MOS3310 MIDTERM

MOS3310 MIDTERM CHAPTER 1 1-3 What is a firm’s fundamental, or intrinsic, value? What might cause a firm’s intrinsic value to be different than its actual market value? Intrinsic value of a company is an estimate of the actual value of the company while the actual market value of the firm is the current value of the firm based on its stock price. Therefore, there are chances that the market value is lower or higher than the intrinsic value because intrinsic value is just an estimation of the value of the firm. 1-4 The president of Eastern Semiconductor Corporation (ESC) made this statement in the company’s annual report: “ESC’s primary goal is to increase the value of our common shareholders’ equity.” Later in the report, the following announcements were made: a. The company contributed $1.5 million to the symphony orchestra in Toronto, Ontario, its headquarters’ city. b. The company is spending $500 million to open a new plant and expand operations in China. No profits will be produced by the Chinese operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision not been made to expand in that market. Discuss how ESC’s shareholders might view each of these actions, and how the actions might affect the share price. a. Shareholders would not like this as it would decrease money that they could have used to increase the shareholder value especially to the shareholders who do not live in the headquarter city. Ultimately all shareholders are interested in actions that would maximize share price which this action does not. b. As long as the analysis is accurate the shareholders should have a positive reaction to the decision and the share price should increase in the future. 1-5 Edmund Enterprises recently made a large investment to upgrade its technology. While these improvements won’t have much of an impact on performance in the short run, they are expected to reduce future costs significantly. What impact will this investment have on Edmund Enterprises’ earnings per share this year? What impact might this investment have on the company’s intrinsic value and share price? The investment made for the upgrade would decline the earnings per share this year as the investment would not have impact on the performance in the short run. However, this investment would increase the intrinsic value for the company as it gives a positive image for the future to investors. This would most definitely increase the share price for the future as the company is expected to save costs. When the investors have a positive perception for the future the demand for shares would increase which in turn would increase the price. 1-6 Describe the different ways in which capital can be transferred from suppliers of capital to those who are demanding capital. Direct transfers business sells its stocks or bonds directly to savers. Transfers also make go through investment bank that underwrites the issue. Transfers can also be made through a financial intermediary.

1-7 What are financial intermediaries, and what economic functions do they perform? Institutions or groups known as financial intermediaries serve as a link between lenders and borrowers. They offer a variety of services, including as collecting deposits, disbursing loans, handling payments, distributing credit and debit cards, and offering investment guidance. By controlling the movement of money between lenders and borrowers, they also help to promote financial stability. Financial intermediaries reduce risk by combining funds from numerous sources and distributing funds to those in need. 1-8 Suppose the population of Area Y is relatively young while that of Area O is relatively old, but everything else about the two areas is equal. a. Would interest rates likely be the same or different in the two areas? Explain. b. Would a trend toward nationwide branching by banks and trust companies, and the development of nationwide diversified financial corporations, affect your answer to part a? (a) Area Y has a relatively young population and therefore their savings would be less and the demand for loan would be high. This would lead to an increase interest rate. Whereas area O has a relative old population and hence would have less loan demand and more savings as they are less consumption oriented. This would lead to lower rate of interest. (b) Nationwide branching would surely affect the answer given above, as through nationwide branching, funds would flow from Area O to Area Y where the demand of funds is high from a place where supply is high. This would increase interest rate of area o and decrease the rate of area Y until the rates become roughly equal. 1-9 Suppose a new government was elected in Ottawa and its first order of business was to take away the independence of the Bank of Canada and to force the BoC to greatly expand the money supply. What effect would this have on the level of interest rates immediately after announcement? If the government takes away the independence of the Bank of Canada and forces it to greatly expand the money supply, the level of interest rates will likely increase immediately after the announcement. This is because an increase in the money supply leads to inflation, which reduces the purchasing power of money. As a result, lenders will demand a higher interest rate to compensate for the expected loss in purchasing power of the money they lend . 1-10 Is an initial public offering an example of a primary or a secondary market transaction? initial public offering (IPO) is an example of a primary market transaction. 1-11 Identify and briefly compare the two primary stock exchanges in Canada today. The two primary stock exchanges in Canada are the Toronto Stock Exchange (TSX) and the Canadian Securities Exchange (CSE). The TSX is the larger and more established of the two, with over 1,500 companies listed and a market capitalization of over $3 trillion. The CSE is a

Corporate governance is the system by which companies are directed and controlled. Boards of directors are responsible for the governance of their companies. d. The corporation’s primary goal is stockholder wealth maximi zation, which translates to maximizing the price of the firm’s common stock. (1) Firms have an ethical responsibility to provide a safe working environment, to avoid polluting the air or water, and to produce safe products. However, the most significant cost-increasing actions will have to be put on a mandatory rather than a voluntary basis to ensure that the burden falls uniformly on all businesses. (2) The same actions that maximize stock prices also benefit society. Stock price maximization requires efficient, low-cost operations that produce high-quality goods and services at the lowest possible cost. Stock price maximization requires the development of products and services that consumers want and need, so the profit motive leads to new technology, to new products, and to new jobs. Also, stock price maximization necessitates efficient and courteous service, adequate stocks of merchandise, and well-located business establishments--factors that are all necessary to make sales, which are necessary for profits. (3) Yes. Results of a recent study indicate that the executives of most major firms in the United States believe that firms do try to maintain high ethical standards in all of their business dealings. Furthermore, most executives believe that there is a positive correlation between ethics and long-run profitability. Conflicts often arise between profits and ethics. Companies must deal with these conflicts on a regular basis, and a failure to handle the situation properly can lead to huge product liability suits and even to bankruptcy. There is no room for unethical behavior in the business world. e. 1. Amount of expected cash flows. 2. Timing of the cash flow stream. 3. Risk of the cash flows. f. free cash flows are the cash flows available for distribution to all investors (stockholders and creditors) after paying expenses (including taxes) and making the necessary investments to support growth. Three factors determine cash flows: (1) current level and growth rates of sales; (2) operating expenses; and (3) capital expenses. g. The weighted average cost of capital (WACC) is the average rate of return required by all of the company’s investors (stockholders and creditors). It is affected by the firm’s capital structure, interest rates, the firm’s risk, and the market’s overall attitude toward risk. h. A firm’s value is the sum of all future expected free cash flows, converted into today’s dollars. … Value of firm formula. i. Households are net savers. Non-financial corporations are net borrowers. Governments are net borrowers. Non-financial corporations (i.e., financial intermediaries) are slightly net borrowers, but they are almost breakeven. Capital is transferred through: (1) direct transfer (e.g., corporation issues commercial paper to insurance company); (2) an investment banking house (e.g., IPO, seasoned equity offering, or debt placement); (3) a financial intermediary (e.g., individual deposits money in bank, bank makes commercial loan to a company) . j. Cost of equity = Required return = dividend yield + capital gain

Four factors affect the cost of money: Production opportunities Time preferences for consumption Risk Expected inflation k. Economic conditions affect the cost of money: Federal Reserve policies Budget deficits/surpluses Level of business activity (recession or boom) International trade deficits/surpluses International conditions affect the cost of money: - Country risk. Depends on the country's economic, political, and social environment. - Exchange rate risk. Non-dollar denominated investment's value depends on what happens to exchange rate. Exchange rates affected by: -International trade deficits/surpluses -Relative inflation and interest rates l. Financial securities are assets or instruments with an economic value that people can buy, sell, and trade. The most common types of financial security are stocks, bonds, mutual funds, and ETF shares. Some of the financial instruments are - Corporate bonds which can be traded on an exchange and are issued by companies to raise funds for the capital expenditure requirements of the companies. Similarly, companies can also issue stock or equity which are also traded in the exchange, and they are also used to fund expansion plans of the company. Stocks or equity carries greater risk than bonds and hence need greater return expectations. m. Investment banks  Commercial banks  Trust companies  Credit unions  Life insurance companies  Mutual funds  Pension funds  Hedge funds  Private equity funds n. A market is a method of exchanging one asset (usually cash) for another asset. Some types of markets are physical assets vs. financial assets; spot versus future markets; money versus capital markets; primary versus secondary markets. CHAPTER 2 2-1 An investor recently purchased a corporate bond that yields 7.68%. The investor is in the 25% federal-plus-state tax bracket. What is the bond’s after -tax yield to the investor? In the given case, the investor has purchased a corporate bond on which the required rate of return (also known as the market rate of interest) is 7.68%. Also, the federal plus state tax rate applicable to the investor is 25%. The Bond’s after Tax yield to the investor can be calculated as follows:

Therefore depreciation and amortization expenses is $2.5 million 2-4 Kendall Corners Inc. recently reported net income of $3.1 million and depreciation of $250,000. What was its net cash flow? Assume it had no amortization expense. Net Income is $3,100,000 Depreciation expenses $500,000 Calculate the Net cash flow amount: Depreciation is typically the largest non-cash item, so net cash flow is often expressed as net income plus depreciation. Net Cash flow amount is $3,600,000 2-5 In its most recent financial statements, Newhouse Inc. reported $50 million of net income and $810 million of retained earnings. The previous retained earnings were $780 million. How much in dividends was paid to shareholders during the year? Given: Net Income = $ 50,000,000 Retained Earnings = $ 810,000,000 Previous Retained Earnings = $ 780,000,000 The net Income of the company is divided into two accounts, namely: Retained earnings and Dividends paid out. Thus,

Further, we can find out the change in retained earnings as: Substituting the value for change in retained earnings account to get, dividends paid out to shareholders: 2-6 Based on the following information, what are Ever Green’s cash flows from operations? The company reported profits of $18,000 and claimed amortization of $4,000, while accounts receivable increased by $4,000, inventories decreased by $8,000, and accounts payable increased by $4,000. CHAPTER 3 3-1 Grey Brothers has a DSO of 27 days. The company’s average daily sales are $35,000. What is the level of its accounts receivable? Assume there are 365 days in a year. Days sales outstanding = (Receivables / Average sales per day) = (Receivables / (Annual sales / 365)) 27 = (Receivables / 35000) AR =$945,000 3-2 Vigo Vacations has an equity multiplier of 2.5. The company’s assets are financed with some combination of long - term debt and common equity. What is the company’s debt ratio?

Change in AP = $46,026 CHAPTER4 4-2 What is an opportunity cost rate? How is this rate used in discounted cash flow analysis, and where is it shown on a timeline? Is the opportunity cost rate a single number that is used in all situations? Opportunity cost rate is the required return that an Investor Could have earned on an alternative Investment with the same risk. In discounted cash flow analysis, it is represented by the symbol "i ”, It is shown on top of the time line. Opportunity rate is not same for all Projects i.e., it is not a single rate, it depends on the riskiness of the Investment Project also On various factors like Inflation, length of the project a. If you deposit $10,000 in a bank account that pays 10% interest annually, how much will be in your account after 5 years? Future value = Present value*(1+r)^n r = Interest rate n = Number of periods Future value after 5 Years = 10000*(1+10%)^5 = 16,105.10 b. What is the present value of a security that will pay $5,000 in 20 years if securities of equal risk pay 7% annually? Using the same above formula Now we have to calculate Present value 5000 = Present value*(1+7%)^20 Present value = 1292.10 c. What is the future value of a 7%, 5-year ordinary annuity that pays $300 each year? If this were an annuity due, what would its future value be? Future value of annuity = P*[(1+r)^n - 1 / r ]

P = Periodical payment = 300 r = Interest rate = 7% n = Number of periods = 5 Future value = 300*[(1+7%)^5 - 1 / 7%] = 1725.22 In case of annuity due, Future value = P*[(1+r)^n - 1 / r ]*(1+r) = 1725.22*(1+7%) = 1846 4-3 An annuity is defined as a series of payments of a fixed amount for a specific number of periods. Thus, $100 a year for 10 years is an annuity, but $100 in Year 1, $200 in Year 2, and$400 in Years 3 through 10 does not constitute an annuity. However, the second series contains an annuity. Is this statement true or false? An annuity is the series of equal payment made at the fixed interval of time period. So, the important feature of annuity is: • Equal payment. • Fixed time period. The payment of a year for 10 years is an annuity because there is equal payment of for 10 years. In the second case, the payment for the first series is made in the following manner: • in first year. • in second year. • in third year and onwards. The payment in such a manner does not constitute annuity because there is no equal payment for fixed interval of time period. When the payment is made in the following manner in the second series it will constitute annuity as there will be equal amount of payments for first and second years and from third year onwards. 4-4 If a firm’s earnings per share grew from $1 to $2 over a 10 -year period, the total growth would be 100%, but the annual growth rate would be less than 10%. True or false? Explain. By using the financial calculator and input

large must each of the four payments be? c. If your father were to offer either to make the payments calculated in part b ($221.92) or to give you a lump sum of $750 one year from now, which would you choose? d. If you have only $750 one year from now, what interest rate, compounded annually, would you have to earn to have the necessary $1,000 four years from now? e. Suppose you can deposit only $186.29 each at Years 1 through 4, but you still need $1,000 at Year 4. What interest rate, with annual compounding, must you seek out to achieve your goal? f. To help you reach your $1,000 goal, your father offers to give you $400 one year from now. You will get a part-time job and make six additional payments of equal amounts each 6 months thereafter. If all of this money is deposited in a bank that pays 8%, compounded semiannually, how large must each of the six payments be? g. What is the effective annual rate being paid by the bank in part f? CR-3 Bank A pays 8% interest, compounded quarterly, on its money market account. The managers of Bank B want its money market account to equal Bank A’s effective annual rate, but interest is to be compounded on a monthly basis. What nominal, or quoted, rate must Bank B set? 4-1 How much money will you have in your bank account in 5 years if it pays 4% annually and you start with the following amounts. (Hint: If you are using a financial calculator, you can enter the known values and then press the appropriate key to find the unknown variable. Then, without clearing the TVM register, you can “override” the variable that changes by simply entering a new value for it and then pressing the key for the unknown variable to obtain the second answer. This procedure can be used in parts b through d, and in many other situations, to see how changes in input variables affect the output variable.) a. $5,000. c. $15,000. b. $10,000. d. $20,000. Using calc a. $6,083.27 b. $12,166.53 c. $18,249.80 d. $24,333.06 4-2 What is the present value of a security that will pay the amounts shown below in 20 years? Securities of equal risk pay 7% annually. a. $20,000. c. $40,000. b. $30,000. d. $50,000. Using calc a.$5168.38 b.$7752.57 c.$10336.76 d.$12920.95 4-3 Your parents will retire in 18 years, and they think they will need $1,000,000 at retirement. What annual interest rate must they earn to reach their goal, based on the starting amounts shown below? Assume they don’t save any additional funds. a. $50,000. c. $200,000. b. $100,000. d. $300,000. Using calc a. 18.11% b. 13.65% c. 9.35% d. 6.92% 4-4 If you deposit money in an account today, how long will it take to triple your money based on the annual interest rates below? a. 2.5%. c. 7%. b. 4%. d. 10%. Using calc a.44.49 b.28.01 c.16.24 d.11.53 4-5 You have $42,180.53 in a brokerage account, and you plan to deposit an additional $5,000 at the end of every future year until your account totals $250,000. You expect to earn 12% annually on the account. How many years will it take to reach your goal? Using calc N = 11 years

4-6 What is the future value of a 9%, 5-year ordinary annuity that pays $300 each year? If this were an annuity due, what would be its future value? Using calc FV=1795.41 FVdue=1795.41(1.09)=1957.00 4-7 An investment will pay $100 at the end of each of the next 3 years, $200 at the end of Year 4, $300 at the end of Year 5, and $500 at the end of Year 6. If other investments of equal risk earn 8% annually, what is its present value? Its future value? Using calc do each ind then add PV = $923.98 FV = $1,466.24 4-8 You want to buy a car, and a local bank will lend you $20,000. The loan would be fully amortized over 5 years (60 months), and the nominal interest rate would be 12%, with interest paid monthly. What would be the monthly loan payment? What would be the loan’s EAR? Here, loan amount is for 60 months. So the monthly coupon rate would be the 1% payable monthly. So, the monthly loan payment of an annuity will be calculated by using the PVA formula as follows: Therefore the month loan payment would be Now the EAR is calculated as follows:

but the investment will pay huge dividends throughout the course. Note, if you do work with the cash flow register, then you must enter CF 0 5 0.) Year. Cash Stream A Cash Stream B 1 $800 $100 2 300 300 3 300 300 4 300 300 5 100 800 b. What is the value of each cash flow stream at a 0% interest rate? Using calc Calculate each then add 4-15 Find the interest rates, or rates of return, on each of the following: a. You borrow $700 and promise to pay back $749 at the end of 1 year. b. You lend $700 and receive a promise to be paid $749 at the end of 1 year. c. You borrow $85,000 and promise to pay back $201,229 at the end of 10 years. d. You borrow $9,000 and promise to make payments of $2,684.80 per year for 5 years. Using calc a. 7%. b. 7%. c. 9%. d. 15% 4-16 Find the amount to which $2,000 will grow under each of the following conditions: a. 8% compounded annually for 5 years. b. 8% compounded semiannually for 5 years. c. 8% compounded quarterly for 5 years. d. 8% compounded monthly for 5 years. Find EFF then Using calc find FV 4-17 Find the present value of $2,000 due in the future under each of the following conditions: a. 8% nominal rate, semiannual compounding, discounted back 5 years. b. 8% nominal rate, quarterly compounding, discounted back 5 years. c. 8% nominal rate, monthly compounding, discounted back 1 year. a. $1,351.13. b. $1,345.94. c. $1,846.72 4-19 Universal Bank pays 7% interest, compounded annually, on time deposits. Regional Bank pays 6% interest, compounded quarterly. a. Based on effective interest rates, in which bank would you prefer to deposit your money? b. Could your choice of banks be influenced by the fact that you might want to withdraw your funds during the year as opposed to at the end of the year? In answering this question, assume that funds must be left on deposit during the entire compounding period in order for you to receive any interest. a. Universal, EAR = 7% Regional, EAR = 6.14% CHAPTER 5 Operating plan: It provides detailed implementation guidance to help meet the corporate objectives. These plans can be developed for any time period but generally, they are developed for 5-year time. This plan explains who is responsible for each function, when specific tasks are to be accomplished, sales and profit targets etc. Financial plan: It provides details about the financial aspect of an operating plan. It also provides the details about the current financial condition of the firm, along with the future financial forecast which includes sales forecast, pro forma financial statements, and external financing plan. Sales forecast: Sales forecast generally starts with the review of past 5 to 10 years data to forecast the future sales. It generally, focuses on number of units and the dollar sales for the

future period. It is generally represented in graphical form. Sales forecasts are based on the past and present sales trend. It also includes the economic conditions, industrial growth, expansion, diversification etc. It is very crucial and important forecast for financial planning. Pro forma financial statement: It is similar to the actual financial statement and depicts it if the assumption under which it is prepared takes place. Forecasted financial statement method: It actually forecasts the complete set of financial statements. Under this the AFN formula is used to forecast the financial statement. Accordingly, sales are forecasted first and all other items supporting the sales are forecasted based on sales. Both the income statement and balance sheet are forecasted based on sales. Thus, the value of the various item increases with sales and decrease with sales as they are estimated with the percentage of sales. Spontaneously generated funds: Spontaneous fund are those funds which are generated automatically with the projected increase in sales. Spontaneous increase in liabilities such as accounts payable, accruals which are the sources of funds in proportion to the increase in assets due to the increase in sales is spontaneously generated funds. Increase in spontaneous liability will lower the need for external financing. Additional funds’ needs (AFN): It indicates the requirement of external source of funds in order to increase the assets of the firm which is essential to support the increase in sales. Increase in sales requires the firm to increase its asset in order to support its increased level of sales. But sometime, the requirements are met with the spontaneous liabilities and the retained earnings of the firm. External sources of fund equals to the balance amount which is required by the firm and cannot be met through internal sources. AFN = (A*/S 0 )∆S – (L*/S 0 )∆S – M(S 1 )(RR) Capital intensity ratio: The amount of assets required per dollar of sales is called as the capital intensity ratio. This ratio has a major effect on capital requirements. Firm having higher assets- to-sales ratio requires more assets for a given increase in sales, hence a greater need for external financing. Lumpy assets: For a firm to be competitive it must add fixed assets in large, discrete units; such assets are often referred to as lumpy assets. It has a major effect on the fixed assets to sales ratio at different sales levels and consequently, on financial requirements. 5-2 Certain liability and net worth items generally increase spontaneously with increases in sales. Put a tick mark ( P ) by those items that typically increase spontaneously: Accounts payable ___P___ Mortgage bonds _______ Notes payable to banks _______ Common stock. _______ Accrued wages. ___P___ Retained earnings ___P___ Accrued taxes ___P___ 5-3 The following equation is sometimes used to forecast financial requirements: AFN = (A*/S 0 )∆S – (L*/S 0 )∆S – M(S 1 )(RR)

Under these conditions, use the AFN formula to determine the amount of additional funds Barnsdale would require during each of the next 2 years. if sales grew at a rate of 20% per year. CR-2 Holden Lumber’s 2015 financial statements are shown below. Holden Lumber: Balance Sheet as at December 31, 2015 (Thousands of Dollars) Cash $ 1,800 Accounts payable $ 7,200 Receivables 10,800 Notes payable 3,472 Inventories 12,600 Accruals 2,520 Total current assets 25,200 Total current liabilities 13,192 Net fixed assets 21,600 Mortgage bonds 5,000 Common stock 2,000 Retained earnings 26,608 Total assets $46,800 Total liabilities and equity $46,800 Holden Lumber: Income Statement for December 31, 2015 (Thousands of Dollars) Sales $36,000 Operating costs 30,783 Earnings before interest and taxes 5,217 Interest 717 Earnings before taxes 4,500 Taxes (28%) 1,260 Net income $ 3,240 Dividends (60%) $ 1,944 Addition to retained earnings $ 1,296 a. Assume that the company was operating at full capacity in 2015 with regard to all items except fixed assets, fixed assets in 2015 were being utilized to only 75% of capacity. By what percentage could 2016 sales increase over 2015 sales without the need for an increase in fixed assets? b. Now suppose that 2016 sales increase by 25% over 2015 sales. Use the forecasted financial statement method to forecast a 12/31/16 balance sheet and 2016 income statement, assuming that (1) the historical ratios of operating cost/sales, cash/sales, receivables/ sales, inventories/sales, accounts payable/sales, and accruals/sales remain constant; (2) Holden cannot sell any of its fixed assets; (3) any required financing is done at the end of 2016 as notes payable; (4) the firm earns no interest on its cash; and (5) the interest rate on all of its debt is 12%. Holden pays out 60% of its net income as dividends and has a tax rate of 28%. How much additional external capital will be required? (Hints: Base the forecasted interest expense on the amount of debt at the beginning of the year, because any new debt is added at the end of the year; also, use the forecasted income statement to determine the addition to retained earnings for use in the balance sheet.) PROBLEMS 5-1 Broussard Skateboard’s sales are expected to increase by 15% from $8 million in 2015 to $9.2 million in 2016. Its assets totaled $5 million at the end of 2015. Broussard is already at full capacity, so its assets must grow at the same rate as projected sales. At the end of 2015, current liabilities were $1.4 million, consisting of $450,000 of accounts payable, $500,000 of notes payable, and $450,000 of accruals. The after-tax profit margin is forecasted to be 6%, and the forecasted payout ratio is 40%. Use the AFN equation to forecast Broussard’s additional funds needed for the coming year. Sales Expected = 9200000 After tax profit margin = 9200000*0.06 = 552000 Dividend payments = 552000*0.4 = 220800

Addition to retained earnings = 552000-220800 = 331200 Increase in assets = 750000 Increase in liabilities = 135000 AFN = Increase in assets - Increase in Liabilities - Addition to Retained Earnings AFN = 283800+ 5-2 Refer to Problem 5- 1. What would be the additional funds needed if the company’s year -end 2015 assets had been $7 million? Assume that all other numbers6556, including sales, are the same as in Problem 5-1 and that the company is operating at full capacity. Why is this AFN different from the one you found in Problem 5- 1? Is the company’s “capital intensity” ratio the same or different? Additional fund needed is the amount of fund required by the firm to expand its business operations. A firm can determine additional fund needed by estimating the amount of new assets necessary to support the forecasted level of sales and then subtracting from that amount the spontaneous funds that will be generated from operations. The additional fund needed (AFN) will be calculated by the formula shown below: Mathematically, this formula can be expressed as follows: Where: M = profit margin = Assets at the beginning = Liabilities at the beginning = Change in sales = New sales