BUS 302 Financial Management

Chapter 1. Overview of Financial Management

1. Explain the difference between real assets and financial assets.

2. Describe the three key cash-related activities of a firm.

3. How do sole proprietorships, general partnerships, limited liability companies,

S corporations, and C corporations differ?

4. Suppose three optometrists wished to form a business that was expected to last

until the oldest one was about to retire. The three had known each other since

college and were close friends who rusted one another. What type of firm might

be appropriate?

5. What is the primary goal of an enterprise?

Chapter 2. Sizing-up a Business

6. Describe the four stages of the business cycle.

7. How is a recession typically measured?

8. What are the four key components of gross domestic product?

9. What are the three goals of the Federal Reserve?

10. Describe Porter’s Five Forces that govern the competition within an industry.

Chapter 3. Understanding Financial Statements

11. Explain why equity is not the same as cash.

12. Why do we refer to depreciation and amortization as “noncash items”?

13. If a firm has goodwill on its balance sheet, what, if anything, does this imply about the firm’s previous acquisition activities?

14. Explain why a company may have deferred income taxes on its balance sheet.

15. Bigco’s balance sheet one year ago indicated retained earnings of $450 million. This year, Bigco’s net income was $35 million. It paid its preferred shareholders a dividend of $5 million and paid its common shareholders a regular dividend of $6 million, along with a special one-time dividend of $10 million. What should be the retained earnings amount on this year’s balance sheet? (3 points)

16. Jesters-R-Us, Inc. is a publicly traded company that has assets on its balance sheet of $125 million and liabilities of $75 million. The firm also has 4 million common shares that are currently trading for $21 per share. Estimate the firm’s market-to-book ratio.

17. Wholesale Lumber, Ltd. is a firm that distributes lumber to building supply and home improvement retail stores. The firm’s cost of sales for the most recent year was $45 million, its beginning inventory was $16 million, and its ending inventory was $18 million. Estimate Whole-sale Lumber’s purchases of lumber materials for the year.

18. Number One Retail, Inc. has a gross profit of $55 million, operating expenses of $22 million (which includes $6 million in depreciation and amortization), and interest expenses of $8 million. Its corporate tax rate is 35 percent. Calculate the firm’s earnings before interest, taxes, depreciation, and amortization (EBITDA).

19. Indicate whether each of the following is a source or use of cash:

a. An increase in accounts receivable:

b. A decrease in inventories

c. An increase in accounts payable

d. A decrease in a bank loan

e. An increase in retained earnings

20. Smallco has cash from operating activities of $220 million, cash from investing activities of ($93 million), cash from financing activities of ($107 million), and a beginning cash balance of $27 million. What will Smallco’s ending cash balance be?

Chapter 4. Measuring Financial Performance

21. Star Inc. has year 1 revenues of $80 million, net income of $9 million, assets of $65 million, and equity of $40 million, as well as year 2 revenues of $87 million, net income of $22 million, assets of $70 million, and equity of $50 million. Calculate

Star’s return on equity (ROE) for each year based on the DuPont method and compare it with a direct ROE measure. Next, explain why the firm’s ROE changed between year 1 and year 2.

22. Nextime Ltd. has operating profits (EBIT) of $87 million, a tax rate of 35 percent, net working capital of $129 million, and fixed assets of $285 million. Calculate Nextime’s return on invested capital, or ROIC. Then describe three methods by which a firm can increase its ROIC.

23. BE Enterprises has fixed costs of $50 million. Its gross margin percentage is 18 percent. What sales level must it achieve in order to break even?

24. Fixem Co. has revenue of $125 million, property and equipment of $42 million, and accumulated depreciation and amortization of $6 million. Estimate the fixed asset turnover ratio.

25. Wally Wholesale has revenue of $487,000, end-of-year receivables of $112,000, account payables of $70,000, and inventory of $91,000. Assume purchases equal cost of sales of $372,000. Estimate Wally Wholesale’s age of inventory, age of receivables, and age of payables.

26. Quick-E Inc.’s current assets consist of cash of $5 million, account receivables of $27 million, inventory of $37 million, and it has current liabilities of $48 million. Calculate Quick-E’s current ratio and quick ratio.

27. Deb Co. has interest-bearing debt of $122 million, non–interest-bearing debt of $33 million, and equity of $76 million. Calculate Deb Co.’s debt-to-assets, debt-to-equity, and long-term-debt-to-capital ratios.

28. IOU Inc. has EBIT of $58,000, depreciation and amortization of $12,000, interest expenses of $21,000, principal repayments of $17,000, and a tax rate of 35 percent. Calculate IOU Inc.’s interest coverage ratio and debt service coverage ratio.

29. Which financial statement presents information related to changes in retained earnings and share repurchase?

30. Using Home Depot’s 2011 balance sheets in Figure 3.2 and statements of earnings in Figure 3.3 in Chapter 3, set up the ratios presented below for Home Depot for 2011, indicating the numerator and denominator of each.

Performance Measure Numerator Denominator Measure

Return on Equity

Profit margin

Asset turnover

Financial leverage

Profitability Numerator Denominator Measure

Gross margin

EBIT margin

Operating expense ratio

ROIC

Resource management Numerator Denominator Measure

Fixed asset turnover

Age of inventory

Age of receivables

Age of payables

Liquidity Numerator Denominator Measure

Current ratio

Quick ratio

Leverage Numerator Denominator Measure

Debt to assets

Debt to equity

Long-term debt to capital

Interest coverage

Debt service coverage

Chapter 7. Time value of Money

31. Calculate the present value (PV) of (i) a cash inflow of $500 in one year and (ii) a cash inflow of $1,000 in five years, assuming a discount rate of 15 percent.

32. Calculate the present value (PV) of an annuity stream of five annual cash flows of $1,200, with the first cash flow received in one year, assuming a discount rate of 10 percent.

33. What is the present value of a perpetual stream of annual cash flows of $100, with the first cash flow to be received in one year, assuming a discount rate of 8 percent?

34. What is the present value of a perpetual stream of annual cash flows, with the first cash flow of $100 to be received in one year and with all subsequent cash flows growing at a rate of 3 percent, assuming a discount rate of 8 percent?

35. Consider two bonds, Bond A and Bond B, both with a coupon rate of 10 percent and a yield to maturity of 10 percent. These are standard bonds with semiannual coupon payments. Bond A matures in 5 years; Bond B matures in 10 years. What is the price of each bond?

36. Consider the bonds in question 5. Suppose interest rates decline, causing the yield to maturity for each bond to immediately decline to 9 percent. What is the new price of each bond? Which bond price is lower and why? (Hint: Consider the semiannual yield to maturity.)

37. Consider two bonds, Bond C and Bond D, both with a yield to maturity of 10 percent and with 5 years to maturity. These are standard bonds with semiannual coupon payments. Bond C has a coupon rate of 10 percent (with semiannual coupon payments); Bond D does not pay any coupons (i.e., it a zero-coupon bond). What is the price of each bond?

38. Consider the bonds in question 7. Suppose interest rates decline, causing the yield to maturity for each bond to immediately decline to 9 percent. What is the new price of each bond? (Hint: Consider the semiannual yield to maturity.)

39. Suppose a preferred share pays perpetual quarterly dividends of $1.00 and has a per annum dividend yield of 8 percent. What is the fair value of this preferred share?

40. What is the air value today of a common share with expected annual dividends of $1.00, $1.05, and $1.10 in each of the next three years and an expected share price of $20 in three years, assuming a required return of 9 percent?

41. What is the value of a common share with an expected perpetual stream of annual dividends, with the first dividend of $2.00 to be received in one year and with all subsequent dividends growing at a rate of 5 percent, assuming a required rate of return of 12 percent?

Chapter 8. Making Investment Decisions

42. What is the payback period of a project with average annual cash outflows of $8,000, average annual cash inflows of $10,000, and an initial investment of $13,000?

43. What is the net present value of a simple one-period project with an initial investment of $12,000 and an expected net cash flow in one year of $15,000, assuming a discount rate of 8 percent?

44. What is the internal rate of return for the project in question 13?

45. What is the profitability index for the project in question 13?

46. What is the highest discount rate at which the project would still be acceptable in question 13 (i.e., a zero NPV)?

47. What is the net present value of a project with a $40,000 initial investment and expected net cash flows of $15,000, $20,000, and $25,000 in each of the next three years, assuming an appropriate discount rate of 10 percent?

48. What is the internal rate of return for the project in question 17?

49. What is the profitability index for the project in question 17?

50. What is the modified internal rate of return for the project in question 17 if the finance rate is 10 percent and the reinvestment rate is 13 percent?

51. What is the equivalent annual cost of a piece of equipment that requires an initial investment of $50,000, is expected to last seven years, and requires

annual maintenance costs of $4,000 if the appropriate discount rate is 9 percent?

Chapter 10. Cost of Capital

52. Fastest Company’s common shares are currently trading for $30. It is expected that Fastest Company will pay an annual common share dividend of $2 next year. It is also expected that the dividend will grow at a rate of 5 percent each year in perpetuity. Based on the constant growth dividend discount model, what is Fastest Company’s cost of common equity?

53. How would your answer in question 17 change if the dividend was expected to be $1.80 and the perpetual growth of the dividend 4 percent?

54. Suppose the current long-term government bond yield is 2 percent and the estimated market risk premium is 5 percent. Fastest Company’s beta is estimated to be 1.15. Using CAPM, estimate Fastest Company’s cost of common equity.

55. Suppose Fastest Company’s current balance sheet showed book value weights of 32 percent debt, 11 percent preferred shares, and 57 percent common equity. Assuming its cost of debt was 3 percent, the cost of preferred shares was 5 percent, and the cost of common equity was 9 percent, estimate Fastest Company’s WACC (based on these book value weights).

Chapter 1. Overview of Financial Management

1. Explain the difference between real assets and financial assets.

2. Describe the three key cash-related activities of a firm.

3. How do sole proprietorships, general partnerships, limited liability companies,

S corporations, and C corporations differ?

4. Suppose three optometrists wished to form a business that was expected to last

until the oldest one was about to retire. The three had known each other since

college and were close friends who rusted one another. What type of firm might

be appropriate?

5. What is the primary goal of an enterprise?

Chapter 2. Sizing-up a Business

6. Describe the four stages of the business cycle.

7. How is a recession typically measured?

8. What are the four key components of gross domestic product?

9. What are the three goals of the Federal Reserve?

10. Describe Porter’s Five Forces that govern the competition within an industry.

Chapter 3. Understanding Financial Statements

11. Explain why equity is not the same as cash.

12. Why do we refer to depreciation and amortization as “noncash items”?

13. If a firm has goodwill on its balance sheet, what, if anything, does this imply about the firm’s previous acquisition activities?

14. Explain why a company may have deferred income taxes on its balance sheet.

15. Bigco’s balance sheet one year ago indicated retained earnings of $450 million. This year, Bigco’s net income was $35 million. It paid its preferred shareholders a dividend of $5 million and paid its common shareholders a regular dividend of $6 million, along with a special one-time dividend of $10 million. What should be the retained earnings amount on this year’s balance sheet? (3 points)

16. Jesters-R-Us, Inc. is a publicly traded company that has assets on its balance sheet of $125 million and liabilities of $75 million. The firm also has 4 million common shares that are currently trading for $21 per share. Estimate the firm’s market-to-book ratio.

17. Wholesale Lumber, Ltd. is a firm that distributes lumber to building supply and home improvement retail stores. The firm’s cost of sales for the most recent year was $45 million, its beginning inventory was $16 million, and its ending inventory was $18 million. Estimate Whole-sale Lumber’s purchases of lumber materials for the year.

18. Number One Retail, Inc. has a gross profit of $55 million, operating expenses of $22 million (which includes $6 million in depreciation and amortization), and interest expenses of $8 million. Its corporate tax rate is 35 percent. Calculate the firm’s earnings before interest, taxes, depreciation, and amortization (EBITDA).

19. Indicate whether each of the following is a source or use of cash:

a. An increase in accounts receivable:

b. A decrease in inventories

c. An increase in accounts payable

d. A decrease in a bank loan

e. An increase in retained earnings

20. Smallco has cash from operating activities of $220 million, cash from investing activities of ($93 million), cash from financing activities of ($107 million), and a beginning cash balance of $27 million. What will Smallco’s ending cash balance be?

Chapter 4. Measuring Financial Performance

21. Star Inc. has year 1 revenues of $80 million, net income of $9 million, assets of $65 million, and equity of $40 million, as well as year 2 revenues of $87 million, net income of $22 million, assets of $70 million, and equity of $50 million. Calculate

Star’s return on equity (ROE) for each year based on the DuPont method and compare it with a direct ROE measure. Next, explain why the firm’s ROE changed between year 1 and year 2.

22. Nextime Ltd. has operating profits (EBIT) of $87 million, a tax rate of 35 percent, net working capital of $129 million, and fixed assets of $285 million. Calculate Nextime’s return on invested capital, or ROIC. Then describe three methods by which a firm can increase its ROIC.

23. BE Enterprises has fixed costs of $50 million. Its gross margin percentage is 18 percent. What sales level must it achieve in order to break even?

24. Fixem Co. has revenue of $125 million, property and equipment of $42 million, and accumulated depreciation and amortization of $6 million. Estimate the fixed asset turnover ratio.

25. Wally Wholesale has revenue of $487,000, end-of-year receivables of $112,000, account payables of $70,000, and inventory of $91,000. Assume purchases equal cost of sales of $372,000. Estimate Wally Wholesale’s age of inventory, age of receivables, and age of payables.

26. Quick-E Inc.’s current assets consist of cash of $5 million, account receivables of $27 million, inventory of $37 million, and it has current liabilities of $48 million. Calculate Quick-E’s current ratio and quick ratio.

27. Deb Co. has interest-bearing debt of $122 million, non–interest-bearing debt of $33 million, and equity of $76 million. Calculate Deb Co.’s debt-to-assets, debt-to-equity, and long-term-debt-to-capital ratios.

28. IOU Inc. has EBIT of $58,000, depreciation and amortization of $12,000, interest expenses of $21,000, principal repayments of $17,000, and a tax rate of 35 percent. Calculate IOU Inc.’s interest coverage ratio and debt service coverage ratio.

29. Which financial statement presents information related to changes in retained earnings and share repurchase?

30. Using Home Depot’s 2011 balance sheets in Figure 3.2 and statements of earnings in Figure 3.3 in Chapter 3, set up the ratios presented below for Home Depot for 2011, indicating the numerator and denominator of each.

Performance Measure Numerator Denominator Measure

Return on Equity

Profit margin

Asset turnover

Financial leverage

Profitability Numerator Denominator Measure

Gross margin

EBIT margin

Operating expense ratio

ROIC

Resource management Numerator Denominator Measure

Fixed asset turnover

Age of inventory

Age of receivables

Age of payables

Liquidity Numerator Denominator Measure

Current ratio

Quick ratio

Leverage Numerator Denominator Measure

Debt to assets

Debt to equity

Long-term debt to capital

Interest coverage

Debt service coverage

Chapter 7. Time value of Money

31. Calculate the present value (PV) of (i) a cash inflow of $500 in one year and (ii) a cash inflow of $1,000 in five years, assuming a discount rate of 15 percent.

32. Calculate the present value (PV) of an annuity stream of five annual cash flows of $1,200, with the first cash flow received in one year, assuming a discount rate of 10 percent.

33. What is the present value of a perpetual stream of annual cash flows of $100, with the first cash flow to be received in one year, assuming a discount rate of 8 percent?

34. What is the present value of a perpetual stream of annual cash flows, with the first cash flow of $100 to be received in one year and with all subsequent cash flows growing at a rate of 3 percent, assuming a discount rate of 8 percent?

35. Consider two bonds, Bond A and Bond B, both with a coupon rate of 10 percent and a yield to maturity of 10 percent. These are standard bonds with semiannual coupon payments. Bond A matures in 5 years; Bond B matures in 10 years. What is the price of each bond?

36. Consider the bonds in question 5. Suppose interest rates decline, causing the yield to maturity for each bond to immediately decline to 9 percent. What is the new price of each bond? Which bond price is lower and why? (Hint: Consider the semiannual yield to maturity.)

37. Consider two bonds, Bond C and Bond D, both with a yield to maturity of 10 percent and with 5 years to maturity. These are standard bonds with semiannual coupon payments. Bond C has a coupon rate of 10 percent (with semiannual coupon payments); Bond D does not pay any coupons (i.e., it a zero-coupon bond). What is the price of each bond?

38. Consider the bonds in question 7. Suppose interest rates decline, causing the yield to maturity for each bond to immediately decline to 9 percent. What is the new price of each bond? (Hint: Consider the semiannual yield to maturity.)

39. Suppose a preferred share pays perpetual quarterly dividends of $1.00 and has a per annum dividend yield of 8 percent. What is the fair value of this preferred share?

40. What is the air value today of a common share with expected annual dividends of $1.00, $1.05, and $1.10 in each of the next three years and an expected share price of $20 in three years, assuming a required return of 9 percent?

41. What is the value of a common share with an expected perpetual stream of annual dividends, with the first dividend of $2.00 to be received in one year and with all subsequent dividends growing at a rate of 5 percent, assuming a required rate of return of 12 percent?

Chapter 8. Making Investment Decisions

42. What is the payback period of a project with average annual cash outflows of $8,000, average annual cash inflows of $10,000, and an initial investment of $13,000?

43. What is the net present value of a simple one-period project with an initial investment of $12,000 and an expected net cash flow in one year of $15,000, assuming a discount rate of 8 percent?

44. What is the internal rate of return for the project in question 13?

45. What is the profitability index for the project in question 13?

46. What is the highest discount rate at which the project would still be acceptable in question 13 (i.e., a zero NPV)?

47. What is the net present value of a project with a $40,000 initial investment and expected net cash flows of $15,000, $20,000, and $25,000 in each of the next three years, assuming an appropriate discount rate of 10 percent?

48. What is the internal rate of return for the project in question 17?

49. What is the profitability index for the project in question 17?

50. What is the modified internal rate of return for the project in question 17 if the finance rate is 10 percent and the reinvestment rate is 13 percent?

51. What is the equivalent annual cost of a piece of equipment that requires an initial investment of $50,000, is expected to last seven years, and requires

annual maintenance costs of $4,000 if the appropriate discount rate is 9 percent?

Chapter 10. Cost of Capital

52. Fastest Company’s common shares are currently trading for $30. It is expected that Fastest Company will pay an annual common share dividend of $2 next year. It is also expected that the dividend will grow at a rate of 5 percent each year in perpetuity. Based on the constant growth dividend discount model, what is Fastest Company’s cost of common equity?

53. How would your answer in question 17 change if the dividend was expected to be $1.80 and the perpetual growth of the dividend 4 percent?

54. Suppose the current long-term government bond yield is 2 percent and the estimated market risk premium is 5 percent. Fastest Company’s beta is estimated to be 1.15. Using CAPM, estimate Fastest Company’s cost of common equity.

55. Suppose Fastest Company’s current balance sheet showed book value weights of 32 percent debt, 11 percent preferred shares, and 57 percent common equity. Assuming its cost of debt was 3 percent, the cost of preferred shares was 5 percent, and the cost of common equity was 9 percent, estimate Fastest Company’s WACC (based on these book value weights).