Which one of the following statements matches m&m proposition i without taxes?

SAN FRANCISCO STATE UNIVERSITY (SFSU) FIN 351: FINANCIAL MANAGEMENT

SAMPLE FINAL REVIEW by Professor Yi Zhou

1. Which of the following best defines the concept of corporate governance?

A. A system for monitoring managers’ activities, rewarding performance, and disciplining misbehavior.

B. Corporate values and governance structures that ensure the business is conducted in an ethical, competent, fair, and professional manner.

C. A system of principles, policies, and procedures used to manage and con- trol the activities of a corporation so as to overcome conflicts of interest inherent in the corporate form.

D. A system to ensure complete transparency in disclosures regarding oper- ations, performance, risk, and financial position.

E. A system of fairness and accuracy in identifying inherent conflicts of in- terest.

Answer: C. Corporate governance is the system of principles, policies, proce- dures, and clearly defined responsibilities and accountabilities used by stakehold- ers to overcome the conflicts of interest inherent in the corporate form. [Directly from the Lecture Note.]

2. Which of the following best defines the objectives of an effective system of corporate governance?

A. ensure that the assets of the company are used efficiently and productively.

B. eliminate or mitigate conflicts of interest among stakeholders.

C. A and B.

D. D. ensure complete transparency in disclosures regarding operations, per- formance, risk, and financial position.

E. A and D.

Answer: C. OBJECTIVES: To eliminate or mitigate conflicts of interest. Particularly those between corporate managers and shareholders; and To ensure that the assets of the company are used efficiently and productively and in the best interests of its investors and other stakeholders. [Directly from the Lecture Note.]

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Question 3 to 8 use the following set-up:

Suppose a company has the opportunity to bring out a new product, the Vitamin-Burger. The initial cost of the assets is $90 million, and the company’s working capital would increase by $20 million during the life of the new product. The new product is estimated to have a useful life of four years, at which time the assets would be sold for $15 million. Management expects company sales to increase by $120 million the first year, $160 million the second year, $140 million the third year, and then trailing to $50 million by the fourth year because competitors have fully launched competitive products. Operating expenses are expected to be 60% of sales, and depreciation is based on an asset life of three years under MACRS (modified accelerated cost recovery system). The MACRS deprecation schedule is Year 1: 33.33%. Year 2: 44.45%. Year 3: 14.81%. Year 4: 7.41%. Assume the required rate of return on the Vitamin-Burger project is 10% and the company’s tax rate is 35%.

Year 0 1 2 3 4 Investment Outlays: Fixed capital -90.00 Net working capital -20.00 Total -110.00

Annual after-tax operating cash flows: Sales 120.00 160.00 140.00 50.00 − Cash operating expenses 72.00 96.00 84.00 30.00 − Depreciation 30.00 40.01 13.33 6.67 Operating income before taxes 18.00 24.00 42.67 13.33 − Taxes on operating income 6.30 8.40 14.93 4.67 Operating income after taxes 11.70 15.60 27.74 8.67 + Add back: depreciation 30.00 40.01 13.33 6.67 After-tax operating cash flow 41.70 55.60 41.07 15.33

Terminal year after-tax nonoperating cash flows: Salvage value 15.00 After-tax salvage value 9.75 Return of net working capital 20.00 Total after-tax cash flow -110.00 41.70 55.60 41.07 45.08

Tax Rate 35% Required Rate of Return 10% Net Present Value 35.51

−110 + 41.70 (1 + 0.1)

+ 55.60

(1 + 0.1)2 +

41.07

(1 + 0.1)3 +

45.08

(1 + 0.1)4 = 35.51

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3. What is the investment outlay?

A. −100 million.

B. −110 million.

C. −120 million.

D. −90 million.

E. −70 million.

Answer: B.

Outlay = FCInv +NWCInv − (1− T )Sal0 − TB0

• FCInv = Investment in new fixed capital • NWCInv = Investment in net working capital • Sal0 = Cash proceeds (salvage value) from sale of old fixed capital. • T = Tax rate • B0 = Book value of old fixed capital.

In this question

• FCInv = −$90 million (The initial cost of the assets is $90 million.) • NWCInv = −$20 million (The company’s working capital would increase by

$20 million during the life of the new product.)

• Sal0 = $0 million (No information). • T = 35% (The company’s tax rate is 35%.) • B0 = $0 million (No information).

Outlay = FCInv +NWCInv = −90− 20 = −110.

4. What is the cash operating expense for Year 2?

A. 100 million

B. 106 million

C. 96 million

D. 92 million

E. 90 million

Answer: C. “Operating expenses are expected to be 60% of sales”, and “Man- agement expects company sales to increase by $120 million the first year, $160 million the second year,”... Thus Cash operating expense for Year 2 is 60%×$160 = 96.

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5. What is the depreciation for Year 3?

A. 30.68 million

B. 24.12 million

C. 20.56 million

D. 13.33 million

E. 12.08 million

Answer: D. The MACRS deprecation schedule is Year 1: 33.33%. Year 2: 44.45%. Year 3: 14.81%. Year 4: 7.41%. Deprecation is of the initial cost of assets. Thus the depreciation for Year 3 is 14.81%×90=13.33.

6. What is the after-tax operating cash flow for Year 4?

A. 55.60 million

B. 41.07 million

C. 41.70 million

D. 17.33 million

E. 15.33 million

Answer: E. After-tax operating cash flow = Operating cash flow (OCF)

OCF = (S − C −D)(1 − T ) +D

S4 = 50, C4 = 60% × 50 = 30, D4 = 7.41% × 90 = 6.67, T = 35%

OCF4 = (S4−C4−D4)(1−T4)+D4 = (50−30−6.67)×(1−35%)+6.67 = 15.33

7. What is the total terminal after-tax non-operating cash flows for Year 4?

A. 45.08 million

B. 41.70 million

C. 41.07 million

D. 55.60 million

E. 15.33 million

Answer: A. The Total terminal after-tax non-operating cash flows = After-tax operating cash flow + TNOCF where

TNOCF = SalT (1 − T ) +NWCInv + TBT

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• SalT = Cash proceeds (salvage value) from sale of fixed capital on termi- nation date.

• NWCInv = Investment in working capital.

• BT = Book value of fixed capital on termination date.

In this question:

• SalT = $15 million (At which time the assets would be sold for $15 mil- lion.)

• T = 35% (The company’s tax rate is 35%.)

• NWCInv = $20 million (The company’s working capital would increase by $20 million during the life of the new product.)

• BT = $0 million (No information).

TNOCF = SalT (1−T )+NWCInv+TBT = 15×(1−0.35)+20 = 9.75+20 = 29.75

The Total terminal after-tax non-operating cash flows = OCF4 + TNOCF = 15.33 + 29.75 = 45.08.

8. What is the NPV value of the project?

A. 30.51 million

B. 35.51 million

C. 37.51 million

D. 39.45 million

E. 41. 23 million

Answer: B. Management expects company sales to increase by $120 million the first year, $160 million the second year, $140 million the third year, and then trailing to $50 million by the fourth year because competitors have fully launched competitive products. S1 = 120, S2 = 160, S3 = 140, S4 = 50.

Operating expenses are expected to be 60% of sales, C1 = 120 × 60% = 72, C2 = 160 × 60% = 96, C3 = 140 × 60% = 84, C4 = 50 × 60% = 30.

and depreciation is based on an asset life of three years under MACRS (modified accelerated cost recovery system). The MACRS deprecation sched- ule is Year 1: 33.33%. Year 2: 44.45%. Year 3: 14.81%. Year 4: 7.41%. D1 = 90 × 33.33% = 30, D2 = 90 × 44.45% = 40.01, D3 = 90 × 14.81% = 13.33, D4 = 90 × 7.41% = 6.67.

Outlay = FCInv +NWCInv = −90 − 20 = −110.

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Total after-tax cash flow1 = OCF1 = (S1 − C1 −D1)(1 − T1) +D1 (1) = (120 − 72 − 30) × (1 − 35%) + 30 = 41.70

Total after-tax cash flow2 = OCF2 = (S2 − C2 −D2)(1 − T2) +D2 = (160 − 96 − 40.01) × (1 − 35%) + 40.01 = 55.60

Total after-tax cash flow3 = OCF3 = (S3 − C3 −D3)(1 − T3) +D3 = (140 − 84 − 13.33) × (1 − 35%) + 13.33 = 41.07

Total after-tax cash flow4 = OCF4 + TNOCF

= (S4 − C4 −D4)(1 − T4) +D4 + TNOCF = (50 − 30 − 6.67) × (1 − 35%) + 6.67 + 29.75 = 45.08

The required rate of return on the Vitamin-Burger project is 10%, r = 10% = 0.1.

NPV = Outlay + Total after-tax cash flow1

(1 + r) +

Total after-tax cash flow2 (1 + r)2

(2)

+ Total after-tax cash flow3

(1 + r)3 +

Total after-tax cash flow4 (1 + r)4

= −110 + 41.70 (1 + 0.1)

+ 55.60

(1 + 0.1)2 +

41.07

(1 + 0.1)3 +

45.08

(1 + 0.1)4 = 35.51

9. Suppose the Widget Company has a capital structure composed of the following, in billions: Debt $30, Common equity $60, Preferred stock $30. The debt rating is of AA. The yield on AA debt is 8%. The marginal tax rate is 30%. The preferred annual dividend is $10, current stock price is $100. If the risk-free rate is 3%, the expected market risk premium is 5%, and the company’s stock beta is 1.5. What is Widget’s weighted average cost of capital?

A. 0.0725

B. 0.0830

C. 0.0915

D. 0.1018

E. 0.1013

Answer: C. Weighted Average Cost of Capital (WACC)

WACC = wdrd(1 − t) + wprp + were

• wd is the proportion of debt.

• rd is the before-tax marginal cost of debt.

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• t is the company’s marginal tax rate.

• wp is the proportion of preferred stock.

• rp is the marginal cost of preferred stock.

• we is the proportion of equity.

• re is the marginal cost of equity.

Total Value of the Firm = Debt + Preferred Stock + Common Equity = 30 + 30 + 60 = 120.

• wd = DebtTotalV alueoftheFirm = 30 120 = 0.25 is the proportion of debt.

• rd is the before-tax marginal cost of debt 8%. (The debt rating is of AA. The yield on AA debt is 8%)

• t = 30% is the company’s marginal tax rate.

• wp = PreferredDividendTotalV alueoftheFirm = 30 120 = 0.25 is the proportion of preferred stock.

• rp = PreferredDividendStockPrice = 10 100 = 0.1 is the marginal cost of preferred stock.

• we = CommonEquityTotalV alueoftheFirm = 60 120 = 0.5 is the proportion of equity.

• re is the marginal cost of equity. Using CAPM

re = rf + β × (rM − rf ) = rf + β ×MRP

The market risk premium MRP = rM − rf = 5%, the company’s stock beta β is 1.5, the risk-free rate rf is 3%, thus re = rf + β × MRP = 0.03 + 1.5 × 0.05 = 0.03 + 0.075 = 0.105

WACC = wdrd(1 − t) + wprp + were (3) = 0.25 × 0.08 × (1 − 0.3) + 0.25 × 0.1 + 0.5 × 0.105 = 0.014 + 0.025 + 0.0525 = 0.0915

10. Suppose the Widget Company has a capital structure composed of the following, in billions: Debt $40, Common equity $60, Preferred stock $20. The debt rating is of AA. The yield on AA debt is 10%. The marginal tax rate is 30%. The preferred annual dividend is $10, current stock price is $120. If the risk-free rate is 3%, the expected market risk premium is 5%, and the company’s stock beta is 1.25. What is Widget’s weighted average cost of capital?

A. 0.0725

B. 0.0830

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C. 0.0915

D. 0.1018

E. 0.1013

Answer: B. Weighted Average Cost of Capital (WACC)

WACC = wdrd(1 − t) + wprp + were

• wd is the proportion of debt.

• rd is the before-tax marginal cost of debt.

• t is the company’s marginal tax rate.

• wp is the proportion of preferred stock.

• rp is the marginal cost of preferred stock.

• we is the proportion of equity.

• re is the marginal cost of equity.

Total Value of the Firm = Debt + Preferred Stock + Common Equity = 40 + 20 + 60 = 120.

• wd = DebtTotalV alueoftheFirm = 40 120 = 0.333 is the proportion of debt.

• rd is the before-tax marginal cost of debt 10%. (The debt rating is of AA. The yield on AA debt is 10%)

• t = 30% is the company’s marginal tax rate.

• wp = PreferredDividendTotalV alueoftheFirm = 20 120 = 0.167 is the proportion of preferred

stock.

• rp = PreferredDividendStockPrice = 10 120 = 0.0833 is the marginal cost of preferred

stock.

• we = CommonEquityTotalV alueoftheFirm = 60 120 = 0.5 is the proportion of equity.

• re is the marginal cost of equity. Using CAPM

re = rf + β × (rM − rf ) = rf + β ×MRP

The market risk premium MRP = rM − rf = 5%, the company’s stock beta β is 1.25, the risk-free rate rf is 3%, thus re = rf + β ×MRP = 0.03 + 1.25 × 0.05 = 0.03 + 0.0625 = 0.0925

WACC = wdrd(1 − t) + wprp + were (4) = 0.333 × 0.10 × (1 − 0.3) + 0.167 × 0.0833 + 0.5 × 0.0925 = 0.0231 + 0.167 × 0.0833 + 0.5 × 0.0925 = 0.0830

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Question 11 to 12 use the following set-up:

Number of units produced and sold: 1,000 Sales price per unit: $300 Variable cost per unit: $150 Fixed operating cost: $50,000 Fixed financing expense: $10,000

11.What is the degree of operating leverage?

A. 1.1

B. 1.2

C. 1.4

D. 1.5

E. 1.3

Answer: D.

• The degree of operating leverage (DOL): DOL = Q(P−V )Q(P−V )−F

• The degree of financial leverage (DFL): DFL = Q(P−V )−FQ(P−V )−F−C

• The degree of total leverage (DTL): DTL = DOL×DFL.

• Q: Number of units sold.

• P : Price per unit.

• V : Variable operating cost per unit.

• F : Fixed operating cost.

• C: Fixed financing expense.

In this question:

• Q = 1, 000: Number of units sold.

• P = $300: Price per unit.

• V = $150: Variable operating cost per unit.

• F = $50, 000: Fixed operating cost.

• C = $10, 000: Fixed financing expense.

• DOL = Q(P−V )Q(P−V )−F = 1,000×(300−150)

1,000×(300−150)−50,000 = 150,000 100,000 = 1.5

• DFL = Q(P−V )−FQ(P−V )−F−C 1,000×(300−150)−50,000

1,000×(300−150)−50,000−10,000 = 100,000 90,000 = 1.11

• DTL = DOL×DFL = 1.5 × 1.11 = 1.665.

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12. What is the degree of total leverage?

A. 1.105

B. 1.125

C. 1.110

D. 1.135

E. 1.665

Answer: E. Please see the previous question’s answer.

13. Which one of the following statements matches M&M Proposition I without taxes?

A. The cost of equity capital has a positive linear relationship with a firm’s capital structure.

B. The dividends paid by a firm determine the firm’s value.

C. The cost of equity capital varies in response to changes in a firm’s capital structure.

D. The value of a firm is independent of the firm’s capital structure.

E. The value of a firm is dependent on the firm’s capital structure

Answer: D.

• ModiglianiMiller (MM) Proposition I (No tax): The market value of a company is independent of its capital structure.

• ModiglianiMiller (MM) Proposition II (No tax): The cost of equity is a linear function of the company’s capital structure (debt/equity ratio).

RA = WACC = E

V ×RE +

D

V ×RD

RE = RA + (RA −RD) × D

E

14. Which one of the following states that a firm’s cost of equity capital is a positive linear function of the firm’ s capital structure?

A. Financial risk of capital structure

B. M&M Proposition I without taxes

C. M&M Proposition II

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D. Operating risk of capital structure

E. M&M Proposition I with taxes

Answer: C.

• ModiglianiMiller (MM) Proposition I (No tax): The market value of a company is independent of its capital structure.

• ModiglianiMiller (MM) Proposition II (No tax): The cost of equity is a linear function of the company’s capital structure (debt/equity ratio).

RA = WACC = E

V ×RE +

D

V ×RD

RE = RA + (RA −RD) × D

E

15. Paying interest reduces the taxes owed by a firm. Which one of the following terms applies to this relationship?

A. Theory of interest rates

B. M&M Proposition I

C. Financial risk

D. Interest tax shield

E. Financial leverage

Answer: D.

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• The tax shield lowers the cost of debt.

• The tax shield lowers the WACC as more debt is used.

• The tax shield increases the value of the firm by tD.

16. Which one of the following is the date on which the board of directors agrees to pay a dividend and passes a resolution to do so?

A. Date of record

B. Ex-dividend date

C. Payment date

D. Declaration date

E. Public announcement date

Answer: D.

17. On which one of the following dates is the determination made as to which shareholders will receive a dividend payment?

A. Date of record

B. Ex-dividend date

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C. Payment date

D. Declaration date

E. Public announcement date

Answer: A. The ex-dividend date is set exactly two business days before the dividend record date. On and after the ex-dividend date, a buyer of the stock will not receive the dividend as the seller is entitled to it.

18. The clientele effect states that investors fall into various groups because of differences in their preferences for which one of the following?

A. Share price levels

B. Risk level

C. Short-term versus long-term investments

D. Rates of return

E. Dividends

Answer: E.

• The clientele effect is the influence of groups of investors attracted to companies with specific dividend policies. Clientele are simply a group of investors who have the same preference.

• Types of clientele: –If an investor has a marginal tax on capital gains lower than the marginal tax on dividends, the investor prefers a return in the form of capital gains.

–Investors who are tax exempt (e.g., pension funds) are indifferent about dividends and capital gains.

–Some investors, by policy or restrictions, only invest in stocks that pay dividends.

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• The importance of the existence of clientele is that investors will have a preference for stocks with a specific dividend policy.

The clientele effect does not necessarily imply that dividends affect value.

19. This morning, Structural Steel purchased 3,500 of its outstanding shares in the open market. What type of transaction was this?

A. Stock payout

B. Stock distribution

C. Stock dividend

D. Stock repurchase

E. Stock reversal

Answer: D. A share repurchase is the transaction in which the stock issuer buys back its shares from investors. –Also known as a share buyback.

20. Which one of the following increases the number of shares outstanding but does not affect the dividend yield or dividend payout ratio?

A. Reverse stock split

B. Cash distribution

C. Stock split

D. Liquidation dividend

E. Special dividend

Answer: C. A stock split is a proportionate increase in the number of shares outstanding.

• Stated in the following form: Number of new shares:Number of old shares

• So, 2:1 means that for each share held before the split, the shareholder holds two shares after the split.

• Stock splits do not affect the dividend yield or the dividend payout ratio.

• The announcement is generally viewed as a positive signal.

21. UXZ has sales of $683,200, cost of goods sold of $512,900, and inventory of $74,315. What is the inventory turnover rate?

A. 7.33 times

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B. 6.90 times

C. 5.70 times

D. 7.14 times

E. 8.47 times

Answer: B.

Inventory turnover = Cost of goods sold

Inventory =

$512, 900

$74, 315 = 6.90.

22. Galaxy Sales has sales of $938,300, cost of goods sold of $764,500, and inventory of $123,600. How long on average does it take the firm to sell its inventory?

A. 6.40 days

B. 7.23 days

C. 48.68 days

D. 59.01 days

E. 61.10 days

Answer: D.

Inventory turnover = Cost of goods sold

Inventory =

$764, 500

$123, 600 = 6.185.

Number of days of inventory = 365

Inventory turnover =

365

6.185 = 59.01

23. Leisure Products has sales of $738,800, cost of goods sold of $598,200, and accounts receivable of $86,700. How long on average does it take the firm’s customers to pay for their purchases? Assume a 365-day year.

A. 8.65 days

B. 11.28 days

C. 25.01 days

D. 42.83 days

E. 45.33 days

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Answer: D.

Receivables turnover = Total revenue

Accounts receivable =

$738, 800

$86, 700 = 8.521

Number of days of receivables = 365

Receivables turnover =

365

8.521 = 42.83

24. Fast Kars has a return on equity of 22.3 percent, a profit margin of 14.2 percent, and total equity of $467,000. What is the net income?

A. $69,608

B. $113,875

C. $104,141

D. $66,314

E. $109,897

Answer: C.

Return on equity = Net income

Total equity

Net income = Return on equity × Total equity =22.3%× 467, 000 = 104, 141.

25. Health Centers, Inc., has total equity of $948,300, sales of $1.523 million, and a profit margin of 4.4 percent. What is the return on equity?

A. 4.21 percent

B. 6.49 percent

C. 7.18 percent

D. 8.68 percent

E. 7.07 percent

Answer: E.

Return on equity = Net income

Total equity

Profit margin = Net profit margin = Net income

Total revenue

Net income = Profit margin × Total revenue

Return on equity = Profit margin × Total revenue

Total equity

Return on equity = 0.044 × 1, 523, 000

948, 300 = 7.07%.

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Question 26 to 30 use the following set-up:

Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. The value of Little Company stock before the bid was made public was $15 per share. Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Big Company estimates that it is likely to reduce costs through economics of scale with this merge of $2 million per year, forever. The appro- priate discount rate for these gains is 10%.

• Suppose that the Big Company has made an offer for the Little Company that consists of the purchase of 1 million shares at $18 per share. Price paid for the Target = $18 million.

• The value of Little Company stock before the bid was made public was $15 per share. Pre-merger value of the Target = $15 million.

• Big Company stock is trading at $40 per share, and there are 10 million shares outstanding. Pre-merger value of the Acquirer = $40 × 10 = $400 million.

• Big Company estimates that it is likely to reduce costs through economics of scale with this merger of $2 million per year, forever. The appropriate discount rate for these gains is 10%. Synergistic gains S = $2 million/10% = $20 million.

• Synergistic gains S = $2 million/10% = $20 million.

• Target’s gain = Premium = Price paid for the Target − Pre-merger value of the Target = $18 million − $15 million = $3 million. (3/20 = 15% of the synergistic gains.)

• Acquirer’s gain = Synergistic gains − Premium = $20 million − 3 million = $17 million. (17/20 = 85% of the synergistic gains.)

• Post-merger value of the Acquirer = Pre-merger value of the Acquirer + Acquirer’s gain = $400 million + $17 million = $417 million.

26. What are the synergistic gains from this merger?

A. 20 million

B. 18 million

C. 16 million

D. 14 million

E. 12 million

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Answer: A.

27. What is the target shareholder’s gain?

A. 4 million

B. 3 million

C. 2 million

D. 1 million

E. 5 million

Answer: B.

28. What is Acquirer’s gain?

A. 15 million

B. 16 million

C. 17 million

D. 19 million

E. 20 million

Answer: C.

29. What do Big shareholders get?

A. 25% of the gain

B. 75% of the gain

C. 15% of the gain

D. 85% of the gain

E. 90% of the gain

Answer: D.

30. What is the value of Big Company post-merge?

A. 300 million

B. 350 million

C. 390 million

D. 410 million

E. 417 million

Answer: E.

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