DISCUSSION QUESTION 1-1
MF620: Financial Statement Development and Analysis
1. Explain how the cash flow cycle works.
2. Describe how financial management is related to accounting.
3. How do sole proprietorships, general partnerships, limited liability companies, S corporations, and C corporations differ?
4. Suppose three optometrists wished to form a business that was expected to last until the oldest one was about to retire. The three had known each other since college and were close friends who trusted one another. What type of firm might be appropriate? Why?
DISCUSSION QUESTION 1-2
1. Describe the four stages of the business cycle.
2. Describe the two hypotheses that explain the shape of the yield curve.
3. Describe the three shapes of the yield curve that tend to be associated with different business cycle stages.
4. Compare the typical profitability of a stage 2 firm versus a stage 3 firm.
5. Develop a list of factors that would result in a firm having high supply risk and high demand risk.
Activity 2: Financial Performance (4 pages, 100 points)
Part A Bigco’s balance sheet one year ago indicated retained earnings of $450 million. This year, Bigco’s net income was $35 million. It paid its preferred shareholders a dividend of $5 million and paid its common shareholders a regular dividend of $6 million, along with a special one-time dividend of $10 million. What should be the retained earnings amount on this year’s balance sheet?
Part B Wholesale Lumber, Ltd. is a firm that distributes lumber to building supply and home improvement retail stores. The firm’s cost of sales for the most recent year was $45 million, its beginning inventory was $16 million, and its ending inventory was $18 million. Estimate Wholesale Lumber’s purchases of lumber materials for the year.
Part C Star Inc. has year 1 revenues of $80 million, net income of $9 million, assets of $65 million, and equity of $40 million, as well as year 2 revenues of $87 million, net income of $22 million, assets of $70 million, and equity of $50 million. Calculate Star’s return on equity (ROE) for each year based on the DuPont method and compare it with a direct ROE measure. Next, explain why the firm’s ROE changed between year 1 and year 2.
DISCUSSION QUESTION 3-1
1. Calculate the present value (PV) of a cash inflow of $500 in one year and a cash inflow of $1,000 in five years, assuming a discount rate of 15 percent.
2. Calculate the present value (PV) of an annuity stream of five annual cash flows of $1,200, with the first cash flow received in one year, assuming a discount rate of 10 percent.
3. What is the present value of a perpetual stream of annual cash flows, with the first cash flow of $100 to be received in one year and with all subsequent cash flows growing at a rate of 3 percent, assuming a discount rate of 8 percent?
4. Consider two bonds, Bond C and Bond D, both with a yield to maturity of 10 percent and with 5 years to maturity. These are standard bonds with semiannual coupon payments. Bond C has a coupon rate of 10 percent (with semiannual coupon payments); Bond D does not pay any coupons (i.e., it a zero-coupon bond). What is the price of each bond?
5. What is the fair value today of a common share with expected annual dividends of $1.00, $1.05, and $1.10 in each of the next three years and an expected share price of $20 in three years, assuming a required return of 9 percent?
DISCUSSION QUESTION 3-2
1. What is the payback period of a project with average annual cash outflows of $8,000, average annual cash inflows of $10,000, and an initial investment of $13,000?
2. What is the net present value of a simple one-period project with an initial investment of $12,000 and an expected net cash flow in one year of $15,000, assuming a discount rate of 8 percent?
3. What is the net present value of a project with a $40,000 initial investment and expected net cash flows of $15,000, $20,000, and $25,000 in each of the next three years, assuming an appropriate discount rate of 10 percent?
a. What is the internal rate of return for the project?
b. What is the profitability index for the project?
c. What is the payback period for the project?
d. What is the modified internal rate of return for the project if the finance rate is 10 percent and the reinvestment rate is 13 percent?
Activity 4: Long Term Financing (4 pages, 100 points)
Choose a publicly traded company on which to focus, modeled on the Walmart analysis in chapter 14.
Part A Project an income statement for next year for the firm based on your assessment of revenue growth, key projected financial ratios, and any other key assumptions, making sure to justify any assumptions.
1. What is your projection for net income and how does it compare with the previous year?
2. Based on your assessment of anticipated dividends, what is your projection for a change in retained earnings?
Part B Project a balance sheet for next year for the firm based on your assessment of the change in retained earnings, key projected financial ratios, and any other key assumptions, making sure to justify any assumptions. Use external borrowing as your balancing “plug.” What is your assessment of the firm’s financial needs?
Part C Based on your projection of financial needs, what recommendation would you make to the firm—for example, how to meet increased financing needs or what to do with excess financial capacity?
DISCUSSION QUESTION 5-1
1. Explain why a hotel company might have a higher proportion of debt in its capital structure relative to a drug company.
2. According to Modigliani and Miller (M&M), in a world of perfect capital markets, what will be the expected equity return (or cost of equity) for a firm that has a cost of capital of 10 percent, a cost of debt of 6 percent, debt valued at $1.2 million, and equity valued at $1.0 million?
3. Suppose a firm has $10 million in debt that it expects to hold in perpetuity. If the interest rate is 7 percent and the corporate tax rate is 35 percent, what is the value of the interest tax shield?
4. What is the value of an all-equity firm that: has a dividend payout ratio of 100 percent, is expected to generate net income each year (forever) of $1 million, and has a required equity return (also the ROE) of 16 percent?
DISCUSSION QUESTION 5-2
1. Assume that a firm’s earnings per share (EPS) are expected to be $2.00 next year and that analysts have determined that an appropriate forward-looking multiple is 15 times the projected earnings. What should the stock price be?
2. Suppose that the firm in question #1 plans to increase the proportion of debt as part of its capital structure. The projected EPS would then be $2.50. In a world with no financial distress, determine what the stock price should be and explain why in the real world the stock price would be less than that amount.
3. Calculate an EBIT breakeven between a debt firm (DF) and an all-equity firm (EF) based on the following information: DF interest = $40,000; DF number common shares = 6,000; EF number of common shares = 10,000; and tax rate = 35 percent. Check your answer by calculating the EPS for both DF and EF at the breakeven EBIT.
4. Calculate the cash flow coverage ratio based on the following information: EBIT = $540,000; depreciation and amortization = $65,000; interest payments = $180,000; principal repayment = $75,000; and tax rate = 35 percent.
5. Suppose a firm has an EBIT of $5 million, interest expenses of $2 million, depreciation expenses of $1 million, and a tax rate of 35 percent. Its bank agrees to lend up to 4 times its EBITDA. How much debt can the firm borrow from the bank?
6. Suppose an all-equity firm has a beta estimated to be 1.2. If the firm changes its capital structure such that its debt-to-equity ratio is now 0.4, what should be the revised beta estimate if it also faces a tax rate of 35 percent?
Activity 6: Creating Value (4 pages 100 points)
Free Cash Inc. is anticipated to make earnings before interest and taxes (EBIT) of $30,000, $40,000, and $50,000 in each of the next three years. Depreciation is estimated to be $3,000, $3,500, and $4,000 in each of the next three years. Capital expenditures are estimated to be $8,000, $9,000, and $10,000 in each of the next three years. Incremental increases in working capital requirements are estimated to be $2,500, $3,000, and $3,500 in each of the next three years. Free Cash Inc.’s tax rate is 35 percent.
FOUR PARTS OF THIS ACTIVITY.
ANSWER WILL BE SENT ON EMAIL.
