2. 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 tradeoff theory would suggest that firms should increase their use of debt.
3. Which of the following statements is CORRECT?
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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
c. A firm with 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 financing.
4. Companies HD and LD have identical amounts of assets, operating income (EBIT), tax rates, and business risk. Company HD, however, has a much 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.
5. 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. Drug companies (prescription, not illegal!) generally have high debt-to-equity ratios because
their earnings are very stable and, thus, they can cover the high interest costs associated with high debt levels.
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
e. Since most stocks sell at or very close to their book values, book value capital structures are
almost always adequate for use in estimating firms' costs of capital.
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.
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 liabilities are far more than sufficient to finance the additional assets needed.
e) If the ratios of assets to sales and spontaneous liabilities to sales do not remain constant, then the AFN equation will provide more accurate forecasts than the forecasted financial statements method.
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.
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?
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.
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 A0*/S0.
Which of the following assumptions is embodied in the AFN equation?
a) None of the firm's ratios will change.
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.
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.
Which of the following is NOT one of the steps taken in the financial planning process?
a) Forecast the funds that will be generated internally. If internal funds are insufficient to cover the required new investment, then identify sources from which the required external capital can be raised.
b) Monitor operations after implementing the plan to spot any deviations and then take corrective actions.
c) Determine the amount of capital that will be needed to support the plan.
d) Develop a set of forecasted financial statements under alternative versions of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios.
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.
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 switch to a just-in-time inventory system and outsourcing production.
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.
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?
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.
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, economies of scale exist, or if excess capacity exists.
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) Spontaneous funds are generally defined as follows: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 short-term or long-term borrowing and/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 immediate increases in accounts payable, accrued wages, and accrued taxes
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.
Based on the corporate valuation model, the value of a company s operations is $900 million. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stock s price per share?
Based on the corporate valuation model, the value of a company s operations is $1,200 million. The company s balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of the stock s price per share?
Which of the following is NOT normally regarded as being a barrier to hostile takeovers?
a) Abnormally high executive compensation.
b) Targeted share repurchases.
c) Shareholder rights provisions.
d) Restricted voting rights.
e) Poison pills.
Which of the following statements is NOT CORRECT?
a) The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends.
b) The corporate valuation model discounts free cash flows by the required return on equity.
c) The corporate valuation model can be used to find the value of a division.
d) An important step in applying the corporate valuation model is forecasting the firm s pro forma financial statements.
e) Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value.
Which of the following is NOT normally regarded as being a good reason to establish an ESOP?
a) To increase worker productivity.
b) To enable the firm to borrow at a below-market interest rate.
c) To make it easier to grant stock options to employees.
d) To help prevent a hostile takeover.
e) To help retain valued employees.
Suppose Leonard, Nixon, & Shull Corporation s projected free cash flow for next year is $100,000, and FCF is expected to grow at a constant rate of 6%. If the company s weighted average cost of capital is 11%, what is the value of its operations?
Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be -$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%, what is the firm s value of operations, in millions?
Based on the corporate valuation model, Bernile Inc. s value of operations is $750 million. Its balance sheet shows $50 million of short-term investments that are unrelated to operations, $100 million of accounts payable, $100 million of notes payable, $200 million of long-term debt, $40 million of common stock (par plus paid-in-capital), and $160 million of retained earnings. What is the best estimate for the firm s value of equity, in millions?
Akyol Corporation is undergoing a restructuring, and its free cash flows are expected to be unstable during the next few years. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5?
Which of the following does NOT always increase a company s market value?
a) Increasing the expected growth rate of sales.
b) Increasing the expected operating profitability (NOPAT/Sales).
c) Decreasing the capital requirements (Capital/Sales).
d) Decreasing the weighted average cost of capital.
e) Increasing the expected rate of return on invested capital.
Based on the corporate valuation model, Hunsader s value of operations is $300 million. The balance sheet shows $20 million of short-term investments that are unrelated to operations, $50 million of accounts payable, $90 million of notes payable, $30 million of long-term debt, $40 million of preferred stock, and $100 million of common equity. The company has 10 million shares of stock outstanding. What is the best estimate of the stock s price per share?
A company forecasts the free cash flows (in millions) shown below. The weighted average cost of capital is 13%, and the FCFs are expected to continue growing at a 5% rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and beyond, what is the Year 0 value of operations, in millions?
Year: 1 2 3
Free cash flow: -$15 $10 $40
forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5% thereafter. If the weighted average cost of capital is 10% and the cost of equity is 15%, what is the horizon value, in millions at t = 3?
Suppose Yon Sun Corporation s free cash flow during the just-ended year (t = 0) was $100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the weighted average cost of capital is 15%, what is the firm s value of operations, in millions?
Leak Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments).
Year: 1 2
Free cash flow: -$50 $100