FIN 470 Exam 1 NAME________________________

1. What are the three types of financial management decisions? For each type of decision, give an example
of a business transaction that would be relevant.
Capital budgeting (deciding whether to expand a manufacturing plant), capital structure (deciding
whether to issue new equity and use the proceeds to retire outstanding debt), and working capital
management (modifying the firms credit collection policy with its customers).
2. Evaluate the following statement !anagers should not focus on the current stoc" value because doing so
will lead to an overemphasis on short#term profits at the expense of long#term profits.
Presumably, the current stock value reflects the risk, timing, and magnitude of all future cash flows,
both shortterm and longterm. !f this is correct, then the statement is false.
$. Why might the revenue and cost figures shown on a standard income statement not be representative of
the actual cash inflows and outflows that occurred during a period?
"he recognition and matching principles in financial accounting call for revenues, and the costs
associated with producing those revenues, to be #booked$ when the revenue process is essentially
complete, not necessarily when the cash is collected or bills are paid. %ote that this way is not necessarily
correct& its the way accountants have chosen to do it.
%. &etson 'pacecraft (orp. shows the following information on its 2))* income statement sales + 1*,,)))-
costs +1)%,)))- other expenses +,,.))- depreciation expense +*,1))- interest expense +1%,.))- taxes
+21,%//- dividends +1),%)). 0n addition, you1re told that the firm issued +/,2)) in new e3uity during 2))*
and redeemed +2,$)) in outstanding long#term debt.
a. What is the 2))* operating cash flow?
4(F 5 E607 8 9epreciation : 7axes 5 +2,,1)) 8 *,1)) : 21,%// 5 $63,745
b. What is the 2))* cash flow to creditors?
(F( 5 0nterest : ;et new <79 5 +1%,.)) : =:2,$))> 5 $22,100
c. What is the 2))* cash flow to stoc"holders?
(F' 5 9ividends : ;et new e3uity 5 +1),%)) : /,2)) 5 $4,700
d. 0f net fixed assets increased by +22,))) during the year, what was the addition to ;W(?
We "now that (F? 5 (F( 8 (F', so
(F? 5 +22,1)) 8 %,2)) 5 +2,,.))
(F? is also e3ual to 4(F : ;et capital spending : (hange in ;W(. We already "now 4(F. ;et capital
spending is e3ual to
;et capital spending 5 0ncrease in ;F? 8 9epreciation 5 +22,))) 8 *,1)) 5 +$,,1))
;ow we can use
(F? 5 4(F : ;et capital spending : (hange in ;W(
+2,,.)) 5 +,$,2%/ : $,,1)) : (hange in ;W(
'olving for the change in ;W( gives +.%/, meaning the company increased its ;W( by $845.
/. Explain what it means for a firm to have a current ratio e3ual to ./). Would the firm be better off if the
current ratio were 1./)? What if it were 1/.)? Explain your answers.
' current ratio of (.)( means that the firm has twice as much in current liabilities as it does in current
assets& the firm potentially has poor liquidity. !f pressed by its shortterm creditors and suppliers for
immediate payment, the firm might have a difficult time meeting its obligations. ' current ratio of *.)(
means the firm has )(+ more current assets than it does current liabilities. "his probably represents an
improvement in liquidity& shortterm obligations can generally be met completely with a safety factor built
in. ' current ratio of *).(, however, might be excessive. 'ny excess funds sitting in current assets
generally earn little or no return. "hese excess funds might be put to better use by investing in productive
longterm assets or distributing the funds to shareholders.
,. @$A, 0nc., has sales of +/,22,, total assets of +$,1)/, and a debt:e3uity ratio of 1.%). 0f its return on
e3uity is 1/ percent, what is its net income?
7his is a multi#step problem involving several ratios. 7he ratios given are all part of the 9uBont 0dentity.
7he only 9uBont 0dentity ratio not given is the profit margin. 0f we "now the profit margin, we can find
the net income since sales are given. 'o, we begin with the 9uBont 0dentity
C4E 5 ).1/ 5 =B!>=7?7>=E!> 5 =B!>=' D 7?>=1 8 9DE>
'olving the 9uBont 0dentity for profit margin, we get
B! 5 E=C4E>=7?>F D E=1 8 9DE>='>F
B! 5 E=).1/>=+$,1)/>F D E=1 8 1.%>= +/,22,>F 5 .)$$*
;ow that we have the profit margin, we can use this number and the given sales figure to solve for net
income
B! 5 .)$$* 5 ;0 D '
;0 5 .)$$*=+/,22,> 5 $194.06
2. 0n chapter %, the boo" used Cosengarten (orporation to demonstrate how to calculate EF;. 7he C4E for
Cosengarten is about 2.$ percent, and the plowbac" ratio is about ,2 percent. 0f you calculate the
sustainable growth rate for Cosengarten, you will find it is only /.1% percent. 0n the calculation for EF;, a
growth rate of 2/ percent was used. 0s this possible? Explain.
"wo assumptions of the sustainable growth formula are that the company does not want to sell new
equity, and that financial policy is fixed. !f the company raises outside equity, or increases its debtequity
ratio it can grow at a higher rate than the sustainable growth rate. ,f course the company could also
grow faster than its profit margin increases, if it changes its dividend policy by increasing the retention
ratio, or its total asset turnover increases.
.. Given the following data and assuming no taxes, what is EF;?
0ncome 'tatement 6alance 'heet
'ales +%,*)) ?ssets +11,12/ 9ebt +,,*22
(osts $,1$, E3uity %,1*.
;et income +1,2,% 7otal +11,12/ 7otal +11,12/

?ssets and costs are proportional to sales. 9ebt and e3uity are not. ;o dividends are paid.
;ext yearHs sales are proIected to be +/,..)
?n increase of sales to +/,..) is an increase of
'ales increase 5 =+/,..) : %,*))> D +%,*))
'ales increase 5 .2) or 2)J

?ssuming costs and assets increase proportionally, the pro forma financial statements will
loo" li"e this

Bro forma income statement
'ales +/,..)
(osts $,2,$
;et income +2,112

Bro forma balance sheet
?ssets +1$,$/) 9ebt +,,*22
E3uity ,,$1/
7otal
+1$,$/)

7otal +1$,2%2

0f no dividends are paid, the e3uity account will increase by the net income, so
E3uity 5 +%,1*. 8 2,112
E3uity 5 +,,$1/
'o the EF; is
EF; 5 7otal assets : 7otal liabilities and e3uity
EF; 5 +1$,$/) : 1$,2%2 5 $108
*. 6ased on the following information, calculate the sustainable growth rate for Kendrix Guitars, 0nc.
Brofit margin %..J
7otal asset turnover 1.2/
7otal debt ratio .,/
Bayout ratio $)J
We should begin by calculating the 9DE ratio. We calculate the 9DE ratio as follows
7otal debt ratio 5 .,/ 5 79 D 7?
0nverting both sides we get
1 D .,/ 5 7? D 79
;ext, we need to recogniLe that
7? D 79 5 1 8 7E D 79
'ubstituting this into the previous e3uation, we get
1 D .,/ 5 1 8 7E D79
'ubtract 1 =one> from both sides and inverting again, we get
9DE 5 1 D E=1 D .,/> : 1F
9DE 5 1..,
With the 9DE ratio, we can calculate the E! and solve for C4E using the 9uBont identity
C4E 5 =B!>=7?7>=E!>
C4E 5 =.)%.>=1.2/>=1 8 1..,>
C4E 5 .121% or 12.1%J
;ow we can calculate the retention ratio as
b 5 1 : .$)
b 5 .2)
Finally, putting all the numbers we have calculated into the sustainable growth rate e3uation, we get
'ustainable growth rate 5 =C4E M b> D E1 : =C4E M b>F
'ustainable growth rate 5 E.121%=.2)>F D E1 : .121%=.2)>F
'ustainable growth rate 5 .1$,% or 13.64%
1). 6usinesses sometimes advertise that you should, N(ome try our product. 0f you do, we1ll give you +1))
Iust for coming byOP 0f you read the fine print, what you find out is that they will give you a savings
certificate that will pay you +1)) in 2/ years or so. 0s it deceptive advertising? 0s it unethical to advertise
a future value li"e this without a disclaimer?
!t would appear to be both deceptive and unethical to run such an ad without a disclaimer or
explanation.
11. @ou are scheduled to receive + 2),))) in two years. When you receive it, you will invest it for six more
years at ..% percent per year. Kow much will you have in eight years?
We need to find the FQ of a lump sum. Kowever, the money will only be invested for six years, so the
number of periods is six.
FQ 5 BQ=1 8 r>
t
FQ 5 +2),)))=1.).%>
,
5 $32,449.33
12. 'hould lending laws be changed to re3uire lenders to report E?Cs instead of ?BCs? Why or why not?
-es, they should. 'P.s generally dont provide the relevant rate. "he only advantage is that they are
easier to compute, but, with modern computing equipment, that advantage is not very important.
1$. ? local finance company 3uotes a 1, percent interest rate on one# year loans. 'o, if you borrow +2/,))),
the interest for the year will be +%,))). 6ecause you must repay a total of +2*,))) in one year, the finance
company re3uires you to pay +2*,)))D 12, or +2,%1,.,2, per month over the next 12 months. 0s this a 1,
percent loan? What rate would legally have to be 3uoted? What is the effective annual rate?
7o find the ?BC and E?C, we need to use the actual cash flows of the loan. 0n other words, the interest
rate 3uoted in the problem is only relevant to determine the total interest under the terms given. 7he
interest rate for the cash flows of the loan is
BQ? 5 +2/,))) 5 +2,%1,.,2R=1 : E1 D =1 8 r>F
12
> D r S
?gain, we cannot solve this e3uation for r, so we need to solve this e3uation on a financial calculator,
using a spreadsheet, or by trial and error. Tsing a spreadsheet, we find
r 5 2.$,1J per month
'o the ?BC is
?BC 5 12=2.$,1J> 5 28.33%
?nd the E?C is
E?C 5 =1.)2$,1>
12
: 1 5 .$2$1 or 32.31%
1%. What is the value of an investment that pays + 1/,))) every other year forever, if the first payment occurs
one year from today and the discount rate is 1) percent compounded daily?
7he cash flows in this problem occur every two years, so we need to find the effective two year rate.
4ne way to find the effective two year rate is to use an e3uation similar to the E?C, except use the
number of days in two years as the exponent. =We use the number of days in two years since it is daily
compounding- if monthly compounding was assumed, we would use the number of months in two years.>
'o, the effective two#year interest rate is
Effective 2#year rate 5 E1 8 =.1)D$,/>F
$,/=2>
: 1 5 .221% or 22.1%J
We can use this interest rate to find the BQ of the perpetuity. 9oing so, we find
BQ 5 +1/,))) D.221% 5 +,2,2,).)2
7his is an important point Cemember that the BQ e3uation for a perpetuity =and an ordinary annuity>
tells you the BQ one period before the first cash flow. 0n this problem, since the cash flows are two years
apart, we have found the value of the perpetuity one period =two years> before the first payment, which is
one year ago. We need to compound this value for one year to find the value today. 7he value of the cash
flows today is
BQ 5 +,2,2,).)2=1 8 .1)D$,/>
$,/
5 $74,885.44
1/. ? company is contemplating a long#term bond issue. 0t is debating whether to include a call provision.
What are the benefits to the company from including a call provision? What are the costs?
"here are two benefits. /irst, the company can take advantage of interest rate declines by calling in an
issue and replacing it with a lower coupon issue. 0econd, a company might wish to eliminate a covenant
for some reason. 1alling the issue does this. "he cost to the company is a higher coupon. ' put provision
is desirable from an investors standpoint, so it helps the company by reducing the coupon rate on the
bond. "he cost to the company is that it may have to buy back the bond at an unattractive price.
1,. 6oth 6ond 'am and 6ond 9ave have * percent coupons, ma"e semiannual payments, and are priced at par
value. 6ond 'am has $ years to maturity, whereas 6ond 9ave has 2) years to maturity. 0f interest rates
suddenly rise by 2 percent, what is the percentage change in the price of 6ond 'am? 4f 6ond 9ave?
?ny bond that sells at par has a @7! e3ual to the coupon rate. 6oth bonds sell at par, so the initial @7!
on both bonds is the coupon rate, * percent. 0f the @7! suddenly rises to 11 percent
B
'am
5 +%/=BQ0F?
/./J,,
> 8 +1,)))=BQ0F
/./J,,
> 5 +*/).)%
B
9ave
5 +%/=BQ0F?
/./J,%)
> 8 +1,)))=BQ0F
/./J,%)
> 5 +.$*./%
7he percentage change in price is calculated as
Bercentage change in price 5 =;ew price : 4riginal price> D 4riginal price
B
'am
J 5 =+*/).)% : 1,)))> D +1,))) 5 5.00%
B
9ave
J 5 =+.$*./% : 1,)))> D +1,))) 5 16.05%
12. ? substantial percentage of the companies listed on the ;@'E and ;?'9?U don1t pay dividends, but
investors are nonetheless willing to buy shares in them. Tnder what circumstances might a company
choose not to pay dividends?
!n general, companies that need the cash will often forgo dividends since dividends are a cash expense.
-oung, growing companies with profitable investment opportunities are one example& another example is
a company in financial distress. "his question is examined in depth in a later chapter.
1.. 'torico (o. Iust paid a dividend of + 2.%/ per share. 7he company will increase its dividend by 2) percent
next year and will then reduce its dividend growth rate by / percentage points per year until it reaches the
industry average of / percent dividend growth, after which the company will "eep a constant growth rate
forever. 0f the re3uired return on 'torico stoc" is 11 percent, what will a share of stoc" sell for today?
Kere we have a stoc" with supernormal growth, but the dividend growth changes every year for the first
four years. We can find the price of the stoc" in @ear $ since the dividend growth rate is constant after the
third dividend. 7he price of the stoc" in @ear $ will be the dividend in @ear %, divided by the re3uired
return minus the constant dividend growth rate. 'o, the price in @ear $ will be
B
$
5 +2.%/=1.2)>=1.1/>=1.1)>=1.)/> D =.11 : .)/> 5 +,/.).
7he price of the stoc" today will be the BQ of the first three dividends, plus the BQ of the stoc" price in
@ear $, so
B
)
5 +2.%/=1.2)>D=1.11> 8 +2.%/=1.2)>=1.1/>D1.11
2
8 +2.%/=1.2)>=1.1/>=1.1)>D1.11
$
8 +,/.).D1.11
$

B
)
5 $55.70
1*. What is the relationship between 0CC and ;BQ? ?re there any situations in which you might prefer one
method over the other? Explain.
!.. is the interest rate that causes %P2 for a series of cash flows to be 3ero. %P2 is preferred in all
situations to !..& !.. can lead to ambiguous results if there are nonconventional cash flows, and it also
ambiguously ranks some mutually exclusive pro4ects. 5owever, for standalone pro4ects with conventional
cash flows, !.. and %P2 are interchangeable techniques.
2). ?n investment under consideration has a paybac" of seven years and a cost of +22%,))). 0f the re3uired
return is 12 percent, what is the worst#case ;BQ? 7he best#case ;BQ? Explain. ?ssume the cash flows are
conventional.
Given the seven year paybac", the worst case is that the paybac" occurs at the end of the seventh year.
7hus, the worst#case
;BQ 5 :+22%,))) 8 +22%,)))D1.12
2
5 $396,499.17
"he best case has infinite cash flows beyond the payback point. "hus, the bestcase %P2 is infinite.