BEC 2 - Financial Management

Question 1

what is the formula for the zero growth model?

Answer 1

Stock Price = Dividend Amount divided by the discount rate

Question 2

Current stock price is $15 per share while EPS is $3; the PEG ratio is 1.25. What is the projected growth rate?

Answer 2

PEG Ratio = ((Stock Price / EPS) / (Growth * 100))

1.25 = (($15 / $3) / (G * 100))

1.25 = $5/ (G*100)
G *125 = $5
G = 4%

Question 3

What is the free cash flow formula?

Answer 3

= NI + Noncash Expenses - Increase in WC - Capital Expenditures

Question 4

The NPV of the proposed investment is negative, therefore, the discount rate used is:

greater or less than the project’s internal rate of return

Answer 4

the discount rate is greater than the project’s internal rate of return

Question 5

What is the EOQ formula?

Answer 5

EOQ = square root of (2OD/C)

The EOQ model determines the order quantity that minimizes the sum of ordering costs and carrying costs. It is calculated using the following formula if O is the cost per order, D is the periodic unit demand, and c is the periodic carrying cost.

Question 6

Cost of C/S equity for ABC Co. is 8.4%, cost of P/S equity is 6.8%, average weighted interest rate on debt is 6%. The market value % of each component of the capital structure are 55% C/S, 20% P/S, and 25% Debt. Corporate tax rate is 30%.

Answer 6

1. cost of debt after tax = interest rate x (1 - tax rate); = 6% x 30%; = 4.2%
2. WACC = (8.4% x 55%) + (6.8% x 20%) + (4.2% x 25%) = 7.03%

Question 7

P/S component of WACC is 10%, $100 par value P/S that was issued at par value with a flotation cost of $5 per share. Compute the cost of P/S.

Answer 7

1. P/S dividend = dividend % times par value = 10% x 100 = $10
2. Cost of preferred stock = dividend / net proceeds

= $10/$95

= 10.53%

Question 8

Firm’s beta is 1.25, the risk free rate is 8.75%, and the market rate of return is 14.25%. Compute the cost of retained earnings using the Capital Asset Pricing Model (CAPM).

Answer 8

Cost of R/E = [Beta x (Market return - risk-free rate)]

=0.0875 + [1.25 x (0.1425 - 0.0875)]

=0.0875 + 0.0688

=15.63%

Question 9

Assume that a firm is a constant growth firm that just paid an annual C/S dividend of $2, has a dividend growth of 7.5%, and a current market price for C/S of $25.25 per share.

Compute the cost of R/E using the discounted cash flow method.

Answer 9

1. compute the dividend per share expected at the end of the year:
   Future Dividend = current dividend x (1 + dividend growth rate)
   = $2 x (1 + 0.075)
   = $2.15
2. Cost of R/E using the DCF method

= (future dividend / current stock price) + dividend growth rate
= ($2.15 / $25.25) + 0.075
= 0.0851 + 0.075
= 16.01%

Question 10

Assume that a firm has a estimated its market risk premium at 4.5% and has determined that the yield on its own bonds is 11.34%.

Compute the cost of R/E using the bond yield plus risk premium (BYRP) method

Answer 10

Cost of R/E = firms own bond yield + market risk premium

= 0.1134 + 0.045
=15.84%

Question 11

The cost of R/E under:

CAPM method: 15.63%
DCF method: 16.01%
BYRP method: 15.84%

Compute the average cost of capital

Answer 11

=(CAPM + DCF + BYRP) / 3
=(15.63% + 16.01% + 15.84%) / 3

Question 12

A company calculates return on assets of 7.5% in the current year and follows a policy of paying out 40% of all earnings as dividends.

Calculate the company’s expected growth rate.

Answer 12

growth rate = (Return on assets x Retention) / [1 - (Return on Assets x Retention)]

= (7.5% x 60%) / [1 - (7.5% x 60%)]

**if 40% of all earnings are paid out as dividends, then 60% are retained by the company

Question 13

What is operating leverage?

Answer 13

the degree to which a company uses fixed operating costs rather than variable operating costs

Question 14

What is financial leverage?

Answer 14

the degree to which a company uses debt rather than equity to finance the company

Question 15

What is the difference between a levered firm vs an unlevered firm?

Answer 15

a levered firm is a company that has debt in its capital structure, whereas an unlevered firm has only equity (no debt) in its capital structure

Question 16

The value of a company with no debt in its capital structure is $130M. The company has recently issued $25M in debt at an interest rate of 5.75%.

Assuming that the corporate tax rate is 30%, calculate the value of the levered firm.

Answer 16

1. value of levered firm = value of an unlevered firm + present value of the interest tax savings
2. PV of the interest tax savings = [Corporate tax rate x (int rate x debt amount)] / interest rate

= [30% x (0.0575 x $25M)] / 0.0575
= $7.5M

3. $130M + $7.5M = $137.5M

Question 17

What is the formula for debt ratio?

Answer 17

= total liabilities / total assets

Question 18

What is the formula for equity multipler?

Answer 18

= total assets / total equity

Question 19

What is the working capital turnover formula?

Answer 19

= Sales / average working capital

Question 20

Six months ago Duffy Inc purchased inventory for $55 per unit. The current replacement costs is $48 per unit, while the net selling price less costs to complete (NRV) is $51 and the normal profit margin is $5.

Determine the value of the inventory on the balance sheet if the inventory is costed using LIFO and FIFO

Answer 20

Under LIFO, the inventory is valued at the lower of cost or market

Cost - $55
Market - $48

Market is the median value of the replacement costs ($48), market ceiling ($51), and market floor ($46 = $51 - $5)

The value of the inventory per unit on the balance sheet will be $48

Under FIFO, the inventory is valued at the lower of costs and NRV

Cost - $55
NRV - $51

The value of the inventory per unit on the balance sheet will be $51

Question 21

Worldwide Widgets sells 8,000 widgets per year, manufactures widgets in groups of 1,500, and requires five weeks of lead time for widget production. Worldwide also maintains an absolute minimum safety stock of 1,200 widgets.

Assuming a 50 week year and constant demand, compute the Worldwide’s reorder point for widgets

Answer 21

1. Worldwide sells an average of 160 widgets per week (8,000 widgets per year/50 weeks)
2. reorder point = safety stock + (lead time x sales during lead time)

1,200 widgets + (5 weeks x 160 widgets per week) = 2,000 widgets

Question 22

Maximus Company incurs carrying costs of $50 a month and each order costs the firm $5,625.

Calculate Maximus’ economic quantity if Maximus goes through 100 units of inventory monthly?

Answer 22

EOQ = square root of (2OD/C)

= square root of [(2 x 100 x $5,625) / $50]

= 150 units

Question 23

What is Economic Order Quantity?

Answer 23

when managing inventory, there is a trade off between carrying costs and ordering costs. EOQ attempts to minimize total ordering and carrying costs

EOQ does not consider stock out costs, nor does it account for costs of safety cost. also assumes that carrying costs per unit and ordering costs per unit are fixed

Question 24

Terranova Company’s main vendor offers a quick payment discount of 1/10, net 30 to its customers

Assuming a 360 day a year, calculate the annual cost to Terranova of not taking advantage of the discount?

Answer 24

APR of quick payment discount = [360 / (Pay period - Discount period)] x [Discount % / 100% - Discount %)]

= [360 / (30 - 10)] x [1% / (100% - 1%)]
= (360 / 20) x 1% / 99%
= 18.2%

Question 25

Radon Technologies enters into an agreement with a firm that will factor the company’s accounts receivable. The factor agrees to buy the company’s receivables, which average $50K a month, and have an average collection period of 30 days. The factor will advance up to 80% of the face value of receivables at an annual rate of 12 percent and a charge fee of 2 percent on all receivables purchased. The controller of the company estimates that the company would save $10K in collection expenses over the year. Fees and interest are no deducted in advance. Assuming a 360 day year, what is the annual cost of financing.

Assuming a 360 day year, compute the annual cost of financing?

Answer 25

1. AR is $50K x 2% x (360/30) = $12K
2. AR subject to Interest = $40K x (12%/12) x (360/30) = $4.8K
3. Total cost of company = $16.8K
4. Net Cost = $16.8K - $10K (collection expense estimate)

Question 26

Baker corporation pays an constant annual dividend per share of $5 per year. Able wants to invest in baker and earn a 20% return.

Calculate the value of Baker’s stock.

Answer 26

P = D/R
P = $5 / 20%
P = $25

Able should pay $25 for a share of Baker

**this formula is used for a zero growth stock.

Question 27

Baker Corporation pays a current dividend per share of $5 per year and is projected to grow at 4% per year. Able wants to invest in Baker and earn a 20% rate.

Calculate the value of Baker’s stock today.

Answer 27

P = Dividend (t+1) / (Return Rate - Growth rate)

Dividend (t+1) = $5 x (1 + 4%)
= $5.20

= $5.20 / (20% - 4%)
= $32.50

Question 28

Baker Corporation pays a current dividend per share of $5 per year and is projected to grow at 4% per year. Able wants to invest in Baker and earn a 20% return

Calculate the value of Baker’s stock three years from today

Answer 28

P = Dividend (t+1) / (Return Rate - Growth rate)

Dividend (t+1) = [$5 x (1 + 4%)/^4
= $5.85

= $5.85 / (20% - 4%)
= $36.56

**in order to value Baker in three years, the dividend to be paid in the 4th year is required.

Question 29

Assume that Baker has current year earnings per share of $1.50 and anticipates earnings per share in the coming of $2.

If the P/E ratio is 7.5x calculate the expected value of Baker’s shares

Answer 29

P = (P/E) x Expected Dividend
P = 7.5 x $2

Question 30

Baker wants to use PEG ratio to estimate the price of its stock. The company’s PEG ratio is 2.5x and its current earnings per share is $5. The growth rate is anticipated to be 4%.

Calculate the current price of Baker’s stock?

Answer 30

Expected dividend is $5 x (1 + 4%) = $5.2

Stock Price = PEG x Expected Dividend x Growth rate

Stock Price = 2.5 x $5.20 x 4

Question 31

An analyst assembles the following financial and market data for Bolden Corporation’s most recent year end. The analyst projects that the firm’s operating cash flow will increase 20% in the upcoming year.

C/S stock price = $18
C/S shares O/S - 10M

Total Assets - $250M
Total Liabilities - $110M
Preferred Stock - $20M
Common Stock - $25M
APIC - $45M
R/E - $50M
Total SHE - $140M
CF from Ops - $25M

Calculate the P/B and P/CF Multiples:

Answer 31

The P/B multiple for Bolden Corporation’s current year is derived as follows:

1. Determine BV of Common Equity = $25M C/S + $45M APIC + $50M = $120M
2. Demine the book of common equity per share = $120M / 10M = $12 per share
3. Calculate P/B multiple = $18 / $12 = 1.5

The P/CF multiple for Bolden Corporation’s current year is derived as follows:

1. Determine the firm’s expected cash flow per share = $25M x 1.2 = $30M
   then $30M / 10M shares = $3 per share
2. Calculate P/CF Multiple = $18 / $3 = 6.0

Question 32

A $1,000 face value bond maturing in three years pays annual interest of 4%.

Calculate the bond’s price if the market rate at the time of issuance is 5%

Answer 32

Year 1 PMT = 40/ $1.05 = $38.10
Year 2 PMT = 40/($1.05^2) = $36.28
Year 3 PMT = (1000+40) / $1.05^3 = $898.39

add all three to determine the bond price

Question 33

If a bond pays a lower coupon rate than market rate then it will be issued at…

Answer 33

a discount to par

Question 34

What is the profitability index?

Answer 34

is the ratio of PV of net future cash flows to the present value of the net initial investment.

= PV of Cash flows / cost (PV) of initial investment

Question 35

What are the three elements needed to estimate the cost of equity?

Answer 35

1. current dividends per share
2. Expected growth rate in dividends
3. current market price per share of common stock

Question 36

Management would like to calculate return on investment (ROI) for the current year. The following information is available:

Operating assets at the end of the year - $6,600,000
Operating assets at the beginning of the year - 5,400,000
Sales - 1,150,000
Operating expenses - 550,000

What percentage amount is the ROI?
A. 11%
B. 10%
C. 9%
D. 19%

Answer 36

B.10%

Return on investment can be calculated as follows:
ROI = Operating income ÷ Average invested capital
= ($1,150,000 – $550,000) ÷ [($5,400,000 + $6,600,000) ÷ 2]
= $600,000 ÷ $6,000,000
= 10%

Question 37

What cash flow does the payback period consider and what is the formula?

Answer 37

the annual net after tax cash flow

net initial investment / increase in annual net after tax cash flow

Question 38

Is the discount rate required for the Black Scholes model?

Answer 38

no it isnt; The Black-Scholes method requires the following inputs: exercise price, price of the underlying, applicable interest rates, and the time until expiration

Question 39

Which of the following assumptions applies to the basic theory underlying the Black-Scholes option-pricing model?

A. There are no transaction costs for buying or selling the stock or option.
B. The call option can be exercised at any time before its expiration date.
C. Purchasers of the underlying securities cannot borrow any of the proceeds used to buy the securities.
D. The stock underlying the call option pays dividends during the life of the option.

Answer 39

A. There are no transaction costs for buying or selling the stock or option.

The absence of transaction costs is an assumption of the Black-Scholes model. Investors can adjust their positions continuously and without cost. Another assumption is that the price of the underlying asset essentially follows a random walk. That is, the successive changes in price are independent (uncorrelated and without pattern). Moreover, the model assumes the risk-free interest rate is known, and the underlying asset pays no dividends.

Question 40

The common stock of a company is currently selling at $80 per share. The leadership of the company intends to pay a $4 per share dividend next year. With the expectation that the dividend will grow at 5% perpetually, what will the market’s required return on investment be for the common stock?

A. 7.5%
B. 5.25%
C. 5%
D. 10%

Answer 40

D. 10%

The dividend growth model estimates the cost of retained earnings using the dividends per share, the market price, and the expected growth rate. The current dividend yield is 5% ($4 ÷ $80). Adding the growth rate of 5% to the yield of 5% results in a required return of 10%.

Question 41

In the current year, Company A has a degree of total leverage (DTL) of 8 and a degree of financial leverage (DFL) of 2. If sales in dollars are twice that of the previous year, what is the percentage change in EBIT in the current year?

A. 200%
B. 400%
C. 800%
D. 100%

Answer 41

B. 400%

The DTL (8) is the product of the degree of operating leverage (DOL) and the DFL (2). The DOL therefore is 4 (8 ÷ 2). The DOL is the ratio that measures the effect that given fixed operating costs have on earnings. It equals the percentage change in earnings before interest and taxes (EBIT) divided by the percentage change in sales. Thus, the percentage change in EBIT in the current year is 400% (DOL of 4 × 100% change in sales).

Question 42

A corporation just paid a dividend of $2.00 per common share. Historical data indicate that dividends grow at a steady rate of 5% per year. The required rate of return for investing in such stock is 18%. The current value of one share of common stock is

A. $15.38
B. $16.15
C. $11.67
D. $11.11

Answer 42

B. $16.15
.
The dividend discount model (also known as the dividend growth model) is a method of arriving at the value of a stock by using expected dividends per share and discounting them back to present value. The next dividend is calculated as $2.10 [$2.00 dividend × (1 + .05 growth rate)]. Thus, the current value of one share of common stock is calculated as $16.15 [$2.10 next dividend ÷ (18% cost of capital – 5% dividend growth rate)].

Question 43

The economic order quantity (EOQ) model is a mathematical tool for determining the order quantity that minimizes the sum of ordering costs and carrying costs. The following assumptions underlie the EOQ model:

Answer 43

(1) demand is uniform, (2) order (setup) costs and carrying costs are constant, and (3) no quantity discounts are allowed

Question 44

What is the effective interest rate on a discounted loan?

Answer 44

Effective rate = Stated rate ÷ (1.0 – Stated rate)

Question 45

What is the cost of the two alternatives below:

3. Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every 6 months.)
4. Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.

Answer 45

3. Issue $110,000 of 6-month commercial paper to net $100,000. (New paper would be issued every 6 months.)

20.0%

By issuing commercial paper, the company will receive $100,000 and repay $110,000 every 6 months. Thus, for the use of $100,000 in funds, the company pays $10,000 in interest each 6-month period, or a total of $20,000 per year. The annual percentage rate can therefore be calculated as follows:
Effective rate=Interest expense ÷ Usable funds
=$20,000 ÷ $100,000
=20.0%

4. Borrow $125,000 from a bank on a discount basis at 20%. No compensating balance would be required.

25.0%

The company will receive $100,000 ($125,000 × 80%) at an annual cost of $25,000 ($125,000 – $100,000). The effective interest rate on this loan can thus be calculated as follows:

Question 46

PV Corp is evaluating an investment with an annual $150,000 pretax cash inflow for the next five years. The project will require additional working capital of $35,000. The tax rate is 35% and the anticipated additional depreciation for the project is $50,000. The company’s hurdle rate is 8% and the related annuity and present value of $1 factors are:

PV of annuity at 8% for 5 years 3.9927
PV of $1 at 8% for 5 years 0.6806

What would ABC compute the first annual after tax cash flows ?

Answer 46

$115,000. Pretax cash flow $150K x 65% AND additional depreciation $50K x 35%

Question 47

What are circumstances that create Exchange Rate Fluctuations:

Answer 47

1. Trade Factors - inflation rates, income levels, government controls
2. Financial Factors - interest rates and capital flows

Question 48

What is the impact of the following?

1. increased US capital Invesment in a foreign economy?
2. Foreign currency inflation and US dollar constant?
3. declining domestic income?
4. low foreign interest rates?

Answer 48

1. this would likely cause the exchange rate for the US dollar to deteriorate
2. this would reduce the buying power of the foreign currency, thereby increasing the value of the US dollar
3. will reduce the amount of domestic currency spent. reduced demand for foreign currency from a declining pool of domestic currency will effectively strengthen the domestic currency and improve exchange rates
4. this will reduce incentives for foreign investments. the less demand for foreign currency, the stronger the domestic currency exchange rates improve.

Question 49

If the $1 = 1 Euro, what is the following impact if receiving Euro?

1. if the US $ appreciates to $0.75 = $1 Euro
2. If the US $ depreciates to $1.25 = $1 Euro

Answer 49

1. if the company is receiving Euros, it will result in a loss; if the company is paying Euros, it will result in a gain
2. if a company is receiving Euros, it will result in a gain; if the company is paying Euros, it will result in a loss

Question 50

Company A has a $100 Euro receivable. The US $ appreciates from $1 = Euro $1 to $0.75 = $1 Euro. is this a gain or loss?

Answer 50

Company A would realize a loss on the receivable as the Euro depreciated.

Question 51

Company A has a $100 Euro payable. The US $ appreciates from $1 = Euro $1 to $0.75 = $1 Euro. is this a gain or loss?

Answer 51

Company A would realize a gain on the receivable as the Euro depreciated.

Question 52

Company A has a $100 Euro receivable. The US $ depreciates from $1 = Euro $1 to $1.25 = $1 Euro. is this a gain or loss?

Answer 52

Company A would realize a gain on the receivable as the Euro appreicated

Question 53

Company A has a $100 Euro payable. The US $ depreciations from $1 = Euro $1 to $1.25 = $1 Euro. is this a gain or loss?

Answer 53

Company A would realize a loss on the payable as the Euro depreciated

Question 54

What the difference between a futures hedge and a forwards hedge?

Answer 54

Futures hedge - entitle the holder to either purchase or sell a number of currency units for a negotiated price on a stated basis. Future hedges are used for smaller amounts

Forward hedge - similar to a futures hedge but the owner of the contract is entitled to buy or sell volumes of currency at a point in time. Forward contracts identify groups of transactions for larger amounts

Question 55

Rice, Inc., uses the allowance method to account for uncollectible accounts. An account receivable that was previously determined uncollectible and written off was collected during May. The effect of the collection on Rice’s current ratio and total working capital is

Answer 55

no impact on either;

Answer (A) is correct.
The entry to record this transaction is to debit receivables, credit the allowance for credit losses, debit cash, and credit receivables. The result is to increase both an asset (cash) and a contra asset (allowance for credit losses, formerly bad debts). These appear in the current asset section of the balance sheet. Thus, the collection changes neither the current ratio nor working capital because the effects are offsetting. The credit for the journal entry is made to the allowance account on the assumption that another account will become uncollectible. The firm had previously estimated its bad debts and established an appropriate allowance for credit losses. It then (presumably) wrote off the wrong account. Accordingly, the journal entry reinstates a balance in the allowance account to absorb future uncollectibles.

Question 56

Bond has a coupon rate of 10% and an effective interest rate of 15%. Tax rate is 40%. What is the firms cost of debt?

Answer 56

EFFECTIVE RATE (1 - tax) =

15% x 60% = 9%

Question 57

What working capital financing policy that subjects the firm to greatest risk of being unable to meet the firms maturing obligations is a policy that?

1. Fluctuating current assets with long term debt
2. Permanent current assets with short term debt
3. Fluctuating current assets with short term debt

Answer 57

2. Permanent current assets with short term debt

Question 58

A company is seeking to establish better controls over its cash receipts. As part of its strategy, the company establishes a single bank as its central repository, what is this called?

Answer 58

concentration banking

Question 59

If a new machine costs $200 and requires an immediate increase in working capital of $25, what is the initial cash outflow?

Answer 59

$225

Question 60

What is the accounting rate of return for capital budgeting?

Answer 60

The accounting rate of return is a capital budgeting technique that ignores the time value of money. It is calculated by dividing the increase in average annual accounting net income by the required investment. Thus, both an average of annual revenues over the life of the project and annual expenses are relevant.

Question 61

A multiperiod project has a positive net present value. Which of the following statements is correct regarding its required rate of return?

A. Greater than the company’s weighted average cost of capital.
B. Greater than the project’s internal rate of return.
C. Less than the project’s internal rate of return.
D. Less than the company’s weighted average cost of capital.

Answer 61

C. Less than the project’s internal rate of return.

A project’s internal rate of return is the discount rate at which its net present value is zero. Thus, a discount rate (required rate of return) at which the net present value is positive is lower than the internal rate of return.

Question 62

A company has just borrowed $2 million from a bank. The stated rate of interest is 10%. If the loan is discounted and is repayable in 1 year, the effective rate on the loan is approximately

A. 11.11%
B. 8.89%
C. 10.00%
D. 9.09%

Answer 62

A. 11.11%
Answer (A) is correct.
The effective interest rate on a discounted loan can be calculated as follows:

Effective rate = Stated rate ÷ (1.0 – Stated rate)
=10% ÷ (100% – 10%)
=10% ÷ 90%
=11.11%

Note that the amount of the loan is not needed to calculate the effective rate.