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					                    ACCTG 440 - Financial Management for Accountants
                                     Winter 2000

                             Sample Quiz #2 - February 23, 2000

Name: _________________________________________

Multiple Choice questions (2 points each)

a) Companies that consistently earn rates of return above the competitive floor in the
    industry are considered to possess a
a) Dominant market share
b) Niche market
c) Competitive advantage
d) Monopolistic advantage

2.    Earnings in excess of stockholder's required dollar return on invested capital are
a)    Sustainable earnings
b)    Transitory earnings
c)    Abnormal earnings
d)    Noise

3.    Firms that earn less than the cost of equity capital have a share price
1.    Above the market average
1)    Equal to book value
2)    Above book value
3)    Below book value

4. In applying the discounted free cash flow valuation model (not APV), the discount
    rate used is the
a) Weighted average cost of capital
b) Prevailing borrowing rate
c) Equity cost of capital
d) Unlevered cost of capital

5. When the ownership percentage of stock exceeds 20 percent, GAAP presumes that
   the investor
a) Has no influence to exert over the investee company
b) Is only investing or a short term trading position
c) Is able to exert influence over the investee company
d) Is trying to take over the investee company
Short Problem (10 points)

Steve Sefcik has an opportunity to invest $100,000 for a franchise kitchen accessories
shop for gourmet chefs. The franchiser provided an analysis of projected free cash flows
based on twenty years of experience for similar installations (research shows the
franchiser is known for honesty in its business dealings).

                    Year 1        Year 2           Year 3           Year 4         Beyond 4
Estimated Free
    Cash Flow     $(10,000)          $5,000         $15,000          $20,000         $21,500

    PFIF: 12%        .89286          .79719          .71178           .63552
    PFIF: 16%        .86207          .74316          .64066           .55229

After the 4th year cash flows are expected to grow at a constant rate of 3% per year.
e) If Steve expects to earn 12% on his investment, should he make the investment?
   What is the maximum he should pay for the franchise to earn 12%?
f) If Steve expects to earn 16% on his investment, should he make the investment?
   What is the maximum he should pay for the franchise to earn 16%?

                                          Year 1         Year 2           Year 3         Year 4     Beyond 4
Estimated Free Cash Flow               ($10,000)         $5,000          $15,000        $20,000      $21,500
PFIF: 12%                                0.89286        0.79719          0.71178        0.63552
PFIF: 16%                                0.86207        0.74316          0.64066        0.55229

DCF analysis
A - 12%                                                                                            238,888.89
PV of Cash Flow                   ($8,928.60)         $3,985.95       $10,676.70      $12,710.40   151,818.67
Total Present Values               170,263.12
Mid year Adjustment                $10,215.79           alternate      $9,926.43
Total Value                        180,478.90                         180,189.55
    Good project, maximum value is 180,478.90

Terminal Value = 21,000/(R-g) = 21,500/(.12-.03)=238,888.89
Mid year adjustment = 170,263.12*.12/2 = 10,215.79
Alternate Adjustment = 170,263.12*(sqrt(1.12)-1) = 9,926.43

B -16%                                                                                             165,384.62
PV of Cash Flow                      ($8,620.70)      $3,715.80        $9,609.90      $11,045.80   $91,340.27
Total Present Values                  107,091.07
Mid year Adjustment                    $8,567.29        alternate      $8,249.54
Total Value                           115,658.35                      115,340.61
Good project, maximum value is

Terminal Value = 21,000/(R-g) = 21,500/(.16-.03)=165,384.62
Mid year adjustment = 107,091.07*.16/2 = 8,567.29
Alternate Adjustment = 107,091.07*(sqrt(1.16)-1) = 8,249.54

Extra Credit Essay (3 points - This one is tough so don't do it unless you have extra time)

The SEC has asked the FASB to consider firm's practice of immediately writing off any
R&D intangible asset purchased in an acquisition. The SEC's position is that this write
off understates the assets of the firm and the stockholders equity. Firms desire to write
off the assets because they feel that the amortization charge taken each year reduces
future net income and thus the value analysts assign to the firm. Assume the write off vs.
amortize decision has no effect on the timing of the tax deduction for R&D expense. Use
either the discounted cash flow valuation model or abnormal earnings valuation model to
evaluate what affect the write-off will have on firm value as compared to amortizing the
R&D asset over several years?

This is easy to explain in terms of cash flow valuation. If the write-off of the asset does
not affect taxes then the write-off has absolutely no affect on cash flows and thus no
affect on the value of the firm. If the asset is amortized each year an amount, x, is
expensed. In the calculation of free cash flow this expense would reduce net income by
x. At the same time the reduction of the asset by the amortization would result in an
addition of x in the calculations of free cash flows (with taxes it is more complicated but
the associated tax benefit and deferred tax asset/liability would also offset). The
amortization thus has no net affect on cash flow and it does not matter if we amortize
over multiple years or just one year (write-off).

The same result holds true with the abnormal earnings valuation model that there is no
change in the valuation. If the asset is writen off immediately the book value of equity
declines by that amount. This decline in equity has two offsetting affects: first the value
of equity added in at the end of the process declines, second the normal income required
in all future years declines by the amount written off times the capital charge. The
second affect increases all forecasted abnormal earnings amounts and the present value of
those increases will exactly offset the decline in the current book value of equity.

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