S Answer: b  MEDIUM
 . If a firm switched from taking trade credit discounts to paying on the net due date, this might cost the firm some money, but such a policy would probably have only a negligible effect on the income statement and no effect whatever on the balance sheet.

a. True
b. False

(16-9) Stretching payables F S Answer: a  MEDIUM
 . If a profitable firm finds that it simply must "stretch" its accounts payable, then this suggests that it is undercapitalized, i.e., that it needs more working capital to support its operations.

a. True
b. False

(16-9) Stretching payables F S Answer: b  MEDIUM
 . If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it does not represent a real financial cost to your firm as long as the customer periodically pays off its entire balance.

a. True
b. False

(16-10) Prime rate F S Answer: b  MEDIUM
 . The prime rate charged by big money center banks at any one time is likely to vary greatly (for example, as much as 2 to 4 percentage points) across banks due to banks' ability to differentiate themselves and because different banks operate in different parts of the country.

a. True
b. False

(16-10) Revolving credit F S Answer: a  MEDIUM
 . A revolving credit agreement is a formal line of credit.  The firm must generally pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds.

a. True
b. False

(16-10) Promissory note F S Answer: b  HARD
 . A promissory note is the document signed when a bank loan is executed, and it specifies financial aspects of the loan.  The bank can hold the note in its loan portfolio, sell it to a permanent investor like a life insurance company or pension fund, or bundle it with other notes payable and use it as collateral for an asset-backed security that trades on the open market.

a. True
b. False


 
 
Multiple Choice:  Conceptual

(16-1) Working capital C S Answer: c  EASY
 . Other things held constant, which of the following will cause an increase in net working capital?

a. Cash is used to buy marketable securities.
b. A cash dividend is declared and paid.
c. Merchandise is sold at a profit, but the sale is on credit.
d. Long-term bonds are retired with the proceeds of a preferred stock issue.
e. Missing inventory is written off against retained earnings.

(16-3) Current asset financing C S Answer: a  EASY
 . Firms generally choose to finance temporary current assets with short-term debt because

a. matching the maturities of assets and liabilities reduces risk under some circumstances, and also because short-term debt is often less expensive than long-term capital.
b. short-term interest rates have traditionally been more stable than long-term interest rates.
c. a firm that borrows heavily on a long-term basis is more apt to be unable to repay the debt than a firm that borrows short term.
d. the yield curve is normally downward sloping.
e. short-term debt has a higher cost than equity capital.

(16-4) Cash conversion cycle C S Answer: b  EASY
 . Helena Furnishings wants to reduce its cash conversion cycle.  Which of the following actions should it take?

a. Increases average inventory without increasing sales.
b. Take steps to reduce the DSO.
c. Start paying its bills sooner, which would reduce the average accounts payable but not affect sales.
d. Sell common stock to retire long-term bonds.
e. Sell an issue of long-term bonds and use the proceeds to buy back some of its common stock.

(16-6) Lockbox C S Answer: d  EASY
 . A lockbox plan is

a. used to protect cash, i.e., to keep it from being stolen.
b. used to identify inventory safety stocks.
c. used to slow down the collection of checks our firm writes.
d. used to speed up the collection of checks received.
e. used primarily by firms where currency is used frequently in transactions, such as fast food restaurants, and less frequently by firms that receive payments as checks.

 
(16-6) Lockbox C S Answer: e  EASY
 . A lockbox plan is most beneficial to firms that

a. have suppliers who operate in many different parts of the country.
b. have widely disbursed manufacturing facilities.
c. have a large marketable securities portfolio, and cash, to protect.
d. receive payments in the form of currency, such as fast food restaurants, rather than in the form of checks.
e. have customers who operate in many different parts of the country.

(16-8) Credit policy C S Answer: e  EASY
 . Which of the following is NOT commonly regarded as being a credit policy variable?

a. Credit period.
b. Collection policy.
c. Credit standards.
d. Cash discounts.
e. Payments deferral period.

(16-3) Current asset financing C S Answer: c  MEDIUM
 . Swim Suits Unlimited is in a highly seasonal business, and the following summary balance sheet data show its assets and liabilities at peak and off-peak seasons (in thousands of dollars):

Peak Off-Peak
Cash $ 50 $ 30
Marketable securities 0 20
Accounts receivable 40 20
Inventories 100 50
Net fixed assets 500 500
  Total assets $690 $620

Payables and accruals $ 30 $ 10
Short-term bank debt 50 0
Long-term debt 300 300
Common equity 310 310
  Total claims $690 $620

From this data we may conclude that

a. Swim Suits' current asset financing policy calls for exactly matching asset and liability maturities.
b. Swim Suits' current asset financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt.
c. Swim Suits follows a relatively conservative approach to current asset financing; that is, some of its short-term needs are met by permanent capital.
d. Without income statement data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy.
e. Without cash flow data, we cannot determine the aggressiveness or conservatism of the company's current asset financing policy.

 
(16-3) Current asset financing C S Answer: b  MEDIUM
 . Which of the following statements is CORRECT?

a. Net working capital is defined as current assets minus the sum of payables and accruals, and any increase in the current ratio automatically indicates that net working capital has increased.
b. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive strategy because of the inherent risks associated with using short-term financing.
c. If a company follows a policy of "matching maturities," this means that it matches its use of common stock with its use of long-term debt as opposed to short-term debt.
d. Net working capital is defined as current assets minus the sum of payables and accruals, and any decrease in the current ratio automatically indicates that net working capital has decreased.
e. If a company follows a policy of "matching maturities," this means that it matches its use of short-term debt with its use of long-term debt.

(16-4) Cash conversion cycle C S Answer: d  MEDIUM
 . Other things held constant, which of the following would tend to reduce the cash conversion cycle?

a. Carry a constant amount of receivables as sales decline.
b. Place larger orders for raw materials to take advantage of price breaks.
c. Take all discounts that are offered.
d. Continue to take all discounts that are offered and pay on the net date.
e. Offer longer payment terms to customers.

(16-4) Cash conversion cycle C S Answer: a  MEDIUM
 . Which of the following actions would be likely to shorten the cash conversion cycle?

a. Adopt a new manufacturing process that speeds up the conversion of raw materials to finished goods from 20 days to 10 days.
b. Change the credit terms offered to customers from 3/10, net 30 to 1/10, net 50.
c. Begin to take discounts on inventory purchases; we buy on terms of 2/10, net 30.
d. Adopt a new manufacturing process that saves some labor costs but slows down the conversion of raw materials to finished goods from 10 days to 20 days.
e. Change the credit terms offered to customers from 2/10, net 30 to 1/10, net 60.

 
(16-5) Cash budget C S Answer: e  MEDIUM
 . Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket?

a. Payments lags.
b. Payment for plant construction.
c. Cumulative cash.
d. Repurchases of common stock.
e. Writing off bad debts.

(16-5) Cash budget C S Answer: b  MEDIUM
 . Which of the following is NOT directly reflected in the cash budget of a firm that is in the zero tax bracket?

a. Payments lags.
b. Depreciation.
c. Cumulative cash.
d. Repurchases of common stock.
e. Payment for plant construction.

(16-5) Cash budget C S Answer: a  MEDIUM
 . Which of the following statements concerning the cash budget is CORRECT?

a. Depreciation expense is not explicitly included, but depreciation's effects are reflected in the estimated tax payments.
b. Cash budgets do not include financial items such as interest and dividend payments.
c. Cash budgets do not include cash inflows from long-term sources such as the issuance of bonds.
d. Changes that affect the DSO do not affect the cash budget.
e. Capital budgeting decisions have no effect on the cash budget until projects go into operation and start producing revenues.

(16-5) Cash budget C S Answer: b  MEDIUM
 . Which of the following items should a company report directly in its monthly cash budget?

a. Its monthly depreciation expense.
b. Cash proceeds from selling one of its divisions.
c. Accrued interest on zero coupon bonds that it issued.
d. New shares issued in a stock split.
e. New shares issued in a stock dividend.

 
(16-5) Cash budget C S Answer: e  MEDIUM
 . Which of the following statements is CORRECT?

a. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control.
b. The cash budget and the capital budget are developed separately, and although they are both important to the firm, one does not affect the other.
c. Since depreciation is a non-cash charge, it neither appears on nor has any effect on the cash budget.
d. The target cash balance should be set such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it should be changed to reflect long-term changes in the firm's operations.
e. The typical cash budget reflects interest paid on loans as well as income from the investment of surplus cash.  These numbers, as well as other items on the cash budget, are expected values; hence, actual results might vary from the budgeted amounts.

(16-6) Marketable securities C S Answer: c  MEDIUM
 . Which of the following is NOT a situation that might lead a firm to increase its holdings of short-term marketable securities?

a. The firm must make a known future payment, such as paying for a new plant that is under construction.
b. The firm is going from its peak sales season to its slack season, so its receivables and inventories will experience a seasonal decline.
c. The firm is going from its slack season to its peak sales season, so its receivables and inventories will experience seasonal increases.
d. The firm has just sold long-term securities and has not yet invested the proceeds in operating assets.
e. The firm just won a product liability suit one of its customers had brought against it.

(16-6) Marketable securities C S Answer: d  MEDIUM
 . Which of the following statement completions is CORRECT?  If the yield curve is upward sloping, then the marketable securities held in a firm's portfolio, assumed to be held for emergencies, should

a. consist mainly of long-term securities because they pay higher rates.
b. consist mainly of short-term securities because they pay higher rates.
c. consist mainly of U.S. Treasury securities to minimize interest rate risk.
d. consist mainly of short-term securities to minimize interest rate risk.
e. be balanced between long- and short-term securities to minimize the adverse effects of either an upward or a downward trend in interest rates.

 
(16-7) Inventory management C S Answer: b  MEDIUM
 . Which of the following statements is most consistent with efficient inventory management?  The firm has a

a. below average inventory turnover ratio.
b. low incidence of production schedule disruptions.
c. below average total assets turnover ratio.
d. relatively high current ratio.
e. relatively low DSO.

(16-8) Receivables management C S Answer: b  MEDIUM
 . Which of the following statements is CORRECT?

a. A firm that makes 90% of its sales on credit and 10% for cash is growing at a constant rate of 10% annually.  Such a firm will be able to keep its accounts receivable at the current level, since the 10% cash sales can be used to finance the 10% growth rate.
b. In managing a firm's accounts receivable, it is possible to increase credit sales per day yet still keep accounts receivable fairly steady, provided the firm can shorten the length of its collection period (its DSO) sufficiently.
c. Because of the costs of granting credit, it is not possible for credit sales to be more profitable than cash sales.
d. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio must also have a high payables-to-sales ratio.
e. Other things held constant, if a firm can shorten its DSO, this will lead to a higher current ratio.

(16-8) Days sales outstanding (DSO) C S Answer: c  MEDIUM
 . Which of the following statements is CORRECT?

a. Other things held constant, the higher a firm's days sales outstanding (DSO), the better its credit department.
b. If a firm that sells on terms of net 30 changes its policy to 2/10, net 30, and if no change in sales volume occurs, then the firm's DSO will probably increase.
c. If a firm sells on terms of 2/10, net 30, and its DSO is 30 days, then the firm probably has some past due accounts.
d. If a firm sells on terms of net 60, and if its sales are highly seasonal, with a sharp peak in December, then its DSO as it is typically calculated (with sales per day = Sales for past 12 months/365) would probably be lower in January than in July.
e. If a firm changed the credit terms offered to its customers from 2/10, net 30 to 2/10, net 60, then its sales should increase, and this should lead to an increase in sales per day, and that should lead to a decrease in the DSO.

 
(Comp.) Current asset financing C S Answer: b  MEDIUM
 . Which of the following statements is CORRECT?

a. Trade credit is provided only to relatively large, strong firms.
b. Commercial paper is a form of short-term financing that is primarily used by large, strong, financially stable companies.
c. Short-term debt is favored by firms because, while it is generally more expensive than long-term debt, it exposes the borrowing firm to less risk than long-term debt.
d. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate.
e. Commercial paper is typically offered at a long-term maturity of at least five years.

(Comp.) Current asset financing C S Answer: a  MEDIUM
 . Which of the following statements is NOT CORRECT?

a. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate.
b. Accruals are "free" in the sense that no explicit interest is paid on these funds.
c. A conservative approach to working capital management will result in most if not all permanent assets being financed with long-term capital.
d. The risk to a firm that borrows with short-term credit is usually greater than if it borrowed using long-term debt.  This added risk stems from the greater variability of interest costs on short-term debt and possible difficulties with rolling over short-term debt.
e. Bank loans generally carry a higher interest rate than commercial paper.

(Comp.) Short-term financing C S Answer: a  MEDIUM
 . Which of the following statements is CORRECT?

a. Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but using short-term debt would probably increase the firm's risk.
b. Conservative firms generally use no short-term debt and thus have zero current liabilities.
c. A short-term loan can usually be obtained more quickly than a long-term loan, but the cost of short-term debt is normally higher than that of long-term debt.
d. If a firm that can borrow from its bank at a 6% interest rate buys materials on terms of 2/10, net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet.
e. If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it will not have an adverse financial impact on your firm if the customer periodically pays off its entire balance.

 
(Comp.) Working capital policy C S Answer: d  MEDIUM
 . Which of the following statements is NOT CORRECT?

a. A company may hold a relatively large amount of cash and marketable securities if it is uncertain about its volume of sales, profits, and cash flows during the coming year.
b. Credit policy has an impact on working capital because it influences both sales and the time before receivables are collected.
c. The cash budget is useful to help estimate future financing needs, especially the need for short-term working capital loans.
d. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10, net 30 to net 60.
e. Managing working capital is important because it influences financing decisions and the firm's profitability.

(Comp.) Working capital concepts C S Answer: b  MEDIUM
 . Which of the following statements is CORRECT?

a. Depreciation is included in the estimate of cash flows (Cash flow = Net income + Depreciation), hence depreciation is set forth on a separate line in the cash budget.
b. If cash inflows from collections occur in equal daily amounts but most payments must be made on the 10th of each month, then a regular monthly cash budget will be misleading.  The problem can be corrected by using a daily cash budget.
c. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales.
d. If a firm wants to generate more cash flow from operations in the next month or two, it could change its credit policy from 2/10, net 30 to net 60.
e. If a firm sells on terms of net 90, and if its sales are highly seasonal, with 80% of its sales in September, then its DSO as it is typically calculated (with sales per day = Sales for past 12 months/365) would probably be lower in October than in August.

(Comp.) Working capital concepts C S Answer: c  MEDIUM
 . Which of the following statements is CORRECT?

a. Accruals are an expensive but commonly used way to finance working capital.
b. A conservative financing policy is one where the firm finances part of its fixed assets with short-term capital and all of its net working capital with short-term funds.
c. If a company receives trade credit under terms of 2/10, net 30, this implies that the company has 10 days of free trade credit.
d. One cannot tell if a firm has a conservative, aggressive, or moderate current asset financing policy without an examination of its cash budget.
e. If a firm has a relatively aggressive current asset financing policy vis-à-vis other firms in its industry, then its current ratio will probably be relatively high.


 
Problems

(16-3) Maturity matching C S Answer: e  EASY
 . Halka Company is a no-growth firm.  Its sales fluctuate seasonally, causing total assets to vary from $320,000 to $410,000, but fixed assets remain constant at $260,000.  If the firm follows a maturity matching (or moderate) working capital financing policy, what is the most likely total of long-term debt plus equity capital?

a. $260,642
b. $274,360
c. $288,800
d. $304,000
e. $320,000

(16-4) Cash conversion cycle C S Answer: d  EASY
 . Cass & Company has the following data.   What is the firm's cash conversion cycle?

Inventory conversion period = 50 days
Receivables collection period = 17 days
Payables deferral period = 25 days

a. 31 days
b. 34 days
c. 38 days
d. 42 days
e. 46 days

(16-4) Cash conversion cycle C S Answer: b  EASY
 . Romano Inc. has the following data.  What is the firm's cash conversion cycle?

Inventory conversion period = 38 days
Receivables collection period = 19 days
Payables deferral period = 20 days

a. 33 days
b. 37 days
c. 41 days
d. 45 days
e. 49 days

(16-4) Cash conversion cycle C S Answer: e  EASY
 . Whittington Inc. has the following data.   What is the firm's cash conversion cycle?

Inventory conversion period = 41 days
Receivables collection period = 31 days
Payables deferral period = 38 days

a. 31 days
b. 34 days
c. 37 days
d. 41 days
e. 45 days
(16-4) Cash conversion cycle C S Answer: d  EASY
 . Inmoo Company’s average age of accounts receivable is 45 days, the average age of accounts payable is 40 days, and the average age of inventory is 69 days.  Assuming a 365-day year, what is the length of its cash conversion cycle?

a. 63 days
b. 67 days
c. 70 days
d. 74 days
e. 78 days

(16-5) Cash budget C S Answer: d  EASY
 . Singal Inc. is preparing its cash budget.  It expects to have sales of $30,000 in January, $35,000 in February, and $35,000 in March.  If 20% of sales are for cash, 40% are credit sales paid in the month after the sale, and another 40% are credit sales paid 2 months after the sale, what are the expected cash receipts for March?

a. $24,057
b. $26,730
c. $29,700
d. $33,000
e. $36,300

(16-8) Accounts receivable balance C S Answer: a  EASY
 . Dyl Pickle Inc. had credit sales of $3,500,000 last year and its days sales outstanding was DSO = 35 days.  What was its average receivables balance, based on a 365-day year?

a. $335,616
b. $352,397
c. $370,017
d. $388,518
e. $407,944

(16-2) ROE and WC policy C S Answer: c  MEDIUM
 . Edwards Enterprises follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy.  The firm’s annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its tax rate is 40%.  With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales.  What is the difference in the projected ROEs between the restricted and relaxed policies?

a. 4.25%
b. 4.73%
c. 5.25%
d. 5.78%
e. 6.35%

 
(16-4) Days sales outstanding C S Answer: c  MEDIUM
 . Data on Shick Inc. for 2008 are shown below, along with the days sales outstanding of the firms against which it benchmarks.  The firm's new CFO believes that the company could reduce its receivables enough to reduce its DSO to the benchmarks' average.  If this were done, by how much would receivables decline?  Use a 365-day year.

Sales $110,000
Accounts receivable $16,000
Days sales outstanding (DSO) 53.09
Benchmarks' days sales outstanding (DSO) 20.00

a. $8,078
b. $8,975
c. $9,973
d. $10,970
e. $12,067

(16-4) Inventory conv. period C S Answer: d  MEDIUM
 . Your firm's cost of goods sold (COGS) average $2,000,000 per month, and it keeps inventory equal to 50% of its monthly COGS on hand at all times.  Using a 365-day year, what is its inventory conversion period?

a. 11.7 days
b. 13.0 days
c. 14.4 days
d. 15.2 days
e. 16.7 days

(16-4) Inventory conv. period C S Answer: e  MEDIUM
 . Data on Shin Inc for 2008 are shown below, along with the inventory conversion period (ICP) of the firms against which it benchmarks.  The firm's new CFO believes that the company could reduce its inventory enough to reduce its ICP to the benchmarks' average.  If this were done, by how much would inventories decline?  Use a 365-day year.

Cost of goods sold = $85,000
Inventory = $20,000
Inventory conversion period (ICP) = 85.88
Benchmark inventory conversion period (ICP) = 38.00

a. $7,316
b. $8,129
c. $9,032
d. $10,036
e. $11,151

 
(16-4) Payables deferral period C S Answer: e  MEDIUM
 . Data on Wentz Inc. for 2008 are shown below, along with the payables deferral period (PDP) for the firms against which it benchmarks. The firm's new CFO believes that the company could delay payments enough to increase its PDP to the benchmarks' average.  If this were done, by how much would payables increase?  Use a 365-day year.

Cost of goods sold = $75,000
Payables = $5,000
Payables deferral period (PDP) = 24.33
Benchmark payables deferral period = 30.00

a. $764
b. $849
c. $943
d. $1,048
e. $1,164

(16-4) Cash conversion cycle C S Answer: e  MEDIUM
 . Your consulting firm was recently hired to improve the performance of Shin-Soenen Inc, which is highly profitable but has been experiencing cash shortages due to its high growth rate.  As one part of your analysis, you want to determine the firm’s cash conversion cycle.  Using the following information and a 365-day year, what is the firm’s present cash conversion cycle?

Average inventory = $75,000
Annual sales = $600,000
Annual cost of goods sold = $360,000
Average accounts receivable = $160,000
Average accounts payable = $25,000

a. 120.6 days
b. 126.9 days
c. 133.6 days
d. 140.6 days
e. 148.0 days

(16-4) Cash conversion cycle C S Answer: d  MEDIUM
 . Dewey Corporation has the following data, in thousands.  Assuming a 365-day year, what is the firm's cash conversion cycle?

Annual sales = $45,000
Annual cost of goods sold = $31,500
Inventory = $4,000
Accounts receivable = $2,000
Accounts payable = $2,400

a. 25 days
b. 28 days
c. 31 days
d. 35 days
e. 38 days

 
(16-4) Cash conversion cycle C S Answer: d  MEDIUM
 . Desai Inc. has the following data, in thousands.  Assuming a 365-day year, what is the firm's cash conversion cycle?

Annual sales = $45,000
Annual cost of goods sold = $30,000
Inventory = $4,500
Accounts receivable = $1,800
Accounts payable = $2,500

a. 28 days
b. 32 days
c. 35 days
d. 39 days
e. 43 days

(16-4) Cash conversion cycle C S Answer: a  MEDIUM
 . Zervos Inc. had the following data for 2008 (in millions).  The new CFO believes (1) that an improved inventory management system could lower the average inventory by $4,000, (2) that improvements in the credit department could reduce receivables by $2,000, and (3) that the purchasing department could negotiate better credit terms and thereby increase accounts payable by $2,000.  Furthermore, she thinks that these changes would not affect either sales or the costs of goods sold.  If these changes were made, by how many days would the cash conversion cycle be lowered?

Original Revised
Annual sales: unchanged $110,000 $110,000
Cost of goods sold: unchanged $80,000 $80,000
Average inventory: lowered by $4,000 $20,000 $16,000
Average receivables: lowered by $2,000 $16,000 $14,000
Average payables: increased by $2,000 $10,000 $12,000
Days in year 365 365

a. 34.0
b. 37.4
c. 41.2
d. 45.3
e. 49.8

 
(16-4) Cash conversion cycle C S Answer: b  MEDIUM
 . Edison Inc. has annual sales of $36,500,000, or $100,000 a day on a 365-day basis.  The firm's cost of goods sold is 75% of sales.  On average, the company has $9,000,000 in inventory and $8,000,000 in accounts receivable.  The firm is looking for ways to shorten its cash conversion cycle.  Its CFO has proposed new policies that would result in a 20% reduction in both average inventories and accounts receivable.  She also anticipates that these policies would reduce sales by 10%, while the payables deferral period would remain unchanged at 35 days.  What effect would these policies have on the company's cash conversion cycle?  Round to the nearest whole day.

a. -26 days
b. -22 days
c. -18 days
d. -14 days
e. -11 days

(16-4) Cash conversion cycle C S Answer: e  MEDIUM
 . Van Den Borsh Corp. has annual sales of $50,735,000, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000.  The firm's cost of goods sold is 85% of sales.  The company makes all purchases on credit and has always paid on the 30th day.  However, it now plans to take full advantage of trade credit and to pay its suppliers on the 40th day.  The CFO also believes that sales can be maintained at the existing level but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000.  What will be the net change in the cash conversion cycle, assuming a 365-day year?

a. -26.6 days
b. -29.5 days
c. -32.8 days
d. -36.4 days
e. -40.5 days

(16-5) Cash budget C S Answer: c  MEDIUM
 . Nogueiras Corp’s budgeted monthly sales are $5,000, and they are constant from month to month.  40% of its customers pay in the first month and take the 2% discount, while the remaining 60% pay in the month following the sale and do not receive a discount.  The firm has no bad debts.  Purchases for next month’s sales are constant at 50% of projected sales for the next month.  “Other payments,” which include wages, rent, and taxes, are 25% of sales for the current month.  Construct a cash budget for a typical month and calculate the average cash gain or loss during the month.

a. $1,092
b. $1,150
c. $1,210
d. $1,271
e. $1,334

 
(16-6) Lockbox C S Answer: d  MEDIUM
 . Whitmer Inc. sells to customers all over the U.S., and all receipts come in to its headquarters in New York City.  The firm's average accounts receivable balance is $2.5 million, and they are financed by a bank loan at an 11% annual interest rate.  The firm is considering setting up a regional lockbox system to speed up collections, and it believes this would reduce receivables by 20%.  If the annual cost of the system is $15,000, what pre-tax net annual savings would be realized?

a. $29,160
b. $32,400
c. $36,000
d. $40,000
e. $44,000

(16-9) Trade credit: nom. cost C S Answer: a  MEDIUM
 . A firm buys on terms of 3/15, net 45.  It does not take the discount, and it generally pays after 60 days.  What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year?

a. 25.09%
b. 27.59%
c. 30.35%
d. 33.39%
e. 36.73%

(16-9) Trade credit: nom. cost C S Answer: e  MEDIUM
 . Atlanta Cement, Inc. buys on terms of 2/15, net 30.  It does not take discounts, and it typically pays 60 days after the invoice date.  Net purchases amount to $720,000 per year.  What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year?

a. 10.86%
b. 12.07%
c. 13.41%
d. 14.90%
e. 16.55%

(16-9) Trade credit: nom. cost C S Answer: b  MEDIUM
 . Your company has been offered credit terms of 4/30, net 90 days.  What will be the nominal annual percentage cost of its non-free trade credit if it pays 120 days after the purchase?  (Assume a 365-day year.)

a. 16.05%
b. 16.90%
c. 17.74%
d. 18.63%
e. 19.56%

 
(16-9) Trade credit: EAR cost C S Answer: d  MEDIUM
 . Bumpas Enterprises purchases $4,562,500 in goods per year from its sole supplier on terms of 2/15, net 50.  If the firm chooses to pay on time but does not take the discount, what is the effective annual percentage cost of its non-free trade credit?  (Assume a 365-day year.)

a. 20.11%
b. 21.17%
c. 22.28%
d. 23.45%
e. 24.63%

(16-9) Trade credit:  EAR cost C S Answer: c  MEDIUM
 . A firm buys on terms of 2/8, net 45 days, it does not take discounts, and it actually pays after 58 days.  What is the effective annual percentage cost of its non-free trade credit? (Use a 365-day year.)

a. 14.34%
b. 15.10%
c. 15.89%
d. 16.69%
e. 17.52%

(16-9) Free trade credit C S Answer: a  MEDIUM
 . Buskirk Construction buys on terms of 2/15, net 60 days.  It does not take discounts, and it typically pays on time, 60 days after the invoice date.  Net purchases amount to $450,000 per year.  On average, how much “free” trade credit does the firm receive during the year?  (Assume a 365-day year, and note that purchases are net of discounts.)

a. $18,493
b. $19,418
c. $20,389
d. $21,408
e. $22,479

(16-9) Costly trade credit C S Answer: a  MEDIUM
 . Ingram Office Supplies, Inc., buys on terms of 2/15, net 50 days.  It does not take discounts, and it typically pays on time, 50 days after the invoice date.  Net purchases amount to $450,000 per year.  On average, what is the dollar amount of costly trade credit (total credit – free credit) the firm receives during the year?  (Assume a 365-day year, and note that purchases are net of discounts.)

a. $43,151
b. $45,308
c. $47,574
d. $49,952
e. $52,450

 
(16-9) Costly trade credit C S Answer: a   MEDIUM
 . Roton Inc. purchases merchandise on terms of 2/15, net 40, and its gross purchases (i.e., purchases before taking off the discount) are $800,000 per year.  What is the maximum dollar amount of costly trade credit the firm could get, assuming it abides by the supplier’s credit terms?  (Assume a 365-day year.)

a. $53,699
b. $56,384
c. $59,203
d. $62,163
e. $65,271

(16-9) Total trade credit C S Answer: a  MEDIUM
 . Kirk Development buys on terms of 2/15, net 60 days.  It does not take discounts, and it typically pays on time, 60 days after the invoice date.  Net purchases amount to $550,000 per year.  On average, what is the dollar amount of total trade credit (costly + free) the firm receives during the year, i.e., what are its average accounts payable?  (Assume a 365-day year, and note that purchases are net of discounts.)

a. $90,411
b. $94,932
c. $99,678
d. $104,662
e. $109,895

(16-9) Stretching accts payable C S Answer: e  MEDIUM
 . Affleck Inc.'s business is booming, and it needs to raise more capital.  The company purchases supplies on terms of 1/10, net 20, and it currently takes the discount.  One way of getting the needed funds would be to forgo the discount, and the firm's owner believes she could delay payment to 40 days without adverse effects.  What would be the effective annual percentage cost of funds raised by this action?  (Assume a 365-day year.)

a. 10.59%
b. 11.15%
c. 11.74%
d. 12.36%
e. 13.01%

 
(16-10) Revolving credit agreement C S Answer: b  MEDIUM
 . Weiss Inc. arranged a $9,000,000 revolving credit agreement with a group of banks.  The firm paid an annual commitment fee of 0.5% of the unused balance of the loan commitment.  On the used portion of the revolver, it paid 1.5% above prime for the funds actually borrowed on a simple interest basis.  The prime rate was 9% during the year.  If the firm borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar annual cost of the revolver?

a. $612,750
b. $645,000
c. $677,250
d. $711,113
e. $746,668

(16-4) Cash conversion cycle C S Answer: a  HARD
 . Soenen Inc. had the following data for 2008 (in millions).  The new CFO believes that the company could improve its working capital management sufficiently to bring its NWC and CCC up to the benchmark companies' level without affecting either sales or the costs of goods sold.  Soenen finances its net working capital with a bank loan at an 8% annual interest rate, and it uses a 365-day year.  If these changes had been made, by how much would the firm's pre-tax income have increased?

Original Benchmarks’
Data Related CCC CCC
Sales $100,000
Cost of goods sold $80,000
Inventory (ICP) $20,000 91.25 38.00
Receivables (DSO) $16,000 58.40 20.00
Payables (PDP) $5,000 22.81 30.00
126.84 28.00

a. 1,901
b. 2,092
c. 2,301
d. 2,531
e. 2,784

(16-4) Cash conversion cycle C S Answer: c  HARD
 . Margetis Inc. carries an average inventory of $750,000.  Its annual sales are $10 million, its cost of goods sold is 75% of annual sales, and its receivables collection period is twice as long as its inventory conversion period.  The firm buys on terms of net 30 days, and it pays on time.  Its new CFO wants to decrease the cash conversion cycle by 10 days, based on a 365-day year.  He believes he can reduce the average inventory to $647,260 with no effect on sales.  By how much must the firm also reduce its accounts receivable to meet its goal in the reduction of the cash conversion cycle?

a. $123,630
b. $130,137
c. $136,986
d. $143,836
e. $151,027

(16-9) Trade credit: EAR cost C S Answer: b  HARD
 . Suppose the credit terms offered to your firm by its suppliers are 2/10, net 30 days.  Your firm is not taking discounts, but is paying after 25 days instead of waiting until Day 30.  You point out that the nominal cost of not taking the discount and paying on Day 30 is approximately 37%.  But since your firm is neither taking discounts nor paying on the due date, what is the effective annual percentage cost (not the nominal cost) of its costly trade credit, using a 365-day year?

a. 60.3%
b. 63.5%
c. 66.7%
d. 70.0%
e. 73.5%

(16-9) Accounts payable balance C S Answer: e  HARD
 . Aggarwal Inc. buys on terms of 2/10, net 30, and it always pays on the 30th day.  The CFO calculates that the average amount of costly trade credit carried is $375,000.  What is the firm's average accounts payable balance?  Assume a 365-day year.

a. $458,160
b. $482,273
c. $507,656
d. $534,375
e. $562,500

(16-9) Fin. stmts. and trade credit C S Answer: d  HARD
 . Gonzales Company currently uses maximum trade credit by not taking discounts on its purchases.  The standard industry credit terms offered by all its suppliers are 2/10, net 30 days, and the firm pays on time.  The new CFO is considering borrowing from its bank, using short-term notes payable, and then taking discounts.  The firm wants to determine the effect of this policy change on its net income.  Its net purchases are $11,760 per day, using a 365-day year.  The interest rate on the notes payable is 10%, and the tax rate is 40%.  If the firm implements the plan, what is the expected change in net income?

a. $32,964
b. $34,699
c. $36,526
d. $38,448
e. $40,370

(Comp.) Inventory turnover and DSO C S Answer: c  HARD
 . Zarruk Construction’s DSO is 50 days (on a 365-day basis), accounts receivable are $100 million, and its balance sheet shows inventory of $125 million.  What is the inventory turnover ratio?

a. 4.73
b. 5.26
c. 5.84
d. 6.42
e. 7.07

 
(Comp.) Working capital, FCF C S Answer: b  HARD
 . Madura Inc. wants to increase its free cash flow by $180 million during the coming year, which should result in a higher EVA and stock price.  The CFO has made these projections for the upcoming year:

EBIT is projected to equal $850 million.
Gross capital expenditures are expected to total to $360 million versus depreciation of $120 million, so its net capital expenditures should total $240 million.
The tax rate is 40%.
There will be no changes in cash or marketable securities, nor will there be any changes in notes payable or accruals.

What increase in net working capital (in millions of dollars) would enable the firm to meet its target increase in FCF?

a. $72
b. $90
c. $108
d. $130
e. $156

Multiple Part:

(The following data apply to Problems 126-128.)

Zorn Corporation is deciding whether to pursue a restricted or relaxed working capital investment policy.  The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets.  EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 40%.  If the company follows a restricted policy, its total assets turnover will be 2.5.  Under a relaxed policy its total assets turnover will be 2.2.

(16-3) WC investment policy C S Answer: d  MEDIUM
 . If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy?

a. $8,418
b. $8,861
c. $9,327
d. $9,818
e. $10,309

(16-3) WC investment, ROE C S Answer: b  MEDIUM
 . What's the difference in the projected ROEs under the restricted and relaxed policies?

a. 1.20%
b. 1.50%
c. 1.80%
d. 2.16%
e. 2.59%

 
(16-3) WC investment, ROE C S Answer: a  MEDIUM
 . Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same.  In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies?

a. 2.24%
b. 2.46%
c. 2.70%
d. 2.98%
e. 3.27%


 CHAPTER 17
FINANCIAL PLANNING AND FORECASTING
(Difficulty Levels:  Easy, Easy/Medium, Medium, Medium/Hard, and Hard)


Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject lines.

Multiple Choice:  True/False

(17-2) Sales forecast F K Answer: a  EASY
 . The first, and most critical, step in constructing a set of forecasted financial statements is the sales forecast.

a. True
b. False

(17-2) Sales forecast F K Answer: a  EASY
 . A typical sales forecast, though concerned with future events, will usually be based on recent historical trends and events as well as on forecasts of economic prospects.

a. True
b. False

(17-2) Sales forecast F K Answer: b  EASY
 . Errors in the sales forecast can be offset by similar errors in costs and income forecasts.  Thus, as long as the errors are not large, sales forecast accuracy is not critical to the firm.

a. True
b. False

(17-3) Spontaneously gen. funds F K Answer: a  EASY
 . As a firm's sales grow, its current assets also tend to increase.  For instance, as sales increase, the firm's inventories generally increase, and purchases of inventories result in more accounts payable.  Thus, spontaneously generated funds arise from transactions brought on by sales increases.

a. True
b. False

(17-3) Spontaneously gen. funds F K Answer: b  EASY
 . The term "spontaneously generated funds" generally refers to increases in the cash account that result from growth in sales, assuming the firm is operating with a positive profit margin.

a. True
b. False

 
(17-3) Asset increase F K Answer: a  EASY
 . A rapid build-up of inventories normally requires additional financing, unless the increase is matched by an equally large decrease in some other asset.

a. True
b. False

(17-3) Additional funds needed F K Answer: b  EASY
 . If a firm wants to maintain its ratios at their existing levels, then if it has a positive sales growth rate of any amount, it will require some amount of external funding.

a. True
b. False

(17-3) Additional funds needed F K Answer: b  EASY
 . To determine the amount of additional funds needed (AFN), you may subtract the expected increase in liabilities, which represents a source of funds, from the sum of the expected increases in retained earnings and assets, both of which are uses of funds.

a. True
b. False

(17-4) Forecasted statements F K Answer: a  EASY
 . One of the key steps in the development of the forecasted balance sheet is to identify those assets and liabilities that increase at the same rate as sales.

a. True
b. False

(17-3) Additional funds needed F K Answer: a  MEDIUM
 . If a firm with a positive net worth is operating its fixed assets at full capacity, if its dividend payout ratio is 100%, and if it wants to hold all financial ratios constant, then for any positive growth rate in sales, it will require external financing. 

a. True
b. False

(17-3) Additional funds needed F K Answer: b  MEDIUM
 . A firm's profit margin is 5%, its debt/assets ratio is 56%, and its dividend payout ratio is 40%.  If the firm is operating at less than full capacity, then sales could increase to some extent without the need for external funds, but if it is operating at full capacity with respect to all assets, including fixed assets, then any positive growth in sales will require some external financing.

a. True
b. False

 
 
(17-3) Capital intensity ratio F K Answer: a  MEDIUM
 . Two firms with identical capital intensity ratios are generating the same amount of sales.  However, Firm A is operating at full capacity, while Firm B is operating below capacity.  If the two firms expect the same growth in sales during the next period, then Firm A is likely to need more additional funds than Firm B, other things held constant.

a. True
b. False

(17-3) Capital intensity ratio F K Answer: b  MEDIUM
 . If a firm's capital intensity ratio (A*0/S0) decreases as sales increase, use of the AFN formula is likely to understate the amount of additional funds required, other things held constant.

a. True
b. False

(17-4) Financial forecasting F K Answer: b  MEDIUM
 . The fact that long-term debt and common stock are raised infrequently and in large amounts lessens the need for the firm to forecast those accounts on a continual basis.

a. True
b. False

(17-5) AFN formula and linear reg. F K Answer: a  MEDIUM
 . When we use the AFN formula to forecast the additional funds needed (AFN), we are implicitly assuming that all financial ratios are constant.  If financial ratios are not constant, regression techniques can be used to improve the financial forecast.

a. True
b. False


Multiple Choice:  Conceptual

(17-1) Strategic planning C K Answer: c  EASY
 . Which of the following is NOT a key element in strategic planning as it is described in the text?

a. The mission statement.
b. The statement of the corporation’s scope.
c. The statement of cash flows.
d. The statement of corporate objectives.
e. The operating plan.

 
(17-3) AFN formula method C K Answer: b  EASY
 . Which of the following assumptions is embodied in the AFN formula?

a. All balance sheet accounts are tied directly to sales.
b. Accounts payable and accruals are tied directly to sales.
c. Common stock and long-term debt are tied directly to sales.
d. Fixed assets, but not current assets, are tied directly to sales.
e. Last year’s total assets were not optimal for last year’s sales.

(17-3) Additional funds needed C K Answer: a  EASY/MEDIUM
 . Jefferson City Computers has developed a forecasting model to estimate its AFN for the upcoming year.  All else being equal, which of the following factors is most likely to lead to an increase of the additional funds needed (AFN)?

a. A sharp increase in its forecasted sales.
b. A sharp reduction in its forecasted sales.
c. The company reduces its dividend payout ratio.
d. The company switches its materials purchases to a supplier that sells on terms of 1/5, net 90, from a supplier whose terms are 3/15, net 35.
e. The company discovers that it has excess capacity in its fixed assets.

(17-3) Additional funds needed C K Answer: b  EASY/MEDIUM
 . The term “additional funds needed (AFN)” is generally defined as follows:

a. Funds that are obtained automatically from routine business transactions.
b. Funds that a firm must raise externally from non-spontaneous sources, i.e., by borrowing or by selling new stock, to support operations.
c. The amount of assets required per dollar of sales.
d. The amount of internally generated cash in a given year minus the amount of cash needed to acquire the new assets needed to support growth.
e. A forecasting approach in which the forecasted percentage of sales for each balance sheet account is held constant.

(17-3) Capital intensity ratio C K Answer: e  EASY/MEDIUM
 . The capital intensity ratio is generally defined as follows:

a. Sales divided by total assets, i.e., the total assets turnover ratio.
b. The percentage of liabilities that increase spontaneously as a percentage of sales.
c. The ratio of sales to current assets.
d. The ratio of current assets to sales.
e. The amount of assets required per dollar of sales, or A*0/S0.

 
(17-1) Financial planning C K Answer: e  MEDIUM
 . Which of the following is NOT one of the steps taken in the financial planning process?

a. Assumptions are made about future levels of sales, costs, and interest rates for use in the forecast.
b. The entire financial plan is reexamined, assumptions are reviewed, and the management team considers how additional changes in operations might improve results.
c. Projected ratios are calculated and analyzed.
d. Develop a set of projected financial statements.
e. Consult with key competitors about the optimal set of prices to charge, i.e., the prices that will maximize profits for our firm and its competitors.

(17-3) Spontaneously gen. funds C K Answer: d  MEDIUM
 . Spontaneously generated funds are generally defined as follows:

a. Assets required per dollar of sales.
b. A forecasting approach in which the forecasted percentage of sales for each item is held constant.
c. Funds that a firm must raise externally through borrowing or by selling new common or preferred stock.
d. Funds that arise out of normal business operations from its suppliers, employees, and the government, and they include spontaneous increases in accounts payable and accruals.
e. The amount of cash raised in a given year minus the amount of cash needed to finance the additional capital expenditures and working capital needed to support the firm’s growth.

(17-3) Additional funds needed C K Answer: b  MEDIUM
 . A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise.  Which of the following conditions would cause the AFN to increase?

a. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity.
b. The company increases its dividend payout ratio.
c. The company begins to pay employees monthly rather than weekly.
d. The company’s profit margin increases.
e. The company decides to stop taking discounts on purchased materials.

 
(Comp.) Forecasting concepts C K Answer: b  MEDIUM
 . Which of the following statements is CORRECT?

a. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings.
b. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales.
c. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where management’s historical performance is evaluated.
d. The capital intensity ratio gives us an idea of the physical condition of the firm’s fixed assets.
e. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy and economies of scale exist.

(17-1) Strategic planning C K Answer: c  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. Once a firm has defined its purpose, scope, and objectives, it must develop a strategy or strategies for achieving its goals.  The statement of corporate strategies sets forth detailed plans rather than broad approaches for achieving a firm's goals.
b. A firm’s corporate purpose states the general philosophy of the business and provides managers with specific operational objectives.
c. Operating plans provide management with detailed implementation guidance, consistent with the corporate strategy, to help meet the corporate objectives.  These operating plans can be developed for any time horizon, but many companies use a 5-year horizon.
d. A firm’s mission statement defines its lines of business and geographic area of operations.
e. The corporate scope is a condensed version of the entire set of strategic plans.

(17-3) Additional funds needed C K Answer: d  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. Since accounts payable and accrued liabilities must eventually be paid off, as these accounts increase, AFN as calculated by the AFN equation must also increase.
b. Suppose a firm is operating its fixed assets at below 100% of capacity, but it has no excess current assets.  Based on the AFN equation, its AFN will be larger than if it had been operating with excess capacity in both fixed and current assets.
c. If a firm retains all of its earnings, then it cannot require any additional funds to support sales growth.
d. Additional funds needed (AFN) are typically raised using a combination of notes payable, long-term debt, and common stock.  Such funds are non-spontaneous in the sense that they require explicit financing decisions to obtain them.
e. If a firm has a positive free cash flow, then it must have either a zero or a negative AFN.

 
(17-3) Additional funds needed C K Answer: d  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. Any forecast of financial requirements involves determining how much money the firm will need, and this need is determined by adding together increases in assets and spontaneous liabilities and then subtracting operating income.
b. The AFN equation for forecasting funds requirements requires only a forecast of the firm’s balance sheet.  Although a forecasted income statement may help clarify the results, income statement data are not essential because funds needed relate only to the balance sheet.
c. Dividends are paid with cash taken from the accumulated retained earnings account, hence dividend policy does not affect the AFN forecast.
d. A negative AFN indicates that retained earnings and spontaneous capital are far more than sufficient to finance the additional assets needed.
e. If assets and spontaneously generated liabilities are not projected to grow at the same rate as sales, then the AFN method will provide more accurate forecasts than the projected financial statement method.

(17-3) AFN equation C K Answer: a  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds.  In other words, it is the growth rate at which the firm's AFN equals zero.
b. If a firm’s assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firm’s AFN to be negative.
c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firm’s actual AFN must, mathematically, exceed the previously calculated AFN.
d. Higher sales usually require higher asset levels, and this leads to what we call AFN.  However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio.
e. Dividend policy does not affect the requirement for external funds based on the AFN equation.


 
(17-5) Forecasting financial reqs. C K Answer: c  MEDIUM/HARD
 . Which of the following statements is CORRECT?

a. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A*0/S0 and L*0/S0) vary from year to year in a stable, predictable manner.
b. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow.
c. Firms whose fixed assets are “lumpy” frequently have excess capacity, and this should be accounted for in the financial forecasting process.
d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets.
e. Regression techniques cannot be used in situations where excess capacity or economies of scale exist.


Problems

(17-3) Excess capacity C K Answer: a  EASY
 . Last year Godinho Corp. had $250 million of sales, and it had $75 million of fixed assets that were being operated at 80% of capacity.  In millions, how large could sales have been if the company had operated at full capacity?

a. $312.5
b. $328.1
c. $344.5
d. $361.8
e. $379.8

(17-5) Forecasting inv.--regression C K Answer: d  EASY
 . Kamath-Meier Corporation's CFO uses this equation, which was developed by regressing inventories on sales over the past 5 years, to forecast inventory requirements:  Inventories = $22.0 + 0.125(Sales).  The company expects sales of $400 million during the current year, and it expects sales to grow by 30% next year.  What is the inventory forecast for next year?  All dollars are in millions.

a. $74.6
b. $78.5
c. $82.7
d. $87.0
e. $91.4

(17-3) Excess capacity C K Answer: c  MEDIUM
 . Last year Wei Guan Inc. had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity.  In millions, by how much could Wei Guan's sales increase before it is required to increase its fixed assets?

a. $170.09
b. $179.04
c. $188.46
d. $197.88
e. $207.78
(17-3) Excess capacity C K Answer: e  MEDIUM
 . Last year Handorf-Zhu Inc. had $850 million of sales, and it had $425 million of fixed assets that were used at only 60% of capacity.  What is the maximum sales growth rate the company could achieve before it had to increase its fixed assets?

a. 54.30%
b. 57.16%
c. 60.17%
d. 63.33%
e. 66.67%

(17-3) Finding target FA/S ratio C K Answer: b  MEDIUM
 . Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its FA/Sales ratio was 40%.  However, its fixed assets were used at only 75% of capacity.  Now the company is developing its financial forecast for the coming year.  As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity.  What target FA/Sales ratio should the company set?

a. 28.5%
b. 30.0%
c. 31.5%
d. 33.1%
e. 34.7%

(17-5) Forecasting inv. turnover C K Answer: a  MEDIUM
 . Fairchild Garden Supply expects $600 million of sales this year, and it forecasts a 15% increase for next year.  The CFO uses this equation to forecast inventory requirements at different levels of sales:  Inventories = $30.2 + 0.25(Sales).  All dollars are in millions.  What is the projected inventory turnover ratio for the coming year?

a. 3.40
b. 3.57
c. 3.75
d. 3.94
e. 4.14

(17-3) Positive AFN C K Answer: d  MEDIUM/HARD
 . Clayton Industries is planning its operations for next year, and Ronnie Clayton, the CEO, wants you to forecast the firm's additional funds needed (AFN).  Data for use in your forecast are shown below.  Based on the AFN equation, what is the AFN for the coming year?  Dollars are in millions.

Last year’s sales = S0 $350 Last year’s accounts payable $40
Sales growth rate = g 30% Last year’s notes payable $50
Last year’s total assets = A*0 $500 Last year’s accruals $30
Last year’s profit margin = M 5% Target payout ratio 60%

a. $102.8
b. $108.2
c. $113.9
d. $119.9
e. $125.9
(17-3) Negative AFN C K Answer: c  MEDIUM/HARD
 . Chua Chang & Wu Inc. is planning its operations for next year, and the CEO wants you to forecast the firm's additional funds needed (AFN).  Data for use in your forecast are shown below.  Based on the AFN equation, what is the AFN for the coming year?

Last year’s sales = S0 $200,000 Last year's accounts payable $50,000
Sales growth rate = g 40% Last year's notes payable $15,000
Last year’s total assets = A*0 $135,000 Last year's accruals $20,000
Last year’s profit margin = M 20.0% Target payout ratio 25.0%

a. -$14,440
b. -$15,200
c. -$16,000
d. -$16,800
e. -$17,640

(17-3) AFN--changing div. payout C K Answer: b  MEDIUM/HARD
 . Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN).  Data for use in the forecast are shown below.  However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended.  Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level?  All dollars are in millions.

Last year’s sales = S0 $300.0 Last year’s accounts payable $50.0
Sales growth rate = g 40% Last year’s notes payable $15.0
Last year’s total assets = A0 $500.0 Last year’s accruals $20.0
Last year’s profit margin = M 20.0% Initial payout ratio 10.0%

a. $31.9
b. $33.6
c. $35.3
d. $37.0
e. $38.9

(17-3) Finding target FA/S ratio C K Answer: b  HARD
 . Last year Emery Industries had $450 million of sales and $225 million of fixed assets, so its FA/Sales ratio was 50%.  However, its fixed assets were used at only 65% of capacity.  If the company had been able to sell off enough of its fixed assets at book value so that it was operating at full capacity, with sales held constant at $450 million, how much cash (in millions) would it have generated?

a. $74.81
b. $78.75
c. $82.69
d. $86.82
e. $91.16