FINANCIAL PLANNING
SAMPLE MID-TERM QUESTIONS
SPRING 1999
INSTRUCTIONS: Be specific, but not wordy.
1.a. Discuss the following statement in light of our diagram of the corporation: “The cost of capital depends primarily on the use of the funds, not the source.”
1.b. What implications does the above statement have for calculating the cost of capital for the acquisition of one company by another, and for assigning divisions of a company a cost of capital for use in capital budgeting decisions.
1.c. A company is about to construct a new 10 million dollar factory, for which it sold 10 million dollars of bonds yielding 9.5%. The cost of capital for this project is therefore 9.5%. Do you agree or disagree with this statement, and why?
1.d. In practice the cost of capital is difficult to estimate, particularly for small, privately owned businesses. Fully explain how you would estimate the cost of debt, the cost of equity and the weighted average cost of capital for such a company.
2. Consider the following two companies:
| (#s in $millions) | Company A | Company B |
| EBIT | 600 | 1120 |
| Interest | 40 | 320 |
| Earnings Before Tax | 560 | 800 |
| Taxes @ 40% | 224 | 320 |
| Net Income | 336 | 480 |
| Debt | 400 | 3,200 |
| Equity | 1,600 | 800 |
a. Calculate each company's ROE, ROA, and ROIC.
b. Why is company B's ROE so much higher than A's? Does this mean B is a better company? Why or why not?
c. Why is company A's ROA higher than B's? What does this tell you about the two companies?
d. How do the two companies' ROIC compare? What does this suggest about the two companies?
3.a. One of the frequently cited advantages of debt is the tax advantage. Explain some other advantages of debt.
3.b. Too much debt can lead to financial distress and the associated costs. What are the costs of `financial distress?' What are some other disadvantages of debt besides these costs?
4. XYZ, Inc. is considering purchasing Widget, Inc. XYZ would finance the purchase using its current target mix of debt and equity: 60% debt, 40% equity. Widget currently has 8% coupon debt outstanding, which pays interest semiannually, matures in 25 years and is now priced at $833.13 per bond. Widget equity is not publicly traded, so its beta is not available. You are able to gather the following information however:
Historical risk premium 6.5%
Long run T-bonds 6.0%
In addition, you found a portfolio of comparable firms to Widget. The beta of such portfolio is 1.6, and its debt/equity ratio is 1. In addition, XYZ'a marginal tax rate is 40%. The expected internal rate of return on Widget's cash flows is 12%. Should XYZ purchase Widget?
5. One advantage of equity financing is that the corporation is not committed to a fixed cash payout. It can pay dividends when money becomes available. Yet many managers are reluctant to issue equity because of its dilutive effect on EPS, share value, and ownership. Additionally, the market may respond negatively to the annoucement of an equity issue. Fully explain these concerns.
6a. You are preparing to discuss borrowing needs with your bank's loan officer who asks you to prepare pro-forma financial statements. Below are the financial statements for the year just ended. Your sales department is projecting a 30% increase in sales. Days sales outstanding are expected to improve to 90. With respect to inventory and accounts payable, assume that purchases will be $8,700,000 and cash payments will be $9,000,000. Operations are running at 75% of capacity and have recently been streamlined. Accordingly, gross profit margins are expected to be 11% in the future. Other expenses are expected to remain the same percentage of sales. The retention ratio is 25%. For ease of calculation, assume interest expense remains the same. Prepare pro-forma financial statements and determine the amount of borrowing needs, which will be reflected in long-term debt.
| Cash | 200,000 | Sales | 7,500,000 | |
| Accts receivable | 2,500,000 | Cost of sales | 6,750,000 | |
| Inventory | 1.800,000 | Gross profit | 750,000 | |
| Total current assets | 4,500,000 | Other expenses | 250,000 | |
| Fixed assets | 400,000 | EBIT | 500,000 | |
| Total assets | 4,900,000 | Interest | 100,000 | |
| EBT | 400,000 | |||
| Accounts Payable | 1,200,000 | Taxes (40%) | 160,000 | |
| Long-term debt | 700,000 | Net income | 240,000 | |
| Total debt | 1,900,000 | |||
| Common stock | 2,300,000 | |||
| Retained Earnings | 700,000 | |||
| Total debt & equity | 4,900,000 |
6b. Using the projections from question 6a., compute the projected cash flows from assets. (for simplicity, assume depreciation = 0) Show they are equal to expected cash flows to bondholders and shareholders.
7. In our first couple of cases we saw that growth and financing needs were related. Explain this relation, and explain the options available to management in dealing with this relation. Under what conditions might growth be harmful?
8. Consider a firm with the following perpetual cash flows:
EBIT = 3,000
Tc = 34%
Debt = 7,500
Rd = 8%
Ru = 18%
a. What is the value of the value of the firm if it had no debt?
b. What is the value of the firm with debt? What is the value of equity?
c. Find Re and the weighted average cost of capital
d. Find the value of equity by discounting equity's cash flows at equity's cost of capital.
e. Find the value of the firm by discounting the firm's cash flows by WACC.
9. Business risk and financial risk combine to help determine a firm's cost of capital. Explain this statement in light of the diagram that was handed out the first day of class and to which we have referred all term.
10. Consider the following firm which is considering taking on more debt:
| Borrowing: Rate Shares o/s Re EBIT Interest EBT Taxes Earnings EPS Share Price |
0 0% 100,000 15% 360,000 0 360,000 122,400 237,600 2.38 15.84 |
480,000 13% 70,000 17% 360,000 62,400 297,600 101,184 196,416 2.81 16.51 |
600,000 15% 62,500 18% 360,000 90,000 270,000 91,800 178,200 2.85 15.84 |
720,000 16% 55,000 19% 360,000 115,200 244,800 83,232 161,568 2.94 15.46 |
a. What is the optimal capital structure and why?
b. What is the WACC at this debt level?
c. How does the WACC at the optimal level of debt compare with the WACC with no debt, and what is the intuition for this difference?
d. Are earnings per share highest at your optimal level of debt? If not, explain why a level of debt with higher EPS is not optimal.
e. How does the introduction of debt in this example affect EBIT? Under what conditions might EBIT change with the introduction of debt?
11. Explain the difference between the 'accounting' model and the 'economic' model of firm valuation as discussed in our readings. What implication does each of these models have for firms engaging in either research and development costs or a capital budgeting project which has an immediate dilutive effect on EPS? What does empirical evidence indicate?
12. What is an efficient market? Why do we care whether or not markets are efficient?
Potentially useful `formulas':
Bl = Bu * [1 + D/E*(1 - t)]
Bu = Bl / [1 + D/E*(1 - t)]
Re = Rf + B(Rm - Rf)
Re = D1/P0 + g
Re = Ra + (Ra - Rd)*D/E*(1-t)
Vl = Vu + PV(tax advantage)
V = CF's to Firm/WACC
Inventory turnover = COS/Inventory
Days Sales O/S = A/R / (Sales/day)
DuPont = Net Income/Sales x Sales/Assets x Assets/Equity
ROIC = Return on Invested capital = EBIT (1-t) / Invested Capital