FUNDAMENTALS OF CORPORATE FINANCE

1.     Suppose that you own 2,200 shares of Nocash Corp. and the company is about to pay a 25% stock dividend. The stock currently sells at $100 per share.

 

a. What will be the number of shares that you hold after the stock dividend is paid? (Do not round intermediate calculations.)

 

  Number of shares

 

b. What will be the total value of your equity position after the stock dividend is paid? (Do not round intermediate calculations.)

 

  Total value

 

c. What will be the number of shares that you hold if the firm splits five for four instead of paying the stock dividend?

 

  Number of shares hold

 

2.     Consolidated Pasta is currently expected to pay annual dividends of $10 a share in perpetuity on the 1.5 million shares that are outstanding. Shareholders require a 10% rate of return from Consolidated stock.

 

a. What is the price of Consolidated stock?

 

  Stock price

 

b. What is the total market value of its equity? (Enter your answer in millions.)

 

  Market value of equity million

 

Consolidated now decides to increase next year’s dividend to $20 a share, without changing its investment or borrowing plans. Thereafter the company will revert to its policy of distributing $10 million a year.

 

c. How much new equity capital will the company need to raise to finance the extra dividend payment? (Enter your answer in millions.)

 

  New equity million

 

d. What will be the total present value of dividends paid each year on the new shares that the company will need to issue? (Enter your answer in millions.)

 

  Present value million

 

e. What will be the transfer of value from the old shareholders to the new shareholders? (Enter your answer in millions.)

 

  Transfer of value million

 

f. Is this figure more than, less than, or the same as the extra dividend that the old shareholders will receive?
   
 
More than
Less than
The same

 

3.     The expected pretax return on three stocks is divided between dividends and capital gains in the following way:

 

Stock Expected Dividend Expected Capital Gain
A $  0  $ 6
B   1     1
C  24     0

 

a. If each stock is priced at $100, what are the expected net percentage returns on each stock to (i) a pension fund that does not pay taxes, (ii) a corporation paying tax at 35% (The effective tax rate on dividends received by corporations is 10.5%), and (iii) an individual with an effective tax rate of 15% on dividends and 10% on capital gains? (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

 

Stock   Pension   Investor Corporation   Individual
A % % %
B % % %
C % % %

 

b. Suppose that investors pay 50% tax on dividends and 20% tax on capital gains. If stocks are priced to yield an after-tax return of 8%, what would A, B, and C each sell for? Assume the expected dividend is a level perpetuity. (Do not round intermediate calculations. Round your answers to 2 decimal places.)

 

Stock      Price
A
B
C

 

 

4.     The following is the financial statement of Executive Fruit Company for the year ended December 2014.

 

INCOME STATEMENT, 2014
(Figures in $ Thousands)
  Revenue $ 5,500  
  Cost of goods sold   4,950  
 


 
  EBIT $ 550  
  Interest   110  
 


 
  Earnings before taxes $ 440  
  State and federal tax   176  
 


 
  Net income $ 264  
  Dividends   176  
 


 
  Additions to retained earnings $ 88  
 




 

 

BALANCE SHEET (Year-End, 2014)
(Figures in $ Thousands)
  Assets      
     Net working capital $ 550  
     Fixed assets   2,200  
 


 
     Total assets $ 2,750  
 




 
  Liabilities and shareholders’ equity      
     Long-term debt $ 1,100  
     Shareholders’ equity   1,650  
 


 
     Total liabilities and shareholders’ equity $ 2,750  
 




 

 

The following are the first stage and second stage pro forma financial statements of Executive Fruit Company for the year ended December 2015.
 
First stage pro forma statements:

 

PRO FORMA INCOME STATEMENT, 2015
(Figures in $ Thousands)
  Revenue $ 6,050  
  Cost of goods sold   5,445  
 


 
  EBIT $ 605  
  Interest   110  
 


 
  Earnings before taxes $ 495  
  State and federal tax   198  
 


 
  Net income $ 297  
  Dividends   198  
 


 
  Additions to retained earnings $ 99  
 




 

 

PRO FORMA BALANCE SHEET (Year-End, 2015)
(Figures in $ Thousands)
  Assets      
     Net working capital $ 605  
     Fixed assets   2,420  
 


 
     Total assets $ 3,025  
 




 
  Liabilities and shareholders’ equity      
     Long-term debt $ 1,100  
     Shareholders’ equity   1,749  
 


 
     Total liabilities and shareholders’ equity $ 2,849  
 




 
        Required external financing $ 176  
 




 

 

Second stage pro forma balance sheet:

 

PRO FORMA BALANCE SHEET (Year-End, 2015)
(Figures in $ Thousands)
  Assets      
     Net working capital $ 605  
     Fixed assets   2,420  
 


 
     Total assets $ 3,025  
 




 
  Liabilities and shareholders’ equity      
     Long-term debt $ 1,276  
     Shareholders’ equity   1,749  
 


 
     Total liabilities and shareholders’ equity $ 3,025  
 




 

 

How would Executive Fruit’s financial model change if the dividend payout ratio were cut to 1/3? Use the revised model to generate a new financial plan for 2015 assuming that debt is the balancing item. What would be the required external financing? (Do not round intermediate calculations.)

 

  Dividends fall by $ . Therefore, the requirement for external financing falls from $ to $ . On the other hand, shareholders’ equity will be increased by $ .  

 

The right-hand side of the balance sheet becomes (Do not round intermediate calculations. Enter your answers in thousands.):

 

   
  Long-term debt
  Shareholders’ equity
 

  Total
 

 

5.     Find the sustainable and internal growth rates for a firm with the following ratios: asset turnover = 2.00; profit margin = 4%; payout ratio = 35%; equity/assets = .30. (Do not round intermediate calculations. Enter your answers as a percent rounded to 2 decimal places.)

 

   
  Sustainable growth rate %
  Internal growth rate %

 

 

 

6.     Executive Fruit’s financial manager believes that sales in 2015 could rise by as much as 20% or by as little as 5%. Assets and costs change in proportion to sales, debt remains constant, and no new equity financing occurs.
 

 

a. Recalculate the first-stage pro forma financial statements under these two growth assumptions and calculate the required external financing (All figures are in thousands). (Enter your answers in thousands.)

 

  Base Case      20% Growth        5% Growth
INCOME STATEMENT            
  Revenue $ 6,000    
  Cost of goods sold   5,400    
 


 

 

  EBIT $ 600    
  Interest   120    
 


 

 

  Earnings before taxes $ 480    
  State and federal tax   192    
 


 

 

  Net income $ 288    
  Dividends   192    
 


 

 

  Retained earnings $ 96    
 




 


 


             
BALANCE SHEET            
  Assets            
     Net working capital $ 600    
     Fixed assets   2,400    
 


 

 

     Total assets $ 3,000    
 




 


 


  Liabilities and shareholders’ equity            
     Long-term debt $ 1,200    
     Shareholders’ equity   1,800    
 


 

 

     Total liabilities and shareholders’ equity $ 3,000    
 




 


 


  Required external financing        

 

b. Assume any required external funds will be raised by issuing long-term debt and that any surplus funds will be used to retire such debt. Prepare the completed (second-stage) pro forma balance sheet. (Enter your answers in thousands.)

 

BALANCE SHEET
  Base Case 20% Growth   5% Growth
  Assets            
     Net working capital $ 600    
     Fixed assets   2,400    
 


 

 

     Total assets $ 3,000    
 




 


 


  Liabilities and shareholders’ equity            
     Long-term debt $ 1,200    
     Shareholders’ equity   1,800    
 


 

 

     Total liabilities and shareholders’ equity $ 3,000    
 

 

 

7.     Plank’s Plants had net income of $4,000 on sales of $70,000 last year. The firm paid a dividend of $1,480. Total assets were $200,000, of which $80,000 was financed by debt.

 

a. What is the firm’s sustainable growth rate? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.)

 

  Sustainable growth rate %

 

b. If the firm grows at its sustainable growth rate, how much debt will be issued next year? (Do not round intermediate calculations.)

 

  New debt

 

c. What would be the maximum possible growth rate if the firm did not issue any debt next year? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

 

 

8.     An all-equity-financed firm plans to grow at an annual rate of at least 24%. Its return on equity is 37%. What is the maximum possible dividend payout rate the firm can maintain without resorting to additional equity issues? (Do not round intermediate calculations. Enter your answer as a percent rounded to 1 decimal place.)

 

  Maximum dividend payout ratio %

 

 

9.     The 2015 financial statements for Growth Industries are presented below:

 

INCOME STATEMENT, 2015
  Sales   $ 270,000
  Costs     185,000
   


  EBIT   $ 85,000
  Interest expense     17,000
   


  Taxable income   $ 68,000
  Taxes (at 35%)     23,800
   


  Net income   $ 44,200
   




    Dividends $ 17,680    
    Addition to retained earnings 26,520    

 

BALANCE SHEET, YEAR-END, 2015
Assets     Liabilities    
  Current assets       Current liabilities    
    Cash $ 3,000     Accounts payable $ 10,000
       


    Accounts receivable   8,000     Total current liabilities $ 10,000
    Inventories   29,000   Long-term debt   170,000
 


     
      Total current assets $ 40,000   Stockholders’ equity    
  Net plant and equipment   210,000     Common stock plus additional paid-in capital   15,000
          Retained earnings   55,000
 


 


  Total assets $ 250,000   Total liabilities and stockholders’ equity $ 250,000
 




 





 

Sales and costs in 2016 are projected to be 30% higher than in 2015. Both current assets and accounts payable are projected to rise in proportion to sales. The fixed assets of Growth Industries are operating at only 75% of capacity. Interest expense in 2016 will

equal 10% of long-term debt outstanding at the start of the year. The firm will maintain a dividend payout ratio of .40.

 

What is the required external financing over the next year?

 

  Even if sales increase by 30%, the firm still has more than enough fixed assets to meet production. Only working capital will increase. Net working capital of the firm in 2015 was $. The increase in net working capital will be $, which is less than the increase in the retained earnings. Thus required external financing is $. A negative external financing value indicates the firm will generate more cash than it needs to finance the projected growth. This extra cash can be used to reduce debt, repurchase shares, increase cash reserves, or fund future growth. This extra cash was primarily due to the firm’s excess production capacity.

 

 

     
  Income statement data:    
     Sales $ 6,000
     Cost of goods sold   5,200
  Balance sheet data:    
     Inventory $ 590
     Accounts receivable   210
     Accounts payable   370

 

10.

Calculate the accounts receivable period, accounts payable period, inventory period, and cash conversion cycle for the above firm: (Use 365 days in a year. Do not round intermediate calculations. Round your answers to 1 decimal place.)

 

     
  a.   Accounts receivable period days
  b.   Accounts payable period days
  c.   Inventory period days
  d.   Cash conversion cycle days

 

 

11.  Complete the statement of sources and uses of cash from the following entries:

 

   
  Net income $2,000
  Dividends 800
  Additions to inventory 170
  Additions to receivables 200
  Depreciation 140
  Reduction in payables 600
  Net issuance of long-term debt 350
  Sale of fixed assets 110

 

   
  Sources  
     Issued long-term debt
     Sale of fixed assets
     Cash from operations:  
         Net income
         Depreciation
 

     Total sources
 


  Uses  
     Additions to inventory
     Increase in accounts receivable
     Decrease in accounts payable
     Payment of dividends
 

     Total uses

 

 

12.  Here is a forecast of sales by National Bromide for the first 4 months of 2015 (figures in thousands of dollars):
 

 

Month:  1  2   3   4
  Cash sales   26     35     29     25  
  Credit sales   155     175     145     125  

 

 

On average, 60% of credit sales are paid for in the current month, 20% in the next month, and the remainder in the month after that. What are the expected cash collections in months 3 and 4? (Enter your answers in whole dollars.)

 

  Expected cash collections
  Month 3
  Month 4

 

 

13.  A firm sells its $1,090,000 receivables to a factor for $1,079,100. The average collection period is 1 month. What is the effective annual rate on this arrangement? (Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

 

  Effective annual rate %

 

 

14.  Company X sells on a 1/10, net 60, basis. Customer Y buys goods with an invoice of $2,000.

 

a. How much can company Y deduct from the bill if it pays on day 10?

 

  Discount

 

b. How many extra days of credit can company Y receive if it passes up the cash discount?

 

  Number of days days

 

c. What is the effective annual rate of interest if Y pays on the due date rather than day 10? (Use 365 days in a year. Do not round intermediate calculations. Enter your answer as a percent rounded to 2 decimal places.)

 

  Effective annual rate %

 

 

15.  Microbiotics currently sells all of its frozen dinners cash on delivery but believes it can increase sales by offering supermarkets 1 month of free credit. The price per carton is $80, and the cost per carton is $55. The unit sales will increase from 1,030 cartons to 1,090 per month if credit is granted. Assume all customers pay their bills and take full advantage of any credit period offered.

 

a. If the interest rate is 1% per month, what will be the change in the firm’s total monthly profits on a present value basis if credit is offered to all customers? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

 

  Change in total monthly profit $ 

 

b. If the interest rate is 1.5% per month, what will be the change in the firm’s total monthly profits on a present value basis if credit is offered to all customers? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

 

  Change in total monthly profit $ 

 

c. Assume the interest rate is 1.5% per month but the firm can offer the credit only as a special deal to new customers, while existing customers will continue to pay cash on delivery. What will be the change in the firm’s total monthly profits on a present value basis under these conditions? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

 

16.  On each nondelinquent sale Cast Iron receives revenues with a present value of $1,280 and incurs costs with a present value of $1,130. Assume there is no possibility of repeat orders and that the probability of successful collection from the customer is p = .97.

 

a-1. What is the expected profit of granting credit? (A negative amount should be indicated by a minus sign. Do not round intermediate calculations. Round your answer to 2 decimal places.)

 

  Expected profit per sale

 

a-2. Should Cast Iron grant or refuse credit?
   
 
Grant
Refuse

 

b. What is the break-even probability of collection? (Enter your answer as a percent rounded to 1 decimal place.)

 

  Break-even probability %

 

 

17.  Anne Teak, the financial manager of a furniture manufacturer, is considering operating a lock-box system. She forecasts that 450 payments a day will be made to lock boxes with an average payment size of $3,000. The bank’s charge for operating the lock boxes is $.50 a check. The interest rate is .012% per day.

 

a-1. If the lock box makes the cash available 2 days earlier, calculate the net daily advantage of the system. (Do not round intermediate calculations.)

 

  Daily interest saved

 

a-2. Is it worthwhile to adopt the system?
   
 
Yes
No

 

b. What minimum reduction in the time to collect and process each check is needed to justify use of the lock-box system? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

 

  Minimum reduction in time days

 

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