Ch 3 Higgins
1.Which of the following statements is correct if a firm’s pro forma financial statements project net income of $12,000 and external financing
required of $5,000
A. Total assets cannot grow by more than $10,000.
B. Dividends cannot exceed $10,000.
C. Retained earnings cannot grow by more than $12,000.
D. Long-term debt cannot grow by more than $5,000
2. You are preparing pro forma financial statements for 2014 using the percent-of-sales method. Sales were $100,000 in 2013 and are projected
to be $120,000 in 2014. Net income was $5,000 in 2013 and is projected to be $6,000 in 2014. Equity was $45,000 at year-end 2012 and
$50,000 at year-end 2013. Assuming that this company never issues new equity, never repurchases equity, and never changes its dividend
payout ratio, what would be projected for equity at year-end 2014?
A. $55,000
B. $56,000
C. $60,000
D. Insufficient information is provided to project equity in 2014.
3.On May 1, Vaya Corp. had a beginning cash balance of $175. Vaya’s sales for April were $430 and May sales were $480. During May, the firm
had cash expenses of $110 and made payments on accounts payable of $290. Vaya’s accounts receivable period is 30 days. What is the firm’s
beginning cash balance on June 1?
A. $145
B. $155
C. $205
D. $215
E. $265
4.Ruff Wear expects sales of $560, $650, $670, and $610 for the months of May through August, respectively. The firm collects 20 percent of
sales in the month of sale, 70 percent in the month following the month of sale, and 8 percent in the second month following the month of sale.
The remaining 2 percent of sales is never collected. How much money does the firm expect to collect in the month of August?
A. $621
B. $628
C. $633
D. $639
E. $643
5.You are developing a financial plan for a corporation. Which of the following questions will be considered as you develop this plan?
I. How much will our sales grow?
II. Will additional fixed assets be required?
III. Will dividends be paid to shareholders?
IV. How much new debt must be obtained?
A. I and IV only
B. II and III only
C. I, III, and IV only
D. II, III, and IV only
E. I, II, III, and IV
6.Steve has estimated the cash inflows and outflows for his sporting goods store for next year. The report that he has prepared summarizing
these cash flows is called a:
A. pro forma income statement.
B. sales projection.
C. cash budget.
D. receivables analysis.
E. credit analysis.
F. None of the above.
7.The Limited collects 25 percent of sales in the month of sale, 60 percent of sales in the month following the month of sale, and 15 percent of
sales in the second month following the month of sale. During the month of April, the firm will collect:
A. 60 percent of February sales.
B. 15 percent of April sales.
C. 60 percent of March sales.
D. 15 percent of March sales.
E. 25 percent of February sales.
8.Assume each month has 30 days and AmDocs has a 60-day accounts receivable period. During the second calendar quarter of the year (April,
May, and June), AmDocs will collect payment for the sales it made during which of the months listed below?
A. October, November, and December
B. November, December, and January
C. December, January, and February
D. January, February, and March
E. February, March, and April
9.Which one of the following statements is correct concerning the cash balance of a firm?
A. Most firms attempt to maintain a zero cash balance at all times.
B. The cumulative cash surplus shown on a cash budget is equal to the ending cash balance plus the minimum desired cash balance.
C. Most firms attempt to maximize the cash balance at all times.
D. A cumulative cash deficit on a cash budget indicates the need to acquire additional funds.
E. The ending cash balance must equal the minimum desired cash balance.
10. Which of the following are viable techniques to cope with the uncertainty inherent in realistic financial projections?
I. Simulation
II. Ad hoc adjustments
III. Scenario analysis
IV. Sensitivity analysis
A. II and IV only
B. III and IV only
C. II, III, and IV only
D. I, II, and III only
E. I, III, and IV only
F. I, II, III, and IV
11. The most common approach to developing pro forma financial statements is called the:
A. cash budget method.
B. financial planning method.
C. seasonality approach.
D. percent-of-sales method.
E. market-oriented approach.
F. None of the above.
12.To estimate Missed Places Inc.’s (MP) external financing needs, the CFO needs to figure out how much equity her firm will have at the end of
next year. At the end of the most recent fiscal year, MP’s retained earnings were $158,000. The Controller has estimated that over the next year,
gross profits will be $360,700, earnings after tax will total $23,400, and MP will pay $12,400 in dividends. What are the estimated retained
earnings at the end of next year?
A. $169,000
B. $170,400
C. $181,400
D. $506,300
E. $518,700
F. None of the above.
13. You are estimating your company’s external financing needs for the next year. At the end of the year you expect that owners’ equity will be
$80 million, total assets will amount to $170 million, and total liabilities will be $70 million. How much will your firm need to borrow, or
otherwise acquire, from outside sources during the year?
A. $20 million
B. $70 million
C. $150 million
D. $160 million
E. $180 million
F. None of the above.
14. Cash budgets are less informative than pro forma financial statements: t/f
15. Scenario analysis involves changing one input to a financial forecast, whereas sensitivity analysis involves changing multiple inputs: t/f
16. A drawback of forecasting using spreadsheets is that typical spreadsheet programs are not equipped to deal with the circularity involving
interest expense and debt. t/f
17. Given the same assumptions, cash flow forecasts and pro forma projections will yield the same need for external funding: t/f
18. All else equal, increasing the assumed payables period in a financial forecast will decrease external funding required: t/f
19. An annual financial forecast for 2013 showing no external funding required assures a company that no cash shortfalls are likely to occur
during 2013: t/f
CH 4. Higgins
1. If a company seeks to maximize firm value, it should never grow at a rate above its sustainable growth rate t/f
2. The only way a company can grow at a rate above its current sustainable growth rate is by increasing leverage. t/f
3. In recent years, U.S. companies as a whole have repurchased more equity than they have issued. t/f
4. Share repurchases usually decrease earnings per share. t/f
5. Issue costs of equity are high relative to those of debt t/f
6. One way to manage an actual growth rate above a sustainable growth rate is to decrease prices. t/f
7. Which one of the following will increase the sustainable rate of growth a corporation can achieve?
A. avoidance of external equity financing
B. increase in corporate tax rates
C. reduction in the retention ratio
D. decrease in the dividend payout ratio
E. decrease in sales given a positive profit margin
F. None of the above.
8. Which of these ratios are the determinants of a firm’s sustainable growth rate?
I. Assets-to-equity ratio
II. Profit margin
III. Retention ratio
IV. Asset turnover ratio
A. I and III only
B. II and III only
C. II, III, and IV only
D. I, II, and III only
E. I, II, III, and IV
F. None of the above
9. The retention ratio is:
A. equal to net income divided by the change in total equity.
B. the percentage of net income available to the firm to fund future growth.
C. equal to one minus the asset turnover ratio.
D. the change in retained earnings divided by the dividends paid.
E. the dollar increase in net income divided by the dollar increase in sales.
F. None of the above.
10. Which of the following statements is true?
A. Rapid growth spurs increases in market share and profits and thus, is always a blessing.
B. Firms that grow rapidly only very rarely encounter financial problems.
C. The cash flows generated in a given time period are equal to the profits reported.
D. Profits provide assurance that cash flow will be sufficient to maintain solvency.
E. Due to required cash investments in current assets, fast-growing and profitable companies can literally “grow broke”.
F. None of the above.
11. Which one of the following correctly defines the retention ratio?
A. one plus the dividend payout ratio
B. additions to retained earnings divided by net income
C. additions to retained earnings divided by dividends paid
D. net income minus additions to retained earnings
E. net income minus cash dividends
F. None of the above.
12. Which one of the following policies most directly affects the projection of the retained earnings balance to be used on a pro forma
statement?
A. net working capital policy
B. capital structure policy
C. dividend policy
D. capital budgeting policy
E. capacity utilization policy
F. None of the above.
13. Which of the following questions are appropriate to address upon conducting sustainable growth analysis and the financial planning
process?
I. Should the firm merge with a competitor?
II. Should additional equity be sold?
III. Should a particular division be sold?
IV. Should a new product be introduced?
A. I, II, and III only
B. I, II, and IV only
C. I, III, and IV only
D. II, III, and IV only
E. I, II, III, and IV
F. None of the above.
14. The sustainable growth rate of a firm is best described as the:
A. minimum growth rate achievable assuming a 100 percent retention ratio.
B. minimum growth rate achievable if the firm maintains a constant equity multiplier.
C. maximum growth rate achievable excluding external financing of any kind.
D. maximum growth rate achievable excluding any external equity financing while maintaining a constant debt-equity ratio.
E. maximum growth rate achievable with unlimited debt financing.
F. None of the above.
15. The sustainable growth rate:
A. assumes there is no external financing of any kind.
B. assumes no additional long-term debt is available.
C. assumes the debt-equity ratio is constant.
D. assumes the debt-equity ratio is 1.0.
E. assumes all income is retained by the firm.
F. None of the above.
16. Which of the following can affect a firm’s sustainable rate of growth?
I. Asset turnover ratio
II. Profit margin
III. Dividend policy
IV. Financial leverage
A. III only
B. I and III only
C. II, III, and IV only
D. I, II, and IV only
E. I, II, III, and IV
F. None of the above.
17. Gujarat Corporation doubled its shareholders’ equity during the year 2014. Gujarat did not issue any new equity, repurchase any equity, or
pay out any dividends during the year. What is Gujarat’s sustainable growth rate for 2014?
A. 50%
B. 100%
C. 150%
D. 200%
18. Hayesville Corporation had net income of $5 million this year on net sales of $125 million per year. At the beginning of this year, its debtto-equity ratio was 1.5 and it held $75 million in total liabilities. It paid out $2 million in dividends for the year. What is Hayesville
Corporation’s sustainable growth rate?
A. 3%
B. 4%
C. 5%
D. 6%
19. Milano Corporation has experienced growth of 20% for each of the last 5 years. Over this 5-year period, Milano’s return on equity has
never exceeded 15%, its profit margin has held steady at 5%, and its total asset turnover has not changed. Over the 5-year period, Milano
paid no dividends and issued no new equity. Based on this information, which of the following can you most likely infer about Milano’s
performance over the past 5 years?
A. Milano’s leverage has decreased.
B. Milano’s leverage has remained constant.
C. Milano’s leverage has increased.
D. None of the above.
20. Which of the following would increase a company’s need for external finance, all else equal?
A. An increase in the dividend payout ratio
B. A decrease in sales growth
C. An increase in profit margin
D. A decrease in the collection period
21. You constructed a pro forma balance sheet for next year and found that external financing required was negative (i.e., the company
projected a financing surplus). Which of the following options, all else equal, would NOT correct the projected imbalance?
A. A stock repurchase
B. A decrease in accounts payable
C. An increase in cash and marketable securities
D. An increase in the retention ratio
22. The sustainable growth rate:
A. is the highest growth rate attainable for a firm that pays no dividends.
B. is the highest growth rate attainable for a firm without issuing new stock.
C. can never be greater than the return on equity.
D. can be increased by decreasing leverage.
23. Wax Music expects sales of $437,500 next year. The profit margin is 4.8 percent and the firm has a 30 percent dividend payout ratio. What
is the projected increase in retained earnings?
A. $14,700
B. $17,500
C. $18,300
D. $20,600
E. $21,000
F. None of the above.
24. Komatsu has a 4.5 percent profit margin and a 15 percent dividend payout ratio. The asset turnover ratio is 1.6 and the assets-to-equity
ratio (using beginning-of-period equity) is 1.77. What is Komatsu’s sustainable rate of growth?
A. 1.91%
B. 6.12%
C. 10.83%
D. 11.26%
E. 12.74%
F. None of the above.
25. A firm has a retention ratio of 40 percent and a sustainable growth rate of 6.2 percent. Its asset turnover ratio is 0.85 and its assets-toequity ratio (using beginning-of-period equity) is 1.80. What is its profit margin?
A. 3.79%
B. 5.69%
C. 6.75%
D. 10.13%
E. 18.24%
26. Westcomb, Inc. had equity of $150,000 at the beginning of the year. At the end of the year, the company had total assets of $195,000.
During the year, the company sold no new equity. Net income for the year was $72,000 and dividends were $44,640. What is Westcomb’s
sustainable growth rate?
A. 15.32 percent
B. 15.79 percent
C. 17.78 percent
D. 18.01 percent
E. 18.24 percent
27. Which of the following actions would help a firm’s growth problem if its actual sales growth exceeds its sustainable rate of growth?
I. Increase prices
II. Decrease financial leverage
III. Decrease dividends
IV. Prune away less-profitable products
A. I and II only
B. I and III only
C. I, II, and IV only
D. I, III, and IV only
E. I, II, III, and IV
F. None of the above.
28. Please refer to the selected financial information for Boss Stores above. What is the retention ratio for 2013?
A. 0.32
B. 0.68
C. 0.97
D. 1.00
E. None of the above
29. Please refer to the selected financial information for Boss Stores above. What is the actual sales growth rate for 2013?
A. – 17.6%
B. – 7.9%
C. 8.51%
D. 21.4%
E. None of the above.
30. Please refer to the selected financial information for Boss Stores above. What is the sustainable growth rate for 2013?
A. – 17.6%
B. – 7.9%
C. 9.97%
D. 10.27%
E. 12.23%
F. 21.40%
31. Please refer to the selected financial information for Boss Stores above. What is the difference between Boss’s sustainable growth rate and
its actual growth rate for 2014?
A. – 11.40%
B. – 7.09%
C. – 3.04%
D. 5.47%
E. 13.98%
F. 21.40%
Higgins ch 6:
1. Financial leverage:
I. Increases expected ROE but does not affect its variability
II. Increases breakeven, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved
III. Is a fundamental financial variable affecting sustainable growth
IV. Increases expected return and risk to owners
A. I and II only
B. I and III only
C. II and IV only
D. II, III, and IV only
E. I, II, III, and IV
F. None of the above
2. The best financing choice is the one that:
A. Sets the debt to assets ratio equal to 1
B. Trades off the tax disadvantage of debt against the signaling effects of equity
C. Maximizes expected cash flows
D. Ignores the false comfort of financial flexibility
E. Results in the lowest possible financial distress costs
3. Homemade leverage is:
A. The incurrence of debt by a corporation in order to pay dividends to shareholders
B. The exclusive use of debt to fund a corporate expansion project
C. The borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage
D. Best defined as an increase in a firm’s debt-equity ratio
E. The term used to describe the capital structure of a levered firm
F. None of the above
4. The basic lesson of M&M theory is that the value of a firm is dependent upon:
A. The firms capital structure
B. The total cash flow of the firm
C. Minimizing the marketed claims
D. The amount of marketed claims to that firm
E. The size of the stockholder’s claims
F. None of the above
5. The term ‘financial distress costs’ includes which of the following?
I. Direct bankruptcy costs
II. Indirect bankruptcy costs
III. Direct costs related to being financially distressed but not bankrupt
IV. Indirect costs related to being financially distressed but not bankrupt
A. I only
B. III only
C. I and II only
D. III and IV only
E. I, II, III, and IV
F. None of the above
6. Which of the following is/are helpful for evaluating the effect of leverage on a company’s risk and potential returns?
I. Estimated pro forma coverage ratios
II. The recognition that financing decisions do not affect firm shareholder value
III. A range of earnings chart and proximity of expected EBIT to the breakeven value
IV. A conservative debt policy that obviates the need to evaluate risk
A. I only
B. III only
C. I and III only
D. II and III only
E. IV only
F. None of the above
7. In general, the capital structures used by non-financial US firms:
A. Typically result in debt to asset ratios between 60 and 80 percent
B. Tend to converge to the same proportions of debt and equity
C. Tend to be those that maximize the use of the firms available tax shelters
D. Vary significantly across industries
E. None of the above
8. Which of the following factors favor the issuance of debt in the financing decision?
I. Market signaling
II. Distress costs
III. Tax benefits
IV. Financial flexibility
-D. I, II, and III only
9. Which of the following factors favor the issuance of equity in the financing decision?
I. Market signaling
II. Distress costs
III. Management incentives
IV. Financial flexibility
-C II and IV only
10. Which of the following factors favor the issuance of debt in the financing decision?
V. Market signaling
VI. Distress costs
VII. Management incentives
VIII. Financial flexibility
-B I and III only
11. Which of the following is not a likely financing policy for a rapidly growing business?
-B borrow funds rather than limit growth, thereby limiting growth only as a last resort
12. According to the pecking order theory, which of the following are correct?
I. for financing needs, firms prefer to first tap internal sources such as retained profits and excess cash
II. there is an inverse relationship between a firms profit level and its debt level
III firms prefer to issue new equity rather than source external debt
IV a firms capital structure is dictated by its need for external financing
-D I, II , and IV only
13. TIMES BURDEN COVERED RATIO:
14. CALCULATE EARNINGS PER SHARE
15. INTEREST EARNED RATIO:
16. The interest tax shield has no value when a firm has:
I. No taxable income
II. Debt equity ratio of 1
III. Zero debt
IV no leverage
-C I, III, and IV
Higgins Ch 7:
Higgins Ch 8:
1. Total risk is measured by ____ and systematic risk is measured by ______.
A. Beta; alpha
B. Beta; standard deviation
C. WACC; beta
D. Standard deviation; beta
E. Standard deviation; variance
F. None of the above
2. When investment returns are less than perfectly positively correlated, the resulting diversification effect means that:
A. making an investment in two or three large stocks will eliminate all of the unsystematic risk.
B. making an investment in three companies all within the same industry will greatly reduce the systematic risk.
C. spreading an investment across five diverse companies will not lower the total risk.
D. spreading an investment across many diverse assets will eliminate all of the systematic risk.
E. spreading an investment across many diverse assets will eliminate some of the total risk.
F. None of the above.
3. Unsystematic risk:
A. can be effectively eliminated by portfolio diversification.
B. is compensated for by the risk premium.
C. is measured by beta.
D. is measured by standard deviation.
E. is related to the overall economy.
F. None of the above.
4. Which of the following are examples of diversifiable risk?
I. An earthquake damages Oakland, California.
II. The federal government imposes an additional $1,000 fee on all business entities.
III. Employment taxes increase nationally.
IV. Toymakers are required to improve their safety standards.
A. I and III only
B. II and IV only
C. II and III only
D. I and IV only
E. I, III, and IV only
F. None of the above.
5. Which of the following statements are correct concerning diversifiable, or unsystematic, risks?
I. Diversifiable risks can be largely eliminated by investing in thirty unrelated securities.
II. There is no reward for accepting diversifiable risks.
III. Diversifiable risks are generally associated with an individual firm or industry.
IV. Beta measures diversifiable risk.
A. I and III only
B. II and IV only
C. I and IV only
D. I, II, and III only
E. I, II, III, and IV
F. None of the above.
6. Which of the following statements concerning risk are correct?
I. Systematic risk is measured by beta.
II. The risk premium increases as unsystematic risk increases.
III. Systematic risk is the only part of total risk that should affect asset prices and returns.
IV. Diversifiable risks are market risks you cannot avoid.
A. I and III only
B. II and IV only
C. I and II only
D. III and IV only
E. I, II, and III only
F. None of the above.
7. Which one of the following is an example of systematic risk?
A. The Federal Reserve unexpectedly announces an increase in target interest rates.
B. A flood washes away a firm’s warehouse.
C. A city imposes an additional one percent sales tax on all products.
D. A toymaker has to recall its top-selling toy.
E. Corn prices increase due to increased demand for alternative fuels.
F. None of the above.
8. The excess return earned by a risky asset, for example with a beta of 1.4, over that earned by a risk-free asset is referred to as a:
A. market risk premium.
B. risk premium.
C. systematic return.
D. total return.
E. real rate of return.
F. None of the above.
9. The dividend growth model can be used to compute the cost of equity for a firm in which of the following situations?
I. Firms that have a 100 percent retention ratio
II. Firms that pay an unchanging dividend
III. Firms that pay a constantly increasing dividend
IV. Firms that pay an erratically growing dividend
A. I and II only
B. I and IV only
C. II and III only
D. I, II, and III only
E. I, III, and IV only
F. None of the above.
10. The cost of equity for a firm:
A. tends to remain static for firms with increasing levels of risk.
B. increases as the unsystematic risk of the firm increases.
C. ignores the firm’s risks when that cost is based on the dividend growth model.
D. equals the risk-free rate plus the market risk premium.
E. equals the firm’s pretax weighted average cost of capital.
F. None of the above.
11. The pre-tax cost of debt:
A. is based on the current yield to maturity of the firm’s outstanding bonds.
B. is equal to the coupon rate on the latest bonds issued by a firm.
C. is equivalent to the average current yield on all of a firm’s outstanding bonds.
D. is based on the original yield to maturity on the latest bonds issued by a firm.
E. has to be estimated as it cannot be directly observed in the market.
F. None of the above.
12. The after-tax cost of debt generally increases when:
I. a firm’s bond rating increases.
II. the market-required rate of interest for the company’s bonds increases.
III. tax rates decrease.
IV. bond prices rise.
A. I and III only
B. II and III only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
F. None of the above.
Key facts and assumptions concerning FM Foods, Inc. at December 31, 2011, appear below.
13. Estimate FM’s after-tax cost of equity capital.
A. 4.50%
B. 6.92%
C. 7.93%
D. 12.20%
E. 17.48%
F. None of the above.
14. Estimate FM’s after-tax cost of debt capital.
A. 2.21%
B. 4.10%
C. 4.55%
D. 6.30%
E. 7.00%
F. None of the above.
15. Estimate the appropriate weight of equity to be used when calculating FM’s weighted average cost of capital.
A. 11.5%
B. 19.3%
C. 80.7%
D. 88.5%
E. 100.0%
F. None of the above.
16. Estimate the appropriate weight of debt to be used when calculating FM’s weighted average cost of capital.
A. 11.5%
B. 19.3%
C. 80.7%
D. 88.5%
E. 100.0%
F. None of the above.
17. Estimate FM’s weighted-average cost of capital.
A. 6.46%
B. 6.58%
C. 11.27%
D. 11.32%
E. 11.52%
F. None of the above.
18. FM is contemplating an average-risk investment costing $100 million and promising an annual after-tax cash flow of $15 million in
perpetuity. Which of the following statements is/are correct?
I. FM should reject the project because the IRR is greater than the firm’s WACC.
II. FM should accept the project because the IRR is greater than the firm’s WACC.
III. FM should accept the project because the NPV is greater than zero.
IV. FM should reject the project because the NPV is less than zero.
A. I only
B. II only
C. IV only
D. I and IV only
E. II and III only
F. None of the above.
19. Which of the following statements are correct?
I. Using the same risk-adjusted discount rate to discount all future cash flows adjusts for the fact that the more distant cash flows are often more
risky than cash flows occurring sooner.
II. If you can borrow all of the money you need for a project at 5%, the cost of capital for this project is 5%.
III. The best way to obtain the cost of debt capital for a firm is to use the coupon rates on its bonds.
IV. The cost of capital, or WACC, is not the correct discount rate to use for all projects undertaken by a firm.
A. I and III only
B. II and IV only
C. I and II only
D. I and IV only
E. I, II, and III only
F. None of the above
20. The capital structure weights used in computing the weighted average cost of capital:
A. are based on the book values of total debt and total equity.
B. are based on the market value of the firm’s debt and equity securities.
C. are computed using the book value of the long-term debt and the book value of equity.
D. remain constant over time unless the firm issues new securities.
E. are restricted to the firm’s debt and common stock.
F. None of the above.
21. The discount rate assigned to an individual project should be based on:
A. the firm’s weighted average cost of capital.
B. the actual sources of funding used for the project.
C. an average of the firm’s overall cost of capital for the past five years.
D. the current risk level of the overall firm.
E. the risks associated with the use of the funds required by the project.
F. None of the above.
22. The weighted average cost of capital for a firm is the:
A. discount rate which the firm should apply to all of the projects it undertakes.
B. rate of return a firm must earn on its existing assets to maintain the current value of its stock.
C. coupon rate the firm should expect to pay on its next bond issue.
D. minimum discount rate the firm should require on any new project.
E. rate of return shareholders should expect to earn on their investment in this firm.
F. None of the above.
23. Blue Diamond Equipment has 80,000 bonds outstanding that are selling at par. Bonds with similar characteristics are yielding 6.75 percent.
The company also has 750,000 shares of 7 percent preferred stock and 2.5 million shares of common stock outstanding. The preferred stock
sells for $53 a share. The common stock has a beta of 1.34 and sells for $42 a share. The U.S. Treasury bill is yielding 2.8 percent and the return
on the market is 11.2 percent. The corporate tax rate is 38 percent. What is the firm’s weighted average cost of capital?
A. 10.39 percent
B. 10.64 percent
C. 11.18 percent
D. 11.30 percent
E. 11.56 percent
F. None of the above.
24. Honest Abe’s is a chain of furniture retail stores. Integral Designs is a furniture maker and a supplier to Honest Abe’s. Honest Abe’s has a
beta of 1.38 as compared to Integral Designs’ beta of 1.12. Both firms carry no debt, i.e., are 100% equity-financed. The risk-free rate of return is
3.5 percent and the market risk premium is 8 percent. What discount rate should Honest Abe’s use if it considers a project that involves the
manufacturing of furniture?
A. 12.46 percent
B. 12.92 percent
C. 13.50 percent
D. 14.08 percent
E. 14.54 percent
F. None of the above.
Short Answer Questions
Key facts and assumptions concerning Costco Company, at December 31, 2011, appear below.
25. Use the above information to answer the following questions.
a. Estimate Costco’s cost of equity capital.
b. Estimate Costco’s weighted-average cost of capital.
26. Explain the difference between systematic and unsystematic risk, and why one of these types of risks is rewarded with a risk premium while
the other type is not.
27. Suppose that your company’s weighted-average cost of capital is 9 percent. Your company is planning to undertake a project with an internal
rate of return of 12%, but you believe that this project is not a good investment for the firm. What logical arguments might you use to convince
your boss to forego the project despite its high rate of return? Is it possible that making investments with expected returns higher than your
company’s cost of capital will destroy value? If so, how?
28. The standard deviation of returns on Wildcat Oil Drilling is very high. Does this necessarily imply that Wildcat Oil Drilling is a high-risk
investment when investors hold diversified portfolios? Explain why or why not.
29. Investments A and B both cost $100,000 and each promises a single payoff in one year. The distribution of payoffs for each investment
appears below.
Ignoring possible differences in nondiversifiable risk, which investment would a risk-averse investor prefer, and why?
30. What is the present value of a cash flow stream of $10,000 per year annually for 11 years that then grows at 2 percent per year forever?
Assume the appropriate discount rate is 12 percent.
Higgins Ch 9:
1. Which of the following statements are correct?;
I. Liquidation value of a firm is equal to the present worth of expected future;cash flows from operating activities.;
II. When an acquiring firm purchases a target firm’s equity, the acquirer must;assume the target’s liabilities.;
III. III. The market value of a public company reflects the worth of the business to;minority investors.;
IV. IV. The fair market value of a business is usually the lower of its liquidation;value and its going-concern value.;
A. I and III only;
B. II and IV only;
C. II and III only;
D. I, II, and III only;
E. II, III, and IV only;
F. None of the above.;
2. Ginormous Oil entered into an agreement to purchase;all of the outstanding shares of Slick Company for $60 per share. The number
of;outstanding shares at the time of the announcement was 82 million. The book;value of liabilities on the balance sheet of Slick Co. was
$1.46 billion. What;was the cost of this acquisition to the shareholders of Ginormous Oil?;
A. $1.46 billion;
B. $3.46 billion;
C. $4.92 billion;
D. $6.38 billion;
E. $8.38 billion;
F. None of the above.;
3. Ginormous Oil entered into an agreement to purchase;all of the outstanding shares of Slick Company for $60 per share. The
number of;outstanding shares at the time of the announcement was 82 million. The book;value of liabilities on the balance sheet of
Slick Co. was $1.46 billion.;Immediately prior to the Ginormous Oil bid, the shares of Slick Co. traded at;$33 per share. What value
did Ginormous Oil place on the control of Slick;Co.?;
A. $2.21 billion;
B. $2.71 billion;
C. $4.17 billion;
D. $6.38 billion;
E. None of the above.;
4. Which of the following statements is/are correct?;
I. Going-concern value of a firm is equal to the present value of expected net;income.;
II. When a buyer values a target firm, the appropriate discount rate is the;buyer’s weighted-average cost of capital.;
III. The liquidation value estimate of terminal value usually vastly understates;a healthy company’s terminal value.;
IV. The value of a firm’s equity equals the discounted cash flow value of the;firm minus all liabilities.;
A. II only;
B. III only;
C. I and II only;
D. II and III only;
E. II, III, and IV only;
F. None of the above.;
5. Which of the following statements are correct?;
I. Going-concern value of a firm is equal to the present value of expected;future cash flows to owners and creditors.;
II. When an acquiring firm purchases a target firm’s equity, the acquirer need;not assume the target’s liabilities.;
III. The market value of a public company reflects the worth of the business to;minority investors.;
IV. The fair market value of a business is usually the lower of its liquidation;value and its going-concern value.;
A. I and III only
B. II and IV only;
C. II and III only;
D. I, II, and III only;
E. II, III, and IV only;
F. None of the above.;
6. The following table presents forecasted financial;and other information for Scott’s Miracle-Gro Co.;What is an appropriate
estimate of Scott’s terminal value as of the end of;2014, using the perpetual-growth equation as your estimate?;
A. $161 million;
B. $363 million;
C. $3,690 million;
D. $3,838 million;
E. $5,357 million;
F. None of the above.;
7. The following table presents forecasted financial;and other information for Scott’s Miracle-Gro Co.;What is an appropriate estimate of
Scott’s terminal value of equity as of the;end of 2014?;A. $225 million;B. $3,833.0 million;C. $4,207.5 million;D. $4,365.0 million;E.
$6,788.1 million;F. None of the above.;
8. The following table presents forecasted financial;and other information for Scott’s Miracle-Gro Co.;What is an appropriate estimate of
Scott’s terminal value as of the end of;2014, using a warranted multiple of free cash flow as your estimate?
A. $155 million;
B. $2,898.5 million;
C. $3,007.0 million;
D. $4,365.0 million;
E. $7,042.2 million;
F. None of the above.;
9. Atmosphere, Inc. has offered $860 million cash for;all of the common stock in ACE Corporation. Based on recent market information;ACE
is worth $710 million as an independent operation. For the merger to make;economic sense for Atmosphere, what would the minimum
estimated value of the;enhancements from the merger have to be?
A. $0
B. $75 million;
C. $150 million;
D. $710 million;
E. $860 million;
F. None of the above.;
10. Consider the following premerger information about;a bidding firm (Buyitall Inc.) and a target firm (Tarjay Corp.). Assume that;neither
firm has any debt outstanding.;Buyitall has estimated that the present value of any enhancements that Buyitall;expects from acquiring
Tarjay is $2,600. What is the NPV of the merger assuming;that Tarjay is willing to be acquired for $28 per share in cash?;
A. $400;
B. $600;
C. $1,800;
D. $2,200;
E. $2,600;
F. None of the above.;
Figure 9.1In March of 2011, Macklemore Corp. considered an acquisition of Blue;Scholar Learning, Inc. (BSL), a privately-held educational
software firm. As a;first step in deciding what price to bid for BSL, Macklemore’s CFO, Ryan Lewis;has prepared a five-year financial
projection for the company assuming the;acquisition takes place. Use this projection and BSL’s 2010 actual financial;figures to answer the
questions below.;
11. What is BSL’s free cash flow (in $ millions) for;2011?;
A. – $938;
B. – $792;
C. – $7;
D. $122;
E. $1,091;
F. None of the above.;
12. Estimate the present value of BSL’s free cash flow;(in $ millions) for the years 2011 – 2015. Macklemore’s WACC is 8.0 percent.;BSL’s WACC is
11.5 percent, and the average of the two companies’ WACCs;weighted by sales, is 8.2 percent.;
A. – $1.29;
B. $628.24;
C. $720.58;
D. $726.68
E. $743.94;
F. None of the above.;
13. Estimate BSL’s value (in $ millions) at the end of;2010 assuming it is worth the book value of its assets at the end of 2015.;Macklemore’s
WACC is 8.0 percent. BSL’s WACC is 11.5 percent, and the average;of the two companies’ WACCs, weighted by sales, is 8.2 percent.;
A. $628.24;
B. $3,669.01;
C. $4,297.25;
D. $4,412.94;
E. $4,984.28;
F. $6,951.24;
G. None of the above.;
14. Assume BSL is worth the book value of its assets;at the end of 2015. Macklemore’s WACC is 8.0 percent. BSL’s WACC is 11.5;percent, and the
average of the two companies’ WACCs, weighted by sales, is 8.2;percent. What is the maximum acquisition price (in $ millions)
Macklemore;should pay to acquire BSL’s equity?;
A. $1,702.25;
B. $2,227.25;
C. $2,342.94;
D. $2,383.94;
E. $2,603.25;
F. $4,297.25;
G. None of the above.;
15. Estimate BSL’s value (in $ millions) at the end of;2010 assuming that in the years after 2015 the company’s free cash flow grows 4;percent
per year in perpetuity. Macklemore’s WACC is 8.0 percent. BSL’s WACC is;11.5 percent, and the average of the two companies’ WACCs, weighted
by sales;is 8.2 percent.
A. $4,297.25
B. $4,571.09;
C. $4,686.78;
D. $6,181.09;
E. $5,351.19;
F. $7,423.16;G. None of the above.;
16. Assume that in the years after 2015 the company’s;free cash flow grows 4 percent per year in perpetuity. Macklemore’s WACC is
8.0;percent. BSL’s WACC is 11.5 percent, and the average of the two companies;WACCs, weighted by sales, is 8.2 percent. What is the maximum
acquisition price;(in $ millions) Macklemore should pay to acquire BSL’s equity at the end of;2010?;
A. $1,976.09;
B. $2,501.09;
C. $2,877.09;
D. $4,195.09;
E. $4,571.09;
F. None of the above.;
17. Estimate BSL’s value (in $ millions) at the end of;2010 assuming that at year-end 2015 the company’s equity is worth 15 times;earnings after
tax and its debt is worth book value. Macklemore’s WACC is 8.0;percent. BSL’s WACC is 11.5 percent, and the average of the two
companies;WACCs, weighted by sales, is 8.2 percent.;
A. $628.24;
B. $3,669.01;
C. $7,429.74
D. $6,343.26;
E. $6,755.83;
F. $7,008.06;
G. None of the above.;
18. Assume that at year-end 2015 the company’s equity;is worth 15 times earnings after tax and its debt is worth book value.;Macklemore’s
WACC is 8.0 percent. BSL’s WACC is 11.5 percent, and the average;of the two companies’ WACCs, weighted by sales, is 8.2 percent. What is
the;maximum acquisition price (in $ millions) Macklemore should pay to acquire;BSL’s equity at the end of 2010?;
A. $3,484.68;
B. $4,723.26;
C. $4,938.06;
D. $5,554.68;
E. $6,343.26
F. None of the above.;
Short Answer Questions;
19. The following information is available about;Chiantivino Corp. (CC);An activist investor is confident that by terminating CC’s moneylosing;fortified wine division, she can increase free cash flow by $4 million annually;for the next decade. In addition, she estimates that an
immediate, special;dividend of $10 million can be financed by the sale of the division.;a. Assuming these actions do not affect CC’s cost of
capital, what is the;maximum price per share the investor would be justified in bidding for control;of CC? What percentage premium does this
represent?;b. Show your answer if you conduct a sensitivity analysis by assuming the cost;of capital is 15 percent and the increased cash flow is
only $3.5 million per;year.;
20. Below is a recent income statement for Gatlin;Camera;Calculate Gatlin’s free cash flow in this year assuming it spent $510 on new;capital
equipment and increased current assets net of noninterest-bearing;current liabilities $340.;The following table presents a four-year forecast
for;Kenmore Air, Inc.;
21. Estimate the fair market value of Kenmore Air at;the end of 2012. Assume that after 2016, earnings before interest and tax will;remain
constant at $200 million, depreciation will equal capital expenditures;in each year, and working capital will not change. Kenmore Air’s;weightedaverage cost of capital is 11 percent and its tax rate is 40;percent.;
22. Estimate the fair market value per share of;Kenmore Air’s equity at the end of 2016 if the company has 40 million shares;outstanding and
the market value of its interest-bearing liabilities on the;valuation date equals $250 million.;
23. Estimate the fair market value of Kenmore Air’s;equity per share at the end of 2012 under the following assumptions;a. EBIT in year 2016 is
$200 million, and then grows at 5 percent per year;forever.;b. To support the perpetual growth in EBIT, capital expenditures in year 2017;exceed
depreciation by $30 million, and this difference grows 5 percent per;year forever.;c. Similarly, working capital investments are $15 million in
2017, and this;amount grows 5 percent per year forever.;
24. Estimate the fair market value of Kenmore Air’s;equity per share at the end of 2012 under the following assumptions;a. EBIT in year 2016
will be $200 million.;b. At year-end 2016, Kenmore Air has reached maturity, and analysts expect its;equity will sell for 12 times year 2016 net
income.;c. At year-end 2016, Kenmore Air has $250 million of interest-bearing;liabilities outstanding at an average interest rate of 10 percent.;
25. Ametek, Inc. is a billion dollar manufacturer of;electronic instruments and motors headquartered in Paoli, Pennsylvania. Use the;following
information on Ametek and five other similar companies to value;Ametek, Inc. on December 31, 2010.;*American Power Conversion has no
interest-bearing debt;outstanding.;MV = Market value, BV = Book value. Market value is estimated as book value of;interest-bearing debt +
market value of equity. Earnings are fiscal year earnings.;
26. Rainy City Coffee’s (RCC) free cash flow next year;will be $100 million and it is expected to grow at a 4 percent annual rate;indefinitely. The
company’s weighted average cost of capital is 10 percent, the;market value of its liabilities is $1 billion, and it has 20 million
shares;outstanding.;a. Estimate the price per share of RCC’s common stock.;b. A hedge fund believes that by selling the company’s private jet
and;instituting other cost savings, it can increase RCC’s free cash flow next year;to $110 million and can add a full percentage point to RCC’s
growth rate;without affecting its cost of capital. What is the maximum price per share the;hedge fund can justify bidding for control of RCC?;
27. Empirical evidence indicates that the returns to;shareholders of the target firm vary significantly from the returns to the;shareholders of the
acquiring firm. Identify the shareholders that tend to;realize the smaller return. Does your answer depend on the way the acquisition;is
financed?