PRACTICE PROBLEMS TOPIC 1 COMPANY GOALS 1. What is the difference between stock price maximization and profit maximization? 2. What is the best measure of stockholder welfare? Why? 3. Explain why limited liability is often a fiction for small corporations. 4. How do small corporations often escape any income taxation? 5. If you were the Vice President of a large, publicly owned corporation, would you make decisions to maximize stockholders' welfare or your own personal interests? What are some actions stockholders could take to insure that management's interests and those of stockholders coincided? 6. Would the ―normal‖ rate of return on investments be the same in all industries? Would ―normal‖ rates of return change over time? Explain. 7. Should stockholder wealth maximization be thought of as a long-term or a short-term goal? 8. Assume that you are serving on the board of directors of a medium-sized corporation and that you are responsible for establishing the compensation policies of senior management. You believe that the company’s CEO is very talented, but your concern is that she is always looking for a better job and may want to boost the company’s short-run performance (perhaps at the expense of long-run profitability) to make herself more marketable to other corporations. What effect would these concerns have on the compensation policy you put in place? 9. What are the major determinants of a company’s P/E ratio? 10. What are ―agency problems?‖ TOPIC 2 FINANCIAL MARKETS AND INTEREST RATES 1. What is the basic purpose of SEC regulation? 2. What is the difference between ―going public‖ and ―being listed?‖ Why do companies go public? 3. What is the difference between the money markets and capital markets? 4. What are the two main factors that determine the cost of raising money for a company? 5. What are venture capital firms? What do they provide and how much do they charge? 6. What is the most valuable service investment bankers provide? 7. What are the three types of security offerings? Which of the three types have to be registered with the SEC? 8. An investor decided to sell 100 shares of General Motors. Is this transaction part of the primary market or the secondary market? Explain. 9. What is a "continuous" market and how does an exchange attempt to meet this objective? 10. What is the function of "financial intermediaries"? Name at least 6 major types of financial intermediaries. What advantages do mutual funds offer to investors? 11. What are the main differences between the organized security exchanges and the over-the-counter market? 12. Look in the Wall Street Journal or any other newspaper that carries stock quotes and select a major company such as General Electric. What kinds of information does the stock quote provide? 13. What is the difference between the real risk-free rate of interest and the nominal risk-free rate of interest? 14. If the real risk-free rate of interest is 3% and inflation over the next year is expected to be 2%, what rate of return can be earned on 1 year T-bills? 15. How can you measure the default risk premium? 16. What is interest rate risk? 17. Is the interest rate risk a bigger problem for stocks or bonds? Why? 18. What is a yield curve? 19. Briefly describe the three theories that attempt to explain the term structure of interest rates. 20. Suppose the annual yield on a 2-year Treasury bond is 11.5%, while that on a 1-year bond is 10%. The real risk-free rate is 3%. Using the expectations theory: a) What is the expected inflation rate in year 1? b) Forecast the interest rate on a 1-year bond during the second year.13% 21. Assume that the real risk-free rate is 4% and that the maturity risk premium is zero. If the nominal rate of interest on 1-year bonds is 11% and that on comparable-risk 2 year bonds is 13%, what is the 1-year interest rate that is expected for year 2? What inflation rate is expected during the second year? 22. Which are more volatile, short-term interest rates or long-term interest rates? Why? 23. How difficult is it to predict interest rates? TOPIC 3 FINANCIAL STATEMENTS 1. Earnings per share is ________ divided by _______________. 2. Cash flow equals _________ plus ____________. 3. An increase in an item on the right hand side of the balance sheet provides ________ for the company. 4. Retained Earnings 12/31/xx $600 Net Income xx 80 Dividends to common stockholders 20 Retained Earnings, 12/31/x1 a) How much was in Retained Earnings on 12/31/ x1? b) What was the retention or plowback ratio? c) Does retained earnings represent cash? 5. What are the five important questions that financial managers ask about cash—and where do they get the answers? 6. Define each of the following: current ratio quick ratio inventory turnover ratio days sales outstanding (average collection period) fixed assets turnover debt ratio times interest earned profit margin return on assets PE ratio market/book ratio THE FOLLOWING 6 QUESTIONS ARE BASED ON THE FINANCIAL STATEMENTS BELOW: SKI AND GOLF MANUFACTURING BALANCE SHEET 12/31/xx (Dollars in Thousands) Cash $ 200 Accts. Pay. $ 205 Receivables 245 Notes Pay. 425 Inventory 625 Other Current Liab. 115 Total Current Assets 1,070 Total Current Liab. 745 Net Fixed Assets 1,200 Long-Term Debt 420 Common Equity 1,105 Total Assets 2,270 Total Liab. & Eq. 2,270 INCOME STATEMENT (Year Ending 12/31/xx) Sales $2,400 Cost of goods sold: Materials 1,000 Labor 600 Heat, light, and power 89 Indirect labor 65 Depreciation 80 1,834 Gross profit 566 Selling expenses 175 General & Admin. expenses 216 Earnings before interest & taxes 175 Interest expense 35 Earnings before taxes 140 Taxes 56 Net Income 84 7. Calculate the company's current ratio and quick ratio. 8. Calculate the company's asset management ratios, that is, the inventory turnover ratio, fixed assets turnover, total assets turnover, and days sales outstanding. 9. Calculate the debt management ratios, that is, the debt ratio and times- interest-earned ratio. 10. Calculate the profitability ratios, that is, the profit margin on sales, return on total assets, and return on common equity. 11. Calculate the market value ratios, that is, the P/E ratio and the market/book value ratio. The company had an average of 10,000 shares outstanding during 2004, and the stock price on 12/31/04 was $40.00. 12. Use the DuPont equation with the equity multiplier to determine the company's return on equity. 13. Return on assets is equal to _______multiplied by ________. 14. Return on equity is equal to return on assets multiplied by _____ . 15. What are "window dressing" techniques? 16. National Appliance Stores, Inc. had sales of $1,800,000 last year. If the firm maintains $600,000 in inventory, what is its inventory turnover? What is it inventory turnover period? 17. Plumber's Supply House has sales of $5,760,000. Its accounts receivable balance is $688,000. a) If all sales are on credit, what is the company's days sales outstanding? b) What is the firm's days sales outstanding if 10 percent of the firm's sales are for cash? 18. The "XYZ Company" had a quick ratio of 1.4, a current ratio of 3.0, and inventory turnover of 6 times, total current assets of $810,000, and cash and marketable securities of $120,000 in 19xx. Assuming the company's current assets consisted only of cash, marketable securities, accounts receivable, and inventory, what were the company's annual sales and its DSO for that year? 19. Complete the balance sheet in the table below using the following financial data: Debt ratio 50% Quick ratio .80x Total assets turnover 1.5x DSO 36 days Sales $450,000 Inventory turnover 5x Cash _ Acct. Pay. _______ Accts. rec. __ LT debt $60,000 Inventories __ Common stock _______ Fixed assets ___ Retained Earnings 97,500 Total $300,000 Total _______ 20. The "ABC" Company has become concerned about the following figures which are only a continuation of a trend over the past several years. Year 1 Year 2 Assets $50,000 $60,000 Total debt 20,000 10,000 Net income 10,000 11,000 Sales 100,000 120,000 One financial officer has argued that the company needs to expand its advertising campaign, but another officer believes the company should raise its prices. Explain, by analyzing the return on assets, which officer you would tend to agree with. 21. Is the Market / Book ratio generally a good measure of the value of a company? Why or why not? 22. What is the problem of ―double counting‖ when performing ratio analysis? TOPIC 4 TIME VALUE OF MONEY 1. What is the terminal value of an initial deposit of $100 in 3 years assuming an annual interest rate of: a. zero % b. 100 % c. 10 % 2. What is the terminal value of an initial deposit of $100 assuming an annual interest rate of 10% at the end of: a. 1 year b. 10 years c. 20 years 3. If $100 is deposited at the end of each year for 10 years and earns 8% interest, how much will be accumulated? 4. What is the terminal value of an initial deposit of $1,000 on January 1, 2005 and $100 deposits made on December 31 each year for 10 years, assuming 8% is earned on deposits? 5. Which amount is worth more at 7%, $1,000 today or $2,000 in 10 years? 6. If $1,016.70 is invested for 10 years at 7%, how much will be accumulated? 7. Which amount is worth more at 7%, $1,016.70 today or $2,000 in 10 years? 8. What is the present value of a perpetuity of $100 per year if the appropriate discount rate is 7%? In interest rates in general were to double and the appropriate discount rate rose to 14%, what would happen to the present value of the perpetuity? 9. If money is worth 12%, what is the present value of $5,000 each year for the next 10 years? (Do not need to use the CF register) 10. Find the present values of the following cash flow streams: a) at 0% Year Stream A Stream B 1 $100 $300 2 400 400 3 400 400 4 400 400 5 300 100 b) at 8% USING THE CASH FLOW REGISTER: For Stream A: CF, 2nd, CE/C, Enter 0 for CF 0, down arrow, 100, Enter, down arrow (twice), $400, Enter, down arrow, 3 Enter, down arrow, $300, Enter, down arrow, NPV, 8, Enter, down arrow, CPT 11. At 10%, what is $1,000 per year for the next 5 years followed by $400 each year for the next 3 years now worth? 12. Find the present value of the following cash flow stream, discounted at 7%: Year 1 $100; Year 2 $400, Years 3 through 20 $300. 13. At 15%, how long does it take to double an initial amount? 14. Last year a company's sales were $12 million. Sales were $6 million 5 years earlier. a) To the nearest percentage point, at what rate have sales been growing? b) What's wrong with this approach? "Sales doubled in 5 years. This represents a growth of 100% in 5 years, so, dividing 100% by 5, we find the growth rate to be 20% per year." 15. An investor purchased an asset for $100,000 and 5 years later it was worth $161,100. What rate of return does this represent? 16. The Knight Company buys a machine for $50,000 and expects a return of $11,511.19 per year for the next 8 years. What is the expected rate of return on the machine? 17. Carolina-Atlantic invests $4 million to clear a tract of land and to set out some young pine trees. The trees will mature in 10 years, at which time Carolina-Atlantic plans to sell the forest at an expected price of $8 million. What is the company's expected rate of return? 18. What is the future value of $3,000 compounded at 10% (annually) for 8 years? What is the future value if the $3,000 is compounded semi- annually? 19. If you borrow $40,000 for 5 years at 10%, what is the annual level payment to amortize the loan? 20. Using the facts in the previous question, how much interest will be paid in year 2? 21. How much total interest will be paid over the 5 year period? 22. The Jackson family is interested in buying a home. The family is applying for a $125,000, 30 year mortgage. Under the terms of the mortgage, they will receive $125,000 today to help purchase their home. The loan will be fully amortized over the next 30 years. Current mortgage rates are 8%. Interest is compounded monthly and all payments are due at the end of the month. a) What is the monthly mortgage payment? b) What portion of the mortgage payments made during the first year will go toward interest? c) What will be the remaining balance on the mortgage after 5 years? d) How much could the Jacksons borrow today if they were willing to have a $1,200 monthly mortgage payment? (Assume the interest rate and the length of the loan remain the same). 23. You want to buy a car that costs $20,000 and you have $5,000 for a down payment. Using an interest rate of 6.9%, how much will you pay per month if you spread your payments over 4 years? TOPIC 5 RISK AND RATES OF RETURN 1. Stocks X and Y have the following probability distributions of expected returns: (Note: parentheses signifies a negative amount) Probability X Y 0.1 (10%) (35%) 0.2 2 0 0.4 12 20 0.2 20 25 0.1 38 45 a) Calculate the expected rate of return for Stock Y. (It is 12% for Stock X.) b) The standard deviation of expected returns for Stock X is 12.2% and it is 20.35% for Stock Y. Now calculate the coefficient of variation for Stock Y. Is it possible that most investors might regard Stock Y as less risky than Stock X? Explain. 2. The "ABC" Investment Fund has $1,000,000 invested in the following stocks: Expected Standard Amount Return Deviation Stock A $100,000 10% 15% Stock B 150,000 5% 8% Stock C 400,000 14% 22% Stock D 250,000 12% 18% Stock E 100,000 11% 19% a) What is the expected return on the portfolio? b) Should the riskiness of the portfolio be measured by the weighted average of the standard deviations of the individual securities? Explain why or why not. 3. A portfolio consists of only two stocks, A and B, with 50% invested in each. The correlation coefficient is +.3. The standard deviation of A is 15% and it is 25% for B. We know the portfolio risk will be less than _____ . Why is this true? 4. What is the relationship between the correlation coefficient and portfolio risk? 5. Describe two types of investment risk. 6. Explain why company-specific risk can be essentially eliminated in a well- diversified portfolio. 7. What is "beta" and why is it the appropriate measure of a stock's riskiness in a portfolio? 8. A company is evaluating three investment opportunities. Its financial manager has forecasted the risk-free rate and the expected market rate of return as being krf = 9% and km = 13%, respectively. What is the appropriate required rate of return for each stock if: a) Investment A has a beta of 0.5? b) Investment B has a beta of 1.0? c) Investment C has a beta of 2.0? 9. Explain the meaning of the Security Market Line. THE NEXT 4 QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: krf = 5%, km = 11%, and b= 1.3 for a stock 10. What is k, the required rate of return for the stock? 11. What would k be if investors expected the inflation rate to increase by 2 percentage points? 12. Go back to the original assumptions and determine what would k be if investors' risk aversion increased by 3 percentage points? 13. Go back to the original assumptions and determine what would k be if investors expected the inflation rate to increase by 2 percentage points and their risk aversion increased by 3 percentage points? 14. The Adler Investment Fund has total capital of $500 million invested in 5 stocks: Amount Stock's Stock (in millions) Beta A $160 0.5 B 120 2.0 C 80 4.0 D 80 1.0 E 60 3.0 The beta coefficient for a fund like Adler Investment can be found as a weighted average of the fund's investments. The current risk-free rate is 8%, whereas market returns have the following estimated probability distribution for the next period: Market Probability Return 0.1 10% 0.2 12 0.4 13 0.2 16 0.1 17 a) Determine the expected market return. b) What is the estimated equation for the Security Market Line? c) Compute the fund's required rate of return for the next period. d) Suppose Mike Adler, the president, receives a proposal for a new stock. The investment needed to take a position in the stock is $50 million; it will have an expected return of 18%; and its estimated beta coefficient is 2.0. Should the new stock be purchased? At what expected rate of return should Adler be indifferent to purchasing the stock? TOPIC 6 BONDS 1. What is a ―bond indenture?‖ What is the main purpose of the Trust Indenture Act? 2. What are ―debentures‖ and ―subordinated debentures?‖ 3. A bond that matures in 10 years sells for $985. The bond has a face value of $1,000 and a 7 percent annual coupon. a. What is the bond’s current yield? b. What is the bond’s YTM? c. Assume that the YTM remains constant for the next 3 years. What will be the price of the bond 3 years from today? 4. If interest rates in the economy rise after a bond has been issued, what will happen to the bond’s price and to its YTM? Does the length of time to maturity affect the extent to which a given change in interest rates will affect the bond’s price? 5. Indicate whether each of the following actions will increase or decrease a bond’s yield to maturity: a. A bond’s price increases b. The company’s bonds are downgraded by the rating agencies. c. A change in the bankruptcy code makes it more difficult for bondholders to receive payments in the event a firm declares bankruptcy. d. The economy enters a recession. e. The bonds become subordinated to another debt issue. 6. Callaghan Motors’ bonds have 10 years remaining to maturity. Interest is paid annually, the bonds have a $1,000 par value, and the coupon interest rate is 8 percent. The bonds have a yield to maturity of 9 percent. What is the current market price of these bonds? 7. What is the call premium and when do companies normally call their bonds? 8. Thatcher Corporation has issued some 10 year bonds that have a 9 percent coupon rate, payable semiannually. The price of the bonds is $1,100. The bonds are callable in 5 years at a call price of $1,050. What is the yield to maturity? What is the yield to call? 9. Nungesser Corporation has issued some bonds that have a 9 percent coupon rate, payable semiannually. The bonds mature in 8 years, have a face value of $1,000, and a YTM of 8.5 percent. What is the price of the bonds? 10. A zero coupon bond provides a positive cash flow to the issuer during the life of the bond. Explain. 11. What is the value of a 30-year zero coupon bond if the appropriate discount rate is 12 percent? 12. What are junk bonds and why do people buy them? 13. What are warrants? Do they provide one or two cash inflows to the issuing company? 14. What are the characteristics of term loans? TOPIC 7 STOCKS 1. What does the ―par‖ value of common stock mean? 2. Two investors are evaluating AT&T’s stock for possible purchase. They agree on the expected value of D1 and also on the expected future dividend growth rate. Further, they agree on the riskiness of the stock. However, one investor normally holds stocks for 2 years, while the other normally holds stocks for 10 years. On the basis of this information, should they both be willing to pay the same price for AT&T stock? Explain. 3. Montoya Company has enjoyed many years of growth through franchising. Financial analysts now believe that the firm is moving into a mature, constant-growth phase of its life cycle. Next year's dividend is expected to be $4.50, and dividends and earnings are expected to grow at a constant 5% rate in the future. What price should investors pay for a share of Montoya common stock if they require a 14 percent rate of return on their investment? 4. Carolina Tobacco has been paying a $4.00 dividend for several years. Growth prospects for higher earnings are dim, but the company's treasurer is confident that the firm can continue to provide the current dividend into the foreseeable future. If investors require a 15% return, what is the current market price of the stock? 5. You buy a share of Barngrover Corporation common stock for $21.40. You expect it to pay dividends of $1.07, $1.1449, and $1.2250 in Years 1, 2, and 3, respectively, and expect to sell it at a price of $26.22 at the end of 3 years. a) Calculate the growth rate in dividends. (Use 3 years for the growth period). b) Calculate the expected dividend yield. c) Assuming that the calculated growth rate is expected to continue, what is this stock's expected total rate of return? 6. Wendt Mining Company's ore reserves are being depleted, so its sales are falling. Also, its pit is getting deeper each year, so its costs are rising. As a result, the company's earnings and dividends are declining at the constant rate of 5% per year. If D0 = $5, and ks = 15%, what is the value of Wendt Mining's common stock? 7. Company X is expected to pay an end-year dividend of $10 per share. After the dividend, its stock is expected to sell for $210. If the market capitalization rate is 10%, what is the current stock price? 8. Company Z’s dividends per share are expected to grow indefinitely by 5% per year. If next year’s dividend is $10 and the market capitalization rate is 10%, what is the current stock price? 9. You believe that next year the ABC Company will pay a dividend of $2 on its common stock. Thereafter you expect dividends to grow at a rate of 4% a year in perpetuity. If you require a return of 12% on your investment, how much should you be prepared to pay for the stock? 10. A company always pays a dividend that is 80% of it's earnings per share. The return on equity in this company averages 12%. If the dividend this year is $5 and an investor requires a return of 15%, what is the value of this stock? 11. What are the pros and cons of issuing common stock? 12. A company has hard assets worth $500,000 and the industry average rate of return is 28%. Actual, true earnings are $200,000 per year. The capitalization rate for goodwill is 40%. Using the excess earnings method what is the value of the: a) Goodwill? b) Company? 13. Using the reduced P/E approach and the following data, what is the value of Company X if there is a 20% discount for lack of marketability? True earnings for Company X are $800,000. Average P/E ratios Co. A 8X Co. B 10 X Co. C 6X Co. D 7X 14. Americal Corporation has a $100 par, $7 dividend perpetual preferred stock outstanding. Investors require a 12% return on investments of this type. a) What is the current market price of Americal's preferred stock? b) Is the price computed in (a) above the same price that you would find if you discounted each future dividend back to the present using the 12% discount factors? c) If the investment community's required rate of return fell for Americal's preferred stock, what would happen to the price? 15. A company has a $100 par value preferred stock outstanding that pays a dividend of $14 per year and which has no sinking fund feature. The required rate of return on preferred stock with this degree of risk is 8%. What is the value of this preferred stock? 16. A financial manager (of a company that is not a public utility) has decided to raise funds either by selling bonds or preferred stock. a. What is the major attraction to the financial manager that is shared by both bonds and preferred stock? b. What is the major disadvantage to the financial manager of issuing preferred stock rather than bonds? c. Why is an individual investor likely to prefer the company’s bonds rather than the preferred stock? 17. Define each of the three levels of market efficiency. 18. What level of efficiency does the NYSE have? TOPIC 8 CAPITAL BUDGETING 1. Explain why the NPV of a relatively long-term project, defined as one in which a high percentage of its cash flows are expected in the distant future, is more sensitive to changes in the cost of capital than is the NPV of a short-term project. 2. Project K has a cost of $52,125, and its expected net cash inflows are $12,000 per year for 8 years. a) What is the project's payback period? a) The cost of capital is 12%. What is the project's NPV? c) What is the project's IRR? 16%. 3. Sound Design is investigating a project that costs $1,392,960 and is expected to produce net cash inflows of $600,000 annually for 3 years. a) What is the project's payback period? b) If the cost of capital is 12 percent, what is the project's NPV? c) What is the project's IRR? 4. The management of Hytec Electronics is evaluating the following investment opportunity, which costs $47,678.50 today but promises to return the following net cash flows: Year Net Cash Flows 1 $20,000 2 15,000 3 10,000 4 20,000 a) What is the project's payback? 3.134 years. b) What is the project's NPV if Hytec's cost of capital is 14%? c) What is the project's IRR? 5. The Homes Corp. is faced with two mutually exclusive investment proposals. Cost Net Cash Flows Project A $100,000 $30,000 per year for 5 years Project B $ 50,000 $16,000 per year for 5 years Homes has a 10% after-tax cost of capital. Compute the NPV and profitability index for each project. Which should be accepted? 6. A project has a cost of $100,000 and will provide net cash inflows of $10,000 per year for 11 years. a) What is the reciprocal of the project's payback period? b) What is the project's IRR? a) Now assume all the same facts as above except that the project will provide net cash inflows of $10,000 per year for 55 years. What is the reciprocal of the project's payback period? What is the project's IRR? 7. The Tallman Coffee Company is evaluating the within-plant distribution system for its new roasting, grinding, and packing plant. The two alternatives are (1) a conveyor system with a high initial cost but low annual operating costs and (2) several forklift trucks, which cost less but have considerably higher operating costs. The decision to construct the plant has already been made, and the choice here will have no effect on the overall revenues of the project. The cost of capital for the plant is 9%, and the project's expected net costs are listed below: Expected Net Cash Flows Year Conveyor Forklift 0 ($300,000) ($120,000) 1 (66,000) (96,000) 2 (66,000) (96,000) 3 (66,000) (96,000) 4 (66,000) (96,000) 5 (66,000) (96,000) Which alternative would you choose? Why? 8. Los Morales Corp. is considering a computer costing $70,000. The presence of this machine is expected to save one part-time worker at an annual savings of $20,000. The computer has a useful life of 7 years, and a 10% investment tax credit is available at the time the computer is placed in service. The company's marginal tax rate is 40% and the after-tax required rate of return on the project is 14%. a) Using straight line depreciation, what is the project's net present value? b) If a working capital investment of $5,000 in addition to the cost of the computer were needed over the life of the project, what would be the effect on the net present value? (Assume straight line depreciation). 9. The Mammoth Ski Resort is considering a half dozen capital improvement projects. It has allocated $1 million for capital budgeting purposes. The following proposals and associated profitability indexes have been determined. The projects themselves are independent of one another. Project Amount Index A Extend ski lift #4 $500,000 1.22 B New sports shop 150,000 .95 C Extend ski lift #16 350,000 1.20 D New restaurant 450,000 1.18 E Additional housing 200,000 1.12 F Skating rink 400,000 1.05 Question 1: With strict capital rationing, which of the above investments should be undertaken? Question 2: Is this an optimal strategy? 10. Your firm is considering the purchase of a machine with the following data: a. The machine will cost $2,000. If you decide to buy the machine, $200 will be used as a down payment and the balance paid off in 4 years at 6% interest (assume interest payments the same in each year--$106 per year). b. Depreciation is computed on a straight line basis (4 years) with no salvage value. c. The machine is expected to generate gross cash flows of $1,000 a year for 4 years. d. Operating costs are expected to be $200 a year. The company's cost of capital is 8% and its tax bracket is 48%. What is the NPV of the machine? 11. An investment will cost $8,426 and will provide cash inflows of $4,000 each year for 3 years. (a) What is the investment's IRR? (b) If the interim cash flows are reinvested at 20%, how much will be accumulated by the end of the third year? (c) If the interim cash flows are reinvested at the company's cost of capital of 32%, what rate of return will be earned on this investment? (d) If the interim cash flows are reinvested at a "safe rate" of 12%, what rate of return will be earned on this investment? $13,497.60 will be accumulated. 12. Explain how each of the following in capital budgeting decisions: a) sunk costs b) opportunity costs c) externalities 13. John bought a rental house in 1998 for $140,000. He paid 10% down and financed the remainder over 15 years. To pay the house off as soon as possible he arranged for the mortgage company to take $1,000 from his bank account for the mortgage payment on the first and fifteenth of each month. John rents the house for $1,400 per month but he pays $150 for association dues for the house. He estimates that an average of $100 per month will cover repairs and the vacancy factor. The current market value of the house is $170,000. Do you think this is a good investment for John? Explain your reasoning. TOPIC 9 COST OF CAPITAL 1. Calculate the after-tax cost of debt under each of the following conditions: a) Interest rate, 13%; tax rate, 0%. b) Interest rate, 13%, tax rate, 20%. c) Interest rate, 13%, tax rate, 34%. 2. The O'Brien Company's financing plans for next year include the sale of long-term bonds with a 10% coupon. The company believes it can sell the bonds at a price that will provide a yield to maturity of 12%. If the federal plus state tax rate is 34%, what is O'Brien's after-tax cost of debt? 3. Bildersee Industries plans to issue some $100 par preferred stock with an 11 percent dividend. The stock is selling on the market for $97.00, and Bildersee must pay flotation costs of 5% of the market price. What is the cost of the preferred stock for Bildersee? 4. Percy Motors has a target capital structure of 40 percent debt and 60 percent equity. The yield to maturity on the company’s bonds would be 9 percent if they issued bonds today, and the company’s tax rate is 30%. Percy’s CEO has calculated the company’s WACC to be 9.96%. What is the company’s cost of common equity? 5. The earnings, dividends, and stock price of Rivoli Technologies Inc. are expected to grow at 7% per year in the future. Rivoli's common stock sells for $23 per share, its last dividend was $2.00, and the company will pay a dividend of $2.14 at the end of the current year. a) Using the discounted cash flow approach, what is its cost of retained earnings? b) If the firm's beta is 1.6, the risk-free rate is 9%, and the average return on the market is 13%, what will be the firm's cost of equity using the CAPM approach? c) If the firm's bonds earn a return of 12%, what will ks be using the bond yield plus risk premium approach? d) Based on the results of the previous parts (a-c), what would you estimate Rivoli's cost of retained earnings to be? 6. Javits and Sons’ common stock is currently trading at $30 per share. The stock is expected to pay a dividend of $4 per share, and the dividend is expected to grow at a constant rate of 5 percent a year. If the company were to issue external equity, it would incur a 10 percent flotation cost. What are the costs of internal and external equity? 7. The Shalit Company's EPS was $6.50 last year and $4.42 five years earlier. The company pays out 40% of its earnings as dividends, and the stock sells for $36. a) Calculate the past growth rate in earnings. (Hint: Use a 5 year growth period). b) Calculate the next expected dividend per share, D1. (Do = 0.4($6.50) = $2.60) c) What is the cost of retained earnings, ks, for the Shalit Company? 8. The Cordell Company's next expected dividend, D1, is $3.18; its growth rate is 6%; and the stock now sells for $36. New stock can be sold to net the firm $32.40 per share. b) What is Cordell's percentage flotation cost, F? c) What is Cordell's cost of new common stock, ke? 9. How would each of the following affect a firm’s cost of debt, its cost of equity, and its weighted average cost of capital? Indicate by a plus (+), a minus (-), or a zero (0) if the factor would raise, lower, or have an indeterminate effect on the item in question. Assume other are held constant. Effect on kd(1 –t) ks WACC a. The corporate tax rate is lowered. ______ ____ _____ b. The Fed tightens credit. ______ ____ _____ c. The dividend payout ratio is increased ______ ____ _____ d. The firms expands into a risky new area. ______ ____ _____ e. The stock market falls drastically and the stock price drops ______ ____ _____ f. Investors become more risk averse ______ ____ _____ TOPIC 10 FINANCIAL FORECASTING 1. What is a pro forma financial statement? 2. Certain liability and net worth items generally increase spontaneously with increases in sales. Put a check mark by those items that typically increase spontaneously: Accounts payable ____ Notes payable to banks ____ Accrued wages ____ Accrued taxes ____ Mortgage bonds ____ Common stock ____ Retained earnings ___ 3. A company is estimating the additional funds needed for the coming year. In the year just ended, sales were $1,500,000, the profit margin on sales was 8%, the dividend payout ratio was 40%, sales for the coming year are expected to be $2,200,000, and the fixed assets are operating at full capacity, but can be increased proportionately with sales. Using the percent of sales method and the following balance sheet information, what is the amount of funds that must be obtained through borrowing or by selling new common stock? Cash $20,000 Accounts Payable $50,000 Receivables 185,000 Accrued Taxes 130,000 Inventories 195,000 Mortgage Bonds 170,000 Fixed Assets 200,000 Common Stock 100,000 Retained Earnings 150,000 4. At year end 20xx a company's total assets were $3.4 million. Sales, which were $5 million, will increase by 20% in 20x1. The 20xx ratio of total assets to sales will be maintained in 20x1. Common stock amounted to $850,000 in 20xx, and retained earnings were $590,000. Spontaneous liabilities will continue to be 22% of sales in 20x1, and the company plans to sell new common stock in the amount of $100,000. Net income is expected to be 5% of sales, and 60 percent of earnings will be paid out as dividends. a) What was the company's total debt in 20xx? b) How much new debt financing will be needed in 20x1? (Hint: AFN - New stock = New debt) 5. A firm has the following balance sheet and other data (in thousands of dollars): Cash 20 Accts. Pay. $ 20 Accts. Rec. 20 Notes Pay. 40 Inventory 20 LT Debt 80 FA 180 CS 80 RE 20 Total 240 Total 240 Fixed assets are being used at 80% of capacity; sales for the year just ended were $400,000; sales will increase $20,000 per year for the next four years; the profit margin is 5%; and the dividend payout ratio is 60%. What are the total outside financing requirements for the entire 4 years? (Assume that fixed assets cannot be sold). (Hint: It is easier to project to year 4 without making projections for years 1, 2, and 3). 6. Dandy Computers makes bulk purchases of small computers, stocks them in conveniently located warehouses, and then ships them to its chain of retail stores. Dandy's balance sheet as of December 31, 20x1, is shown below (in millions of dollars): Cash $ 2.0 Accounts Payable $ 5.0 Receivables 15.0 Notes Payable 10.0 Inventories 33.0 Accruals 5.0 Total CA 50.0 Total CL 20.0 Net F.A. 20.2 Mortgage 3.4 Common Stock 8.4 Retained Earnings 38.4 Total Assets 70.2 Total L. & NW 70.2 Sales for 20x1 were $200 million, while net income after taxes for the year was $5,670,000. Dandy paid dividends of $2,268,000 to common stockholders. The firm is operating at full capacity. a) If sales are projected to increase by $50 million, or by 25 %, during 20x2, what are Dandy's projected external capital requirements? b) Construct Dandy's pro forma balance sheet for December 31, 20x2. Assume that all external capital requirements are met by bank loans and are reflected in Notes Payable. c) Now calculate the following ratios, based on your projected December 31, 19x2, balance sheet. Dandy's 20x1 ratios and industry average ratios are shown below for comparison. Dandy Dandy Industry Computers Computers Average 12/31/x2 12/31/x1 12/31/x1 Current ratio (a) 2.5 X 3X Debt/TA (b) 33.3 % 30 % Rate of return on NW (c) 12.1% 12% 7. Assume: Sales last year $ 75 Sales for the coming year 180 Fixed assets last year 40 Fixed assets were operating at 65% of capacity last year. Fixed assets can be added in whatever amounts are needed a) What is the company's full capacity sales level? b) What should be the company's target FA/S ratio? c) How much should the company have in fixed assets for the coming year? 8. How does each of the following affect external capital requirements: a) Dividend policy b) The capital intensity ratio c) Profit margin 9. The relationship between certain assets and sales can be described as: (1) constant ratio, (2) economies of scale, and (3) lumpy assets. Describe each of these relationships and provide a type of asset that often falls into each category. TOPIC 11 INTERNATIONAL FINANCE 1. You are planning a trip to England and have located a hotel on the Internet that lists the price of the rooms as 50 pounds per night. How much will one of these rooms cost you in US dollars if $1 = .5222 British pounds? 2. If the Euro appreciates against the US dollar, can a dollar buy more or fewer Euros as a result? 3. If the US imports more goods from abroad than it exports, foreigners will tend to have a surplus of US dollars. What will this do to the value of the dollar with respect to foreign currencies? 4. Should firms require higher rates of return on foreign projects than on identical projects located at home? 5. If British pounds sell for $1.50 (US), what should dollars sell for in pounds per dollar? 6. Suppose that 1 Danish krone could be purchased in the foreign exchange market for 14 US cents today. If the krone appreciated 10 percent tomorrow against the dollar, how many krones would a dollar buy tomorrow? 7. Suppose the exchange rate between the US dollar and the Swedish kronaa was 10 krona = $1.00, and the exchange rate between the dollar and the British pound was ₤1 = $1.50. What was the exchange rate between Swedish kronas and pounds? 8. You are the Vice President of International InfoXchange, headquartered in Chicago. All shareholders of the firm live in the US. Earlier this month, you obtained a loan of 5 million Canadian dollars for a bank in Toronto to finance the construction of a new plant in Montreal. At the time the loan was received, the exchange rate was 75 US cents to the Canadian dollar. By the end of the month, it has unexpectedly dropped to 70 cents. Has your company made a gain or loss as a result, and by how much? Consider only the immediate effect of the change in the rate of exchange. 9. Does interest rate parity imply that interest rates are the same in all countries? 10. Why might purchasing power parity fail to hold?