MBAP 6061 Managerial Finance Exam 1 Thursday, September 30, Dr. William A. Dowling

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1 MBAP 6061 Managerial Finance Exam 1 Thursday, September 30, 2010 Dr. William A. Dowling Name You are to provide answers to the following questions. 1. What advantages does the corporate form of organization have over sole proprietorships or partnerships? The advantages of the corporate form of organization over sole proprietorships and partnerships are the ease of transferring ownership, the owners limited liability for business debts, the ability to raise more capital, and the opportunity of an unlimited life of the business. 2. What should be the goal of the financial manager of a corporation? Why? The correct goal is to maximize the current value of the outstanding stock. This goal focuses on enhancing the returns to stockholders who are the owners of the firm. Other goals, such as maximizing earnings, focus too narrowly on accounting income and ignore the importance of market values in managerial finance. 3. Assume for a moment that the stockholders in a corporation have unlimited liability for corporate debts. If so, what impact would this have on the functioning of primary and secondary markets for common stock? With unlimited liability, you would be very careful which stocks you invest in. In particular, you would not invest in companies you expected to be unable to satisfy their financial obligations. Both the primary and secondary markets for common stock would be severely hampered if this rule existed. It would be very difficult for a young, untested business to acquire enough capital to grow. 4. One thing lenders sometimes require when loaning money to a small corporation is an assignment of the common stock as collateral on the loan. Then, if the business fails to repay its loan, the ownership of the stock certificates can be transferred directly to the lender. Why might a lender want such an assignment? What advantage of the corporate form of organization comes into play here? In the event of a loan default, a lender may wish to liquidate the business. Often it is time consuming and difficult to take title of all of the business assets individually. By taking control of the stock, the lender is able to sell the business simply by reselling the stock in the business. This illustrates once again the ease of transfer of ownership of a corporation. 5. Why might a corporation wish to list its shares on a national exchange such as the NYSE as opposed to a regional exchange or NASDAQ? Being listed on a regional exchange effectively limits the capital access for the business. Plus, there is a prestige factor in being listed on one of the national exchanges. There is still a perceived prestige factor in moving from NASDAQ to the NYSE since the NYSE has more restrictive membership requirements. However, the lure of greater prestige certainly hasn t prompted some major corporations, such as Microsoft, to move to the NYSE. 1

2 6. Given the tax rates as shown, what is the average tax rate for a firm with taxable income of $126,500? Taxable Income Tax Rate $0 50,000 15% 50,001 75,000 25% 75, ,000 34% 100, ,000 39% Tax =.15($50,000) +.25($25,000) +.34($25,000) +.39($126,500 $100,000) = $32,585; Average tax rate = $32,585 $126,500 =.2576 = 25.76% 7. Your firm has net income of $198 on total sales of $1,200. Costs are $715 and depreciation is $145. The tax rate is 34%. The firm does not have interest expenses. What is the operating cash flow? Earnings before interest and taxes = $1,200 $715 $145 = $340; Tax = [$198 (1.34)] $198 = $102; Operating cash flow = $340 + $145 $102 = $383 2

3 8. Teddy s Pillows has beginning net fixed assets of $480 and ending net fixed assets of $530. Assets valued at $300 were sold during the year. Depreciation was $40. What is the amount of capital spending Net capital spending = Ending NFA ($530) Beginning NFA ($480) + Depreciation ($40) = $90 9. At the beginning of the year, long term debt of a firm is $280 and total debt is $340. At the end of the year, long term debt is $260 and total debt is $350. The interest paid is $30. What is the amount of the cash flow to creditors? Cash flow to creditors = Interest ($30) (Ending LTD Beginning LTD ($260 $280)) = $ Thompson s Jet Skis has operating cash flow of $218. Depreciation is $45 and interest paid is $35. A net total of $69 was paid on long term debt. The firm spent $180 on fixed assets and increased net working capital by $38. What is the amount of the cash flow to stockholders? Cash flow of the firm = [OCF Change in NWC Change in NFA] $218 $38 $180 = $0 Cash flow to creditors = [Interest ( payment on LTD)] $35 ( $69) = $104 Cash flow to stockholders = [Cash flow of the firm Cash flow to creditors] $0 $104 = $104 3

4 The following information should be used for problems #11 17: Net sales $9,610 Less: Cost of goods sold 6,310 Less: Depreciation 1,370 Earnings before interest and taxes 1,930 Less: Interest paid 630 Taxable Income $1,300 Less: Taxes 455 Net income $ 845 Nabors, Inc Income Statement ($ in millions) Nabors, Inc and 2006 Balance Sheets ($ in millions) Cash $ 310 $ 405 Accounts payable $ 2,720 $ 2,570 Accounts rec. 2,640 3,055 Notes payable Inventory 3,275 3,850 Total $ 2,820 $ 2,570 Total $ 6,225 $ 7,310 Long term debt 7,875 8,100 Net fixed assets 10,960 10,670 Common stock 5,000 5,250 Retained earnings 1,490 2,060 Total assets $17,185 $17,980 Total liab.& equity $17,185 $17, What is the change in the net working capital from 2005 to 2006? Change in net working capital = ($7,310 $2,570) ($6,225 $2,820) = $1, What is the amount of the non cash expenses for 2006? The non cash expense is depreciation in the amount of $1, What is the amount of the net capital spending for 2006? Net capital spending = $10,670 $10,960 + $1,370 = $1, What is the operating cash flow for 2006? Operating cash flow = $1,930 + $1,370 $455 = $2, What is the cash flow of the firm for 2006? Operating cash flow = $1,930 + $1,370 $455 = $2,845 Change in net working capital = ($7,310 $2,570) ($6,225 $2,820) = $1,335 Net capital spending = $10,670 $10,960 + $1,370 = $1,080 Cash flow of the firm = $2,845 $1,335 $1,080 = $ What is the amount of net new borrowing for 2006? Net new borrowing = $8,100 $7,875 = $ What is the cash flow to creditors for 2006? Cash flow to creditors = $630 ($8,100 $7,875) = $405 4

5 The following information should be used for problems #18 25: Knickerdoodles, Inc Sales $ 740 $ 785 COGS Interest Dividends Depreciation Cash Accounts receivables Current liabilities Inventory Long term debt Net fixed assets 1,680 1,413 Common stock Tax rate 35% 35% 18. What is the net working capital for 2006? Net working capital = $75 + $502 + $640 $405 = $ What is the change in net working capital from 2005 to 2006? Change in net working capital = ($75 + $502 + $640 $405) ($70 + $563 +$662 $390) = $ What is net capital spending for 2006? Net capital spending = $1,413 $1,680 + $210 = $ What is the operating cash flow for 2006? Earnings before interest and taxes = $785 $460 $210 = $115 Taxable income = $115 $35 = $80 Taxes =.35($80) = $28 Operating cash flow = $115 + $210 $28 = $ What is the cash flow of the firm for 2006? Cash flow of the firm = $297 ( $93) ( $57) = $ What is net new borrowing for 2006? Net new borrowing = $410 $340 = $ What is the cash flow to creditors for 2006? Cash flow to creditors = $35 ($410 $340) = $ What is the cash flow to stockholders for 2006? Cash flow to stockholders = $447 ( $35) = $482 Cash flow to stockholders = $17 ($235 $700) = $482 5

6 The following information should be used for problems #26 28: 2006 Cost of goods sold $3,210 Interest $215 Dividends $160 Depreciation $375 Change in retained earnings $360 Tax rate 35% 26. What is the taxable income for 2006? Net income = $160 + $360 = $520 Taxable income = $520 (1.35) = $ What is the operating cash flow for 2006? Earnings before interest and taxes = $800 + $215 = $1,015 Operating cash flow = $1,015 + $375 ($800 $520) = $1, What are the sales for 2006? Sales = $1,015 + $375 + $3,210 = $4, Explain why the income statement is not a good representation of cash flow. The income statement attributes sales to the period in which they occured which is not necessarily the period in which the revenues from the sales was received. 30. Jessica s Boutique has cash of $50, accounts receivable of $60, accounts payable of $200, and inventory of $150. What is the value of the quick ratio? Quick ratio = ($50 + $60) $200 = A firm has sales of $3,600, costs of $2,800, interest paid of $100, and depreciation of $400. The tax rate is 34%. What is the value of the cash coverage ratio? Cash coverage ratio = ($3,600 $2,800) $100 = Syed s Industries has accounts receivable of $700, inventory of $1,200, sales of $4,200, and cost of goods sold of $3,400. How long does it take Syed s to both sell its inventory and then collect the payment on the sale? Inventory turnover = $3,400 $1,200 = 2.83 Days in inventory = = Accounts receivable turnover = $4,200 $700 = 6 Days sales in receivables = = Total days in inventory and receivables = = days = 190 days (rounded) 33. Lee Sun s has sales of $3,000, total assets of $2,500, and a profit margin of 5%. The firm has a total debt ratio of 40%. What is the return on equity? Return on equity = (.05 $3,000) [$2,500 (1.40)] = $150 $1,500 =.10 = 10% 34. Patti s has net income of $1,800, a price earnings ratio of 12, and earnings per share of $1.20. How many shares of stock are outstanding? Number of shares = $1,800 $1.20 = 1,500 6

7 35. Frederico s has a profit margin of 6%, a return on assets of 8%, and an equity multiplier of 1.4. What is the return on equity? Return on equity = 8% 1.4 = 11.2%, using the Du Pont Identity 36. Windswept, Inc. has 90 million shares of stock outstanding. Its price earnings ratio for 2006 is 12. What is the market price per share of stock? Earnings per share for 2005 = $481 million 90 million = $ Market price per share = $ = $ Katelyn s Kites has net income of $240 and total equity of $2,000. The debt equity ratio is 1.0 and the plowback ratio is 40%. What is the internal growth rate? Total assets = $2,000 + $2,000 = $4,000 (The debt equity ratio of 1.0 means TD = TE.) Return on assets = $240 $4,000 =.06 Internal growth = [.06.40] [1 (.06.40)] = 2.46% 38. You are going to loan your friend $1,000 for one year at a 5% rate of interest. How much additional interest can you earn if you compound the rate continuously rather than annually ; EAR = 5.127% Additional interest = $1,000 ( ) = $1.27 EAR = 5.127% 39. Your grandmother invested one lump sum 17 years ago at 4.25% interest. Today, she gave you the proceeds of that investment which totaled $5, How much did your grandmother originally invest? Present value = $5, [1 ( ) 17 ] = $2, The common stock of Eddie s Engines, Inc. sells for $25.71 a share. The stock is expected to pay $1.80 per share next month when the annual dividend is distributed. Eddie s has established a pattern of increasing its dividends by 4% annually and expects to continue doing so. What is the market rate of return on this stock? ;R = 11.00% 7

8 41. Shares of common stock of the Samson Co. offer an expected total return of 12%. The dividend is increasing at a constant 8% per year. The dividend yield must be: Dividend yield = 4% 42. The common stock of Grady Co. had an 11.25% rate of return last year. The dividend amount was $.70 a share which equated to a dividend yield of 1.5%. What was the rate of price appreciation on the stock? g = =.0975 = 9.75% 43. The Merriweather Co. just announced that it will pay a dividend next year of $1.60 and is establishing a policy whereby the dividend will increase by 3.5% annually thereafter. How much will one share be worth five years from now if the required rate of return is 12%? ;P 5 = $ The Bell Weather Co. is a new firm in a rapidly growing industry. The company is planning on increasing its annual dividend by 20% a year for the next four years and then decreasing the growth rate to 5% per year. The company just paid its annual dividend in the amount of $1.00 per share. What is the current value of one share if the required rate of return is 9.25%? Dividends for the first 4 years are: $1.20, $1.44, $1.728, and $ P 4 = $ P 0 = $

9 45. Nu Tek, Inc. is expecting a period of intense growth and has decided to retain more of its earnings to help finance that growth. As a result it is going to reduce its annual dividend by 10% a year for the next three years. After that, it will maintain a constant dividend of $.70 a share. Last month, the company paid $1.80 per share. What is the value of this stock if the required rate of return is 13%? P 3 = $ P 0 = $ The Lory Company had net earnings of $127,000 this past year. Dividends were paid of $38,100 on the company's equity of $1,587,500. If Lory has 100,000 shares outstanding with a current market price of $ per share, what is the required rate of return R = Div/P 0 + g = (.381(1.056))/11.625)+.056 = (.40/11.625)+.056 = =.0906 = 9% 47. Doctors On Call, a newly formed medical group, just paid a dividend of $.50. The company s dividend is expected to grow at a 20% rate for the next 5 years and at a 3% rate thereafter. What is the value of the stock if the appropriate discount rate is 12%? Years 1 5: ($.50(1.2) t /(1.12) t + (1.28/.09)/(1.12) 5 = $ Calculate the YTM on a bond priced at $1,036 which has 2 years to maturity, a 10% annual coupon rate, and a return of $1,000 at maturity. YTM = 7.98% 9